Natural Resources: Hedging Against inflation

Just slightly over one year ago, inflation was not a concern; since then, it has spiked enormously and reached levels not seen since the late 1970s and early 1980s. Right now (late April 2022), inflation is over 8%, as measured by the consumer price index, and the latest producer price index[1] increased at an annual rate that exceeds 10%. Building a balanced portfolio means combining different asset classes that can respond positively to other economic conditions. Having Natural Resources and Real Estate is essential since they can provide some protection against inflation.

When we experienced the high inflation in the 1970s and 1980’s we also had high-interest rates and high yields on bonds, including treasury bonds. We now see a significant negative return on cash and bonds; the ten-year treasury yield is only 2.8%, nearly 6% below the current CPI. Those invested in bonds are losing money as the dollar depreciates. So what caused inflation to spike? Students of classical economics know that inflation is directly related to increases in money supply, especially if increases do not match increases in supplies of goods and services; in effect, there are too many dollars chasing too few goods. The famous economist and author of the voluminous monetary history of the United States, Milton Friedman, famously said:

Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Those who believe in the non-classical theory, Modern Monetary Theory, who advocate for governments to print any money necessary to fund welfare programs, need to reconsider their idea seriously. The chart below shows the growth in the money supply vs. the inflation rate as measured by the CPI.

Money supply vs. CPI

The relationship between the two is apparent. You may note that the increase in the money has tailed off, but the damage already exists. This money supply growth, combined with a restrictive attitude towards energy production in the current administration, has led to the high inflation we are now experiencing.

Natural Resources

We have held Natural Resources in client portfolios for many years, even though it was a poorly performing asset class for several years, with five-year annualized returns in the 3-4% range while stock market returns average well over 15% annually. NR’s close correlation to inflation and apparent ability to improve portfolio efficiency (more later on) led us to retain it at levels ranging from 4-7% in models. The chart below shows how closely commodities track inflation[2]:


Commodities vs Inflation

Investing in Natural Resources

There are three primary investment vehicles available, mutual funds, ETFs, and ETNs. We lean toward ETFs (Exchange Traded Funds), especially those that do not report their income on a K-1. K-1s can be complex, frequently corrected, and complicate your taxes. ETNs (Exchange Traded Notes) are a form of debt issued by companies that trade like ETFs. They are subject to another level of risk, counterparty risk since they are debt issued by firms with performance similar to a basket of commodities. Unfortunately, that additional layer of risk is not something we want, it is not easy to quantify, and the level of risk depends on the issuer’s financial stability. Mutual funds are not as tax efficient as ETFs. Our portfolios include the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF, symbol PDBC. It comprises 14 heavily traded commodities in four categories, energy, precious metals, industrial metals, and agriculture products. It has performed well among its peers:

PDBC vs peers 1

Natural resources have been our best performing asset class this year (through 4/25/2022):

NR vs other asset classes

Relationship to Other Asset Classes

This year has been rough for most asset classes except for commodities. The S&P has fallen over 9% through April 25th, and most other asset classes have also declined in value this year. Yet commodities have continued their outperformance, up over 30% through April 25th.

Many times, we’ve mentioned that the key to modern portfolio theory is finding assets whose prices do not move in unison; the technical term is “Correlation.” Correlation is the mathematical measure of their price relation; a correlation of 1 means their prices are in sync. A correlation of -1 means the two asset classes do not move together. Opportunities for increased “portfolio efficiency exist if two assets correlate less than one. Here is a “correlation table for some asset classes in our models compared to commodities. In this chart, we display the statistics for actual holdings.

NR correlation to other assets 1

Natural resources are on the bottom row; for example, on the first column in that row, we see the correlation with an S&P 500 index ETF; you can see it is less than one at  .53, which means combining the two in a portfolio enhances the return vs. risk for the portfolio. You can see that the correlation of commodities is less than one compared to all the asset classes in the chart, which is why we have always held commodities in our models.

In summary:

  • Inflation is still highly correlated with increases in the money supply
  • Stocks do protect from inflation, but they are not as highly connected to it as are commodities
  • Commodities can perform poorly during times of low inflation, but they can quickly make up for that low return when inflation increases
  • Efficient portfolios need assets that respond to different economic conditions.

[1] The Producer Price Index is a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.

[2] Bloomberg Commodities Index (BCOM) and the U.S. Consumer Price Index (CPI) Source: Bloomberg, BLS, Dow Jones, FactSet, .P. Morgan Asset Management.Data reflect most recently available as of 05/10/21.

You may watch this video here or on our YouTube channel:

https://www.youtube.com/channel/UCWSB3UQN3y4IXAUh7dEBMzA

Here is the video that accompanies this blog:


Share

Leave a Comment

Your email address will not be published.

Get news from Atlas Fiduciary Financial, LLC in your inbox

Email

*

By submitting this form, you are consenting to receive marketing emails from: Atlas Fiduciary Financial, LL, 393 Ramapo Valley Rd Fl 2, Fl 2, Oakland, NJ, 07436, US, https://atlasfiduciary.com. You can revoke your consent to receive emails at any time by using the SafeUnsubscribe® link, found at the bottom of every email.