The Alpha and Inflation of Commodities

Commodity prices rise and the world screams hyperinflation.

Elsewhere, alternative investment managers espouse the virtues of commodities as an asset class that generates “alpha” returns (i.e. returns not related to the overall direction of markets). The thing is, it’s hard to have it both ways.  The link between unexpected/expected inflation and equity prices in the short- and long-run is complicated.  High inflation grows earnings in nominal terms, which should grow equity prices in nominal terms. High inflation often leads to higher interest rates and a reduction in money supply through decisions by central banks to put a break on inflation. These higher interest rates stifle the economy and can lead to decreases in earnings, which will give rise to lower share prices ceteris paribus. Built-in inflation expectations where monetary policy is fairly predictable will probably give rise to high nominal equity market returns (but probably not high real returns as inflation has a frictional cost on the economy which often surpasses any gains from real wage declines.)

So if commodity inflation was linked to core price inflation, we would expect a much stronger link between commodities and equities. (Yes, there are a million more points to consider here and not all support this hypothesis.) (Also, obviously as an input into broad measures such as consumer price inflation commodity prices increase that measure, but the point is there is limited knock-on effect on other prices, so core inflation which typically excludes volatile energy and food prices is hardly moved. It’s core inflation that is a strongly autoregressive time series.)

But better than all that, the smarter, better education (and certainly more focussed) people at the Chicago Fed had put together a pretty compelling research paper on commodity prices and inflation (pdf). Check it out.

Commodity prices rise and the world screams hyperinflation. Of course they’re wrong.