Mining stocks: a weak inflation play

There are tentative signs that China's economy might be recovering. While this is generally a good thing, it poses a danger that commodity prices might rise again - a danger that might be exacerbated by the Federal Reserve continuing to print money. This poses the question: to what extent are mining stocks protection against this risk?

The answer is: only partially.

Let's take as our measure of commodity price inflation the industrial commodities component of the US producer price index. This is a wider measure of prices than metals alone as it includes fuel and other commodities, but it is a fair gauge of the sort of inflation that pessimists think might be unleashed by a combination of China's recovery and quantitative easing.

The FTSE mining sector is significantly correlated with this measure; for annual changes in the two since January 2000, the correlation has been 0.45.

This is not just because higher inflation is sometimes the result of stronger global economic growth which raises share prices. Even if we control for moves in the All-Share index, there's still a significant positive correlation between mining stocks and commodity price inflation.

But here's the problem. Mining stocks are more sensitive to the All-Share index than they are to commodity prices. A regression equation for annual changes since January 2000 shows that a one percentage point change in commodity inflation - controlling for the All-Share index - is associated (on average) with a one percentage point change in mining stocks. But a one percentage point change in All-Share returns (controlling for commodity prices) is associated with a 1.4 percentage point change in mining returns.

This difference might not seem much. But it is, because big moves in share prices are more common than big moves in our measure of commodity price inflation; since 2000 the standard deviation of annual All-Share returns has been 17 percentage points, while that of commodity price inflation has been 6.2 percentage points. This implies that a one standard deviation move in All-Share returns (a one-in-six chance) has four times the impact on mining shares as a one standard deviation move in commodity price inflation.

Mining stocks, then, are more of a play upon the stock market than they are upon commodity price inflation.

This poses the danger that if the market generally does badly, mining stocks could fall even if commodity price inflation rises. There's plenty of precedent for this. It happened in 1990, 2000, 2002-03 and last year.

Now, this doesn't mean you should dump mining shares. It just means that the possibility of higher commodity price inflation is not sufficient reason to be bullish of them. If you expect commodity price inflation to take off, mining stocks are not a guaranteed way of benefiting from this.

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