Time-varying dependence dynamics between international commodity prices and Australian industry stock returns: a Perspective for portfolio diversification

Abstract

This paper investigates the time-varying dependence dynamics between the international commodity prices of Brent crude oil, natural gas, cocoa, and Australia's sectoral stock returns, using daily prices ranging from 1st December 2011 to 23rd April 2020. The considered sector stocks include Technology, Telecom, Real Estate, Energy, Basic Materials, Utilities, Industrials, Financials and Health Care. We employ the time-varying Markov-switching copulas to investigate the dynamic dependence between those international commodity prices and the Australian industry stocks returns, as well as using various portfolio techniques including the minimum variance portfolio, the minimum correlation portfolio and the recently developed minimum connectedness portfolio to test portfolio performance. We establish that the dependence between the commodities and sectoral stock returns is Markov switching and time varying. Our results further show that Brent crude oil is a good hedge for the financial sector, natural gas is a good hedge for all sectors except the real estate, and cocoa co-crashes with the technology, industrials and real estate sectoral returns. Based on the hedging effectiveness of the competing portfolios, we show that bivariate and multivariate portfolios significantly reduce the risk of investing in a single asset. In particular, the results indicate the significant role for commodities, with weights ranging from approximately 25% to 50%, depending on the portfolio construction of choice. Australian stocks typically have the lowest portfolio weights under all competing portfolios, thus confirming their hedging role to a commodity investment portfolio. Our analysis contributes unique evidence to the literature on the role of commodity assets as a complement to mainstream investment.