“Inflation is taxation without legislation.” — Milton Friedman

Commodities and Inflation

In the hierarchy of investment narratives, few are as persistent as the idea that commodities are the ultimate shield against inflation. The logic appears sound: inflation is, by definition, the rising price of goods and services. Since those goods are composed of raw materials—oil, copper, wheat, and corn—owning the raw materials should protect an investor’s purchasing power.

However, institutional-grade investing requires moving beyond intuitive narratives to examine the structural mechanics of the asset class. While commodities do offer a unique relationship to the consumer price index (CPI), they also introduce specific risks, costs, and volatility profiles that can undermine a long-term financial plan if not properly understood.

When evaluating this asset class, the central question is whether commodities serve as a reliable diversifier or a costly distraction. For a deeper look at where these assets fit into a broader strategy, see our guide: [Alternative Investments: Diversification or Distraction?].

The Correlation Between Inputs and Inflation

Commodities are unique because they are "workhorse" assets. Unlike a stock, which represents a claim on future cash flows, or a bond, which is a contractual loan, a commodity is a physical utility. Its value is derived entirely from current supply and demand.

Historically, commodities have shown a positive correlation with inflation, particularly "unexpected" inflation. When the economy experiences a sudden supply shock—such as a geopolitical event affecting oil or a drought affecting grain—commodity prices spike. Because these inputs are at the beginning of the global supply chain, those costs eventually filter through to the consumer.

This makes commodities one of the few asset classes that tends to perform well when both stocks and bonds are struggling due to rising prices. In a traditional 60/40 portfolio, inflation is a dual threat: it erodes the real value of fixed-income coupons and can compress equity multiples. Commodities, in theory, provide a counter-balance.

The Problem of Negative Real Returns

While the correlation is real, the long-term return profile of commodities is often misunderstood. Over decades, the "real" (inflation-adjusted) return of a broad basket of commodities has historically hovered near zero.

This is due to human ingenuity and technological advancement. We have become more efficient at extracting oil, increasing crop yields, and mining minerals. In a capitalist system, the long-term trend for raw materials is toward abundance and efficiency, which exerts downward pressure on prices.

Therefore, an investor should not view commodities as a growth engine. They are a defensive tool designed to offset specific risks. If you hold commodities for thirty years, you should expect them to preserve your purchasing power at best, whereas equities are expected to grow it through the compounding of earnings.

Understanding the Cost of Carry

For most retail investors, owning physical commodities is impractical. You cannot easily store 5,000 bushels of wheat or 1,000 barrels of crude oil. Consequently, most investors access this market through futures contracts or ETFs that hold those contracts.

This introduces a layer of complexity known as the "roll yield." Because futures contracts expire, a fund must sell the current contract and buy the next one to maintain exposure.

If the future price is higher than the current price (a state called Contango), the investor is effectively "buying high and selling low" every month. This "negative roll yield" can act as a persistent leak in the portfolio. During periods of Contango, a commodity ETF can lose value even if the "spot" price of the commodity remains flat.

[Internal Link: Understanding the Cost of Carry in Alternative Assets]

Conversely, when the future price is lower than the current price (Backwardation), the investor earns a "positive roll yield." This usually happens during periods of extreme scarcity. Relying on commodities for inflation protection requires an understanding that the price of the "good" is not the same as the "return" of the investment vehicle.

The Volatility Paradox

A common error in portfolio construction is attempting to hedge a relatively stable risk with a highly volatile instrument.

In developed economies, inflation might fluctuate between 2% and 8%. Commodities, however, routinely experience annual price swings of 20% to 50%. By adding a significant commodity allocation to "hedge" inflation, an investor may inadvertently increase the total volatility of their portfolio to an uncomfortable level.

The behavioral risk here is significant. If an investor adds commodities after inflation has already spiked, they are often buying at the peak of a cycle. When inflation eventually cools, commodities often experience sharp drawdowns. If the investor lacks the discipline to hold through a 30% decline in their "hedge," they realize a loss that outweighs the inflation protection they were seeking.

Implementation: Equities vs. Futures

Investors typically choose between two paths for commodity exposure:

1. Commodity Producer Equities Buying stocks of mining companies or oil producers. These companies are productive assets that pay dividends and have the potential for capital appreciation. However, they are also highly correlated with the broader stock market. During a market crash, an oil stock may fall even if the price of oil remains high.

2. Broad Commodity Indices (Futures) These provide the purest exposure to commodity prices and the best diversification benefit because they do not behave like stocks. However, they are subject to the roll yield issues mentioned above and do not produce cash flow.

[Internal Link: Asset Allocation Matters More Than Asset Selection]

The Role of Gold

Gold is often grouped with commodities, but it functions differently. While copper and oil are consumed by industry, gold is primarily held as a monetary reserve and a store of value.

Gold does not track the CPI as closely as energy or food does. Instead, it tends to respond to "real interest rates" (the interest rate minus inflation). When real rates are negative, gold tends to perform well. When real rates are high, the opportunity cost of holding gold—which pays no interest—becomes too high, and prices often stagnate.

A Disciplined Framework for Decision Making

If you are considering commodities for your portfolio, apply the following rules-based criteria:

• Determine the Objective: Are you looking for a short-term tactical hedge or a long-term structural diversifier? Tactical moves require timing that most investors fail to execute. Structural moves require the discipline to hold an asset that may underperform for years at a time.

• Limit Allocation Size: Because of their volatility and lack of yield, most institutional frameworks limit broad commodities to 5% to 10% of a total portfolio.

• Acknowledge the Drag: Accept that in "normal" economic environments, commodities will likely be a drag on your total returns. Their value is realized only during periods of high macro-economic stress.

• Focus on Rebalancing: The primary way to extract value from commodities is through systematic rebalancing. Selling commodities when they spike and buying them when they are neglected allows an investor to capture "rebalancing alpha" from the asset's volatility.

Summary

Commodities are not a panacea for inflation. They are a complex, volatile, and often expensive asset class that serves a very specific purpose: providing a non-correlated return stream during periods of unexpected price shocks.

For the disciplined investor, the goal is not to "beat the market" by guessing the next move in oil or gold. The goal is to build a resilient portfolio that can withstand various economic regimes. Whether commodities are a "diversification" or a "distraction" depends entirely on your ability to maintain a rules-based approach and resist the urge to chase performance after the headlines have already changed.

The most effective hedge against inflation remains a diversified portfolio of productive assets—companies that can raise prices and grow earnings over time. Commodities may have a place at the margin, but they are no substitute for the compounding power of disciplined equity and fixed-income investing.

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