Powering Your Portfolio with Commodities

by: , Director of Index Strategies, IndexIQ
  • Do you have concerns about a weakening U.S. dollar?
  • Is U.S. inflation a worry?
  • Are you seeking diversification opportunities?

If you answered yes to any of these questions, then an allocation to commodities may be worth considering. Commodities are physical assets, which include metals such as copper and gold, energy resources like oil and natural gas, and agricultural goods such as wheat and cattle.

A Hedge Against a Falling U.S. Dollar

Commodities are priced in U.S. dollars, which has certain implications on the performance of commodities in the global marketplace. The chart below shows the price movement of a broad commodity index (orange), gold (grey), and the U.S. dollar versus a basket of international currencies (blue).

Commodity Prices and U.S. Dollar

Source: FactSet, 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

As you can see, the value of commodities moved inversely with the value of the U.S. dollar. Therefore, when the U.S. dollar weakened, commodities often strengthened (and vice versa). To understand why, consider when the U.S. dollar weakens relative to another currency, the latter will conversely appreciate in value. This leads to an increase in the purchasing power of the non-U.S. currency for U.S.–priced goods. Since commodities are priced in U.S. dollars, this means it takes fewer foreign currency units to purchase a given commodity. Fundamental economics indicate that when the cost of an item goes down, the demand increases which, in turn, leads to rising prices. Therefore, when the dollar weakens, the price of a given commodity is expected to move higher.

A Hedge Against Inflation

Commodities are also generally considered to be a hedge against inflation. That’s because when inflation rises, the value of commodities also rises. Said differently, rising inflation reduces the purchasing power of a currency. This reduction in purchasing power can be hedged with commodities.

The following chart shows the movement of a broad basket of commodities (blue) and the five-year inflation breakeven rate (the difference between nominal and real interest rates (orange)). The breakeven rate represents the additional yield required to preserve the purchasing power of the U.S. dollar. The chart demonstrates that the co-movement of commodities and inflation is generally closely aligned, which indicates that as inflation rises or falls, commodity prices tend move in the same direction.

Commodity Price and Inflation

Source: FactSet, 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

Intuitively, this makes sense. Commodities are a real asset, and unlike financial assets such as stocks or bonds that are purchased for price appreciation or income, commodities also offer a special benefit for their usefulness. Consider a commodity to be a production input for industrial, agricultural, or energy purposes and can therefore be used or consumed in the manufacturing of finished goods.

For example, metals are needed for car bodies, building structures, and wires for electronics. Bakeries need grain to make flour for bread and cakes. Power production requires sources of energy, such as oil and natural gas, in order to generate electricity. Inflation causes the prices of these finished goods to rise, in part, because the prices of production inputs (i.e., commodities) are also rising.

Commodities Have a Diversifying Effect

As discussed, the inclusion of commodities in a diversified portfolio can serve as a useful potential hedge to a falling U.S. dollar and an increase in inflation. In addition, the low correlation of commodities with other asset classes, such as stocks and bonds, supports the use of commodities as a means to help diversify risk in a portfolio. By including assets that are less correlated with each other, the assets’ co-movements are not closely in sync, which help reduce how a given market event may impact the portfolio as a whole. We can see that there is low/negative correlation between stocks/bonds and commodity asset classes.

Correlation of Weekly Returns from January 1991 to February 2018

Correlation Equities Bonds Commodities
Equities 1.00
Bonds -0.05 1.00
Commodities 0.26 -0.06 1.00

Sources: FactSet, as of February 2018. Equity is represented by the S&P 500, Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index, and Commodities are represented by the Bloomberg Commodities Index (BCOM). A correlation of 1.00 represents a positive correlation between two variables – the closer the value is to 1.00, the stronger the linear relationship. A -1.00 correlation represents a negative correlation and an inverse relationship between two variables.

To be sure, commodities underperformed during the recent low interest rate environment. However, the emergence of inflation has prompted the gradual raising of interest rates, and not surprisingly, upward support for commodities. During the period from the Federal Reserve’s first rate hike in December 2015 through January 31, 2018, commodities have gained 37.62%. This is consistent with our earlier observations of the correlation between commodities and inflation. Furthermore, as my colleague, Dan Petersen, explains in his blog, commodities also provide an opportunity to participate in the current, synchronized, global economic expansion.

About Risk:

All investments are subject to market risk and will fluctuate in value. Past performance is not indicative of future results. An investment cannot be made in an index. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors, who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government, as to the timely payment of principal and interest.

Diversification does not ensure a profit or protect against a loss in a declining market.

Neither New York Life Investment Management LLC, its affiliates, nor its representatives provide tax, legal, or accounting advice. Please contact your own professionals.

Bloomberg Commodity Index (BCOM) is a broadly diversified commodity price index distributed by Bloomberg Indexes.

Bloomberg Commodity Spot Index (BCOMSP) measures the price movements of commodities included in the Bloomberg CI and select subindexes.

Bloomberg Dollar Spot Index (BBDXY) tracks the performance of a basket of leading global currencies versus the U.S. dollar. The index represents both developed and emerging market currencies that have the highest liquidity in the currency markets and the biggest trade flows with the U.S.

Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.

Commodity refers to investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments or other factors) could have an adverse impact on those companies.

Correlation is a statistic that measures the degree to which two securities move in relation to each other.

Gold Commodity Spot Index measures the price movements of gold.

S&P 500 is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.

The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report and are subject to change without notice. Past performance is no guarantee of future results.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, New Jersey 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Mark Lacuesta, FRM, CAIA, CIPM

Director of Index Strategies, IndexIQ

Mark is Director of Index Strategies at IndexIQ where he is responsible for overseeing IndexIQ’s proprietary and third-party indexes underlying the firm’s ETF offerings. In this role, Mark is involved with research, product development, trading, sales, and marketing

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