Commodity Futures Return Predictability and Intertemporal Asset Pricing

We find out-of-sample predictability of commodity futures excess returns using forecast combinations 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 significantly positive predictive power for future economic activity. Two-factor models featuring innovations in each of the combination forecasts and the market factor explain a substantial proportion of the cross-sectional variation of commodity and equity returns. The associated positive risk prices are consistent with the Intertemporal Capital Asset Pricing Model (ICAPM) of Merton (1973), given how the predictors forecast an increase in future economic activity in the time-series. Overall, combination fore- casts act as state variables within the ICAPM, thus resurrecting a central role for macroeconomic risk in determining expected returns.