Friday, October 1, 1999
After a 45-minute jog/walk in the sweltering heat that gripped most of the nation this summer, I could have wrung a bucketful of water out of my T-shirt. Was it La Nina, little sister to El Nino, causing this heat wave? President Clinton’s agriculture department declared five states surrounding West Virginia a disaster region. Forecasts report agricultural fields in the Ohio valley will face the worst drought in the last 30 years. The financial and commodities markets, as usual, anticipated some of this. Agricultural commodities, that is, grains like soybeans, corn and wheat have been going up in prices on the Chicago Board of Trade. Is this the beginning of a new trend? Most commodities, in general, have been in a secular downtrend since the second oil price shock in 1979 and the peak in gold prices in the early 80s.
Attack on Inflation
After Paul Volcker, former Chairman of the Federal Reserve, declared war on inflation in late 1979, central bankers around the world attempted to stop the inflationary spiral. Inflation is seen when commodities and other goods’ prices go up, as well as when wages and benefit costs spike. Volker wanted to attack inflation using tight monetary policy, a policy continued by Alan Greenspan after he became Chairman in 1987.
Geopolitical Shifts
In the past decade, with the fall of communism and the investment boom in Asia as well as in the rest of the world, the global capacity to produce goods has increased tremendously. We have almost three billion people to the global labor force — in India, China and the ex-Communist world, where economies are being liberalized. With this new production capacity, supply of commodities from the Communist world and a cheap labor pool, the overall inflation around the world came down. This downtrend has been more pronounced in the developed world, which benefits from goods exported by the developing world. Plummeting inflation had a direct impact on the global commodities markets, as prices of gold, oil, copper and grains have all come down over the past 20 years. In fact, the price of oil on an inflation adjusted basis, is at its lowest in almost 30 years. US inflation is at its lowest level since the ‘60s, while the economy has been buoyant.
The US Economy
Although old economic textbooks put the long-term rate of growth of the US economy at around 2.5 percent, the US economy has grown well over 3.5 to 4 percent over the past few years. This high level of growth should inevitably lead to inflation. Still, inflation over the past few years has averaged between only 1 and 2 percent — well below the 10 percent inflation seen in the late 1970s, and even significantly less than the approximate 5 percent of the late 1980s.
From time to time, Chairman Greenspan has warned that such conditions may not last long. Planning to tighten monetary conditions in 1997, he raised the interest rate in March of that year. However, the Asian crisis in mid-1997 and the Russian debt default last August as well as fragile financial markets restrained the Fed from further tightening conditions.
Now however, things seem to be changing. Recently, the Employment Cost Index (ECI), an economic indicator watched closely by Greenspan and Co., showed a rise of 1.2 percent over the previous month – its highest jump since early 1992! Oil has been rising, too. The heat and the anticipated drought are lifting the grains. The world seems to be recovering from its economic downturn — at least judging from the stock markets in Southeast Asia, Japan, Latin America, Europe and the US. Are we going to see return of inflation and therefore rising commodities?
Commodities Make Sense
If the theory of synchronized global recovery is accurate, the commodities should go up, at least modestly. Any sharp rise may be pre-empted by the Federal Reserve tightening. But La Nina, OPEC resolve, and the recent consumer tendency to buy bigger and better merchandise could lead to rising prices. If investors want to diversify their portfolio of bonds and stocks and get some protection against inflation, then commodities make sense.
Commodities trading isn’t for everyone. Almost all commodity markets are “futures” markets where you buy or sell commodities as forward settling contracts. And any change in price of the commodity future is settled daily by the futures exchange. These futures contracts are traded on margin, a small down payment for a large value of the contract. For example, oil is traded as a 40,000-barrel contract. If the price of oil is, say, $20a barrel; the face value of the contract is $800,000. But investors may need to put up only thousands upfront. It’s like buying a $200,000 house with only a 10 percent down payment. But, because the price of oil fluctuates daily, you will have to make up for any of your loss by depositing the difference into your brokerage account (or conversely, your account will be credited with the profit for that day). Same with corn, pork bellies, sugar and even stock index futures and bond futures contracts.
The large amount of leverage associated with commodity futures trading makes the investment in commodities riskier; the higher degree of volatility of prices adds even more risk. You can trade commodities with your stock brokerage firm or with firms that specialize in commodities trading. You can find advertisements for these firms on the commodities pages of most financial newspapers, or on the Web.
Is inflation really creeping up again? If you believe that the new economy is driven by the information revolution where the most important commodities are air, sand and light . . . that is, telecommunication through air; sand (silica) for computers’ silicon chips, and light for transmission through the optical fiber network, then inflation might not go up much. But remember, we still live in the real world.
