Commodities as inflation hedge

Not all commodities react the same to inflation

Though we may think of commodities in general as being inflation hedges, it’s actually a very mixed bag. The best performers historically have been precious metals and energy. But other commodities, such as industrial metals and many agricultural products can actually decline in price as physical demand declines due to financial constraints.

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Long term vs. short term reactions

Another complication in commodities is time frames. The reaction of commodities to inflation is often short-lived. During peak periods of inflation, commodity prices can explode, but once inflation begins to subside, commodities could fall hard and fast. And when the threat from inflation subsides, commodity prices can sink, and go quiet for a very long period of time.

The problem with this arrangement is that there’s acute inflation – the type commodities react best to – and then there’s the slow, gradual type that is always with us. During the past 30 years for example, inflation has averaged about 3% per year. During most of those years commodities hardly reacted to gradual rising prices. Gold, in particular, was flat to declining during most of the 1980s, 1990s, and even the early 2000s. There was inflation for sure, but not the type that gold reacts to.

A new dilemma for commodities

There is a glitch with commodities right now in that prices have already risen substantially at a time of historically low inflation. In fact, at times since 2000 we’ve even flirted with deflation – and yet still commodities continued to rise.

With oil hovering around $100 a barrel and gold at nearly $1,700 an ounce, you have to wonder if the absence of inflation has anything to do with running them up to that level. As absurd as it sounds on the surface, is it possible that a surge of inflation might be negative for commodities in some way that is not entirely obvious right now?

The other concern is that these two bellwether commodities have experienced incredible price increases in the past decade. Would that somehow reduce their effectiveness as inflation hedges going forward?

Oil and gold were two of the best-performing assets during the inflation-plagued 1970s, but the whole dynamic was very different. Gold started out the decade at $35 an ounce, while oil was less than $3 a barrel. As inflation increased during the decade those commodities had plenty of room to run. Will that be the case now?

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Are there better inflation hedges?

There’s a tendency to recognize inflation only during those times when it reaches uncomfortable levels. But in truth, there is inflation all the time and commodities don’t always react to it. The best strategy to brace yourself for inflation may be a combination of a small position in commodities – for those times when inflation is on a tear – and other assets that react better to the slow, gradual type of inflation that is so much more common. Read more about this at our inflation-proof investments article here.

The likely loser

If you have to pick one asset class that will get clobbered by inflation it’s certain to be bonds. The problem with bonds is that they are long-term investments that pay a fixed rate of interest that does not adjust for inflation.

Rising inflation causes higher interest rates, and higher interest rates will result in lower bond prices. You will be holding an investment that is

• a) locked at a low-interest rate while it is
• b) declining in price.

If you had to pick one asset class to get out of during an inflationary period, it would certainly be bonds.

Balance to the rescue

In truth, no one really knows how any asset category will perform during high inflation. Asset classes that one would expect to react positively to inflation may turn out to do the opposite for reasons that are not fully understood right now. The best reaction to inflation, from an investment standpoint, it’s probably a balanced portfolio.

It is hard to argue with the success of energy and precious metals during periods of high inflation. That doesn’t mean that you should move all or most of your money into these commodities at the first sign of rising prices. Since there are different types of inflation – and different market reactions to them – there is a strong case to be made keeping positions in stocks, money market funds, and TIPS, in addition to commodities. Because of the inflation/interest rate connection, real estate can be more speculative in nature.

A balanced portfolio will almost certainly be the best response to rising inflation. For most investors, that will probably mean adding (or increasing) positions in energy and precious metals, lightening up some on stocks, and getting out of bonds completely.