DIVERSIFICATION


period 2006-2010, where index investing gained momentum, commodities have started to form a coherent asset class with correlations not only within sectors but also across different sectors. This development is probably due to the behaviour of commodity index investors, who pour money into all commodities when they enter and sell all commodities at the same time when they withdraw. Beyond classical correlation metrics,


which only give insights on the behaviour in the core of the distribution, the differences in diversification power across commodities can be better grasped by the behaviour in periods of large scale market downturns. Figure 5 compares the diversification properties of different commodities sectors. Gold has the most versatile behaviour, alternating between a highly speculative mode in 2006-2008 and a status of diversifier if not haven in 2008- 2010. The transformation of energy and agricultural commodities from diversifying to liquidity-sensitive assets is noticeable. As regards metals, their cyclicality has kept increasing over the period.


Medium-Term Perspectives: Commodities, China & the Fed The Fed intervention is an essential part


of the problem. Since September 11, 2001, the Fed has been indeed feeding a liquidity doom loop. When liquidity dries up to a point where the integrity of the financial system is endangered, the Fed has no other choice than to lower its target interest rates and bail out failed systemic institutions. This creates the conditions for new asset price bubbles whose implosion may again lead to a large scale market dislocation and prompt a new Fed intervention, and so on and so forth.


Source: Riskelia Commodities will certainly be


... commodities have started to form a coherent asset class with correlations not only within sectors but also across different sectors


The recent QE II has provoked a maniac bullish move on base


and precious metals (Figure 6) coordinated with an attack on the dollar. However, recent developments in China warn us that this new card stack is fragile and could well collapse. Commodities are indeed becoming the stake of a fierce central banks’ war: while the People Bank of China tries to combat domestic inflation by tightening its monetary policy, the Fed is engaged in a resolute fight against deflation through its quantitative easing policy.


Footnote: 1. The CFTC disaggregated reports available for US agricultural futures markets


reveal that long passive (index) investors hold between 20% and 50% of the long positions in commodity futures markets


the least diversifying asset if China defeats the Fed and a deflationary spiral sets off on risky asset prices. The other looming threat for commodities stems from European banks. The recent Irish debt crisis, although severely dampening eurozone banks’ financing abilities, has so far spared commodities and equities outside the EU but, given the system interconnectedness, a repetition of the May 2010 market dislocation cannot be excluded. •


Steve Ohana is Professor of finance at ESCP Europe and Jean-Jacques Ohana, CEO of Riskelia, a risk management consulting firm which provides market intelligence products and services


www.riskelia.com December 2010 13


Figure 6: Commodities & Hedge Funds Net cumulative flows of hedge funds into commodities (US$ Billions)


Net hedge funds commodities exposure (US$ Billions)


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