Commodity exposure - Off the lows and worth considering

From the high in June 2008, the Bloomberg Commodity index (formerly the DJ-UBS index) is still down from its high by 61.6%. The index is off the all-time lows since the crisis which was reached last February 2016 by about 16.5%, but the index is nowhere near old highs.  

Yet, there are some relative changes going on with cross-asset performance which should cause a closer look. Although commodities have even been the worst performing sector over the last two years, it has seen double-digit gains since the beginning of 2016. Commodities have outperformed bonds over this period and have moved up with equities. Of course, this is the same time when inflation expectations have increased significantly with 5-yr/5-yr forwards showing a gain of close to 50% since their lows last year. 

Asset allocation has to consider not the past but what the futures may hold. Past performance would have led to severe under-weighting of commodities over the last two years, but a more dynamic allocation process which includes momentum would start to increase weightings based on better performance, greater diversification, and factor diversification relative to inflation.

What are big endowments doing with their allocations?

This above chart from thetrustedinsight.com provides an interesting tale about asset allocation for large endowments. Forgot about the traditional 60/40 stock/bond mix. Forget about the 50/30/20 stock/bond/alternatives mix. If you don't need liquidity, as is the case for the endowment portfolio allocations, a mix between liquid and illiquid is a better base framework. Hold private equity and real estate as core allocations. This core is for long-term appreciation and cash flow greater than bonds, but is generally illiquid. Take money from fixed income and cash. Take funds from public equities and use hedge funds, which may have mixed liquidity, as an additional return enhancer. The public equity and bond/cash portion of portfolios is between 25 and 50%, while hedge funds are from 7.5 to 32.5% for these key endowments. The majority of their allocations are not with traditional equity and bond beta.

Making a generalization, the new endowment allocation is 35/45/20 or 35% liquid beta, 45% illiquid investments, and 20% alpha. Of course, you can come up with other descriptors given the chart numbers but we are looking for some simple commonality on the asset allocation.

First, if you don't need the liquidity find investments that you will get paid a premium for taking on illiquidity. Second, look for alpha or return enhancements where you can find them. Hedge funds can be alpha enhancers and substitutes for fixed income or beta. Third, cut your public beta exposure or at least change it to more illiquid investments that can give more beta per dollar invested. Most private equity will be at higher market beta or credit beta.

This endowment liquidity sensitive approach is not for everyone. You have to be able to sit on investments for long periods without a need for cash and you have to have skill to find the alpha enhancers or private investment managers. Yet, it is worth thinking about how these portfolios can be replicated in a different more accessible form. 

A falling correlation with equities makes for greater commodity value

Commodities were supposed to be the great portfolio diversifier, a real asset that protects against inflation, offered positive roll yield, and gains from a super cycle. The reality over the last eight years has been much different. The roll yield disappeared as markets turned in many cases from backwardation to contango. Investors were penalized with negative roll. The super cycle ended with the Great Financial Crisis with a market decline over 75%. The markets have been digesting an excess supply/demand imbalance for years. The final kicker for investors was the financialization of commodities. Correlations with equities rose so investors did not get the diversification free lunch that was expected from looking at historical data.  Now times are different, so throw out the old thinking.

1. The negative roll has subsided. The great backwardation period of the '90's is not here, but the huge penalties when there were large oversupplies are also gone. The cost of holding commodities through an index has declined.

2. The large cyclical decline in commodities is over for many markets, not all, but many with the bottom of the super cycle seeming to have occurred last February. The market is a long way from retaking loses, but there seems to be more market balance.

3. The correlation between equities and commodities has declined. Many of the large money managers who traded commodities as a simple adjunct to equity and bond portfolios have left and many pensions have under-allocated to commodities. The correlation between the Bloomberg commodity index and market index has fallen and the long-term rolling correlation while still positive has fallen to the lowest levels since the Financial Crisis.

Note, an asset can have a positive contribution to a portfolio's Sharpe ratio even when the marginal return contribution of an asset is lower than the overall portfolio when the asset's correlation is lower or negative to the target portfolio. Given the strong diversification value and the opportunity for upside if there is a rise in growth or inflation, increasing commodity allocations may be appropriate. The correlation between inflation and commodities is actually not strong, but the combination of higher inflation with expected stronger economic growth is a recipe for better commodity prices and for stronger relative performance especially against bonds. 

Global macro on one page - More of the same

Just because there is the passage of time does not mean that market themes will change. The big issues could be unresolved with no information that will change expectations. We are at one of those times. 

Put politely, there is a lot going on with the new Trump Administration, but that does not mean market uncertainty has been resolved or macro policy has been outlined. We would argue that little has been resolved with macroeconomics and policy may have actually gotten more uncertainty. 

The TPP trade deal has been pulled but what is next is less clear. For tax policy, we have little new information on next steps. The same can be said for fiscal policy. New regulation may on hold, but a regulatory uncertain environment is not a pro-business environment. The Fed should be on track to raise rates, but with fiscal policy and the dollar direction highly uncertain caution may still be the watch word for policy. 

The major themes for February have not changed since last month. Nothing has been changed to place something else in our big three list. Many of the factors themes have not changed. There is little new economic information to cause a change. We still believe we will move between two extremes, our bimodal world, but the big moves are not going to be revealed in the short-run.