Beginning 2024: Notes on Commodities and Inflation

A Guest Blog by Ivo A. Sarjanovic

One year after publishing Commodities as an Asset Class with Alan Futerman, the tranquillity of the year-end holidays provides an excellent opportunity to review data and literature regarding commodities and inflation.

In summary, our book's thesis argued that contrary to the "conventional wisdom" of some financial advisors, the concept of passive-static investment in a commodities index as a hedge against inflation does not always prove effective.

For instance, Goldman Sachs projected for 2023 a 43% return for the S&P GSCI TR, but the index closed at -4.27%. The more traditional S&P GSCI closed at -12.55% for 2023. The Credit Suisse Commodity Index closed at minus 10.5 %, despite the bank's advice at the end of 2022 that commodities were a good hedge against inflation, especially when invested across a very broad and equally weighted portfolio of different raw materials (not actually available in any existing index given that the different degrees of liquidity in many of the suggested markets would make it unsuitable for investing purposes).

The Bloomberg Commodity Index ended the year at -12.55%, and the Dow Jones Commodity Index finished 2023 at -8.7%. By any measure, these performances were far from impressive. But if you were seeking to diversify your portfolio, you have undoubtedly succeeded, considering that equities gained 24.2%, as measured by the S&P 500. The debate about the correlation, or lack thereof, between commodities and equities or bonds is endless...

Adding to the challenge, when factoring in the 3.1% US CPI inflation for the 12 months ending November 2023, which investors initially sought to hedge, the real return for each index becomes even more dismal. Consequently, the capital invested in these indexes not only failed to keep pace with the annual inflation rate but actually depreciated further, as commodity prices did not consistently align with the various price indexes used to gauge currency purchasing power losses.

As expected, commodity prices took divergent paths throughout the year, as illustrated in the graph, thanks to Peak Trading Research. Despite the overall weakness, notable opportunities arose on the long side, particularly among certain soft agricultural commodities.

Seeing the richness of the wide menu of price moves, one cannot help but notice that commodities are assets to be actively traded, not to be invested in passively. As outlined in our book, there are years when micro and macroeconomic conditions align in a bullish scenario, causing commodities to overshoot and generate compelling results—sometimes surpassing the originally targeted inflation rate as a hedge. However, these same conditions often trigger reactions that reverse the rally, causing commodity prices to lose momentum and struggle to maintain gains.

When prices deviate upwards from their long-term fundamental trend, the dynamics of price elasticity shift, leading to a decline in demand and an expansion of supply. Economic authorities, concerned with general price increases, tighten monetary policy, and financial investors, realizing that their bet exceeded rational bounds, often reevaluate their positions. This cycle demonstrates the need for dynamic management and a nuanced approach to trading commodities, as passive investment strategies may prove inadequate in navigating the complex and dynamic nature of commodity markets.

It's essential to bear in mind that commodity prices are ultimately shaped in the long run by the microeconomic fundamentals of supply and demand. While macroeconomic conditions, especially those of the US and China, can undoubtedly impact their price trajectories, fund activity also has the potential to catalyze price movements in either direction, accelerating but not distorting the manifestation of fundamentals, revealing their effects at a pace different from what might be anticipated under normal circumstances.

This graph tries to summarize it:

Commodity supercycles occur when both micro and macroeconomic conditions align within the Very Bullish quadrant. In 2023, monetary policy progressively tightened, pushing real interest rates into positive territory and decelerating inflation and growth. China's reopening proved to be disappointing, yet supply chains began to exhibit more normal behaviour, and stocks rebounded, transitioning from the Very Bullish quadrant to both the Gradually Bullish and Very Bearish quadrants, contingent on the specific commodities in consideration.

For a summary of how different macroeconomic conditions affect commodity prices:

Observing the evolution of commodity prices in 2023, some analysts are beginning to adjust their opinions, acknowledging that commodities may underperform when inflation is slowing down. Conversely, others propose that commodities serve as an effective hedge only when inflation experiences an unexpected surge.

This perspective implies that the recommendation for a suitable hedge against inflation remains valid solely during periods of rising inflation and not against any level of inflation. However, such an approach challenges the notion that commodities are a reliable long-term hedge and reinforces the argument that commodities are assets meant to be dynamically traded. This involves capitalizing on precise entry-exit levels and strategically employing both long and short positions.

For those interested in going deeper into this subject, let me recommend three recently published works which reach a similar conclusion to ours:

“The Inflation Commodities Cycle: A Regime Switching Approach to Inflation Hedging” (June 2023) by Fredrik Findsen from the Copenhagen Department of Economics, where he warns against the idea of commodities as a long-term hedge Vs. inflation and also highlights how different commodity families react to the erosion of value in money inviting investors to rethink the conventional wisdom about inflation hedging with commodities, proposing a dynamic, regime-driven strategy in place of a static asset allocation.

"Are commodity futures a hedge against inflation? A Markov-switching approach," International Review of Financial Analysis, Elsevier, vol. 86(C) by Liu, Chunbo & Zhang, Xuan & Zhou, Zhiping, 2023, where they find that total commodity futures fail to provide a hedge against inflation over the sample period between January 1983 and December 2021. However, industrial metals and precious metals are able to hedge against inflation. Other sub-indexes, including energy, agriculture, and livestock, do not have a significant inflation hedging ability.

“Essays in Liquidity, Monetary Policy, and the Commodity Market” (September 2022) by Miruna-Daniela Ivan, from the University of Essex, where she expounds how the level of liquidity of different commodity markets make them react in a non-homogeneous way to changes in monetary policy.

Lastly, I recommend these two pieces that I came across in 2023 and thoroughly enjoyed. As someone who values the insights of myth-debunkers, these articles resonated with me.

The Roll Yield Myth by Hendrik Bessembinder from Arizona State University  (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3011634 ) where he writes:

“A futures investor does not earn or pay the difference in futures prices across contracts on the date that contract positions are rolled, or on any other date for that matter. Gains and losses on futures positions depend only on changes in the prices of individual contracts during the time an investor has an open position, never on differences in prices across contracts. Assertions that a futures trader can “pocket the difference” between the futures prices for two different contracts so as to generate a “steady income” or that “buying” a futures contract with a “more expensive” futures price (as compared to the contract simultaneously sold) involves a loss of investor monies reflect a fundamental misunderstanding of how gains and losses on futures positions are determined.”

“Speculation By Commodity Index Funds: The Impact on Food and Energy Prices” by Scott H. Irwin, Dwight R. Sanders (https://www.cabidigitallibrary.org/doi/book/10.1079/9781800622104.0000 ) where, among other things, they explain that:

“We then used exhaustive empirical tests across numerous markets, time frames, and data sets to show that there was no consistent evidence that positions held by index investors caused large changes in commodity futures prices. Batteries of time series and cross-sectional tests failed to find consistent temporal causality between index positions and futures prices. This body of work conclusively demonstrated that index speculation was not the main driver of the great commodity price spikes that occurred between 2007 and 2013.”

Happy 2024 to all, hopefully learning more about commodities!