Commodities do well in the later stages of the economic cycle, specifically in the expansion phase. This is because excess capacity in the economy has been used up during the recovery phase. Once capacity utilisation is at maximum levels (typically around 80-90%), price pressures start to emerge. These price pressures are often felt heavily in input prices to companies’ production of goods, and since raw commodities are important inputs to production, commodity prices begin to rise on the back of higher demand from producers of goods. This higher demand is not just for the raw materials but also from end consumers who are spending more during an expansion. The performance of commodities during expansion is what makes them often a good inflation hedge. Commodities form a part of inflation indices themselves but also inflation is generally higher in the expansion phase because existing capacity has been used up.
However, one must also look at the supply response. Supply tends to increase in response to higher demand putting downside pressure on commodity prices. While supply-side shocks can also reduce supply these are difficult to predict and so difficult to position for.
In terms of accessing commodities, the simplest way is to use a broad commodities exposure, perhaps through an ETF. If the investor’s view is more nuanced, they might choose to invest in subsets of the commodity universe. For example, if they believed the global economic expansion is being driven by an increase in Chinese industrial activity then they might prefer industrial metals and energy. It is important to distinguish gold and other precious metals from industrial metals, energy, and soft commodities. Gold has unique features as a typically “risk-off” safe-haven and is not always a good hedge against inflation because it depends also on the direction of travel for interest rates, something we discuss in another article.
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