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Defensive Assets: Gold, a precious ally in the fight against equity drawdown

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WisdomTree
WisdomTree

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.

Performance in periods of equity drawdown
Source: WisdomTree, Bloomberg. In EUR. Enhanced Commodities Data starts only in May 2001 so it is not represented in the period of the Tech Bubble. More details on the indices used in the figure are available at the end of the blog. The 6 well known equity drawdown periods used in this graph are the Tech Burst (September 2000 to March 2003), the Financial Crisis(July 2007 to March 2009), the Euro Crisis I (April 2010 to July 2010), the Euro Crisis II (My 2011 to October 2011), the China Crisis (April 2015 to February 2016) and Q4 2018.

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.

10 worst equity quarters since july 2000
Source: WisdomTree, Bloomberg. In EUR. More details on the indices used in the figure are available at the end of the blog.

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.

Roling correlation of commodities with european equities.
Source: WisdomTree, Bloomberg. Period July 2000 to December 2019. Calculations are based on monthly returns in EUR. European Equities is proxied by STOXX Europe 600 net total return index.

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.

Average performance
Source: WisdomTree, Bloomberg. Period July 2000 to December 2019. Calculations are based on monthly returns in EUR. More details on the indices used in the figure are available at the end of the blog.

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

WisdomTree, Bloomberg. In EUR.

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. 

Analys

Breaking some eggs in US shale

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SEB - analysbrev på råvaror

Lower as OPEC+ keeps fast-tracking redeployment of previous cuts. Brent closed down 1.3% yesterday to USD 68.76/b on the back of the news over the weekend that OPEC+ (V8) lifted its quota by 547 kb/d for September. Intraday it traded to a low of USD 68.0/b but then pushed higher as Trump threatened to slap sanctions on India if it continues to buy loads of Russian oil.  An effort by Donald Trump to force Putin to a truce in Ukraine. This morning it is trading down 0.6% at USD 68.3/b which is just USD 1.3/b below its July average.

Bjarne Schieldrop, Chief analyst commodities, SEB
Bjarne Schieldrop, Chief analyst commodities, SEB

Only US shale can hand back the market share which OPEC+ is after. The overall picture in the oil market today and the coming 18 months is that OPEC+ is in the process of taking back market share which it lost over the past years in exchange for higher prices. There is only one source of oil supply which has sufficient reactivity and that is US shale. Average liquids production in the US is set to average 23.1 mb/d in 2025 which is up a whooping 3.4 mb/d since 2021 while it is only up 280 kb/d versus 2024.

Taking back market share is usually a messy business involving a deep trough in prices and significant economic pain for the involved parties. The original plan of OPEC+ (V8) was to tip-toe the 2.2 mb/d cuts gradually back into the market over the course to December 2026. Hoping that robust demand growth and slower non-OPEC+ supply growth would make room for the re-deployment without pushing oil prices down too much.

From tip-toing to fast-tracking. Though still not full aggression. US trade war, weaker global growth outlook and Trump insisting on a lower oil price, and persistent robust non-OPEC+ supply growth changed their minds. Now it is much more fast-track with the re-deployment of the 2.2 mb/d done already by September this year. Though with some adjustments. Lifting quotas is not immediately the same as lifting production as Russia and Iraq first have to pay down their production debt. The OPEC+ organization is also holding the door open for production cuts if need be. And the group is not blasting the market with oil. So far it has all been very orderly with limited impact on prices. Despite the fast-tracking.

The overall process is nonetheless still to take back market share. And that won’t be without pain. The good news for OPEC+ is of course that US shale now is cooling down when WTI is south of USD 65/b rather than heating up when WTI is north of USD 45/b as was the case before.

OPEC+ will have to break some eggs in the US shale oil patches to take back lost market share. The process is already in play. Global oil inventories have been building and they will build more and the oil price will be pushed lower.

A Brent average of USD 60/b in 2026 implies a low of the year of USD 45-47.5/b. Assume that an average Brent crude oil price of USD 60/b and an average WTI price of USD 57.5/b in 2026 is sufficient to drive US oil rig count down by another 100 rigs and US crude production down by 1.5 mb/d from Dec-25 to Dec-26. A Brent crude average of USD 60/b sounds like a nice price. Do remember though that over the course of a year Brent crude fluctuates +/- USD 10-15/b around the average. So if USD 60/b is the average price, then the low of the year is in the mid to the high USD 40ies/b.

US shale oil producers are likely bracing themselves for what’s in store. US shale oil producers are aware of what is in store. They can see that inventories are rising and they have been cutting rigs and drilling activity since mid-April. But significantly more is needed over the coming 18 months or so. The faster they cut the better off they will be. Cutting 5 drilling rigs per week to the end of the year, an additional total of 100 rigs, will likely drive US crude oil production down by 1.5 mb/d from Dec-25 to Dec-26 and come a long way of handing back the market share OPEC+ is after.

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Analys

More from OPEC+ means US shale has to gradually back off further

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SEB - analysbrev på råvaror

The OPEC+ subgroup V8 this weekend decided to fully unwind their voluntary cut of 2.2 mb/d. The September quota hike was set at 547 kb/d thereby unwinding the full 2.2 mb/d. This still leaves another layer of voluntary cuts of 1.6 mb/d which is likely to be unwind at some point.

Bjarne Schieldrop, Chief analyst commodities, SEB
Bjarne Schieldrop, Chief analyst commodities, SEB

Higher quotas however do not immediately translate to equally higher production. This because Russia and Iraq have ”production debts” of cumulative over-production which they need to pay back by holding production below the agreed quotas. I.e. they cannot (should not) lift production before Jan (Russia) and March (Iraq) next year.

Argus estimates that global oil stocks have increased by 180 mb so far this year but with large skews. Strong build in Asia while Europe and the US still have low inventories. US Gulf stocks are at the lowest level in 35 years. This strong skew is likely due to political sanctions towards Russian and Iranian oil exports and the shadow fleet used to export their oil. These sanctions naturally drive their oil exports to Asia and non-OECD countries. That is where the surplus over the past half year has been going and where inventories have been building. An area which has a much more opaque oil market. Relatively low visibility with respect to oil inventories and thus weaker price signals from inventory dynamics there.

This has helped shield Brent and WTI crude oil price benchmarks to some degree from the running, global surplus over the past half year. Brent crude averaged USD 73/b in December 2024 and at current USD 69.7/b it is not all that much lower today despite an estimated global stock build of 180 mb since the end of last year and a highly anticipated equally large stock build for the rest of the year.

What helps to blur the message from OPEC+ in its current process of unwinding cuts and taking back market share, is that, while lifting quotas, it is at the same time also quite explicit that this is not a one way street. That it may turn around make new cuts if need be.

This is very different from its previous efforts to take back market share from US shale oil producers. In its previous efforts it typically tried to shock US shale oil producers out of the market. But they came back very, very quickly. 

When OPEC+ now is taking back market share from US shale oil it is more like it is exerting a continuous, gradually increasing pressure towards US shale oil rather than trying to shock it out of the market which it tried before. OPEC+ is now forcing US shale oil producers to gradually back off. US oil drilling rig count is down from 480 in Q1-25 to now 410 last week and it is typically falling by some 4-5 rigs per week currently. This has happened at an average WTI price of about USD 65/b. This is very different from earlier when US shale oil activity exploded when WTI went north of USD 45/b. This helps to give OPEC+ a lot of confidence.

Global oil inventories are set to rise further in H2-25 and crude oil prices will likely be forced lower though the global skew in terms of where inventories are building is muddying the picture. US shale oil activity will likely decline further in H2-25 as well with rig count down maybe another 100 rigs. Thus making room for more oil from OPEC+.

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Analys

Tightening fundamentals – bullish inventories from DOE

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SEB - analysbrev på råvaror

The latest weekly report from the US DOE showed a substantial drawdown across key petroleum categories, adding more upside potential to the fundamental picture.

Ole R. Hvalbye, Analyst Commodities, SEB
Ole R. Hvalbye, Analyst Commodities, SEB

Commercial crude inventories (excl. SPR) fell by 5.8 million barrels, bringing total inventories down to 415.1 million barrels. Now sitting 11% below the five-year seasonal norm and placed in the lowest 2015-2022 range (see picture below).

Product inventories also tightened further last week. Gasoline inventories declined by 2.1 million barrels, with reductions seen in both finished gasoline and blending components. Current gasoline levels are about 3% below the five-year average for this time of year.

Among products, the most notable move came in diesel, where inventories dropped by almost 4.1 million barrels, deepening the deficit to around 20% below seasonal norms – continuing to underscore the persistent supply tightness in diesel markets.

The only area of inventory growth was in propane/propylene, which posted a significant 5.1-million-barrel build and now stands 9% above the five-year average.

Total commercial petroleum inventories (crude plus refined products) declined by 4.2 million barrels on the week, reinforcing the overall tightening of US crude and products.

US DOE, inventories, change in million barrels per week
US crude inventories excl. SPR in million barrels
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