For those prepared to put aside considerations of waistline and wallet in order to enjoy Christmas dining to the full, we should raise a special toast. Not only is their resolve to indulge a welcome change from the caution and anxiety that has gripped the British consumer for so long, but they’re doing so at the end of a year when global food prices have climbed, often to multi-year highs.
Food prices have been increasing for much of 2012 and in the coming decades this will be spurred on by a rapidly rising world population, many of whom will be growing wealthier and therefore eating more meat. This in turn increases demand for grain, which is used as animal feed. For this reason, some investors are putting money into agriculture, farming equipment and food production in order to profit from a long-term global trend. Periodic spikes in food prices reinforce their appetite for so-called “soft commodities.”
Some people, myself included, don’t buy this. It’s worth thinking about food and agricultural commodities as an investment—but mainly because these markets offer outstanding illustrations of the various types of risk that investors end up taking.
For a start, agricultural markets are loaded with political and regulatory risk because food is the ultimate strategic asset. Such is the sensitivity of almost every government to rising food costs (especially since the Arab Spring) that they will intervene to secure supplies or move prices without a second thought. This usually happens when prices are already rising and amplifies the swings in the market: when world grain supplies looked tight this summer due to shortfalls in the US, there were fears that Russia would try to limit exports to ensure its own needs were met. All markets are subject to political risk, but few so nakedly as food.
Second, agricultural markets are unusually exposed to huge and unpredictable events: droughts, flooding, pests and disease. The increasing vagaries of the weather in recent years offer a powerful reminder of the financial risks that farmers have been taking for centuries, and extreme weather events have played their part in some of the recent food price increases.
To control these risks, farmers became the earliest adopters of financial derivatives. These were contracts that allowed them to sell their future production at a fixed price in order to have greater certainty about what their income would be. If you are a farmer, it reduces the risk of bankruptcy. But if you are investing in agriculture, perhaps via an exchange-traded product, it greatly increases the risk since you will have to buy futures contracts—effectively a commitment to buy or sell at a fixed price on a fixed date in the future—rather than actual bushels of wheat. Understanding how futures are priced is the preserve of the professionals, and so investing in food amounts to an opportunity to buy a financial product that most people will not fully understand.
Finally, and perhaps most importantly, food markets are strongly cyclical. High prices in all commodity markets tend to encourage the entry of new producers, although in most cases it takes a long time for the supply of wood pulp or iron ore to come into line with demand. Growers can react much more quickly to high food prices by cultivating more land or changing the mix of crops, so prices can swing violently from one year to the next.
This brings us back to another of the big dangers investors face. In a market as cyclical as this one, you can be pretty sure that by the time you’re reading that food prices are high, the smart money has already been made. These headlines represent a classic opportunity to buy high in the hope of selling higher. Leaving aside any moral scruples you might have about profiting from a rise in the price of basic foodstuffs, if your success depends upon the arrival of a greater fool, the risk is that it might be you.