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Can Commodities Hedge Inflation?

November 03
21:07 2009

Many industry analysts and academic economists have long held the view one could mitigate inflation by investing in particular commodities. As market turbulence continues to feed doubt concerning the viability of traditional equity and fixed income asset classes, the typical 401k fiduciary may find the need to answer questions about commodity investments. Certainly, a constant barrage from the financial media and internet advertisements pose the issue to plan participants. Who else can employees turn to but the plan sponsor and fiduciaries?

brownie-300Andrew Clark, Chief Index Strategist at Thomson Reuters Indices sought to address this at the 2009 Art of Indexing Summit in New York last week. What he relayed may surprise you. While almost everywhere you look you’ll see a plea to buy gold as a hedge against inflation, Clark discovered the best commodities to hedge against inflation included crude oil, heating oil and copper, followed closely by silver, natural gas and cocoa. If you really wanted to stretch the list, you could add cotton, lean hogs, corn, sugar and wheat. But not gold.

What led Clark to this insight? He used a common economic test for the relationship between commodities and inflation (and, in fact, for most any other kind of relationship) called “co-integration.” As Clark explained, unlike the more widely known “correlation,” which relates co-movements in returns, co-integration compares the co-movements of raw asset prices. He offered the following example. Let’s say the spreads are mean reverting, meaning the asset prices are tied together in the long term by some common stochastic trend. In this case, we can state the asset prices are co-integrated.

Clark stipulates co-integration has emerged as a powerful tool for investigating common trends in multivariate time series. As such, he believes it provides a sound methodology for modeling both long-run and short-run dynamics in a system. Unfortunately, he’s found most of the major commodities indices fail the co-integration test with the US CPI or PPI. The Journal of Commerce’s ECRI IPI, which is co-integrated with the PPI, comes closest.

He concludes two commodities – crude oil and copper – can theoretically provide a “decent” inflation hedge (although he’s quick to add the impact of costs remain unknown). The model requires more testing, but Clark feels the hedge does generate a tradable asset, an index based on the crude oil and copper structure.

But if you are a fiduciary of a 401k plan worried about potential liability, be warned. Much of the work of commodities trading remains speculative and may not be appropriate for unsophisticated investors – no matter what the TV tells them.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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