Commodities’ redemption

Commodities’ redemption

Ben Ross

Head of Commodities

More by this author

Michelle Butler

Senior Portfolio Specialist

More by this author

17 minute read

April 2022

Share

Sign up to get our insights
Subscribe

Commodities have delivered historically strong performance, providing inflation hedging, diversification and compelling returns, with the potential to contribute meaningfully to a real assets allocation.

KEY TAKEAWAYS

 

  • Commodities historically have provided an effective hedge against inflation and event risk.
  • With sectors including energy, agriculture and industrial metals, the asset class offers meaningful portfolio diversification potential.
  • Commodities may offer attractive total returns, propelled by a favorable macroeconomic environment and attractive supply/demand fundamentals.

Why commodities?

The Russian invasion of Ukraine has thrown a spotlight on commodities as virtually every sector—from energy to agriculture to metals—has surged on supply concerns stemming from the war.

The longer the war continues, the higher the likelihood that supply disruptions will persist, with the possibility of lasting shifts in trade flows that could reshape commodity markets for years. While direct sanctions have been limited thus far, port closures, self-imposed embargoes and trade financing obstacles have directly affected the flow of commodities from the region, impacting spot markets.

As a result of the war, tail risks are skewed to the upside for commodities produced in the Black Sea region, in our opinion. However, a pullback in commodity prices is possible. Catalysts for a pullback could include: de-escalation of the war, additional supplies of affected commodities, or a lower-than-expected ultimate impact to flows of Russian- or Ukrainian- produced commodities.

The pronounced price appreciation that commodities have experienced in the face of this geopolitical and inflationary supply shock compared with the reaction in traditional risk assets such as equities and bonds is a stark reminder of why we believe commodities should be a strategic allocation in a well-diversified real assets portfolio.

Even before geopolitical tensions reached a boiling point, commodities had delivered returns ahead of equities in this inflationary environment. We believe the reasons to hold commodities in a real assets portfolio—namely, their strong inflation-hedging characteristics, diversification potential and historical ability to produce attractive total returns over full market cycles— are as strong as ever.

We believe the reasons to hold commodities in a real assets portfolio are as strong as ever.

Commodities have historically outperformed in inflationary environments

In contrast to the slow and shallow recovery out of the global financial crisis, which was characterized by deflationary globalization forces and insufficient demand, the fast and furious recovery out of the Covid pandemic has been characterized by inflationary anti-globalization forces and insufficient supply.

Unprecedented levels of consumer savings and pent-up demand will continue to support economic growth and consumption, in our opinion. At the same time, tight labor markets and impaired supply chains are driving inflationary pressures from the supply side of the economy.

Since the second half of 2021, inflation in the United States has surprised to the upside, with the consumer price index reaching a 40-year high in early 2022, and we think a combination of strong demand and impaired supply points to persistent inflation pressures with the potential to pass through to commodity prices.

Historically, commodities have outperformed traditional asset classes such as stocks and bonds in periods of rising inflation as well as unexpected inflation (Exhibit 1). In fact, even among its real asset peers, such as resource equities, real estate and infrastructure, the historical inflation sensitivity of commodities is superior.

Why is that? Commodities such as energy, grains, softs, livestock and metals serve as direct inputs to inflation measures. Commodities, which are raw materials, also tend to respond more quickly to economic forces—such as supply constraints and changes in global demand—that often drive the prices of other goods higher.

EXHIBIT 1
Historically outperforming stocks and bonds

Average annual real returns in periods of…

Average annual real returns in periods of inflation

Commodities can provide meaningful portfolio diversification

In an environment of elevated inflation and rising interest rates, portfolio diversification may be more important than ever. Commodities have distinct economic sensitivities that tend to differentiate them from stocks and bonds, most notably in relation to inflation and growth periods.

And in times when geopolitical tension and potential supply shocks are high, the factors that negatively impact asset classes such as equities and bonds can positively impact commodities.

Commodities historically have had a low correlation to global stocks (0.42 from 1991 through the first quarter of 2022), adding potential diversification benefits to inflation sensitivity (Exhibit 2). In this case, the low market beta of commodities suggests significant diversification potential, helping to reduce portfolio volatility and, we believe, improve risk-adjusted returns.

EXHIBIT 2
Diversification potential of commodities

Beta to global equities(1) 1991-Q1 2022

Beta to global equities 1991-Q1 2022

Attractive total return potential

A highly favorable macroeconomic environment for real assets generally— and commodities specifically—has unfolded quickly, at a time when supply/ demand fundamentals for commodities were already supportive.

From a fundamental perspective, inventories for many commodities were at multi-year lows at the end of 2021, leaving producers scrambling to meet a resurgence in demand when Covid lockdowns were relaxed (Exhibit 3).

However, the lack of investment in supply in recent years means that ramping up output will take time. Lingering Covid-related production issues, supply-chain constraints and elevated power costs driven by the Russia- Ukraine war only add to the low inventory situation. In sum, we believe the risk of continued supply chain disruptions and tight inventories across many sectors is high. Further evidence of fundamental support can be seen in the shape of the futures curve for many commodities. Elevated demand and tight supplies have resulted in 80% of the commodities in the Bloomberg Commodity Index in backwardation (when spot prices are higher than future prices) as of March 31, 2022.

EXHIBIT 3
Inventory support

Commodity inventories ended 2021 below their 10-year peaks

Commodity inventories ended 2021 below their 10-year peaks

Looking beyond immediate spot fundamentals, support for the asset class may come from global decarbonization. A fixed asset investment cycle linked to the green energy transition, which we believe will incrementally increase demand for many commodities over the next 10 years, is just beginning.

Combined, these fundamental economic factors should provide a solid environment for commodities to offer total returns that are competitive with global equities, as they have done over the last 50 years (Exhibit 4).

EXHIBIT 4
Competitive long-term total returns

March 14, 1972–March 14, 2022

Competitive long-term total returns

Poised to contribute to a multi-strategy real assets portfolio

Commodities are one of the four main asset classes typically included in a real assets allocation. The others are real estate, infrastructure and resource equities. Together, they comprise the “core four” real assets categories. Within a multi-strategy portfolio, real assets are typically employed to meet three goals:

  • Deliver outperformance in inflationary periods
  • Enhance risk-adjusted returns via diversification
  • Maintain strong returns over full market cycles

Historically, no single real asset has excelled across each of the criteria of inflation sensitivity, diversification potential and total returns. Commodities, for example, have historically delivered the strongest results in the areas of inflation sensitivity and diversification, while real estate has historically delivered relatively consistent attractive total returns (Exhibit 5).

EXHIBIT 5
Three goals for real assets

Commodities typically strong contributors to inflation sensitivity, diversification

Commodities typically strong contributors to inflation sensitivity diversification

While many investors allocate individually to each of the core four categories, a turnkey real assets solution that strategically and tactically invests across all four has the potential to overcome the tradeoffs of standalone real assets exposures and better capture the positive attributes of real assets.

A resurgent global inflationary environment—not seen in more than 40 years—is causing investors to take a closer look at their asset allocation. Outsized exposure to traditional risk assets such as equities and bonds, which excelled in the prior disinflationary decade, appears unlikely to provide the inflation protection, diversification and return profile that investors have grown accustomed to.

This new world order, marked by elevated inflation, rising interest rates, deglobalization, tight labor markets and heightened geopolitical risks, has driven renewed investor interest in commodities. Commodities’ high inflation beta, relatively low correlations with traditional asset classes, and attractive long-term return potential cements its critical role in a diversified real assets portfolio in our view.

While many investors continue to prefer stand alone commodities investments, more are gaining exposure to commodities via an actively managed, multi-strategy real assets portfolio, seeking the benefits of the blend in a single allocation.

ABOUT THE AUTHORS
Author Profile Picture

Ben Ross, Senior Vice President, is Head of Commodities and a portfolio manager for Cohen & Steers’ commodities strategy.

Author Profile Picture

Michelle Butler, Senior Vice President, is a Real Assets Portfolio Specialist for Cohen & Steers, specializing in Global Listed Infrastructure, Midstream Energy, and Commodities.

FURTHER READING

Capital Market Assumptions

Capital Market Assumptions: Expectations for the next 10 years amid a generational change for markets

June 2024 | 22 mins

We expect higher fixed income and real asset returns alongside lower U.S. equity returns for the next decade.

Secular drivers of inflation

Secular drivers of inflation

January 2024 | 4 mins

Recent data indicates a slowing inflation trend, yet risks persist. Secular forces suggest that a prolonged elevated inflation period is underway with the potential for periodic price spikes. Factors driving long-term inflation include commodity underinvestment, tight labor markets, geopolitics, deglobalization and fiscal uncertainty. We see parallels to past inflationary eras, which highlight the difficulty of controlling inflation. While not predicting a return to 9%, the expectation is for a decade of higher-than-accustomed inflation, underscoring the importance of having a real assets allocation.

Commodities recovery poised to continue

June 2021 | 11 mins

After a decade-long bear market, commodities are showing signs of life. We see further upside potential despite significant repricing from pandemic lows, driven by a supportive macro backdrop, attractive fundamentals and growing investor demand for inflation-sensitive assets.

2182721