Wlook at jerome powell Testifying before Congress on March 7 brought an irrepressible sense of déjà vu. The Fed chair warned that “the journey to get inflation back to 2% is a long way off and likely to be bumpy.” Recent economic data suggests that “the final level of interest rates may be higher than previously Expectations.” Powell and his colleagues have been repeating that message in various forms since the Fed began raising rates a year ago. As many times before, markets that let themselves into complacency get spooked and sell off.
Investors have repeatedly been reluctant to take Mr. Powell’s word for what it means to be unpleasant for them. An ideal portfolio will contain a mix of asset classes, each of which does well in different economic scenarios. But all traditional categories — cash, bonds and stocks — underperform when inflation is high and interest rates are rising. Inflation erodes the value of cash and the coupons paid by fixed-rate bonds. Rising rates depress bond prices, keeping their yields in line with the prevailing market, and hit stock prices by reducing the value of future earnings today.
Three academics Elroy Dimson, Paul Marsh and Mike Staunton at Credit Suisse Global Investment Return YearbookThey show that, globally, from 1900 to 2022, both stocks and bonds handily beat inflation, with annualized real returns of 5% and 1.7%, respectively. But in years of high inflation, both underperform. On average, real bond returns turn from positive to negative when inflation is well above 4%. Equities performed the same, around 7.5%. Things got worse during the “stagflation” years, when high inflation coincided with low growth. Stocks fell 4.7%, while bonds fell 9%.
In other words, neither bonds nor stocks are short-term hedges against inflation, even though they both outperform inflation in the long run. But this gloomy conclusion is paired with a brighter one. Commodities, a common source of inflation, provide an effective hedge. What’s more, commodity futures — contracts that provide exposure without buying actual barrels of oil or bushels of wheat — look like a diversified investor’s dream asset.
To see why, start with their excess returns relative to cash-like T-bills. In the long term, yearbookThe author of the book puts the annualized rate of return for dollar investors at 6.5%, which even exceeds the 5.9% of the US stock market. Even better, that return came with little to no correlation to stocks, the opposite of the trend for bonds.
Commodity futures can be mixed with other assets to form a portfolio that achieves a better trade-off between risk and return. At historical exchange rates, a portfolio split evenly between stocks and commodity futures would have outperformed a stock-only portfolio with only three-quarters the volatility. Most importantly for investors worried about high inflation and low growth, commodity futures have averaged an excess return of 10% in stagflation years.
All of this appeals to the high-octane end of the financial industry. aquarium Capital Management, a hedge fund known for its proficiency in mathematics, published a paper last April titled “Building Better Commodity Portfolios.” Citadel, an investment firm that broke a record for its biggest annual gain in dollar terms last year, has been building its commodities unit for years. That segment accounts for a substantial portion of Citadel’s reported $16 billion net profit for clients.
However, commodity futures remain an esoteric asset class rather than a major component of a portfolio. As history has proven, like any investment, they do not offer guaranteed returns. A 2006 paper by two academics, Gary Gorton and Geert Rouwenhorst, drew widespread attention to the value of commodities. That coincided with a deep, lengthy crash that began in February 2008. Since then, the broad index of commodity prices has actually fallen 42% and won’t return to its peak until September 2021. Investors were scared off.
Another reason is that the market is small. Commodity futures account for less than $500 billion, or 0.2%, of the $230 trillion in total global investable assets. Meanwhile, physical supplies are constrained. If the world’s largest investors put money into the futures market, they would likely distort the price and render the practice futile. But for smaller companies — and companies that make quick money like Citadel — commodity futures offer a lot of advantages. This is the case even as Mr. Powell keeps delivering bad news.
Learn more from our financial markets columnist Buttonwood:
Anti-ESG industries are attracting investors (March 2)
Wall Street takes China with reservations despite bullish rhetoric (Feb. 23)
Investors expect economy to avoid recession (February 15)
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