With diverse drivers such as an ever-increasing population and changes in food consumption, agricultural commodities are looking a good bet - but which is best: equities, or the commodities themselves? Cherry Reynard investigates
The soaring prices of agricultural commodities have created worldwide fears over food shortages and inflation. At a time when the potential of rival asset classes looks lacklustre, investing in agricultural commodities promises big gains. But there have been rumours of excessive speculation in this type of commodity, which have led to doubts about the sustainability of prices.
So are agricultural price rises a short or long-term trend? And if prices are sustainable, should investors buy into the commodities themselves or into commodities companies?
Short and long-term drivers
There is no question that some agricultural commodities have seen phenomenal price rises over the past year. Corn is up 69.94% over the last 12 months; wheat is up 66.08%; and soybeans are up 79% (prices to 12 May, source: Financial Times). In general, the prices peaked in March and have weakened subsequently. Henry Boucher, manager of the Sarasin AgriSar fund, says this is typical of the way agricultural commodity prices tend to behave. They were flat from 1940 to 1973, then shot up in the 1970s. They were then fairly stable until the current round of price rises.
These recent price rises have had short and long-term drivers. Boucher says: "Rising energy costs have been an important factor. Agricultural commodities are very energy-dependent because they use machinery and fertiliser is made out of gas."
Gonzalo Baranda, investment marketing manager at JPMorgan Asset Management, says: "More recently, we've seen massive interest from many investors in this asset class because it offers some protection against a falling dollar." Many investors have also seen the wider commodities market as a hedge against inflation.
Climate change has been another factor. Australia has seen a two-year drought. More extreme weather conditions elsewhere have destroyed crops. Swathes of land have also been given over to biofuels as governments try to ensure a secure energy supply in the face of a rising oil price. Ashok Shah, chief investment officer at London & Capital, says: "Once you start to use food as an energy replacement, you get an increased correlation between food and oil."
Boucher believes all these factors could be reversed fairly quickly. Shah points out that agricultural prices may fall as policies giving farmers incentives not to grow certain types of food are unwound.
However, both Shah and Boucher believe there are major long-term trends in favour of higher agricultural commodity prices: global population growth has accelerated, with an additional one billion people on the planet over the past 12 years.
Boucher adds: "Most of these new mouths are in the developing world. Therefore, there is also a gearing factor whereby these countries are moving to richer diets - they are becoming more indulgent; they are eating more fresh food and more processed food. Global food demand was rising at 1.5-2% from the 1960s to 2003/04. It is now more like 2.5-3%."
This shift has significant consequences. Baranda points to higher inflation, which is curtailing central banks' ability to cut interest rates at a time of weak growth. There will be a shift in the balance of power to commodity exporters, who will be able to build up strong reserves, away from commodity importers who will see balance of payment deficits increase.
Ultimately, Boucher believes solutions will emerge as more land is put to work and productivity improves. Boucher says that the AgriSar fund will invest in companies that are developing these solutions. This is the choice for many investors: to invest directly in the commodity itself through, for example, the burgeoning exchange-traded funds (ETF) market, or to invest in funds that aim to take advantage of agricultural companies and the wider trends.
Boucher is firmly on the side of active management. He says: "The speculative activity is in buying the commodities direct. You are only ever buying this year's crop, and agricultural prices are very volatile. In buying agricultural equities, you can spread out the risk across a huge spectrum - from 'field to fork'. Also, with direct commodities you are confined to those traded on the Chicago Mercantile Exchange, which excludes, for example, rice or fish. This is the narrow part of the story, and it is hugely over-hyped."
Shah believes the situation is less clear-cut. He says: "Both the commodities themselves and agricultural stocks can be extremely volatile. They are good for portfolios in small measures, but a bad idea in large measures." That said, he prefers to focus on a range of stocks such as distribution and transportation.
Agricultural commodities have hit a sweet spot. While prices are likely to remain high by historic standards thanks to long-term drivers such as population growth and changing consumption habits, the short-term drivers - such as market speculation, weak farming policies and weather conditions - could change quickly and exert downward pressure. Ongoing volatility is the only certainty and, as such, investors should spread their risk by investing across the spectrum of agricultural commodity companies rather than solely in the commodities themselves.
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From 1 March