Inflation seemed to be a dead topic for many years. For an extended period of time, central banks tried to stimulate price growth, mainly through higher wages. The inflation targets were more than achieved, unfortunately mainly through supply factors. It is sometimes difficult to answer the question whether high inflation is caused by rising commodity prices, or rather high inflation causes an increase in commodity prices (as investors are trying to hedge themselves against higher prices). Currently we can quite clearly state that rising commodities prices caused the ubiquitous increase in prices of all products. In this article, we will look at consumer prices and individual groups of commodities in the US and Eurozone.
Direct impact of commodity prices on inflation
In the analysis of the contribution of consumer inflation, we chose those categories that can be easily and directly linked with the corresponding commodity prices. Of course, price changes in these categories also depend on other factors, such as labor costs. However, it cannot be denied that the recent rise in the importance of these categories is primarily the result of rising commodities prices. Last year, many classes of raw materials increased by several dozen percent, so it should not be surprising that the selected categories have gained huge importance.
Looking from the long term perspective, the impact of categories such as bread, grains, meat, coffee, home energy and fuel for transport is negligible:
- In the United States, the joint contribution of these categories accounts for 0.1 percentage points to the average inflation of 2%
- In the euro area, the impact of raw material categories over the last 10 years is around 0.3 percentage points, with the average inflation at 1.3%
- Analyzing the above data, one can reach similar conclusions to other economists – commodities have a limited impact on inflation in the long term
However, the situation is now quite different. Looking at the last 12 months, and especially data for March, the selected commodity categories account for around 50-60% of inflation for the euro zone, while for the US it is 30%. What else is worth paying attention to?
- Energy resources have the largest share, both those for domestic use and those used to produce electricity and heat. Producer inflation in this category increased nearly 100% on an annual basis!
- Agricultural commodity categories are less important in the overall inflation reading, but their contribution increased several times compared to the long-term average
- The impact of domestic energy prices in the US is much smaller than in the euro area, but this may be due to the way in which the categories are defined. In the United States, the category of shelter (mainly rental costs) has increased sharply, which indirectly also shows a significant increase in energy prices.
It turns out that in the longer term, the impact of commodity prices on inflation is rather limited. On the other hand, at a time when raw material price increases reach several dozen percent, their contribution often exceeds 50%. Source: Macrobond, XTB
Indirect impact of commodities on inflation
We have shown that the direct impact of commodity prices on inflation in the long term is rather limited, while in the short term it is much more important. However, it should be remembered that commodity prices, and in particular energy commodity prices, have a powerful indirect impact on costs in almost every sector of the economy. For example, energy is a significant cost of bread production as well as its transport. Another example is coffee, which is often transported from South America, Africa or Asia to the other side of the world. In fact, there could be endless examples of where energy is needed for transportation. Jerome Powell recently pointed out during the hearing before Congress that every time oil price rises by $ 10 per barrel it adds 0.2 percentage point to inflation. This is a lot, considering that the weight of fuel prices in US CPI inflation and other countries is usually around 4-5% (directly).
We would like to point out that in addition to energy and food, the prices of industrial metals, which are the backbone in the construction of infrastructure and means of transport, are also rising. For example, it is estimated that the prices of steel, copper, aluminum and nickel account for 10% of all car production costs. If we take into account the rising prices of all raw materials that are used in the production of the above-mentioned car, the cost of the final product must be higher.
It is worth remembering that in the case of a healthy economy, higher commodity prices may not necessarily translate into an increase in the prices of the final product. It is related to the scale effect. In addition, producers do not always pass on all costs to consumers. The volatility of PPI inflation is definitely higher than the CPI. However, if PPI inflation reaches extreme levels like 30% YoY in Germany or 15% YoY in the US, then it has to be assumed that some of the costs will eventually be transferred to consumers.
In other words, if the price of nickel or zinc rises by 100% but the economy is stable, then there is a good chance that companies will not pass the costs on to consumers in order to avoid their negative reaction. However, when all commodities are expensive, and at the same time demand is strong, companies will at some point try to remain profitable, even at the cost of losing buyers. Hence, measuring the long-term impact of commodity prices on inflation can be misleading. Commodities have the greatest impact on inflation just when it rises sharply, which is the worst possible moment from the consumer’s point of view.
Producer inflation, where the impact of commodities is higher, is much more volatile. Highly expensive raw materials may force producers to pass on costs to consumers to an even greater extent. Source: Macrobond, XTB
How to take advantage of current situation?
Inflation is often said to force investors to buy physical assets, such as commodities, in order to protect their funds against a decline in purchasing power. In this case, the investor may choose either a passive or an active approach. The former can be done by investing in an ETF (Exchange Traded Fund) or ETC (Exchange Traded Commodity). In this case, we do not use financial leverage and we cannot take a short position, and the fund’s units are traded during the hours of the stock exchange on which they are listed.
The most extensive range of exposure to commodities is provided by the iShares Diversified Commodity SWAP UCITS ETF (ICOM.UK in XTB’s offering), which aims to replicate changes in the Bloomberg Commodity USD Total Return Commodity Index.
ETF fund based on the Bloomberg commodity index is strongly correlated with crude oil, although not in 100%. This is due to the very high importance of crude oil in the commodity index. Source: xStation5
Of course it is possible to get exposure directly to one market, for example ETC Deutche Boerse Commodities Gmbh Xetra-Gold Bearer Notes (4GLD.DE) replicates the changes in the price of gold. For oil, this could be Wisdomtree Crude WTI Crude Oil (CRUD.UK), which not only tracks the Bloomberg sub-index for WTI, but also gives a collateral return.
Taking a more proactive approach, we can decide to invest in commodities through CFDs. In this case, we have a wide range of raw materials at our disposal, where we can additionally use the financial leverage, take both long and short positions and trade 24/5. The most popular raw material markets are oil (OIL), natural gas (NATGAS), coffee (COFFEE), wheat (WHEAT) and copper (COPPER).
There is also an indirect way of investing in this group of assets. Investors can buy shares of companies that deal, for example, with the extraction of raw materials, such as the Polish KGHM (KGH.PL), which is strongly correlated with copper prices, or Shell (RDSA.UK), very closely related to oil prices. We can also find more “exotic” companies which operate on markets that are not easily accessible through contracts such as Lithium Americas Corp. (LAC.US) which is correlated with lithium prices, or Cheniere Energy (LNG.US) related to LNG gas.
How long the upward move may last?
Commodity growth cycles can last for even 10-years. Theoretically, recent bottom occured at the beginning of pandemic in March 2020. This would mean that we are only at the very beginning of the uptrend. Of course, rampant inflation can also lead to a recession which could push commodity prices lower. Another factor to watch out for are rising interest rates, which could make bonds a relatively safe and profitable investment. However, it should be remembered that the prices of raw materials are influenced by many factors that may lead to the continuation of the current trends for many years to come.
The share of energy commodities in the global GDP is really high and has been growing in recent years, which indicates that changes in the prices of this asset class may have a significant impact on the inflation in the near future. The prices of some commodities are approaching their all-time highs, however the most important ones are still well below their record levels. Source: Bloomberg, XTB