The Best Commodities To Hedge Inflation

February 01, 2010

Sure, you've heard commodities make a good hedge against inflation—but which ones? We run the numbers and find a few surprises.
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"Commodities are a hedge against inflation!" We've all heard the advice—and if we say it often enough, then it must be true. But while commodities are a market most investors should have at least some exposure to, claiming the entire asset class will act as a strong inflation hedge is seriously misleading. But hey, I suppose it makes a nice little sound bite.

Of course, to some degree, commodities as a whole are a hedge against inflation, insofar as any useful thing will have some functional worth, regardless of the currency in which it's priced. But when it comes to inflation hedging, not all commodities are created equal.

So which commodity—or class of commodity—actually provides the best hedge against U.S. dollar inflation?

 

Hedging By The Numbers

To answer this question, I've selected a representative commodity from each of the most common categories—energy, softs, grains, metals, livestock and even lumber—and run a full regression analysis, comparing their daily prices with the U.S. dollar/Swiss franc exchange rate over the last five years (2005 - present).[1] (Why the USD/CHF exchange rate? Of all the possible currency pairs, I think USD/CHF acts as the best gauge of the worth of the U.S. dollar, given the stability of the Swiss economy, coupled with its rock-solid banking industry and high global economic standing.)

For the statistically un-inclined, "R_squared" is a measure of the extent to which the change in value of one factor can be explained by the change in value of another. In this case, it tells us how much of the returns for our representative commodities can be explained by their correlation to the dollar. (A negative correlation, by the way, implies that one factor goes up when the other declines, while a positive value means the two move in the same direction. No correlation means the values move independently of each other.)

One thing to keep in mind, however, is that both currencies and commodities tend to possess cyclical, time-series correlations. So you shouldn't take this analysis to mean that commodity x and commodity y are and will forever be correlated to the dollar by some set amount. Instead, this analysis should offer a general base of comparison between the commodities themselves.

Take a look at the results, and see for yourself which commodities truly do provide the best inflation hedge.

 

Energy

Representative: Crude Oil

Correlation Type: Negative

R_Squared: 0.3119

 

Gold

Surprised? So was I. Given the much-ballyhooed oil-dollar link, I fully expected the two to exhibit a much closer statistical relationship.

However, previous analyses I've done comparing oil prices to the dollar have revealed that the oil-dollar correlation has grown much stronger throughout 2008 and 2009 (which offered R_Squareds of .5692 and .8374, respectively). This may be due, at least in part, to a changing global economic climate; as emerging powers modernize, they are bound to consume more oil.

Therefore, although oil may not have been the best inflation hedge for most of the previous decade, as oil becomes a more important ingredient in the vitality of emerging economies, such as China and India, look for this relationship to strengthen.

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