What the bond market is trying to tell you about the next four years

America’s frustration with inflation was a big motivator in the most recent presidential election. But the party they voted for is likely to add trillions to the national debt with its policy, which, in turn, could stoke more inflation. And in a way, that’s just how it goes. Life is full of little paradoxes.

But this one matters if you’re investing because inflation worries the bond markets.

What does this mean?

Yields on US Treasuries have already climbed – and that’s making mortgages and other loans more expensive in a self-fulfilling spiral. And that’s because investors are expecting the incoming president’s tariff and tax plans to push inflation higher.

And in Europe, yields have been headed in the same direction, as so-called bond vigilantes sell off those countries’ debt to protest against increased government spending. That’s their thing, after all: they don’t like anything that could be inflationary.

The common thread here is that this recent era of high inflation isn’t likely to be reversed as easily as markets had assumed.

And for you, that’s important because higher inflation typically causes bond prices to fall, which may cause you to rethink whether you want to stick with the classic 60/40 portfolio of 60% in stocks and 40% in bonds.

How are the pros handling this?

With all this going on, fund managers are turning to commodities for a hedge against inflation. Makes sense: those assets tend not to have a close correlation with stocks but they do tend to do well during times of geopolitical tension – which right now is probably at its highest in a half-century. That makes commodities excellent at diversifying a portfolio.

It’s an approach Anthony Rayner, a fund manager for Premier Miton macro thematic multi-asset funds, is taking. He’s leaning into commodities for three critical functions – diversification, hedge against inflation, and protection against geopolitical risks.

Which commodities are best?

Those do tend to be the big questions: which commodities to buy, how big your allocation should be, and what products to use. And that’s not easy to answer. Commodities are far from homogeneous, and 2024 has produced a record level of dispersion among them. The top performer – cocoa – is up 157%, while the worst performer – natural gas – is down 34%.

Even within sectors, performance has been split, noted Robert Shimell, a portfolio manager on the diversified alternatives team at Janus Henderson. In the agriculture sector alone, soft commodities are up and grains are down. Or as Shimell puts it: “the breakfast basket” of cocoa, sugar, coffee, and orange juice has become more expensive (mostly because of bad weather and crop disease), while bread, pasta, and baked goods have become cheaper.

Commodities can be a bit unpredictable – each one reacts differently to its own unique set of factors. That’s why chasing the highest returns in any given year usually isn’t about buying a broad basket of them.

That said, a broad commodity index is still your best (and safest) bet if you’re aiming for a solid diversification strategy. The basket itself spreads out risk, whereas investing in a single commodity – especially something like an industrial metal or a foodstuff – can be risky business. You’re not just dealing with market swings, but also wildcard stuff like freak weather or unforeseen events.

Research by WisdomTree shows that an allocation of around 12% to a basket of commodities in a 60/40 portfolio, achieved by co-opting 12% of the bond allocation, would have made the same risk-adjusted return over the past 50 years as the traditional 60/40 portfolio – but with better performance. So the firm argues that, even for a risk-conscious investor, adding some commodities can lead to better outcomes.

What’s more, WisdomTree’s research reveals that although commodities and government bonds have behaved similarly during deflationary environments and economic downturns, the two asset classes behave differently during inflationary periods and supply-side turmoil like the oil crisis in 1974, the financial crisis in 2008-09, and the pandemic in 2020.

Is there a simple way to invest in a mix of commodities?

ETFs make it easy – and often cheap – to gain exposure to a group of assets. And for commodities, you could consider the abrdn Bloomberg All Commodity Strategy K-1 Free ETF (ticker: BCI; expense ratio: 0.26%) or for non-US investors, the WisdomTree Enhanced Cmdty ETF or the L&G Multi-Strategy Enhanced Cmdts ETF.

But maybe you don’t want the whole universe of commodities: some folks prefer to invest in a single commodity – usually a precious metal such as gold and silver, which are largely prized for their value as a store of wealth. And that can be a savvy play right now, with central banks lately choosing to buy gold as a reserve asset, rather than US Treasuries.

What’s the downside?

Commodities, unlike stocks or bonds, don’t generate cash flows – so that part of your portfolio is less likely to grow. Because of that, some investors end up regretting their commodity holdings. And sure, too large a holding, say 15%, could keep your portfolio from realizing its growth potential by edging out stocks, while too small an amount, say 5%, might do too little to offset a crisis and keep the boat afloat.

The price of wheat today is comparable to its value 50 years ago, notes Stefano Amato, a fund manager in the multi-asset team at M&G Investments. And that underscores the cyclical and often stagnant nature of certain commodities. On the other hand, gold is up about 30% so far this year.

Investors who want diversification and decent returns from their commodities have to keep abreast of global developments, and there are an awful lot of stories to follow. With so many factors for an investor to assess, there is a greater risk of a bad call.

Gold is a great example of that. The yellow metal is often the go-to asset for hedging against geopolitical tensions. But when those tensions are centered on the Middle East, oil prices usually spike over fears of supply disruptions. Surprisingly, though, oil’s been pretty steady this year, while gold has rallied.

The thing with commodities is they’re not a set-it-and-forget-it kind of investment. Over time, they tend to go through big boom-and-bust cycles. Just look at the MSCI World Metals and Mining Index: in the past decade, it’s tanked by more than 20% four times, but it’s also shot up by at least 30% just as often.

Here’s one more thought: agricultural commodities might be worth a closer look for long-term growth. They’re backed by big structural trends, like tighter supply from increasingly unpredictable weather patterns and rising demand as populations grow and diets become more diverse.

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