Why is investing in commodities recommended during a stagflation period?

Question

Not looking for investing advice.

Instead, I would like to understand the underlying logic and mechanic as to why commodities could be beneficial as an investment during a stagflation. I believe there are few modern precedents on this.

Answer 1

They, generally, are not investments unless you need three train cars of heating oil.

The perception, and it is to some extent just perception, is that there is some pure play on inflation via commodities. Commodities are goods that are fungible. If you have two identical apples, one in each hand, then you should not prefer one to the other. So, it follows that their prices should be identical. They reduce the mental complication created by choosing between a Big Mack and Whopper, which would imply you would need to perform securities analysis on the two underlying securities.

However, both McDonald's and Burger King have other factors and so they could move in the opposite direction from inflation. Also, they could amplify the effect.

The difficulty is that commodities trading laws do not prohibit insider trading. Indeed, it is assumed that insider trading must happen. If you write a bad contract, the parties with real information will know that and buy it or sell it depending on how it is defective. So a private buyer or seller may not realize their inflation goals because they may have overpaid at the open and under received at the close.

It would be impossible to ban insider trading because the insiders control a large enough of the global production of the commodity to be fully aware of supply and demand issues. As classroom mental abstractions, they are great pure plays. In the real world, they are not.

The other problem is that stagflation can suddenly stop being stagflation. Stagflation isn't really a thing, it is a description of a state of the world. People do not make stagflation on purpose. Likewise, governments usually do not have enough ability to alter the state of affairs to end it. It ends when it ends.

Growth right now is stagnant because the supply and demand curves cannot intersect. The war between Russia and Ukraine is exacerbating that. The labor part of the problem can be automated out, eventually. The ships sitting off the coast of California will, at some point, dock, and the world will return to normal. The war will end. When all of that happens, it will be over.

If Russia had not invaded, it is likely that the supply shock would have ended by the end of this year, assuming no more serious shocks from COVID. We are looking at a few years now. There is no government that can do much to fix it because the solutions are politically unpalatable. This inflation is not monetary in nature, it is structural and shocking the supply side. No change in the interest rate will remove landmines from the wheat fields of Ukraine. No increase in government spending, except to send explosive ordinance crews to Ukraine, will remove those mines either.

The other problem is Engel's law. Engel's law says that as income increases, the percentage of income spent on agricultural goods should fall. That is not uniquely an agricultural effect. Other commodities tend to experience downward drift. One of the reasons that 9/11 happened was a multidecade fall in the price of oil relative to inflation.

The logic is that they are simple and tend to move with inflation. Apples are simple if you eat them. Go ask the owner of an orchard how simple it is. Go visit Motts and ask them how challenging the apple market is to get raw materials to make applesauce.

Answer 2

They hold value.

During times of high inflation, money loses value (that's the definition of inflation). Bonds obviously lose value because of this (unless you can get an interest rate equal to inflation), and stocks may also lose value as it's hard for businesses to operate when money is losing value. But a tomato is always a tomato.

We save money as a proxy for saving commodities. Every tomato worth of money saved is another tomato you can eat when you are retired. When money starts losing its connection to commodities, we may need to go "down a level of abstraction" and save tomato futures instead.

If the futures market also fails, we would need to go down another level, and hoard actual cans of tomatos in our basements, in order to have canned tomatos in retirement.

Answer 3

The logic of commodities as a hedge against inflation is that commodities have an intrinsic value, and they sell for however much money it takes to equal that value. Therefore, in this view, when money loses value through inflation, the prices of commodities should rise. However, this logic is wrong, and you should not rely on it.

It is easy to find historical periods where commodity prices have failed to keep up with inflation. The most famous of these is the wager between Julian Simon and Paul Ehrlich, which ran between 1980 and 1990. The motivation behind their wager was resource scarcity, but the results are relevant to resource prices generally. Ehrlich bet that the prices of copper, chromium, nickel, tin, and tungsten would rise in inflation adjusted terms over the period of the bet. In fact, the prices of all five of those metals fell in inflation adjusted terms, with three of the five falling in nominal terms.

With regard to stagflation, particularly, commodities like metals are unlikely to provide a good inflation hedge because demand for them is largely driven by industrial use. A stagnating economy can produce sluggish industrial demand, leading to a glut of supply and declining prices.

In summary, the idea that commodities are a hedge against inflation is based on an overly simplistic view of the relationship between commodity prices and macroeconomic indicators like the inflation rate. Inflation means that goods and services get more expensive on average, but the effect is not uniform, and therefore you can't hedge against it by naively investing in "stuff".