Commodities Can Continue to Impress

With support from gold, oil and many, many more, commodities are thrilling again in the first quarter after ranking as last year's best-performing asset class. At one point earlier this month, commodities were the only asset class in the green on a year-to-date basis.

Between the aging business cycle, high inflation, elevated demand, crimped supply and geopolitical risk, the stars aligned for more commodities upside this year. Some market observers even go so far as to say that's it's time for clients to increase commodities exposure as an avenue for diversifying 60/40 portfolios.

“We expect, high and volatile inflation – rather than growth – may be the biggest driver of equity and fixed income returns over the coming year, making commodities a valuable potential hedge to the traditional 60/40 portfolio,” according to PIMCO.

The bond giant highlights low oil inventories, high roll yields and diversification as catalysts for more commodities upside.

Oil Obvious Catalyst, But Don't Forget Roll Yields

Owing to Russia's invasion of Ukraine, there's ample talk of oil prices in the mainstream media. However, it's foolhardy to believe that's the primary reason oil prices are high. It's not.

U.S. production was derailed by the coronavirus pandemic and it can't be – no matter what politicians say – restarted overnight with immediate impact on prices at the pump. That takes time. Plus, many exploration and production firms are concerned about access to financing and an unfavorable policy climate. Bottom line: Oil prices are high and that situation may not relent anytime soon.

“This imbalance is most acute in energy markets, where producers, faced with environmental restrictions and poor returns, have underinvested in drilling new wells -- both shale oil and conventional. In turn, prices have escalated. And the sting of higher energy costs can be felt in the rising prices of other commodities,” adds PIMCO.

Then there's the matter of roll yields – the result of selling a longer-dated commodities futures contract into a near-term contract with a higher price. The rolled yield on the Bloomberg Commodity Index (BCOM) is around 5%, which as advisors know, is well above what's earned on 10-year Treasuries and the dividend yield on the S&P 500. Time will tell, but that could be a precursor to more commodities upside.

BCOM's 5% roll yield “is the highest level of backwardation after adjusting for short term rates since the early 2000s, which preceded the last commodities supercycle. While we think it is premature to call a supercycle, as higher prices will ultimately beget more supply, holding commodities to hedge inflation risks is more attractive when carry provides a tailwind,” notes PIMCO.

Inflation, of Course

As advisors and clients by now well, inflation is acting as a primary driver of commodities price appreciation, confirming the asset class is living up to its reputation as a solid inflation-fighting tool.

“In the near-term, we expect inflationary pressures fueled by loose monetary policy and the recent unprecedented expansion of the money supply in the U.S. to provide a strong tailwind for commodity prices, especially if demand for goods and services rebounds with the lifting of Covid pandemic restrictions,” according to First Trust research.

The point: There are no guarantees, but with the exception of the Russia/Ukraine war, it's hard to envision the other factors supporting commodities upside disappearing anytime soon.

Related: How Advisors Can Present Clients with a Feel Good Opportunity