Wadding Jerome Powell Testifying before Congress on March 7 brought on an irresistible sense of deja vu. “The process of getting inflation back to 2% has a long way to go and is likely to be difficult,” the Federal Reserve chairman warned. Recent economic data suggest that “the final level of interest rates is likely to be higher than previously estimated.” It’s a message Mr. Powell and his allies have been repeating in various forms since the Fed started raising rates a year ago. As at times before, markets that had covered themselves with a sense of complacency got scared and sold out.
Investors are progressively reluctant to listen to Mr. Powell because the implications are unpleasant to them. An ideal portfolio consists of a mix of asset classes that each prosper in different economic scenarios. But when inflation is high and rates are rising, all traditional classes—cash, bonds, and stocks—underperform. Inflation erodes the value of both the cash and the coupons paid by fixed-rate bonds. Rising rates push bond prices down to align with their prevailing market yields, and drive down stock prices by making future earnings less valuable today.
Elroy Dimson, Paul Marsh and Mike Staunton, three academics, demonstrate this in a book by Credit Suisse global investment returns annuity, They show that globally, between 1900 and 2022, both stocks and bonds handily beat inflation, posting annual real returns of 5% and 1.7%, respectively. But both performed poorly during years of high inflation. On average, real bond returns went from positive to negative when inflation rose above 4%. Stocks did the same at about 7.5%. In years of “stagflation”, when high inflation coincided with low growth, things got much worse. Shares fell 4.7% and bonds fell 9%.
In other words, neither bonds nor stocks are short-term hedges against inflation, even though both tend to outpace it over the long term. But this dismal conclusion is paired with a brighter conclusion. Commodities, as a persistent source of inflation, provide an effective hedge. What’s more, commodity futures — contracts that offer exposure without the need to purchase actual barrels of oil or bushels of wheat — look like a diversified investor’s dream asset.
To see why, start with their excess returns on Treasury bills such as cash. In the long run, the annualThe authors put it at an annualized 6.5% for dollar investors, outperforming even US stocks’ 5.9%. Better still, this is achieved with returns being slightly correlated with stocks and inversely with bonds.
Commodity futures can be mixed with other assets to better trade-off between risk and return for the portfolio. At historical rates, a portfolio that is split evenly between stocks and commodity futures will have better returns and three-quarters the volatility than a stock-only portfolio. Best of all, for an investor fearing high inflation and low growth, commodity futures had an average excess return of 10% in stagflationary years.
All this is appealing to the high-octane end of finance. aqr Capital Management, a hedge fund known for its mathematical sophistication, published a paper last April titled: “Constructing Better Commodity Portfolios”. Citadel, the investment firm that last year broke the record for the biggest annual profit in dollar terms, has been building its commodities arm for years. This part of the business is said to have made up a major portion of the $16 billion net profit generated for clients.
Yet commodity futures remain a rather esoteric asset class as a portfolio staple. Like any investment, they do not offer guaranteed returns, as history shows. Gary Gorton and Geert Rovenhorst, two academics, brought the merits of objects into wider focus with a paper published in 2006. It was the perfect time for a deep, protracted crash that began in February 2008. From this point, a broad index of commodity prices lost 42% in real terms and did not reach its peak until September 2021. Investors got scared.
Another reason is that the market is small. Of the total global investable assets of $230 trillion, commodity futures account for $500 billion, or less than 0.2%. Meanwhile, physical supply is constrained. Were the world’s largest investors to commit capital to the futures market, they would be liable to distort prices to render the exercise futile. But for smaller organizations – and fast-money bastions like these – commodity futures offer a number of advantages. This is true even if Mr. Powell carries bad news.
Read more from Buttonwood, our columnist on the financial markets:
The anti-ESG industry is misleading investors (2 March)
Despite Bullish Talk, Wall Street Has Objections to China (23 February)
Investors hope the economy will avoid recession (15 February)
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