Commodities tend to behave differently than traditional asset classes, especially when commodity price shocks are driven by unexpected changes in supply. (Consider the impact of wheat and oil disruption after the Russian invasion of Ukraine, or the extended shutdown of Chinese factories amid a long-standing national zero-COVID policy.) Vanguard research found that commodities had an inflation beta that fluctuated between 6 and 9 over the past three decades, the highest among all the asset classes the authors examined. This suggests that a 1% rise in unexpected inflation would produce a 6% to 9% rise in commodities. In short, a small yet strategic commodity position can offer an outsized safeguard for an overall portfolio.
“There is no silver bullet to fight inflation, but if short-term inflation hedging is the goal, historically, commodities have been an excellent choice,” said Shtekhman.
That said, it’s worth noting that commodities aren’t the only tool in the inflation-fighting toolbox, especially for investors with a longer time horizon. They may be better served by a more traditional mix of stocks and bonds, where equity risk premium will likely outpace inflation and deliver real return over longer time periods.
TIPS are commonly used as inflation fighters but can be limiting in terms of capital efficiency. They have a relatively low inflation beta, which means that only the TIPS portion of a portfolio is inflation-hedged. An allocation to commodities, meanwhile, can hedge a significant amount of a portfolio, even beyond the commodity portion. “A small addition of commodities can be a more efficient diversifier than the addition of TIPS, which means the rest of your portfolio can be unlocked to pursue other strategic initiatives,” said Shtekhman.
The energy sector also has a significant relationship with unexpected inflation, which makes it another commonly used inflation hedge. However, in addition to its very high correlation (beta) with the broad equity market, the sector also has the potential for idiosyncratic company risk (an accident on a drilling platform, for example), variations in corporate capital structure and management quality, and other factors that can mute the full impact of the relationship.