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Can Commodities Still Provide Shelter in the Storm as Both Stocks and Bonds Suffer Losses?

Celia Dallas

Yes, although such investments are not for the faint of heart. As we have seen in 2022, both stocks and bonds have lost value as inflation expectations have escalated. The current environment favors building robustness into portfolios, and exposure to commodities—in addition to high quality bonds—could be a part of this, particularly for investors whose finances are more exposed to inflation risk. While rising recession pressures would favor bonds, continued elevated inflation favors commodity futures and natural resources equity allocations. Prospects for commodity-related assets have improved over a three- to five-year holding period, even considering commodities’ recent strong run.

The case for natural resources equities is two-fold. First, investors have been hesitant to provide capital to commodity producers to expand productive capacity. Historically, mining companies have been notoriously bad stewards of capital, over-expanding capacity when supply is constrained only to face a glut of supply after the long period it takes to bring new capacity online. However, in recent years, capital expenditures beyond maintaining capacity have been low for both energy and metals. Environmental, social, and governance (ESG) concerns have also constrained capital flowing into commodity production. This discipline helps keep supply in check and is supportive to commodities like energy and metals, which can take years to bring new capacity online. Second, as the investor base for natural resources equities has demanded that such companies return capital to investors rather than invest in expanding capacity, cash flows and cash distributions to investors have increased. Normalized price-to–cash earnings ratios are roughly in line with historical medians since 1985, albeit on the high side of recent history.

Investing in near-dated commodity futures is another means of gaining access to commodities. Like natural resources equities, the outlook for commodity futures has improved. In contrast to the experience of the last two decades, most commodity futures trade in backwardation, which produces positive returns as futures prices converge to higher spot prices as futures expire. Second, if central banks move as aggressively as they have indicated they will, cash returns on collateral will improve from the near-zero rates on offer for more than a decade. Provided supplies remain tight relative to demand, commodities futures should perform well. However, commodity-related assets would suffer amid escalating recession concerns, a near-term resolution to the war in Ukraine, or technological leaps that accelerate the transition to a low-carbon economy, and commodity futures would likely suffer worse than natural resources equities under such circumstances.

For those willing to invest in natural resources equities and commodity futures, recognizing the complexities of doing so is critical, including the regulatory and transition risk in a world moving to a low-carbon economy. The ESG case has always been complicated and today is even more so. Instead of blanket bans, we urge thoughtful implementation. Investors must consider the trade-offs they face when investing in fossil fuels, metals, and minerals. For example, such investments carry high-carbon footprints, although investors focused on moving to a low-carbon economy can concentrate investments in those companies seeking to transition to a lower carbon environment or liquid investments that can be sold over time. (Investors are accelerating commitments to bring greenhouse gas emissions to net zero by 2050. The aim is consistent with the 2015 Paris Agreement to “limit global warming to well below 2°C, preferably to 1.5°C, compared to pre-industrial levels.) At the same time, under-investment in fossil fuels has created more price volatility in these necessary commodities. Recent high prices have pushed up heating bills and transportation costs with the greatest impact felt by the lowest-income consumers —a form of regressive tax.

As we have long emphasized, allocating capital to help protect against unexpected inflation and deflation may lead to lower returns. This is true of commodity futures and natural resources equities, which may prosper if inflation risks remain elevated, but may retreat if inflation subsides. As such, investors must carefully consider the role of the long-term investment pool and the degree to which such protection is necessary to meet investment goals and objectives. To complement investments in commodity-related assets, or in lieu of them, exposure to infrastructure or real estate could also diversify traditional portfolio holdings, even if their sensitivity to changes in the inflation rate is less.