by Inflation hedging
Commodity returns have tended to pick up when inflation has been rising and decline when inflation has been falling, in contrast to both equities and bonds.
Other asset classes which are typically considered inflation hedges, such as real estate and inflation-linked bonds, currently trade on historically very expensive valuations, unlike commodities.
While deflationary pressures exist, there are signs that inflation is building.
Labour markets are tight and the 12-month core inflation rate, which excludes commodity prices, has been running above 2% since last November. It would be complacent to ignore the dangers of inflation.
All the more so given the sums that have been pumped into the financial system and the policy bias towards generating inflation.
Commodities diversify equity risk
Commodities diversify equity risk but, given their intrinsic link with economic growth, it would be unrealistic to expect them to hedge so-called tail risks such as the economic downturn resulting from the financial crisis of 2008-09.
In reality, the relationship between commodities and equities varies considerably. At times there is a negative correlation, but on average they show a low but positive correlation.
Nonetheless, so long as commodities are not perfectly correlated with equities, even a small allocation to an equity-heavy portfolio can result in a reduction in overall volatility.
Assuming a 0.2 correlation between equities and commodities, reasonable given historic experience, we estimate that commodities only have to generate returns of around 2% a year to improve portfolio risk-adjusted returns.
Potential for more attractive risk-adjusted returns
So far we have argued that there is a case for a strategic allocation to commodities even if returns are relatively muted. In fact, however, current conditions suggest that they could actually be much better than that.
Certainly, commodities look cheap compared with their history, particularly against equities.
Furthermore, many commodities are trading below their costs of production, a key valuation anchor. They are one of the few global asset classes that can lay a claim to being cheap.
So, we would argue, there has rarely been a better time to buy commodities. However, effective implementation is key.
Passive investors tracking well known benchmarks are exposed to a host of undesirable costs and consequences which active managers can avoid or even profit from.
With prices low and many commodities poorly-researched, this should be an excellent environment in which active managers could add value.
