Hedge your bets with commodities

When inflation gets going, investors need a decent hedge - and commodities are a good answer.

In recent months inflation has picked up sharply and is set to continue rising in the near future amid a stuttering economic recovery.

Mark Bolsom, head of UK trading desk at Travelex commented: "Inflation is to continue rising, as the pound continues to depreciate in value against a basket of currencies. Long-term inflation forecasts are very dependent on the policy-makers ability to bring it under control and at the moment they are unable to use traditional inflationary control measures because they don't want to choke recovery in its infancy."

Latest figures from the Office of National Statistics show the headline rate of inflation hit a 14 month high in February. Its rapid rise to 3.5% - the peak predicted by the Bank of England  - has fuelled fears that it will prove stickier than expected and fall back to the government's 2% target more slowly.

If this is the case, investing in commodities could prove a smart move.

Remy Penin, strategy analyst at Societe Generale, commented: "Investment in commodities is likely to rise as a result of higher inflation. Indeed, commodities returns and inflation are co-integrated which means that they are likely to move together over a long period of time. Knowing that, commodities are likely to represent a good hedge against inflation."

Penin argues that the real attraction to commodities during inflationary periods is the real-asset nature they posses; they have an intrinsic value that remains whatever the currency depreciation.

"Despite the persistently low level of long-term rates, financial markets seem to have begun to partially price-in this inflation risk, as witnessed by the almost uninterrupted surge in gold prices," Penin added.
 
Gold has historically been the more obvious choice of hedge because, in contrast to its fellow precious metals such as palladium and platinum, which are typically used in industrial applications, gold is used as an accumulation tool.  

Brad Yim, research analyst at asset manager Castlestone Management, commented: "While the level of inflation is still quite low in most countries we are seeing the general pattern of rising inflation.

"Gold should do particularly well in an inflationary environment triggered by loose money as gold is an anti-paper currency. The more money there is in the world the more valuable gold becomes as general debasement of currencies will prompt investors to flock to the oldest and the safest storage of wealth known to mankind - gold."

The proof is in the pudding as they say and during the mid to late 1970s when US inflation was at its highest, the Dow Jones posted the average real return on gold at 130.4%, while other stocks lagged behind at -12.33%.

Charles Gibson, gold analyst at Edison Investment Research, commented: "What gold does, in my opinion, is to discount 'cost-push' inflation that has typically been allowed into the system as a result of loose monetary policy and/or quantitative easing.

"So I would say that gold is a good hedge against one particular sort of inflation only, albeit that is the inflation that we are to some extent suffering from now - and in my opinion, will suffer from a lot more in the next few years."

Many analysts believe that as well as gold, a basket of commodities offers an even greater hedge against inflation.

Eugen Weinberg, commodities strategist at Commerzbank, notes rapidly rising interest across the entire commodities sector, with a particular focus on oil and metals.

Oil prices are currently at their highest point in two months and have fuelled talk of $100 price tag within a year among the likes of Bank of America and Barclays Capital as the depleting assets battles with rising global demand.

The International Energy Agency revised its oil demand forecast for 2010 upwards amid surging demand from developing countries, in particular Asia.

Societe Generale's Remy Penin said: "Since the US Consumer Price Index trend changed in the early seventies, gold and crude oil have more than outperformed US inflation on average.
 
"Crude oil has always been co-integrated with the US CPI since 1977. The relationship has kept strengthening over time. So, crude oil seems to be one of the best candidates to hedge against inflation."
 
However, investors have more options than simply gold and oil. In periods of persistent inflation, soft commodities such as sugar and wheat also pose a good bet as they are integral consumer goods.

Michael McDougall, soft commodities analyst at Newedge group said: "Softs and commodities have certainly attracted investor interest and I would think this year it is due to the low interest rate environment and the possibility that this could turn inflationary.

Weinberg agrees that the interest in soft commodities has been on the rise, and while inflation remains in the distance, those with a longer term view will be cautious to organise their portfolio around inflation hedges.

Furthermore, agricultural commodities are in finite supply, while global appetite is on the rise as the global population increases and people in developing countries grow richer. With this scarcity in mind, the price of agricultural commodities is expected to remain constant or increase in real terms, even if the value of key currencies such as the US dollar decline in an inflationary environment.

Sugar proved to be a fantastic outperformer during the previous year, reaching its highest level in 29 years, according to Weinberg. "[The] rally takes place against the backdrop of a physical shortage on the sugar market and there is, in contrast to other commodities, justified by fundamental factors," he says.
 
However, McDougall warned that it was still very early days to be taking bets just yet. "With the job market still soft the possibility of inflation is still sometime down the road and with the US dollar attracting interest, commodities have had a more difficult time in rallying," McDougall added.
 
But if fears of inflation do prove justified, it might just be worth taking a walk on the commodities side.

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