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Commodities provide less inflation protection than you might hope [ClearOnMoney]
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Commodities provide less inflation protection than you might hope

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Commentary

Commodities provide less inflation protection than you might hope

2 Mar 2011 by Jim Fickett.

The prices of commodities did go up as the dollar went down during the inflation of 1966-1996. However many commodities failed, after tax, to preserve capital. Commodities should probably be part of one's inflation protection strategy, but it will matter which commodities are chosen, which investment vehicles are used, and when one gets in and out.

The US experienced an extended period of high inflation from about 1966 to 1996, with inflation almost always, during that period, above 3%, and hitting a high of 14.8% in March of 1980. (Though I was, during most of that period, blissfully unaware of investing concerns, I do remember my father being very unhappy about it all, and lecturing the family at the dinner table about what the government was doing wrong.)

As one way to gain some perspective about how to protect oneself from the effects of possible future inflation, I am looking at how various investments performed in the US during that period. Past posts looked at money market funds and US Treasuries. Today it is commodities' turn.

“Commodities” covers a wide range, and different commodities behave very differently. I've made no attempt to be comprehensive, but have chosen a few different commodities and subclasses of commodities to illustrate how different the results can be.

(The gold price is from Kitco. Others are from the Producer Price Index, produced by the BLS. The CPI, of course, is also from the BLS. All prices except gold are normalized to 1 in 1966. Since the gold price was artificially low under Bretton Woods, I have given it a lower – and somewhat arbitrary – normalization so that its price is in a normal range with the other commodities in the first few years after 1971, when Nixon took the US off of the gold standard.)

The first thing to notice is that the prices of all commodities do generally go up as the dollar goes down, as expected. However the prices of some commodities go up less than the general price level. Further – and the second main thing to notice – even for those that go up by more than CPI, if one were to subtract out 20% or so for tax on the nominal “profits”, it turns out none of the items or classes chosen for this exercise would have fully preserved capital (I leave gold out, because of the price control in the early years).

For example, a dollar invested in lumber in 1966 was worth $5.58 in 1996, or $4.67 after a 20% tax on nominal profit. On the other hand, a dollar's worth of the CPI basket in 1966 cost $4.84 in 1996.

The third thing to notice is that different commodities behaved very differently or, to say the same thing in a different way, inflation was not all that was going on. The Iranian revolution (1978) and the Iran-Iraq war (1980) were big drivers of the gold and oil prices. Perhaps gold's early rise was also in part an anticipation of inflation – Bernholz points out that the exchange rate almost always reacts before the price index, as those who understand the danger seek better money.

Lumber turned in one of the best performances, supporting Jeremy Grantham's recommendation of investing in timber.

Farm products turned in the worst performance. This is due to the green revolution, in which farming was heavily industrialized and fertilizers became more common. Due to efficiency gains, real prices continued to fall until 2005.

One last thing to notice is that generally commodities did better before the inflation peak and worse after. This is the opposite of bonds which, you may remember, did better after the peak.

So the overall lesson from this one historical period seems to be that

  1. commodities do reasonably well before the inflation peak,
  2. but not well enough over the whole period to preserve capital, and
  3. it matters a lot which commodity you choose.

I think the outcome in any future bout of inflation might well be somewhat different. The real cost of food has risen since 2005, due both to the green revolution reaching its limits and to rising population. Somewhat similarly, many mineral resources are in shorter supply now than in the past. So commodities may well fare better than they did in the past. Nevertheless, it will still be necessary to think carefully about which commodities and which investment vehicles to choose.