Is correlation killing metals too?

Is correlation killing metals too?

Metal derivative markets are in an unprecedented period of change. Although one of the principal arguments for trading commodities is that they are counter-cyclical, trading in them has risen, even though they have become increasingly correlated with other market indicators such as equity indices.

Does this mean that metals, like other commodities, will lose their attraction for those who want to diversify their portfolios? Or are they now perceived as a higher return asset class, which will draw investors for the momentum play, not caring if their investment is no longer so uncorrelated?

The link between metals and equity prices has grown significantly over the past few years. Catherine Virga, director of research at CPM Group, a commodities research and asset management firm in New York, says the correlation coefficient between the S&P 500 Index and the LME Index grew from 0.19 in 2007 to 0.28 in 2008 and 0.58 in 2009.

The LME Index tracks prices in dollars of the six main metals traded on the London Metal Exchange. The metals are weighted according to global production volume and trading liquidity, averaged over the past five years.

Market participants give two main reasons for the heightened correlation. One is that, at the moment, the focus of metals traders has switched from the supply side to the demand side, as future demand is much more uncertain than in normal times.

Some believe that this trend is temporary and will become less pronounced when the recession ends.

Steve Hardcastle, head of client services on Sucden Financial’s industrial commodities desk in London, says of the metals and equity markets: “At the surface level, they’re correlated, because they’re responding to the same announcements.”

But he believes that, in normal times, markets tend to focus on supply and demand figures. He says the present focus on the demand side means commodities respond to similar announcements as equities, but that after the recovery there will be more attention to supply.

Telling the future

“It’s not surprising to see equities as a driver,” says Virga. “Since markets are moving on expectations and gauging the future, one can expect it.”

She adds: “The market is aware that demand will recover quicker than supply can – it is pricing that in.”

Another reason for the correlation is that increased speculation in commodities means prices are affected by the amount of leverage investors have, so there will be more buying in good times and selling off when the market is less healthy.

Virga believes the correlation is partly being caused by the trading patterns and models. “It’s not necessarily temporary, but it’s momentum-driven,” she says. She doesn’t believe that this is necessarily linked to the downturn. “It’s not necessarily going to be at certain levels of the market it’s whether it has the momentum behind it.”

Funds’ power

As with other commodity markets, the increase in the proportion of metals trades executed by financial companies such as investment funds and hedge funds has provoked debate and some criticism. Lakshmi Mittal, chief executive of steelmaker ArcelorMittal, was reported to have said that financial institutions should not participate in metals markets.

“A big feature has been the impact of funds and index investors,” says Fred Demler, MF Global’s head of global commodities, who estimates that funds represent 70%-80% of the total volume. “That will continue to grow as investors diversify their portfolios,” he says.

Most market participants agree that funds’ presence will continue to grow. David Wilson, metals analyst at Société Générale, says: “Investment by funds is on the rise, especially with the advent of more intelligent indices such as GSCI, which can be shorted as well.”

Commodity trading is becoming increasingly common among pension funds, as well as hedge funds. The way they trade differs, though. One market source says: “Hedge funds tend to be proactive but pension funds typically invest in commodities via indices rather than directly.”

Bubble risk

Such a trend naturally prompts concerns that metals prices may once again be building to artificially high levels, as fluctuations in investment demand add to the volatility caused by changing physical demand.

For example, commentators are divided as to how change in interest rates may affect metals prices. The present low rates make it much more difficult to get a decent return on bank deposits or bonds. Commodities have offered comparatively better returns.

But when interest rates eventually rise, will commodities therefore become less attractive? Against that view, by the time rates rise, economies should be growing again, which is likely to be bullish for metals.

The worry that investment money may be distorting the metals market and masking real changes in supply and demand becomes more acute when you reflect that all investors have to do to make money is correctly predict when other investors are going to move money into or out of the asset class.

“At pure fundamentals,” Demler says, “metals are 50%-100% overvalued. Index funds, long-only funds and ETNs are affecting the price. The fundamentals are important for base metals but so is the impact of these long-only funds.”

Wilson has a similar view. “Fundamentals of last year didn’t support a rally in copper prices,” he says. “People can argue that prices run ahead of fundamentals. Our view is to look at fundamentals.”

Whether these market conditions constitute a speculative bubble, or could lead to one, is disputed. Even a market minimally affected by speculation would be subject to volatility, after all, as participants overreacted to changes in supply and demand.

And changes in demand expectations are adding volatility to today’s market.

From a fundamental perspective, Hardcastle says an upwards overshoot on prices is possible because the market is taking into account perceived supply shortages which may be less severe than predicted.

“The least risk comes with commodities which do not deteriorate and are not liable to short term extreme fluctuation,” he says.

Lavelle points out that there is a supply cushion in several metals because at a certain price, mines with high operating costs will be able to come on stream. “As prices go higher, there is the opportunity to exploit previously unmined areas,” he says.


Funds making long bets on commodities are not the only ones adding a new dynamic to the market. As the proportion of algorithmic trading activity in the equity and financial derivatives markets continues to rise, the black boxes are beginning to grow in prevalence in the metals markets, though at a slower rate.

In fact, people point to them as the reason why the proportion of LME trades executed electronically has risen dramatically over the past decade.

Metals markets have resisted migrating to screens as fast as other derivative markets. While the trading floors at many global exchanges are now a shadow of their former selves, or in many cases closed years ago, the LME’s Ring for open outcry trading remains dynamic.

Nevertheless, electronic trading is growing – from less than 1% of the LME’s volumes in 2002 to 19% in 2009. One of the biggest reasons for this is algorithmic trading.

Gavin Lavelle, chief executive of Brady, which provides trading and risk management software to commodity markets, says: “Growth in electronic trading has been spectacular. It’s had a profound impact on how people trade.”

As a technology service provider to the electronic market, Lavelle recognises the efficiencies this type of trading can create. “It’s cheaper, faster and easier to comply,” he says.

Industrial companies using the metal markets have been slower to go electronic than financial players, Lavelle says. There are several possible reasons. Financial companies are naturally better placed to trade electronically as there are often synergies between their existing systems and processes and the ones required to trade electronically on the LME.

Another reason, though, is that the LME’s Ring remains the place where each day’s price is discovered, and many do not feel the need to change the way it operates.

Algos arrive

Many say that because of this unusual set of circumstances, the metals market has not yet been as affected as much as many others by the black boxes proliferating in the market. That is not to say that their presence has gone unnoticed.

“It’s created some quirky liquidity,” says Demler. He adds that although electronic trading has added an element of liquidity, “most of it is coming from algo traders, so is nominal liquidity”.

Developments have also taken place in the back office. LMESword, introduced earlier this year, replaced the previous Sword system provided by LCH.Clearnet.

The system acts as a delivery allocation system, granting warrants to firms with a net long position on the prompt date. Though the LME acknowledges that price discovery takes place in the Ring, it sees its electronic platform as important and continually invests in it.

London calling

It is hardly surprising that, given its increasing prominence and economic growth, China is the big story in metals markets at the moment.

The Shanghai Futures Exchange’s volumes have dwarfed those of the LME over the past few years. Now, the LME is trying to fight back by entering into a collaborative agreement with the Singapore Exchange.

The SGX will list mini versions of some of the LME’s monthly metal futures, which will be cash-settled against LME prices. The first four, subject to regulatory approval, are likely to be copper, zinc, nickel and aluminium.

Patrick McCormick, managing partner at World Steel Dynamics in New Jersey, says collaboration between eastern and western exchanges is “a mega-trend which is already on its way and it’s going to continue”. He believes this is a good opportunity for the LME. “It would be great to be able to tap that liquidity,” he says.

Though Shanghai has swelled to a huge size in its domestic isolation – foreigners are restricted from trading there – when it comes to international trade, the LME is still the hub.

The exchange’s dominant place in world metals markets is increasingly being called into question because of the growing interest in Asia. But, as Lavelle points out, it may be harder for other exchanges to compete with the LME than it is for them to challenge financial derivatives exchanges.

“The key to the LME is it’s a physical market,” Lavelle says, “and it needs warehousing to support its business. That’s not easy to replicate.”

(Photo by Paul Goyette)