Analys
Defensive Assets: Gold, a precious ally in the fight against equity drawdown
In the previous instalments of this blog series, we highlighted the defensive behaviour of quality and high dividend equities, long duration government bonds and safe haven currencies as an asset, as well as an overlay to other asset classes. The last few weeks really put investors’ portfolio to the test and the least we can say is that those defensive assets did very well. While Global Equities (MSCI World net TR) lost 17.91% from the most recent tops on 12th February up to 9th March, Long Duration Treasuries (proxied by the Bloomberg Barclays US Treasury 10+) have return an incredible +21.99%. In the same period, Japanese Yen was up 7.54% versus the US Dollar and Quality stocks (proxied by the WisdomTree Global Quality Dividend Growth net TR) did cushion the fall, losing 15.73% and therefore outperforming the market by 2.27%1.
This week, our journey takes us to a fourth asset class, Commodities. Using our defensive framework, we will assess how single commodities or commodity sectors react to equity downturn. In particular, we will highlight how:
- precious metals such as Gold can bring potential diversification and defensiveness to a portfolio as well as act as inflation hedge on the upside. Gold was up 6.96% from 12th February to 9th March 2020;
- Broad commodities could act as a diversifier in a multi asset portfolio.
In the following, we analyse traditional Commodity benchmarks that use front month futures to invest in the different commodities in the universe (being commodities in general or sectors). The only exception are precious metals, were physical investments are considered (physical bullions in vaults for Gold for example). Enhanced commodities are meant to represent “smart beta” in commodities where the strategy can invest further along the curve (i.e. not always in the front month future) to improve the roll yield available to the investor while delivering similar spot and collateral returns. More information on this topic is available on our website. Those strategies have historically delivered strong outperformance over time while keeping the correlation with the benchmark very high.
Precious Metals stands out in Commodities
Our framework focuses on 4 characteristics, risk reduction, asymmetry of returns, diversification and valuation. Starting with drawdown protection in Figure 1, it is pretty clear that broad commodities and most commodities sectors are cyclical in nature. Enhanced Commodities fare better than traditional benchmark overall, but the standout defensive asset is precious metals and in particular Gold. In 5 out of the 6 drawdown periods, Gold performed positively, delivering 14.4% per year on average. To put this result in perspective, over those 6 periods, European equities have delivered -35.2%, Min Volatility equities -17.8%, Cash +2.8%, EUR Treasury AAA 8.4% and USD Treasury 11.3%2.
It is worth noting, however, that Energy can also deliver some downside protection when the equity downturn is the result of external shocks such as geopolitical uncertainties. In such, cases Energy and Oil, in particular, tend to react on the upside providing some protection aligned with Gold.
Looking further at the performance of Precious Metals in periods of drawdown we observe in figure 2 that over the 10 worst quarters for European equities in the last 20 years, Gold has 7 quarters of positive performance – a rate of 70%. On average gold outperformed equities by 19% in those quarters. Silver provides results that are more mixed despite outperforming equities by 14% on average. While over the full period commodities didn’t provide a positive return, in 8 of the 10 periods they outperformed equity markets by 8% on average proving that they are still a powerful diversifier. Enhanced Commodities fared even better outperforming equities by 9.6% on average per quarter.
Commodities a chief diversifier
In fact, the rolling 3Y correlation between commodities and equities remains consistently below 50% with long periods where it is nil or even negative. From a pure portfolio construction point of view, this is very exciting as it hands us a diversifying asset that can help reduce the overall volatility of the portfolio.
Gold, a precious tool to build defensive portfolios
From a more macroeconomic perspective and looking at Commodities performance across business cycles, it is again very clear that Precious Metals offer a protection in economic slowdown or recession. In Figure 3, we have split the last 20 years in 4 types of periods using the Organisation for Economic Co-operation and Development (“OECD”) Composite Leading indicator (“CLI”). The CLI has been designed to decrease a few months before economy start to slow down or increase before the economy restarts. So, a strong decline in CLI tends to indicate a probable downturn in equity markets for example.
Enhanced Commodities behaved very well compared to front month commodities, cutting significantly the downside in negative economic environments and doing better in positive ones. It is worth noting as well the extent to which commodities and enhanced commodities perform when the economic signals are strong. This is linked to the well documented properties of commodities as an inflation hedge. Precious Metals exhibit a very strong and versatile profile driven mainly by gold.
It is interesting to note that Gold has outperformed very strongly in very negative or negative economic scenarios but also has done very well in periods of strong economic rebound, buoyed by its inflation hedge proprieties. This makes Gold a pretty asymmetric asset with strong positive performance in difficult economic periods but also good performance in strong rebound and when yields are expected to increase. Silver, similarly to palladium and platinum, offers also an interesting payoff, behaving part like a precious metal and part like an industrial metal. In periods where the economy is strong, it benefits from being used in the industry and behave more pro cyclically than gold. However, in economic downturn, it benefits from its status as a precious metal and delivers some protection.
This brings us to our fourth pillar in our framework: valuation. WisdomTree issued its quarterly outlook for Gold in January 2020, offering a number of scenarios fo the metal this year. In “Gold: how we value the precious metal”, we explain how we characterise gold’s past behaviour. Unlike other commodities where the balance of physical supply and demand influence the price, gold behaves more like a pseudo currency, driven by more macroeconomic variables like the interest rate environment, inflation, exchange rates and sentiment. Characterising gold’s past behaviour allows us to project where gold could go in the future (assuming it maintains consistent behaviour) using an internal model. In recent weeks, given the sharp rise in volatility of many asset markets and decisive action by a number of central banks across the globe, we are treading a path that looks like the bull case scenario presented our January 2020 outlooks. That scenario would see gold prices head over US$2000/oz by the end of the year. In that scenario, the Federal Reserve of the US embarks on policy easing (which has already started), that drives Treasury yields lower than where they were in December 2019 (Treasury yields have already broken new all-time lows of 0.35% on March 10th 2020). Inflation in that scenario is at an elevated 2.5% (which is in line with the January 2020 actual reading). Lastly, speculative positioning in gold futures markets remains elevated throughout the course of the year (at 350k contracts net long). In February 2020, we saw speculative positioning hit fresh highs (388k) and at the time of writing (10th March 2020), it remains above the 350k. We caution that if the current shock we are experiencing is temporary, we could get the recent interest rate cuts reversed, Treasury yields could rise to 2% and positing in gold futures could head back to more normal levels (closer to 120k). That was what we presented as a base case in January, where gold would end the year at US$1640/oz. So the downside from the levels ate the time of writing is somewhat limited (with gold trading at US$1650/oz at the time of writing) even if we end up in what was the base case.
This concludes our 6 weeks grand tour of the “natural” defensive assets among the main 4 asset classes. Next week we will start focusing on portfolio construction and on different ideas to design defensive and versatile portfolios.
Europe Equities is proxied by the STOXX Europe 600 net total return index. Broad Commodities (Commo) is proxied by the Bloomberg Commodity Total Return Index. Enhanced Commodities is proxied by Optimized Roll Commodity Total Return Index. Energy is proxied by the Bloomberg Energy subindex Total Return Index. Precious Metals is proxied by the Bloomberg Precious Metals subindex Total Return Index. Industrial Metals is proxied by the Bloomberg Industrial Metals subindex Total Return Index. Livestock is proxied by the Bloomberg Livestock subindex Total Return Index. Softs is proxied by the Bloomberg Softs subindex Total Return Index. Grains is proxied by the Bloomberg Grains subindex Total Return Index. Gold is proxied by the LBMA Gold Price PM Index. Silver is proxied by the LBMA Silver Price index.
By: Pierre Debru, Director, Research
Source
1 WisdomTree, Bloomberg. In EUR.
2 WisdomTree, Bloomberg. In EUR. Europe Equities is proxied by the STOXX Europe 600 net total return index. Min Vol is proxied by MSCI World Min Volatility net total return index. Cash Euro is proxied by a series of daily compounded Eonia. EUR Treasury AAA is proxied by the Bloomberg Barclays EUR Aggregate Treasury AAA total return index. USD Treasury is proxied by the Bloomberg Barclays USD Treasury total return index.
So far this week, Brent Crude prices have strengthened by USD 1.3 per barrel since Monday’s opening. While macroeconomic concerns persist, they have somewhat abated, resulting in muted price reactions. Fundamentals predominantly influence global oil price developments at present. This week, we’ve observed highs of USD 89 per barrel yesterday morning and lows of USD 85.7 per barrel on Monday morning. Currently, Brent Crude is trading at a stable USD 88.3 per barrel, maintaining this level for the past 24 hours.
Additionally, there has been no significant price reaction to Crude following yesterday’s US inventory report (see page 11 attached):
- US commercial crude inventories (excluding SPR) decreased by 6.4 million barrels from the previous week, standing at 453.6 million barrels, roughly 3% below the five-year average for this time of year.
- Total motor gasoline inventories decreased by 0.6 million barrels, approximately 4% below the five-year average.
- Distillate (diesel) inventories increased by 1.6 million barrels but remain weak historically, about 7% below the five-year average.
- Total commercial petroleum inventories (crude + products) decreased by 3.8 million barrels last week.
Regarding petroleum products, the overall build/withdrawal aligns with seasonal patterns, theoretically exerting limited effect on prices. However, the significant draw in commercial crude inventories counters the seasonality, surpassing market expectations and API figures released on Tuesday, indicating a draw of 3.2 million barrels (compared to Bloomberg consensus of +1.3 million). API numbers for products were more in line with the US DOE.
Against this backdrop, yesterday’s inventory report is bullish, theoretically exerting upward pressure on crude prices.
Yet, the current stability in prices may be attributed to reduced geopolitical risks, balanced against demand concerns. Markets are adopting a wait-and-see approach ahead of Q1 US GDP (today at 14:30) and the Fed’s preferred inflation measure, “core PCE prices” (tomorrow at 14:30). A stronger print could potentially dampen crude prices as market participants worry over the demand outlook.
Geopolitical “risk premiums” have decreased from last week, although concerns persist, highlighted by Ukraine’s strikes on two Russian oil depots in western Russia and Houthis’ claims of targeting shipping off the Yemeni coast yesterday.
With a relatively calmer geopolitical landscape, the market carefully evaluates data and fundamentals. While the supply picture appears clear, demand remains the predominant uncertainty that the market attempts to decode.
Brent crude has fallen USD 3/b since the peak of Iran-Israel concerns last week. Still lots of talk about significant Mid-East risk premium in the current oil price. But OPEC+ is in no way anywhere close to loosing control of the oil market. Thus what will really matter is what OPEC+ decides to do in June with respect to production in Q3-24 and the market knows this very well. Saudi Arabia’s social cost-break-even is estimated at USD 100/b today. Also Saudi Arabia’s purse is hurt by 21% US inflation since Jan 2020. Saudi needs more money to make ends meet. Why shouldn’t they get a higher nominal pay as everyone else. Saudi will ask for it
Brent is down USD 3/b vs. last week as the immediate risk for Iran-Israel has faded. But risk is far from over says experts. The Brent crude oil price has fallen 3% to now USD 87.3/b since it became clear that Israel was willing to restrain itself with only a muted counter attack versus Israel while Iran at the same time totally played down the counterattack by Israel. The hope now is of course that that was the end of it. The real fear has now receded for the scenario where Israeli and Iranian exchanges of rockets and drones would escalate to a point where also the US is dragged into it with Mid East oil supply being hurt in the end. Not everyone are as optimistic. Professor Meir Javedanfar who teaches Iranian-Israeli studies in Israel instead judges that ”this is just the beginning” and that they sooner or later will confront each other again according to NYT. While the the tension between Iran and Israel has faded significantly, the pain and anger spiraling out of destruction of Gaza will however close to guarantee that bombs and military strifes will take place left, right and center in the Middle East going forward.
Also OPEC+ wants to get paid. At the start of 2020 the 20 year inflation adjusted average Brent crude price stood at USD 76.6/b. If we keep the averaging period fixed and move forward till today that inflation adjusted average has risen to USD 92.5/b. So when OPEC looks in its purse and income stream it today needs a 21% higher oil price than in January 2020 in order to make ends meet and OPEC(+) is working hard to get it.
Much talk about Mid-East risk premium of USD 5-10-25/b. But OPEC+ is in control so why does it matter. There is much talk these days that there is a significant risk premium in Brent crude these days and that it could evaporate if the erratic state of the Middle East as well as Ukraine/Russia settles down. With the latest gains in US oil inventories one could maybe argue that there is a USD 5/b risk premium versus total US commercial crude and product inventories in the Brent crude oil price today. But what really matters for the oil price is what OPEC+ decides to do in June with respect to Q3-24 production. We are in no doubt that the group will steer this market to where they want it also in Q3-24. If there is a little bit too much oil in the market versus demand then they will trim supply accordingly.
Also OPEC+ wants to make ends meet. The 20-year real average Brent price from 2000 to 2019 stood at USD 76.6/b in Jan 2020. That same averaging period is today at USD 92.5/b in today’s money value. OPEC+ needs a higher nominal price to make ends meet and they will work hard to get it.
Inflation adjusted Brent crude price versus total US commercial crude and product stocks. A bit above the regression line. Maybe USD 5/b risk premium. But type of inventories matter. Latest big gains were in Propane and Other oils and not so much in crude and products
Total US commercial crude and product stocks usually rise by 4-5 m b per week this time of year. Gains have been very strong lately, but mostly in Propane and Other oils
Last week’s US inventory data. Big rise of 10 m b in commercial inventories. What really stands out is the big gains in Propane and Other oils
Take actual changes minus normal seasonal changes we find that US commercial crude and regular products like diesel, gasoline, jet and bunker oil actually fell 3 m b versus normal change.
Historically positive Nat gas to EUA correlation will likely switch to negative in 2026/27 onward
Historically there has been a strong, positive correlation between EUAs and nat gas prices. That correlation is still fully intact and possibly even stronger than ever as traders increasingly takes this correlation as a given with possible amplification through trading action.
The correlation broke down in 2022 as nat gas prices went ballistic but overall the relationship has been very strong for quite a few years.
The correlation between nat gas and EUAs should be positive as long as there is a dynamical mix of coal and gas in EU power sector and the EUA market is neither too tight nor too weak:
Nat gas price UP => ”you go black” by using more coal => higher emissions => EUA price UP
But in the future we’ll go beyond the dynamically capacity to flex between nat gas and coal. As the EUA price moves yet higher along with a tightening carbon market the dynamical coal to gas flex will max out. The EUA price will then trade significantly above where this flex technically will occur. There will still be quite a few coal fired power plants running since they are needed for grid stability and supply amid constrained local grids.
As it looks now we still have such overall coal to gas flex in 2024 and partially in 2025, but come 2026 it could be all maxed out. At least if we look at implied pricing on the forward curves where the forward EUA price for 2026 and 2027 are trading way above technical coal to gas differentials. The current forward pricing implications matches well with what we theoretically expect to see as the EUA market gets tighter and marginal abatement moves from the power sector to the industrial sector. The EUA price should then trade up and way above the technical coal to gas differentials. That is also what we see in current forward prices for 2026 and 2027.
The correlation between nat gas and EUAs should then (2026/27 onward) switch from positive to negative. What is left of coal in the power mix will then no longer be dynamically involved versus nat gas and EUAs. The overall power price will then be ruled by EUA prices, nat gas prices and renewable penetration. There will be pockets with high cost power in the geographical points where there are no other alternatives than coal.
The EUA price is an added cost of energy as long as we consume fossil energy. Thus both today and in future years we’ll have the following as long as we consume fossil energy:
EUA price UP => Pain for consumers of energy => lower energy consumption, faster implementation of energy efficiency and renewable energy => lower emissions
The whole idea with the EUA price is after all that emissions goes down when the EUA price goes up. Either due to reduced energy consumption directly, accelerated energy efficiency measures or faster switch to renewable energy etc.
Let’s say that the coal to gas flex is maxed out with an EUA price way above the technical coal to gas differentials in 2026/27 and later. If the nat gas price then goes up it will no longer be an option to ”go black” and use more coal as the distance to that is too far away price vise due to a tight carbon market and a high EUA price. We’ll then instead have that:
Nat gas higher => higher energy costs with pain for consumers => weaker nat gas / energy demand & stronger drive for energy efficiency implementation & stronger drive for more non-fossil energy => lower emissions => EUA price lower
And if nat gas prices goes down it will give an incentive to consume more nat gas and thus emit more CO2:
Cheaper nat gas => Cheaper energy costs altogether, higher energy and nat gas consumption, less energy efficiency implementations in the broader economy => emissions either goes up or falls slower than before => EUA price UP
Historical and current positive correlation between nat gas and EUA prices should thus not at all be taken for granted for ever and we do expect this correlation to switch to negative some time in 2026/27.
In the UK there is hardly any coal left at all in the power mix. There is thus no option to ”go black” and burn more coal if the nat gas price goes up. A higher nat gas price will instead inflict pain on consumers of energy and lead to lower energy consumption, lower nat gas consumption and lower emissions on the margin. There is still some positive correlation left between nat gas and UKAs but it is very weak and it could relate to correlations between power prices in the UK and the continent as well as some correlations between UKAs and EUAs.
Correlation of daily changes in front month EUA prices and front-year TTF nat gas prices, 250dma correlation.
EUA price vs front-year TTF nat gas price since March 2023
Front-month EUA price vs regression function of EUA price vs. nat gas derived from data from Apr to Nov last year.
The EUA price vs the UKA price. Correlations previously, but not much any more.
Forward German power prices versus clean cost of coal and clean cost of gas power. Coal is totally priced out vs power and nat gas on a forward 2026/27 basis.
Forward price of EUAs versus technical level where dynamical coal to gas flex typically takes place. EUA price for 2026/27 is at a level where there is no longer any price dynamical interaction or flex between coal and nat gas. The EUA price should/could then start to be negatively correlated to nat gas.
Forward EAU price vs. BNEF base model run (look for new update will come in late April), SEB’s EUA price forecast.
’wait and see’ mode
Also OPEC+ wants to get compensation for inflation
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Nat gas to EUA correlation will likely switch to negative in 2026/27 onward
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