In a Major Recession, Will Commodities Hold Up?
March 7, 2008
The biggest breakthrough in economic theory since Adam Smith was the discovery by Carl Menger in 1871 that costs do not set prices. Competing bids for resources set prices. These bids are based on the producers' expectations of consumer demand.
In other words, what producers think consumers will pay is what sets factor prices. If consumers are expected to pay more and buy more, the prices of those goods and services that produce consumer goods will rise. This is a result of expected future consumer demand. The capital markets are not independent of consumer demand. Consumer prices don't rise because costs of production have risen. Costs of production have risen because of expectations regarding rising consumer demand.
When these expectations turn out to be false, and consumer demand concentrates on necessities, those sectors of the economy that were aimed at consumers' discretionary spending go into decline. We call this decline a recession.
There are investors these days who expect recession. They have shorted the stock market. They have reduced their debt. They have built up near-cash reserves: bank savings, money market funds, and foreign currencies.
What about commodities? Are these a safe haven? Historically, they have suffered greatly in recessions. When demand for final products falls in most sectors, the prices of raw materials fall.
Rising wages are squeezing profits. So is the rising cost of energy. Then demand falls. Businesses stop buying anything that is not vital to immediate production. This includes commodities.
I do not expect the commodities boom to survive 2008. If a commodity is used in production, and production declines for lack of consumer demand, what will hold up the price of that commodity?