I said recently that there’s a risk that commodity prices might fall. This poses the question: how can we protect ourselves from this danger, other than by cutting our exposure to miners and emerging markets?
There’s little refuge to be found in most equities simply because the All-Share index tends to fall when commodity prices (as measured by the S&P GSCI) fall. Since 2000, the correlation between annual changes in the two has been 0.4. To put this another way, a one standard deviation drop in commodity prices is associated with annual returns on the All-Share index being 6.2 percentage points below average. This is because commodity prices tend to fall as the global economy slows down, something that hurts many stocks.
It’s for this reason that Aim stocks have also tended to move in the same direction as commodities. Economic slowdowns reduce investors’ appetite for risk, which is especially bad for speculative stocks.
| Sensitivities to commodity prices | ||
| Correlation | Response to 1SD fall | |
| All-Share index | 0.40 | -6.2 |
| FTSE Aim index | 0.48 | -13.8 |
| House prices | 0.25 | -1.8 |
| $/£ rate | 0.50 | -4.7 |
| FTSE gilt index | -0.17 | 0.8 |
| Based on annual changes since January 2000 | ||
Granted, defensive stocks are not so sensitive to commodity prices. But this only means they have a low correlation with them, not that we can rely on them to do well if commodities fall. They diversify commodity price risk but don’t reliably hedge against it.
If we want a hedge, we must look elsewhere.
One possibility would be those ETFs that take short positions in commodities. These, however, tend to be very volatile in themselves which suggests they should be only a small part of most portfolios.
Another possibility is gilts. These should do well as commodities fall because investors will buy them as inflation expectations fall and growth slows. However, the correlation between gilt yields and commodity prices, while positive, is weaker than you might think. One reason for this is that commodity producers tend to invest some of their revenues into western bonds. This means that falling commodity prices mean falling demand for bonds, which offsets some of the benefits to gilts of lower prices.
Yet another possibility is US dollars. The last three significant drops in commodity prices were all accompanied by the dollar rising against sterling: in 2000-01, 2008 and 2015-16.
There is, though, a problem with buying both gilts and US dollars. Both are expensive. Real gilt yields are negative and the dollar is high relative to sterling if we control for relative prices. Both might well lose us money therefore unless commodity prices do fall. Insurance is expensive.
This leaves a humbler alternative – cash. It has the virtue that losses on it are limited to the extent to which real interest rates are negative. It thus diversifies risk, and saves us from correlation risk – the danger that our assets will fall in price at the same time. Even it, though, has a drawback. If commodity prices do fall, the Bank of England won’t raise interest rates as much as hoped, and so returns on cash will be disappointing.
There are, therefore, very few ways of reliably profiting from a fall in commodity prices. Although such a move is, for now, only a risk rather than a certainty, it is therefore an unpleasant one.
