The massive amount of monetary and fiscal stimulus injected into the global financial system over the last year has generated much discussion and speculation about the potential for higher future inflation. Predictably, we have been asked by many clients about the appropriateness of commodity investments in such an inflationary environment. In this quarterly review, we attempt to evaluate the pros and cons of commodity investing, while clarifying some firmly-held beliefs about their investment benefits.
Generally speaking, commodities deserve a place in most broadly-diversified investment portfolios. Historically, their inclusion has been for the inflation-hedging benefits they provide. In fact, commodities have outperformed inflation over the past 20 years, with about a 60% correlation. However, over longer periods of time the correlation is not stable enough to justify a large, strategic allocation to the asset class. Importantly, commodities do well in periods of higher inflation when equities and bonds tend to suffer. Their role as an inflation-hedge is more compelling relative to other alternatives during periods when interest rates are likely to rise, though they remain fairly closely correlated to inflation rates under all interest rate environments. Other common inflation protection vehicles, such as real estate, tend to exhibit poorer correlations as interest rates rise.