US inflation is on the rise, but it is certainly not on the run by any stretch of the imagination. In fact, the core Consumer Price Index (CPI) rose 2.2% in September—less than economists expected, dragged lower by declining car and truck prices.1
But after years of accommodative monetary policy meant that inflation felt pretty much non-existent, it is now hovering persistently around the Federal Reserve’s 2% target. While September’s CPI reading missed expectations, core inflation remains above 2%.2 Steady consumer demand, late-cycle fiscal stimulus, accelerating wage growth and increasing import prices are fueling its return. The proposed 25% tariff on $200 billion of Chinese goods, which include a wide range of consumer products, may add more upside risk to inflation in 2019.3 With rising oil prices and a steady increase in input prices, more attention is being paid to managing inflation risk in portfolios.
Investors looking to implement inflation management strategies often turn to commodities, which are typically purchased using futures contracts. But this approach may not be as effective as many believe, and there is another solution investors can consider to efficiently add a commodities exposure: natural resources ETFs.
The imperfect nature of commodity futures contracts
Most commodity investments are linked to futures contracts, which are traded via spot instruments, because physical custody of commodities is nearly impossible for most market participants. Though futures contracts are the popular choice, they can have a downside.
With futures, investors must contend with roll yield. Roll yield describes the profit or loss that results from selling existing contracts and then purchasing, or rolling, into longer-dated contracts. If the longer-dated contracts are more expensive than the currently held contracts—the result of an upward sloping futures curve—the cost of rolling can eat away much of an investor’s total return.
As shown below, the return profile of a futures-based commodity index can diverge significantly from an index based on spot prices, primarily due to the impacts of roll yield. In the last 20 years, the Bloomberg Commodity Spot Index advanced more than 270%, while the Bloomberg Commodity Index declined 2%. In the past year through September 28th, the Bloomberg Commodity Spot Index advanced 5%, doubling the 2.5% gain of the Bloomberg Commodity Index.
Source: Bloomberg Finance L.P., as of 09/30/2018.
Another commodity-driven solution to inflation: Natural resources ETFs
Outside of the spot and futures markets, there is another means of achieving inflation-fighting commodities exposure: the equities of natural resources firms. These businesses are primarily involved in metals and mining, agribusiness and energy. Exposure to these companies via ETFs can be an efficient—but often overlooked—way to harness commodities without the slippage of futures contracts.
Historically, shares of natural resources companies have performed well in inflationary environments because earnings are closely linked to the value of the underlying commodity produced by the firm. As such, when inflation erodes the value of the US dollar, the value of the underlying commodity and the firm’s shares both rise.
As shown below, shares of natural resources companies have historically moved along with inflation expectations.
Source: Bloomberg Finance L.P. as of 9/30/2018
In addition, natural resources ETFs provide investors with equity risk premium, a valuable benefit not afforded traditional commodity investments. Since early 2017, when inflation started to pick up, the S&P® Global Natural Resources Index has advanced 22%, besting the Bloomberg Commodity Spot Index’s 7.5% increase.4
What about valuations?
Overall global equity market valuations are near historical highs based on price-to-earnings, forward price-to-earnings and price-to-book ratios. However, the chart below shows natural resources stocks are trading near their 10-year medians, leading to below-average valuations relative to the broader market and presenting a value opportunity.
When taking into account the structural factors that could drive demand for natural resources and the value of the firms’ physical assets, natural resources stocks may represent a value opportunity with inflation-fighting power to boot.
1“U.S. Inflation Trails Estimates; Prices Remain Near Fed Goal,” Bloomberg.com, as of 10/11/2018
2Bloomberg Finance L.P., as of 11/5/2018
3“Chinese Goods May Face 25% Tariffs, Not 10%, as Trump’s Anger Grows,” nytimes.com, as of 8/1/2018
4Bloomberg Finance L.P., as of 10/11/2018
Bloomberg Commodity Index
A broadly diversified commodity price index distributed by Bloomberg Indexes that tracks 22 commodity futures and 7 sectors. No one commodity can compose less than 2% or more than 15% of the index and no sector can represent more than 33% of the index.
Bloomberg Commodity Spot Index
A “spot price” version of the Bloomberg Commodity Index. This index provides a general estimate of the trend in commodity prices without the positive or negative return effects which may be caused by the rolling process, or the costs involved in actually holding physical commodities.
Consumer Price Index (CPI)
Consumer Price Index is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Financial contracts that obligate buyers and sellers to buy or sell an asset—often physical commodities or financial instruments—at a predetermined future date and price. Futures contracts also stipulate the quality and quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Some futures call for physical delivery; others are settled in cash.
MSCI World Index
The MSCI World Index is a broad global equity benchmark that represents large and mid-cap equity performance across 23 developed markets countries.
Price-to-Book Value Ratio
A valuation metric that compares a stock’s price to the company’s book value, which is calculated by its total assets minus intangible assets and liabilities.
A valuation metric using the ratio of the company’s current stock price versus its earnings per share.
The purchase or sale of a foreign currency, financial instrument, or commodity for immediate delivery.
S&P Global Natural Resources 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 and investable equity exposure across 3 primary commodity-related sectors: agribusiness, energy, and metals & mining.
S&P 500 Index
The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 Index components and their weightings are determined by S&P Dow Jones Indices.