Hard Assets
Investor
submits:
By Charles Armstrong
"Commodities are a hedge against inflation!" We've all heard the
advice-and if we say it often enough, then it must be true. But
while commodities are a market most investors should have at least
some exposure to, claiming the entire asset class will act as a
strong inflation hedge is seriously misleading. But hey, I suppose
it makes a nice little sound bite.
Of course, to some degree, commodities as a whole
are
a hedge against inflation, insofar as any useful
thing
will have some functional worth, regardless of the currency in
which it's priced. But when it comes to inflation hedging, not all
commodities are created equal.
So which commodity-or class of commodity-actually provides the
best hedge against U.S. dollar inflation?
Hedging By The Numbers
To answer this question, I've selected a representative
commodity from each of the most common categories-energy, softs,
grains, metals, livestock and even lumber-and run a full regression
analysis, comparing their daily prices with the U.S. dollar/Swiss
franc exchange rate over the last five years (2005 - present).[1]
(Why the USD/CHF exchange rate? Of all the possible currency pairs,
I think USD/CHF acts as the best gauge of the worth of the U.S.
dollar, given the stability of the Swiss economy, coupled with its
rock-solid banking industry and high global economic standing.)
For the statistically un-inclined, "R_squared" is a measure of
the extent to which the change in value of one factor can be
explained by the change in value of another. In this case, it tells
us how much of the returns for our representative commodities can
be explained by their correlation to the dollar. (A negative
correlation, by the way, implies that one factor goes up when the
other declines, while a positive value means the two move in the
same direction. No correlation means the values move independently
of each other.)
One thing to keep in mind, however, is that both currencies and
commodities tend to possess cyclical, time-series correlations. So
you shouldn't take this analysis to mean that commodity x and
commodity y are and will forever be correlated to the dollar by
some set amount. Instead, this analysis should offer a general base
of comparison between the commodities themselves.
Take a look at the results, and see for yourself which
commodities truly do provide the best inflation hedge.
Energy
Representative: Crude Oil
Correlation Type: Negative
R_Squared: 0.3119
Surprised? So was I. Given the much-ballyhooed oil-dollar link,
I fully expected the two to exhibit a much closer statistical
relationship.
However,
previous analyses
I've done comparing oil prices to the dollar have revealed that the
oil-dollar correlation has grown much stronger throughout 2008 and
2009 (which offered R_Squareds of .5692 and .8374, respectively).
This may be due, at least in part, to a changing global economic
climate; as emerging powers modernize, they are bound to consume
more oil.
Therefore, although oil may not have been the best inflation
hedge for most of the previous decade, as oil becomes a more
important ingredient in the vitality of emerging economies, such as
China and India, look for this relationship to strengthen.
Grains
Representative: Corn
Correlation Type: Negative
R_Squared: 0.5417
The most American of grains turns out to be a fairly reasonable
hedge against inflation in the dollar. And since America grows most
of the world's corn, that makes perfect sense.
One thing to keep in mind, however, is that corn's primary use
the world over is in livestock feed. If American corn prices get
too high or the dollar becomes too strong (or both), farmers in
other nations would be happy to switch to a cheaper, non-American
and/or noncorn-feed for their livestock, thereby decreasing world
corn demand and inevitably, the value of a bushel of corn. So
before going long corn to hedge the dollar, be sure to consider the
fungible nature of feed grains.
Meats/Livestock
Representative: Pork Bellies
Correlation Type: Positive
R_Squared: 0. 2977
Note: Due to the unavailability of reliable prices, the
sample size for pork bellies prices is somewhat smaller (8/29/06
- 1/21/2010).
Sure, pork bellies are perhaps not the first choice proxy for
livestock in general, insofar as the market's open interest and
volume are perpetually an order of magnitude below that of cattle.
But come on, who doesn't like bacon?
As you can see, pork bellies are slightly positively correlated
with the U.S. dollar. I pulled up the USDA's most recent
WASDE report
to get an idea of why this might be, and immediately found my
answer: In 2009, United States farms produced an estimated 23.07
billion pounds of pork, exporting about 4.18 billion pounds while
importing only 841 million. It seems the global pork market is not
one in which the United States has any interest in participating;
we like to keep our bacon right here in the good old US of A.
(Although the hit pork exports took during last year's
"swine flu" fiasco
may have played a part in the low export numbers as well.)
So next time you order a BLT, feel free to cancel out your
gluttony guilt by taking pride in supporting a home-grown industry.
But just don't think about hedging inflation with a pork bellies
contract.
Precious Metals
Representative: Gold
Correlation Type: Negative
R_Squared: 0.7357
As expected, gold and the dollar are inversely linked at the
hip. Nothing particularly surprising here, as everyone and their
mother knows that these two tend to move in opposite directions.
The shiny metal is your textbook inflation hedge.
Non-Precious Metals
Representative: Copper
Correlation Type: Negative
R_Squared: 0.1039
Copper has been one of the major, if not
the
major, inputs in every industry in history, from the eponymous
copper age (before alloying was invented) right up to the digital
age. So the small correlation between the dollar and copper may
come as a surprise.
Historically, copper prices rise as global industry expands and
falls during global recessionary periods, so perhaps the lack of a
serious correlation is the result of copper being too useful and
abundant to provide any hedge whatsoever. Because the Earth is
literally teeming with the stuff, we don't feel the need to melt it
down into ingots and hoard it in vaults. Instead, if and when
demand arises, it's easy enough to just dig it out of the
ground.
Forest
Products
Representative: Random-Length Lumber
Correlation Type: Positive
R_Squared: 0.3777
Like pork bellies, lumber is a largely internal market, in that
the U.S. uses almost all the lumber it grows. However, because we
also import so much of the stuff from Canada, it is better to think
of lumber not as an exclusively U.S. market, but as a North
American market.
In 2008, for example, the U.S. produced 29.18 billion board feet
of lumber, while Canada produced 23.65 billion board feet,
according to the Western Wood Products Association's
Lumber Track
Magazine
. We exported only 295 million board feet to Canada, while
importing 11.62 billion board feet from Canada-nearly half of the
country's yearly production. At the same time, U.S. imports and
exports from non-Canadian countries both remained low, at 1.06
billion board feet and 729 million board feet, respectively.
In that context, lumber would only make a good inflation hedge
if the currency you're hedging has the queen on one side and a bird
on the other.
Softs
Representative: Coffee
Correlation Type: Negative
R_Squared: 0.5469
Note: Due to the unavailability of reliable prices, the
sample size for coffee prices is somewhat smaller (9/19/06 -
1/21/2010).
Coffee is one of the world's most traded and active commodities;
everyone everywhere drinks coffee every day, and it only grows in a
few select regions. Its status as a truly global commodity with an
active market is what makes it a reasonable hedge against dollar
inflation. Coffee seems to be the one luxury that people won't give
up, even when times get tough; the U.S. even included coffee in its
relief supplies during the Berlin airlift. That should say
something about the strength of our collective addiction.
As we can see, if your goal is to hedge against dollar
inflation, blindly investing in a broad basket of commodities may
not be your best option. It pays to be choosy.
If your main investment goal is to protect against the dollar's
devaluation, then opting for precious metals (namely, gold) over
base metals, livestock and even lumber make a great deal of sense.
But you can diversify that position somewhat with an appropriately
weighted collection of precious metals, grains and softs
(especially coffee) to help you achieve your goal.
Full Disclosure: As of writing, author is short March 2010
softwood lumber (LBH10).
Endnote:
1. Unless otherwise noted, analysis is done on daily close data
from 1/1/2005 to 1/21/2010.
See also
Bad Momentum, Bad Fundamentals and 10,000 in the
Rear-View Mirror
on seekingalpha.com