Over the past two decades, prior to the Covid-19 Pandemic, there really wasn't much need to seek additional sources of diversification within the traditional 60% equities and 40% bonds (60/40) portfolio. A 60/40 portfolio historically worked well in delivering attractive risk-adjusted returns ¹. Bonds buffered the portfolio if equities didn't perform well due to a very important phenomenon - a strong negative correlation between equities and bonds (the increase in value of one is associated with the decrease in value of the other) ².

While this worked well for nearly two decades, does this mean it will continue over the next two decades or should we consider if we have been taking this negative correlation for granted? History tells us that this negative correlation holds if inflation remains under 2%³. But perhaps the question investors should be asking is how often does inflation average above 2%?

The surprising answer is most of the time - depending on how far back you look.

Historically speaking, up until 2020, the prior two decades were an anomaly. Over the last 100 years we have spent most of the time in environments where inflation was above 2%, and where bonds and equities were positively correlated⁴. In fact, we've spent roughly 60 of the last 100 years, including the last four, just such an environment.

The "new" need for added portfolio diversification

As we spend more time in an environment that resembles the historical "norm", there is an increased focus on the need for additional diversification. While we feel stocks and bonds remain the bedrock of a diversified portfolio, commodities are interesting for their low to negative correlation with both bonds and equities over the last 50 years, and more importantly over the last five years⁵. Because of this negative correlation, adding commodities to a portfolio can potentially result in better risk adjusted returns.

As we look ahead, there are other dynamics at play that need to be considered. The volatility of inflation is clearly higher in the current era than it was in the prior two decades. We live in a world of elevated geopolitical risk and uncertainty which has been driving countries to become more economically independent through near shoring/friend shoring/reshoring. This trend is inflationary as the world builds parallel supply chains and loses economies of scale. Against this backdrop, concerns of low growth are coming to the forefront as the increasing uncertainty rising from the unpredictability of U.S policy could result in a contraction of business activity. For the first time in several decades there is a real possibility of an economy with stagflation (a combination of high inflation, stagnant economic growth, and elevated unemployment).

Portfolio considerations with stagflation in mind

Asset classes perform differently during different economic periods. As seen in the charts below, using different combinations of high/low economic growth and high/low inflation helps illustrate the different returns for equities, bonds and commodities during different macro-economic environments.

Asset Class Returns in Different Macro Environments

¹ 3-month return, annualized. Note: For illustrative purposes only. Data from January 1970 to December 2024. High Growth = Monthly GDP greater than trailing 5-year GDP average. Low Growth = Monthly GDP lower than trailing 5-year GDP average. High Inflation = Trailing 3-month average CPI greater than trailing 3-year average CPI. Low Inflation = Trailing 3-month average CPI less than trailing 3-year average CPI. Global Equities = NDDUWI Index. Fixed Income = LUATTRUU Index. Commodities= BCOMTR Index. Source: Bloomberg Finance L.P. As of Dec 31, 2024.

There is no surprise that commodities perform well in high growth and high inflation environments. What may surprise some is that commodities tend to be the best performing asset in the stagflation quadrant, when growth is low, but inflation is high. What's also important to note is that although fixed Income appears to have provided reasonable returns during periods of stagflation, these previous periods were when nominal yields were over 10% during a period in the 1980s. Considering the starting point of yields today, it would be highly unlikely that fixed income would be able to return 7% if the economy fell into a period of stagflation.

Mitigating equity pullbacks

The diversifying benefits of commodities also include helping to mitigate equity pullbacks. As seen in the chart below, over the last 50 years, roughly 2/3rds of the time a portfolio with a 10% allocation to commodities had a lower pullback versus a portfolio without.  It is also worth highlighting that the 1/3^rd of the time in which commodities didn't help was predominantly in the decade prior to the Covid-19 Pandemic.  A decade in which commodities were in a bear cycle and an era characterized by low growth, low interest rates, and low inflation.  This is unlikely in the decade ahead as it looks like we are in the early innings of a commodity supercycle.

Including Commodities Can Help Lower Max Drawdowns