Commodity correlation returning to pre-2008 levels, say analysts
The tight link between commodities and equities is easing as firms become less worried about macro shocks, say analysts.
During the past five years, commodity prices often moved in lockstep with those of other asset classes, especially equities, as investor sentiment shot up and down in response to broader financial woes. Fears related to the eurozone sovereign debt crisis, the US debt ceiling and a possible slowdown in Chinese growth fuelled the so-called risk-on/risk-off trade, in which investors piled in and out of risky assets depending on the latest headline. In the past few months, however, correlations between commodities and equities have fallen – by some measures, retreating to levels that existed prior to the global financial crisis.
“We’re in a period now where exogenous shocks are having less impact,” says Kevin Norrish, London-based managing director of commodities research at Barclays. “There are fewer of them, and they’re having less impact.”
As of February 1, the rolling six-month correlation between the S&P 500 index and the Dow Jones-UBS Commodity Index, which measures a diversified basket of commodities, was 0.47. That is down from 0.88 a year earlier, according to Norrish.
Correlations between individual commodities have also dropped, suggesting that commodity markets are being driven more by fundamental physical factors specific to each market, as opposed to broader trends. Barclays measures cross-commodity correlation by taking the 90-day correlation of daily price moves in different commodity sectors – including precious metals, industrial metals, energy and livestock – and taking the average of the resulting pairs. In January 2011, cross-commodity correlation was 0.45, according to Barclays. In 2012, this figure diminished to 0.33 and now sits at just 0.19, according to the bank. For the past three months, cross-commodity correlation has been lower than at any point since 2007, says Norrish.
Energy has also shown signs of decoupling from equities. In 2006, the average correlation between the S&P 500 and the price of Brent North Sea crude oil was 0.54, according to data from Société Générale Corporate and Investment Banking (SG CIB). In 2007, this rose to 0.68, before surging to reach 0.82 during 2008. The average correlation between the S&P 500 and Brent crude stayed above 0.8 between 2008 and 2011, before sinking to 0.7 in 2012. This figure was pulled down by a precipitous drop over the past three months – on January 11, the 10-week moving average correlation even hit negative territory, dipping to –0.01.
“There’s less to talk about in terms of tail risk than there was before,” explains Michael Haigh, New York-based global head of commodities research at SG CIB. “For that reason, sentiment appears to have improved. Consequently, commodities should start to behave a little more independently than the broader markets.”
As tail risks have receded over the past six months, fundamental factors have made a comeback in driving the price of crude oil, says Haigh. In July 2012, macroeconomic factors explained about 60% of price moves in Brent, according to a model developed by SG CIB’s quants that seeks to determine which factors are having the greatest impact on commodity prices. In contrast, macro factors were capable of explaining a mere 20% of Brent price movements in late January, while fundamentals accounted for 66%, according to the bank. The difference between these two figures is made up of “dollar factors”, which are related to the value of the US dollar. “The macro has started to take a back seat,” notes Haigh.
Nonetheless, some analysts are sceptical and point out that energy prices still tend to move up and down with equities. “Crude oil prices are still being driven by the stock market,” says Walter Zimmermann, senior technical analyst with United Icap, the New Jersey-based energy brokerage. “Maybe the correlation has slipped, but where’s the evidence that they’re going their separate ways?”
Other market observers say the drop-off in correlations could herald a return to an environment in which commodities behave independently of other asset classes. The high correlations of 2008–2011 were “unprecedented”, notes Amrita Sen, chief oil analyst at Energy Aspects, a London-based research consultancy.
“I don’t think we are back to normality yet, but at least we’re getting to a phase where correlations are starting to stabilise a bit,” she says. “We are slowly returning to a more normal world.”
This article was first published on Risk