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Trends Winter 10 |11

Multi Asset Class Solutions

How commodities can help investors face the

uncertainty of the inflation/deflation debate
Nelson Louie, Global Head Commodities Group and Christopher Burton, Portfolio Manager 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 de-
bate: on the one hand, some believe
that quantitative easing in the United
States, Japan and the United King-
dom could precipitate an inflation-
ary environment; on the other hand,
some argue that deflation is the main
concern because of slack capacity
in developed economies, low aggre-
gate 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 inves-
tors: 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 “unex-
pected” (i.e., it will not be properly priced
into market valuations). We believe that
exposure to real assets such as commod-
ities can help investors address this chal-
lenge.
choice investors can make to help protect
their portfolios against changing inflation
environments over the long run. Our anal-
ysis shows that long-term investments in
commodities have historically provided in-
flation-hedging benefits to investors.
Another important potential benefit to in-
vestors is the diversification that the as-
set class can provide to investors’ portfo-
lios due to their low correlations over time
with equities. Return drivers for commodi-
ties are often quite different than those
of stocks and bonds, and relate to their
idiosyncratic supply-and-demand fluctu-
ations. In our view, this diversification is
best achieved using a broad basket of
commodities to smooth out the volatil-
ity of individual commodities, such as oil
or gold.
Hedging inflation with commodities
Commodities are part of the “real asset”
class that can help protect against the
impairment of future value of portfolio as-
sets 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.
Commodities’ high correlation with infla-
tion, which provides purchasing power
protection against rising prices (Chart 1),
can help address this concern. The pro-
tection comes from the fact that com-
modities reflect prices in areas such as
energy, industrial metals and agricultural
commodities. As such, commodities are

In this light, we believe that an allocation

to commodities should not be seen as a
tactical move, but rather as a strategic

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directly linked to the components of in-
flation (one measure of which in the US
is the Consumer Price Index, commonly
known as CPI), and therefore tend to in-
crease in price during inflationary peri-
ods. We should keep in mind, 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.
Correlation
On the other hand, financial assets such
as stocks and bonds tend to face head-
winds when inflation rises, particularly if
it is 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 prin-
cipal. As such, Treasury Inflation Pro-
tected Securities (TIPS) have emerged as
a popular inflation hedging tool. Similar to
standard Treasury bonds, TIPS pay inter-
est at regular intervals as well as the prin-
cipal upon the bond’s maturity. However,
unlike standard Treasury bonds, both the
interest payments and principal amount
are automatically increased during peri-
ods of rising inflation as determined by
the CPI. While TIPS provide targeted in-
surance against inflation, they do not ex-
hibit 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 un-
expected inflation, and how commodi-
ties work as an inflation hedge in each of
these environments.
Trends Winter 10 |11
Chart 1: Commodities correlations with inflation may help provide
purchasing power protection2
Based on average annual returns (January 1970 – December 2009)
Inflation Unexpected Inflation
0.5
0.41
0.4
0.34
0.3
0.2
0.1
0
0.1
-0.08
-0.2
-0.18 -0.21
-0.3
-0.4 -0.34
S&P GSCI Ibbotson S&P 500 S&P GSCI Ibbotson S&P 500
Intermediate Intermediate
Term Bond Term Bond
Source: Credit Suisse Asset Management, Ibbotson and Bloomberg
Commodities in expected versus not been properly priced into market valu-
unexpected inflation environments ations. Chart 2 shows that Commodities,
Commodities are most effective at hedg- as represented by S&P GSCI Risk Pre-
ing “unexpected” inflation, which repre- mium returns (i.e., the return of the S&P
sents the difference between expected GSCI Total Return Index minus the risk-
(or projected) inflation and realized infla- free rate), outperform equities, as repre-
tion. In other words, commodities prices sented by the S&P 500 Risk Premium
perform better when realized inflation has returns,3 by almost 3% in periods of ex-
1
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 commodi-
ties. 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.
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.
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Trends Winter 10 |11
treme high unexpected inflation.4 One of
the reasons Commodities perform bet-
ter in this environment is that commodi-
ties indices invests 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 mar-
ket conditions. As a result, commodities
Returns (%)
indices may fluctuate in concert with un-
expected deviations from components of
inflation.5 As a driver of inflation, com-
modities inherently rise with it.
Stocks and bonds, however, tend to per-
form better when the rate of inflation is
stable or slowing. This is usually because
the market has already discounted the im-
pact 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 un-
expected inflation environments, the next
question we address is the risk of inflation
versus that of deflation.
Analyzing the inflation/deflation
debate
An inflation/deflation debate is taking
place among many policy makers and in-
vestors in developed markets. These de-
bates encompass a number of economic,
fiscal and financial factors that could po-
tentially affect the path that inflation takes.
Some believe that new rounds of stimu-
lus 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
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Chart 2: Commodities returns historically outperform equities in periods of
extreme unexpected inflation
Based on average annual returns (January 1970 – December 2009)
Average Monthly Returns (%) with Extreme Unexpected Inflation
1.82%
2.00%
1.50%
1.00%
0.37%
0.50%
0.00%
-0.50%
-1.00%
-0.97%
-1.50%
1.59%
-2.00%
Extreme Higher-Than-Expected Extreme Lower-Than-Expected
Inflation Inflation
S&P GSCI Risk Premium S&P 500 Risk Premium
Source: Credit Suisse Asset Management, Bloomberg, Federal Reserve of Saint Louis
environment. Here is a short summary of ily from the following drivers: a) a strong
these two positions: deleveraging process; b) high unemploy-
ment; c) idle industrial capacity; and d)
Inflationary risks: US Federal Reserve fiscal restraint on the part of some gov-
Chairman Ben Bernanke announced ernments.
$600 billion in quantitative easing (QE)
on November 3 in an effort to boost GDP These forces can potentially exert down-
growth. The prospect of this monetary ward pressure on broader consumer price
easing by the Fed, as well as similar ini- indicators and lead to lower costs and
tiatives in other countries such as Japan higher inventory levels for raw materials.
and the UK, has renewed expectations of It’s worth noting that much of this “slack”
inflation for many. has been picked up by faster-growing
emerging economies in the current cy-
Deflationary risks: Concerns about de- cle. In fact, emerging markets have been
flation in developed nations stem primar- strong buyers of industrial metals and ag-
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.
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Trends Winter 10 |11

ricultural products, a move that may con- the inflation outlook also lends support to
tinue to bolster commodities prices. the idea that as new inflationary environ-
We believe that no matter which of the ments develop around the world, they will
two forces prevails in developed econ- likely be unexpected.
omies, one thing appears clear: the in-
flationary outcome is likely to be “unex- As our analysis shows that commodities
pected.” Our view is that this supports futures tend to be more highly correlated
the argument that commodities can help to periods of unexpected inflation, we be-
hedge a diversified portfolio against lieve this creates a compelling case for
changing inflation conditions, particularly incorporating commodities in an asset al-
when unexpected. location framework. Finally, the inclusion
of commodity futures into a portfolio con-
Incorporating commodities into a text may also provide diversification ben-
portfolio efits based on their historical low corre-
When considering a commodities invest- lations to traditional asset classes which
ment, investors should carefully evaluate may help improve an investor’s overall
their current portfolio holdings to deter- risk/return profile.
mine 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 ad-
ditional risk while diminishing the diversi-
fication benefits offered by a commodities
investment. For example, holding short
duration bonds will likely reduce the im-
pact of interest rate fluctuations on the
overall portfolio. By contrast, credit ex-
posures, as well as long duration bonds,
including TIPS, can result in increased
volatility and correlations to fixed income
markets.

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 on in-
flation expectations can present a chal-
lenge to investors. The lack of clarity on

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