Download Commodities and the Inflation/Deflation Debate

Asset Management
How Commodities Can Help Investors Face
The Uncertainty of the Inflation/Deflation Debate
December 2010
WHITE PAPER
Executive Summary
Nelson Louie
Global Head,
Commodities Group
In the wake of the 2007–2009 global financial crisis there have been heated debates among
economists, central banks and investors over which is the greater macroeconomic risk facing
the world’s developed economies: inflation or deflation. The case has been made for each side
of the debate: on the one hand, some believe that quantitative easing in the United States,
Japan and the United Kingdom could precipitate an inflationary environment; on the other
hand, some argue that deflation is the main concern because of slack capacity in developed
economies, low aggregate demand, deleveraging in the private sector and fiscal restraint in
some countries.
The lack of consensus on the outlook for inflation presents a challenge to investors: how
to prepare for unexpected shifts in the global inflationary environment? We believe that the
uncertainty increases the risk that any rise in inflation will be “unexpected” (i.e., it will not
be properly priced into market valuations). We believe that exposure to real assets such as
commodities can help investors address this challenge.
Christopher Burton
Portfolio Manager,
Commodities Group
In this light, we believe that an allocation to commodities should not be seen as a tactical
move, but rather as a strategic choice investors can make to help protect their portfolios
against changing inflation environments over the long run. Our analysis shows that long-term
investments in commodities have historically provided inflation-hedging benefits to investors.
For more information
or to comment on any
views expressed here,
please write to us at
ir.betastrategies
@credit-suisse.com
Another important potential benefit to investors is the diversification that the asset class can
provide to investors’ portfolios due to their low correlations over time with equities. Return
drivers for commodities are often quite different than those of stocks and bonds, and relate
to their idiosyncratic supply-and-demand fluctuations. In our view, this diversification is
best achieved using a broad basket of commodities to smooth out the volatility of individual
commodities, such as oil or gold.
How Commodities Can Help Investors Face the Uncertainty of the Inflation/Deflation Debate
Hedging Inflation With Commodities
Commodities are part of the “real asset” class that can help
protect against the impairment of future value of portfolio assets
from rising inflation.1 In recent years, an increasing number
of investors have been taking an interest in these assets,
particularly those with heavy exposures to assets that are
sensitive to loss of value because of inflation, including equities
and traditional bonds.
unexpected. One reason that stocks may suffer during rising
inflation periods is increasing raw material costs may reduce
corporate profit margins if companies are unable to pass price
increases along to consumers. Lower margins may have a
negative impact on equity valuations.
Rising inflation impacts bonds because it diminishes the
purchasing power of a bond’s future interest payments and
principal. As such, Treasury Inflation Protected Securities
(TIPS) have emerged as a popular inflation hedging tool.
Similar to standard Treasury bonds, TIPS pay interest at
regular intervals as well as the principal upon the bond’s
maturity. However, unlike standard Treasury bonds, both the
interest payments and principal amount are automatically
increased during periods of rising inflation as determined
by the CPI. While TIPS provide targeted insurance against
inflation, they do not exhibit the same low correlations with
bonds as commodities, and therefore may not provide the
same level of diversification within a portfolio. Next, we discuss
the difference between expected versus unexpected inflation,
and how commodities work as an inflation hedge in each of
these environments.
Commodities’ high correlation with inflation, which provides
purchasing power protection against rising prices (Display 1), can
help address this concern. The protection comes from the fact
that commodities reflect prices in areas such as energy, industrial
metals and agricultural commodities. As such, commodities are
directly linked to the components of inflation (a common measure
of which in the US is the Consumer Price Index, or CPI), and
therefore tend to increase in price during inflationary periods. We
note, however, that commodities prices can be volatile, so this
correlation to inflation is better captured by the asset class in
aggregate rather than a single commodity.
On the other hand, financial assets such as stocks and bonds
tend to face headwinds when inflation rises, particularly if it is
Display 1: Commodities correlations with inflation may help provide purchasing power protection 2
Unexpected
Inflation
Inflation
0.5
0.4
0.41
0.34
0.3
Correlation
0.2
0.1
0.0
-0.1
-0.08
-0.2
-0.18
-0.3
-0.21
-0.34
-0.4
S&P GSCI
Ibbotson
Intermediate
Term Bond
S&P 500
S&P GSCI
Ibbotson
Intermediate
Term Bond
S&P 500
Based on average annual returns: January 1970-December 2009
Source: Credit SuisseAsset Management, Ibbotson and Bloomberg.
A widely used, broad measure of inflation is the Consumer Price Index (CPI), which consists of the average price of a broad basket of goods and services that includes
housing, transportation (e.g., vehicles, energy, airfares), food, recreation, apparel and medical care, among other things.
2
Unexpected inflation is based on the historical relationship between1 month Treasury bills and CPI. The S&P Goldman Sachs Commodities Index (S&P GSCI) is a
composite index of commodity sector returns, representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum
of commodities. The Ibbotson Intermediate-Term Government Bond Index is a one-bond portfolio with a maturity near 5 years. The Standard & Poor’s 500 Index (S&P
500) is an unmanaged index of US companies with market capitalization in excess of $3 billion and generally representative of the US stock market.
1
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| Credit Suisse Asset Management
How Commodities Can Help Investors Face the Uncertainty of the Inflation/Deflation Debate
Commodities in Expected versus Unexpected Inflation Environments
Commodities are most effective at hedging “unexpected” inflation,
which represents the difference between expected (or projected)
inflation and realized inflation. In other words, commodities prices
perform better when realized inflation has not been properly
priced into market valuations. Display 2 shows that Commodities,
as represented by S&P GSCI Risk Premium returns (i.e., the
return of the S&P GSCI Total Return Index minus the risk-free
rate), outperform equities, as represented by the S&P 500
Risk Premium returns, by almost 3% in periods of extreme
high unexpected inflation.3 One of the reasons Commodities
perform better in this environment is that commodities indices
invest in futures contracts. While they reflect where spot prices
are expected to be in the future, the prices of these futures’
contracts also move in response to unexpected changes to
market conditions. As a result, commodities indices may fluctuate
in concert with unexpected deviations from components of
inflation.5 As a driver of inflation, commodities inherently rise
with it.
Stocks and bonds, however, tend to perform better when the
rate of inflation is stable or slowing. This is usually because the
market has already discounted the impact of expected inflation,
and therefore “expected” changes to inflation may not have a
dramatic effect on the performance of these traditional assets.
As a result, we believe that the primary risk to investment
portfolios exposed to these assets is one where prices change
unexpectedly. Since our research suggests that commodities
can provide protection to portfolios in unexpected inflation
environments, the next question we address is the risk of
inflation versus that of deflation.
Display 2: Commodities returns historically outperform equities in periods of extreme unexpected inflation4
Average Monthly Returns with Extreme Unexpected Inflation
2.0
1.82%
1.5
Returns (%)
1.0
0.37%
0.5
0.0
-0.5
-1.0
-0.97%
-1.5
-2.0
-1.59%
Extreme Higher-Than-Expected
Inflation
S&P GSCI Risk Premium
Extreme Lower-Than-Expected
Inflation
S&P 500 Risk Premium
Based on average annual returns: January 1970 – December 2009
Source: Credit Suisse Asset Management, Bloomberg, Federal Reserve of Saint Louis
3
S&P GSCI Risk Premium returns are calculated by subtracting the risk-free rate of return from the S&P GSCI Total Return Index. Similarly, the S&P 500 Risk
Premium returns are calculated by subtracting the risk-free rate of return from the S&P 500 Total Return Index. The Federal Funds Rate, as quoted by the Federal
Reserve of Saint Louis, was used to represent the risk-free rate in both calculations.
4
Unexpected inflation estimates are based on the historical relationships between 3-month Treasury Bills and CPI. Extreme unexpected occurrences of inflation are
defined as those which fall one standard deviation from the mean in either direction.
5
Gorton, Gary and Rouwenhorst, K. Geert. “Facts and Fantasies about Commodity Futures.” The Wharton School, University of Pennsylvannia/School of Management,
Yale University. 2004.
Credit Suisse Asset Management
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How Commodities Can Help Investors Face the Uncertainty of the Inflation/Deflation Debate
Analyzing the Inflation/
Deflation Debate
Incorporating Commodities
Into a Portfolio
An inflation/deflation debate is taking place among many policy
makers and investors in developed markets. These debates
encompass a number of economic, fiscal and financial factors
that could potentially affect the path that inflation takes. Some
believe that new rounds of stimulus spending by governments are
needed to forestall deflation with its falling prices and wages. On
the other side are those who believe that additional government
borrowing could foster a rising inflation environment. Here is a
short summary of these two positions:
When considering a commodities investment, investors should
carefully evaluate their current portfolio holdings to determine
their existing exposure to certain commodities sectors, such as
energy, to avoid unintentionally over-allocating to any one area.
Investors should also closely monitor the cash management
portion of any commodities investment to ensure unnecessary
duration or credit risk is not being taken in an attempt to
outperform a collateral benchmark. This can add additional
risk while diminishing the diversification benefits offered by a
commodities investment. For example, holding short duration
bonds will likely reduce the impact of interest rate fluctuations
on the overall portfolio. By contrast, credit exposures, as well
as long duration bonds, including TIPS, can result in increased
volatility and correlations to fixed income markets.
Inflationary risks: US Federal Reserve Chairman Ben Bernanke
announced $600 billion in quantitative easing (QE) on November
3 in an effort to boost GDP growth. The prospect of this
monetary easing by the Fed, as well as similar initiatives in other
countries such as Japan and the UK, has renewed expectations
of inflation for many.
Deflationary risks: Concerns about deflation in developed nations
stem primarily from the following drivers: a) a strong deleveraging
process; b) high unemployment; c) idle industrial capacity; and d)
fiscal restraint on the part of some governments.
These forces can potentially exert downward pressure on broader
consumer price indicators and lead to lower costs and higher
inventory levels for raw materials. It’s worth noting that much
of this “slack” has been picked up by faster-growing emerging
economies in the current cycle. In fact, emerging markets have
been strong buyers of industrial metals and agricultural products,
a move that may continue to bolster commodities prices.
We believe that no matter which of the two forces prevails in
developed economies, one thing appears clear: the inflationary
outcome is likely to be “unexpected.” Our view is that this
supports the argument that commodities can help hedge
a diversified portfolio against changing inflation conditions,
particularly when unexpected.
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| Credit Suisse Asset Management
Conclusion
We believe debates will continue among economists, central
banks and investors over which is the greater macroeconomic
risk that we face: inflation or deflation. Reconciling these
opposing views can present a challenge to investors. The lack of
clarity on the inflation outlook also lends support to the idea that
as new inflationary environments develop around the world, they
will likely be unexpected.
As our analysis shows that commodities futures tend to be more
highly correlated to periods of unexpected inflation, we believe
this creates a compelling case for incorporating commodities
in an asset allocation framework. Finally, the inclusion of
commodity futures into a portfolio context may also provide
diversification benefits based on their historical low correlations
to traditional asset classes which may help improve an investor’s
overall risk/return profile.
How Commodities Can Help Investors Face the Uncertainty of the Inflation/Deflation Debate
Credit Suisse Asset Management Publications
The Anatomy of a Modern Emerging Markets Portfolio
November 2010—This paper examines the quickly evolving
emerging markets investment landscape and argues that the
proliferation of sophisticated investment vehicles in these markets
presents an opportunity for investors to augment the efficiency of
their emerging markets portfolios.
Credit Suisse Asset Management’s Tactical Quarterly
November 2010—Credit Suisse Asset Management’s Tactical
Quarterly offers important insights from our leading Alternative
portfolio managers on the trends and opportunities shaping
today’s financial markets. Investment strategies covered in this
quarterly publication include quantitative and fundamental hedge
funds, private equity, credit strategies and commodities.
Robert Parker, Credit Suisse Senior Advisor
November Market Update
November 2010—The Market Update provides Bob’s views
on global financial markets and economic trends, including the
November announcement by the US Fed on quantitative easing,
global monetary policy expectations, the challenges facing the
Eurozone’s peripheral economies and market implications across
equities, bonds, commodities and currencies.
Liquid Alternative Beta:
Enhancing Liquidity in Alternative Portfolios
June 2010—How to increase a portfolio’s liquidity without
sacrificing returns, especially in a post-crisis, low-yield
environment? The paper illustrates how institutional investors can
use Liquid Alternative Beta to seek to enhance portfolio liquidity,
increase portfolio transparency, short hedge fund sectors and
gain hedge-fund-like exposure when investment policies restrict
direct hedge fund investments.
Can Infrastructure Investing Enhance Portfolio Efficiency?
May 2010—The paper provides an in-depth look at infrastructure
as an investment tool, and analyzes what role the asset class
might play in institutional portfolios. Specifically, the paper
examines whether infrastructure can be an effective tool to
mitigate inflation and duration risks, reduce funding gaps, and
enhance portfolio efficiency.
Gaining Efficient Hedge Fund Exposure Through
Passive Investing
January 2010—This paper examines the benefits of an indexbased approach to hedge fund investing: Cost efficient access to
the broad hedge fund industry, strong performance versus active
fund of funds, reduced manager-specific risk and a simplified
core holding.
Credit Portfolio Management in 2010:
A Nimble Approach Needed
January 2010—Tracking and timing credit cycles can be
challenging, particularly since today’s credit environment appears
to be going through increasingly rapid cycle changes. We believe
that fixed income investors need to be increasingly nimble and
tactical in 2010, while at the same time considering strategic
preparations for medium-to-longer-term regime changes in
interest rates and inflation.
Risk Management: A Changing Paradigm
November 2009—Renewed interest in risk management and
the creation of a culture of risk awareness are driving current
investment committee meeting agendas. This should come as no
surprise in light of market events in 2008 and early 2009. While
experience and judgment that have been battle-tested under
various market conditions prepares CIOs for uncertainty in the
future, how do they implement risk-based solutions while facing
real-world events?
Risk Parity—A Risk-Based Approach to Portfolio Structuring
November 2009—This paper discusses a different approach
to portfolio risk management, called risk parity, which aims to
equate the contribution of risk across asset classes and, as a
result, create a portfolio which performs better in a variety of
market conditions.
In Search of Liquidity and Transparency: Managed
Accounts, Single Investor Funds and Custom Portfolios
October 2009—Investor interest in managed accounts has
grown. This paper outlines four investment structures which
may offer investors a range of solutions for greater liquidity and
transparency in their hedge fund investments.
Preparing for Inflation—Is It Too Early to Position
Your Portfolio?
September 2009—As governments continue to implement
stimulus programs, some investors worry about potential future
inflation. Positioning your portfolio for increasing inflation before it
strikes is critical.
Equity Market Neutral—Diversifier Across Market Cycles
September 2009—This paper examines the role that the Equity
Market Neutral strategy can play in an alternatives portfolio, as
it was one of the few strategies that remained uncorrelated to
other asset classes during the 4Q 2008 market dislocation.
The views and opinions expressed within these publications are those of the authors, are based on matters as they exist as of the date of preparation and not
as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or
changes occurring, after the date hereof.
For a copy of any of these papers, please contact your relationship manager or visit our website at www.credit-suisse.com.
Credit Suisse Asset Management
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How Commodities Can Help Investors Face the Uncertainty of the Inflation/Deflation Debate
About the Authors
Nelson Louie, Managing Director, is Global Head of the Commodities Group. Mr. Louie re-joined Credit Suisse Asset
Management, LLC in August 2010. From May 2009 to August 2010 he was an Executive Director in the Commodity
Index Products area at UBS Securities, LLC. From June 2007 to May 2009 he was a Managing Director at AIG Financial
Products responsible for North American Marketing of commodities-based solutions. From April 1993 to June 2007 he held
various positions within Credit Suisse Asset Management, LLC. He was a Senior Portfolio Manager overseeing a team that
was responsible for enhanced commodity and equity index strategies, option based hedging solutions and option arbitrage
products. He was a team member of the commodity funds from their inception through June 2007. Mr. Louie holds a
Bachelor of Arts degree in Economics from Union College.
Christopher Burton, Director, is a Portfolio Manager and Trader for the Commodities Group within Credit Suisse Asset
Management. In this role, Mr. Burton is responsible for analyzing and implementing the team’s hedging strategies, indexing
strategies, and excess return strategies. Prior to joining Credit Suisse in 2005, Mr. Burton served as an Analyst and
Derivatives Strategist with Putnam Investments, where he developed the team’s analytical tools and managed their optionsbased yield enhancement strategies, as well as exposure management strategies. Mr. Burton earned a B.S. in Economics
with concentrations in Finance and Accounting from the University of Pennsylvania’s Wharton School of Business.
Additionally, Mr. Burton holds the Chartered Financial Analyst designation and has achieved Financial Risk Manager®
Certification through the Global Association of Risk Professionals (GARP).
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How Commodities Can Help Investors Face the Uncertainty of the Inflation/Deflation Debate
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