How commodities help beat inflation
As the key inputs into most goods and many ser vices, commodities are intimately related to inflation. Our analysis of the commodity-related components of the Consumer Price Index (CPI) basket shows that 38% of our total monthly expenditure is directly affected by commodity prices (e.g. food, electricity and transport services). For the lowest earning 20% of the population, its impact is even greater – 65% of their income is spent on these goods and services (53% on food alone).
The experience of the Seventies clearly shows the potential inf lation-hedging characteristics of this asset class: during the period between 1968 and 1982, in which domestic inf lation averaged 10% per annum, commodity prices were up an average of 17% in Rand terms. When compared with other assets, this return was beaten only by equities, which averaged 18% per annum over the same period, albeit with a slightly higher level of risk (volatility – see graph). Importantly, however, the low historic correlation between equities and commodities – just 0.27 during over the period in question – suggests that there are clear diversification benefits from combining the two.
Until now, investors have not been able to invest directly into the commodities that are driving the inf lation they experience, as traditionally, investing in commodities has been restricted to buying funds or indices comprising commodity bundles which have been constructed on a somewhat arbitrary basis.
In South Africa, for example, the only currently investable commodity basket – Standard Bank’s African Commodities Index – uses pan-African production quantities to determine the weights for their basket of commodities. Similarly, within the international space, the Thompson Reuters Commodity Research Bureau (CRB) Index – the oldest established commodities index in the world – currently comprises 19 commodities that are selected on the following basis: Energy-related commodities get the highest allocation (33% – always); Highly liquid (i.e. frequently traded) and then less liquid commodities get the next biggest allocations; and finally, Those commodities that provide diver- sification are also included. In both cases, neither of these baskets relate to the commodities that consumers are faced with when they purchase their goods and services and are, therefore, unlikely to be the best hedge against their personal inf lation experience.
To overcome this shortfall, we have developed for our clients a Commodities Consumption Index (CCI), which best ref lects the bundle of commodities that consumers are most directly exposed to through their normal purchasing behavior, as measured by the CPI. It is a combination of six commodities: oil, coal, maize, wheat, sunf lower and sorghum, all of which are individually available to investors through the South African Futures Exchange (SAFEX). Unlike other indices, our CCI does not include any precious or base metals which, by virtue of the fact that they are manufacturing inputs, are components of the Producer Price Index (PPI), rather than the CPI.
Beating inf lation is the minimum requirement for any long-term investor. Our analysis of the performance of this bundle of consumption commodities shows that it has good inf lation hedging properties. Moreover, its returns offer diversification benefits to investors and, in some cases, it can also enhance the returns from a diversified portfolio. Having direct access to the commodities that they consume is a very intuitive and effective way for investors to protect themselves against the effects of this insidious erosion of the value of their savings.