Rising inflation, along with infrastructure and alternative energy initiatives, could support the outlook for commodities and related exchange traded funds.
“Commodities may provide a uniquely valuable diversifying component to any long-term investment portfolio,” Ed Egilinsky, managing director, head of sales and distribution, head of alternative investments, Direxion, said on the recent webcast, Commodities: A Tactical Opportunity in Inflationary Times.
Commodities represent a significant portion of the CPI’s volatility, resulting in a positive and often out-sized response to inflation. Their low correlation to equity and fixed income can lead to enhanced risk-adjusted returns. Commodity markets offer unique active trading opportunities for capable investment managers to generate alpha.
Additionally, commodity demand could experience a shock due to post COVID “build back better” infrastructure spending in both developed and emerging markets. Tim Pickering, founder, president, and CIO of Auspice, argued that the extended period of underinvestment in supply and generational demand could contribute to a commodity super cycle ahead.
Commodity futures may offer the most practical solution for responsible investors seeking commodity exposure. According to Auspice, futures do not affect consumption or production — they affect exposure to risk, and these are fundamentally different. The ability to invest in an instrument for which value is affected by nothing other than the underlying price of the commodity itself is undeniably the lowest-impact method of attaining valuable commodity risk exposure.
The role of a weakening U.S. dollar could continue to support the commodities market ahead. USD-denominated commodities become cheaper for foreign buyers, and weakness in the dollar and rising inflationary pressures could support hard assets as well.
Looking ahead, the unprecedented M2 money supply growth to combat COVID-19 recessionary pressures has contributed to greater inflation risk.
In addition, favorable conditions for a move higher in commodity prices have returned. The demand vs. supply ratio is over 1.0 while prices are low, according to the Bloomberg Commodity Index. Global commodity demand is increasing while supply has not kept up in face of demand trending higher.
“Every single commodity market with the exception of wheat is in a deficit today,“ according to Goldman Sachs. “It’s the beginning of a structural bull market not only in oil, but across the entire commodity complex.”
Commodities have long been an alternative asset class that many institutional investors utilize to diversify a traditional stock and bond portfolio. Specifically, institutions utilize alternative assets like commodities for capital preservation to mitigate risks, with the average State Pension Fund holding about 20% in alternatives.
Historically, lower correlation has helped investors diversify a traditional portfolio mix. Specifically, commodities have exhibited a historically low correlation of 0.57 to equities, 0.03 to fixed income assets, and -0.70 to the U.S. dollar.
While many have focused on gold as a source of diversification and an inflation hedge, the reflation trade has seen most commodities bid except gold.
“Historically, a broad basket commodity exposure has been a better inflation hedge,” Pickering said.
Pickering highlighted the Auspice Broad Commodity strategy, which combines opportunistic commodity exposure with capital preservation. It takes an upside opportunistic while limiting downside based on observed momentum and trends within individual commodities. Consequently, the methodology is tactically invested by going long in rising markets, but it also exits positions to preserve capital as markets fall.
“We combine systematic long/flat positioning, dynamic risk management, and contract roll optimization to selectively participate in commodity gains while minimizing volatility and drawdowns,” Pickering said.
ETF investors who are interested in the strategy can look to the actively managed Direxion Auspice Broad Commodity Strategy ETF (NYSEArca: COM), which tries to provide total return that exceeds that of the Auspice Broad Commodity Index over a complete market cycle.
Financial advisors who are interested in learning more about the commodities markets can watch this webcast here on demand.