Physical commodities are not an inflation hedge

March 16, 2015 12:00 PM

No trader ever makes a mistake just once, an observation scalable to markets and economies themselves. All the ever-increasing level of automation in trading via algorithms will do is eliminate predictable human emotions--and it may open the door for an exponentially expanding series of new and different errors in lieu of the same errors repeated ad nauseam.

Let’s take the simple notion that physical commodities are a good hedge against inflation. If we debase money, and the principal complaint of central banks in recent years is that we are not debasing it quickly enough for their tastes, then the price you pay for “stuff” has to rise. All hail stuff. The only problem with this construct is a higher price for any commodity induces new supply while slowing  the growth in demand. Over time, this leads to decline in real prices for physical commodities.

Consider the following passage previously published in “Next Civilization, No Commodities!” Futures, July 2001— almost 15 years ago.

Of course, real commodity prices should fall over time. Not only does each mouth come with a pair of hands; those hands come equipped with a brain. Productivity increases allow us to feed more people with a better diet. If real prices didn’t fall, the forces of competition would ensure the obsolescence of that given commodity: Who still uses whale oil for illumination? For this reason, the Malthusians and their tiresome arguments starting with “the world’s running out of...” are, have been, and always will be wrong. More than 60% of all crude oil ever consumed has been consumed since the first oil shock of 1973, and yet proven reserves of petroleum stand higher today. If it seems we create resources by consuming them, that’s correct. Markets do wonderful things when given the chance.

Index trends

Let’s start with an observation intended to make commodity devotees’ heads explode: Financial assets have outperformed commodity index investments over time and therefore by definition have offered greater protection against inflation and currency debasement.  

First, let’s take two spot commodity indexes: the Continuous Commodity index (CCI), a successor to the venerable CRB index, and the CRB’s Spot Raw Materials index (RIND). If we go back to the May 1981 inception of the RIND and deflate these indexes by the producer price index, we see neither index has been able to hold its own against the PPI. The RIND has remained below 100% of its deflated May 1981 value since August 2011; the CCI last saw the 100% mark in January 2012 
(see “Inflation factor,” below).

In addition to producer price inflation, physical commodities face currency devaluation. The Federal Reserve’s broad trade-weighted dollar declined 7.65% between May 1981 and November 2014. If we add this currency depreciation into the mix, how well did these spot commodity indexes do? The answer in a word is “badly.” You would have to go back almost 30 years to the period just before the U.S. government embarked on a weak-dollar policy as part of the September 1985 Plaza Agreement to find a period when spot commodity indexes offset both forms of monetary debasement combined.

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About the Author

Howard L. Simons is president of Rosewood Trading. @simonsresearch