Commodities can be useful diversifiers for inflation risk when included in a portfolio, but the shape of the futures curve is important. When the spot price is lower than deferred futures prices (contango), changes are likely due to demand, while a backwardated market suggests supply issues. Evaluating the term structure allows investors to better understand if commodities will diversify portfolio risk from inflation.

1. Diversifying financial assets from inflation risk can often be
effectively managed by including commodities in a portfolio.
However, the portfolio manager needs to be careful of the timing
and execution of this hedge. In particular, the shape of the futures
curve for commodities can be just as important as the price levels.
Depending upon the relative magnitude of deferred futures relative
to spot commodities, commodities can be useful diversifiers or
redundant assets. This relationship between spot prices and deferred
futures is referred to as “backwardation” or “contango”, and its
importance in portfolio theory can be demonstrated.
As numerous academic studies show, it has generally been agreed
upon that inflation and the stock market are inversely correlated. This
implies that investors benefit from finding an inflation “hedge” that
can help diversify their portfolios and reduce risk without sacrificing
proportional return. While inflation itself cannot be traded,
investors have sought trading proxies close to it. In the past, real estate
investments were often used as such a proxy. However, with the recent
collapse of real estate, attention has moved to “alternative asset classes”,
particularly commodity investments. Commodity investments have
the virtue of being global in nature and are not subject to the vagaries
of the U.S. economy. In the world of alternative investments, the
addition of commodity assets serve as inflationary indicators since they
are very sensitive to small changes in supply and demand, and can be
early warning signs of inflation to come. This is different than actual
inflation measures, which tend to be lagging indicators and generally
aren’t tradable.
With the rise of Asian economies in the last decade, the weakness of
the U.S. Dollar, and the quantitative easing programs of the Federal
Reserve, fears of future inflation have caused alarm in the investment
community. The net result has been a renewed interest in investment
vehicles and trading strategies to counter the ill effects of inflation on
equity portfolios. These investment vehicles are diverse. They include
exchange-traded funds and notes, futures, options on physical holdings,
options on futures contracts, and various OTC securities, forwards and
swaps. At times, they are on individual commodities and at other times
they are on broad indexes.
The truth about the relationship between the stock market and
inflation, especially commodity price inflation, can be more complex
than academic studies have generally surmised. One point of
contradiction has been the distinct tendency for the stock market to go
down when price deflation reflects economic distress. Consequently,
during these times, the stock market tends to react adversely to
depressed profit outlook. Stronger inflation numbers have at times
fueled higher stock prices, as profit outlooks brighten. However, they
are more often associated with lower equities. This can be attributed
to higher interest rates leading to greater earnings discount factors,
growth uncertainty, and a foreshadowing of restrictive monetary policy.
Cases can be made for both positive and negative correlation between
inflation and stock prices. The underlying economic forces behind
inflation have a major impact upon whether inflation (deflation)
is beneficial or detrimental for the stock market. Once these
fundamentals come into play, the role of commodity investments acting
as an inflation hedge can be determined with more precision.
Economics tells us that the fundamentals of supply and demand can be
attributed to the inflation dynamic. For investors, the underlying cause
of the inflation is more important than the inflation itself, for purposes
of diversifying equity portfolios. Inflation can be determined by demand
changes, supply changes, or both. For example, in a vibrant economy, if
prices are rising as demand increases, it can be a positive development
for stock prices as investors anticipate rising profits and cash flow.
However, in a recessionary environment, prices, corporate profits and
cash flows all fall with demand. In either case, demand-led inflation and
deflation tend to have positive correlation with the stock market and
falling commodity investments don’t help much in cushioning the fall
of stock prices.
MARKET EDUCATION
Inflation, Commodity Prices, and Portfolio
Diversification

2. For more information, please contact Bob Biolsi, Associate Director, Energies and Metals Research and Product Development
at bob.biolsi@cmegroup.com or visit www.cmegroup.com/education.
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The effects on prices from the supply side tend to have the opposite
effect. A supply shortage that results in rising commodity prices is
likely to have a positive effect on prices, but a negative effect on the
stock market as production costs rise. Similarly, an abundance of supply
will likely result in lower prices and boost stock market prices. When
supply changes result from supply-side impacts, commodity prices and
the stock market tend to be negatively correlated. Negative correlation
is ideal in modern portfolio theory. Having negative correlation implies
that diversification benefits are likely to exist between the two assets.
The challenge for investors is to distinguish between supply-led
changes and demand-led changes in commodity prices. One way of
accomplishing this is to evaluate the futures term structure, such as
the relationship between the cash prices of the commodities and the
deferred futures months. When the spot price (or first month futures
as a proxy) is lower than the deferred futures month, the market is
said to be in “contango”. This generally occurs when the market is
well supplied and producers incur a cost for storing their inventories.
Consequently, they tend to charge for the cost of storing the inventory
in the form of higher deferred futures prices. However, when the spot
(or first nearby futures month) is higher than the deferred month
(known as a backwardated market), it is usually reflective of supply
shortages. In other words, consumers scrambling to combat actual or
perceived shortages would drive up near term prices relative to longer
term prices. When the market is in contango, price changes tend to
have demand-related causes whereas for backwardated markets, price
changes may be mostly attributed to supply changes.
Backwardation is shown in the chart below. Backwardation markets
(i.e. when the right scale is positive), tend to show the two indexes
moving in opposite directions. Contango markets (i.e. when the right
scale is negative) show the two indexes moving in tandem. The year
2003 was generally characterized by backwardated commodity markets.
That is the first nearby futures contract higher than the second nearby
futures contract. It can be observed that falling stock market values
would have been offset and hedged by rising commodity prices. In
contrast, during the latter part of 2008 through the 2009 financial
crisis, marked a falling stock market as well as falling commodities.
Commodities were not particularly useful diversifiers at this time.
Deferred futures were higher than the spot, i.e. a contango market.
By conditioning investment decisions on the futures term structure, an
investor can have more refined ways of evaluating the diversification
properties of commodity investments.
Class III Milk Futures: Percentage of Contacts Traded Electronically