As a speaker at this summer’s Risk Management Conference in Muskoka, ON (August 12 to 14), Geert Rouwhenhorst, Robert B and Candice J. Haas Professor at Yale School of Management and Deputy Director for International Financial Center at Yale, will lead a session on commodities and inflation.
In advance of the conference, we asked Geert a few questions about the historical correlations between inflation and commodities, how to invest in commodities and where they fit in a portfolio.
Over two centuries, how closely have commodities followed inflation?
There has been 60% correlation between annual changes of commodity prices and inflation over 200 years from 1800 to 2011. There is virtually no correlation between inflation and stocks and bonds.
The 200-year survey is about commodity spot prices and we have seen similar results from futures prices between 1959 and 2014.
What’s in the basket of commodities?
It’s an equal-weighted index and it has more than 100 commodities. Over two centuries of course, the mix has changed – whale oil has fallen out of demand, for example. An equally weighted index is a better tracker of inflation than individual commodities are. At the same time, the correlation between individual commodities has typically been around 10%, so an index is a diversifier.
How do you invest in commodities: futures or producers?
It’s impractical for retail investors to invest in physical commodities. They don’t necessarily want to own them – they would have to pay storage costs, for example — so the futures market is the most accessible way.
With companies you don’t just have the risk premium for commodity price volatility, especially when producers hedge the price risk. You also have the business premium – the risk associated with the individual company. So there can be a disconnect between the price of the commodity and the value of the company. They both merit consideration in a diversified portfolio.
But over the past 10 years, commodities have produced a risk premium of about 5.25% over the risk-free rate of T-bills. This is similar to the equity risk premium that people associate with investing in stocks. But like the equity risk premium, this will vary over time.
Some commentators worry that as institutional investors turn to commodities through the futures markets, they are artificially inflating prices.
Investor interest in commodities has certainly gown over the past decade. At the same time markets have expanded. If you look at the composition of the open interest in futures markets – that seems to have has remained relatively stable. So markets have grown proportionally. It is not the case that the markets have been flooded by speculators as some people have argued.
How would you put commodities in a portfolio?
Asset allocation is complex and dependent on a number of assumptions about risk and return. It also really depends on the investor’s preference. Futures provide a form of inflation exposure. Some investors may want inflation exposure to hedge against inflation. Over shorter time frames, stocks and bonds are pretty poor inflation hedges – they are negatively correlated with inflation. An equally weighted commodity index, however, is significantly correlated with inflation.
To learn more about the Risk Management Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Alison Webb to be considered, as limited space available.