Linking shares and commodities

My chart summarises this fact. Each point on the line shows the correlation between annual changes in the All-Share index and in the S&P/GSCI over the previous five years. In much of the 1990s the correlation between the two was negative: commodities and equities tended to move in opposite directions. Increasingly, though, the two have tended to move in the same direction, as we saw when both fell at the end of last year and both have bounced back since. Because UK equities are highly correlated with global equities, much the same is true of commodities’ correlation with the latter.

One reason for this increased correlation is that there are some things that stock markets no longer worry about as much as they used to. In the early 1990s, investors feared that rising commodity prices would lead to sustained inflation as rising costs would cause workers to demand higher wages, thus causing an inflationary wage-price spiral and higher real interest rates as central banks tried to control inflation. Today, equity investors don’t worry much about this. (Whether this is because wage militancy has disappeared or because investors have faith in the Bank of England’s inflation target is another matter.)

Also, in the 1990s investors feared that the OPEC cartel would raise oil prices, which would squeeze the real incomes of western companies to the detriment of equities. With OPEC’s power much diminished, such fears are largely absent.

Instead, something else now dominates the link between commodities and equities – cyclicality. Especially since 2008 the dominant question for investors worldwide has been: will the global economy grow well or not? When investors believe the answer is yes, commodities and equities both rise together, as we saw in 2009-10, 2017 and so far this year. When they believe the answer is no, both fall together – as we saw in 2012, 2016 and late last year.

The connection here is not simply (or even mainly) that higher growth increases corporate earnings. It is also that decent economic growth, and expectations thereof, cause investors to take on more risk. When the outlook is good they make 'risk on' trades, buying equities and commodities. And when it’s bad they go 'risk off' and dump both. We thus get a positive correlation between equities and commodities.

This isn’t to say the correlation is very strong. It’s well short of unity, in part simply because there’s lots of noise rather than signal in both equity and commodity prices.

All this has mixed implications for investors. The good news is that if the faint signs of economic recovery in China and the eurozone get stronger we should see further rises in equities and commodities. On this score, the recent pick-ups in monetary growth in the two regions are encouraging, but signs of an intensification of the trade war between Mr Trump and China are not. If this happens, it would be good news for savers, too. The Bank of England might well interpret better economic growth and the slight rise in inflation caused by higher commodity prices as reasons to implement the “ongoing tightening of monetary policy” which governor Mark Carney promised last week.

There is, however, also some bad news. This positive correlation between commodities and equities means that investors no longer have a useful portfolio diversifier. Commodity funds are less useful at spreading equity risk than they used to be – especially as commodity prices are so volatile that large losses on them are possible in bad times.

This means that we must look to other assets to spread risk. One of these, humble as it is, is plain old cash. One of its virtues is that it protects us from correlation risk – the danger that previously uncorrelated assets will fall together. And this is one reason why it will always have a place in portfolios.