Food inflation on the rise

Bourse Securities Ltd

In recent months, the upward trajectory of local food prices continued as the Central Bank once again reported a double-digit headline inflation rate.  In its latest Repo Report, the Bank noted food prices remained the main driver of headline inflation, with June’s food-price  inflation rate at 24.1 per cent and headline inflation at 11 per cent. Given the high dependence on food imports, the escalating prices of international agricultural commodities in recent weeks is likely to translate to higher local food prices in the near future. This week, we examine the rationale for the spiralling prices of grains in the international markets, before discussing the implications on the local economy.

Scorching heat and soaring prices
The rising prices of grains such as corn, soybean and wheat are largely attributable to adverse weather conditions in several of the main global grain exporters, including the United States, Russia and Australia. Amid supply concerns, year-to-date wheat prices rose by 41.59 per cent, while corn and soybean prices have increased by 21.06 per cent and 45.17 per cent, respectively. The soaring prices of these agricultural staples are significantly higher than the general price movements of commodities for the year thus far. This trend is reflected in Figure 1, which illustrates the outperformance of soybean, corn and wheat prices relative to the Thomas Reuters CRB Index that tracks the performance of a basket of commodities, and generally reflects the overall trend in commodity markets. The muted performance of the CRB Index could be attributable to declines in the energy, industrial and precious metals sectors, which accounts for roughly 60 per cent of the index. Drought conditions in the US Midwestern corn belt, which includes the states of Iowa, Illinois, Indiana and Michigan, prompted the largest increase in US grain prices in over two decades amid expectations of tightening supplies.
In fact, the US Department of Agriculture estimates nearly 90 per cent of the US corn crops are grown in the drought-ravaged areas. Consequently, the deteriorating output prospects for US corn production has resulted in the US Department of Agriculture reducing the forecast for US corn production by 12 per cent.

Global corn consumption has followed an upward trend in recent years and the US Department of Agriculture expects it will rise by 4.1 per cent in 2012/2013. As such, the recent decline in production is expected to place upward pressure on corn prices, as world inventories are forecasted to decline to its lowest level since 1974. As Figure 2 illustrates, the International Grains Council expects world inventories to fall to 115 million tonnes, or equivalently 13 per cent of expected consumption in 2012/2013. Similar to corn, wheat prices have also rallied in recent months. This is largely attributable to concerns arising from adverse weather conditions in some of the largest wheat producers globally, including the US, Russia and Australia. These extreme dry-weather conditions can reduce the crop’s output potential and may have implications for the global wheat supply.  For instance, there has been some speculation that the Russian government may introduce measures to limit its grain exports, similar to the temporary ban that was imposed in 2010, following the severe drought that drastically reduced the country’s wheat crop. The significant price increases in these key grains also has the potential to adversely affect dairy and wheat products. Higher corn and wheat (used in animal feed) prices are likely to translate to higher prices of meat and dairy products in the global market. Additionally, higher grain prices are also likely to result in price increases for grain-based oils.

 The inflationary effect
Locally, rising food prices have largely been the main impetus for the volatile inflation rate. In fact, very few need to read the Central Bank’s monthly Repo Report to be aware of the escalating food prices. With a food import bill of over $4 billion, the recent surges in agricultural prices in the international markets are likely to result in even higher prices in the near future. The consumer is likely to face the brunt of any cost hikes, as retailers pass on the costs in key staples and, by extension, other food establishments. However, the time lag between the effects of higher international prices on domestic prices usually varies across commodities. Recent research reports from the Central Bank indicates higher prices of wheat in the international markets usually takes four to five months on average to affect flour prices, while increases in corn prices may affect corn-based oils within two to three months. The investors’ perspective
In this period of historically low interest rates, investors will find their returns are being eroded by inflationary pressures. As such, the looming increase in food prices is likely to affect the real returns earned by investors in the local market. With short-term interest rates currently ranging between zero to two per cent, investors can seek to benefit from higher commodity prices to offset the inflationary pressures. In fact, the international houses recommend a five per cent portfolio allocation to commodity investments.

In order to gain exposure to the commodities markets, investors can utilise exchange-traded funds (ETFs). ETFs track the performance of commodities by attempting to mirror the performance of a specific commodity or index or basket of commodities. Similarly to the other well-known commodity ETFs, such as gold and oil, investors can also choose specific directional agricultural ETFs depending on their outlooks. Inverse or short ETFS that gain when commodity prices fall and vice versa are suited to investors who expect the price of agricultural commodities to fall. Similarly, investors who expect agricultural prices to maintain its upward trajectory can consider investing in long ETFs that benefit from price increases. Commodity ETFs can provide investors with added diversification and enhanced portfolio returns. While ETFs can provide a direct and relatively cost effective route to investing in commodities, these instruments are traded like stocks and are subjected to frequent price changes. As such, ETFs are suited to investors who are willing to be exposed to the volatility associated with these instruments. Owing to their complex nature, investors should only purchase ETFs after fully understanding the risks and potential returns associated with these instruments. Investors should seek advice from a qualified investment adviser who can provide thorough research and consultation. These instruments are available locally from several licensed brokerage firms, including Bourse.