Mining Stocks help investors to hedge against inflation

Investors value the commodities asset class for both diversification and inflation protection - but they may be investing in commodities the wrong way. As the U.S. economy has begun to dig its way out of the massive hole left by the COVID-19 pandemic, ultra-loose monetary policy and multiple rounds of fiscal stimulus have raised concerns that inflationary pressures may be around the corner. In response to these fears, more and more investors are considering allocating to commodities as they are drawn to the asset class for its anti-inflation properties. While the most common way to get exposure to commodities is by investing in a portfolio of commodity futures, many investors believe that owning a portfolio of commodity stocks is an easier solution. The logic behind this position is often that the biggest driver of returns for those stocks should be the price of the underlying commodity - for example, a mining company's stock price should be largely driven by the price of iron ore. However, this seemingly reasonable argument couldn't be further from the truth. For one thing, the price movements of commodity stocks show dramatically different return patterns than those of the commodity they belong to. On the other hand, commodity stocks show a higher correlation with the stocks asset class compared to an exposure to commodity futures, while they show a significantly higher volatility. Most importantly, they have historically been less sensitive to actual inflation. The result is that this intuitively appealing substitution of commodity stocks with futures-based commodity exposure leads to a less effective solution for both inflation protection and portfolio diversification. The idea that a commodity company's stocks behave differently than the underlying commodity may seem puzzling. Why shouldn't the price of copper, shall we say, be the biggest factor in a copper producer's price movements? However, there are fundamental differences between these two asset classes that cause their price levels to move independently of one another. First, company-specific factors affect a company's share price, but not the price of the underlying commodity. While stock prices change to reflect company-specific changes in dividend policy, corporate governance, or earnings potential, there is no reason to expect this to affect the associated commodity. For example, the Deepwater Horizon oil spill in the Gulf of Mexico in 2010 had a dramatically negative impact on BP's share price due to many company-specific risks, including a change in management, fines imposed by the US government, and a change in dividend policy. However, the oil spill had little impact on the price of crude oil, which initially recovered after the incident as the market reacted to the negative supply shock. Second, market-level factors that affect stock prices are not reflected in commodity prices. These factors are categorically referred to as stock beta, which includes things like the expansion or compression of earnings multiples, a negative regulatory environment for commodity stocks, and the tendency for stock prices to move together as an asset class. For example, general fear in the markets during the outbreak of the COVID-19 pandemic in early 2020 caused the price of the widely watched NYSE Arca Gold Miners Index to fall over 25% by March 23. While a slightly similar return pattern can be seen in the Gold Price, its return over the same period was up 3%, with many investors fleeing into gold due to the supposedly safe haven. Thirdly, many commodity-related companies are aware of their commodity exposure and can actively hedge this risk through forward price agreements or other instruments. While this does not completely immunize these companies from the price impact of the underlying commodity, it lowers the relationship between a company's profitability - and indirectly its share price - and the price of the underlying commodity.