Inflation and your investments: Commodities and the business cycle

The price action of commodities such as copper, natural rubber, aluminum, and steel provides very useful information to investors. Commodities are very sensitive to demand. Since demand for commodities depends on how strong the economy is, they provide very timely information on the direction of the business cycle. Their importance comes from their price sensitivity to demand. As demand increases because of stronger business conditions, commodities provide immediate, unbiased information to the investor on what is happening in the economy. If commodities decline, they tell the investor that the economy is not as strong as it used to be. Their action, therefore, provides an objective measure on how the markets are responding to economic conditions. The importance of commodities is that they provide prompt feedback to the investor on what is happening to the economy. It is an objective and unbiased measure as reflected by the markets.

Economic indicators assembled by the government are available with at least one-month lag after the facts. They come in too late. Commodities are available every day and are not subject to revision. For this reason every financial newspaper around the world has many, many pages devoted to the price of commodities. They provide the sophisticated businessman and investor crucial input to make important decisions based on their understanding of the behavior of commodity prices. Trends in commodity prices such as copper, aluminum, natural rubber, crude oil, gold, silver, palladium, platinum and steel give the investor important clues on what is happening in the economy. The CRB commodity indices are also very useful in assessing trends in business conditions because they represent the action of a basket of most commonly used commodities. The rise in price of these commodities suggests the economy is strengthening considerably. On the other hand, their weakness suggests business is slowing down in a visible way.

Another important feature of commodities is that they all tend to move in the same direction. It is very unusual to see one commodity strong and all the other commodities weak. Eventually, the commodity that has risen too fast will decline and display a rate of growth similar to the rate of growth of other commodities. For instance, in the 1999-2000 period, although crude oil soared from $10 to about $32, gold prices remained stable around $300 while other commodities displayed small changes. This was a sign that commodity price increases were not wide spread. Commodities are a lagging indicator but they do not lag changes in economic growth by much. As such, the increase in commodity prices is a sign the economy is strengthening. A weakening or slowdown in the growth of commodity prices signals the economy is slowing down.

Another important element is that commodity prices rise only when the economy is strong, but we saw that the economy is strong only when the Fed has eased aggressively and real interest rates are low. If real interest rates are high it is very unusual to see firm commodity prices for an extended period of time. The odds are that commodity prices will either stay stable or decline when real interest rates are high.

In the 1970s all commodity prices rose due to easy monetary policy: strong growth in money supply, and low real short-term interest rates. Commodities are more volatile than producer or consumer prices. As a result, their change provides clues on the future direction of inflation. If commodity prices accelerate across the board, this is a signal that inflation will eventually start rising. Sharply rising commodity prices are the outcome of too much growth in the money supply, low real short-term interest rates, and a strong economy. This is the perfect combination of ingredients driving up inflation in a major way. If the economy slows down and commodities decline or slow down, this is a signal that the forces of inflation are subsiding. This is particularly so if the slowdown in the economy and in commodities has been preceded by a slowdown in the growth of the money supply and by high real short-term interest rates.

(From Chapter 7 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

Disclaimer.The content on this site is provided as general information only and should not be taken as investment advice nor is it a recommendation to buy or sell any financial instrument. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.

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