Commodity prices have fallen in the last few weeks; the S&P/GSCI, an index of commodity prices, is down by 10 per cent in US dollar terms since the end of April. Whether that's good or bad for equities depends largely on your time horizon.
Theory linking shraes and commodities is ambiguous. The good news is that lower commodity prices raise the disposable incomes of commodity users; they are, in economic jargon, a positive supply shock. The bad news is that they can be a signal of weaker global demand for commodities and hence of weaker world output.
In recent years, however, the facts have not been ambiguous. Since 2000, there has been a strong positive correlation (0.64) between annual changes in the S&P/GSCI and in US industrial production. Falling commodity prices are a sign of weaker output.
This matters for equity investors. Because fluctuations in the US economy affect investors' appetite for risk, there's also a strong correlation between US industrial production and UK share prices. Because of this - and not just because such a large part of the UK market comprises commodity producers - there's also a positive correlation between annual changes in commodity prices and in UK equities: 0.47 since 2000. What's bad for commodities is bad for shares.
However, this does not mean you should sell shares because commodity prices have fallen. These correlations are contemporaneous. They tell us that US output and UK equities tend to fall at the same time as commodities fall. If we look at what happens after commodity prices have fallen, a different picture emerges. The correlation between changes in commodity prices during a 12-month period and changes in US industrial production in the following 12 months is negative - minus 0.33 since 2000. Thanks to this, the correlation between commodity prices and equities in the following 12 months is also negative, albeit only slightly so - minus 0.14.
Our ambiguous theory is, therefore, right in both senses. Falling commodity prices are bad for output and equities while they are falling, but good for both after they have fallen.
If you're confident that commodity prices will fall further, you therefore have a reason to sell shares. Most of us, however, cannot be so confident. For us, the recent historical record suggests that the drop in commodity prices is, on a 12-month view, probably slightly good news for shares.
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