The farming sector is rejuvenating, says BlackRock’s Cheung
Desmond Cheung, portfolio manager and member of BlackRock’s Natural Resources Equities Team, comments on the implications food price inflation has for investors and how agricultural equities are a suitable hedge.
Much has been said about the food price volatility arising from the export ban of wheat imposed by Russia in 2010 and the drought in the US in 2012, to the extent that the rise of food prices might appear like a phenomenon that fades away when the disruption on supply subsides. This first impression could turn us away from the real long-term issue.
Taking a glance at the evolution of prices of different food categories over the last 25 years, there is a clear pattern that all types of foodstuffs have gone through an upward trending trajectory. At times, the trend was exacerbated by price spikes during periods of supply disruption. While prices tend to moderate from sharp spikes, they have been making ‘higher-lows’ over time.
Demand-driven food price inflation
First and foremost, long-term food price inflation is driven by consumption growth on a global scale. Demand for food has exhibited consistent growth through different economic times. For instance, grains and meat demand has continued to grow steadily in the last few years in spite of the global economy being under pressure.
The resilience of growth in food demand goes beyond its nature as non-discretionary spending and driven by several structural factors:
• Global population is projected to grow from 7bn today to 9.6bn by 2050. To put that into context, food supply will need to increase every year for the next 35 by almost the same volume as is required to feed the entire United Kingdom.
• The rising income of consumers in emerging markets has created a wealth effect on food consumption and has fuelled the growth of demand for protein, ranging from meat, fish to dairy products. Production of protein is far more resource-intensive. For instance, to produce a kilogram of beef would require feeding eight kilograms of grains to cattle. The appetite for protein consumption can only be met by an even steeper increase in grain production.
• Biofuel production has created demand for food from non-food sectors. Having gone through a substantial investment cycle, the sector has become scalable and, in some cases, economically viable without government subsidies, therefore creating a stable demand base for grains and cereals that compete with the already rising food demand.
Uncertainty around supply growth
Unlike the consistent growth of food demand, the path of supply growth has been less dependable. While we often attribute fluctuation in food production to the unpredictable weather, there are fundamental reasons why food production is challenged with uncertainty.
• Annual crop yields have been going up, but at a slower rate compared to the last few decades. In the past, when the farming sector started to adopt modern technology in the Green Revolution during the 1970s, the industry was able to deliver an annual yield gain as high as 2-3%. Now that these technologies have become more commonly adopted, the incremental yield gain has dropped to 1% or below per year.
• Globally, farming area has been expanded, but into territories of lower and more volatile yield. While Eastern Europe, South America and Asia have opened up new land and become more important crop producers, crop yields in these countries remain lower than North America and Western Europe due to the less sophisticated agronomic practices and under-investment in the soil over the past few decades. Therefore, the resilience of crops to withstand harsh weather tends to be lower. This has led to further variability in crop supply, particularly in the newly developed farming regions.
Combining the persistent demand growth for food and the less dependable supply growth, the world has drawn down food inventory, both in terms of grains and meat. The lower inventory level reduces our ability to absorb supply shocks arising from weather and trade restrictions, therefore leaving consumers more exposed to the risk of price spikes.
Why food price inflation matters
Food price inflation also has implications for investors. For investors with exposure to emerging markets, the significance of food inflation in the consumer price index (CPI) calculation and the proportion of income spent on food can have an impact on government policies and the ability of consumers to spend. Beyond that, the uncertainty on food input costs creates challenges to food companies’ earnings.
Agricultural equities: A hedge against food price inflation
The significant impact and persistent nature of long-term food price inflation is a risk that we are concerned about. Fortunately, a crop of companies has developed in the farming industry and it has become an investable sector that offers a proxy to food price inflation.
As farming has become more profitable, driven by the need to supply more food to cope with rising consumer demand, agricultural companies have built businesses along the supply chain to serve the needs of farmers and consumers. On one hand, the upstream companies provide products and solutions, such as seeds and fertilisers, to farmers to help them to improve productivity. On the other hand, companies in the midstream and downstream sectors have invested in supply chain assets and food technology to deliver food supply from farming regions to the hands of urban consumers.
Over time, we observe a strong positive correlation between agricultural equities and food price inflation. More interesting still, while food prices spike and subside around episodes of supply disruption, companies in the sector as a whole have outperformed the performance of the food commodities over the long term. This highlights the ability of companies to create value for shareholders by carefully investing in strategic assets and intellectual property, thus delivering long-term growth for investors.
It may be the oldest of industries in human civilisation, but the farming sector is rejuvenating, presenting opportunities for long-term thinking investors.