wJerome Powell sweep Testifying before Congress on March 7 brought an irrepressible sense of déjà vu. The Fed Chairman warned that “the process of bringing inflation down to 2% still has a long way to go and is likely to be bumpy.” Recent economic data indicates that “the final level of interest rates is likely to be higher than previously expected.” It’s a message that Powell and his colleagues have been repeating, in various forms, since the Fed began raising interest rates a year ago. As so often before, markets that have calmed themselves into complacency dimmed and sold off.
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Investors are serially reluctant to take Powell at his word because the implications are unpleasant for them. An ideal portfolio might contain a mix of asset classes that each thrive in different economic scenarios. But all traditional categories – cash, bonds and equities – do poorly when inflation is high and rates are rising. Inflation erodes the value of both the cash and coupon payments of fixed-rate bonds. Higher rates push down bond prices to match their yields to those prevailing in the market, and hit stock prices by making future earnings less valuable today.
Elroy Dimson, Paul Marsh, and Mike Staunton, three academics, explain this at Credit Suisse’s Global Investment Returns Yearbook. They show that between 1900 and 2022, both stocks and bonds beat inflation handily, posting annual real returns of 5% and 1.7%, respectively. But during the years of high inflation, both have performed poorly. On average, real bond yields flipped from positive to negative when inflation rose to more than 4%. Stocks did the same at about 7.5%. In “stagflationary” years, when high inflation coincided with low growth, things got a lot worse. Stocks lost 4.7 percent and bonds 9 percent.
In other words, neither bonds nor stocks are short-term hedges against inflation, even if it exceeds both in the long term. But this dismal conclusion is accompanied by a brighter one. Commodities, as a frequent source of inflation, provide an effective hedge. Moreover, commodity futures contracts that offer exposure without having to buy actual barrels of oil or bushels of wheat seem like a diversified investor’s dream asset.
To see why, start with the excess yield on cash-like Treasury notes. In the long term, the yearbookThe report’s authors put that at 6.5% annually for dollar investors, outperforming even US equities at 5.9%. Better yet, this return is achieved while not correlating too much with stocks, and moving inversely with bonds.
Commodity futures contracts can be mixed with other assets for a portfolio with a much better trade-off between risk and return. At historical rates, a portfolio that’s evenly split between stocks and commodity futures will have a better return than a stock-only portfolio, and three-quarters of the volatility. Best of all for an investor who fears high inflation and low growth, commodity futures have had an average excess return of 10% in stagflationary years.
All this appeals to those with higher incomes from finance. M Capital Management, a hedge fund known for its mathematical sophistication, published a paper this past April titled: “Building a Better Commodity Portfolio.” Citadel, an investment firm that last year broke the record for the largest annual gain in dollar terms, has been building its commodities arm for years. This part of the business is said to have generated a significant portion of Citadel’s $16 billion in net profits for customers.
However, commodity futures remain an esoteric asset class rather than a staple of a portfolio. Like any investment, they do not offer guaranteed returns, as history shows. Gary Gorton and Geert Roanhorst, two academics, brought widespread attention to the merits of commodities with a paper published in 2006. It was just in time for a deep and prolonged crash, starting in February 2008. From this point on, a broad index of commodity prices emerged It lost 42% in real terms and didn’t regain its peak until September 2021. Investors were scared.
Another reason is that the market is small. Of the $230 trillion in total global investable assets, commodity futures contracts make up just under $500 billion, or 0.2%. Physical supply, meanwhile, is restricted. If the world’s largest investors pumped capital into the futures market, they would be subject to enough price distortion to make the process unfeasible. But for smaller fashions — and fast-money ones like Citadel — commodity futures offer plenty of advantages. This is true even if Powell continues to spread the bad news.
Read more from Buttonwood, our financial markets columnist:
Anti-ESG Industry Takes Investors for a Tour (March 2)
Despite the bullish talk, Wall Street has reservations about China (Feb 23)
Investors Expect Economy to Avoid Recession (Feb 15)
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