Oil - A Slippery Commodity Amid A Sticky Situation

While inflation may not be a headline concern to the degree it was in the post-COVID recovery, that episode nonetheless exposed the delicacy of supply-side-driven inflation risks. As Consumer Price Indexes (CPI) hit levels not seen in many years, consumers had to adjust to a new reality which only effective policy and the natural clearing mechanisms in the economy were able to address in due course.

Investors, for their part, also felt the discomfort of inflation as portfolios built around a traditional 60/40 model exhibited a high degree of sensitivity to the level and direction of interest rates and the assumed diversification benefit bonds were meant to offer stocks, failed to offer ballast as interest rates rose off historical lows in response to the inflation episode. Our research in portfolio construction shows that at levels of inflation above 3%, stocks and bonds become positively correlated: they begin to behave the same, directionally. For years, bonds had been an effective hedge to stocks in periods of growth shocks, but investors learned a hard lesson in 2022 when they failed to protect downside in equities during inflation shocks.

What is an investor to do? Shortening duration in fixed income allocations may help play defense in an environment of rising rates, but when policymakers raise short-term interest rates to quell inflation, even shorter duration may not properly insulate a portfolio from losses during inflation shocks. So why not play offense in an inflationary environment? What assets or strategies could benefit from inflationary risk? The short answer, and most accessible asset class is likely commodities.

Drawing On Our Research:

This piece is not meant to expand upon the historical linkages and conventional wisdoms, but suffice to say, our portfolio construction whitepaper, “Fortifying Investment Portfolios” (published December 11, 2019) drilled into years of asset class behaviour in various market regimes. We arrived at nine investible asset class building blocks for a well-diversified strategic asset allocation. We believe this new buy-and-hold baseline portfolio framework could support resilient across varying regimes and may provide investors with a higher quality of return than the traditional 60/40 portfolio construction model. In the attached diagram which shows an efficient frontier composed of these nine asset classes, the opportunity for enhanced risk-adjusted return (relative to the traditional 60/40) exists largely around the inclusion of commodity asset classes.

To be sure, we were not beating the drum on inflation risks as this research culminated in 2019. However, we respect the longer market and economic history which shows that inflation can and does happen…the crux is that it can be difficult to predict, not only in terms of timing, but it’s magnitude and degree of “stickiness”. Having a well-diversified portfolio therefore means having an appropriate risk budget for inflation-sensitive returns before the inflation risk episode occurs.

The Here And Now – Addressing Volatility In Inflation Assets:

For many months, as Consumer Price Index (CPI) has stabilized (albeit above the U.S. Federal Reserve’s long-term target of 2%), we have reminded investors that inflation is an erosion of purchasing power. It doesn’t always come in the form of higher prices, but can also manifest in the debasement of currency one uses to consume, save and invest. For this reason, our view is precious metals, led by gold and followed vigorously by silver, may act as a diversifying asset class. Yet, as we highlighted in our most recent “Off The Desk” missive, “The Silver Selloff”, in creating diversification benefits to complement a traditional 60/40 approach, one must be careful to not take a single-asset view. Put another way, diversification is important within one’s inflation strategy.

Turning again to the enclosed exhibit, simply observe the volatility characteristics of the commodity asset classes as diversifying portfolio components. One need not squint to recognize that the energy asset class, with its high return potential, is also volatile. To allocate effectively in seeking higher and consistent risk-adjusted returns, our multi-strategy team approaches the inclusion of these asset classes as an exercise in risk-budgeting rather than capital allocation. More dollars chasing more returns can lead to uncomfortable volatility experiences. Not to mention that with the headline risk prevalent in the Middle East, prices in energy assets are gyrating wildly. Investors should consider the diversifying benefits of these asset classes, while being mindful that the path-dependency of prices predicated on the newfound “fundamentals” related to this conflict could evolve over time. Risk-weighting, respecting trend and crowding in assets, and taking profits prudently are all hallmarks of the risk-management process embedded in the PICTON Inflation Opportunities Alternative Fund.