Do Commodities Go Up With Inflation?
The Consumer Price Index (CPI), a key measure of inflation, reached nearly 8% in February 2022, a four-decade high. We covered the topic in Notes on Inflation and discussed concerns related to investors’ expectations for future inflation rates. Higher expected inflation could lead to potential complications, such as difficulty for the Federal Reserve (Fed) engineering a soft landing with interest rate hikes while bringing inflation back to its 2% target.
During a period of high inflation, a major concern for investors is the relationship between their portfolios and inflation. Several commodities like precious metals, oil, and gas have often been considered portfolio diversifiers that serve as a hedge against inflation. That is because the prices of these commodities tend to rise when the prices of goods and services go up; hence investors can protect the overall purchasing power of their portfolios.
This doesn’t universally apply to all commodities in every situation, however. Let’s take a closer look at the implications of this relationship for investors, especially as inflation is on the rise around the globe.
Why should investors care about inflation?
Inflation refers to the decline in purchasing power of each money unit. In practice, inflation means that your money buys fewer goods because those goods are now more expensive. As a simple example, milk previously cost $2.00, and now it costs $2.50. The aggregation of all these price increases is called inflation. People build portfolios and invest with the mindset of building wealth. That means generating total returns above inflation so their money can buy more goods and services in the future.
Some investors consider investment real estate an inflation hedge. Forbes explains that investors can combat inflation by increasing the rental fees of their properties.  This generates a return or cash flow equal to or greater than inflation, allowing real estate investors to hedge against inflation. Though, increasing rents only works as long as tenants are willing and able to pay higher prices. But what if you aren't interested in owning and managing properties? How can you incorporate inflation-sensitive investments into your portfolio?
Commodity performance during inflationary periods
There are several dollar-denominated commodities, like gold or oil, and soft commodities, such as soybeans. Investors buy these assets with the hope that as the prices of goods and services rise, so will commodity prices. Vanguard research points to commodities as the best hedge against unexpected price increases:
“Over the last three decades, commodities have had a statistically significant and largely consistent positive inflation beta, or predicted reaction to a unit of inflation. The research, led by Sue Wang, Ph.D., an assistant portfolio manager in Vanguard Quantitative Equity Group, found that over the last decade, commodities' inflation beta has fluctuated largely between 7 and 9. This suggests that a 1% rise in unexpected inflation would produce a 7% to 9% rise in commodities.”
Not every commodity-inflation relationship holds, however. Consider a situation where demand for new houses increases, leading to higher home prices and more lumber demand. At the same time, new regulation makes it easier to farm and produce lumber, increasing supply. In this situation, the prices of homes could increase, but the price of lumber as a commodity could decrease.
Are commodities right for my portfolio?
Commodity returns can be stable or volatile depending on market dynamics. Gold, which serves as a reserve asset for central banks, tends to show more stability, whereas volatility is higher for oil, natural gas, and agricultural commodities.
As we go through this inflation cycle, there are new options that investors can consider to hedge their portfolios. For instance, there is an ongoing debate among experts on whether cryptocurrency is a good inflation hedge. As it stands today, Bitcoin and other virtual currencies are considered commodities and regulated by the Commodity Futures Trading Commission.
Maryville University highlights cryptocurrency’s similar behavior to other high-beta equities and emphasizes how Bitcoin has a limit of 21 million coins that can be created.  Bitcoin advocates have argued that this scarcity should help Bitcoin maintain its value and offset inflation. The counterargument is that the price of crypto is still based largely on consumer sentiment, leading to high volatility and contradicting its reputation as a reliable inflation hedge. Bitcoin’s poor performance in 2022 would suggest the cryptocurrency does not offer a viable alternative to traditional commodities as an inflation hedge.
Bitcoin’s failure to hedge inflation risks in investor portfolios puts more emphasis on traditional commodities because of the relationship between commodity prices and the price level in the economy. In general, commodity prices move based on specific industry conditions. Because commodities are the raw materials used to fuel and create products for everyday life, they often become more expensive during times of high inflation and generate portfolio returns during those periods. When looking at commodities to invest in, focus on the specific factors that drive each one. You can purchase physical goods, such as gold, or ETFs that track specific commodity indexes to avoid trading futures or derivatives. Stocks of commodity-related businesses, such as oil and gas producers or miners of precious metals, can work as well.
Check out the 5 Best Commodity ETFs for recommendations or Hedging Portfolio Risk By Investing in Commodities to understand the different ways investors can access this asset class.
What drives commodity prices?
Supply-and-demand dynamics in the global economy are the main driver behind commodity prices, though local and global events can also impact prices. On a local level, cold weather can result in increased demand and higher prices for natural gas in a specific region. On a global level, commodity prices across the globe may drop when economic forecasts for a major economy like China decrease.
Global conflicts such as the Ukraine-Russia crisis can create supply chain disruptions too. Russia is the largest oil and products exporter in the world, but its invasion of Ukraine has led to a ban on the majority of Russian crude oil and petroleum product imports.  The subsequent tight conditions of the commodity market led to a surge in oil prices around the globe.
Commodities vs. TIPS
Treasury Inflation-Protected Securities (TIPS) are another option for investors seeking to hedge inflation. But how do they compare to commodities? TIPS are fixed-income securities that adjust their coupon payment based on inflation, making them a valuable tool for hedging unexpected inflation. However, TIPS have a lower beta to unexpected inflation, and investors would require a significantly higher portfolio allocation to achieve the same hedging effect of commodities.
When using apps like Composer to illustrate the performance and correlation with other investments in your portfolio, the difference is clearer. Over the past three years, a general commodities ETF, DBC, and an oil ETF, DBO, dramatically outperformed iShares TIPS ETF.
Because of its historical track record behavior, it’s a good bet that commodities will go up with inflation. The key, however, is for investors to appropriately diversify their portfolios with commodities. This requires a thorough understanding of the drivers of prices, risks, and behavior. Only then will commodities be a smart choice for hedging against inflation.
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