What caught my eye this week.

We all want to believe in magic. Rational citizens of the 21st Century we might be, but we still wish to tilt the universe just enough to catch a glimpse of the future, as it rounds the next bend of space-time.

What insight! Enabling us to dodge a bullet, or jump on the most lucrative gravy train about to depart the station. This is why the contemporary forecaster still has an allure that’s analogous to the ancient oracle offering a Greek king an edge over the fates.

Credibility back then rested upon delivering your prophecy in the form of a riddle from the gods, with a side of cowled performance theatre, cackling, and trance-induced seizure.

Nowadays we prefer our foretellings served as data-led projections, backed by a proprietary model rather than goat entrails, while a dispersion of outcomes substitutes for the riddles of antiquity.

Even a cynic like me can’t resist this stuff, so I always appreciate it when a voice of reason like Joachim Klement skewers the market-prediction trade with a quick fact-check.

In a short and pointed piece of debunkery, Klement shows how three major US equity forecast surveys are not only routinely wide of the mark, but are typically worse than a random guess and would likely have destroyed value (versus simply holding the market) if you’d acted upon their guidance.

To me, articles like this are a necessary inoculation against our very human desire to control our destiny, and the contemporary belief that if we wield the power to wreck a planet, and know the video-viewing habits of almost every person on Earth, then someone, somewhere, must know what the hell is going on.

Sadly they don’t. Not the Pentagon, not Google, not Renaissance Technologies, not OpenAI, not the Chinese.

Take a single decision that’s cascading change upon the world – say the invasion of Ukraine. It wasn’t inevitable. Yes, it was long a possibility but, right up until the eve of war, it could have gone either way.

As an active investor, you could have made an outsized bet on the outcome. Even then would you have bet on a short war or a quagmire?

Or, you could admit that the world is a chaotic system with fundamentally unpredictable outcomes – as chance collides with contingency and ricochets into randomness.

Which means the only sane response is to reject any notion that events are proceeding along a set path. And to hedge your bets so that something in your portfolio or, more broadly, your quiver of personal assets and capabilities, will enable you to ride-out any turbulence that comes your way.

Have a great weekend.

The Accumulator

PS – The Investor is off on a faintly-deserved holiday – living it up in a paradise retreat somewhere the cocktails never run dry. I’m just the temp, and normal service will be resumed next week.

[continue reading…]

This guest post on the ramifications of the demise of the gold standard is by Rob Dix. A long-time Monevator reader, Rob is co-host of the popular Property Podcast and co-founder of Property Hub. Rob is also the author of the Penguin bestseller The Price of Money.

You may have been taught as a child the golden rule, ‘Do unto others as you’d have them do unto you.’ A more cynical golden rule was made famous in the movie Aladdin: ‘Whoever has the gold makes the rules.’

But a more accurate (if less pithy) formulation might be, ‘Whoever has the power makes the rules about the gold.’

The amount of money in the economy has been increasing dramatically over the last 50 years, and the pace is only getting faster.

How is that even possible? Well, for most of history, it wasn’t. It was only in the latter part of the twentieth century that the brakes came off and the creation of money became so unrestrained.

So what exactly changed towards the end of the twentieth century? To understand that we’ll start with a quick romp through the history of money up to that point.

The earliest money

People exchanged goods with each other long before the development of physical money. ‘Tally sticks’ were used at least 30,000 years ago to keep track of who owed what to whom. Eventually, these were replaced by clay tokens. But both seem to have been used simply as claims of ownership: the tokens themselves weren’t traded between people.

The first physical currency appears to have been the Mesopotamian shekel, dating back somewhere around 7,000 years. Metal coins are more recent still – seemingly originating independently in China around 1000 BC, and ancient Greece around 650 BC.

Eventually, these small pieces of metal would become the dominant way of organising an economy.

The UK is a good case study – and not just because it’s where I live! Records go back a long way, and Britain was a major global power during a period when critical innovations in the history of money were taking place.

We’ll link back up with other currencies later, when we reach the twentieth century.

Coining it

Coins started being used in England as early as the second century BC. But it wasn’t until the eighth century AD that their use became widespread and the coins themselves more standardised.

These later coins were made of silver, and the name ‘pound sterling’ derives from a pound weight of sterling silver. This was important, because the value of the coin was in the metal itself. Whether it was melted down or moulded into a convenient disc, it should be worth exactly the same.

A pound of silver was divided into 240 pennies. There were 12 pennies in a shilling and 20 shillings to a pound (12 x 20 = 240). Each penny was further subdivided into four farthings. We organised our coinage this way for about 1,300 years – until in 1971 someone finally came up with a less mentally-taxing structure. (“The British resisted decimalised currency for a long time,” as Neil Gaiman put it, “because they thought it was ‘too complicated’.”)

All those centuries ago, everything operated on a far more local basis – primarily owing to the time it took to convey messages across long distances. In the case of money, each town would produce its own coinage. There wasn’t one ‘Royal Mint’ as there is today.

The problem with this? It created ample opportunity for any individual ‘moneyer’ (the name for the trade that produced coins) to cheat the system by mixing in much cheaper tin with the silver that should have been used.

In other words, the unwary trader might think they were being given a valuable pound of sterling silver, but find they had nothing of the sort if they ever decided to melt it down.

Moneyers would come to regret giving in to this temptation. When Henry I became king in 1100 and discovered what was going on, he arranged for all the moneyers to be castrated and have their right hand cut off.

Royal flush

Seven Henrys and nearly 400 years later we find Henry VIII on the throne – coming to power in 1509.

Henry VIII wanted more centralised control of the currency. So he shut down all the local mints and decreed that the Royal Mint in London could be the only entity to create new coins.

This removed the opportunity for moneyers to meddle with the silver content of coins. But it introduced the opportunity for monarchs to do exactly the same thing centrally – without the risk of castration.

The effect was what you might expect from giving control to someone with a desire to accumulate as many goods as possible and no fear of retribution. About 30 years after the creation of the Royal Mint, the silver content of coins fell from over 90 per cent to just over one-third. The pound coin, originally named for its weight in silver, now very much wasn’t.

A similar pattern of increased centralisation has played out around the world.

In Germany, for example, the city of Hamburg had its own currency until 1873, until it adopted the mark upon German unification, then the euro in 2002.

In the US, although the dollar was established as the principal unit of currency in 1793, private local and regional banks were allowed to issue their own banknotes until 1861 – and approximately 1,600 of them did.

Some 244 separate clans issued their own forms of money in Japan until the yen was adopted in 1871.

In every case, this removed the ability for powerful local figures to manipulate money for their own benefit – and shifted that privilege to the central state.

The central bank is born

By about 1600, monarchs in much of the world had centralised their mints in this way. But another revolution was just around the corner: the development, in England, of the world’s first central bank.

By the 1600s, silver in England had become scarce because so much of it was being sent overseas as payment for foreign goods. In its place, gold started being used to define the value of the pound instead. (The change was overseen by one Mr. I. Newton – of ‘gravity’ fame.)

Around this same time, the country developed a serious requirement for state funds. England had lost a key naval battle in its ongoing wars with France. It needed to raise £1.2 million to rebuild the fleet.

In those days, it was normal for monarchs to personally borrow the money needed to fund wars. Unfortunately, the recently deceased Charles II had defaulted on a huge amount of debt before his death. That put everyone off the idea of lending to his successors.

To give confidence to potential lenders, in 1694 William III agreed to the establishment of a new national ‘central’ bank: the Bank of England. Importantly, the Bank would be overseen by Parliament, rather than the king. Any money it borrowed would be the responsibility of the state as a whole rather than the reigning monarch.

The strategy worked: within 12 days, the new Bank had raised the £1.2 million that the war effort needed (from about 1,200 individuals).

And so the national debt – meaning the money owed by the government to those who’ve loaned it money, and a figure that’s in the trillions today – was born in 1694 with this loan of £1.2 million.

That loan was the start but certainly not the end. By 1815, at the end of the Napoleonic Wars, government debt had risen to around £800 million.

From bullion to banknotes

The creation of the Bank of England also led to the issuance of banknotes. Up until this point, the value of the pound had been in the silver or gold coins themselves. Now, for the first time, this value could also be represented by a piece of paper with no intrinsic value of its own.

Why would people start accepting worthless paper as a representation of valuable metal? Because these banknotes could be exchanged at the Bank of England for a fixed quantity of gold. The note was effectively a ‘receipt’ for real gold stored at the bank.

It was important for public confidence that the banknotes could be exchanged for gold on demand, but in practice they rarely were. People would happily accept banknotes in exchange for goods and services, safe in the knowledge that they were backed by something they trusted.

Of course, the Bank did actually have the gold it needed to repay everyone – just in case they all turned up at the same time bearing their paper banknotes and demanding the equivalent amount of gold… right?

Well, no, not really.

The Bank cottoned on to the fact that people were quite happy with the notes and rarely turned up to claim the gold, so it started issuing many more banknotes than it had the gold to back.

In the 1730s, the Bank almost collapsed when too many people turned up demanding gold at the same time. But it survived, and 50 years later it was still paying out gold on demand.

Money for nothing

In our quick whizz through financial history so far, we’ve seen a pattern. Whenever there’s an opportunity to create or obtain extra money, it’s enthusiastically seized:

• The local ‘moneyers’ of old had the opportunity to reduce the precious metal content of coins, so they did. And they had their bits chopped off as a consequence.
• Henry VIII had the chance to reduce the precious metal content of coins in a similar way once their production was centralised, so he did too. (His bits remained intact because, well, that’s a benefit of being in charge).
• The creation of the Bank of England gave the government the ability to borrow – and it racked up over £1 billion of debt in a little over a hundred years.
• The Bank also issued banknotes that could be converted to gold on demand… and issued more of these notes than it had the gold to back.

These specific actions – and this general tendency to game whatever system was in force at the time – meant that over the years, more and more money was being created.

Money, supply, demand, and inflation

The more money that is in circulation, the less each individual pound becomes worth.

In the next chart you can clearly see a collapse in buying power between 1750 (the furthest back I can find data, and about 50 years after the Bank of England’s founding) and 1815 (the end of the very expensive Napoleonic wars):

Buying power of £100 over time, 1750–1815

And it’s not just the pound. As we’ll see, the pattern of currencies being abused to benefit whoever is in power holds up across the world and throughout time.

The classical gold standard

As the chart above shows, the buying power of the pound actually picked up after 1815, and then stayed relatively steady all the way through to 1914.

One reason for this is a lack of war. Although there was war aplenty across Europe during the mid-nineteenth century, the UK largely stayed out of it and concentrated on building its empire. Less war means less need to print new money or pile up new debt.

But the other reason for the steady value of the pound was the implementation of the ‘gold standard’, which was introduced in the 1870s.

The gold standard was the solution to a problem that became apparent after Western countries decided to trade with one another rather than kill one another.

While increased international trade was far more prosperous and less gruesome than war, it came with one massive headache – the effort involved in constantly converting between national currencies.

To overcome this, most nations decided to join the United Kingdom in ‘pegging’ their currencies to an amount of gold.

The gold standard in practice

Every currency could be converted into gold at a set price, which had the effect of fixing exchange rates between different currencies too. (This is very different from today’s floating exchange rates.)

Effectively, this meant that gold would underpin international trade. The precious metal was literally shipped between each country’s central bank to settle payments. If a particular country bought more from other countries than it sold to them, its central bank’s gold reserves would diminish (and vice versa).

The gold standard, although it was only introduced as a way to facilitate international trade, also had the side effect of limiting the ability of the Bank of England to print endless quantities of banknotes. If those notes were used to buy goods from overseas, the Bank would have to ‘settle up’ by sending gold abroad – and eventually it would run out.

Nevertheless, although this meant the Bank had to be careful about the quantity of banknotes it issued (which stopped the money supply from growing as quickly as it had done before the international gold standard was introduced), nothing else within the UK had changed.

Banknotes continued to be notionally convertible into gold on demand, and there still wouldn’t be enough gold to go around if everyone turned up with their banknotes at once.

The gold standard and Word War One

The system wasn’t perfect, but it held well until the outbreak of World War One. At that point international co-operation (obviously) broke down and every country focused on doing whatever it took to fund the war effort.

In the UK, the Bank of England didn’t have anywhere near enough gold to prepare for war. This predicament was made even worse by individuals who, spooked by the rumours of war being declared, began doing the one thing the Bank didn’t want: queuing up to convert their notes into gold.

As a result, the day after war was declared on Germany, the Currency and Bank Notes Act of 1914 was signed into law. The Act gave the government the power to print millions of pounds worth of new banknotes. These had to be accepted as legal tender and, critically, could not be converted into gold.

This is why in the next chart you can see the buying power of a pound take a sharp leg downwards in 1914. The money supply suddenly increased, which naturally reduced its value:

Buying power of £100 over time, 1750–2020

This was a landmark moment. Although the banknotes that had been issued previously turned out not to be fully backed by gold (as became clear when people rushed to redeem them en masse), they were supposed to be. The Currency and Bank Notes Act of 1914 marked the first time the central bank issued money that had no notional link to gold at all.

These new pounds were pounds purely because they had ‘one pound’ printed on them, and because the authorities said that’s what they were worth.

The link with gold was briefly reinstated after World War One, but in 1931 the Bank of England permanently stopped offering to redeem banknotes for gold.

From that day on, the pound has been a ‘fiat’ currency – meaning it has value purely because the government says so, and has no link to anything tangible whatsoever.

The gold standard, rebooted

Once World War Two ended, there was a clear need for a new arrangement to rebuild trust and facilitate international trade.

Returning to basing everything on gold seemed to work pretty well in the pre-war years. But that wasn’t going to work this time – for the simple reason that the US now held three-quarters of the world’s gold supply.

How did it accumulate so much?

First, in 1933, President Franklin D. Roosevelt issued an order banning American citizens from owning gold. All gold had to be sold to the government in exchange for paper dollars. This was intended to boost the central bank’s supply, and it did.

Another factor was that before entering World War Two the US supplied the Allies with weapons and other resources, which they paid for with gold. And because it entered the conflict later than other countries, the war effort also drained US resources less.

Good as gold

Indeed the US’s post-war power – as well as its quantity of gold reserves and general trust in the strength of the dollar – meant that the dollar was seen to be ‘as good as gold’. So, in 1944, a new system was devised and signed up to by 44 countries.

The new system had three defining characteristics:

1. The dollar was given a fixed value in terms of gold (1oz to $35).
2. Every other currency fixed its exchange rate in relation to the dollar.
3. Countries (but not individuals) could hand their dollars back to the US central bank (called the Federal Reserve) at any time, and receive the equivalent amount of gold.

This created a consistent and predictable basis for countries to trade with one another because everything was ultimately still based on gold. It established the dollar as a convenient, trusted currency that could be used for global trade

For example, the owners of a Japanese factory selling products to Greece might not want to receive drachmas in exchange for goods. But they’d be happy to receive dollars, knowing they could use those dollars in another international trade. Alternatively, they could convert them back into their home currency (the yen) at a pre-set exchange rate.

Goldilocks scenario

Under this system, currencies including the pound were effectively ‘backed by’ gold – just as they had been in the past – but with the dollar sitting in the middle to facilitate. And it worked: post-war stability was achieved and global trade was rebuilt.

For the system to continue functioning indefinitely, one thing was essential. Countries needed to believe that they would always be able to exchange dollars for a fixed amount of gold. In other words, they needed to believe that there really was enough gold to back up the dollars being issued.

All the US government had to do, therefore, was avoid creating millions of extra dollars without first accumulating more gold to back it up. Not too much to ask, in the scheme of things.

Oh. It was too much to ask. But – let’s be honest – not completely unexpected.

As we’ve already seen several times over, when leaders are given the power to create money and the full negative consequences will become some future leader’s problem, it often proves impossible for them to resist.

Under consecutive governments, the US ran massive social programmes, fought a lengthy war in Vietnam and raced Russia to the Moon. All of which required money the country didn’t actually have, so could only be achieved by creating more dollars.

When other countries realised what was going on, they started to lose faith that they’d be able to convert their dollars into gold in the future, because there couldn’t possibly be enough of it.

The upshot: many countries started exercising their right to hand back their dollars and demand gold.

Suspended animation

The US gold supply dwindled to the point where some kind of action was needed. So on 15 August 1971, President Nixon announced that the convertibility of the US dollar into gold would be ‘temporarily’ suspended.

In other words, on a temporary basis, $35 would stop equalling 1oz of gold – or any amount of gold. On a temporary basis, a US dollar would be backed by nothing – and therefore so would every currency with its exchange rate tied to the dollar.

That temporary basis has now been going on for 50 years and counting.

If questioned, I imagine most people would have the vague notion that something is giving value to the pound, the dollar or any other national currency. Either because they remember a time when there was, or because it just seems logical that there must be.

Yet since that day in 1971, there isn’t even the pretence that a currency is backed by anything tangible.

In principle, this means there’s nothing to prevent governments from creating as much of their own currency as they want to.

And naturally, as they have throughout history when the opportunity presents itself, they do.

More money, more price rises

When government take advantage of their ability to create more of their own currency, what happens?

A three-step pattern which we’re now very familiar with: 

1. The amount of money in circulation goes up.
2. Each unit of money therefore becomes worth less – meaning you can buy less with it. (It loses buying power).
3. So prices – when denominated in pounds, or dollars, or whatever – go up.
   

Step 1 is why the amount of money in existence in the UK exploded in the late twentieth and early twenty-first centuries – to such an extent that everything before that point is barely visible, as you can see in the next chart:

Broad money (M4) in United Kingdom, 1900–2020, stated in millions of pounds sterling

The three-step pattern is also why, as this follow-up chart shows, the buying power of the pound has decreased so sharply (step 2 – and therefore also step 3):

Buying power of £100 over time, 1967–2021

 And it isn’t just the pound. As you can see below, a whole host of major currencies have lost the vast majority of their buying power since the 1970s:

Buying power of 100 units of major currencies, 1967–2021. US dollar = black solid line, Australian dollar = black dashed line, German mark and euro = black dotted line, Japanese yen = grey solid line

Our new financial world

Ever since President Nixon made that announcement in 1971, we’ve been living in a completely new financial world. And that’s not hyperbole.

As we’ve seen, there have been times throughout history when the link between government-issued currency and an underlying ‘something’ (usually gold) has been weakened or broken. But the concept has always been there – in principle, at least.

Now though, for the first time, the only reason major global currencies have value is because governments say they do.

You could argue that this isn’t, in itself, a bad thing.

Clearly, a currency strictly backed by a fixed amount of gold isn’t dynamic enough to cope with extreme events. That’s why we’ve seen the normal rules abandoned during times of war. (However, you could also very reasonably argue that it’s only the overnight creation of large amounts of money that makes large-scale war possible – so it’d be better if governments were more restricted.)

A lack of restrictions also liberates the government to intervene in helpful ways in peacetime. For example, if an economic downturn causes widespread unemployment, the government can just create the money needed to provide jobs or welfare to prevent people from falling into destitution.

So flexibility can be positive, but it also has the disadvantage of introducing human nature.

Mo’ money, mo’ problems

If money had been created in tough times, then destroyed or repaid when conditions improved, that would be one thing.

Yet from the earliest moneyers to today’s governments, we’ve seen that once the value of money is diluted, it’s never reinstated. And since 1971, when the last practical constraint on money creation was suspended (‘temporarily’), we’ve witnessed a vastly higher amount of money creation than at any other point in history – with a corresponding effect on buying power.

As I explain in The Price Of Money, this certainly doesn’t affect everyone equally. Those closest to the source of the new money (or who have more of it to start with) often benefit, while everyone else suffers. I also explore the events of the years 2008 and 2020 in detail – both of which are on a par with 1971 in terms of how they’ve shaped the financial world we live in today.

To discover what happened next, grab a copy of Rob’s book The Price of Money: How to Prosper in a Financial World That’s Rigged Against You.

The recent commodities bear market – 2008 to 2020 – was like watching a faraway, failed state descend into chaos. Hard to understand, it went on for years, and all you really knew was that you didn’t want to go there. Hence I’d guess that many Monevator readers instinctively recoil from the very idea of commodities investing.  

But ongoing research and long-term data pieced together by multiple teams of investing academics suggests that commodities have been unfairly tarnished.

What happened to the asset class in that slump is most likely explained by a terrible sequence of returns. Bad luck for commodity investors, but a perfectly standard manifestation of investing risk. 

If that thesis is correct, then by ruling out commodities we make the same mistake as a risk-shy investor who has a lifelong aversion to equities because they came of age during the Great Depression. 

The bigger picture – filled in by 150 years worth of investment returns – is that broad commodities deliver excellent results over time, can diversify equity / bond portfolios, and boast some inflation-hedging capability, too. 

• Please read our commodities investing explainer for our intro to the asset class, how it works, and the drivers of return that make it profitable. 

The ghost of futures past

The following long-run UK returns chart shows why commodities futures are worth a second look:

Data from AQR1, Summerhaven2, JST Macrohistory3, and FTSE Russell. May 2023.

Since 1870, equal-weighted commodities have delivered a surprisingly good annualised real return of 4.3%. 

Meanwhile, UK equities paced ahead with a 5.3% return, while government bonds brought up the rear on 1.4%. 

Investing returns sidebar – All returns quoted in this piece are real annualised total returns. That is, they’re the average annual return (accounting for gains and losses) realised in a given time period. These returns include the impact of reinvested dividends and interest, but strip out the vanity growth delivered by inflation that does nothing to boost your spending power. Commodities dollar returns have been converted to GBP4.

Equities’ stronger returns mean we could forget about commodities if all that was happening was that shares and commodities rose and fell in synchronicity.

But the chart above also shows that commodities wax and wane to a different beat.

They’re highly volatile, but the fact that they often perform when equities (and bonds) falter is central to the pro-commodities case

They’re also a potent diversifier because the record shows that they’ve delivered superior long-term returns compared to gold, cash, or bonds.

Reality check 

Before we go any further, I have to deliver a reality check that takes the gloss off these results. (Although with that said it doesn’t undermine the nub of the issue: that commodities generate good returns – and otherwise unattainable diversification benefits – for a passive investor.)

The 150-year index shown above enables us to see the long-term pattern of commodity returns. But that index is very difficult to actually invest in. 

That’s because the Summerhaven and AQR research teams behind the historical data reconstituted it as an equal-weighted commodities futures index. 

This is a standard academic practice. It apportions the same weighting to every commodity futures contract included in the index. 

However there’s currently only one broad commodities ETF that tracks an equal-weighted index – and it excludes agricultural products. 

The majority of commodity indices weight their constituents by world production quantities and / or trading volume. 

This method is intended to represent the global economic significance of each commodity type. (Just as equity indices represent firms according to their market capitalisation.)

The issue is that production and liquidity-weighted indices typically underperform their historical equal-weighted counterparts. 

So to ensure we stay firmly grounded in the real world, I’ll only use data from historically investable commodities indices for the rest of these articles. 

Happily we have just such an index going back to 1933, thanks to the forensic efforts of Summerhaven’s research team. They published the data alongside their paper The First Commodity Futures Index of 1933. 

Their reconstruction of the Dow Jones Commodity Index can be directly linked to the contemporary Bloomberg Commodity Index, which is tracked by some of the largest ETFs in the space today. 

Do long-term investable commodity returns stack up? 

Thankfully, still yes. Here’s the chart:

Data from Summerhaven5, S&P GSCI TR, BCOM TR, A Century of UK Economic Trends, and FTSE Russell. May 2023.

The annualised return of commodities is 4.5% versus 5.5% for UK equities over this 89-year timeframe. Bonds dawdled along at a paltry 0.85%. 

Happily, aside from confirming that investable commodities deliver very handy returns, the chart also demonstrates that commodities often soared when equities stumbled. 

You can see commodities spike as equities sold off during World War Two, again in the early 1950s, and incredibly so in the stagflationary ’70s.

The same happens in reverse, too. Equities did the heavy lifting when commodities crashed in the aftermath of the Credit Crunch. 

How do commodities help as a portfolio diversifier?

The next chart shows how the main diversifying asset classes performed in years when equities were down, from 1934 to 2022.

Even at a glance, the cyan bars tell us that commodities sometimes spectacularly outperform everything else. 

That’s true in 1939 and in the post-war years of 1947 and 1949. It happens again in 1973, during the first leg of the UK’s worst-ever stock market crash, the opening innings of the dotcom crash in 2000, and most recently in 2022. 

There are also times when commodities are the only asset class that registers a positive return, while the others burrow into the ground. 

Indeed, commodities are the best asset in the portfolio 32% of the time. That’s a record only bested by cash’s 34% score. And cash earns pitiful long-term returns by comparison. 

Yet the fact remains that commodities can be a difficult bedfellow. They made portfolio returns worse in 42% of the years examined in our chart above. (Of course this also means they improved portfolio returns 58% of the time…)

Commodities won’t always bail you out. Sometimes they’ll make you rue the day. But there have been crises when they were the only thing that worked. 

We’ll examine how much commodities improve overall portfolio performance across the entire 89-year timeframe in a future post in this series.

Commodity correlations 

A correlations asset class matrix can help us assess the diversification benefit of commodities over different periods. An effective diversifier registers low positive or negative numbers against the other main asset classes.

Asset class returns correlations: annual returns 1934-2022 (inflation-adjusted)

	Commodities	UK equities	Gilts	Cash	Gold
Commodities	1	-0.11	-0.16	0.05	0.37
UK equities	-0.11	1	0.39	0.08	-0.21
Gilts	-0.16	0.39	1	0.29	-0.05
Cash	0.05	0.08	0.29	1	0.04
Gold	0.37	-0.21	-0.05	0.04	1

Gold data from The London Bullion Market Association and Measuring Worth. Cash is UK Treasury Bills data from JST Macrohistory and JP Morgan Asset Management. Other assets as per previous charts. May 2023.

Quick correlation recap:

• 1 = Perfect positive correlation: when one asset goes up so does the other
• 0 = Zero correlation: the two assets being measured have no influence upon each other 
• -1 = Perfect negative correlation: when one asset goes up, the other goes down

On this measure, commodities look like an excellent diversifier. The asset’s slightly negative correlation with equities and gilts means that it will sometimes spike when they stall or fall. 

Of course this also means that commodities can hold a portfolio back when shares and bonds are steaming ahead. But on balance, the historical record shows the asset class is a net positive. 

One of the exciting things about these correlation numbers is you rarely see other assets produce a combination of numbers that gel so well with equities and bonds and deliver strong long-run returns. 

By way of contrast, gold’s weak results over extended time periods (and the lack of a strong economic rationale for decent expected returns in the future) make me nervous about owning significant quantities of the yellow metal. 

Most of us buy into the idea of equity and bond diversification – even though they’re relatively highly correlated, and thus likely to be less effective diversifiers at times. 

Once again, it’s the combination of strong positive returns and low correlations with equities and bonds that make commodities worthy of serious consideration.

2008-2020 be damned!

Well, maybe…

Commodity drawdowns and crashes

I still can’t help being scared by that horrendous -66% commodities drawdown lasting from June 2008 to April 2020. 

Other lowlights include a 20-year bear market that dragged on from 1951 to 1971. And another -62% beasting that ravaged commodities from the end of 1974 to the beginning of 1982.

Overall there are several lost decades to wince at. Especially if we go back to the 1870s via the equal-weighted index.

By the way, don’t forget that these figures are real returns. Most commentators will talk about crashes and bear market recoveries in nominal terms – a much gentler standard. 

However it’s my duty to tell you that commodities investing is no easy ride. Although historically they’ve been a touch less volatile than equities.

On that note, it’s important to remember that all this and worse has also happened to the other asset classes we stake our future wealth on. 

UK equities caved -79% from 1972 to 1974, for instance. The UK’s worst bond market crash also plunged to -79% depths, from 1935 to 1974. Gold suffered a near 20-year bear market between 1980 and 1999.

Nothing is ‘safe’. 

If commodities still give you the willies, I can only say I’m right there with you.

They’re an unfamiliar asset class that works in an arcane way. And we’ve just lived through one of the worst commodities drawdowns on record. 

None of that helps my rational self override my emotional self. 

Which begs a serious question…

Are commodities a broken asset class?

Was the 2008 to 2020 losing streak just a bad bear market, or did something fundamentally change to impair the future fortunes of commodities? 

To answer this question, let’s bring in the big guns. Namely the venerable financial academics Dimson, Marsh and Staunton (hereafter DMS). 

DMS looked at precisely this question as part of their commodities investing chapter in the Credit Suisse Global Investment Returns Yearbook 2023. 

A particular concern is that the launch of commodity index trackers shortly before the Global Financial Crisis – and the concomitant flood of institutional investment capital – might have led to a permanent reduction in the historical advantages of the asset class.

DMS highlighted three possible dangers associated with the ‘financialization’ of the relatively small commodities market: 

First, inflows could have lowered the risk premium through the increased competition in the provision of insurance to hedgers. Second, because institutional investors hold portfolios of commodities and their allocation to commodities competes to some extent with that to other assets, their activities might increase the correlation between individual futures, and between futures and other asset classes. Finally, passive index investments might weaken the link between futures prices and fundamentals. 

However, DMS then go on to survey the work of other researchers who’ve examined this question and say:

The authors conclude that, despite the high growth in commodity markets during this decade, the proportion of hedgers and speculators was broadly constant. Nor, in terms of risk and return, was this decade significantly different from the longer historical experience. Correlations between commodities rose, then fell again. The authors attribute this to the Global Financial Crisis, not financialization. 

Citing additional evidence, DMS judge that:

It would seem quite wrong, therefore, to conclude that the risk premium from futures had disappeared simply because of the Global Financial Crisis drawdown in commodity futures that followed the publication of GR’s [Gorton and Rouwenhorst] research. This was a disinflationary and low inflation period, and, as we will see below, these are challenging conditions for commodity futures. 

DMS go on to show that commodities tend to perform poorly during recessions and disinflationary periods, concluding: 

The disinflationary decade following the crisis was a very difficult time for commodities. Many institutions capitulated, reducing or removing their commodity positions – before they turned useful again in 2021/22. It is harder for investors to stay the course in commodities than equities amid a comparable drawdown, given that commodities are less ‘conventional’. This can be a typical fate for a good diversifying asset. 

Indeed, the academic trio believe that the commodities risk premium remains alive and well: 

What risk premium should we expect from a long-run investment in a portfolio of collateralized futures? Ilmanen (2022) concludes that the best long-term, forward-looking estimate is the historical premium. He suggests that “a constant premium of some 3% over cash seems appropriate for a diversified commodity portfolio – though not for single commodities!” 

Other researchers float that 3% excess return figure too as the average long-term return you would hope to gain over and above the interest rate earned on cash in the bank. 

Vanguard’s 2023 commodities paper for instance employs an expected returns model to draw in data beyond the historical record. It proposes a highly finessed base-case estimate of a 2.85% future expected excess return.

Though it then hedges its bets by citing a range anywhere between 0.5% to 3%.

Where does this leave us?

It’s because I think we should all hedge our bets that I’m writing this commodities series in the first place. 

I want to evaluate the evidence for and against as well as I can, especially as it’s an asset class with enough ifs, buts, and maybes to fill a comedy of manners. 

Perhaps we need to move on from considering the strengths and weaknesses of commodities in isolation? After all, what really matters is their potential contribution as part of our properly diversified portfolios.

Let’s get to that in part three. 

Take it steady,

The Accumulator

1. Levine, Ooi, Richardson, and Sasseville. “Commodities for the Long Run.” FAJ, 2018. [↩]
2. Bhardwaj, Geetesh and Janardanan, Rajkumar and Rouwenhorst, K. Geert. 2019. “The Commodity Futures Risk Premium: 1871–2018.” [↩]
3. Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics, 134(3), 1225-1298. [↩]
4. British Pound Sterling [↩]
5. Bhardwaj, Geetesh and Janardanan, Rajkumar and Rouwenhorst, K. Geert, “The First Commodity Futures Index of 1933,” Journal of Commodity Markets, 2020. [↩]