Inflation had been a factor largely dismissed by investment strategies for well over a decade following the 2008 financial crisis, which preceded an 11-year period of historically below-average inflation. This disregard, however, quickly shifted to fixation following the pandemic as US inflation hit a 40-year high in 2022. While prices have come off their peaks, pressures from higher commodity prices, a shift towards de-globalization, and upward wage pressures from tight labor markets may keep inflation sticky and persistent — closer to the historical average than the preceding decade.
To combat this new regime, investors have dusted off textbook strategies for how to navigate an elevated inflationary environment. Liquid real assets, particularly broad commodities, have seen renewed interest. But not all real asset exposures may serve portfolios in the same manner or with the same efficiency. Investors need to take into account the inflation sensitivity of real asset exposures alongside the portfolio impact from risk-adjusted performance and diversification benefits.
When evaluating the correlation and beta of key real assets to inflation, both commodities and natural resources lead the way. Broad commodities historically exhibited the highest correlation and beta to US Consumer Price Index (CPI) over time which reflects the impact commodities have as economic inputs for business and consumption (energy and food prices).
Natural resource equities, however, also carry a much higher sensitivity compared to a global 60/40 stock and bond portfolio, as well as other commonly referenced liquid real assets such as infrastructure, real estate investment trusts (REITs), and gold. This makes intuitive sense since the highest contribution to revenue of these natural resource companies is commodity prices.
While gold may not carry a high sensitivity to broad price inflation, it may provide protection against another form of inflation — monetary inflation — by protecting against currency depreciation and loss of purchasing power over time. This is the dynamic historically at play when gold is referred to as an “inflation hedge.”
Inflation sensitivity shouldn’t be the sole determinant when constructing a real asset exposure. Taking into account the overall risk-adjusted performance over time is another key factor to consider.
Since November 2002, broad commodities posted a total return of 1.32% with a standard deviation of 16.40%. Comparatively, natural resources posted a total annualized return of 8.60% with an annualized volatility of 20.82%. Translating this to a risk/return layout, natural resources provided a better option than broad commodities with higher return per unit of risk, 0.41 for natural resources versus 0.08 for commodities.
Over this 20+ year period, gold provided an attractive risk/return trade off as well, with an annualized return of 9.01% and 16.90%, resulting in a 0.53 return per unit of risk.
Figure 3: Combining Gold With Natural Resources Historically Created a Better Risk/Return Profile Than Either Asset Individually
While these historical returns are representative of a set period from late 2002 through early 2023, what is most interesting is the dynamic yielded when combining these real assets. When natural resources are combined with gold on an equal-weighted basis, the historical annualized volatility is reduced (15.49%) while the annualized return increased (9.46%) compared to either of these assets’ performance statistics independently. Interestingly, the combination of gold and broad commodities does not result in a similar improvement from a risk/return standpoint.
One possible explanation for the improvement with both gold and natural resources? The low correlation between gold and equities may provide ballast against natural resource equities’ higher volatility over time. Meanwhile, natural resources’ equity risk premium provides comparative outperformance versus broad commodity indices that invest directly in underlying commodities through futures contracts and typically exhibit negative performance drag due to the rolling of futures contracts at maturity.
The combination of gold with natural resources is an attractive option for portfolios because it may also improve a diversified portfolio’s Sharpe ratio. Gold’s diversification and risk-management characteristics coupled with the inflation-sensitive characteristics of natural resources show improved Sharpe ratios, whether allocations to this mix are a percent or two, or perhaps more. While a standalone gold allocation historically exhibits a higher Sharpe ratio, the higher inflation beta from including natural resources may prove valuable against a backdrop of elevated inflation. Additionally, including gold provides a more efficient option than global natural resources or commodities alone, which historically exhibit a drag against a portfolio’s Sharpe ratio across various allocations.
Figure 4: Combining Gold With Natural Resources Provides an Improved Sharpe Ratio With Inflation Protection
As inflation and elevated prices are expected to persist in the near term, investors seeking to manage portfolios against this environment may be best served by seeking to combine gold with natural resource equities rather than broad commodity exposures. Gold’s diversification benefit coupled with the equity risk premium and high inflation sensitivity of natural resources may provide a complementary solution for real asset exposures in the future.
Beta is a measure of the volatility—or systematic risk—of a asset or portfolio compared to the market as a whole
Bloomberg Commodity Index Total Return
A broadly diversified commodity price total return index distributed by Bloomberg Indexes that tracks 22 commodity futures and seven sectors. No one commodity can compose less than 2 percent or more than 15 percent of the index, and no sector can represent more than 33 percent of the index.
Bloomberg Global Aggregate Total Return USD Index
A flagship measure of global investment grade debt from a multitude local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The correlation coefficient is a statistical measure of the strength of a linear relationship between two variables. Its values can range from -1 to 1
FTSE NAREIT All Equity REITS Total Return Index
A free float adjusted market capitalization weighted index that includes all tax qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market.
ICE BofA US 3-Month Treasury Bill Index
The ICE BofA US 3-Month Treasury Bill Index is comprised of a single issue purchased at the beginning of the month and held for a full month. At the end of the month that issue is sold and rolled into a newly selected issue.
MSCI ACWI Net Total Return USD Index
A market cap weighted equity total return index that includes both emerging and developed world markets.
S&P Global Infrastructure Net Total Return Index
The S&P Global Infrastructure Index is designed to track 75 companies from around the world chosen to represent the listed infrastructure industry while maintaining liquidity and tradability. To create diversified exposure, the index includes three distinct infrastructure clusters: energy, transportation, and utilities.
S&P Global Natural Resources Total Return Index
The index includes 90 of the largest publicly-traded companies in natural resources and commodities businesses that meet specific investability requirements, offering investors diversified, liquid and investable equity exposure across 3 primary commodity-related sectors: Agribusiness, Energy, and Metals & Mining.
Spot Gold Price
The price in spot markets for gold. In US dollar terms, spot gold is referred to with the symbol “XAU,” which refers to the price of one troy ounce of gold in USD terms.
US CPI Urban Consumers NSA Index
Measure of prices paid by consumers for a market basket of consumer goods and services.
Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured from either the standard deviation or variance between returns from that same security or market index.
Important Risk Information
The views expressed in this material are the views of the Gold Strategy Team as of March 21, 2023 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
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Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates.
Commodities and commodity-index linked securities may be affected by changes in overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes, or political and regulatory developments, as well as trading activity of speculators and arbitrageurs in the underlying commodities.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
Foreign (non-US) Securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.