The Strategic Case for Commodities

With their ability to act as an inflation hedge, diversified, and return enhancer, commodities should be considered an important portfolio allocation over the long term.

Commodities tend to offer three strong benefits to portfolios: diversification, inflation protection, and return potential. Commodities have been the best-performing asset class in the last three years as of 3/31/2023 with the BCOM index outperforming both the S&P 500 and the Bloomberg Global Aggregate Index. This is likely due to fundamentally driven, structural dynamics in the sector, including underinvestment. But the strong recent performance has also been enhanced by ongoing geopolitical developments, highlighting how commodities may provide critical portfolio diversification during inflationary periods.

This backdrop raises a natural question: Should investors continue to allocate to commodities even if, for example, inflation concerns diminish, or we experience a mild recession? We believe the answer is yes. In examining the three well-known potential benefits of investing in this asset class, we find the strategic case for commodities is strong today and in the long term.

Diversification remains critically important

The typical 60/40 stock/bond portfolio construction assumes that fixed income and equities are inherently diversifying, with low correlations (when asset class returns tend to move in the same direction over time, we say they are highly correlated) – that is ideally sufficient for investors seeking to weather various macroeconomic conditions. For much of the past 25 years, this assumption has been largely met, until the past year or two. Correlations between stocks and bonds recently have reached levels not seen since the late 1990s, with recent rolling 12-month correlations around 0.75 versus the long-term average of 0.19 for the period 1977–2023. This greatly reduces any assumed diversification benefits and underscores the need for true sources of diversification to traditional 60/40 portfolios. Long-term data for stocks, bonds, commodities, and inflation indicate commodities historically tend to be the most correlated with inflation (0.43), while they are negatively correlated with bonds (−0.27) and only slightly positively related to stocks (0.24).

Figure 1: This table shows the correlations between three assets (U.S. equities, global bonds and commodities) using annual returns and the U.S inflation rate. Correlation is a measure of the strength of the relationship between two variables and ranges from -1 to +1. A negative value means they generally move in the opposite direction and a positive number means they move in the same direction. The chart shows that commodities are the most positively correlated with inflation. Stocks and bonds are negatively correlated with inflation.

Why do commodities tend to offer these diversifying tendencies? Commodities are “real assets” that react to changing supply and demand fundamentals in different ways than stocks and bonds, which are “financial assets.” The supply and demand of commodities is affected by many factors such as capex (or lack thereof) within commodity industries, geopolitics, and regulation/policy. Today, policy efforts to address climate change by transitioning away from traditional hydrocarbons, combined with efforts to re-shore supply chains and build resiliency, are likely, at least on our secular horizon, to be quite supportive of commodities as an asset class. Climate change itself also appears to be having real adverse effects on agricultural commodities supplies.