Soaring inflation puts commodities and CTAs in the spotlight
By Chris Stevens, Director, Diversification Strategies at bfinance
After more than twenty years of non-inflationary growth in the Western world, inflation has made a serious comeback. Will macroeconomic changes restore favor to commodities in the portfolios of institutional investors?
Institutional investors’ allocations to commodities have been in secular decline for a decade, despite the asset class offering strong inflation protection. These reductions are due, in large part, to weak performance and high volatility: although the Bloomberg Commodity Index (BCOM) generated a return of 27% in 2021, the picture over the decade is still negative.
Instead, many pension plans and other asset owners have preferred to rely on historically “inflation-sensitive” asset classes – stocks, real estate and infrastructure – to hedge against the effects of erosion of the value of inflation. An investor’s decision on how much inflation sensitivity is required will depend on the nature of their objectives: a pension plan, for example, may focus on funding ratios rather than actual returns.
Yet the past few months have brought a change in sentiment, with inflation continuing to beat forecasters’ expectations. More and more economists have moved from a “transitional team” (ignoring price spikes resulting from increased short-term consumer demand or supply chain disruption) to a “structural team” “. The jury is still out on whether continued inflation is likely to be accompanied by strong or weak economic growth and the severity of the impact the Ukraine/Russia conflict will have on supply chains and the global economic system. .
In a benign “demand-pull” inflationary scenario, in which mismatches between supply and demand cause prices to rise over the medium term and interest rates to gradually rise over time, a wide range equity and real asset strategies could perform well. In a “cost-push” or stagflation scenario, in which supply-side bottlenecks become entrenched, risky assets are likely to be negatively affected and real interest rates will rise more. quickly. Their sensitivity to inflation largely depends on their ability to raise prices, rents or incomes – and that becomes difficult without reasonable economic growth to support it.
As the macroeconomic situation evolves, investors should continue to reassess, analyze and test their approaches.
Commodity markets are (partially) regaining lost ground
The BCOM index is now up almost 90% from its post-COVID lows, offering a return of 27% in 2021 and further increases in 2022 (about 9% in January, 6% in February). Although the price of gold and precious metals fell in 2021, undermining their reputation as hedges against inflation, there were massive increases for energy, food and industrial metals.
Yet, although the index is up nearly 90% from its post-COVID lows, it remains well below its 2011 high and its ten-year annualized performance remains negative (-1.9% ). While a continued inflation scenario would likely be very supportive of a positive performance, few market participants are (yet) expecting a return to the “commodity super cycle” theme of the 2000s.
It is certainly possible that investment strategies dedicated to commodities will find more favor with investors in the coming months. However, we have yet to see an increase in searches for dedicated managers from institutional clients focused on this sector.
CTAs attract assets, but non-commodity strategies struggle to perform
Commodity Trading Advisors (CTAs), also known as Managed Futures, are one of the few strategies in which institutional investors are currently likely to have direct exposure to commodities. This sector has seen strong investor demand in 2021-2.
These strategies (largely trend-following) tend to give investors a bumpy ride. Yet they often attract attention in times of uncertainty because of their “convex diversification” profile: their ability to perform during specific periods when stock markets are doing poorly. Today, we see managers and investors increasingly emphasizing their potential inflation sensitivity.
It is crucial to note that many CTAs do not invest in commodities and those that do usually also invest in other asset classes. The acronym CTA has long been a misnomer, with these strategies also trading the “financials” of stock, bond and currency markets alongside the commodity markets where many of the early CTA companies had their roots. The choice to avoid commodities can be motivated by a number of considerations, including the type of vehicle (it is more complex and expensive to include commodities in a UCITS structure), beliefs about investment or even ESG factors (some clients do not want to be seen speculating on commodities, especially food prices).
The Societe Generale CTA Index (SG CTA) returned 6.2% in 2021, while the SG Trend sub-index returned 9.1%. The inclusion (or exclusion) of commodities was a major determinant of performance during the year: based on a recent bfinance study of a large group of CTAs, the median performance of CTA followers of trend “with commodities” was +6.7% in 2021, while the median performance of those without commodities was strongly negative at -4.9%. The strong gains in CTAs continue in 2022: managers who offer long exposure to commodities and short positions to fixed income securities are ideally positioned to ride inflation-driven markets.
These strong results follow a decade of positive, albeit rather anemic, returns. The SG CTA Index has returned 2.4% per year over the ten years to February 2022, while the SG Trend Index has returned 3.3% annualized over the same period. These strategies have also, in particular, performed well during some particularly difficult recent periods, such as March 2020.
Reassessment of award
Investors are increasingly likely to re-evaluate the role of commodity exposure as we grapple with the prolonged macroeconomic effects of the pandemic and war. Long-only or long-short commodity allocations can play a role in improving the portfolio’s inflation sensitivity and can become particularly important in a low-growth inflationary scenario. At the same time, CTAs remain among the most diversified liquid alternative strategies, able to provide positive performance when traditional markets suffer and offering indirect exposure to commodity trends.