While growing up in the Midwest with a family history of farming, listening to the local news discuss the prices of pork bellies, cattle, and wheat futures was a part of our daily lives. Fast forward to today, and rather than having the local farm report transmitted via radio, my inbox is now flooded with emails containing headlines regarding the recent spike in commodity prices.
Unlike my childhood, when the commodity reports centered around corn and soybeans, today’s headlines are centered around oil, aluminum, and nickel due to many macro-economic forces that are playing a part in the recent price fluctuations.
Below we take a look at what is driving the recent spike in commodity prices, the repercussions of higher commodity prices, and how financial advisors can strategically incorporate commodities in client portfolios.
Other than a two-year period of gains directly following the credit crisis, commodity prices, represented by the Bloomberg Commodities index, were in a free fall from their peak in 2008. From April 2011 to March 2016, commodities fell over 14% per annum, after bottoming out in March of 2016, commodities stabilized and posted a +7.85% per annum return through March 2018 (figure 1).
Figure 1 - Source: Informa Zephyr Platform. Bloomberg Commodity Index performance through March 2018
The driving forces behind the recent spike in commodities is a combination of U.S. sanctions, trade war rhetoric, tightening oil supplies, and investors hedging against a weaker U.S. dollar. Since commodities are pegged to the U.S. dollar, they historically have an inverse relationship to the greenback, making them a good hedge when the U.S. dollar weakens.
As we are experiencing today, there are many macro-economic forces that can affect commodity prices, in turn, higher commodity prices affect other areas, other than the price of bacon. Higher commodity prices can dent corporate profits, as raw materials and shipping costs increase. Additionally, since higher commodity prices are inflationary, we could see the Fed pick up the pace on their monetary tightening, resulting in higher borrowing costs.
While commodities can be used to hedge inflation or a weakening U.S. dollar, commodities can be a useful diversifier for financial professionals building client portfolios. Figure 2 shows us the relationship commodities have with equities and fixed income. Other than the first few years following the bottom of the credit crisis, the Bloomberg Commodity index has had a very low correlation to U.S. equities (Russell 3000 index), and in some cases, the two are inversely correlated. The correlation between commodities and U.S. fixed income (Bloomberg Barclays U.S Aggregate) is even lower, and during many periods, there’s an inverse relationship between the two (Figure 2).
Figure 2 – Source: Zephyr StyleADVISOR
Now that we’ve discussed the different macro-economic factors that can drive commodity prices, the effects commodities have on markets, and why commodities can be useful in an investment portfolio, the next step is to look at some of the top performing commodity strategies. Below are some of the top managers found within the PSN Global Manager Neighborhood database over the past five years. As you can see, these managers provide compelling performance and risk metrics against the Bloomberg Commodity index (Figure 3).
Figure 3 - Source: Zephyr StyleADVISOR
The evolution of financial products has made it easier for retail investors to gain exposure to commodities, no longer do you have to buy futures on the Chicago Mercantile Exchange in order to invest in lean pork. The wide-reaching effects commodities have on the global economy, coupled with the benefits they can offer, whether they are used as a hedge or portfolio diversifier, make them worthy of consideration when constructing a portfolio for your clients.
Ryan Nauman is a VP, Product and Market Strategist at Informa Financial Intelligence.