The new era of quantitative tightening and gradual withdrawal of liquidity from the global financial system is likely to have wide-ranging implications for investors.
Duration risk, inflation risk, constraints on market liquidity, and a lack of diversification are among investors’ concerns.
Commodities can help investors address these concerns and enhance the overall stability of their portfolios.
Although short-dated fixed income investments can help to lower duration risk in investors’ portfolios, commodities offer greater protection against rising rates compared to financial assets more broadly, as they have historically outperformed stocks and bonds in a rising rate environment.
We believe this traditional advantage offered by commodities will become even more apparent as the rising rate cycle persists.
Correlation is low between commodities and traditional assets, including stocks and bonds. Importantly, it is also low between assets within the commodities complex.Many investors’ liabilities are linked to inflation and addressing the rising nominal value of these liabilities presents investors with additional challenges.
Unlike stock and bond returns, which are often challenged amid rising inflation, commodities have consistently responded favourably under these conditions. Just as rising commodity prices drive consumer price inflation, they also drive commodity returns.
Furthermore, the asset class is highly liquid and a strong diversifier.
Correlation is low between commodities and traditional assets, including stocks and bonds. Importantly, it is also low between assets within the commodities complex.
Base commodity demand does not vary greatly and is relatively price inelastic. For example, agricultural commodities and energy are required to feed populations, to transport goods, and heat homes.
Commodities are the most liquid component of the real assets chain, as they are traded in vast quantities multiple times a day, across a number of exchanges, and accessed using different investment vehicles.
Low intra-sector correlations within the commodities complex and the scale of the opportunity set require an active and flexible investment approach in order to source the most rewarding investment opportunities in the asset class, in our view.
Instead of treating commodities as a single undifferentiated asset class in the manner of commodity index funds, which typically include a smaller cross-section of the commodities complex, we can actively seek out value among widely differing commodities sectors.
We invest in commodities and commodity-related equities. This further broadens the opportunity set and deepens liquidity. Meanwhile, the equity component offers a potential incremental source of alpha with lower volatility, compared to conventional commodity funds.
We tilt our portfolio between direct and indirect exposure, depending on the dynamics of the futures market. Allocations to commodity-related equities can be particularly additive to returns when the commodity futures curve is upward sloping (i.e., in contango), as this drags on commodity investors’ returns.
In these circumstances, the portfolio can tilt toward commodity-related equities, seeking to profit from the companies that stand to benefit from higher spot prices in the future.
A core part of the fundamental analysis we conduct is to assess the sustainability risks associated with any potential investment and, as active managers, we regularly engage with company management to better understand a company’s business strategy, use of shareholder capital, and environmental, social, and governance (ESG) practices.
While there is a growing acceptance that a company’s ESG practices can affect its valuation and financial performance, tying the underlying factors together is rarely a straightforward process, as many factors relating to ESG are often subjective, and difficult to track and quantify.
Frequent and thorough company engagement, and the integration of rigorous ESG analysis into investment processes could offer investors unique insights into how different businesses are developing, and ultimately help them to better anticipate the risks and opportunities.
For investors considering a commodities allocation, the prevailing macroeconomic conditions have created an optimal entry point, in our view.
Although escalating trade tensions have introduced some near-term uncertainty in recent months, the structural case for investing in the asset class remains intact. Lower capital expenditure by commodity suppliers over the past several years portends a spike in commodity prices as global inventories are drawn down.
With capacity so stretched, any disruption resulting from natural disasters or geopolitical threats could cause commodities prices to spike.
Trade tensions, in conjunction with the chronic undersupply of commodities and the price inflation it implies, could bid up the value of commodity investments for as long as it takes capital expenditure in the commodity complex to recover.
Rising interest rates and low commodity prices are forcing greater discipline on capital spending among commodity producers, a factor that will likely serve to further tighten supply.
Active managers with the expertise to identify the most rewarding opportunities from a broad opportunity set, and the flexibility to use the most appropriate vehicle to exploit them, offer clear competitive advantages when investing in this asset class.
Terence Brennan is portfolio manager on the commodities team at Lazard Asset Management
