Consider commodities as inflation hedge and to diversify portfolios
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THE dual crises of the past 2 years have shone the spotlight on commodity markets. The first is the pandemic-induced disruptions across the commodity supply chain. The second is the Russia-Ukraine war which, coupled with rising demand from the post-pandemic reopening, has sent commodity prices through the roof.
But while this price volatility may be alarming, it is not without precedent. The inelastic nature of demand and supply implies that short-term price fluctuations in individual commodities are common. Beyond the immediate ebb and flow of commodity prices, however, are more enduring trends that underpin the asset class. These trends include:
- Fossil fuels’ continued relevance in the medium term: Despite the ESG narrative which sets out to phase out fossil fuels in favour of renewables, oil and gas are expected to continue fuelling a significant share of the world’s energy needs in the medium term. Most of the world’s infrastructure is still outfitted to utilise fossil fuels, and renewables are still playing catch-up, for example, in terms of energy density and transportability – 2 key traits for usability in aviation and shipping applications. Couple that with chronic underinvestment in fossil fuel production given the energy transition narrative, and we could see persistent elevated prices as the sector juggles de-carbonisation targets and meeting ongoing energy demand
- A long-term transition to lower carbon intensity: The continued significance of fossil fuels does not detract from a longer-term green-energy transition. This transition is on track to reshape commodity markets in the long run, given the vast amounts of metals that are crucial for the construction of low-carbon infrastructure, such as iron ore for wind farms, copper for solar panels, and lithium for battery storage. Despite this, mining and resource companies continue to underinvest in the production of metals due to regulatory roadblocks. This layers a cost-push element to “greenflation” – or rising costs of materials used in the green transition.
- Global fragmentation driving up price risks: Pandemic-induced supply disruptions over the past two years have fuelled protectionist inclinations as policymakers focus on safeguarding supplies, especially food and energy, as a matter of national security. To add to this, the Russia-Ukraine war may have implications on commodity markets beyond the ongoing sanctions. Firstly, starving Russian hydrocarbon and mineral extraction resources of foreign capital flows will limit supply from Russia in the longer term. Secondly, the current conflict may amplify risks of global fragmentation between democracies and autocracies, with extended ramifications on global trade. This would exacerbate commodity price risks given Russia’s prominence in global commodity trade.
The above trends reiterate that while demand for specific materials could be dramatically altered, the world will always need commodities. The world’s dependence on commodities and the interaction between commodity supply, demand and overall development of technology, make commodities a unique asset class that provides the following benefits to investors:
- Inflation protection: Amid de-globalisation pressures and geopolitical uncertainties that have driven up cost-push inflation, other changes in the structural backdrop such as rising labour power suggest that we may be standing at the cusp of a new inflationary era. Given that high inflation is often accompanied by soaring commodity prices, investors would do well to consider exposure to commodities as an inflation hedge. As a key component of inflation, commodities help defend a typical 60/40 portfolio against the impact of rising prices. In contrast to equities and bonds which have historically shown low or negative beta against inflation, returns of broad commodities displayed significant beta against inflation over the past 50 years, demonstrating commodities’ effectiveness as an inflation-hedging tool.
- Diversification: Recent volatility in both equity and bond markets amid rallying commodities illustrates the diversification benefits of commodities. Low correlations against stocks and bonds allow commodities to reduce the volatility of a typical 60/40 portfolio. Indeed, compared against long-term historical data over the past 50 years, commodity returns displayed low correlations of 0.12 against equities and -0.05 against bonds. These low correlations stem from the sensitivity of commodities to non-financial drivers such as weather, pestilence, and political unrest in producing countries, which are unlikely to influence global equities and bonds to the same extent. To illustrate, over the past two decades, commodities broadly outperformed equities during all but four of the S&P 500’s worst 20 months, demonstrating the value of this asset class in insulating against equity downturns.
On the flipside, investors should also be mindful of risks associated with commodity investing. Since few investors would be interested in receiving physical barrels of oil or bales of cotton, most funds get exposure to commodity prices via the futures market. This comes with the potential of negative roll yields when markets are in contango. This refers to a situation when investors exit futures as they approach maturity, and simultaneously long a now more expensive contract with a more distant maturity date as a replacement.
Additionally, black-swan events such as WTI crude oil futures turning negative during the height of the pandemic on 20 April 2020, brought attention to the possibility that investing in futures could have more downside in prices than expected.
The world’s dependence on commodities, the interaction between supply, demand, and the structural shifts in commodity markets make a compelling investment case for this asset class. Investors can consider complementing their core portfolio with satellite exposure to commodities in order to diversify risk and participate in potential upside from the secular growth trends mentioned in this article. This can be done by exposure to commodity prices through futures or managed funds, or indirectly via equities or ETFs of commodity-related companies across the value chain.
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The writer is chief investment officer at DBS Bank.
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