Wednesday, October 14, 2015



The question for the first few posts is “are commodities cheap?” They are certainly cheaper than a year ago. But we are going to start out with a very long term view. The longest commodity price index I know is the US producer price index for crude materials. Here’s a graph going back to 1947:

Important note: In these posts I will normally use the IMF all-commodity index as a baseline. This is a very broad-based index of 53 commodities. Many of them do not have active futures markets. Nonetheless they are all economically important, and are all investable via equity or debt markets. However, this index only starts in 1980. So I spliced the IMF series to the crude PPI.

The chart is mostly flat prior to 1998 with the exception of the inflation in the 1970s. Around 1998 it started rising again, but with much more volatility. The inflation in the 70s was both a reaction to macroeconomic cost push inflation, the cartelization of important commodities and prior underinvestment. The rise since 1998 is more due to unexpected emerging market demand as well as cheap credit.

Of course with a series as long as this overall inflation really does matter. Here’s the same graph in constant 2015 dollars.

The pattern here really is different. It essentially shows a continuous decline in real commodity prices until 1998, interrupted only by the oil shock of the early 70s. After 1998, I will argue that the sharp rise until 2008 was the result of both unexpected EM demand and a credit bubble. Since 2008 EM demand has slowed and the credit bubble is slowly deflating.

Here are some numbers. The average deflated price of the index over the whole period is 131. We are now at 102. That is almost exactly one standard deviation below average. On this basis, commodities do seem cheap.

But wait. Many economists claim that commodities should slowly decline relative to overall inflation. Commodity production is subject to the increasing productivity of human innovation. In the rest of the economy much of the service sector has stagnant productivity. Think of government, education, and health care. This is in fact what happened until 1998. If we assume the last 15 years have been an anomaly and extrapolate the 1947 - 1998 trend to now, the number comes out to be 41. That’s two standard deviations below where we are now. In this argument going long commodities is betting against human ingenuity.

There are some good counterarguments to this. Many commodities, including some important industrial ones, are subject to depletion. We see this vividly in the current oil market. The new supplies of oil from shale and oil sands are definitely a product of human ingenuity. But they come at a higher price than supplies from traditional reservoirs. Energy from renewable sources is more expensive yet. All this points to an upward trend.

I have another counterargument. Services are more labor-intensive than commodity production. That’s why service productivity growth is low. As long as labor was the scarce input it was reasonable to expect that service prices would rise relative to commodities. But labor is no longer scarce. Globalization and immigration have expanded the pool of labor. Unemployment and underemployment are elevated in most developed countries. So we have a larger pool of workers offering services and bidding for commodities.

My own view is that commodities in general are somewhat cheap. Not enough to be a screaming buy and not enough to offset the contango in hard-to-store markets like natural gas. Nonetheless, they are generally a buy. As this blog progresses, I will give my view on what exactly is cheap and ways in which they can be invested in.

NEXT POST What is the expected return from commodities at current levels?

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