'Dr Copper' says an economic recovery is coming. The metal has reached its highest price for over two years. Given its use in so many industries, such a rise has traditionally been regarded as a sign of a general upturn in the global economy. And it’s not just copper that’s rising. Since March, aluminium and zinc have risen by 30 per cent while oil is up 74 per cent.
Which poses the question: should investors be buying commodities in the hope of further rises? There are two reasons to believe so, but also reasons for caution.
One encouraging sign is that China’s economy is recovering. Not only is the manufacturing purchasing managers’ index close to a 10-year high but also annual growth in the M1 measure of the money stock is at its highest rate since early 2018. In the past, this has been a good lead indicator of upturns in output growth. That is good news for commodity prices, as there’s a decent correlation between the PMI and the S&P/GSCI index of commodity prices.
What’s more, commodity prices – like the prices of many risky assets – are prone to momentum. One test of this is the performance of the 10-month moving average rule, which says we should buy when prices are above their 10-month average and sell when they are below it. Had you adopted applied this rule to the S&P/GSCI since 1986 (being in sterling cash when not in commodities) you would have made 3.5 per cent a year before dealing costs compared with 1.7 per cent a year on a buy-and-hold strategy. This is because the rule would have got us into commodities at the early stages of bull markets but would have protected us from big falls, such as in 2008-09 or 2014-15.
Right now, this rule is telling us to buy commodities.
On the other hand, though, there are also two reasons to be cautious.
One is that there has traditionally been a strong correlation between commodities and bond yields. Rising bond yields are usually accompanied by falling commodity prices and vice versa.
One reason for this is that commodities don’t pay interest. This means that when returns on financial assets are high, you sacrifice a lot of income if you hold them. That makes them unattractive and so their prices will be low. As bond yields fall however this opportunity cost of holding commodities falls and so their prices rise.
Another reason for it lies in a rule proposed by Harold Hotelling back in 1931. He showed that commodity prices should rise in line with the level of current interest rates, so when rates are around zero as they are now commodity prices should not rise. The logic for this is simple. Other things equal, high interest rates give producers an incentive to sell a lot and so raise cash. That supply depresses commodity prices, to a level from which they should subsequently rise. When rates are low, however, the incentive to sell commodities is weaker. That restricts supply and raises prices to a level from which they’ll not rise further unless rates fall again.
All this has two implications. It means that near-zero interest rates now predict flat prices. And it warns us that if bond yields rise, then prices will fall.
Which means that an economic upturn (assuming it happens, which is far from certain) is a mixed blessing for commodities. Yes, rising demand will raise their prices. But on the other hand the upturn might well raise bond yields – as investors dump bonds in favour of riskier assets – which will tend to depress commodities.
There’s another danger. There’s a close negative correlation between commodity prices and the US dollar. Rises in the dollar often see commodities fall. This happened for example in 2011-12, 2014-15 and in 2018-19. The latest rise in commodity prices being accompanied by a weaker dollar conforms to this pattern.
Again, there’s a simple reason for this. Commodities are priced in US dollars, which means they become less affordable in most currencies when the dollar rises. This tends to reduce demand for them, which reduces their price in dollar terms.
A bet on commodities is therefore a bet on the US dollar staying weak. Which is a dangerous bet because as Barbara Rossi at Barcelona’s Pompeu Fabra University has pointed out, exchange rates are incredibly difficult to predict. Of course, the dollar might continue to weaken to the benefit of commodities, but it would be silly to bet a lot upon this.
And, remember, there is another way of playing an economic upturn – to simply hold equities and especially more cyclical ones. These would benefit from such an event not just because corporate profits would rise, but also because the upturn would raise investors’ appetite for risk.
None of this is to deny that there’s a place in many investors’ portfolios for commodities. There is. But the case for commodities lies in the fact that they are only lightly correlated with share prices and so can sometimes be a way of diversifying equity risk: for example in 2002 and in 2007-08 commodities did well as share fell. With uncertainty so high, diversification across assets is important. It is this, rather than a need to bet upon an uncertain future, that justifies holding commodities.
