In the hours following the escalation of rhetoric between North Korea and the U.S., commodities rallied significantly.
Each of the energy, metals, and agricultural sectors experienced gains, with crude oil, natural gas, gold, silver, industrial metals, corn, soybeans and wheat all posting meaningful moves to the upside. At the same time, global equity markets experienced declines. Regardless of how long this initial price action persists, it’s important to realize that this was merely on the basis of an exchange of words. A full-blown crisis could result in a far more dramatic and protracted market reaction.
This across the board commodities mini-rally demonstrates one of the most important, but frequently overlooked, reasons for a commodity allocation: the capture of crisis alpha. We have always highlighted the fact that, in addition to the attractive historical returns and beneficial impact on portfolio risk, commodities also offer an undervalued and essentially perpetual option on both unexpected inflation and, especially, global event risks. Commodities have a higher positive correlation to these risks than any other asset class.* This means that a “flight to quality” is frequently accompanied by a flight to real assets, due both to potential disruptions in global production and distribution mechanisms, and also to the more intrinsic valuations of raw materials vs. financial assets.
Although it may be tempting to dismiss events such as the Korean crisis as idiosyncratic, that’s the nature of higher standard deviation risks, and they should be an investment policy consideration. One of the very best “insurance policies” for these risks is available to investors as part of a commodities allocation, which already enjoys its own strong rationale for investment based on stand-alone expected returns. The implied premium for this insurance is almost nonexistent, given the historically low volatility and inflation environment we’re currently experiencing.
Allocating to commodities has rarely been easier to justify. With a cyclical recovery that began in early 2016, the RICI®, an intelligent beta commodity strategy, was up over 13.00% in 2016*, besting the S&P 500, and without any tailwinds from increases in GDP or CPI, which are arguably still on the horizon. It’s also important to note that our fund products contain only exchange traded futures contracts and very short term U.S. government guaranteed securities in the collateral accounts, maximizing the liquidity (we have discussed the significant proportion of non-commodity assets, including swaps, held by some other strategies in previous Investment Commentaries).
Here we draw attention to an additional important and timely reason for including commodities investments in portfolios: they typically respond to adverse world events in beneficial ways. In the context of the current ominous geopolitical situation in the world, investors should strongly consider increasing allocations to this asset class, and soon.