CIO View: Commodities

For us, they form part of our liquid real assets category, and their particular role is to help provide protection against high inflation. Alongside them in that bucket are liquid real estate (REITS) and inflation linked-bonds. Each of those assets give you inflation protection to some degree, but crucially, they respond differently to different economic conditions. For example, inflation linked bonds benefit from falling real interest rates, meaning they can do well in a negative growth environment, whereas commodities typically do better in a rising growing environment. Real estate arguably sits in between; behaving more like an equity but with characteristics of both. A neutral position would be to work with an equal risk allocation across all three assets, we use about 50% in inflation linked bonds and 25% each in commodities and real estate.

Typically, when you’re investing in commodities, you’re buying commodity futures contracts. What that means in practice, is that you actually get three different drivers of return. People tend to think most about the movement in the spot price, but there are also factors of collateral return (T-Bill return) and roll yield. The collateral return is obtained because when you buy futures most of your capital is invested as collateral in T bills. The roll yield comes from the process of buying and rolling futures contracts to maintain the position. For example, if you buy a 3-month futures contract and the time elapses before it expires, you have to “roll it” by selling the contract you bought, and buy a new contract with 3 months to expiry. If the spot price is higher than the price that you bought into the future, you benefit from the future’s value going up. It’s often overlooked, but roll yield is a major part of the return for commodities future investors. One of the reasons that you get roll yield is that you are effectively providing finance; futures are used in a real sense by both the producers and consumers of commodities, to fix a price and help with their own future spending. So there is real economic benefit; as an investor a key source of your return is driven by the fact that you are providing that liquidity and financing.

At the start of last year, wary of the precarious economic conditions thanks to the onset of the Covid-19 crisis, we reduced our exposure to REITS and moved our commodity exposure to gold. That way, we still provided an inflation hedge, but we increased our portfolios’ defensiveness, with the added benefit of gold doing well when you see currency debasement.

Conditions now are materially different. At the beginning of the year, we moved from gold back into broader commodity exposure. Why? Based on the growth macro environment of recovery, the benefits of diversification, broader protection against ranges of inflationary environment, and more support from roll yields.

The base case for 2021 is a year of increasing economic growth and recovery and in a cyclical recovery commodities typically perform well, particularly more growth-sensitive commodities such as energy as industrial metals. The reason we have seen such precipitous falls in the gold price in recent weeks is because of its negative correlation to real rates, commodities on the other hand, tend to do well as real rates rise. What’s more, exposure to a commodity index offers greater diversification. Having a broad basket of commodity futures, each driven by different supply and demand dynamics, helps to protect you against different types of inflationary impulse. An energy supply shock for example will boost energy prices, while industrial commodities have proven to be an effective hedge against many different inflationary scenarios.

This year not only are we seeing a cyclical recovery as we emerge from the Covid-19 crisis, but because of the global economic shutdown, both inventories and the supply of a number of different commodities are low, which further supports prices in the short term. We think that this is a good time to be invested in the nuts and bolts of the global economy, but by actively managing our liquid real assets exposure we remain highly nimble in our approach to ever changing market conditions.

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