Commodities and inflation
A conversation with Ivo Sarjanovic
Good morning, Ivo, and welcome back to Commodity Conversations. First, could you tell us a little about yourself?
I am from Rosario in Argentina. I studied accountancy at university and then did a master's degree in economics. I joined Cargill in 1989 and worked with them for almost 30 years in Rosario, Buenos Aires, Sao Paulo, and Geneva. I was Cargill's world manager for soybeans until 2011, when I moved to sugar and ran Cargill's sugar division. In 2014 we created Alvean, a joint venture company between Cargill and Copersucar. It was the biggest sugar trading company in the world. I was the CEO until I retired in 2017.
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Did you watch the World Cup final – and how do you feel about being world champions?
Yes, we watched it with family and friends. It was a great match. I am very happy for Messi's achievement, which was still missing in his career, and for my children's generation, who are experiencing this joy for the first time.
How do you spend your time now?
I now divide my professional life into three:
I am a non-executive director in various companies, including Sucafina in Switzerland and Adecoagro in Argentina.
I lecture on agriculture and commodities at the University of Geneva, the Universidad Torcuato Di Tella in Buenos Aires, and the Universidad Austral in Rosario.
I devote the final third of my time to venture capital investing in the ag-tech space with Glocal and Hedgit, among others.
You recently published a book, Commodities as an Asset Class, which questions whether commodities can effectively hedge against inflation. What prompted you to write it?
From March 2021, I began seeing a lot of stuff, mostly from investment banks, advising clients to invest in commodities to hedge against inflation.
I discussed the topic with Alan Futerman, one of my students at the Universidad Torcuato di Tella, and we decided to investigate it. We questioned the conventional wisdom of the time, and our research proved we were right to do so. There is little correlation between commodity prices – particularly the general commodity indexes - and inflation.
Is that the case for all commodities?
You can divide commodities into energy, metals/minerals, and agriculture sectors. Energy makes up about 60 per cent of the pie, of which crude oil takes the lion's share at 42 per cent of the total. Agriculture and metals are around 20 per cent each. Speaking about commodities as one class can be misleading.
Today, most people invest in commodities through indexes, of which there are four main ones: DBC, GSCI, CRB, and BCOM. Each of these indexes includes a different number of markets and gives different weightings to each.
So, no correlation at all?
We concluded that energy markets correlate with inflation better than metals/minerals – and that metals/minerals correlate better than agriculture. But the best correlation, even if far from perfect, is with precious metals prices.
We think this may be because agricultural commodities have a faster supply response than others. You can replant your crops each year – and sometimes you can have two crops a year, for example, with wheat and rice in India. However, opening a new mine or oil field can take five to ten years.
The impact of productivity is a factor in agriculture. We have seen faster productivity gains in agriculture than in metals or energy. In real terms, agricultural prices have been in a long-term downtrend since 1960 – so you must ask why an investor would buy commodity crops as an inflation hedge. Purchasing the total income stream (P x Q) - buying shares in producers – allows you to reap the benefits of efficiency gains. It seems a better alternative than buying just the products.
Although the correlation between inflation and commodity prices has been low in the long term - from 1960 to 2021 - there have been specific periods where the correlation is higher. However, that requires an active strategy rather than a passive one. You need to follow the supply and demand of each commodity. And bear in mind that the energy transition path will certainly change relative values in the future.
Did you look at gold and Bitcoin?
Yes, we looked in detail at the correlation between gold and inflation. We concluded that over the last 60 years, precious metals have correlated better with inflation than other commodities. However, this has been less the case over the recent past. Lately, gold prices have not followed inflation as expected.
Why do you think that is?
We think it may be because people have invested in cryptocurrencies rather than gold. At one stage, cryptocurrencies reached a market capitalisation of $3 trillion. Gold has a market capitalisation of around $12 trillion and silver of $1-1.5 trillion. You can make a case that the $3 trillion that went into crypto would have otherwise gone into gold, boosting its price.
We devote the last chapter of our book to Bitcoin. We ask how a monetary system based on Bitcoin might work; is it money - a medium of exchange - or a speculative asset? We concluded that it is the latter; we call it a hyper-liquid collectable. However, other cryptocurrencies may evolve, which have a better monetary function than Bitcoin. It would avoid Bitcoin's trend to monetary disequilibrium due to its supply inelasticity.
How do you deal with different periods? Correlations can depend on when you start and stop the data series.
We started in 1960 to give us a 60-year data set.
We then analysed the data decade by decade. Commodities lost versus inflation in the 1960s. They gained versus inflation in the 1970s, but that was an exceptional period where you had the end of the Bretton Woods Agreement, two oil embargoes, and massive grain shipments to Russia, now characterised as the Great Grain Robbery.
Although commodities were a good hedge in the 1970s, their prices significantly lagged behind inflation during the 1980s and 1990s.
Commodity prices rose dramatically in the 2000-2010 period, but it had nothing to do with inflation. China entered the world market and needed raw materials – energy and metals - to fuel its economic growth. The Chinese began eating more meat, increasing soybean imports for animal feed. It was a big demand pull across the commodity board.
The 2000s also saw the introduction of biofuel mandates, increasing demand for crops beyond food. During the 2010s, commodities lost once again relative to inflation. Remember, inflation was low throughout the first two decades of this century and only picked up during Covid.
We ended the analysis in our book in Q4 2021, but 2022 didn't change anything. For example, agricultural commodity prices are at about the same level now as they were a year ago.
Commodity markets are usually in a carry or contango structure with forward prices higher than spot prices. Long-only investors typically lose out when they roll their positions forward when the spot month expires. How did you take that into account in your analysis?
We also analysed the spot months series, not considering the roll cost. However, I would like to make two points.
First, you have a positive rather than negative roll return when you have an inverted market - where the spot price is higher than the forward price. However, an inverted market is an anomaly in terms of inflation. In an inflationary environment, forward prices should be higher than spot ones.
Second, rolling has nothing to do with inflation. It costs money to store and finance commodity stocks, so you are correct to say the typical structure is a carry or contango. An inverted market – where spot prices are higher than forward prices - suggests genuine scarcity in the spot market, with demand greater than supply. That is a fundamental and not a nominal phenomenon. But in an inflationary environment, you would expect forward prices to be higher than spot prices. It would negatively affect the strategy of going long commodities as a hedge. There is a contradiction there.
It leads me to the difference between correlation and causation. If a mismatch between demand and supply drives inflation, then that mismatch should result in an inverted market.
There is a debate in economic theory as to the causes of inflation. We side with the people who believe that inflation is a monetary phenomenon.
Prices can also rise because of supply factors, but we don't call that inflation. It's a change in relative values. Commodity prices may increase, but they also fall. Inflation is a general and sustained increase in prices. Supply price changes are more specific in time and place.
In the current environment, you could say that loose monetary policy drives 70 per cent of inflation and that supply-side factors drive the other 30 per cent.
How do you arrive at those estimates?
They are more guesstimates than estimates!
Monetary policy has been loose in the US and Europe, and inflation has reached around 10 per cent per year. Switzerland has a more orthodox or balanced approach to monetary policy, and inflation has been running at three per cent per year. I guess the Swiss inflation rate of three per cent reflects real inflation in food and energy prices, while the additional 7 per cent in the US and Europe is the result of their loose monetary policy.
You must also look at how monetary policy has changed over the past two decades. When we had the first big round of quantitative easing following the 2008 financial crisis, most of the increased money supply disappeared into bank reserves or as excess reserves at the Fed. You had a significant expansion in the monetary base, but M2 did not grow proportionally. It resulted in a contraction of the money multiplier. The new money didn't end up in people's pockets.
With Covid, the central banks changed strategy and printed money that ended up with the public – who then spent it. As people couldn't go out or travel because of Covid, they didn't spend their money on services. Instead, they spent it on goods.
The price of lumber is a helpful indicator. It increased as people spent their money on home improvements but collapsed when the economy opened, and people could go to concerts and restaurants again. In addition, rising interest rates are slowing the housing sector, further reducing lumber demand. Lumber prices are lower today than they were before Covid.
Although commodity prices have a weak correlation with inflation, they have a stronger correlation with monetary policy: prices rally when it loosens, and vice versa. It relates to their correlation to tight or loose financial conditions.
How do you incorporate exchange rates into your analysis?
The dollar exchange rate rises when the US monetary authorities increase interest rates, creating commodity headwinds.
Most people follow the US dollar index. It is a basket of six currencies, some of which, like the Swiss Franc and the Swedish Krone, have nothing to do with commodities. Besides, critical currencies like the Chinese Yuan are missing. Maybe we should look at the US dollar against a basket of commodity-exporting and importing countries' currencies, such as Brazil for soybeans and sugar and Chile for copper.
You should look at the US dollar against the currency most relevant to the commodity that you follow.
You mention sugar. I have previously talked with investors who bought sugar as a hedge against US inflation, but they bought the world market and not the US domestic market.
We looked at commodities in terms of US inflation, but there is room to improve that. There is always room to improve everything!
The US CPI, the Consumer Price Index, has changed over time. If we used the 1980s basket, US inflation would be at 20 per cent, not 10 per cent. It means that your commodity-inflation hedge performs even worse. In 1960, US consumers spent an average of 17.5 per cent of their disposable personal income (DPI) on food. This share has now fallen to less than 10 per cent.
In the past, some academics argued that commodities are a hedge for equities and bonds. Did you look at these correlations?
Not specifically, but we looked at how an investment portfolio performed with and without commodities.
And what did you find?
An investment portfolio that includes commodities performs worse than one without them. It negatively affects its returns.
But we are talking here about passive investment. We are against passive investment in commodities, particularly if you have the wrong entry point.
For example, if you had bought commodities in 2010, you would be losing big money today because of lower nominal prices and about 35 per cent inflation since then. The same applies if you had bought commodities a year ago. Some commodity prices today are about the same as a year ago, while inflation has run at 10 per cent, losing money in real terms. The entry-exit point is critical.
If commodities aren't a good inflation hedge, why do financial advisors and banks promote them as such?
I don't know. Maybe they are stuck in the 1970s.
Your message is that you shouldn't invest in commodities; you should trade them.
You can invest in commodities, but the best way to do it is through a hedge fund with a manager you trust – someone with an active strategy that profits from both falling and rising prices.
If you trade in commodities, you must understand the specifics and dynamics of each market. Commodity trading offers many opportunities, both on the long and the short side. And you need to be aware that not all commodity families behave similarly. So, choosing the right product or sector is crucial.
Is there a hedge against inflation? Is it property, equities, or what?
Perhaps inflation-linked bonds. But you must be careful, too, because once interest rates start to increase, their market value will be affected.
How easy is your book to read? Did you write it for students of economics and professional investors, or is it for a wider audience?
We wrote it for a broad audience - for anyone worried about inflation eroding their savings. You can follow the book's logic without delving deeply into mathematics.
Did you enjoy writing the book?
Yes, I enjoyed working on it. It was an excellent experience.
Alan and I finished the first draft in the last quarter of 2021. We were lucky with the timing, as inflation started to kick in at the same time. We spent the summer of 2022 polishing and editing the draft.
When will you write the next one?
I need to think about that. I have lots of ideas.
Which do you prefer – being a trader or a writer/academic?
I am grateful that I have been able to do both. When I was younger, I began a PhD in economics at NYU but had to abandon it for personal reasons. After 30 years of trading, it is time to complete the circle. I find joy in teaching and writing.
Thank you, Ivo, and congratulations on an excellent book.
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