The turbulence and extent of uncertainty we are currently facing are reaching critical levels. High inflation rates all over the globe have once again pushed the focus towards commodities as an alternative investment to hedge against inflation risk using diversification principles.
Commodity investing has always been gaining interest when inflation spiked. Many research shows that commodities are a great hedging instrument against inflation as it is one of the most highly correlated asset classes with inflation. Below, you can see a graph showing how inversely related the dollar is to the commodities using the Goldman Sachs Commodities Index;
The relationship between inflation and commodities?
Inflation is the rise in prices, generally. Commodities are inputs of manufacturing and delivering processes and are consumed in businesses and households. Thus, inflation is supportive of commodities as a rise in a goods price should push the price of its input commodity. Looking back, gold has been configured to be the face of the “inflation hedge”, however, much research focusing on historical returns shows that oil may be even more beneficial to an investor.
It is typical for commodity prices to rise during times of accelerating inflation, especially when inflation is unexpected. This correlation provides investors protection against the effects of inflation on their investments. The reasoning behind this is to protect the purchasing power of the existing capital. With the addition of a diverse asset class in a portfolio, investors aim for many degrees of protection from downside risk and exposure to upside potential. There are only so many assets that are supported by rising or high inflation, commodities are certainly one of them. Rising demand for goods and services increases their price, which in turn, pushes the price of the underlying commodities used in those goods and services. Below is the performance of the S&P 500 index against the performance of the CRB Index representing 19 different commodities.
As you can see, with inflation rising end of last year and this year, commodity markets have been overperforming the stock market. Commodities such as agricultural goods, oil & gas, and precious metals are commonly used as diversifiers in portfolios to hedge against inflation. However, it is critical to keep in mind that commodities also respond to countless other risk factors, such as natural disasters, in means that do not always correspond with the effects of inflation. Below is another chart showing the S&P GSCI and tech-heavy Nasdaq performance;
Looking back in history, we can understand that oil prices are behind a large proportion of increases in the price of goods. This is because oil is a major input in economies as it is used in critical activities whose demand does not fall at the same pace as the increase in its price. Household heating, fueling cars and a countless number of manufacturing processes are some of these critical activities. This idea has just shown its resilience as gas prices have been rising for so long in the first half of 2022 and demand has just not fallen as much, keeping the prices rising. When oil prices increase, the cost of manufacturing chemical products, synthetic materials, or plastic will rise accordingly to be passed on to the customers. This correlation has proved to be most evident in the 1970s during the energy crisis.
What is the current situation and what impact does inflation have on commodities?
Global inflation has risen to levels not witnessed for over 40 years and the rise has been extremely widespread. The YoY inflation in February was 7.9% in the U.S., 5.9 in the Eurozone, and 6.2% in the UK, and has increased further since then. When we exclude the food and energy prices the inflations are 6.4%, 2.7%, and 5.2% respectively, showing the inflation is not only caused by specific commodities but has become widespread, not concentrated in a number of few items. The chart below represents the harmonic index of consumer (excluding food and energy) prices and food inflation in the Eurozone; clearly indicating the extent of inflation spread on overall consumer prices.
The demand for commodities does show a varying decrease across its categories, however, not sufficient enough to bring the price levels back to normal. higher inflation is a major driver of these high price levels and with the COVID-19 picking up pace once again, worries that China may resort to lockdowns further exacerbates the balance. Below, there are 2 charts embedded into one; one represents the U.S. inflation rates (columns) and the other represents the S&P GSCI (Goldman Sachs Commodity Index) (line).
Looking at the movements over approximately the past 5 years (time series on commodity prices exceed that of inflation), we can say that inflation prices do indeed support commodity prices. And as you can see the most recent commodity prices have shown clear easing. However, that is not caused by decreasing inflation as there are no indications, yet, that inflation will be decreasing to normal levels.
And yes, Inflation has certainly impacted commodity prices to great extents. decrease in purchasing power of the dollar pushed investors towards commodities, building up demand. Additionally, increasing consumer prices support the elevation of global commodity price levels.
What are the predictions on Inflation movements?
The recent decline in the commodity markets can perhaps be a turning point for inflation levels which the markets are patiently waiting for. However, many commodities, especially oil, are forecasted to not sustain the declining trends.
Volatility and elevated commodity prices cause major risks to economies. These effects come in form of inflation and growth and will be spread unevenly across the world. The extent of effects depends on what commodities an exports or imports, how the higher prices affect business and household incomes and costs etc. Generally looking, higher commodity prices are very likely to halt growth and increase inflation. The upside is that history has shown us the commodity effects on inflation levels are relatively short-term. Rising Inflation does not significantly outperform that of commodities concerning their durations. Thus, we can say that aside from the direct factors of inflation such as unemployment, the timeline of the current inflation levels depends on how long the disruptions in the commodity markets will continue.
A UBS report says that; even if commodity prices stay off their highs, it is unlikely to alter the Fed’s path in the near term. The expected inflation numbers to come will still be uncomfortable for the Fed, and the declining oil prices will only make themselves evident in the later prints.
The world is facing many other major events that affect both inflation and commodity markets, which makes it a challenge to distinguish their impact on one another. The war in Ukraine, revival of COVID-19, heatwaves, unemployment, supply chain disruptions, chip shortage, and so on; all of these factors are building up as a portion of the underlying causes of rising inflation and do not seem to be dissipating easily.
The risk of a recession increases day by day and the chances of avoiding it are slim. As we have entered the second half of the year, we will have a better understanding of the collective actions of central banks aiming to slow down economies to fight against high inflation. This will allow the Fed to proceed at a relatively measured pace to fight against inflation but also avoid a recession. It is certainly not inevitable, however, the fine line between decreasing inflation whilst avoiding a recession is slimming up fairly quickly as time passes.
In conclusion, inflation and commodities are fairly connected, as the current circumstances, and history has repeatedly shown us. Nevertheless, it is important to understand that both inflation and commodities have many different factors that affect their final value aside from the effects of one another. Thus, they are never directly linked to each other which must be taken into consideration while making investment decisions.
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