Global equities and bonds both ended 2022 down double digits as we saw a sharp break from the benign, low inflation and low interest rate environment of the 2010s. Heading into 2023, investors will inevitably remain focused on second guessing the persistence of inflation, the pace of central bank rate hikes and whether tighter monetary policy will tip the global economy into recession.
The return of inflation raises questions around traditional approaches to portfolio construction. Bonds are fundamentally unattractive given the negative real returns on offer. At the same time, commodities are receiving renewed interest, due to their strong performance in the post-pandemic environment and their history of providing returns in inflationary environments.
The data is supportive of investing in commodities to counter inflation: during months where US CPI was running at 3% or more, the S&P GS commodity index delivered annualised real returns of 4.9% since 1972 versus a paltry -0.4% real return for the MSCI World stock index.
Commodities are, however, a difficult investment to hold: the S&P GS commodity index is down more than 60% below its 2008 highs today and − despite delivering attractive real returns in the 1970s and 1980s − investors would have still experienced two 30% plus drawdowns during this period. This volatility during inflationary environments is evident in the chart below, which plots the rebased prices of four major commodities back to 1960.
More dynamic approaches to commodity investing may offer a solution for the deep and sustained drawdowns that are a characteristic of the asset class. For example, the trend-following investment strategies have a long history of generating returns from commodities and performing well during periods of high inflation. We saw evidence of this in 2022, with the SG Trend Index − which tracks the performance of 10 of the largest trend-following strategies − returning 27.3% in a difficult environment for traditional stock and bond investments.
Trend following involves taking long positions in markets that are trending higher and short positions in markets that are trending lower in anticipation that these price trends will continue. When the trend comes to an end, the strategy reduces its position and eventually switches direction.
This approach to investing is particularly attractive in commodities, where we see evidence of sustained price trends. Trend following can provide exposure to the upside associated with commodities, while also having the ability to profit on the downside. By positioning for trends, up or down, in dozens of different commodities, trend-following strategies offer an effective way of capturing diversifying price swings across the asset class.