Tactically allocating to individual commodities when conditions are ripe has historically only been within the realm of a small group of domain expert traders. But as the broad cohort of market participants becomes more sophisticated and access to alternative asset classes improves, it is possible that the tactical allocation to commodities will expand. Commodities can be used as building blocks to express thematic macro plays and can easily be traded due to highly liquid and robust markets. Commodities also benefit from being equally tradeable both long and short. Single-commodity indices tracking front-month futures contacts allow market participants to easily gain exposure on the long or short side.
A number of current market trends may be interesting to see through a commodities lens—the post-COVID-19-pandemic recovery and associated inflationary pressures and the growth in green technology, for example.
For many market participants, unprecedented and coordinated fiscal stimulus in the wake of the COVID-19 pandemic has justified concerns over inflation. Historically, commodities, and in particular gold, have demonstrated a high inflation beta and may provide a suitable inflation hedge (see Exhibit 5).
Exhibit 5: S&P GSCI and S&P GSCI Gold Inflation Protection
Source: S&P Dow Jones Indices LLC, Federal Reserve Bank of St. Louis. Data from December 1978 to February 2021. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with back-tested performance. Inflation is defined as the year-over-year percentage change in the monthly U.S. CPI. Average year-over-year S&P GSCI and S&P GSCI Gold returns since index inception.
The risk of inflation centers on whether the post-COVID-19-pandemic recovery will be merely reflationary or truly inflationary. Quantitative easing since 2008 has proved inflationary for only paper assets (i.e., equities), but there is an argument to be made that after the COVID-19 pandemic, coordinated, real-asset heavy fiscal spending may prove inflationary. Even though the trajectory of real asset inflation is likely lower due to structural changes in demographics, technology, consumption, and productivity, starting from a low inflation level means even a small increase in inflationary pressure can lead to notable asset repricing. As the last period of prolonged inflation occurred decades ago, most investors have not experienced it. It may be difficult for them to assign a probability to a sustained period of inflation as well as to adapt portfolio construction should the probability be sufficiently high. Investors tend to have short memories.
Historically, commodities have had higher volatility than most other asset classes over the short and long term (see Exhibit 6). It may not take a lot of exposure to either a single-commodity index or a broad-commodities index to reap the benefits of inflation protection.
Exhibit 6: Short- and Long-Term Asset Class Performance and Volatility
Source: S&P Dow Jones Indices LLC. Bloomberg. Data from February. 28, 1991, to February 26, 2021. Index performance based on total return in USD. Equities are represented by the S&P 500 and bonds are represented by the Barclays US Aggregate Bond Index. Past performance is no guarantee of future results. Table is provided for illustrative purposes.
Technology used to mitigate or reverse the effects of climate change is expected to play a vital role in the near future. Besides rare earth metals, the building blocks for many of these technologies are industrial commodities such as copper, aluminum, nickel, and silver (see Exhibit 7).
According to a recent World Bank Group report, over three billion tons of minerals and metals will be needed to deploy the wind, solar, and geothermal power, as well as energy storage, required for achieving a below 2°C future (Hund et al., 2020).
Historically, technology has worked against commodities, either by encouraging substitution or improving productivity and thereby requiring less of a certain raw material to meet demand. But in the case of decarbonization, the opposite is true; the adoption of green technologies signals strong demand for many commodities.
Exhibit 7: World Bank Low-Carbon Future Scenario Metals
Molybdenum
Neodymium (proxy for rare earth)
Nickel
Silver
Steel (engineering)
Zinc
Source: World Bank. Data as of 2020. Table is provided for illustrative purposes.
