Commodities Remain a Source of Frustration

Earnings start leads to choppy trading

The acceleration of earnings season led to mixed trading throughout the week, leaving the S&P 500 down 0.2% and the DJIA up 0.1%.

Although earnings reports were slightly mixed, news on the economy was positive, particularly in the case of December retail sales.

For December, retail sales increased 0.2%, to finish 2013 up 4.3%. The headline reading was ok, but when you exclude the impact of autos and gas, sales were actually up 0.7%. This suggests that consumers were willing to spend during the holiday season, with gains seen across food & beverage, clothing, personal care, and non-store retailers.

During the same time, consumer sentiment staged a steady comeback, reaching 82.5 in December, near the highest readings of the recovery period. Sentiment gave up some of those gains in early January, though, falling to 80.4. Survey readings suggested consumers felt less optimistic about current and future economic conditions.

Source: Econoday

Despite the slight fall in sentiment, consumers are receiving better news related to labor markets. The Job Openings and Labor Turnover Survey (JOLTs) showed 2.7 unemployed individuals per job opening in November. That is well below the 6.2 reading at the end of the recession, and shows the rate of ongoing improvement in labor markets for the past several years. Further, there were 4 million job openings in November, which was a new post-recession high.

Source: Bureau of Labor Statistics

The manufacturing sector finished the year on a high note, with industrial production rising 0.3% in December, following its 1.1% November gain. Unfortunately, the strong finish could not overcome the fact that production was only up 2.6% for all of 2013, the slowest annual reading since the end of the crisis. Momentum is on the upswing for manufacturers, though.

Commodities Remain a Source of Frustration

The environment following the global financial crisis has been a challenging one for asset allocators, as long held relationships shifted and traditional idioms were turned on their head. As we detailed last week in “The Diversification Obituary,” investors have seen little work in their portfolios other than US stocks, while supposed diversifiers have offered little more than muted beta and unusually high correlations.

One of those perceived culprits has been commodities, long held out as one of the true portfolio diversifiers. The space has been one of the most frustrating for investors over the past few years. Despite the market generating gains in 2011, 2012, and 2013, commodities (as measured by the Dow Jones-UBS Commodity Index) have moved lower in each calendar year. This included a 13% loss in 2011 and a 9.5% decline last year.

But, unlike a bevy of other sectors, commodities have continued to provide returns uncorrelated to the broader equity markets. An examination of rolling 90-day equity market correlations of hedge funds, MLPs, and REITs – three other assets typically offered up as portfolio diversifiers – alongside commodities reveal the latter’s strength in this regard, particularly in the last two years. Over the 2011-2013 period, commodity’s 0.43 correlation to equities is a third lower than MLPs and half of publicly traded REITs.

From a return perspective, recent prognostications from Barclays Capital suggest that commodity price weakness could persist in the near-term. They point to a stronger US dollar, likely withdrawal of Fed accommodation, and economic weakness in major sources of commodity demand such as China, Brazil, and India. While gold and silver are likely to be negatively impacted by tapering, energy markets may also remain sluggish as supply from the US increases and Middle East tensions remain benign.

Despite this, Barclays goes on to note that commodity prices are currently 20% below levels observed last time business confidence was as high as it is now. This divergence is at odds with the typical structural relationship, and analysis of a number of individual markets suggests their fundamental backdrops could improve as the year progresses. At the very least, the report concludes, downside risk appears more limited at current price levels.

Hedge funds, meanwhile, appear to be repositioning their portfolios ahead of any potential turnaround. According to financial website, speculators have become net long agricultural futures for the first time in 12 weeks as indicated by CFTC data. Record short positions in wheat and corn have been eliminated or reversed as profits were locked in and new fundamental information entered the picture. The reduction in wheat positioning was particularly notable, after the commodity’s spot price fell to a three-year low.

For investors, prospects of limited downside from here should be encouraging. Although some near-term ugliness likely still exists, recent price levels may provide an attractive entry point for long-term investors. Commodities are one of the few assets that could potentially perform well in a scenario in which central bankers lose control and inflation suddenly becomes an issue.

The week ahead

The holiday-shortened week brings a light economic schedule. Of note this week is existing home sales for December, and the index of leading economic indicators.

There will be a handful of central bank meetings this week, with the most attention paid to those in Japan, Canada, Turkey, and Hungary. Additional meetings will occur in Thailand and Nigeria.

Earnings season will be in full effect over the course of this week, and investors will be especially interested in reports from J&J, Verizon, McDonald’s, Microsoft, Delta, Netflix, Starbuck’s, and eBay. A total of eight DJIA components report, along with 65 constituents from the S&P 500.

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