Goldman Is Rapidly Losing Patience With You On This Whole Commodities Thing

Look goddammit, you keep asking and Goldman keeps answering and yet you’re clearly not listening because some of you are still bearish on commodities.

Now I know what someone out there is thinking: “surely we’ll be forgiven for having reservations about the outlook given last week’s metals mayhem and the flash crash in crude.”

But you’d be wrong. You are most certainly not forgiven. And for the thousandth time, you will have to pry Goldman’s Overweight commodities reco from their cold, dead hands.

See, you keep trying to distract people by talking about “oversupply,” and “PMIs telegraphing lackluster demand,” and Citi keeps saying shit about “forced physical traders, especially the ones who stocked up with high leverage, liquidating inventories,” and then you’ve got all this talk about “China squeezing everyone with tighter policy,” …. don’t worry about that! Goldman’s “got that shit under control”…

Right.

And besides that, commodities generally go up in a rising rates environment.

I mean sure, “all else equal, higher rates tighten financial conditions and slow down the economy,” but, as Goldman not-so-patiently explains below, “all else is not equal.”

Via Goldman

We look at daily total return indices for five assets: commodities (S&P GSCI), equities (S&P 500), investment-grade US corporate bonds (Bank of America Merrill Lynch Corporate Bond Total Return Index), 3-month US Treasury bills, and 10-year US Treasury bonds. We divide the 1988-2017 sample period into four Fed hiking phases: raising rates (Hike), holding rates unchanged at high levels (Hold High), cutting rates (Cut), and holding rates unchanged at low levels (Hold Low). Exhibit 1 shows that the US has had four full hiking cycles over the past 30 years.

We highlight three sets of findings from our analysis. First, commodities perform the best when the Fed is raising rates. Exhibit 2 shows that the annualized average daily returns is 19% for S&P GSCI in the “Hike” phase, higher than equities, corporate bonds and Treasuries. This makes intuitive sense because the reason why the Fed raises interest rates is that the economy displays signs of overheating. Strong aggregate demand and rising wage and price inflation are precisely the time when commodities perform the best. To be sure, commodities performance can be volatile. Exhibit 3 shows that the annualized volatility of commodities daily total returns is 20% in the “Hike” phase. But even on a risk-adjusted or Sharpe Ratio basis, commodities still outperform equities and bonds when the Fed is raising rates.

Given the outsized role played by China in commodities demand, we also look at the Chinese rates cycle. The Chinese central bank employs a variety of tools to conduct monetary policy. We use the prime lending rate to proxy for the policy stance of the People’s Bank of China (PBOC). Exhibit 4 shows that commodities tend to rally in periods when rates are rising in China and to fall when the PBOC cut rates. Annualized average daily total returns are 14% in the Chinese “Hike” phase and -60% in the Chinese “Cut” phase (Exhibit 5).

Second, within the commodities complex, industrial metals outperform others in the “Hike” phase. Exhibit 6 shows that the annualized daily total returns average 50% for industrial metals when the Fed is raising rates, compared to 28% for energy, 10% for precious metals, and less than 5% for livestock and agriculture commodities. This is consistent with the observation that industrial metals tend to be most levered to economic cycles.

Third, correlations between commodities and other assets are low in the “Hike” phase, providing diversification value in a well-balanced portfolio. Exhibit 7 shows that the correlation between daily total returns of S&P GSCI and that of S&P 500 is only 0.05 when the Fed is raising rates, and are even negative between commodities and bonds. In addition, correlations between different types of commodities are also relatively low in the “Hike” phase (Exhibit 8), suggesting that S&P GSCI itself is a diversified choice of commodities investment.