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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

Brent needs to fall to USD 58/b to make cheating unprofitable for Kazakhstan

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SEB - analysbrev på råvaror

Brent jumping 2.4% as OPEC+ lifts quota by ”only” 411 kb/d in July. Brent crude is jumping 2.4% this morning to USD 64.3/b following the decision by OPEC+ this weekend to lift the production cap of ”Voluntary 8” (V8) by 411 kb/d in July and not more as was feared going into the weekend. The motivation for the triple hikes of 411 kb/d in May and June and now also in July has been a bit unclear: 1) Cheating by Kazakhstan and Iraq, 2) Muhammed bin Salman listening to Donald Trump for more oil and a lower oil price in exchange for weapons deals and political alignments in the Middle East and lastly 3) Higher supply to meet higher demand for oil this summer. The argument that they are taking back market share was already decided in the original plan of unwinding the 2.2 mb/d of V8 voluntary cuts by the end of 2026. The surprise has been the unexpected speed with monthly increases of 3×137 kb/d/mth rather than just 137 kb/d monthly steps.

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

No surplus yet. Time-spreads tightened last week. US inventories fell the week before last. In support of point 3) above it is worth noting that the Brent crude oil front-end backwardation strengthened last week (sign of tightness) even when the market was fearing for a production hike of more than 411 kb/d for July. US crude, diesel and gasoline stocks fell the week before last with overall commercial stocks falling 0.7 mb versus a normal rise this time of year of 3-6 mb per week. So surplus is not here yet. And more oil from OPEC+ is welcomed by consumers.

Saudi Arabia calling the shots with Russia objecting. This weekend however we got to know a little bit more. Saudi Arabia was predominantly calling the shots and decided the outcome. Russia together with Oman and Algeria opposed the hike in July and instead argued for zero increase. What this alures to in our view is that it is probably the cheating by Kazakhstan and Iraq which is at the heart of the unexpectedly fast monthly increases. Saudi Arabia cannot allow it to be profitable for the individual members to cheat. And especially so when Kazakhstan explicitly and blatantly rejects its quota obligation stating that they have no plans of cutting production from 1.77 mb/d to 1.47 mb/d. And when not even Russia is able to whip Kazakhstan into line, then the whole V8 project is kind of over.

Is it simply a decision by Saudi Arabia to unwind faster altogether? What is still puzzling though is that despite the three monthly hikes of 411 kb/d, the revival of the 2.2 mb/d of voluntary production cuts is still kind of orderly. Saudi Arabia could have just abandoned the whole V8 project from one month to the next. But we have seen no explicit communication that the plan of reviving the cuts by the end of 2026 has been abandoned. It may be that it is simply a general change of mind by Saudi Arabia where the new view is that production cuts altogether needs to be unwinded sooner rather than later. For Saudi Arabia it means getting its production back up to 10 mb/d. That implies first unwinding the 2.2 mb/d and then the next 1.6 mb/d.

Brent would likely crash with a fast unwind of 2.2 + 1.6 mb/d by year end. If Saudi Arabia has decided on a fast unwind it would meant that the group would lift the quotas by 411 kb/d both in August and in September. It would then basically be done with the 2.2 mb/d revival. Thereafter directly embark on reviving the remaining 1.6 mb/d. That would imply a very sad end of the year for the oil price. It would then probably crash in Q4-25. But it is far from clear that this is where we are heading.

Brent needs to fall to USD 58/b or lower to make it unprofitable for Kazakhstan to cheat. To make it unprofitable for Kazakhstan to cheat. Kazakhstan is currently producing 1.77 mb/d versus its quota which before the hikes stood at 1.47 kb/d. If they had cut back to the quota level they might have gotten USD 70/b or USD 103/day. Instead they choose to keep production at 1.77 mb/d. For Saudi Arabia to make it a loss-making business for Kazakhstan to cheat the oil price needs to fall below USD 58/b ( 103/1.77).

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Analys

All eyes on OPEC V8 and their July quota decision on Saturday

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SEB - analysbrev på råvaror

Tariffs or no tariffs played ping pong with Brent crude yesterday. Brent crude traded to a joyous high of USD 66.13/b yesterday as a US court rejected Trump’s tariffs. Though that ruling was later overturned again with Brent closing down 1.2% on the day to USD 64.15/b. 

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

US commercial oil inventories fell 0.7 mb last week versus a seasonal normal rise of 3-6 mb. US commercial crude and product stocks fell 0.7 mb last week which is fairly bullish since the seasonal normal is for a rise of  4.3 mb. US crude stocks fell 2.8 mb, Distillates fell 0.7 mb and Gasoline stocks fell 2.4 mb.

All eyes are now on OPEC V8 (Saudi Arabia, Iraq, Kuwait, UAE, Algeria, Russia, Oman, Kazakhstan) which will make a decision tomorrow on what to do with production for July. Overall they are in a process of placing 2.2 mb/d of cuts back into the market over a period stretching out to December 2026. Following an expected hike of 137 kb/d in April they surprised the market by lifting production targets by 411 kb/d for May and then an additional 411 kb/d again for June. It is widely expected that the group will decide to lift production targets by another 411 kb/d also for July. That is probably mostly priced in the market. As such it will probably not have all that much of a bearish bearish price impact on Monday if they do.

It is still a bit unclear what is going on and why they are lifting production so rapidly rather than at a very gradual pace towards the end of 2026. One argument is that the oil is needed in the market as Middle East demand rises sharply in summertime. Another is that the group is partially listening to Donald Trump which has called for more oil and a lower price. The last is that Saudi Arabia is angry with Kazakhstan which has produced 300 kb/d more than its quota with no indications that they will adhere to their quota.

So far we have heard no explicit signal from the group that they have abandoned the plan of measured increases with monthly assessments so that the 2.2 mb/d is fully back in the market by the end of 2026. If the V8 group continues to lift quotas by 411 kb/d every month they will have revived the production by the full 2.2 mb/d already in September this year. There are clearly some expectations in the market that this is indeed what they actually will do. But this is far from given. Thus any verbal wrapping around the decision for July quotas on Saturday will be very important and can have a significant impact on the oil price. So far they have been tightlipped beyond what they will do beyond the month in question and have said nothing about abandoning the ”gradually towards the end of 2026” plan. It is thus a good chance that they will ease back on the hikes come August, maybe do no changes for a couple of months or even cut the quotas back a little if needed.

Significant OPEC+ spare capacity will be placed back into the market over the coming 1-2 years. What we do know though is that OPEC+ as a whole as well as the V8 subgroup specifically have significant spare capacity at hand which will be placed back into the market over the coming year or two or three. Probably an increase of around 3.0 – 3.5 mb/d. There is only two ways to get it back into the market. The oil price must be sufficiently low so that 1) Demand growth is stronger and 2) US shale oil backs off. In combo allowing the spare capacity back into the market.

Low global inventories stands ready to soak up 200-300 mb of oil. What will cushion the downside for the oil price for a while over the coming year is that current, global oil inventories are low and stand ready to soak up surplus production to the tune of 200-300 mb.

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Analys

Brent steady at $65 ahead of OPEC+ and Iran outcomes

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SEB - analysbrev på råvaror

Following the rebound on Wednesday last week – when Brent reached an intra-week high of USD 66.6 per barrel – crude oil prices have since trended lower. Since opening at USD 65.4 per barrel on Monday this week, prices have softened slightly and are currently trading around USD 64.7 per barrel.

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

This morning, oil prices are trading sideways to slightly positive, supported by signs of easing trade tensions between the U.S. and the EU. European equities climbed while long-term government bond yields declined after President Trump announced a pause in new tariffs yesterday, encouraging hopes of a transatlantic trade agreement.

The optimisms were further supported by reports indicating that the EU has agreed to fast-track trade negotiations with the U.S.

More significantly, crude prices appear to be consolidating around the USD 65 level as markets await the upcoming OPEC+ meeting. We expect the group to finalize its July output plans – driven by the eight key producers known as the “Voluntary Eight” – on May 31st, one day ahead of the original schedule.

We assign a high probability to another sizeable output increase of 411,000 barrels per day. However, this potential hike seems largely priced in already. While a minor price dip may occur on opening next week (Monday morning), we expect market reactions to remain relatively muted.

Meanwhile, the U.S. president expressed optimism following the latest round of nuclear talks with Iran in Rome, describing them as “very good.” Although such statements should be taken with caution, a positive outcome now appears more plausible. A successful agreement could eventually lead to the return of more Iranian barrels to the global market.

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