A key argument used to sell commodities to investors ranging from large money managers to high net worth individuals is that commodities provide a good inflation hedge. Two main theses cited to support this view are:
1. The introduction of a long position in commodities provides inflation protection in a traditional portfolio of bonds and stocks due to the negative correlation between interest rates and commodity prices. This negative correlation results from the "usual" transmission mechanism of interest rates which central banks raise in response to the rising threat of inflation from higher commodity prices. In an environment where the world's dominant central bank and protector of the world's reserve currency, otherwise known as the Fed, pursues interest rate policy which relies on an inflation index which specifically EXCLUDES commodity prices, then this very same transmission mechanism is of course broken. Given that a significant proportion of the worlds tradable financial assets are either in dollars or move sympathetically to dollar assets, the traditional argument for including commodities in an investment portfolio is, to put it mildly, utterly flawed.
2. Euphoric commodity bulls in extremis also suggest that when (not if) Armageddon finally arrives and paper money is worthless as a means to purchase goods, commodity indices will rule the day. We should therefore all be invested heavily in commodity indices and bull notes and warrants. These commodity bulls are confused. In particular they are confusing the ownership of physical food and energy with ownership of financial assets linked to commodities prices. If Armageddon ever arrives, take it from me, you will not be able to fill your car up with an oil-linked bull note. And furthermore, it would almost certainly be useless to go back to the bank who sold you these commodity bull notes and indices, to get them to pay for your hyperinflated food at the supermarket, as in a Armageddon type scenario that bank might have ceased to exist or at the very least defaulted on its financial obligations.
Who is to blame for putting forward the faulty logic and driving flows into commodities markets? You have guessed it. Wall Steet.
Michael Lewis has written a very good new book, the Big Short. I recommend anyone who is following the advice of a Wall Street salesperson, or is considering investment in sexy new investment products linked to commodities, should read it as a stark warning of what can happen when you blindly follow the advice and allure of fast talking bankers. CDOs used to be the sexy new products and they were considered a one way bet. Today the one way bet is of course commodities. When you can retire with a large bonus after a single and successful year of dumping toxic waste onto unsuspecting investors by relying on misleading and faulty logic, new bubbles no doubt will keep emerging and then blowing up on a regular basis.