The View Through Copper Colored Glasses

If you own a sailboat you know that copper infused paint protects the hull of your boat from barnacles. Plumbers like copper because it kills bacteria. Copper may also be good for your portfolio. To understand why, we need to keep in mind the method the National Bureau of Economic Research uses to define recessions.

The NBER waits until after GDP falls for two consecutive quarters. The lowest quarter becomes the bottom or end of the recession. The next quarter is the beginning of the recovery. Then the NBER gnomes crawl backwards through the data to find the most recent peak of GDP growth. The quarter after marks the beginning of the recession. So we don’t officially learn that we are in a recession until the recovery starts, sometimes 18 months after the recession has begun.

We could be in a recession right now and won’t get confirmation until long after it is all over. That’s why we need forward looking indicators. A popular one is the price of copper, sometime called “Dr. Copper” according to Brian McRae of Bloomberg:

The nickname originates from analyst consensus that the price of copper often diagnoses the health and well-being of the global economic climate...Oil has plummeted from over $100 to the $80 level recently. Grain prices plunged over the summer. Iron ore and steel prices have sunk... In 2013, total global copper production was 13.8 million tons. The World Bureau of Metal Statistics reported a 296,433-ton deficit in the first half of 2014. Goldman Sachs expects the supply gap to reach 2 million tons in 2018. Production costs are on the rise... copper has been one of the worst performing base metals on the London Metal Exchange. Copper is down almost 10% so far in 2014 while metals like aluminum, zinc and nickel have posted price gains.

So in spite of the shortage of copper, copper prices have been falling. If copper is an honest indicator of the state of the world economy, then it’s possible the next recession to be unveiled by the NBER began last quarter. Mises confirmed the importance of raw material prices to the ABCT:

Technological conditions make it necessary to start an expansion of production by expanding first the size of the plants producing the goods of those orders which are farthest removed from the finished consumers' goods. In order to expand the production of shoes, clothes, motorcars, furniture, houses, one must begin with increasing the production of iron, steel, copper, and other such goods. (Human Action, 557)

Warren Buffet once said that some things take time. You can’t produce a baby in one month by getting nine women pregnant. Unlike mainstream economists who expunge time from their models and minds, Austrian economists understand that some things take time. If Apple wants to expand I-phone production, it must begin with the raw materials used to make the components.

Hayek added that raw materials prices help us to peak into the foggy future:

The undoubted fact here is that during the upswing of the cycle raw material prices rise more than the prices of consumers' goods... a rise in the price of raw materials will not only decrease the demand for both labour and machinery, but will also discriminate against the latter because it will at the same time raise the cost of machinery... This means that as the demand for machinery falls in terms of consumers' goods and the prices of consumers' goods fall in terms of raw materials, the producers of machinery...will be caught between falling prices of their products and rising costs, and will have to curtail production... It should perhaps be added here that owing to the great fluctuations in raw material prices the Ricardo Effect is likely to be particularly important through its effect on the demand for capital goods on the part of the raw material industries. (Profits, Interest and Investment 29-31)

In other words, producers of capital equipment lose business because consumer goods makers are using more labor and buying less equipment. That is the Ricardo Effect. At the same time, the prices of raw materials used to make equipment rise until equipment makers scale back on production. But when they scale back, demand for raw materials falls and prices follow. Then mining companies amplify the cycle by reducing their purchases of equipment. Capital equipment makers are caught in the middle between raw material producers (mining companies) and consumer goods makers and suffer from both sides.

Keep in mind that the nominal prices of raw materials may not rise because productivity increases may mask them. A “real” measure of inflation should adjust for productivity increases. That’s ironic because we deflate nominal GDP by the inflation rate in order to arrive at real GDP, but the inflation rate needs adjusting as well. Still, as Hayek pointed out, the real issue is the fall of raw material prices in terms of consumer goods, not in terms of their prices last year. That’s a harder concept to bend our minds around, but I think we can safely say that if raw materials prices are falling while the prices of consumer goods are rising we have met Hayek’s criteria.

Finally, Ludwig Lachmann added this:

There can be little doubt that in history strong booms have ‘hit the ceiling’, i.e. been checked by a scarcity of resources. But where are we to look for the manifestations of scarcity? We suggest that, historically speaking, they are primarily to be found in the sphere of industrial raw materials, that in the past the raw material ceiling has been the sectional ceiling of crucial importance.  (Capital and its Structure 105)

Until the NBER unveils the latest recession after it’s over, mainstream pundits will trip over each other assuring everyone that the economy looks strong and there is no chance we’re headed into a recession. But long before the NBER enlightens us, the stock market will have fallen considerably. Wise investors need to get out long before.