Rising inflation is costly for consumers and the economy since it raises the prices of goods and services, ultimately lowering the currency’s purchasing power. Besides, it also has an impact on the stock and bond markets, increasing the volatility of value stocks.
When inflation is high, stocks are more volatile. It also induces high interest rates on real and nominal terms. In most cases, high inflation translates to losses on both bonds and stocks. Due to the current rise in inflation and its negative impact on stocks, the value of commodities in a portfolio is becoming more eminent.
Commodities refer to physical goods, like precious metals, livestock, agricultural produce, and energy products. They tend to be a reliable hedge against inflation, which makes them an attractive investment for traders. Plus, they can also provide diversification and stability to a classic stock-and-bond portfolio.
Below, we discuss the potential of commodities as portfolio diversifiers and why it can be profitable to invest in them, given the world’s current economic state.
Why Invest in Commodities?
Commodities typically have three benefits for investors:
- High return potential
- Portfolio diversification
- Inflation hedge
Commodities are tangible assets, due to which they respond differently to economic fluctuations than bonds and stocks. For instance, when inflation is on the rise, commodities benefit from it.
In periods of high inflation, there’s an increased demand for goods. The higher demand usually increases these goods’ prices. Due to this, the prices of commodities or raw materials used to make these goods also increases. Therefore, commodities offer a hedge against inflation.
Market research by a portfolio manager at Vanguard Quantitative Equity Group found that the inflation beta of commodities has fluctuated between seven and nine in the past decade. This indicates that there’s a 7% to 9% spike in commodities with a 1% hike in inflation.
Note: The blue line shows the rolling 10-year beta for Bloomberg Commodity Index inflation. Inflation beta is a statistical measure that indicates the volatility and magnitude of the beta.
Although inflation-protected bonds may provide a hedge against inflation, their lower beta — as compared to commodities — means that they would need to have a much higher allocation in the portfolio to produce the same result against inflation as commodities. Likewise, there’s no uniform evidence to show that equities provide an inflation hedge because the research results are inconsistent.
Pros and Cons of Investing in Commodities
Typically, there are four types of commodities to invest in:
- Precious metals: These include platinum, copper, silver, and gold.
- Energy: This includes gasoline, crude oil, heating gas, and other petroleum products.
- Livestock: This includes cattle, eggs, and meat.
- Agriculture: This includes ragi, rice, wheat, cocoa, and other produce.
Commodities have traditionally been traded around the globe, especially agricultural produce. There has been a greater interest in precious metals and energy products in recent years. Before investing in commodities, investors should know that these assets have their distinct pros and cons.
Advantages of Investing in Commodities
As discussed earlier, the most prominent benefit of investing in commodities is that they offer an inflation hedge. But there are some other benefits to commodity investing as well.
Hedge Against Political Instability
Geopolitical effects, including conflicts, wars, and riots, impact the commodity market because the supply chain can be disrupted. Everything from production to transport of commodities becomes difficult, increasing demand.
The mismatch due to high demand and low supply increases the prices of commodities. At the same time, market pessimism lowers stock and bond prices. Therefore, having commodities in a portfolio can protect investors against global and national political instability.
Higher Leverage
Options, futures, and other derivatives of commodities offer higher leverage amounts. Investors can open a large position by paying anything from 5% to 10% of the total contract value.
Thus, there is a potential for margin trading, in which investors can trade a much higher volume than their account balance. This can lead to greater profits at a time when stocks and bonds may not be doing as well.
Portfolio Diversification
Investors can use commodities to achieve portfolio diversification. This is mainly because commodities tend to move in different directions than stocks and bonds.
Diversification can help offset losses and minimize the collective risk of a portfolio. Because investments are divided among different asset classes, a significant swing in one market does not necessarily have a major impact on the portfolio.
Disadvantages of Investing in Commodities
Although investing in commodities can help protect a portfolio against inflation, there are some downsides to commodities. Investors should be familiar with these disadvantages and weigh the pros and cons before investing.
Volatility
The prices of commodities are volatile and tend to fluctuate more than the stock and bond markets. Historically, a sharp decline in global economic activity in the aftermath of a crisis has led to a downturn in commodity prices.
The high volatility associated with commodities is mainly due to the influence of geopolitics, natural disasters, and liquidity on these assets. In the wake of the COVID-19 pandemic, for example, the world saw the oil market’s volatility reach an all-time high.
Likewise, the prices of energy commodities, such as heating oil and natural gas, are more volatile than other commodities. This is mainly due to the fact that consumers have limited choices in terms of fuel substitutes when the price of a certain energy commodity fluctuates.
Speculation
Due to the high volatility and liquidity of commodities, speculation often drives the prices of these assets. Speculators are people who trade commodities with the sole intention of making a profit from price movements. The role of speculators in the market can lead to exaggerated price swings, especially during periods of market turmoil.
Key Takeaways
- Given the current and projected inflation, commodities can prove to be a good asset class for diversifying portfolios.
- Commodities have proved to be a reliable portfolio diversifier and hedge against inflation in the past.
- Investors should explore a spectrum of options rather than restricting themselves to traditional stock-and-bond portfolios.
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