Commodity and Macro Tail Risk Strategy Commentary
Investment Manager’s Monthly Report
On a net basis, the Commodity and Macro Tail Risk (CAMTR) strategy was up 1.23% in August 2022, to leave it up 9.02% since inception, on the 1st of February.1
Economic background
In recent months, we have highlighted how investors have been attempting to judge which of a number of different macro-economic scenarios was the most likely to develop in the United States. We gauged that four warranted consideration:
- A “soft landing” – in which the Fed’s latest (June) forecasts turn out to be broadly correct, with inflation gradually dropping back to target without unemployment rising by much and a recession being avoided.
- Persistent inflation & recession – in which inflation turns out to be more stubborn than expected, and the Fed is forced to tighten by more than is priced in and/or keep rates high for longer, and thereby eventually precipitating a recession.
- The Fed tolerates higher inflation – in which the Fed tightens to bring inflation down from current levels but is unwilling to take risks with respect to a recession, and so pauses before it has done enough to bring inflation down back to target.
- A “hard landing” – in which the tightening in financial conditions that has already come about leads to a recession, and perhaps quite quickly – and thus the Fed may end up tightening less than is currently priced in.
During July, investors appeared to conclude that the worst might soon be over – putting more weight on the possibility of either a “soft landing” scenario or one in which the Fed pauses. Risky asset classes, such as equities, had rallied.
August, by contrast, witnessed a marked shift in sentiment, as the Fed chair, Jerome Powell, used his Jackson Hole speech as an opportunity to throw cold water on the idea of a pause anytime soon – arguing that, “we must keep at it until the job is done”, and that, “the historical record cautions strongly against prematurely loosening policy”.2 We might note that a variety of FOMC officials had also signaled their hawkishness earlier in the month.
Investors reacted by upping their perceived likelihood of a “persistent inflation, followed by recession” scenario. Thus, fixed income markets repriced to show the Fed keeping rates higher for longer – with, for example, the OIS curve now expecting the level of rates at end-2023 to be very close to what they predict for end-2022 (at a little above 3½%). By contrast, a month earlier rates had been expected to reach only 3¼% by end-2022, and to have fallen by 50 basis points during 2023. As regards growth prospects, on a one-year-ahead horizon, Bloomberg’s latest survey revealed that economists have raised the probability of a US recession occurring, to 50%.
Yields on longer duration fixed income assets also rose markedly, but with some yield curve flattening evident especially at long maturities. So, for example, while 2-year US Treasury yields rose by 61 basis points during August, their 10-year equivalents increased by 54bp, and their 30-year ones by 28bp.
An even more aggressive sell-off occurred in European fixed income markets, as economists judged not only that the ECB and BoE would follow the Fed’s lead, but that fundamentals warranted them adopting a more aggressive line – reflecting higher-than-expected inflation readings and fears that Russian natural gas supply would be intermittent at best this winter (with the Nordstream 1 pipeline again being closed for part of the month and natural gas prices in European futures markets rising by more than a quarter). In Germany, for example, 2-year bund yields surged by 92bp, while their 10-year counterparts saw a rise of 72bp. In the United Kingdom, the comparable increases were 131bp and 94bp respectively. On the growth side of things, economists raised their forecast probability of a recession occurring over the next year to above 50% for both the euro area and for the United Kingdom. Simultaneously, however, they upped their inflation forecasts, not just for 2022 but for 2023 too.
The combination of raised recession risks, upside risks to inflation and more hawkish central banks was a toxic one for most equity markets. In the United States, for example, the S&P500 fell by more than 4%, with falls in excess of 6% in the interest-rate sensitive IT sector. European equity markets typically fell by more than their US counterparts. The Euro Stoxx 50 index, for example, fell by just over 5%. The UK was an exception – down close to 2% – insulated somewhat by a sharp drop in sterling. The MSCI World Index declined by 4.2%.
The dollar was the main beneficiary of the growing risk aversion in markets – with the USDX index appreciating by just over 2½% for the month. The gains were widespread – with depreciations the norm amongst most developed and emerging market currencies. Political uncertainty, along with the deteriorating economic situation, left sterling especially vulnerable, with the pound down 4½% versus the dollar. However, with BoJ policy less impacted than most, so raised interest rate differentials left the yen down nearly as much, by just over 4%. The euro, by contrast, dropped only about 1½%, in part because shortterm rate expectations moved by more than in the US.
Given the raised fears of a global recession, a number of cyclically sensitive commodities saw their prices drop – e.g. in a number of industrial metals (such as nickel, platinum, copper, aluminium and lead). Some commodities in the energy sector also experienced price declines, with, for example, Brent oil price futures down more than a tenth. A few agricultural markets, by contrast, registered strong gains, as fears for future supply rose. (Cotton prices rose by 17% during the month, for example, while coffee prices were up by just over 10%.) Precious metals prices followed their industrial brethren south, in part reflecting the expectation of higher interest rates raising the cost of holding speculative positions. Silver prices were especially weak, down 11.6% during August as a whole.
Performance attribution
Table 1 (overleaf) summarises the CAMTR strategy’s performance by sleeve, for August and since inception (on the 1st February 2022).
We came into August positioned for weaker-than-expected growth outcomes and continuing central bank tightening – and hence short equities while holding yield curve flatteners. We were also long the US dollar, reflecting inter alia our models’ expectation of growing risk aversion. And we were short commodities (both metals and agriculture), although long energy.
Table 1: CAMTR Attribution by Investment Style for the month of August 2022 and since inception
| August | Since Inception | |
|---|---|---|
| Commodities | 0.20% | 7.82% |
| Dynamic Short Equities | 0.61% | 1.97% |
| Currencies (FX Equity Hedge) | 0.26% | 0.38% |
| Yield Curve Slope | 0.21% | 0.67% |
| US Equity Sector | -0.07% | 0.48% |
| Chinese Fixed Income | 0.09% | -0.67% |
| Total | 1.31% | 10.65% |
Notes: Attribution figures are gross internal trading returns calculations excluding fees, expenses and cash interest. Holdings-based analysis is used to illustrate significant performance drivers and is not intended to be a formal accounting of returns. Holdings are subject to change. Totals may not add up due to rounding. The first data column of the table covers the period 1 August 2022 to 31 August 2022, whereas the second (‘Since Inception’) column covers the period 1 February 2022 to 31 August 2022. Source: PGIM Wadhwani.
Past performance is not a guarantee or reliable indicator of future results.
The vast majority of these trades worked well, with both the commodity and non-commodity components of the strategy providing gains. The vast majority came from the latter category, spread across most of its sleeves (as detailed in the following section). The main contributor to our returns were our non-trend strategies, which added about 2¼% to total returns. Our trend strategies, by contrast, lost just shy of 1%.
Since inception, commodities have provided nearly three quarters of CAMTR’s overall gains, which is broadly in line with their risk allocation. Within the non-commodity sleeves, the Dynamic Short Equities model has been the star performer, reflecting the fact that it has managed to take advantage of the numerous periods of stock market weakness this year.
Performance attribution of the non-commodity sleeves
Of the six sleeves within CAMTR, only one – the US Equity Sector model – was unprofitable in August: and its losses were marginal (at 7 basis points). The Dynamic Short Equities sleeve was the single largest contributor. But currencies and fixed income were also profitable areas for us: in both cases, our strategies in the asset class added a little more than what we were able to make in commodities.
In equities, although we were able to take advantage of the pessimism that drove markets down with our directional trading, our relative value (US Equity Sector) model detracted modestly.
In FX, we were able to make money with our US dollar trades against the euro, as well as against the Australian and Canadian dollars. We also prospered from our trading of the Swedish krona versus the euro.
In fixed income, our yield curve slope strategies were profitable. The Chinese fixed income model’s flip to long positioning during July also proved to be helpful in August, albeit to a limited extent (of just 9bp).
Since inception, all but one of the non-commodity sleeves have contributed positively to performance – with Chinese Fixed Income being the exception. The Dynamic Short Equities sleeve has contributed nearly 2% to overall CAMTR returns, while Yield Curve Slope models has added ⅔% and the US Equity Sector close to ½%. The FX Equity Hedge model is not too far behind, having contributed 38bp since the start of February.
Performance attribution of the commodity sleeve
Table 2: CAMTR Commodity Attribution by Commodity Type for the month of August and since inception
| August | Since Inception | |
|---|---|---|
| Energy (ex. Natural Gas) | -0.61% | 0.81% |
| Natural Gas | 0.10% | 3.63% |
| Industrial Metals | 0.17% | 1.86% |
| Precious Metals | 1.01% | 1.12% |
| Softs | -0.40% | 1.46% |
| Livestock | -0.08% | -1.05% |
| Total | 0.20% | 7.82% |
Notes: Attribution figures are gross internal trading returns calculations excluding fees, expenses and cash interest. Holdings-based analysis is used to illustrate significant performance drivers and is not intended to be a formal accounting of returns. Holdings are subject to change. Totals may not add up due to rounding. The first data column of the table covers the period 1 August 2022 to 31 August 2022, whereas the second (‘Since Inception’) column covers the period 1 February 2022 to 31 August 2022. Source: PGIM Wadhwani.
Past performance is not a guarantee or reliable indicator of future results.
Within the Commodities sleeve, August saw a similar pattern to June and July, inasmuch that we suffered losses in Energy and in Agriculture, whereas we made money in Metals. Unlike in those two months, however, in August our gains in the one sub-asset class more than outweighed the losses in the other two. Since inception too, all three sub-classes have been profitable.
Within Energy, we managed to make money from trading natural gas – with a long in the Dutch contract our third most successful trade for the month, reflecting in the main the success of our trend-following strategies. However, these gains were more than offset by losses elsewhere, such as from a long position in coal, and from our trading of Brent crude oil, gas oil, and heating oil futures. Here our non-trend strategies were profitable, but our trend ones struggled. The sharp moves meant that, in several cases (including Brent and heating oil), we started the month short, but ended it long.
In Metals, the stand-out component was Precious – where our shorts in silver and gold turned out to be our top two trades for the month. In Industrials, markets such as platinum, nickel and copper were profitable for us. However, these gains were partly offset by losses in our trading of zinc and palladium. In both Precious and Industrial Metals, it was the case that both trend and non-trend strategies registered gains.
Within Agriculture, Softs contributed about four-fifths of our near-½% loss, with our shorts in cocoa, corn and cotton the three worst performing markets for us. Both trend and non-trend strategies struggled. In Livestock, the losses were predominantly in the (feeder and live) cattle markets.
End-August positioning
Having witnessed significant reductions in the portfolio’s overall net short positions in commodities and in equities in July, August saw both positions being built back up again. In both cases, having ended July with net exposures that were about half what they were at end-June, August saw them roughly double – taking them back to about mid-year levels.
In commodities, the shorts in both industrial and precious increased markedly, while that in crops was little changed. By contrast, the long in energy increased somewhat, while in livestock we retained a small long.
In equities, the Dynamic Short Equities model’s short remains skewed more to European markets than US ones, and with only a small position in emerging markets overall. The build in the overall short during August was also about three times bigger in Europe than in the United States (and with Asia unchanged).
The US Equity Sector model retains a fairly defensive posture, with its three biggest longs still in Health Care, Consumer Staples and Utilities and its three largest shorts now in Materials, Energy and Financials.
As in recent months, the Equity Hedge FX model’s biggest long position remains the US dollar, but with its biggest short now being against the Australian dollar. We also have shorts in three other commodity currencies – the Norwegian krone and the Canadian and New Zealand dollars – as well as a short in the Swedish krona. We have small longs in the yen, the Swiss franc and in the euro.
The Yield Curve Slope model continues to be short the 2-year area, but long 5s and 10s in Germany. In the United States, however, August witnessed some significant shifts. The biggest switch has been in the 5-year area, where we now have a significant short, having been slightly long previously. The 2-year short has shrunk to close to zero. At the 30-year area, we have built a significant long position.
The Chinese Fixed Income model increased its long position somewhat during August.
The Outlook
One consequence of policymakers keeping rates higher for longer and the fact that Fed chair Powell prioritised bringing inflation lower will be increased downside risks to activity – something that our models suggest is not appropriately reflected in consensus earnings expectations as yet. Consequently, we ended August with a bigger net short exposure to equities overall – a delta of close to -0.2, versus one of -0.1 a month earlier.
In fixed income, we also continue to be positioned for the ECB in particular to surprise on the hawkish side, and for the yield curve to flatten. In the United States, we look for less action at the very short-end of the curve, but for 5s-30s to flatten significantly.
Our increased concerns that growth may disappoint consensus expectations means that we have also increased our short positions in commodity prices overall, such as in industrial metals (e.g. copper, aluminium and nickel). In energy, we are long a broader set of markets than a month ago, including heating oil, coal, natural gas and gas oil.
A higher profile for interest rates may continue to weigh on precious metals’ prices. Accordingly, our models have somewhat bigger short positions than a month ago.
In agriculture, we continue to run a small short in crops but a small long in livestock.
In foreign exchange, we continue to run dollar longs, and of similar size to those we’ve held over the past several months.
The clarity of the Federal Reserve rhetoric has meaningfully increased the risk to global equity markets in the coming period, as markets are likely to fully absorb the implications of that message for earnings forecasts. While unlikely to be relevant to markets in the near-term, we must not lose sight of the possibility of our third scenario in which central banks ultimately come to tolerate higher inflation. After all, the notion that the Fed move to a higher inflation target of 3% was discussed by Jason Furman at Jackson Hole, and the incoming UK Prime Minister has pledged to review the Bank of England mandate.
1 The Commodity and Macro Tail Risk (CAMTR) strategy was incepted on 1st February 2022. The returns presented are net of actual fees, based on the highest fee structure available. Please see pages 7 to 10 for additional performance details. Source: PGIM Wadhwani. Past performance is not a guarantee or reliable indicator of future results.
2 For details, see “Monetary Policy and Price Stability”, speech by Federal Reserve chair Jerome Powell at the Jackson Hole conference, 26th August 2022, available at… https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm