Commodities have become over the past ten years part of the portfolio allocation of most asset managers. As such, financial investors detain “paper” commodities, and sometimes physical commodities as well, as any other type of assets. They do not invest in commodities because they are needed for their core business but just to improve the properties of their investment portfolio in terms of risks and returns. Investment banks, hedge funds and commodity specialized asset managers have been offering a wide array of commodity investment products and have actively recommended them to their clients.
Recent research studies have shown the “collateral” effect of such investment allocation. Although at times volatility might be attributed to external shocks like trade bans or adverse weather conditions, financial investors have also contributed in recent years to exacerbate volatility on commodity markets, where prices changes are abrupt and often unpredictable. UNCTAD (2011) has shown that commodity prices tend to move in the same direction that speculative currencies and stock markets over period ranging from days to months.
More recently, Bicchetti and Maystre (2012) show that liquid commodity markets have moved in tandem with the US stock market in a synchronized and persistent fashion since the collapse of Lehman Brothers at intervals ranging from few minutes to few seconds! As incredible as it may look, the short-term returns on live cattle futures contract in the USA have been increasingly moving in tandem with the US stock market returns.
Clearly, these very short-term commodity price co-movements cannot be justified by changes in supply and demand in specific markets. Fundamentals for the US stock and commodity markets differ greatly. Therefore they cannot induce similar price movements simultaneously, continuously and consistently for the past few years across. Indeed, given the large selection of commodities considered, different behaviours would have been expected due to the seasonality, industrial usage and specific physical commodity market dynamics. However these differences have not been observed.
While fundamentals cannot explain these price co-movements, the stock market and commodities do share one common, critical feature: the dominant position of financial investors. In the current period of great economic uncertainty, news about the evolution of the world economy and political announcements have a huge impact on the activities of herds of financial investors whose position-taking in commodity derivatives markets follows market sentiments or expectations, and much less so the fundamentals. It is the famous “risk on/risk off” trades.
Filiminov, Bicchetti, Maystre and Sornette (2013) measure the herding activity of financial investors at 10-, 20- and 30-minute intervals. Their measure of herding is by construction conservative. Nevertheless, they find that herding activity on commodity markets has surged greatly over the past 10 years. If the US stock market is a pertinent benchmark for the past 15 years, monthly averages of herding activity or “endogeneity” have increased from about 30 to 70 per cent of all price changes. In other words over two third of price changes are not based on unpredicted news but on the herding behavior of financial investors. Similar evolutions are observed for highly-liquid commodity contracts with enough historical data. In the case of the Brent oil, for instance, endogeneity has increased from 35 to close to 80 per cent between 2006 and 2009. For sugar, it reaches even 80 per cent in 2012. Surprisingly, Filiminov, Bicchetti, Maystre and Sornette (2013) also found that bubble like behaviours working at scales of months trickle down to minute intervals in the case of oil. In fact, the run up to the oil bubble of 2008 coincides with increasing level of endogeneity and herding by financial investors.
Their results clearly show that the price discovery mechanism is dominated by herding across multiple assets. The high level of endogeneity, coupled to the high level of correlation between commodities and the US stock market observed since 2008, questions the assertion that fundamentals matter over the long term. Financial innovations, like electronic trading, have not brought tangible benefits for the society at large because they do not allow for the process of a greater set of relevant information as claimed by the proponents of financialization. In fact, their study shows that the level of genuine news impacting the market has remained relatively constant over the analysed period.
Evidently, commodity prices are not “right” and tend to reflect the market sentiments rather than fundamentals. The high level of endogeneity makes commodity markets more prone to destabilizing forces and they have a greater tendency to deviate from their fundamentals. These results have serious implications for policy makers in developing and developed countries alike. One should not be too quick to interpret the high prices of commodities as a sign of high demand or scarce supply.
References
Bicchetti D, Maystre N (2012), The synchronized and long-lasting structural change on commodity markets: evidence from high frequency data, UNCTAD Discussion paper, Geneva and New York.
Filiminov V, Bicchetti D, Maystre N, Sornette D (2013), Quantification of the High Level of Endogeneity and of Structural Regime Shifts in Commodity Markets, Submitted to the Journal of International Money and Finance (JIMF).
UNCTAD (2011). Price Formation in Financialized Commodity Markets: The Role of Information. New York and Geneva, United Nations, June.