Issues Relating to Globalization, Financial Markets and Financial Instruments
Exploratory Study of Select Commodity and Equity Indices Around the Meltdown of 2008
Diganta Mukherjee and Arnab Mallick
Abstract Many believe that the world of investment is becoming complicated and more volatile with every passing day. What makes it even more interesting is the complexity of the market particularly for those select instruments which are traded on electronic exchanges, be it equity, commodity or currency, to name a few. Each investment market has its own dynamics and their inter-linkages are even more exciting.
1 Lay of the Land
Many believe that the world of investment is becoming complicated and more volatile with every passing day. What makes it even more interesting is the com- plexity of the market particularly for those select instruments which are traded on electronic exchanges, be it equity, commodity or currency, to name a few. Each investment market has its own dynamics and their inter-linkages are even more exciting. A huge amount of research has been conducted in areas related to equity and currency market, but over the last decade, tremendous amount of interest has been generated around commodity market as well. Although, historically one of the oldest markets known to mankind, exchange (electronic) traded commodity market is rather a relatively recent phenomenon in several key countries, for example, exchange traded commodity market has been operating in India since 1875.
But amidst all development and penetration in thefinancial world, the incident that has shaken the whole investment world has been the globalfinancial meltdown in 2008 triggered by the subprime mortgage crisis. It has been nearly 7 years since the impact could be felt and understood and plenty of water hasflown since then.
The world has witnessed unprecedented monetary policy boosters from economic
D. Mukherjee (&)
Indian Statistical Institute, Kolkata, India e-mail: diganta@isical.ac.in
A. Mallick
Indian Institute of Foreign Trade, New Delhi, India
©Springer India 2016
M. Roy and S. Sinha Roy (eds.),International Trade and International Finance, DOI 10.1007/978-81-322-2797-7_19
387
giants including the United States of America with China and Japan joining the group rather recently. Very few would like to debate that the meltdown and the series of action thereafter to tackle the global meltdown has had a major impact on the investment market. This article is an attempt to touch upon certain softer aspects of the shift in select commodity and equity market spectrum around that period.
In this article, an attempt has been made to provide certain critical observation of select markets which have been severely impacted from the meltdown, purely from an investment point of view. Although, we have tried to provide a holistic picture to provide a sense of developments in the market, there has been effort to link it to different kind of markets (in terms of maturity of the market). Focusing mostly on base metals market, this work has made reference to several other exchange traded commodity baskets like gold, as well key leading equity indices across the work to give a feel of how the recent developments has been influencing these key platforms of investments.
Meanwhile, before getting deep into the topic, it is worth mentioning that the very basic of commodity market has one very unique feature which gives an added layer of complexity to this market. Trends of prices for exchange traded commodities are not entirely determined by equilibrium situation from physical demand and supply configuration but largely influenced by flow of financial funds into the select spectrum purely driven by investment motives. To elaborate it in somewhat more details although, market forces including demand and supply have a huge impact in determining the spot price of commodities but in today’s electronically integrated financial world, in most cases traders take cues from the futures price of commodity contract (in cases, where they exist) and in real world it tends to influence spot market sentiments. Professional investors do not take their positions on commodity-based contracts (on the futures exchanges) only on the fundamental factors like demand, supply, inventory in physical market, but on host of other factors like currency, economic environment, alternative investment opportunities at particular time point, technical indicators arising out of a historic price movement, risk appetite, amongst several others. In reality, often signals from futures market end up having a great influence on physical traders of the commodities and thereby impacts the spot prices. Thus, in reality one often sees a both way causal relationship between spot prices and futures prices. The fact that price of exchange traded commodity prices are often influenced by host of factors in addition to fundamen- tally linked factors like physical demand and supply, can be well felt in the recent rise in volatility of certain commodity basket; for example gold—an extremely critical commodity as historically it is also treated as a hedge against uncertainty and therefore extremely popular amongst a large section of investor community. The recent correction in gold price and sharp rise in volatility is difficult to explain on the back of general theory of market economics only. This very interesting phenomenon has been gaining popularity amongst researcher for long. It has been vividly explored and discussed by Mayer (2009)financial investors regard commodities as an asset class (comparable to equities, etc.) and do not necessarily trade on the basis of fundamental supply and demand relationships in specific commodity markets.
In particular, topic related to exchange traded commodity markets are gaining importance amongst researcher andfinancial professionals as the growing volatility particularly post the recentfinancial meltdown is pretty significant. In particular, the commodities segment including energy, base metal and precious metals is in a critical phase at the moment as most of the commodities are trading at near year lows now after sharp decline and thereafter a sharper recovery post thefinancial meltdown in 2008, clearly suggesting that the basket might have lost investor’s interest in competition to its close counterpart, i.e. the equity market during the respective time frame, or perhaps, market fundamentals surrounding commodity basket complex are clearly not in favour at the moment.
But, at this junction the million dollar question remains whether the current market situation is a result of normal market function or is it a result of fundflows into commodity complex for investment or trading requirements?
The initial sharp upturn in price immediately post the heavy doses of quantitative easing from economic giants in response to initial meltdown to thefinancial crash in 2007–08 was not unexpected. There was huge amount of quantitative easing which was pumped into the market primarily by the US followed by a series of other measures by key sovereign entities as everyone was trying to frame the best pos- sible solution to combat the on-setting downturn. The financial meltdown had caused massive destruction in market capitalization and consequently, jittery investors were waiting on every possible instance to make money through their investments, result of which was clearly visible in the equity and commodity market as it rallied sharply once it got itsfirst chance. Moving pretty much in line with other asset classes, exchange traded commodities also showed strength.
With passage of time, things started getting tricky and are getting seriously difficult at the moment as prices are collapsing fast, and with an impact which is far reaching, and also one of the basic reasons why this work focuses more on commodities to see how has key and select commodities moved in recent past post thefinancial meltdown.
It is worth noting that leading corporations are often associated in business pertaining to several key commodities, but whose prices are largely determined by the commodity exchanges. Thus, these prices therefore are subject to major influ- ence offinancial fundflows mostly fromfinancial communities having little or no interest in the physical commodity per se, for consumption or value addition, as has been mentioned in the past.
As a result, market participants with a commercial interest in physical com- modities (i.e. producers and consumers) are facing increased uncertainty about the reliability of signals emanating from the commodity exchanges. This makes the argument even more contemporary today as business environment is taking sharp turns as downward cycle in commodity price are forcing global leading miners like BHP Billiton, Rio Tinto, and Vale amongst several others to significantly shift their operation strategies which have resulted into sharp reduction in capital and exploration expenditure for next few years. Needless to say, the impact is far more severe with strong linkage effect and impacting global economic recovery, partic- ularly for countries whose economic activities are primarily rotating around com- modity markets, like Australia, Indonesia, Brazil, Chile, amongst several others.
Therefore this is perhaps an appropriate time to once again look into the dynamics of the exchange traded commodity market, particularly with a focus to understand as how fund flows between alternative sources of investment are creating havoc in certain pockets in the commodities market post thefinancial crisis of 2007. As more and more investors are getting exposed to different kinds of investment avenues including commodities, this topic is gaining increasing relevance. It may either be a direct involvement of largefinancial institutions or indirect involvement of retail investors through different products with an exposure into the commodity complex.
Along with key commodity like gold (which has a unique positioning amongst investors) this exploratory study will lay much focus on base metal segment due to some key reasons. A commodity basket like base metals has a huge final con- sumption demand as well because of its huge industrial usage. Once again as mentioned in the past, prices of these commodities in the physical market are directly linked with price discovered on select leading commodity exchanges, which (futures price) is largely a result of speculative fundflow from largefinancial institutions.
Consequently, many believe that there is an apparent increase in disconnect between physical market fundamentals (actually demand and supply of the commodity) with the prevailing prices and surely the emerging prevailing volatility. Needless to say, it is emerging as a bigger threat for stability of those fundamental commodities, and hence once again, its relevance in the globally integrated commodity market is getting bigger with every passing day. At the same time, its relevance for nearly all countries (which are either importers and/or exporters) of this basket of commodity on futures exchange is also gaining a lot of focus. It is also worth noting that currently, there are just a very few essential commodities which are not traded on commodity exchange. But, it will not be wise to assume that the situation will remain like this forever. Hence, an understanding of the dynamics of exchange traded commodities is extremely relevant in the context of international business.
It is not only important for countries which are exposed to these commodity pricefluctuation risks but also for different entities including companies involved with these commodities in some way or the other and surely the global population at large. This exploratory study also aims atfinding these interesting movements across critical investments basket post the great financial shock and tries to pose certain key question which could be looked into greater details at consequent studies, primarily focusing around exchange traded commodity market.
2 Background Literature
The scale at which commodity space is attracting investor interest is relatively rather a recent phenomenon and several recent researches in this regards provide evidence of its growing dominance. Vrugt et al. (2004) have shown in their work that for a long time, commodities were deemed inappropriate investments because of their perceived risky character. The disappointing performance and future
prospects of traditional asset classes and the availability of data and commodity indices have rapidly changed this situation.
Commodities as an investment destination have consequently gained a lot of interest in academic research. There has been plenty of evidence that also supports the incentives of several economic agencies getting increasingly interested in commodities complex.
Kazemi et al. (2009), Georgiev (2001) have explored in detail the benefits of commodity investment. Vrugt et al. (2004) has showed that investors can profit from tactical asset allocation with commodities in real-time and argued that the timing strategy delivers superior investment returns, both in an economical and a statistical sense. Conover (Georgiev2001) has explored the question when com- modities need to be added to someone’s investment portfolio.
A very interesting work in the commodities spectrum has been done by Jacquier et al. (1999) in which they provided evidence that commodities perform well when the general financial market climate is negative. Interestingly, given the current global environment of quite a bit of uncertainty, better to say, confusion, com- modity spectrum has of late been an underperforming asset class.
Another unique aspect in commodities research was provided by Bodie (1983), Froot (1995), Gorton and Rouwenhorst (2004) wherein it was explained that com- modities appeared to serve as a possible hedge against inflation, which makes them even more attractive for entities withfixed liabilities in real terms, like for instance pension funds. Nijman and Swinkels (2003) show that commodity investments are beneficial to pension funds within a mean variance framework. As widely accepted, historically gold has always been considered to a natural hedge against inflation.
However, recent trend shows that the yellow metal has been consistently losing price on the courses with occasionalflips. This price decline is surely difficult to explain purely on basis of demand-supply changes over last few years.
Understanding of price dynamics of exchange traded commodities are no longer a matter of interest of academic research only. As mentioned in the past, it is perhaps of utmost importance as never before considering the impact that it has been showing to have on major economies which are largely driven by commodities cycle and given the interdependence of different economies in today’s trading environment, impact of commodity price is much higher than before. Gruss (2014) has explored the matter in detail for LAC and concluded that the end of the commodity price boom will entail a significant drag on growth for the average commodity exporter of LAC. Needless to suggest that this concretely has a larger implication on policy making which could therefore needs to be framed to minimise the impact.
In any discussion pertaining to global commodity market mostly metals, the name that always secures topmost slot is China, along with the United States of America.
The tremendous consumption appetite of China has clearly emerged as one of the most critical determinants of physical market fundamentals. Also, as time has pas- sed, the Chinese commodity exchange, name the Shanghai Futures Exchange (SHFE) has gained massive attention, surely in the metal space. As an obvious expectation, there has also been tremendous volume of research around this zone and researchers have found unique insights. Roache (2012) in his work to understand
China’s impact on commodity markets with a focus on the spillover of aggregate activity and commodity-specific demand shocks has shown that shocks to aggregate activity in China have a significant and persistent short-run impact on the price of oil and some base metals. Interestingly the study alsofinds that China’s impact on world commodity markets is rising but remains smaller than that of the United States. This is mainly due to the dynamics of real activity growth shocks in the U.S, which tend to be more persistent and have larger effects on the rest of the world. It would be interesting to explore this dynamics in terms of a real business cycle model aug- mented with expectations regarding the relative importance of countries. In fact, if the participating economies believe that USA is more important in terms of leading trade patterns, then in equilibrium this would be a self-fulfilling expectation.
Therefore understanding of the pattern, particularly the change that market may have undergone post the recentfinancial meltdown is of gaining interest to many, finally leading to evaluate the pattern of linkage of a matured market with relatively newer but extremely crucial emerging markets.
There has been some work in this regard in the equity market, but very few in the commodity space with a focus on post meltdown period. Crucial work has been done by Verma (2005) whereinfindings suggested that the magnitude and duration of an upturn in the US market are fully reflected in equity markets of Latin America and that the impact is significantly different from that of a downturn.1This is no longer a surprise in today’s globalised world with volatility cross clustering being often prevalent.2Meanwhile, with the financial turmoil hitting the global market really hard, the market has seen change in reaction to crucial parameters including risk appetite of investors, movements of fund flow, sensitivity towards currency movement, positioning in the derivatives market, reaction to monetary policy changes, amongst many.
Particularly for base metal what is also very interesting is the inter-linkage between select key exchanges on which those commodities are traded. Investors and traders closely follow prices in different markets to take appropriate positions in exchanges of interest. Historically and traditionally, base metals have been long traded on London Metal Exchange (LME) and COMEX with LME setting the lead as benchmark prices. Off late with emergence of Chinese dominance on the com- modity complex, the latest addition to this elite list of exchanges has been Shanghai Futures Exchange (SHFE). As very expected the recent economic turmoil has also resulted in jerk in the way market participants behaves in the market.
All these three exchanges along with India’s Multi Commodity Exchange (MCX) interestingly reflect four significant strata of global economy in terms of
‘economic power centre’. With the US market is fighting hard to maintain its dominance in global commodity market as China has been moving ahead fast to
1This interestingly verifies the reference point dependent utility functions as proposed by Kahneman and Tversky.
2This phenomenon has been verified by econometricians using multidimensional asymmetric GARCH models. For a discussion see Campbell et al. (1996).
possibly replace the US as the most critical component in deciding equilibrium situation in commodity complex, mainly metals. The UK market is unique in the context of base metals, because of the existence of the LME but otherwise a weak economy at the moment, andfinally India, a market which is in everyone’s radar as a fastest emerging market. Similar movement shift is also felt in terms of exchange traded commodity market. There is a growing consensus among market participants that SHFE is emerging fast and may be slowly replacing LME which has tradi- tionally been the most crucial benchmark for the base metal complex. If that happens, it will have immense significance in the scheme of things.
With growing debate on possible shifts in centre of financial and economic power centres of the world, which is an obvious result of several years of macroeconomic development in respective countries, there is also a change in the way market participant is giving weightage to prices movement on different exchange. In case of base metals, it is now a growing competition between SHFE and LME as who would take the centre position amongst investor’s mind.
Some work has been done around these areas of market inter-linkages. Long and Lei (2008) has worked on dynamic relationship among China’s metal futures, spot price and London’s futures price. Researchers in the past have explored the linkage between markets with a special focus of China. Zhao (2002) has studied in detail the degree of association between Chinese commodity futures market with inter- national futures market. In one of the very crucial studies done by Garrigues et al.
(2014) it has been indicated that it is Comex, followed by the SHFE, not the LME which plays the most important role in copper price discovery. Consequently, relatively newer exchanges have emerged including Multi Commodity Exchanges (MCX) and NCDEX in India. What has been really interesting is the linkage between these markets and the nature of their relationship.
3 Exploratory Data Analysis of Select Price Trends
It is worth noting that the fate of commodity market on back of globalfinancial meltdown was similar to that of the equity market at large. But, its impact on common people’s investment kitty (directly) was not felt as it has been the case of equity as exposure of common people to commodity basket as an investment destination that has been relatively low as compared to equity. But things are changing at a rapid pace and it is emerging as a major investment destination in the currentfinancial world.
Apart from the merefinancial aspect, the implication of this emerging trend is sig- nificant. The emerging volatility and price appreciation followed by sharp correction is having a major effect on the macroeconomic fundamentals of most economies.
To begin with, investigating the gold price trend over past few years reveals some very interesting insights. Traditionally treated as a sticky investment option, gold price has rarely seen such a correction as it has been witnessing now (see Fig.1). In particularly, gold has seen one of the sharpest corrections over past 2 years. Interestingly, during the phase of the correction, there was no major shift in