Three straight years of negative returns for broad commodity benchmark indices, such as the Dow Jones-UBS Commodity Total Return Index, have led some investment advisors (and their clients) to begin questioning the rationale for including commodity futures ETFs1 in their asset allocation models. Relatively tame inflation expectations seem to support these doubts, as commodities are often thought of as a hedge against inflation. However, the fact that inflation expectations are so low may actually highlight one of the most important reasons for maintaining (or adding) a strategic allocation to commodity futures ETFs: in order to hedge against unexpected inflation.
Unexpected inflation is a risk worth hedging, in our opinion, because it tends to have a negative impact on both stocks and bonds. For example, when inflation is accurately forecasted, manufacturing companies can utilize futures contracts to lock in their future costs for certain raw materials, in order to manage their profit margins. However, when input costs rise unexpectedly, profit margins may be compressed for companies that have difficulty passing these cost increases along to their customers, which, in turn, tends to hurt stock prices.
Bondholders are negatively impacted by unexpected inflation as well, since bond yields are set by the market with an embedded inflation expectation. When inflation increases unexpectedly, the real value of bond interest payments is reduced, which may also negatively impact bond prices, as the market requires higher nominal yields.
Similar to stocks and bonds, the prices of commodity futures also have embedded inflation expectations, but unlike stocks and bonds, commodity futures prices tend to be positively impacted by unexpected inflation increases.2 This relationship enables investors to potentially utilize commodity futures and related ETFs as an effective hedge against unexpected inflation.
Of course, it’s difficult to make a strong case for when unexpected inflation may show up, which is ultimately what makes it unexpected. While there are certainly conditions in place that could eventually lead to higher levels of inflation, First Trust’s forecast for year-over-year US CPI growth of 1.8% in 2014 and 2.3% in 2015 is only slightly higher than the median forecast among Bloomberg contributors (1.6% for 2014 and 2.0% for 2015). But this underscores why we believe it makes sense to include a strategic allocation to commodity futures ETFs in an asset allocation model: not as a tactical play based on our expectation of unexpected inflation, but as a tool to manage the risk of unexpected inflation, which, by definition, you don’t see coming.