Market volatility could boost commodities

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As most asset classes suffer from rising interest rates and fears of recession, commodities such as oil and wheat have generated high returns on the back of the war in Ukraine and supply chain disruptions.

But institutional investors are not in agreement on the long- term viability of the asset class or its strength as an inflation hedge.

Moves by the Federal Reserve to raise interest rates, combined with World Bank Group’s recent report lowering global growth projections to 2.9% from 4.1% in 2022, have added to investors’ anxiety as they look to stem losses in their portfolios. Even if a global recession is avoided, “the pain of stagflation could persist for several years — unless major supply increases are set in motion,” said David Malpass, president of World Bank Group, Washington, in the foreword of its Global Economic Prospects report.

While many institutional investors hesitate to make commodities a significant portion of their portfolios because of their volatility, others see long-term potential.

“Commodities, I think, are long-term bullish market,” said Patrick Fleming, chief investment officer of Wyoming’s $24.5 billion State Loan and Investment Board, Cheyenne. Mr. Fleming said he believes there is currently a commodities super cycle going on due to underin- vestment in commodities, environmental challenges and the ongoing supply shock.

“This is a real-time example of showing what happens when you don’t have large enough reserves or capacity to increase when you need to … the price goes up dramatically because there’s just certain things you have to have to be able to function,” Mr. Fleming added.

The board has a lot of indirect exposure to oil and through leasing. “Our major feature is the state has significant oil and gas lease exposure,” he said. “So all of the land that we leased to the companies, just for instance, a rule of thumb is every $10 increase in the price of oil we receive about $100 million in additional revenue,” Mr. Fleming said. About a third of the board’s income comes from that leasing exposure.

The board had a little more than $1 billion invested in master limited partnerships as of March 31, according to an investment report.

Stephen Nesbitt, New York-based CEO of alternative investment consulting firm Cliffwater LLC, feels differently. “I don’t know an asset manager that exists today that’s built a business, a successful business, on the back of commodities. … In the long term, there is really no return,” Mr. Nesbitt said. Citing the S&P Goldman Sachs Commodity index, he added that the real, inflation-adjusted return is negative. “Most of our clients need to earn real returns. … We’re looking for strategies not where we can get in and get out but basically can survive the business cycle.”

The S&P Goldman Sachs Commodity index was up 61.6% for the year ended June 14, but was down an annualized 0.6% over the past 10 years and up only 1.3% over the past 20 years.

Defined benefit plans within the 200 largest U.S. plan sponsors reported $21.7 billion in commodities assets as of Sept. 30, up 22.6% from the previous year but up only 1.4% from Sept. 30, 2016, according to Pensions & Investments data.

Like the World Bank report, investors are comparing today’s economy with the stagflation of the 1970s. “We look back at the ’70s, and commodities did well during the first half of stagflation, but as soon as the economy goes into recession, commodities get killed,” Mr. Nesbitt said.

While acknowledging similarities in inflation, Mr. Fleming noted that federal interest rates today are much lower than they were in the 1970s, and that there’s not enough commodity infrastructure to support rising demand. Regarding a recession, “that will definitely hurt commodity prices … but the difference this time is that … we haven’t put the infrastructure costs into building” new mines or deploying oil rigs, and extracting commodities has become more difficult and expensive.

Instead of relying on commodities as a large part of a portfolio, some investors have exposure through risk-parity strategies to diversify and capitalize on inflationary periods. For the $204.7 billion Teacher Retirement System of Texas, Austin, risk parity is “a vehicle to add some diversification in the portfolio. … We obviously try to be tactical, but really our overarching mantra is more fiduciary duty as a long-term investor,” said Mark Telschow, senior investment manager in the risk management and strategies group. Risk parity is one of the places TRS’ trust has exposure to commodities. “They’re expected to help us through stagflation environments as well as rising growth, rising inflation environments. And as we’ve been in this period, they have performed as expected,” Mr. Telschow said.

Risk parity accounts for 7.8% of TRS’ portfolio, or about $16 billion.

Even with diversified portfolios, commodities can only counteract broader losses so much. “Strategies will mitigate the impact of inflation on a well-diversified portfolio, but since the lion’s share of the assets are going to be committed to traditional stocks and bonds, for most investors it will only mitigate the impact of inflation, it won’t offset it. There is no silver bullet,” said Allan Emkin, managing principal and consultant in the San Diego office of Meketa Investment Group Inc.

Further, “the story of commodities as a bucket is actually more complicated under the hood,” said Alison Adams, Portland, Ore.-based executive vice president at Meketa, noting recent falls in lumber and copper prices while wheat and oil are surging. “So I’m a little bit cautious going forward if we can rely on commodities alone to protect our clients’ performance.”

In face of these drops, $2.5 trillion J.P. Morgan Asset Management believes a commodity such as timberland can withstand price declines better than other commodities because it’s “growing all the time” and there’s no pressure to sell, said Vice Chairman Ash Williams, who is based in Tallahassee.

In 2021, JPMAM acquired Campbell Global, which has $5.3 billion in assets under management and manages more than 1.7 million acres of timberland, according to a JPMAM news release.

While there’s money to be made, environmental, social and governance concerns could be preventing investment in commodities. Mr. Fleming described Wyoming as “ESG agnostic,” and said other investors’ ESG concerns have created more commodity opportunities for its fund.

“In last cycle, you had a lot of people jumping in and joining the commodity bandwagon and now it’s a de minimis amount. … We’ve seen a massive rally in energy and commodity prices in general and yet money put toward the sector has been flat, it’s barely up. So the investors are not following through and feeling that this is a sustainable investment,” Mr. Fleming said.

As other assets continue to tumble, though, investors could be drawn back to commodities. “There are very handsome dividends that are being paid out by the energy companies. … So we’ll see if that attracts institutional investors back to the space. That’s a lot of money to leave on the table,” Meketa’s Ms. Adams said. “I don’t want to be definitive because I believe it’s something that’s very much evolving.”