Tuesday, April 23, 2013

What do commodity prices tell us?

Commodity prices on average are down about 15-20% from their all-time highs two years ago, but they remain very high relative to their 2001 lows. The recent weakness in commodity prices could be explained by slower economic growth here and in places like China, but commodity prices are not weak enough to point to any monetary policy errors (i.e., deflationary risk).  

The above chart shows the CRB Raw Industrials Index going back to 1981. This index is composed of basic industrial commodities, many of which do not have associated futures contracts. It's arguably the best index to follow for clues as to the health of global manufacturing activity. Prices today are down 15-20% from their recent all-time highs, but remain very high relative to their 2001 lows—130-150% higher. While this is consistent with the observation that economic growth in recent years has been disappointingly slow, prices are still at lofty levels compared to a decade ago, and much higher than what we saw in late 2008 when global manufacturing suffered a major decline.

This next chart shows inflation-adjusted value of the broader Spot Commodity Index, which adds foodstuffs to the Raw Industrials Index. One thing that stands out is that, despite huge gains since 2001, most commodity prices today are lower in real terms than they were in 1970—on average, commodity prices have risen by less than the rate of inflation for over 40 years. Commodities rose in real terms in the 1970s (after being largely flat throughout the 1960s), a period during which monetary policy was generally accommodative, inflation was rising, and there was lots of speculative purchasing of commodities and other physical assets for their inflation-hedging properties. 

Commodities fell significantly in the 1980s and 1990s, when monetary policy was generally tight and inflation was falling. The Fed began to ease in 2001, and commodity prices have risen significantly since then, suggesting that—as was the case in the 1970s—monetary policy has played a significant role in driving prices higher in the past decade. From this perspective, it would appear that the Fed's policy accommodation over the past decade has been enough to remove the deflationary impact that monetary policy had on commodity prices in the 1980s and 1990s, but not enough to create new inflationary pressures.

The chart above compares the price of gold with the CRB Spot Commodity Index. Note that gold tracked the ups and downs of other commodity prices fairly well from the early 1980s until 2011, when commodity prices fell but gold continued to rise and remained elevated. The latest decline in gold could be the market's attempt to realign gold and commodity prices. I don't see evidence of deflationary pressures here, but rather a decline in gold prices from what were arguably very high levels that in turn were likely driven by speculative activity and geopolitical risk concerns.

The first of these two charts shows the nominal level of crude oil prices (using the futures contract tied to domestic light crude), while the second chart shows the inflation-adjusted level of Arab Light Crude. Crude oil is unique among commodity prices, since it peaked in 2008 and is higher in real terms today than it was in 1970 or 1980. In general, with the brief exception of the spike in prices in 2008, it can be said that crude oil today is almost as expensive, relative to other things, as it has ever been.

Because energy has become so expensive in real terms, we have found ways to use it more efficiently, with the result that energy consumes a much smaller portion of personal consumption today than it did in 1980 despite being more expensive. Expensive crude prices have also helped bring us the miracle of modern fracking technology, which in turn has given us very cheap natural gas.

Industrial metals prices tell roughly the same story: prices have been volatile but range-bound for the past 6-7 years, and they are still much higher today than they were at their 2008 and 2001 lows. Copper is five times more expensive today than it was in late 2001, while industrial metals prices on average are 3 and a half times more expensive. The thing to note here is not that prices have broken down of late, but that they are still very high from a long-term historical perspective.

The chart above shows prices for a small basket of relatively obscure commodities (hides, rubber, tallow, plywood, red oak). It is now at an all-time high. No evidence here of any economic weakness.

To sum up, I don't see much to worry about in the prices of commodities. They have weakened of late, but on average they remain at levels that just a decade ago would have seemed exceedingly high.


Gloeschi said...

You gotta love Scott. 10 out of 12 major commodities trade below their 20- and 50-day moving averages, Treasury yields have dropped more than 30bps since March, TIPS-derived expected inflation has dropped more than 30bps since March, and he pulls out a chart of "obscure" materials to show that "all is fine, don't worry".
Never mind stock prices are 70% correlated with inflation expectations.

steve said...

commodities have had big runs periodically in their long history but from your own charts it looks like they've about doubled over the past 20 yrs which is about 3.5% cagr. A) a poor investment B) nothing to be overly concerned about and C) if you're going to invest in commodities do so through commodity stocks/mf's

steve said...

stocks ARE NOT correlated with commodity prices. check your market history

Scott Grannis said...

Re: commodities and stocks. Note that commodities soared in the 1970s, while stocks were flat to down. Commodities were absolutely crushed from 1980 through 2000, while stocks soared. Since 2000, stocks are up a little and commodities are up a lot. If there is a correlation, it is very low or negative.

Benjamin Cole said...

I have devoted long thought to commodities prices, and now (drum roll) here is my conclusion.

They are sending false signals, for a reason Scott Grannis alludes to: We get better continuously in our use of commodities. we use less, and the price of the commodity becomes less important, as in oil. (Gold is sui generis, the price set by retail buyers in India and China).

So a commodity can rise in price, but that is neither a sign of economic strength, or inflation. It may be a sign we use use less of that commodity, and we are less price sensitive.

My car gets 45 mpg rather than 12, so if gasoline costs double, I am still ahead.

This, many argue, is in fact what happened to Fed policy in 2008. They saw commodity and oil prices rising, and get scared, and tightened monetary policy just as consumers and business leveraged to the hilt to buy real estate.

That was a disaster.

Going forward, anyone who uses commodities prices to set monetary policy will probably end up asphyxiating their economy.

In brief, if you want to know what is happening to inflation, look at the CPI or PCE deflator, and even those indices may overstate the case.

The Cleveland Fed has an index of inflationary expectations, that has been far, far, far more accurate in forecasting inflation than commodity prices.

And gold? Gold collapsed just as the world's central banks went to heavy QE. Yeah, gold ranks up there with astrology.

William said...

Most commodity prices are set by supply and demand as one would expect. Because "Commodities were absolutely crushed from 1980 through 2000" there was minimal investment in new mines so eventually - in the early 2000s - there was a shortage of production relative to demand and prices rose.

At the moment due to new investments in mines and oil fields supply has once again caught up with demand and prices have fallen.

Gloeschi said...

Lookie here @Steve: Please run a correlation between $SPX and $GNX (Goldman Sachs Commodity Index) and you will see that, with the exception of the 2008 crisis, correlation sits nicely around 80%. Awaiting your proof of the opposite.

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