Watching Jerome Powell testify before Congress on March 7 brought on an irresistible sense of déjà vu. “The process of getting inflation back to 2% has a long way to go and is likely to be bumpy,” the Federal Reserve chairman warned. Recent economic data suggests that “the final level of interest rates is more likely than ever.” expected.” It’s a message Mr. Powell and his allies have been repeating in various forms ever since the Fed began raising rates a year ago. As at times before, markets that cloaked themselves in a sense of complacency Well, they 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 Credit Suisse’s Global Investment Returns Yearbook. 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 the 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. Over the long run, the authors of the annuity put it at 6.5% annualized for dollar investors, outpacing even U.S. 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, an investment firm, last year broke the record for the largest annual profit in dollar terms. Having built up its commodities arm over the years, it is reported that this part of the business has made up a large part of the $16bn net profit stronghold it has built up 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 capitalize on 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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