Commodities | Monetary Policy & Inflation
Part I of this series explained why commodities investing is generally problematic: it doesn’t necessarily diversify a portfolio of financial assets, and worse, commodities tend to underperform financial assets in most economic environments. In this second part, the focus shifts to how commodities investing can nevertheless enhance portfolio returns.
Four Economic Environments
Let’s begin by categorising economic environments, which can be divided into four broad categories: a two-dimensional grid of real growth or contraction on one axis, and of price inflation or deflation on the other. Normally, growth and price inflation are positively correlated, as are contraction and deflation. These two combinations are consequently the most common environments, with growth+deflation and contraction+inflation relatively uncommon…
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Part I of this series explained why commodities investing is generally problematic: it doesn’t necessarily diversify a portfolio of financial assets, and worse, commodities tend to underperform financial assets in most economic environments. In this second part, the focus shifts to how commodities investing can nevertheless enhance portfolio returns.
Four Economic Environments
Let’s begin by categorising economic environments, which can be divided into four broad categories: a two-dimensional grid of real growth or contraction on one axis, and of price inflation or deflation on the other. Normally, growth and price inflation are positively correlated, as are contraction and deflation. These two combinations are consequently the most common environments, with growth+deflation and contraction+inflation relatively uncommon.
The last of these, contraction+inflation, is commonly referred to as ‘stagflation’. And of the four possible environments, it is the one most associated with a relative outperformance of commodities vs financial assets. This is due to the impact of declining productivity on growth and corporate profitability assumptions on the one hand, and rising inflation expectations on the other. The former hits equity valuations; the latter hits long-dated bonds. Cash also fails to hold value in stagflation in the event the central bank holds nominal interest rates below the rate of inflation in support of aggregate demand – something that has, since 2008, become rather the policy norm than the exception.
With the notable exception of stagflationary economic environments, commodity price outperformance tends to be short-lived and specific to one commodity or to related groups, such as grains or industrial metals. Therefore, investors without early, high-quality information about these specific markets are at a disadvantage. Moreover, many defensive commodities ‘roll’ negatively; that is, there is a negative carry cost associated with holding them. Investors cannot benefit from sustained positions in negative-carry instruments. For commercial producers and consumers, the issue of negative carry is irrelevant. They use these markets as part of doing business and, where there are costs, businesses can normally pass some of these along to consumers. But this is not the case for investors, who must identify periods of stagflation in advance if they are to benefit from an overweighting of commodities in their portfolios.
Commodities in Stagflation
However, as is becoming increasingly apparent, the COVID-19 scare is causing widespread disruption to global production and logistical supply chains. It consequently represents a historically unusually large negative supply-shock that could result in a stagflationary economic environment for an indefinite period of time. Investors sharing this view should therefore consider overweighting commodities in their portfolios at present, in particular defensive commodities.
By ‘defensive’ I mean those commodities that tend to have either a low or statistically insignificant correlation to the business cycle. Precious metals fall into this category, and they have a proven track record of outperforming financial assets in stagflationary environments. But some of the world’s most widely traded commodities are not defensive in nature. For example, demand for crude oil and distillates tends to follow the business cycle relatively closely. By contrast, extreme weather in the more arable regions of the world has no obvious relationship with the global business cycle. Therefore, grains prices tend to be largely uncorrelated to the equity markets. Other agricultural products, including tropicals and livestock, are also relatively uncorrelated, whereas industrial metals are even more highly correlated with the global business cycle than energy commodities.
While idiosyncratic supply-side factors, such as unusual local weather patterns, may result in the occasional large spike higher or lower in prices, commodity-producing businesses respond to such swings by finding ways to adjust supply accordingly. While this is difficult with certain commodities, which consequently exhibit higher price inelasticity, in other cases a supply response can impact the market within months. However, it is rare for a majority of agricultural commodities all to be affected by idiosyncratic factors at the same time, so their cross-correlations tend to be relatively low. Consequently, a widely diversified basket of agricultural commodities can have a volatility that is comparable to that of a major stock market index.
It is worth noting that, due in part to the globalisation of food production and processing, most major agricultural commodity prices have been in downtrends for years. While pushing prices lower, this has also dampened volatility. With agricultural production increasingly global and occupying many arable regions in both the northern and southern hemispheres, the gap in time between one growing season and another can be quite short. For this reason, the bulk of supply-driven price spikes in agricultural markets tend to be more short-lived than in decades past. Absent large and prolonged trade wars in agricultural products, lower price volatility is likely to be a permanent feature. However, the price-deflationary effects of agricultural globalisation may now largely have run their course. There is no way to know, but agricultural commodities have never been cheaper in relative terms.
The Myth of Scarcity
There is, however, something else requiring explanation here. As explored in a popular study of long-term commodity prices featured in The Economist a few years back, looking back through a half-century it is clear that food prices have chronically lagged those for commodities that are pulled out of the ground, such as crude oil or metals. Now why should this be?
A popular neo-Malthusian explanation is that this is due to the growing scarcity of ‘underground’ relative to ‘above-ground’ commodities. Farmland remains plentiful and it is easy to expand food output to meet rising demand, so the thinking goes. But this has not remained the case with metals or fossil fuels. The following chart showing this phenomenon is from the Economist article:
Chart 1: Under- vs Above-ground Commodity Price Inflation
Source: National Bureau of Economic Research, The Economist
As discussed in Part I of this series, scarcity-based theories for commodity price movements don’t have a great track record, and I am highly sceptical of this particular explanation for the sustained divergence between above- and under-ground commodity prices.
The Impact of Technology on Commodities
Why? Because it is a woefully incomplete argument, failing to take into account the changing sources of demand for commodities and how these evolve over time with technology and the composition of the capital stock of an economy. Consider this: is a bushel of wheat somehow more economically productive today than it was ten, twenty or fifty years ago? Not at all. It contains the same number of calories and makes the same amount of bread or other staple foods. But what about crude oil? With power plants and engines of all kinds now far more efficient, a barrel of oil can add much more economic value today than it could twenty or fifty years ago. It can sow and harvest far more wheat or other agricultural products.
Copper wire can more efficiently carry electricity when attached to a superior electric motor. If, due to technological advancement, a given amount of a given commodity can add more value, it is entirely reasonable that people will be willing to pay relatively more for it. Moreover, innovation in petroleum products has created a huge and growing range of specialty petrochemicals, some of which enable highly advanced industrial processes that simply didn’t exist in any form a generation ago. With technological advancement creating entirely new sources of demand in a highly complex entrepreneurial dynamic, other factors equal, oil prices will rise to reflect that shift. So this is not a scarcity-driven price development but an efficiency-driven one, facilitated by technological advancement.
Expanding this thinking to other industrial commodities, metals are, due to technological advancement, able to provide for far more economic value added today than a generation or more ago. Electronic components are more advanced and efficient but still need copper. Silver has found new applications as an anti-microbial agent. Platinum, palladium and rhodium’s catallactic properties make these metals enormously useful in a growing range of applications beyond autocatalysts. Rare earth metals can provide essential input into some of the most advanced tech components. And on and on.
The fact is, wheat, corn and soybeans may be essential staples, but their economic properties do not change with industrial innovation the way that energy and metals’ properties do. (What use would a primitive society have for crude oil? Palladium? No doubt rice would be far more ‘expensive’.) With tremendous advances in technology through the decades, the substances that we pull out of the ground and then process, refine, etc., are able to add substantially more economic value and naturally we are willing to pay relatively more for them as a result. I’m amazed that many prominent economists overlook this rather obvious point. But then I suppose the scarcity myth and associated Malthusian reflex can overwhelm rational thought, even in those with a PhD or Nobel Prize to their name.
Commodities Investment Strategy
Having determined that long-term commodity price movements are not determined by some abstract concept of ever-increasing ‘scarcity’ but rather primarily by general macroeconomic and monetary factors, technological innovation and associated changes in the economic capital stock, let’s now draw some practical conclusions for a commodities investment strategy.
(1) As should be obvious, if a general, sustained rise (or decline) in the price of commodities is primarily a macro-monetary phenomenon, then it is important to keep an eye on these developments. For example, signs that, even in the face of rising price inflation, major central banks are loath to raise rates to levels previously considered ‘normal’ should be considered potentially bullish. Similarly, signs that the US Fed is concerned about weak final demand, notwithstanding the sharp rise in consumer price inflation in recent months—to a nearly 4% annualized rate—should also be considered bullish. Unlike equity prices, with a few exceptions those for commodities remain near their lowest levels since 2011, indicating good relative value and substantial outperformance potential.
(2) Consider that certain types of environments are particularly supportive of commodity price outperformance, in particular the dreaded ‘stagflation’ in which productivity and profit growth are weak and price inflation is elevated notwithstanding weak economic growth. Recent data showing poor, even negative productivity growth suggest that the recent mix of weak growth yet rising inflation may continue. As we know, this was the case in the 1970s, a decade in which commodities sharply outperformed equities.
(3) Note that industrial commodity prices, including energy, tend to have a strong correlation to the business cycle and provide far less diversification vis-à-vis equities than agricultural or soft commodities or precious metals. Investors seeking diversification through commodities investing should take care to structure holdings and select funds accordingly.
(4) Rather than worry about growing scarcity restricting supply, it is more important to remain abreast of technological developments that could result in entirely new uses or sources of demand for certain commodities. While this is not going to happen with basic foodstuffs, it could well happen to metals or to sources of energy. By way of example, advances in battery or capacitor technology could well introduce new sources of demand for certain metals and, around the margins, potentially reduce relative demand for crude oil as an energy source. In the US, for example, per-capita gasoline demand has been in decline for many years. This could well accelerate as the capital stock evolves further through advances in battery, fuel cell and capacitor technology.
John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)