Navigating Inflation: How Natural Resource Equities Can Buoy Portfolios


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Authored by: Robin Wehbé, CFA, CMT

When considering the last 50 years, investors rightfully look to commodities for an inflation hedge. Commodities tend to outperform broad equity markets during periods of high inflation, so investors look here for some insurance. However, commodities historically have significantly lagged during low to moderate inflation periods. This makes the cost of insurance quite high, as these allocations drag on portfolio returns in all but a high inflation regime. Historically, natural resource equities have provided a better alternative.

Natural resource equities provide exposure to both equity and commodity markets. That dual exposure has historically reduced the return drag on a portfolio during low-to-moderate inflation regimes (see chart). Commodities have only kept pace with broader equities in the highest inflation regime; however, natural resource-specific equities have outperformed both commodities and broader equities.

Exhibit 1: Average Monthly Return by Inflation Regime, January 1970 - December 2017

Sources: St. Louis Fed, Commodity Research Bureau, FactSet.

In fact, it is hard to find any market environment when an allocation to commodities was more favorable than their related equities. While commodities have at times fared well, natural resource equities have historically outperformed through market cycles. Exhibit 2 looks at rolling 3-year holding periods. Equities perform 3% to 5% better, which is expected when considering the equity risk premium (said another way, the value companies create by investing in projects over their cost of capital).

Exhibit 2: Rolling 3-Year Returns, 1972-2017

Sources: St. Louis Fed, Commodity Research Bureau, FactSet.

Investors have used other means to hedge inflation, but we believe some popular vehicles present notable downsides. Private Equity is a common option, but these funds take time to place (creating a performance cash drag), lack liquidity and charge higher fees. High yield complicates the commodity exposure with corporate credit risk, muddying the inflation hedge. Exchange-traded funds (ETFs) provide exposure to commodity-linked equities. However, they are heavily weighted toward large companies that may not correlate well to the underlying commodity. Additionally, ETFs lack the ability to shift defensively in challenging markets, forcing ETF investors to own troubled Index companies all the way to bankruptcy. If inflation is a concern, we believe an active equity global natural resources allocation is an appropriate way to hedge. During periods of low-to-moderate inflation, natural resource equities are less likely to drag on returns, and if inflation gets extreme, this allocation has the potential to perform well.

Exhibit 3: Relative Commodity Exposure Trade-Offs for Various Vehicles

For illustrative purposes only.


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