The current market environment has caused many investors to evaluate their portfolios, including whether they provide adequate diversification for the risks ahead.
When facing uncertainty in the markets, we find it helpful to frame our thinking within the four quadrants made popular by U.S. Secretary of Defense Donald Rumsfeld: known knowns, known unknowns, unknown knowns, and unknown unknowns. Given current conditions, we believe that thinking in this way reveals commodities as an asset class particularly well suited to these unpredictable times.
The simplest of the four quadrants is known knowns. This is base knowledge. Things we are both aware of and can understand.
In this sense, we know today that inflation is at 40-year highs, we know we are very likely entering a tightening regime in monetary policy, and we know the conflict between Russian and Ukraine is spawning massive and escalating broad-based macroeconomic threats.
What are investors’ options for mitigating these known-known risks?
Historically, commodities have typically provided a hedge against inflation, when many other traditional asset classes have been challenged. Commodities have also been one of the best-performing asset classes during rate hike cycles: central banks generally increase rates when the economy is running hot, which tends to coincide with depleted commodity supplies but significant demand. Finally, the conflict between Russia and Ukraine is impacting the supply of commodities such as those in the energy sector, driving prices higher.
There are also known unknowns—events or conditions that we’re aware of, but where we remain unaware of their exact or ultimate impact.
The best examples of known unknowns today are the sanctions against Russia. In response to Russia’s invasion of Ukraine, western countries have come together to impose various sanctions. These include banning Russian financial institutions from the critical SWIFT messaging system, suspending the Nord Stream 2 gas pipeline, restricting Russian airlines in western airspace, and freezing central bank assets.
While we are aware of these sanctions, it’s impossible to know the extent of their medium- to long-term impact. We do know that Russia is a major supplier of energy, metals and grains, however, and that sanctions on these sectors are likely to drive prices up. We think that makes it a potentially opportune time to invest in commodities.
As the unknown element of sanctions plays out, we believe that commodities will continue to act as an effective hedge against their economic disruption—but the picture is likely to become more complex, with some commodities outperforming even more strongly as the impact grows and others trailing off or even losing value. Should sanctions inflict widespread damage on the global economy, for example, the demand for energy and industrial metals may decline to offset supply constraints. By contrast, the world would still need to eat and try to preserve its wealth, potentially raising the prices of grains and precious metals to unprecedented levels.
Similarly, we know that financial sanctions are preventing Russia from accessing the foreign exchange reserves it holds in other countries, but it remains unknown whether this will be enough to persuade other countries to diversify their reserves away from the U.S. dollar, euro, pound sterling or Japanese yen. The descent of such a financial “iron curtain” could lend support to competing reserve currencies and, especially, gold.
The third quadrant is unknown knowns. These can be thought of as hidden facts or untapped knowledge. We know these risks exist, but we don’t know what threshold or conditions would be required to trigger or realize them.
Events such as Russia moving toward other neighboring or even NATO countries, an aggression from North Korea, or Russia being emboldened by close allies in the East are all examples of unknown knowns. Even truly catastrophic outcomes, such as global or nuclear war, are knowable in advance. Any of these events could potentially cut the West’s access to cheap labor and raw materials, via sanctions, embargoes or outright war, pouring yet more fuel on the fires of commodity prices and broad inflation.
But again, investors must consider the unknown quantity of how bad the scenario needs to be to trigger such known eventualities. The more catastrophic the event, the less likely it is that the economic backdrop would support energy and industrial metals and the more likely a scramble for the most basic raw materials would become. Eventually, investors may even have to face massive state intervention to attempt to confiscate and control those basic materials.
Which leads us to our final category, the unknown unknowns—events that we cannot even fathom at this time. So far, every passing day of the conflict appears to raise the threat and fear of these unknowables.
In our view, one of the only assets that can mitigate the fallout from a catastrophic unknown unknown event is gold (or “gold-in-disguise” assets such as silver, platinum and palladium). While investors generally flock to quality when catastrophe strikes, risk-free alternatives like cash or Treasuries still expose investors to minimal returns once inflation is taken into account. In such instances, we think gold is the asset most likely to offer a store of value, just as it has for thousands of years.
Scarcity Leads to Additional “Roll Yield”
In sum, commodities can act as strategic, long-term assets that provide natural diversification to traditional assets. But they can also be useful in a tactical sense.
In our view, the current environment is ripe for commodities. Supply disruption from the pandemic and growing demand had already created a near-perfect storm; increased geopolitical risks only pile on the pressure. The result? We track around 30 commodity markets, and nearly every one of them is currently in backwardation.
Commodity Futures in Backwardation
Roll yields are largely positive, indicating scarcity among the commodities complex and providing a potentially persistent boost to existing price momentum
Source: Bloomberg. Data as of February 28, 2022. For illustrative purposes only. Past performance is no guarantee of future results.
Backwardation, which occurs when nearer-dated futures contracts trade at higher prices that later-dated contracts, is a key factor in commodity investing because it indicates a commodity’s scarcity. If a commodity is scarce, it is generally more valuable, and more valuable in the hand now than theoretically in the hand in three, six or 12 months’ time.
Backwardation makes commodity investing doubly attractive for investors: when near-dated contracts are more expensive than later-dated contracts, investors who hold a position by “rolling” from maturing contracts to later-dated contracts earn the difference—the so-called “roll yield.” This comes in addition to any price appreciation happening across the entire curve. Moreover, backwardation tends to be sticky; commodities have historically tended to stay backwardated for a while.
While commodities may not have been in vogue for the previous decade, we believe the current supply shortages, growing demand and geopolitical risks make it an opportune time for the asset class. Commodities have been one of the few assets to provide a reliable hedge against inflation and, importantly, provide diversification during periods of economic stress and market risk aversion, when portfolios have needed it the most.