No, Copper Doesn’t Diagnose Economic Health

The doctor is in—Doctor Copper, that is. The metaphorical Economics PhD with an allegedly uncanny forecasting ability is back in headlines this month, as many commentators we follow argue copper prices’ recent slide signals a nasty recession looms. Yet in our experience, copper’s record as a leading indicator is pretty spotty. We don’t recommend relying on it to determine what the economy is up to.

The case for copper’s prescience might seem intuitive. Proponents of copper’s prescience argue that a humming economy will have widespread construction of homes, offices, factories, warehouses and stores—driving demand for copper, which is a key construction component. Therefore, if copper prices drop, it allegedly signals falling demand, which means construction is down, which means the economy is sagging.

In our view, this logic doesn’t really hold up in developed-world economies, where services are much more important to growth than construction and physical goods.^[i] Many decades ago, when heavy industry and infrastructure had larger economic roles, we think it made sense to view copper as a leading indicator.^[ii] When pioneering the Leading Economic Index (LEI) in 1938, economists Wesley C. Mitchell (founder of the National Bureau of Economic Research, which dates US business cycles) and Arthur Burns included copper on their initial list of the most telling components.^[iii] But by the time LEI was reconfigured in 1950, copper was out.^[iv] The more growth came from services and intellectual property, the less of a role copper appeared to play.

Don’t take our word for it, though. Exhibit 1 shows monthly copper prices since modern data begin in 1987, with American recessions shaded. We use US data, as America has the largest developed-world economy, making it illustrative for global purposes.^[v] As you will see, whilst copper fell just before recessions (periods of broadly declining economic activity) in 2001 and 2008, it rose just before 1990’s recession and 2020’s lockdown-induced decline. Moreover, there are several drops that occurred nowhere close to a recession. We think it is fair to say 1994 – 1998 was a smashing time for the US economy, with robust growth and booming information technology.^[vi] The multiyear slide off mid-2011’s record high occurred during a record-long economic expansion.^[vii] Anyone heeding Dr. Copper’s supposed signals at these times would have missed significant stock returns.^[viii]

Exhibit 1: Dr. Copper Seemingly Tells a Whopper

Source: FactSet, as of 19/7/2022. Copper spot price, month-end, 30/6/1987 – 30/6/2022. Recession dating from the National Bureau of Economic Research.

The central fallacy underlying Dr. Copper is pretty simple, in our view: Commodity prices move on supply as well as demand. In our experience, the general commodity price life cycle goes like this: High prices drive investment in new mines. A lot of it. New mines take years to come online, so supply remains short in the near term, keeping prices elevated—and incentivising even more investment. Eventually, new mines come online, helping prices ease. And then more, and more, and more, as all the prior investments come to fruition. Soon there is a supply glut, which tanks prices, leading miners to cut costs drastically. That eventually brings a supply shortage, which raises prices, which starts the cycle anew. We think the early-to-mid 2010s’ slide is a prominent example of this so-called supercycle—it took several years for the supply glut to work its way through the system, laying the groundwork for the recovery in the decade’s latter half.

Now, in our experience, copper is also prone to sharp sentiment-fuelled moves—like all liquid assets. For a while now, we have observed sentiment toward China’s economy influencing copper prices at times, due in large part to construction and infrastructure’s relatively larger role there.^[ix] So when commentators warn of potentially severe economic trouble in China, copper can take a hit. We suspect this bears much of the blame for copper’s recent slide, which coincides with China’s Omicron lockdowns sending its economy on a downward spiral—fuelling headlines globally.^[x] Note, too, that this followed an early-year spike, as depicted in Exhibit 1, which we think was part of a global commodity price jump spurred by warnings that the war in Ukraine would disrupt commodity supply chains and spark shortages.^[xi] Those warnings have now eased, bringing all commodity prices down—with copper seemingly getting an extra hit from negative sentiment toward China’s economy.^[xii] We think this fade should as the economic recovery there takes root.

Even if you don’t accept our argument, we don’t think that is a case for basing portfolio positioning on an economic forecast that derives from copper’s drop. In our view, all similarly liquid assets—copper included—digest information simultaneously. Therefore, whatever copper has been pricing in this year, we think stocks have also been pricing it in. There is no edge there, in our view. Considering both copper and stocks have struggled, it seems fair to reason that economic concerns are registered in prices already.^[xiii] So if the US or other developed-world economies are in a shallow recession, we think there is a high likelihood stocks have already dealt with it to a very great degree. In our view, it would take something much deeper than what stocks have already priced in to cause deep declines from here. We don’t think that is probable at the moment, but if it does become a greater risk, we suggest not relying on copper to tell you.