The Strategic Case for Commodities

Commodities tend to offer three strong benefits to portfolios: diversification, inflation protection, and return potential. Commodities have been the best-performing asset class in the last three years as of 3/31/2023 with the BCOM index outperforming both the S&P 500 and the Bloomberg Global Aggregate Index. This is likely due to fundamentally driven, structural dynamics in the sector, including underinvestment. But the strong recent performance has also been enhanced by ongoing geopolitical developments, highlighting how commodities may provide critical portfolio diversification during inflationary periods.

This backdrop raises a natural question: Should investors continue to allocate to commodities even if, for example, inflation concerns diminish, or we experience a mild recession? We believe the answer is yes. In examining the three well-known potential benefits of investing in this asset class, we find the strategic case for commodities is strong today and in the long term.

Diversification remains critically important

The typical 60/40 stock/bond portfolio construction assumes that fixed income and equities are inherently diversifying, with low correlations (when asset class returns tend to move in the same direction over time, we say they are highly correlated) – that are ideally sufficient for investors seeking to weather various macroeconomic conditions. For much of the past 25 years, this assumption has been largely met, until the past year or two. Correlations between stocks and bonds recently have reached levels not seen since the late 1990s, with recent rolling 12-month correlations around 0.75 versus the long-term average of 0.19 for the period 1977–2023. This greatly reduces any assumed diversification benefits and underscores the need for true sources of diversification to traditional 60/40 portfolios. Long-term data for stocks, bonds, commodities, and inflation indicate commodities historically tend to be the most correlated with inflation (0.43), while they are negatively correlated with bonds (−0.27) and only slightly positively related to stocks (0.24).

Why do commodities tend to offer these diversifying tendencies? Commodities are “real assets” that react to changing supply and demand fundamentals in different ways than stocks and bonds, which are “financial assets.” The supply and demand of commodities is affected by many factors such as capex (or lack thereof) within commodity industries, geopolitics, and regulation/policy. Today, policy efforts to address climate change by transitioning away from traditional hydrocarbons, combined with efforts to re-shore supply chains and build resiliency, are likely, at least on our secular horizon, to be quite supportive for commodities as an asset class. Climate change itself also appears to be having real adverse effects on agricultural commodities supplies.

Simply said, while commodities do share a sensitivity to the macro cycle with other assets, commodities also have their own separate, idiosyncratic drivers. Problematically for investors, history has shown that when these idiosyncratic drivers lead to a commodity rally, they often diminish returns in other asset classes. As such, commodities may provide valuable diversification benefits when they are most needed. For example, as shown in Figure 2, commodities can offer significant diversification benefits compared to stocks and bonds when inflation surprises to the upside.

Inflation – upside surprises more common and more problematic than downside

Commodities have long exhibited positive correlation with realized inflation (on average 0.43, since 1976). This should not be surprising as commodities (food and energy, for example) typically represent a large share of the U.S. headline CPI basket directly (currently about 38%), but also indirectly in terms of their inputs into other components of the CPI. Despite only representing roughly 3% of U.S. CPI, gasoline alone accounts for a staggering 50% of U.S. CPI volatility. Outside the developed world, food and energy constitute an even greater share of the inflation basket.

Why is it important to look at inflation surprises? To the extent that equities and fixed income are efficient and forward-looking, it is often the surprises in inflation that pose meaningful risks to portfolios. For much of the past 25 years (the period relied on for much of modern portfolio construction theory and analysis), inflation itself and inflation surprises were relatively mild. However, recent events remind us that a longer history is not so sanguine. Large inflation surprises of 6%–8% are not uncommon and, importantly for investors, we have observed that upside surprises historically are more severe than downside surprises. Notably, the relationship between commodity returns and inflation surprises has been strongly correlated (0.78) since the 1970s (from when we have reasonably complete data). Looking ahead to the next several years, with considerable uncertainty over the path of inflation, we argue that inflation hedging is paramount, and commodities can be a potent inflation hedge. As we illustrate in Figure 4, the BCOM historically has outperformed the traditional 60/40 and even TIPS during inflation surprises.

Recession potential shouldn’t derail the structural outlook

Every recession has its own catalysts, characteristics, depths, longevities, and eventual paths to recovery. Since the end of World War II, the U.S. economy has experienced 12 recessions, which is one every 6.1 years on average. Figure 5 overlays BCOM index returns with periods of growth and recessions (the shaded time periods) from January 1975 to October 2022. As a general observation, commodity prices tend to accelerate before a recession, when demand is strong and the economy is overheating. The exception was the recession of 1981 and the COVID-induced recession of 2020, which was exceptional in that it lasted just two quarters but was severe (with a 29.9% annualized decline in GDP). As commodities are a critical component of economic activity, when the economy suffers, generally speaking the demand for commodities declines and prices retreat (with the exception of gold).

The commodity price response after a recession tends to be closely related to the starting conditions going into it. History suggests that when spare capacity and investment is limited prior to a recession, supply constraints tend to reassert once demand growth resumes, much as we saw in the period following the recession in early 2000s (which preceded the last commodity supercycle) and the more recent COVID demand shock. We believe these two periods provide the most apt comparison to conditions today, and a long-term investor may want to view weakness in the case of a mild recession as an opportunity to gain inflation protection.

Timing is hard, but informed portfolio construction shouldn’t be

As the last few years have demonstrated, inflation poses meaningful risk to the standard 60/40 portfolio. Perfect foresight would enable investors to know when to de-risk and/or add inflation-sensitive assets, but much like forecasts for any macro variable or market, significant uncertainty exists, with unexpected shocks posing the greatest risk to portfolio construction. As has been evidenced in history (Figure 6), a portfolio optimization exercise, with hindsight bias, would at times heavily weight commodities when inflation is rising and other assets classes struggle. It is in these moments of greatest vulnerability for markets that commodities can serve an incredibly important diversification role.