Macroeconomic Fundamentals to the Commodity Risk Premium

Abstract

This chapter aims to build a connection between commodities’ price movements and the growth level in industrial production in different economic regions. Commodities should only be incorporated in a diversified strategy as long they either have a poor correlation to standard assets such as equities, or offer an attractive risk premium. We demonstrate that the part of commodity return not attributed to the roll yield is related to economic activities in the U.S. and China. 40 to 50% of variation in commodities returns are explained by industrial production growth in those both regions. The slow-down of economic activity implies lower excess returns on commodities. Similar to the risk premium on equities and credit, the commodity risk premium is dependent on the economic environment. This finding casts doubt on both commodities’ diversification potential, and investor’s interest in this asset class in terms of expected risk premium, given the current low world structural growth.