Jeremy Grantham, of asset management firm GMO, is one of the most insightful ‘deep thinkers’ in the financial world. His outlooks have also proven remarkably accurate through the years. In his latest essay (free registration required), Grantham takes on the issue of commodities prices. His piece is long and detailed, and the issues he raises are of considerable importance (whether or not you actually agree with his conclusions).
Obviously, commodities prices are currently high. The May 2 issue of Fortune magazine has a small piece, titled “Food for Thought,” — that discussed how many of the ingredients of Subway’s sandwiches have risen in price by double digits in the last twelve months and some by more than 100% (lettuce and green peppers). Kimberly Clark just came out with quarterly earnings and attributed a 9.5% decline in net earnings (year over year) to higher prices of raw materials. Oil is running at around $112 per barrel.
High Commodity Prices: Short Term Anomaly or Permanent Reality?
The question that must be addressed is whether the current high commodity prices are a short term anomaly (attributable to war and unrest in the mid-East, weather, and other effects), or whether we should be planning for higher prices long-term.
Grantham’s essay brilliantly makes the case for long-term scarcity of natural resources. The cost of producing many commodity products has risen as the raw materials have become increasingly hard to obtain. Productivity gains in agricultural seem to have stalled out. Demand from growth-driven China and the rest of the emerging economies further adds to resource scarcity.
Grantham makes some powerful points–and he is a man who is known for his careful analysis:
Accelerated demand from developing countries, especially China, has caused an unprecedented shift in the price structure of resources: after 100 hundred years or more of price declines, they are now rising, and in the last 8 years have undone, remarkably, the effects of the last 100-year decline!
This point really struck me. The cost of the basic commodities, those that enable the high quality of life that we have become accustomed to, can increase dramatically. And they can do so in fairly short order.
Grantham goes on to argue that this increase in prices is not an anomaly, but is rather what Mohammed El Erian at PIMCO refers to as a ‘secular transformation’ — a permanent change in the landscape. Grantham’s article provides supporting data on both supply and demand to bolster his case that the world has moved into a new mode of long-term scarcity and higher cost for all commodities: food, energy, metals, etc.
I am not going to delve into the cases for and against Grantham’s arguments (which range from Thomas Malthus’ concern that population growth would outpace agricultural output, to arguments about peak oil extraction). I am not a natural resource expert. Given Grantham’s background and how well he has called a range of other major trends, this essay certainly deserves close attention and readers will come to their own conclusions.
The Connection Between Commodities and Investing for Retirement
I want to focus on the connection between the recent run-up in commodity prices, Grantham’s analysis, and long-term investing. This is, in my opinion, an issue that does not receive sufficient attention.
The primary challenge for long-term investors (aside from saving enough) is to invest in such a way that their assets match their liabilities. The primary liability that most people face is providing long-term income in retirement. Therefore, it is crucial that investors have substantial allocations to assets that rise when commodity prices rise.
Investors with portfolios that cannot effectively keep up with price inflation will see their purchasing power eroded away. If Grantham is correct, the future costs of food and fuel–the basics–will consume a much larger portion of retirement savings than we are used to spending. The massive rise in commodity prices that Grantham documents, makes it clear that prices can rise very far and very fast–you don’t need to believe any forecasts to see what has happened in the past decade.
That being said, what asset classes should be included in a portfolio to provide some protection from rising commodity prices?
Creating a “No Regrets” Portfolio
The most direct way to manage inflation exposure is to include allocations to commodities funds directly. The Target Date Folios, for example, do that with meaningful allocations to an Exchange Traded Note (ETN) that tracks a broad-based commodities index (DJP). Other asset classes that can help keep up with price inflation are Real Estate Investment Trusts (REITs) and inflation-protected bonds (TIPS). These are both broadly represented in the Target Date Folios as well. In addition, many of the Target Date Folios (depending on expected time to retirement and risk tolerance) also contain explicit exposure to firms that produce natural resources (IGE).
Many investors have little or no exposure to any of these asset classes, beyond the proportions held in the S&P500 and other major stock indexes.
(Please click to enlarge the Yahoo chart of DJP’s performance over the past year.)
The case that I am making here is not that I believe that Grantham can predict the future of commodity prices, nor that investors should try to bet on a rise in prices.
Quite to the contrary.
I suggest that trying to predict the direction of oil, wheat, or iron ore is a speculative activity.
The ideal approach is to create a “no regrets” portfolio that will provide some protection from the eroding purchasing power resulting from a sustained increase in commodities. This is the goal of strategic asset allocation: to create a portfolio that is reasonably well insulated from events that could reduce the ability of an investor to meet his or her goals.
Investors who hold portfolio allocations that do not include asset classes that will keep pace with a rise in commodity prices run a very real risk of seeing their standard of living reduced — dramatically so if Grantham’s outlook plays out.
(photo of oil barrels by L.C.Nøttaasen)