If inflation spikes, investors could use commodities to hedge against it.
Whether you think commodities are an asset class or not, there’s little doubt these days that inflation-protecting a portfolio almost definitely needs to involve commodities, whether with a futures-based or equities-based approach.
That point came through loud and clear at this year’s IndexUniverse Commodities conference last week in Chicago. Commodities as a group show strong correlation to inflation, which makes them vital tools in protecting wealth in the face of slipping value of the U.S. currency, panelists said.
A look at 200 years of economic history shows that a basket of diversified commodities—including grains, softs, livestock and metals—is strongly correlated to inflation in a way in which no other asset class comes even close, according to Yale Professor Geert Rouwenhorst, the father of modern commodities investing and the brain behind some of the indexes in United States Commodity Funds’ ETFs.
“Commodities have a better correlation to inflation than traditional asset classes,” Rouwenhorst said during a luncheon address at the conference, which was held at the Ritz Carlton in Chicago on Wednesday, Oct. 10. “And, a portfolio of commodities tracks inflation better than individual commodities.”
The whole subject of inflation is front and center since the Federal Reserve launched its third round of quantitative easing last month to shore up a weak job market and urge on incipient signs of recovery in housing. The dollar has been slipping and gold prices have risen, particularly in the weeks ahead of the “QE3” announcement.
To be sure, commodities markets are not for the faint of heart, because if there’s one thing commodities have proven to be, it’s that they’re volatile. As Dennis Gartman, editor of “The Gartman Letter,” put it at the conference, “One thing I’ve learned in the world of commodities is that they go up and they go down”—often with great swiftness.
That volatility has kept many risk-averse investors leery of jumping head first into commodities, but the asset class has been gaining momentum. From an assets perspective, commodities ETFs represent roughly 10 percent—or $123.78 billion—of the total U.S.-listed ETF assets of roughly $1.30 trillion, according to data compiled by IndexUniverse.
Not only are commodities highly correlated to inflation, but they often have returns that are largely uncorrelated to other asset classes such as stocks and bonds, giving investors diversification—a concept Rouwenhorst made clear in his 2005 seminal work on commodities investing, Facts and Fantasies about Commodity Futures.
Many at the conference argued a strong case for gold as a solid hedge against inflation, and indeed, Rouwenhorst’s research showed that gold, throughout history, has consistently outperformed inflation.
Still, he argued, if investors are looking for a hedge against inflation, a broad basket of commodities would be a more weatherproof allocation than picking a single market such as gold.
The China Question
At the end of the day, many still seem to think that the commodities rally is not on its last legs, thanks to a growing global population that’s also marked by a booming middle class.
China remains the question mark in the outlook, as its slowing economic growth casts a shadow on demand for various commodities, from soybeans to steel.
China is the largest producer and largest importer of several commodities, and while the country’s slowing growth—now seen at about 7 percent—is causing concern, its planned infrastructure investment over the next 10 years, as well as a growing middle class, should keep demand for goods strong, many said.
To that point, AgResource Chief Economist Bill Tierney noted China’s commodities production constraints such as increasing production costs are rising “sharply and more rapidly than in other emerging countries,” as well as its inadequate water resources and conservation policies.
“China is going to be dependent on imports to meet its growing demand,” Tierney said.