The Impact of Commodity Price Fluctuations on Investment Styles

Abstract

This thesis aims to investigate the impact of fluctuations in commodity prices on the returns of various investment styles and identify the specific commodity classes that exhibit strong predictive power. The study focuses on three commodity classes, food, energy, and precious metals, applied to the value, growth, and momentum investment styles, which exhibit dominance and consistency across all the countries examined. Through empirical analysis, the study seeks to contribute to the existing literature by estimating the predictive power of commodity prices on investment style returns. A deeper understanding of the relationship between investment styles and commodity prices may provide investors with more effective strategies for achieving their investment objectives and navigating the challenges posed by volatility in commodity markets. Drawing upon the research conducted by Dladla and Malikane (2019), our study builds upon the foundational framework of the linear asset pricing model. We extend the stock returns model with commodity prices. We use the real domestic and decomposed prices of commodities, reflecting the real exchange rate and the US dollar denominated international price. In addition to commodity prices, we introduce three macroeconomic variables: interest rates, the output gap, and the real exchange rate. We estimate the baseline models for six countries: the United States, the United Kingdom, Australia, Canada, South Africa, and Brazil. The findings of this investigation indicate that fluctuations in commodity prices, interest rates, and the output gap play an important role in explaining the returns on investment styles. We find that food and energy prices, real interest rates, and the output gap significantly explain returns on investment styles. Real interest rates exert a positive impact on returns on investment styles. This effect has been statistically significant in all the countries. The output gap displays a negative impact on returns on investment styles. Furthermore, we find that commodities have a negative effect on returns on investment styles. Food prices negatively impact returns on investment styles across all the countries. This effect holds statistical significance in the United States, United Kingdom, Australia, and South Africa. We further note that energy prices exert a similar impact as food prices. The effect of energy prices is statistically significant in the United States, United Kingdom, Australia, Canada, and Brazil. Notably, the impact of energy prices on returns appears consistent across the three investment styles. However, we note that the impact of precious metals is not statistically significant in any of the countries, except in Canada, where we note a positive effect on returns on momentum styles. The effect of food and energy prices on returns on investment styles is in line with Gorton and Rouwenhorst (2006), who argue that this is primarily due to the distinct behavior exhibited by commodities across different phases of the business cycle. They suggest that commodities typically demonstrate a positive association with inflation and are influenced by a combination of demand-side fundamentals and supply-side dynamics. This divergence in the behavior of commodities implies that their relationships with equity markets vary inherently. On the other hand, precious metals exhibit a different pattern compared to food and energy prices, as they are often perceived as safe-haven assets