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Economic and Market Commentary

The Strategic Case for Commodities

With their ability to act as an inflation hedge, diversifier and return enhancer, commodities should be considered an important portfolio allocation over the long term.

Commodities tend to offer three strong benefits to portfolios: diversification, inflation protection, and return potential. Commodities have been the best-performing asset class in the last three years as of 3/31/2023 with the BCOM index outperforming both the S&P 500 and the Bloomberg Global Aggregate Index. This is likely due to fundamentally driven, structural dynamics in the sector, including underinvestment. But the strong recent performance has also been enhanced by ongoing geopolitical developments, highlighting how commodities may provide critical portfolio diversification during inflationary periods.

This backdrop raises a natural question: Should investors continue to allocate to commodities even if, for example, inflation concerns diminish, or we experience a mild recession? We believe the answer is yes. In examining the three well-known potential benefits of investing in this asset class, we find the strategic case for commodities is strong today and in the long term.

Diversification remains critically important

The typical 60/40 stock/bond portfolio construction assumes that fixed income and equities are inherently diversifying, with low correlations (when asset class returns tend to move in the same direction over time, we say they are highly correlated) – that are ideally sufficient for investors seeking to weather various macroeconomic conditions. For much of the past 25 years, this assumption has been largely met, until the past year or two. Correlations between stocks and bonds recently have reached levels not seen since the late 1990s, with recent rolling 12-month correlations around 0.75 versus the long-term average of 0.19 for the period 1977–2023. This greatly reduces any assumed diversification benefits and underscores the need for true sources of diversification to traditional 60/40 portfolios. Long-term data for stocks, bonds, commodities, and inflation indicate commodities historically tend to be the most correlated with inflation (0.43), while they are negatively correlated with bonds (−0.27) and only slightly positively related to stocks (0.24).

Figure 1: This table shows the correlations between three assets (U.S. equities, global bonds and commodities) using annual returns and the U.S inflation rate. Correlation is a measure of the strength of the relationship between two variables and ranges from -1 to +1. A negative value means they generally move in the opposite direction and a positive number means they move in the same direction. The chart shows that commodities are the most positively correlated with inflation. Stocks and bonds are negatively correlated with inflation.

Why do commodities tend to offer these diversifying tendencies? Commodities are “real assets” that react to changing supply and demand fundamentals in different ways than stocks and bonds, which are “financial assets.” The supply and demand of commodities is affected by many factors such as capex (or lack thereof) within commodity industries, geopolitics, and regulation/policy. Today, policy efforts to address climate change by transitioning away from traditional hydrocarbons, combined with efforts to re-shore supply chains and build resiliency, are likely, at least on our secular horizon, to be quite supportive for commodities as an asset class. Climate change itself also appears to be having real adverse effects on agricultural commodities supplies.

Simply said, while commodities do share a sensitivity to the macro cycle with other assets, commodities also have their own separate, idiosyncratic drivers. Problematically for investors, history has shown that when these idiosyncratic drivers lead to a commodity rally, they often diminish returns in other asset classes. As such, commodities may provide valuable diversification benefits when they are most needed. For example, as shown in Figure 2, commodities can offer significant diversification benefits compared to stocks and bonds when inflation surprises to the upside.

Figure 2: This chart looks at the returns of the BCOM commodity index, Treasury Inflation-Protected Securities (TIPS) and the 60/40 (Equities/Bonds) portfolio in five-year intervals from 1976 to 2019 and also from 2020-22. The key takeaway from the chart is that when there are large inflation upside surprises, commodities outperform the traditional 60/40 portfolio. Also, commodities outperform TIPS in similar environments.

Inflation – upside surprises more common and more problematic than downside

Commodities have long exhibited positive correlation with realized inflation (on average 0.43, since 1976). This should not be surprising as commodities (food and energy, for example) typically represent a large share of the U.S. headline CPI basket directly (currently about 38%), but also indirectly in terms of their inputs into other components of the CPI. Despite only representing roughly 3% of U.S. CPI, gasoline alone accounts for a staggering 50% of U.S. CPI volatility. Outside the developed world, food and energy constitute an even greater share of the inflation basket.

Figure 3. This chart plots inflation surprises and WTI prices since 1971. Expected inflation is measured using the forecasted values from the Survey of Professional forecasters. Surprises are defined as the expected forecast minus realized inflation. It is evident from the chart that there is a very strong relationship between inflation surprises and the one-year WTI return and if the inflation surprises are positive or negative the relationship is still strong. One clear observation from the chart is that inflation surprises historically have usually been greater to the upside than the downside.

Why is it important to look at inflation surprises? To the extent that equities and fixed income are efficient and forward-looking, it is often the surprises in inflation that pose meaningful risks to portfolios. For much of the past 25 years (the period relied on for much of modern portfolio construction theory and analysis), inflation itself and inflation surprises were relatively mild. However, recent events remind us that a longer history is not so sanguine. Large inflation surprises of 6%–8% are not uncommon and, importantly for investors, we have observed that upside surprises historically are more severe than downside surprises. Notably, the relationship between commodity returns and inflation surprises has been strongly correlated (0.78) since the 1970s (from when we have reasonably complete data). Looking ahead to the next several years, with considerable uncertainty over the path of inflation, we argue that inflation hedging is paramount, and commodities can be a potent inflation hedge. As we illustrate in Figure 4, the BCOM historically has outperformed the traditional 60/40 and even TIPS during inflation surprises.

Figure 4. This chart plots the relative returns of different assets since 1979 along with inflation surprises. The BCOM vs 60/40 (equity/bond) is computed as the three-year moving average of BCOM year-over-year return minus the three-year moving average of 60/40 year-over-year returns. BCOM vs TIPS and TIPS vs 60/40 also uses the three-year moving average. The BCOM commodity index outperforms both the 60/40 (equity/bond) portfolios when there are inflation surprises and also outperforms TIPS when there are inflation surprises.

Recession potential shouldn’t derail the structural outlook

Every recession has its own catalysts, characteristics, depths, longevities, and eventual paths to recovery. Since the end of World War II, the U.S. economy has experienced 12 recessions, which is one every 6.1 years on average. Figure 5 overlays BCOM index returns with periods of growth and recessions (the shaded time periods) from January 1975 to October 2022. As a general observation, commodity prices tend to accelerate before a recession, when demand is strong and the economy is overheating. The exception was the recession of 1981 and the COVID-induced recession of 2020, which was exceptional in that it lasted just two quarters but was severe (with a 29.9% annualized decline in GDP). As commodities are a critical component of economic activity, when the economy suffers, generally speaking the demand for commodities declines and prices retreat (with the exception of gold).

Figure 5. This chart plots the BCOM commodity index price level since 1975 along with periods of time the US has experienced recessions. A total of seven recessions are plotted in the chart and the main takeaway from the chart is that, generally speaking, commodity prices are rising going into a recession, decline during the recession and in several cases accelerate once the recession is coming to an end or is over.

The commodity price response after a recession tends to be closely related to the starting conditions going into it. History suggests that when spare capacity and investment is limited prior to a recession, supply constraints tend to reassert once demand growth resumes, much as we saw in the period following the recession in early 2000s (which preceded the last commodity supercycle) and the more recent COVID demand shock. We believe these two periods provide the most apt comparison to conditions today, and a long-term investor may want to view weakness in the case of a mild recession as an opportunity to gain inflation protection.

Timing is hard, but informed portfolio construction shouldn’t be

As the last few years have demonstrated, inflation poses meaningful risk to the standard 60/40 portfolio. Perfect foresight would enable investors to know when to de-risk and/or add inflation-sensitive assets, but much like forecasts for any macro variable or market, significant uncertainty exists, with unexpected shocks posing the greatest risk to portfolio construction. As has been evidenced in history (Figure 6), a portfolio optimization exercise, with hindsight bias, would at times heavily weight commodities when inflation is rising and other assets classes struggle. It is in these moments of greatest vulnerability for markets that commodities can serve an incredibly important diversification role.

Figure 6.  This chart shows that traditional assets have benefitted from a dedicated commodity allocation. The chart shows that in about half of the 50-year sample, adding commodities to a portfolio was additive to a 60/40 portfolio risk-adjusted return. The portfolio is optimized based on five-year returns, volatility and correlation.

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors.  Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Diversification does not ensure against loss.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. Asset allocation is the process of distributing investments among various classes of investments (e.g., stocks and bonds). It does not guarantee future results, ensure a profit or protect against loss.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Bloomberg Commodity Index Total Return is an unmanaged index composed of futures contracts on a number of physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. The futures exposures of the benchmark are collateralized by US T-bills. Bloomberg Global Aggregate Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market. Bloomberg U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation-Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $500 million par amount outstanding. It is not possible to invest directly in an unmanaged index.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2023, PIMCO.

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