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> but the run-up typically occurs before the UK is hit by a CPI pressure-wave
A cynical fellow might take the line that rather than being the Holy Grail of a leading indicator, CPI in the UK is driven by commodity prices – the commodities in question being hydrocarbons and food, because we import a hefty quantity of both, North Sea oil being largely tapped out these days.
Commodities is perhaps too large a brush, covering pork bellies to gold to energy. History may also be an unsatisfactory guide, inasmuch as historically the UK did produce hydrocarbons whereas now it doesn’t to any significant degree, so we are not comparing like with like in a historical consideration relative to looking forwards.
As a result the impact of that strand of commodities on UK inflation will be quite different in the future. Whereas the impact of food, for instance, will be similar, we aren’t particularly growing any more of what we eat compared to the last 25 years.
@ Ermine – I think we’re saying the same thing: I mentioned that our open economy is liable to import inflation, so rising inflation here seems to follow rising commodity prices. Or, rising commodity prices are an auger of inflation to come. It happened in 2021 when commodity prices went nuts while inflation was quite tame – though rising.
Re: hydrocarbons. I don’t think it makes any difference to the historical record. Oil futures only appear in the index from the 1980s. By then the UK is pumping black gold but heading for disinflation bar a brief early 90s revival. Now inflation is back our domestic oil and gas isn’t a factor.
For me, the takeaway is that commodities don’t work as a fast-acting inflation hedge for UK investors as they do for Americans. That said, there obviously is a relationship, although even in the US it’s tremendously volatile i.e. commodities can shoot up during high inflation, only to drop off a cliff again while the price of M&Ms is still going through the roof.
@TA: thank you for another superb piece, for the clarity of your communication, and for the comprehensiveness of your research. My generic takeaway is the sheer level of difficulty of providing, in advance, significantly reliable and meaningful immediate term portfolio inflation protection, by whatever means that is sought to be accomplished. This isn’t to say that we shouldn’t try, but it is clearly very difficult to do so in practice.
Of course, over the very long term, diversified equities (and not commodities, fixed income or alternatives) have ended up providing the greatest measure of inflation proofing amongst all of the single asset classes available to the retail investor; but at the unavoidable costs of sometimes nerve shredding volatility, occasionally very prolonged and deep drawdowns, and sequence of returns risk.
However, such negative attributes are shared by commodities, perhaps even more so on the volatility side; and commodities don’t pay dividends, don’t have buy backs and don’t have retained earnings. Sorry to sound like a commodity sceptic. I’m finding it hard to find love for the asset class at the moment, albeit I was fascinated (& flabbergasted) to see from your recent commodities piece that a 60% equities/40% commodity blend beat 100% equities over 1934-2022.
I’m not too bothered by the lack of a correlation. You’d expect a substantial time lag between commodity returns and CPI, less so between commodities and PPI. Plus the impact on CPI is also a function of higher order effects. Price acceleration is relevant. Over the correct range, y=x^2 has no correlation and yet a relationship exists. Assuming something is linear is not always helpful. Importers/exporters now hedge to a much greater degree. That process increases the lag. If they didn’t hedge, you would have a stronger relationship but no futures market to invest in.
@TLI. It’s fair to argue commodity futures are not really an asset class. Not an investment. Same as currencies. The market is constructed from hedgers and speculators. Like the fx swap or interest rate swap markets, there is no net position, just open interest. So it’s intrinsically a long-short market. You will lose a level of performance using it in a long-only format.
Nonetheless, it’s still a diversifier since it adds extra degrees of freedom. I’ve always aimed to maximize that aspect. Proper diversification. An equity-bond portfolio really struggles to be “all-weather”. There is clear quadrant where it fails.
@TLI — Evening! 🙂 You write:
To speak for @TA as I understand his position, it’s not really love “at the moment” in a market timing sense, as he sees it.
The ‘love’, for want of a better word, is as I understand it in the new data that that has in the past couple of years put the long-term attractiveness of this asset class in a better light, especially when combined with the newer indices/tracking products now out there.
Unfortunately it’s a side-effect of the deep diving research process, at least as conducted around here and with our constraints, that when we get ‘into’ a subject on Monevator it usually spans a few posts. See the Care Costs series of a couple of years ago, as another example.
The repeated articles on the site are an artifact of that, not of any sudden love affair. 🙂
FWIW (little, as always 🙂 ) my hunch is commodity ETFs will probably languish for at least a couple of years as inflation abates, albeit perhaps buoyed a little bit by dollar weakness if we see that — either as interest rates finally choke global GDP and we see a slowdown in demand, or because we return to the kind of low-growth low-inflation debt-driven sub-par expansions that have typified the past decade. Of course many other things could happen, but those seem likeliest to me.
I imagine that if/when a commodity allocation in a portfolio responds (/’works’), it’ll often be when you don’t really expect it to. (With all the hedging and similar factors going on that @ZX mentions, you’d imagine anything obvious will be somewhat in the price). In other words, a 2022 scenario.
The rest of the time it’ll probably languish, going down 30% etc, up 15%, down 20% and so on. Before, hopefully, popping 50%+ — and perhaps just when you need it to.
Okay that sounds Panglossian I accept (though likely pretty hard to stomach in real-life if you own too much of it) and rarely does anything work so neatly, but that’s the way I’d be thinking of it in a portfolio if I was a passive-type investor. Not in a X, Y, and Z is happening and the prospects look good so I want to buy commodities.
(As an active investor I may have a punt next time unexpected inflation looks likely to me. But I didn’t think this inflation would last this long, honestly. Okay it was Russia’s war in Ukraine that threw a curveball into ‘transitory’ inflation I’d argue, but that’s kind of the point. Unexpectedness everywhere!)
@ZX and @TI: that’s a very helpful and clear explanation of the crucial distinction which I wasn’t seeing hitherto: namely, commodity futures aren’t ‘assets’ at all, but rather they’re an (in aggregate) net neutral hedging activity. No more, no less.
So, if I’ve understood now, then one can’t just compare them to equities or to bonds. It’s not a simple apples to apples versus apples to oranges issue here, as it is with comparing the attributes of different asset classes. Rather it’s a case of a different typology of ‘thing’ entirely. The 4.5% p.a. real return in commodity futures over the 1934-2022 period is not the same type of return, in some sense, as the 5.4% real return (IIRC) from UK equities over that same period, or for that matter the real return from bonds.
Might this apparent structural ‘premia’ from broad commodity futures’ exposure help to explain how combining an asset class with a 5.4% long term real return with some exposure to an activity (hedging commodities) with a 4.5% one can (in a 60/40 mix) produce a 6% long run real return with less volatility?
If so, then the theoretical underpinnings for commodities that I was seeking some assurance for are beginning to emerge (in my mind at least). Sorry to be such a slow learner here.
When I first read of the 6% figure, and saw the improved Sharpe ratio (as against an equity or a commodity only portfolio) for the 60 ‘e’ / 40 ‘c’ mix in @TA’s Part 3, it felt a bit like what I imagine that Saul Perlmutter might have felt back in 1998 when he plotted Type 1A Supernova to measure what he’d thought would be the decelerating expansion of the Universe, only to discover that the expansion was actually accelerating.
Quick addendum: the hopefully enduring structural ‘premia’ here which a broad commodity ETP/ETF should capture is (I think) a combination of any return from the theory of normal backwardation plus the cost of carry return (theory of storage return plus convenience yield, if any).
TLI. Being horribly simplistic, the purpose of the equity market is to raise capital (for companies) and to provide a return on that capital (for investors). Similar for bonds (ok, it really annihilates spot outside money / creates forward outside money but lets ignore that).
The purpose of the commodity futures market isn’t capital raising or providing a return. It’s about global trade, hedging import/export risks etc. The same as currency forwards, interest rate swaps etc. As a function of highly volatile spot commodity prices, the fact it provides a real return is not totally surprising.
Markets with a different purpose tend to be better diversifiers. It’s fortunate that most investors don’t use commodities since the market would need to be about 10x bigger. Moreover, it would then be dominated by investors. That would suppress the risk premia and cause the diversification benefit to drop.
That’s the concern. Will it persist? If so for how long? What are capacity constraints? Are there barriers to it being arbitraged? On the plus side: it’s a fairly decent sized market ($920 bn June 2022, source BIS); commodity futures have formed part of managed futures offered by US CTAs for over 30 yrs & not aware of performance deteriorating in that time. On the negative side: this is a small market compared to equities & bonds (latter $100 tn); theory of normal backwardation doesn’t work for me as it just assumes producers dominate in terms of demand for futures contracts; and, as far as I can tell, size of commodity futures market has grown v. fast indeed recently compared to the past, which may mean observations going back to 1934 don’t provide useful information (perhaps especially as this start date was close to the nadir of the mother of all commodity crashes, the Great Depression).
@ TLI – theory of normal backwardation and theory of storage are alternative explanations as I understand it, not additive.
@ ZX – re: size of commodities market – do US commodity funds generally invest in directly in futures? I’ve been looking at a selection and some indicate that they do and some seem to use other methods to gain exposure. All the commodity ETFs available in Europe use swaps so AFAIK aren’t adding to the weight of money on futures?
@TA. I haven’t looked closely in recent years but most US players directly use futures. It would be cheaper and easier. Some funds/ETFs in other juristictions may use other mechanisms, such as swaps, simply because there are tax issues or costs associated with access to exchanges. Nonetheless, most of that is intermediation, so whoever is on the other side is hedging with futures.
@TLI. Commodity CTAs are more trading (long-short) than long-only. If the long-only, real money community decided to go 5-10% of AUM (spot cash terms) into commodity futures, then the market would struggle since where is the capacity on the other side. Vanguard decides tomorrow to stick 10% in commodities, that is $750bn. So perhaps $150bn in crude oil futures or 2 million contracts. Total open interest (longs+shorts) in all CME crude oil futures is 1.7 million! Fancy taking the other side? Then Blackrock ($9bn) rings up and says they want some …
Think I’ll buy in now before Vanguard read my article 😉
@TA As a subscribing Maven this does not affect me, but weren’t earlier articles in the Commodities series available to all? Was it deliberate policy to put the later articles behind the paywall?
@DavidV — Yes, previous articles open to all and the conclusion of the series in a couple of weeks will be too.
“Deliberate policy” is a bit strong for the thought process around here. 😉 We are experimenting with how to mix up the articles — with one a month Mavens — and this seemed worth an experiment.
My priority at the moment is firstly our paying subscribers/supporters, and secondly encouraging more people into becoming paying subscribers/supporters. Several hundred people have become members, which is great, but not even 1/10 email subscribers have done so let alone most of the several tens of thousands who read the site itself each month (of course many just pass through, but still).
It’s existential for us at this point to at least get to four-figure membership so that’s the priority.
As I said at the time we introduced membership, we do want to keep most of us stuff free, and it remains the case that 80+% of new content and 99% of total content is not behind a paywall. And after some period of time (at least a year) I’ll take the paywall off this article for long-term reference/help purposes for newcomers to the site.
Thanks so much for signing up to Mavens! 🙂
Interesting piece covering commodities in an ‘all terrain’ portfolio:
https://the7circles.uk/all-terrain-investing/
Too early to say of course if the market regime of primary trend disinflation and lower rates from 1982 which followed on from the higher volatility, high inflation and higher rate regime of 1965-81 has in fact ended in 2021, putting us into a new regime.
We seem to have the following tools to hedge / diversity equity exposure:
UK conventional Gilts
UK index linked Gilts
US conventional Treasuries ETFs
US TIPS ETFs
Global AAA bonds hedged to £ ETFs
Broad commodity exposure ETFs
Gold ETFs
Trend / Managed Futures Funds
Systematic Global Macro and Tail Hedge Funds
Maybe REIT ETFs