How Effective Are Commodities As An Inflation Hedge?

Talk about inflation, and investors attention often turns to commodities. The conventional wisdom is that rising inflation turns commodities into winning investments. That can be true, but it depends on the type of commodity and on the type of inflation.

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.

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.

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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 a 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?

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 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.

Stocks. Over the past 100 years stocks have an average return of at least 8% per year. They tend to perform better during the years of low-inflation but an 8% average return over a very long period of time can overcome short-term bursts of inflation.

Real estate. Much like commodities, real estate has a long history of reacting favorably during periods of high inflation. And much like stocks, it also has a winning price record during low inflation too. That would seem to make it the best of all inflation related investments – except that the last few years have thrown some doubt on that assumption.

One of the limitations with real estate is that it is highly leveraged, making it heavily reliant on financing. Should mortgage rates rise to compensate for higher inflation, house prices might fall in a general inflation. Though it has a solid track record with inflation, the situation could be different going forward.

Money market funds. These are not a play on price appreciation so much as on interest rates. Inflation would result in higher interest rates, and because of their liquid nature money market funds would react to this as it happens. If inflation were to increase to 8%, interest rates might rise to say 10%. Your annual returns would at least keep your liquid assets rising consistent with inflation.

Treasury Inflation Protected Securities (TIPS). These are government securities that pay interest, but also adjust the principal based on the Consumer Price Index (CPI). There are two limitations here that are worth considering. The first is that you will not be able collect the additional principal until the securities fully mature, and that may be many years after the fact. The second is that the principle adjustment is based on the CPI, which may not reflect the complete inflation picture. Still, TIPS will be a better investment than most others during a period of heavy inflation. (Editor’s Note: I Savings Bonds are another alternative)

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.

Readers: What asset classes do you think will provide the best protection from inflation?