Reuters – Unprecedented money supply growth, low interest rates and high levels of government debt in the West have sparked fears of a surge in inflation, and as a result, investors have become acutely aware of the need for an effective hedge.
Commodities along with a string of exchange traded funds (ETFs) focused on this asset class have long been able to prove their ability in this regard. Largely, this is due to their importance to both cost structures and pricing, which creates an enduring link between commodities and inflation.
Unlike equities and bonds, where returns are often eroded during inflation spikes, this tight relationship earmarks commodities as a strong potential hedge in the face of a surge in prices of goods and services.
According to commodity ETF specialist ETF Securities (ETFS), drilling down into the sub sectors of the asset class reveals a clear differential in commodities’ ability to act as an inflation hedge. ETFS points out that while gold is typically the go-to precious metal in times of high inflation, commodities focused on the energy sector may be a more judicious bet.
‘Over the past 10 years, commodities have had a pretty consistent strong positive correlation with US inflation, somewhat in contrast to equities and bonds,’ explained Daniel Wills, a senior analyst at ETFS. ‘Breaking this down, over the past decade again, energy has seen the strongest and most consistent correlation with US CPI, and in particular, oil.’
Oil’s leadership in this respect is not a great surprise given its dominance in the broad CPI basket of goods and services. Industrial commodities like copper follow closely behind oil and energy more generally as an effective hedge, he said, while precious metals are best used as an inflation protector in the event of sharp spikes.
Use gold when inflation jumps ‘Gold prices have often led and been a strong performer when moving into a high inflation environment, and have the benefit of having a strong negative correlation to the US dollar and events hedge,’ Wills said.
He argues that while gold is not an effective inflation hedge in all circumstances, it has other benefits. ‘Precious metals have seen mixed performance [as an inflation hedge and] gold in particular tends to spike in very high inflation levels,’ he said.
‘Not necessarily over the shorter to medium term, but gold comes through in periods of very high and accelerating inflation.’
Since their inception roughly a decade ago, hundreds of ETFs have been launched onto the market, giving investors searching for an adequate inflation hedge plenty of choice.
Although oil appears the most effective hedge against inflation from the commodities space, the most important aspect to consider is how strongly a given instrument correlates with the underlying asset, as it is this relationship that provides investors with protection from hikes in the costs of goods and services.
That said, there are few ETFs backed by physical oil stores, while those that track the derivatives market carry the risk of contango.
This leaves investors with two alternatives: buying a broad basket of commodities ETF, which would also track the prices of soft commodities such as rice and grain, or choosing an ETF focused on industrial commodities such as nickel or copper.
While these industrial commodity ETFs might not prove as effective a hedge as instruments in the oil space, there are a plethora of physically backed industrial commodity ETFs on the market, giving investors a decent amount of choice.
Moreover, these would also be well placed to capitalise on the boom in demand for commodities from developing nations looking to build their infrastructure and whose consumers are continuously trading up.
Executing the trade High levels of global inflation look set to persist, so going long on commodities could provide protection. ETFS All Commodities DJ-AIGCISM offers exposure to a broad basket of commodities, while Socit Gnrale offers exposure to copper in isolation via its exchange traded note through its SPGS Copper instrument. An alternative copper ETF is available from ETFS, which offers the physically backed ETFS Physical Copper. Investors seeking exposure to gold via an ETF structure could look to physically backed ETFS Gold, which avoids the risks linked to mirroring an asset class through the use of derivatives. There are downsides to accessing commodities via such ETFs, however, as they often cost more than instruments based on derivatives because the cost of storage must be factored in by providers.