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Investing isn't easy, but there are times when simple strategies payoff for advisors and clients. Take the case of commodities.
As advisors know, commodities have a penchant for performing well in inflationary climates. Indeed, sometimes things are that simple. Commodities lived up to that reputation in 2021. Sure, inflation spiked, but broad-based commodities funds cobbled together impressive showings last year without any help from gold.
The momentum is carrying over to this year as the DBIQ Optimum Yield Diversified Commodity Index, which tracks 14 heavily traded commodities futures contracts is up nearly 12% year-to-date while the S&P 500 is down 7.57%. Obviously, there are no guarantees that gap will persist over the course of this year, but some experts believe there's more upside to be had with commodities.
“We reiterate our view of the advantages of adding commodities to a portfolio in the current environment,” said Goldman Sachs in a note to clients published on Monday. “Not only are commodities a geopolitical hedge, they are also an inflation hedge, and a hedge against valuation risk from shifting central banks reaction function.”
Commodities Catalysts
Obviously, inflation is boosting commodities prices, but there's more to the story, particularly with commodities funds, that clients may not be aware of. Many clients probably aren't aware that there are three sources of returns with commodities funds: commodities spot prices, futures roll and returns earned on the collateral that supports the futures contracts held by the fund.
In theory, those components should contribute equally to commodities' returns, but that hasn't been the case in recent years due to low interest rates and high roll costs caused by contango – the scenario where further out futures contracts are trade above spot prices.
Good news for clients: More than half the members of the Bloomberg Commodity Index are currently in backwardation, or the opposite of commodities. There's positivity beyond that, too.
“First, we have the Fed set to embark on a rate hiking program that should help increase the returns on collateral over the coming years,” says WisdomTree Global Chief Investment Officer Jeremy Schwartz. “Second, a lack of capital expenditures in mining and exploration has constrained the supply of many different commodities, compounded by supply chain issues and infrastructure spending. This gave us a cocktail for strong commodity price trends over the last 12 months that has many looking for a new super cycle of commodity prices.”
Adding to the allure of broad-based commodities strategies this year, going beyond inflation, is that gold is rebounding and geopolitical tensions could send oil prices soaring.
“Russia’s Foreign Minister Sergey Lavrov has reportedly told Russian President Vladimir Putin that the Kremlin should pursue a diplomatic route to obtain concessions from the West, according to Reuters. The report follows comments from U.S. National Security Advisor Jake Sullivan on Friday that an invasion “could begin at any time,” reports Pippa Stevens for CNBC.
Inflation, Too
As noted above, inflation is a primary catalyst for commodities and it doesn't appear to be abating anytime soon.
“Given January’s CPI print, and the risks for rate hikes which will take 12-24 months to slow commodity demand, there has rarely been a better time to add commodities to a portfolio as a hedge against inflation, geopolitical risks and potentially hostile market environments,” Jeffrey Currie, head of global commodity research at Goldman Sachs, said. “Not only are demand levels for all commodities now comfortably above pre-pandemic levels which is stressing supply, but the tailwind from synchronous stimulus is facing a resurgence.”
With money supply increasing an alarming rate, the case for commodities is growing, not diminishing, indicating commodities could buffer client portfolios for some time to come.