Precious metals are all the rage, but a broad basket of commodities might be a better bet against inflation going forward.

ABSR Research LogoToday, you can’t watch television, listen to radio, or surf the web and social media without being bombarded by ads to buy gold and silver. They emphatically recommend purchasing coins and bullion directly or setting up a precious metal IRA. While their rationale to purchase precious metals may have merit, a broad based basket of commodities through an ETF or mutual fund may currently be a better option.

Undoubtedly, sustained levels of inflation and a declining currency are serious concerns for investors. Inflation decreases purchasing power and is the adversary of accumulated wealth. Under the current environment of below normal asset returns, inflation could be particularly devastating, especially for those in their retirement years.  Owning assets that are positively correlated to inflation could help mitigate the effects of sustained price increases for goods and services and protect your spending power in the future.

Heightened inflation risks

The U.S. government attempts to control general price fluctuations for goods and services through monetary policy. Unfortunately, the credit crisis has forced the Federal Reserve to hold short term interest rates well below normal levels for an extraordinarily long time. At the same time, the recession decreased tax receipts and combined with unprecedented increases in government spending has ballooned the debt.  The US money supply as measured by M0 is near the all time high reached in August of 2014 and if not corrected could lead to rising wages, increasing raw materials prices, declining productivity, and even higher taxes, factors that eventually show up as inflation.  

Presently, inflation or the lack thereof, has not materialized, but the environment for elevated inflation and a decline in the currency is concerning. Not only has the money supply increased, but the U.S. trade balance as a percent of GDP sits at a deficit of roughly -2.70%.  Also, according to the most recent data (2016), U.S. debt as a percent of GDP is 106.7%, the highest levels since WWII. Within the G20 nations, only Japan and Italy have a higher debt to GDP ratio and the U.S. is nearly twice that of Argentina (54%). To suggest the potential for inflation is evident would most certainly be an understatement.

Protecting your portfolio

Multiple studies have shown that over longer periods time traditional portfolio assets i.e. stocks and bonds, have been negatively correlated with inflation. As inflation increases the value of stocks and bonds generally decrease.  Gorton and Rouwenhorst (2006) studied a 45 year period from Jul 1959 to Dec 2004 and found that not only were stocks and bonds negatively correlated to inflation, but the magnitude (positive or negative) tends to increase with longer holding periods. In their study, overlapping 5 year periods showed a statistically significant correlation to inflation of -0.42 for stocks and -0.25 for bonds. Commodities in the same study, however, showed a positive 0.45 correlation to inflation.

This makes intuitive sense given that commodities represent a significant input to the components in the Consumer Price Index (CPI) that is generally used to measure inflation. Housing, food and beverage, and transportation categories combined represent over 70% of the total consumer price index. According to the BLS, energy alone, which is indirectly reflected across multiple categories, accounts for about 7% of total household expenditures. Energy, as we will see may ultimately be the best commodity sector hedge against inflation.

Three reasons to favor a broad basket over precious metals

Gold and silver of course are positively correlated with inflation and added to your portfolio could help protect from a decline in the purchasing power of the dollar. However, we believe there are reasons to favor a broad basket of commodities over precious metals alone. Those reasons include the current relative value of gold and silver, avoiding single commodity volatility, and a lower correlation than broad commodities combined.

1. The current relative value of gold

Few other commodities have come close to the increases seen in the value of gold and silver over the past 15 years. On a spot price basis, gold has increased roughly 297% and silver 230%.  On a front month futures basis, it has been 202% and 191% respectively. Chart 1 below illustrates the relative divergence between a balanced basket of commodity futures (ex gold and silver) and the two precious metals.

Source: ABSR Research

Prior to 2005 gold and silver tracked rather closely to other commodities. Since then, however, the two metals have significantly outperformed broad commodities. While the spread between the precious metals and the broad market have declined since 2011, on a relative value basis they still appear overvalued. Much of this divergence can be explained by the declines in the energy sector lead by natural gas and crude oil that began in 2008.

2. Avoiding single commodity volatility

Commodities individually are notoriously volatile assets as measured by annualized standard deviation. Looking at front month futures contracts for measure, since 1997 average annualized monthly volatility of 16 commodities from 5 sectors has been just over 29%. Gold, was one of the lowest at 17% but silver volatility was slightly above 30%. By comparison over the same period, S&P 500 TR index volatility has been just under 15% while domestic bonds as measured by the Bloomberg Barclay US Agg Index was roughly 3.50%. At an average of 23.5%, gold and silver volatility sits slightly above the average legacy commodity indices of 19% since 2000. Through diversification, we can gain inflation protecting exposure at lower overall volatility.

3. Lower correlation to inflation than a broad index

Again, looking at the front futures nearest to spot, we find a wide range of correlation statistics among individual commodities to inflation. Chart 2 below illustrates the rolling monthly, quarterly and annual return correlations of 16 individual commodities and a balanced index to the CPI since 1997. Just as in the Gorton and Rouwenhorst study, we see that the magnitude of correlation increases as the time frame increases.

Source: ABSR Research

More importantly, the average correlations for both gold and silver were considerably lower at each time frame than our commodity index. On an annual basis the average correlation for both gold and silver was positive 0.316. Significant, but less than half the 0.640 correlation for an equally weighted index of commodities over the same period.

Conclusions

In total return, gold and silver have out performed the broad commodity market over the last 15 years. But going forward, there are technical and fundamental reasons to consider a broad basket of commodities instead. Energy commodities which constitute larger weights in most indices, have exhibited higher correlations to inflation than either gold or silver. Currently, on a relative value basis energy would also appear considerably cheaper than either metal. From a risk perspective, diversification through a broad basket decreases volatility and avoids single commodity or sector risk. Owning a broad basket of commodities through an ETF or mutual fund does not mean you are giving up on precious metals. In fact most legacy indices hold on average between 5%-15% of precious metals.  Our own ABSR Rotation Rebalanced Commodity Index (RRCI Link) holds 13% in silver and gold. As a hedge against inflation and declining currency value, skip the home safe and consider a broad based approach.

Source Notes: Trading Economics, “Facts and Fantasies about Commodity Futures” Gorton and Rouwenhorst (2006), Wikipedia, ABSR Research, Bureau of Labor Statistics, Commodity Systems Inc.

Shawn Bingham is a 25+ year veteran of the futures and options industry. He was the co-founder of Midwest Trading Partners LLC, a boutique managed futures business catering to HNW clients and fund of funds. Mr. Bingham has recently launched abs(R) Research, a niche firm dedicated to designing next generation alternative asset indices and benchmarks for the investment management community.

 

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
©2017 ABSR Research. All rights reserved. This document is intended for informational purposes only, it does not constitute an offer or solicitation to buy or sell any security.  While we make every effort to ensure the accuracy of the information, no guarantees can be made that all information is accurate and complete. This report and corresponding data are for use with institutional or qualified eligible persons only, and not for use of non-qualified investors. Investing in futures carries significant risk and is not suitable for all investors. The valuation of futures and options may fluctuate, and, as a result, you may lose more than your original investment.

 

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