Commodities Set to Gain Amid Elevated Inflation Regime
After surging in the post-pandemic recovery, US and developed market inflation has pulled back from historic highs but has yet to revert to pre-pandemic lows. Historically, periods of high inflation have produced notably different outcomes across asset classes compared to the returns we saw over the decades before COVID.
We investigated the implications of elevated inflation levels on asset class returns in a May 2022 piece, Portfolio Implications of a Higher US Inflation Regime. Today, with inflation still elevated (Figure 1, below), the insights from this paper can continue to inform how investors position their portfolios.
Figure 1: Inflation Remains Elevated
Historically, low and stable inflation, along with anchored inflation expectations, have been associated with greater short-term consistency of economic output and higher long-term growth. In contrast, environments of persistently high inflation and unanchored inflation expectations have been associated with weak economic activity in the short term and lower growth in the medium to long term. The unpredictability caused by persistently high inflation and inflation uncertainty distorts relative prices, discouraging savings by households and impacting long-term decision making by businesses.
High-inflation environments are associated with inflation volatility across both developed and emerging economies. Under conditions of high and volatile inflation, households and businesses face extreme difficulty in discerning absolute price changes from relative price changes, which leads to escalating uncertainty. High and volatile inflation also signals the inability of monetary and fiscal policies to ensure economic stability. Such scenarios increase anxiety about the future and discourage real investments, which is reflected in the financial markets in the form of increased term premiums and higher interest rates. We explored this in A New Supercycle Bull Market for Commodities. As with inflation volatility during periods of higher levels of inflation, interest-rate volatility also rises during periods of elevated interest rates. For example, the volatility of 10-year rates from 1965-2000, when interest rates were high, was twice that of the subsequent low-rate period from 2000-2020.
When uncertainty around the future path of inflation is high, monetary policy becomes less predictable for market participants. Central banks are therefore constrained in their ability to provide meaningful forward guidance, unlike during periods of stable/low inflation. Consequently, the odds of a negative monetary policy surprise increase. Expansionary fiscal policy, which is often one of the drivers of higher inflation, is likely to be unsustainable. In such a scenario, economic growth comes under pressure and if these uncertainties persist, inflation expectations – both among households and businesses – ultimately become unanchored. Wage-price spirals typically develop during prolonged high-inflation environments, ultimately forcing significant abrupt monetary policy tightening, which can result in sharp drops in output and lead to more frequent recessions.
An assessment of nearly the last 50 years of US asset returns confirms vastly different outcomes for public-market asset classes in regimes of elevated inflation compared to returns from the low-inflation period from the early 1990s-2020. Our evaluation of asset class performance during the period from 1973-2024 (Figure 2, below), building on the results presented in Portfolio Implications of a Higher US Inflation Regime, finds that high-inflation regimes correspond to subdued returns for equities and nominal bonds relative to commodities. And while equity and nominal bond returns are now positive, real assets (which we define as investments that are understood to have inflation hedging properties, even if they have no “real” physical component) such as Treasury Inflation-Protected Securities (TIPS), Real Estate Investment Trusts (REITs), precious metals, and broad commodities, provide meaningfully higher nominal and real returns during periods of inflation above 3%. REITs perform quite strongly in both low- and high-inflation regimes, while broad commodities stand out with markedly improved nominal and real returns in the high-inflation regime versus the low-inflation regime.
Figure 2: Asset Class Nominal and Real Returns 1973-2024
While TIPS, REITs, precious metals, and a diversified portfolio of commodities have historically performed better than equities and nominal bonds in real terms during regimes of higher inflation, there is a wide dispersion in outcomes among these real assets. Only commodities have performed better in both nominal and real terms in higher-inflationary periods versus low-inflation periods. TIPS and precious metals have better nominal returns in higher-inflation periods than in lower-inflation periods, but lower real returns. REITs, while still delivering positive real returns in higher-inflation periods, underperform on a real-return basis compared to their performance in lower-inflation periods.
A regime of higher inflation and higher-inflation expectations, such as the one that emerged in 2022 and remains in place today, has important implications for investor outcomes, particularly if inflation remains elevated. Strategic allocations like a 60/40 split between equities and nominal bonds have historically delivered negative real returns in periods of elevated inflation. The good news is that there are allocation options for public market real assets that perform materially better than stocks and nominal bonds in higher-inflation regimes. Increasing allocations to real assets, particularly commodities, in an elevated inflation regime can meaningfully improve expected portfolio outcomes.
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