The Long-Term Value of Commodities

Commodities and equities have historically had similar returns and volatility yet commodities as an asset class seem to be overlooked.  Investors were interested in commodities up until the financial crises when they performed very well.  Over the past 10 years, many investors have doubled down on equities and largely forgotten commodities. Recently, commodity performance has investors looking at the asset class again. How can history be a guide?






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Transcript

The Long-Term Value of Commodities

Season 1: Episode 8

Welcome to the Real Spiel with Ryan and Kurt.  This is Ryan Katz with USCF Investments. And this is Kurt Nelson with SummerHaven. 

KATZ:  Let’s get real about the long-term value of commodities.  Every week we are trying to tell people what’s going on.  Most recently on a variety of different topics.  Let’s just take a step back in the context of commodities investing historically.  Investors were interested in commodities twenty years ago.  They performed very well up until the financial crises.  Over the past ten years, we’ve seen a doubling down on equities while many investors have abandoned their commodities exposure as part of their portfolio.

It served them well in that time, but many are giving commodities another look as they are now up 30% year-to-date while equities have pulled back some.  How can history be a guide to explain these performance differences.  

NELSON:  History can be a good guide.  History doesn’t necessarily repeat but it tends to rhyme.  One of the interesting things about commodities is that they are perceived to be new investments.  I don’t think commodities became mainstream until about 15-18 years ago Ryan.  I think there was a large investment wave of maybe a couple of hundred billion in the mid 2000’s as investors became familiar with what’s now called the Bloomberg commodity index or the GSCI, the Goldman Sachs index.  We started to see the introduction of ETF’s and mutual funds for investors to allocate and they did very well performance wise during the 2000’s.  In fact, they did pretty well coming out of the financial crisis.  It really wasn’t until around 2011 where we saw inflation start to dip and expectations for inflation start to fall off and commodities underperformed, and we saw financial assets like stocks perform incredibly.  The risk premium, the return captured by commodities during the 2010’s is I believe unprecedented in history.  In one hundred years of financial history, we have never seen a decade like that for equity returns relative to a risk-free rate.  So, things have been unusual but not unprecedented over the prior decade.  What we are seeing now is a role reversal.  We are seeing equities down while commodities are up a lot.  And the tide is shifting, inflation expectations are higher.  We may be coming on what some people are calling a super cycle of commodities while there are supply shortages relative to demand increases that are hard to resolve.  Some interesting facts for our listeners to consider are commodities are not new.  Commodities have been around in our global economy for thousands of years.  But even as commodity futures markets, they date back maybe 500 years in Japan.  We have data at SummerHaven on all of the major public exchanges and the commodity futures that were traded going back to roughly the 1870’s1.  So almost 150 years of history of exchange traded commodity futures.  So, one of the things I would say is that commodities are not new.  Commodities are just part of human society.  Whether its metals we use in production, energy that we use to heat or fuel our homes or vehicles, or food that we produce to eat.  Futures markets, which is what we use when we are thinking about commodities as an investment are also not new.  If you were to go back to a newspaper 100 years ago, the page covering commodity futures would likely be larger than the page covering equities or bonds.  So, they have been important ways for people like farmers or mining companies or energy companies to hedge risk and secure price certainty for their production.  But they have also been really meaningful important markets for speculators and investors for more than 100 years.  One of the things that we drew out of our study of this data collection effort going back 150 years – we had for the first time an opportunity to look at diversified commodities that were investable, exchange-traded, incorporating all the things that people think of like roll yield or roll cost and compare on a level playing field commodities to stocks and bonds.  Over not just a decade or two decades or three decades, but over 150 years.  One of the interesting things, maybe one of the most important things that we drew from that study was that over very long periods of time equities earned a risk premium of roughly 5-7% above the risk-free rate.  So, if T-bills are 2%, and equities can be expected to earn maybe somewhere around 7-9% per year – the volatility of an equity investment diversified is typically around mid-teens 15% or so.  What we got from our study when we looked at commodities was that the risk/return profile was incredibly similar to equities.  The risk premium capture is roughly 5-7% and the volatility around a commodity investment that is diversified is around mid-teens like around 15%.  So, the very long-term, what we call sharp ratios (returns divided by risk) the long-term sharp ratio for an equity investment is around .38.  The sharp ratio for commodities is around .39.  That’s basically statistically the same.  Now given that, I think it’s natural to ask yourself is why did commodities do so poorly in the 2010’s and equites did so well.  And conversely, why are commodities going up north of 30% year to date, when equities are facing head winds and they are kind of down on average whether its NASDAQ, S&P, what have you, stocks are down about 10% year to date.  So, what’s going on?  One of the key factors is something that you and I have talked a lot about which is inflation.  Inflation for financial markets is a little bit like Kryptonite.  It affects all of them in negative ways.  It causes the cost of borrowing to go up.  It causes the cost structure of production to go up.  It causes wages to go up so labor input costs go up.  And interest rates go up, so mortgage prices go up, etc.  For equities inflation is particularly difficult too because it tends to - in inflationary environments we see the purchasing power of consumers be reduced.  Finished goods are more expensive for them to buy even if wages are rising, they tend not to rise as fast as inflation. And so historically inflation is a real head wind for assets like stocks and bonds. The flip side is true for commodities.  Inflation tends to be maybe the single factor that is the best head wind for commodities in terms of price appreciation and price return.  

KATZ:  Tail wind?

NELSON:   Tail wind. Exactly.   

 KATZ:  I think we also heard from human nature from recency bias, and I think it’s important to point out that in the 2000’s commodity prices were very attractive and equities in that ten-year period largely did nothing.  Then it flipped in the 2010’s.  But if you just look over the past two years, we’ve seen broad commodity benchmarks up over 100% since the beginning of the Covid pandemic.  Equities up 75% from their pandemic lows.  But the last 3-6 months we’ve seen commodities continue to punch up and equities have given up some of their gains.  Commodities are up 35+%, 30%+ up this year and across broad equities benchmarks equities are down 10% this year.  What does that tell us?  You mentioned 150 years of research.  A lot of folks feel like maybe things will normalize and go back to what they were in the 2010’s.  But from a relative value standpoint commodities really still do look attractive in relation to equities.  

NELSON:   Yeah, so one of the things that we’ve done Ryan is we work from this premise that if over 150 years equities and commodities have a similar return capture, and they have a similar volatility, maybe we could plot the ratio of equities relative to commodities specifically and look at their relative returns.  We have very rarely seen a decade of returns like we’ve seen in equities.  In commodities, where we expect prices to appreciate at some kind of nominal level over time, we saw a 40% decline during the 2010’s and so commodities tend to be at the 10-15th percentile of ten-year returns.  So at least looking back in the last decade if these returns are mean reverting it looks like commodities are very cheap and equities look very rich.  Very overpriced or very expensive at least.  So, I think that’s one way to think about commodities relative to equities.  Maybe inflation will go up, maybe it will go down.  I don’t know. What we do know is inflation is up a lot and we’ve been told that inflation is going to calm itself down then flatline and eventually drift back down from recovery levels that we are used to.  That’s not happening.  We’ve also been told that commodities (this is not what you and I say) but we’ve heard from investors that commodities don’t seem to have a return capture.  Because look what happened in the 2010’s and I would argue well look at what’s happening right now and hopefully learn from the lessons of the past which is that over very long periods of time commodities can do as much for a portfolio as equities can, but they are going to do it at different times.  

 KATZ:  Absolutely.  I think we will re-touch this topic on future podcasts as well.

This has been the Real Spiel with Ryan and Kurt.  We will talk to you soon.  

Definitions and Notes:

Mean Reverting (Reversion):  The assumption that an asset's price will tend to converge to the average price over time.

 For this discussion, performance refers to Year to Date 2022 as of 4/30/22:  Commodities represented by Bloomberg Commodity Index Total Return (BCOM) +31%, and equities represented by Standard & Poors 500 Index (S&P 500) -13% and the Nasdaq Composite -21%.

 1Commodities history is based on data collected by SummerHaven Investment Management, as described in “The Commodity Risk Premia: 1871-2018” by Bhardwaj, Janardanan, and Rouwenhorst.