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Correlations between commodities and other asset classes have risen sharply over the past three years, butinvestors and academics are divided over the cause, and the outlook for diversification strategies goingforward. David Wigan reports

Not long ago, it was inconceivable to many that commodity returns would be correlated to stocks and bonds. Inrecent times it has become inconceivable that they are not. The new reality appears to be a so-called market of one,with commodities moving in the same direction as stocks and bonds. However, some suspect current high levels of

correlation are less a new paradigm and more an aberration.

In their seminal study, Yales Gorton & Rouwenhorst (2005) constructed an index of commodity futures monthlyreturns from 1959 to 2004, and showed a strong negative correlation to stocks and bonds. This was due, they said, todifferent behaviours over the business cycle.The view espoused by the academics reflected common wisdom at the time. Rather than representing the presentvalue of future cashflows or some expected payoff, as is the case with stocks and bonds, commodity prices wereseen as a function of supply and demand, with demand inelastic to price and supply determined by inventory andproduction.

Economic theory dictates that short-term price fluctuations of depletable resources are mainly the result of demandand supply shocks, which in the long term tend to disappear, suggesting prices should revert towards equilibrium, orthe marginal cost of extraction.

The traditional theory played out for many years, but around 2005, the world changed. First, the price of commodities,which in sectors such as food had been falling for decades, started to rise fast. The price of wheat, which had been$105 a ton in January 2000, had jumped by January 2006 to $167 a ton, according the International Monetary Fund.

By March 2008, it has spiralled to $481, sparking food riots on the streets of 30 countries.Alongside the increase in prices came a rise in correlations, or co-movements of prices across commodity sectors,with several studies showing average correlations increasing on numerous commodity pairs. From 2006, soybeanand oil, and cotton and oil correlations rose from their long-term average of between 0.2 and 0.2 to between 0.4 and0.6, where1 is uncorrelated and 1 is correlated, according to Xiong & Tang (2009, updated in 2011).

The correlation between energy commodities and non-energy commodities rose from a long-term average of around0.1 in 2004 to as high as 0.7 in 2009, according to Xiong and Tang. They found that a key driver for how correlatedone commodity was to another was whether or not it was included in one of the main commodity indexes, such as theStandard & Poors Goldman Sachs Commodity Index (S&P GSCI) orthe Dow Jones UBS commodity index (DJ-UBS). They showed that the average correlation of indexed commodities was much higher, and it did not take a huge

leap of imagination to draw a connection between the rise in index correlations and the wall of money flowing intoindex products, which jumped 1,233% from an estimated $15 billion in 2003 to at least $200 billion in mid-2008.Towards the end of the last decade, financial players had become dominant traders of commodity futures andoptions, outnumbering traditional market users by three to one, according to the US Commodity Futures TradingCommission. Commodity investing through indexes rose to $376 billion by the end of 2010, according to BarclaysCapital triple the amount in 2005.

What happened was that risk-seeking behaviour in equities and long-only commodities was responding to the samefactorsgrowth in China and elsewhere, and later low interest rates, says Howard Simons, a strategist at Illinois-based Bianco Research. Equity and commodity investment was also populated with the same people, who whenthey needed money sold in equal proportions in the two asset classes.As commodities moved into the investment mainstream, their returns increasingly matched those of equities,particularly after 2008. Bykahin & Robe (2011) showed the correlation between S&Ps GSCI-Energy indexes andthe S&P 500 equity index hovered between0.37 and 0.38 before the demise of Lehman, and then rose quickly,staying almost always above 0.34 and rising to as high as 0.62 in the second half of 2010.

The reason behind the increased levels of correlation was put succinctly in a Bank of Japan report1last year: Once

financial investors face a mounting risk of incurring losses on their balance sheets, market-wide selling pressure islikely to affect prices of risky assets. Also, if the risk-appetite of financial investors increases, it is likely to stimulatemarket-wide demand for risky assets. These amplifying effects have been manifested in the increasing positivecorrelation between the return on commodities and that on other financial assets such as equities.

An interesting factor appears to be the role of hedge funds, Bykahin and Robe said, with dynamic conditionalcorrelations between the rates of return on investable energy and stock market indexes increasing significantly amidgreater activity by speculators in general and hedge funds in particular.

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Specifically, a 1% increase in the overall energy-futures market share of hedge fund participants is associated with anincrease in dynamic conditional energy-equity return correlations of about 5%.Financialisation and fast money has brought commodities into a world of price movements trading on news flow asmuch as fundamentals, says Andrey Kryuchenkov, a London based commodities strategist at VTB Capital. The

increased use of vehicles such as exchange-traded-funds adds to the strength of that correlation.The corollary of the financialisation dynamic is that commodity prices have become less correlated to supply and

demand conditions, and that is borne out by a reduced correlation of the oil price with oil inventory levels. Before2005, there was a close relationship between inventory levels and the oil price: the higher the industrial inventories inrelation to consumption, the lower the price. After 2005, the relationship breaks down, according to analysis byCommerzbank

2, with prices seemingly random against inventories.

Despite seemingly incontrovertible evidence for rising correlations associated with the fashion for investment incommodities, the subject until relatively recently has remained a matter of intense debate, particularly in therelationship between commodities and equities, where correlations only spiked sharply higher following the financialcrisis.

Bykahin, Haigh and Robe (2010) argued that despite an apparent increase in correlation between commoditiesand equities, the asset class retained its benefits as a diversification tool. In fact equity/commodity correlation wasclose to zero in the period between 2003 and early 2008, the authors claim, just as it had been in a period ofeconomic expansion between 1992 and 1997, and in a period of contraction between 1997 and 2003.

Many of the studies that showed rises in correlation included the extraordinary period in late 2008, the authors said,in which correlation across all asset classes rose to record levels. Importantly, we find no evidence of a secularincrease in correlations in the last few years. In particular, even though the correlations between equity andcommodity returns increased sharply in Fall 2008, amid extraordinary economic and financial turbulence, theyremained lower than their peaks in the previous decade, the authors said in the report.

Our finding that the co-movements between equities and commodities have in general not increased in the last fiveyears suggests that commodities retain their role as a diversification tool. This conclusion is tempered, however, byour finding that those benefits may not be as strong when diversification would help the most.

Certainly, a cursory reading of asset class returns over 2011 suggests the case for correlation is not entirely clear-cut.While bonds and emerging markets returned 5.9% and 6.5% respectively, commodities lost 0.7% and equities fell6.9%, according to Deutsche Bank data. Intra-commodity returns on Deutsche Bank indexes were no more coherent,with base metals losing 22.1%, agriculture falling 9.9% and energy gaining 3.4%.

Another driver of divergence between commodity equities and the underlying commodities is the current bottlenecksin labour and technology, which exert downward pressure on equities prices while tending to push commodity priceshigher, according to Roxana Mohammadian-Molina, a New York-based commodities research analyst at BarclaysCapital.

Long-term trends in commodity prices are driven by fundamentals, which is a very different story from equities. If youlook at the mining and energy sectors you see labour and technology costs fuelling a disconnect between the equitiesand underlying prices.

Still, despite uncertainty over the correlation effect, and an apparent drop in correlations over the past year, DeutscheBank is among many in the commodities markets expecting returns over 2012 to be predicated not onsupply/demand fundamentals but on global macro conditions, and particularly the economies of China and the US.That suggests at least a casual connection with equities should remain.

Meanwhile, supply and demand dynamics remain a key driver. The worlds population is growing, boosting demandfor food and materials, and in Asia it is estimated that 75% of land that could be used for crops is already undercultivation. In India that rises to 95%. China has lost 9% of its arable land in the past 10 years.

Michael Haigh, head of commodities research at Socit Gnrale, says a game-changer in the recent period hasbeen the extraordinary amount of liquidity provided by central bank responses to the financial crisis. We have thisfoundation between commodities and broader markets because of the supply side tightness when supplies are tightwe see broader co-movements, but when you add in macro stimulus it is exacerbated. We feel that more quantitativeeasing from the US is around the corner, and some of that money is going to find a home into mainstream assetclasses, including commodities.

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However, it is unlikely asset classes will be as closely correlated forever, says Haigh, and within commodity sectorsthere remains sufficient diversity of price drivers to at least partially offset the impact of financialisation. An exampleis the recent experience in energy markets, where evolving supply dynamics in the US have helped prompt adecoupling of gas and oil price movements, with oil prices remaining relatively high, while gas prices have halvedsince 2008.

The divergence of oil and gas prices is a new dynamic, with the two commodities historically highly correlated

because of similar market dynamics and legal architectures the continuing indexation of European gas contracts tooil prices being one example.

The catalyst for change in the US has been the expansion of shale gas production, realised because ofimprovements in technology and recent high prices. The additional supply is expected to sustain downward pressureon gas prices though 2012, with Deutsche Bank among those predicting falls of more than 10 %. Oil prices,meanwhile, remain benchmarked to global prospects, with Deutsche Bank signalling 3% global GDP growth as thepivot for rising or falling prices from a predicted WTI average price of $105 per barrel. Analysts at Socit Gnraleobserve a deteriorating political situation in Iran has the potential to push oil prices considerably higher.

The diverging fortunes of the oil and gas markets show how difficult it is to generalise over rising correlation incommodities. In simple terms, there is a consensus that commodities such as agricultural, soft commodities, livestockand precious metals offer good diversification from equity and bond markets, while energy and industrial metals aremore pro-cyclical. However, the deeper question is whether financialisation and globalisation have prompted asecular shift to permanent higher levels of correlation.

In the long run, you would expect everything has to return to a level justified by supply and demand, but the issue isone of frequency, and whether this is going to happen sometime soon or not for many years, says Wei Xiong, aprofessor of economics at Princeton University. The amount of money in commodities means prices are moreclosely aligned with other asset classes, and there may have been a temporary additional jump in correlation after thefinancial crisis. But will it eventually go back to zero? I doubt it.

1Bank of Japan Review: Recent Surge in Global Commodity Prices Impact of financialization of commodities and

globally accommodative monetary conditions. International Department: Yasunari Inamura, Tomonori Kimata,Takeshi Kimura, Takashi Muto, March 20112

Commerzbank report: Some consequences of the trend towards cross asset allocation, published in July 2011