Commodity futures return predictability and intertemporal asset pricing

We find out-of-sample predictability of commodity futures excess returns using combination forecasts of 28 potential predictors. Such gains in forecast accuracy translate into economically significant improvements in certainty equivalent returns and Sharpe ratios for a mean–variance investor. Commodity return forecasts are closely linked to the real economy. Return predictability is countercyclical, and the combination forecasts of commodity returns have significant predictive power for future economic activity. Two-factor models featuring the market factor and the innovations in each of the combination forecasts explain a substantial proportion of the cross-sectional variation of both commodity and equity returns. The associated positive risk premiums are consistent with Merton's (1973) intertemporal capital asset pricing model (ICAPM), given how the combination forecasts predict an increase in future economic activity and a decline in stock market volatility in the time-series. Overall, combination forecasts act as state variables within the ICAPM, thus resurrecting a central role for macroeconomic risk in determining expected returns on commodities.