Interactive Investor

Why commodities excel as inflation hedges

26th November 2021 09:56

Faith Glasgow from interactive investor

As well as helping combat rising inflation, commodities make a portfolio more efficient, says Faith Glasgow.

UK consumer price index (CPI) inflation hit 4.2% for the year to October - its highest level for a decade. In the US, it reached 6.2%, a 31-year record.

It’s not just the fact that these figures are so high that is worrying commentators, but that in both cases they exceeded market expectations. For the UK, a Reuters poll of economists had predicted inflation at 3.9% for October, while in the US a Bloomberg consensus survey forecast 5.9%.

ETF provider WisdomTree suggests that market expectations are not based on the realities on the ground. “The central bank mantra of inflation being transitory is becoming harder and harder to swallow,” comments Nitesh Shah, head of commodities and macroeconomic research at WisdomTree, in a recent research note.

“We believe that supply-side shocks are both larger and more persistent than the market had expected,” he adds.  “Tell-tale signs of supply bottlenecks are littered through the details, including elevated energy and autos prices. Even services are showing broad-based price increases indicating a shortage of labour.”

High inflation could be here to stay

Investors are therefore faced with the question of how best to protect their portfolios against erosion by rising prices that could be more significant and deep-seated than the experts predict.

Comparing the performances of a range of US-based asset classes over the past 51 years, relative to US inflation over that time, WisdomTree highlights commodities as the standout hedge of choice.

Over the very long term, broad commodities have returned almost 2.5 times inflation, far outpacing both high-yield bonds and US Treasury inflation-protected securities (TIPS), although both these asset classes also did better than inflation. In comparison, US equities have trailed inflation by 0.72%, and conventional Treasuries and corporate bonds are also behind.

Shah makes the additional point that in a historical context commodities have been particularly valuable in outperforming inflation that was ‘unexpected’. In other words, higher than markets had been pricing in. “If the drivers of inflation today are unexpected, then commodities are the place to turn to,” he observes.

Rory McPherson, head of investment strategy at wealth manager Punter Southall, agrees that commodities are a good choice in inflationary times, pointing out that the firm’s commodities investment is up around 30% this year.

However, the term ‘commodities’ covers a multitude of resources, not all of which are equally sensitive to price increases. McPherson draws a distinction between precious metals and broad commodities as defined by the Bloomberg Commodity Index (which includes the likes of sugar, coffee, cotton, energy, grains, livestock and industrial metals).

“Food and energy drive a lot of the choppiness in inflationary measures,” he explains. “They are what consumers feel in their pocket day-to-day and hence what we as investors want to protect against.” Punter Southall gets its commodities exposure through the Lazard Commodities fund, which buys and sells futures to gain exposure to the underlying physical assets.

“Of course, clients don’t like the extra cost incurred with filling up the car or turning on the heating, but its some comfort to have an investment which directly captures pick up in energy prices as well as other everyday items such as grains and sugar,” McPherson adds. 

An additional benefit of commodities from a portfolio-building perspective, he says, is that “they help to improve the efficiency of portfolios as their correlation to equities and bonds is very close to zero”.

Should investors go for gold?

What about gold, which is probably the first asset people have tended to think about when inflation is mentioned?

“Precious metals such as gold play a slightly different role and help hedge more against a stagflationary environment, where inflation is on the rise but growth is slowing,” explains McPherson.

Against that kind of backdrop, fixed deposits become less attractive and investors look to assets with a proven real store of value, gold being an obvious port of call.

However, gold has disappointed over the past year, athough it did pick up and break through $1,860/oz for the first time in five months in the wake of the US inflation figures.

“Gold miners similarly had their best week since June 2020, with an 8% rise over the week,” adds McPherson.

Says Shah: “Our internal forecast models indicate that with this strength of inflation, gold should be trading closer to $2,300.” Factors such as the strength of the US dollar and the impact of expected tightening of US monetary policy are likely to work against that, he adds, but it “could still rise to $1,900 by the end of this calendar year”.

So both gold and broad commodities have a role to play in helping investors protect their portfolios against the erosive effects of inflation, and both are likely to be in demand in the coming months as a consequence.

In fact, stresses McPherson: “There isnt one single inflation hedge that is going to do the job; we use a broad spread of commodities, index-linked bonds, gold equities, infrastructure equities and certain floating rate fixed interest, to name but some.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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