Commodity returns co-movements: Fundamentals or “style” effect?

Abstract

This paper investigates dynamic correlations both across commodities and between commodities and traditional assets, such as equities and government bonds, using the Regime Switching Dynamic Correlation (RSDC) model. In particular, this paper assesses the dynamics of 32 daily commodity futures returns, spanning a period from May 28, 2003, to June 04, 2014, in the light of economic and financial events before and after the mid-2007 financial crisis. There are three major findings. First, prior to the financial crisis, we detect stronger correlation among the wide range of commodities used in the analysis, indicating that the financialization process started impacting commodity price movements from mid-2005. Between commodities taken as an asset class and traditional asset classes our results generally show very weak commodity-equity and commodity-bond correlations prior to the Lehman Brother collapse. This can be explained by the "style "effect theory that correlations between different asset classes in a portfolio weaken. Second, during the financial crisis, correlations both across commodities and between commodities and equities increase dramatically, with a regime change which coincides exactly with the demise of Lehman Brothers on September 15, 2008. This suggests that a strong commodity-equity integration was temporarily masked by the "style "effect. However, commodity-bond correlations switch to a strongly negative regime, showing that government bonds were considered as refuge securities. Third and most importantly, the new and original finding here is the temporary nature of the financial crisis effect identified, as correlations both across commodities and between commodities and traditional assets revert to pre-crisis level from April 2013. This highlights the impact of the financial-based factors on commodity price movements.

What Drives Commodity Returns? Market, Sector or Idiosyncratic Factors?

“…The Chinese economic variables show some marginal statistical significance but in terms of economical importance only contribute a small amount of the total R 2 . The positive sign for global demand is especially interesting since it suggests that there is more common movement in expansions rather than recessions while conventional wisdom suggests that correlations increase during bad times (for commodities see Charlot et al ., ); however our result complements Büyükşahin and Robe (2014) who find less co‐movement of commodites with equities during periods of financial stress…”

“…* is significant at 10% level, ** is significant at 5% level and *** is significant at the 1% level. See Table 3 for variable descriptions. see Charlot et al, 2016); however our result complements Büyükşahin and Robe (2014) who find less co-movement of commodites with equities during periods of financial stress. 18 Results are robust to (i) the impact of outliers on our main results and (ii) testing that the change in the average contribution of the individual factor is a reflection of the common factor.…”

“…A number of studies have reported decreasing or non‐increasing trends in return correlations between commodities and stocks before the recent financial crisis (Chong and Miffre, ; Buyuksahin, Haigh and Robe, ). However, recent work finds that greater participation by speculators, especially hedge funds, is associated with a higher correlation between commodity and equity indices (Büyükşahin and Robe, 2014, Bruno, Büyükşahin and Robe, ), that global economic activity impacts co‐movements between agricultural markets and equities (Bruno et al ., ) and that commodity co‐movements increased temporarily during the financial crisis period (Charlot, Darné and Moussa, ). These characteristics of commodity returns suggest an opportunity for diversification.…”

The tail dependence structure between investor sentiment and commodity markets

“…The increase investment in commodities by financial investors (e.g. swap dealers and money managers) placed a greater importance on commodity futures exchanges as an asset class and led consequently to the financialization of commodity markets (among many others; see, Henderson et al (2015) ; Adams and Glück, 2015 ; Gao and Suss, 2015 ; Charlot et al, 2016 ; Algieri and Leccadito, 2017 ; Nguyen et al, 2020a , b ; Yang et al, 2020 ; Ali et al, 2020 ). 1…”