Commodities as Cycle Signals

Why Commodities Signal Economic Cycles

Commodities occupy a unique position in the economic system. Unlike financial assets that represent claims on future cash flows, commodities are physical goods consumed in economic activity. Their prices respond directly to changes in supply and demand, making them real-time indicators of global economic conditions.

When industrial activity expands, demand for raw materials rises, pushing commodity prices higher. When economic activity contracts, demand falls, and commodity prices typically decline. This relationship creates a feedback loop where commodity prices both reflect and influence economic conditions.

Different commodities serve as signals for different aspects of economic activity. Industrial metals like copper respond to manufacturing and construction demand. Energy commodities like crude oil respond to transportation and industrial activity. Precious metals like gold respond to risk sentiment and inflation expectations. Understanding what each commodity tells you, and equally important, what it does not tell you, helps investors interpret these signals correctly.

Copper: The Doctor with a PhD in Economics

Copper earned the nickname "Dr. Copper" for its reputation as a leading economic indicator. The metal's widespread industrial applications, from construction and electronics to transportation and power generation, make it particularly sensitive to global manufacturing activity.

Why Copper Works as an Indicator

Copper demand is heavily concentrated in economically sensitive sectors:

When these sectors expand, copper demand and prices rise. When they contract, copper prices fall. The metal has limited substitutes in most applications, making demand relatively inelastic to price changes over short periods.

China consumes approximately 50% of global copper production, making Chinese economic activity the dominant driver of copper demand. This concentration means copper prices often serve as a real-time gauge of Chinese construction and manufacturing activity, which in turn affects global growth.

Historical Performance as an Indicator

Copper has provided useful signals at several major turning points:

2007-2008: Copper peaked in July 2008 at $4.08 per pound, approximately four months before the S&P 500 peaked in October 2008. The metal had been warning of demand weakness before equity markets fully priced in recession risk.

2011: Copper peaked in February 2011 at $4.62 per pound and then entered a prolonged decline, foreshadowing the global manufacturing slowdown that became evident later that year.

2020: Copper bottomed in March 2020 at $2.10 per pound and then staged a dramatic recovery, signaling the post-COVID manufacturing rebound before many economic data series confirmed it.

2022: Copper peaked in March 2022 at $4.94 per pound and declined through the year, reflecting weakening Chinese demand and global growth concerns.

Limitations of Dr. Copper

Copper's diagnostic value has limits:

Supply disruptions: Strikes, mine closures, and logistical problems can move copper prices independent of demand conditions. Chile and Peru produce approximately 40% of global copper, making supply vulnerable to political and operational disruptions.

Chinese stimulus: China's ability to boost construction and infrastructure spending can create demand surges that mask underlying global weakness.

Structural demand shifts: The energy transition and electric vehicle adoption may create persistent copper demand growth that complicates cyclical interpretation.

Financialization: Increased commodity investment and speculation can introduce volatility unrelated to physical demand.

Oil: Global Growth in a Barrel

Crude oil prices respond to global transportation and industrial demand, making them useful indicators of economic activity. However, oil's complex supply dynamics require careful interpretation.

The Demand Signal

Global oil demand runs approximately 100 million barrels per day. Transportation accounts for roughly 60% of demand, with road transportation dominant. Industrial uses account for approximately 25%, while residential and commercial heating represents most of the remainder.

Oil demand growth correlates strongly with global GDP growth. The International Energy Agency (IEA) estimates that a 1% increase in global GDP typically produces 0.3-0.5% growth in oil demand. This relationship means oil prices often reflect and anticipate global growth trajectories.

Supply Complications

Unlike copper, oil supply responds actively to price signals and OPEC production decisions. This creates interpretation challenges:

OPEC management: The Organization of Petroleum Exporting Countries (OPEC) and its allies (OPEC+) actively manage production to influence prices. Supply cuts can support prices even during weak demand, masking economic signals.

US shale response: US shale producers can increase production relatively quickly in response to higher prices, dampening price rallies and obscuring demand signals.

Geopolitical disruptions: Conflicts, sanctions, and political instability in oil-producing regions can create supply-driven price spikes unrelated to demand conditions. The 2022 surge to $130 per barrel reflected Russia-Ukraine conflict supply fears as much as demand strength.

Using Oil Prices Effectively

To extract demand signals from oil prices:

Monitor inventory data: Rising inventories despite stable prices suggest softening demand. Falling inventories during price declines suggest supply is the issue.

Track refining margins: Crack spreads (the difference between crude oil prices and refined product prices) indicate end-use demand. Strong crack spreads suggest robust product demand.

Compare with other industrial commodities: If copper and industrial metals are falling while oil holds steady, supply management rather than demand strength likely explains oil's resilience.

Watch OPEC announcements: Production cut announcements during price weakness confirm that demand is soft and producers are responding.

Gold: The Risk and Inflation Signal

Gold occupies a distinct position in the commodity complex. Unlike copper or oil, gold has limited industrial applications. Approximately 50% of gold demand comes from jewelry, 25% from investment, 15% from central bank purchases, and 10% from industrial uses.

Gold as a Risk-Off Indicator

Gold typically performs well during risk-off episodes when investors seek safe-haven assets. The metal has no counterparty risk (unlike Treasury bonds, which depend on government creditworthiness) and has maintained purchasing power over centuries.

Key risk-off episodes where gold performed:

Gold's risk-off behavior is not perfectly reliable. During severe liquidity crises, investors may sell gold to raise cash, as occurred briefly in March 2020. Gold also responds to real interest rates, so rising rates during risk-off episodes can offset safe-haven demand.

Gold as an Inflation Signal

Gold has historically served as an inflation hedge, maintaining purchasing power when fiat currencies depreciate. However, the relationship is more nuanced than commonly understood.

Gold responds primarily to real interest rates (nominal rates minus inflation expectations). When real rates are negative, holding non-yielding gold becomes relatively attractive. When real rates are positive and rising, gold typically underperforms.

The 2022-2023 period illustrated this dynamic. Despite elevated inflation, gold struggled as the Federal Reserve aggressively raised rates, pushing real rates from negative to positive territory. The 10-year Treasury Inflation-Protected Securities (TIPS) yield rose from -1.0% to +2.5%, creating significant headwinds for gold.

Using Gold Signals

Gold provides the most useful cycle signals when:

• Real rates are moving significantly in either direction
• Flight-to-quality flows are evident in other safe-haven assets
• Central bank demand is stable (not distorting the signal)
• Currency movements confirm the thesis (weak dollar typically supports gold)

The copper-to-gold ratio offers a particularly useful cycle signal. When copper outperforms gold, risk appetite and growth expectations are strong. When gold outperforms copper, defensive positioning and growth concerns dominate.

Commodity Indexes and Cycle Timing

Broad commodity indexes aggregate the signals from individual commodities, providing a comprehensive view of real economy demand.

Major Commodity Indexes

Energy-heavy indexes like the S&P GSCI are more volatile and heavily influenced by oil price movements. Broader indexes like the Bloomberg Commodity Index provide more diversified signals but may lag turning points.

Commodity Cycles and Economic Cycles

Commodities typically exhibit the following pattern relative to economic cycles:

Early expansion: Commodities begin recovering as demand picks up. Inventories draw down, supporting prices. Industrial metals often lead.

Mid-expansion: Commodity prices rise steadily as demand growth outpaces supply additions. Energy prices typically catch up to industrial metals performance.

Late expansion: Commodity prices may spike as capacity constraints bind. Inflationary pressures become evident. Gold may outperform as inflation concerns rise.

Recession: Commodity prices fall sharply as demand collapses. Energy and industrial metals typically decline most. Gold may outperform on safe-haven demand.

The 2020-2022 commodity cycle illustrated this pattern in compressed form. Commodities bottomed in April 2020, rallied through 2021, spiked in early 2022, and then corrected through late 2022 as recession fears mounted.

Practical Application

To use commodity indexes for cycle timing:

Track 12-month momentum: Rising commodity index momentum suggests strengthening growth. Falling momentum suggests weakening growth.

Compare to equity performance: When commodities outperform equities, late-cycle inflationary conditions may be developing. When equities outperform commodities, disinflationary conditions may prevail.

Monitor inventory data: Commodity inventory reports from the DOE (energy), LME (metals), and USDA (agriculture) provide demand confirmation.

Watch the contango/backwardation structure: Futures curves in backwardation (near-term prices above long-term prices) indicate tight supply conditions. Contango (near-term prices below long-term prices) indicates ample supply and weak demand.

Building a Commodity Signal Checklist

Synthesize commodity signals into a structured monitoring framework:

Weekly Monitoring Checklist

1. Copper price and 50-day trend: Rising trend supports growth outlook; falling trend raises caution
2. Oil price relative to OPEC supply announcements: Distinguish demand signals from supply management
3. Copper-to-gold ratio direction: Rising ratio confirms risk-on; falling ratio confirms risk-off
4. Bloomberg Commodity Index momentum: Compare to 200-day moving average for trend
5. LME inventory trends: Rising inventories signal demand weakness

Signal Interpretation Table

Integration with Other Indicators

Commodity signals gain credibility when confirmed by:

• PMI manufacturing surveys showing similar trends
• Freight and shipping rates moving directionally with commodities
• Credit spreads moving inversely (tighter spreads with rising commodities)
• Emerging market currencies strengthening with rising commodities

Commodity signals should prompt questions, not automatic allocation changes. When copper falls 15% while other risk assets hold steady, investigate further before concluding that copper is correct and other markets are wrong.

Key Takeaways

• Copper ("Dr. Copper") responds to global manufacturing and construction demand, providing a real-time growth signal
• Oil demand correlates with global GDP, but supply management by OPEC complicates interpretation
• Gold serves as a risk-off indicator and responds to real interest rates, not nominal inflation alone
• The copper-to-gold ratio offers a useful growth vs. safety sentiment gauge
• Commodity indexes aggregate signals but vary significantly in energy weighting
• Combine commodity signals with inventory data, shipping rates, and manufacturing surveys for confirmation
• Supply disruptions and financialization can distort commodity signals from underlying demand fundamentals
• Use commodities as context for economic cycle positioning, not as timing triggers for allocation changes