By Oliver Taylor, Multi-Asset Fund Manager, and Joven Lee, Multi-asset Strategist, at Schroders
Commodities have come under greater scrutiny in recent months. Being one of the only winners in 2022, where most assets saw huge declines, investors have been asking if commodities should play a more strategic role in multi-asset portfolios.
The post-global financial crisis era saw an unprecedented period of loose monetary policy combined with low and steady inflation. That has since come to an end, and looking ahead, we’re expecting a more “typical” period of inflation.
Before adding a new asset class into an investor’s SAA, we need to consider if there are any improvements to the portfolio’s risk-adjusted returns. Investors need to consider the overall investment objectives and asset allocation constraints, which will include diversification or correlations to other asset classes. Commodities have definitely behaved more akin to equities than bonds, but how do correlations look?
Better diversification than bonds?
With equities being the primary driver of portfolio returns, it’s important for investors to have diversification away from equity volatility in a portfolio. That’s why for the past two decades, a 60/40 portfolio consisting of equities and bonds worked; bonds helped offset losses whenever equities underperformed. With the role of bonds in a portfolio being questioned after a horrendous 2022, investors are turning to other assets to act as diversifiers.
Using the inflationary periods of 1972 to mid 1994 for reasons explained above, our analysis suggests that commodities might just be able to do the trick. The figure below shows that in different inflationary environments, the relationship between assets will shift. In environments where inflation is greater than 3%, regardless of whether it’s rising or falling, equities have typically had more negative correlations with commodities compared to bonds.
So how do we include commodities in strategic allocations?
Since the introduction of modern portfolio theory, portfolio constructors have always been concerned about maximising expected returns for a given and acceptable level of risk. Here, using our proprietary in-house modelling tool, we can see that for investors with lower risk tolerance (<6% p.a. volatility), allocating to commodities will offer diversification benefits that bumps expected returns upwards.
As we’ve mentioned earlier, we believe that in periods of heightened inflation, commodities should provide better diversification than bonds. The correlation matrix in Figure 6 directly contradicts this, as the lookback period conducted covered periods of low inflation. This is an important point - commodities have fallen out of favour in multi-asset portfolios as inflation hasn’t been a problem for over 15 years. If we accept that we are in a new regime where at the very least, inflation is once again a threat to investment returns, then the prior 15 years of persistent low inflation can be considered an anomaly, and a structural allocation to commodities can once again make sense.
To further support our theory, we split our historical window into periods where the market was experiencing greater fluctuations in inflation over growth, and vice versa, as a method to determine which of the two is driving the market. We then calculated the correlations for each scenario.
We find that when the market is focused on inflation rather than growth, equity/commodity correlations are negative while equity/bond seem to be strongly correlated. With inflation coming back as a key threat, coupled with the Fed’s focus now firmly on bringing inflation back to the 2% target, the case for including commodities in portfolios grows stronger. What happens to our efficient frontiers if we update our correlation matrix (Figure 8) to reflect the findings in Figure 7?
Conclusion
Commodities have been irrelevant after almost 15 years of insignificance in the multi-asset portfolio construction process, as inflation remained well under control. More recent history in the past year shows that inflation can, and most probably will, be an issue. Our analysis shows that commodities are a better hedge than bonds in inflationary environments, and multi-asset investors should re-consider commodities as a strategic holding in portfolios. An arbitrary 10% allocation to commodities could provide a pickup of ~0.3% expected returns for portfolios with 10% expected volatility.
Further reading : Commodities: a structural allocation for the next decade? by Oliver Taylor, Multi-Asset Fund Manager, and Joven Lee, Multi-asset Strategist, at Schroders
