January 04, 2022
Farmland & Inflation: The Ideal Real Asset
One year ago, the average price of gasoline in the United States was around $2.11. Now, it’s $3.42. Bacon prices are up 20% from last year. Used car prices are up over 25%. It’s fairly easy to notice the impact of inflation when buying groceries or making major purchases. However, inflation can have an equally impactful effect on your portfolio’s risk profile and investment value.
Let's dive into inflation, how it's caused, and how farmland has historically protected investors against it.
A Synopsis Of What Causes Inflation
The Federal Reserve defines inflation as an increase in the prices of goods and services over time. Inflation can also be thought of as a decrease in purchasing power of a specific currency. As prices of goods and services rise, it takes more money to buy the same quantity as before.
Inflation hasn’t always been considered a bad thing, however. Prior to World War II, politicians openly promoted creating inflation to benefit domestic manufacturers, producers, and industries tied to natural resources. It wasn’t until after the Second World War and the rise of consumerism when sentiment around inflation began to change.
Although inflation is commonly seen in a negative light, it usually occurs as a byproduct of good intentions. During periods of economic downturn, unemployment tends to rise as consumers spend less, businesses are less profitable, and workers are laid off. The government can intervene with monetary policy or fiscal policy; expansionary monetary policies like lowering the central bank interest rate or fiscal policies like stimulus checks act to promote economic activity.
The general theory is if more people and businesses have money to spend, fewer people will be unemployed.
The risk however is that these policies may generate inflation in several ways. First, demand-pull inflation is created when consumer demand suddenly exceeds production. For example, with millions of Americans having received multiple stimulus checks, consumer demand severely outpaced the production of gaming consoles, causing supply shortages and secondary market pricing pressure. Second, cost-push inflation occurs when the cost to produce something rises. As the labor and material expenses to cultivate crops rises, those price increases are felt when people go grocery shopping as those costs are passed to the consumer.
How Inflation Is Measured
Because of its complexity, there are several ways of measuring inflation, and those methods have even changed over time. The most widely used measurement is the Consumer Price Index (CPI) produced by the Bureau of Labor Statistics (BLS). The BLS gathers pricing data through direct data collection and surveys of American households. The household surveys also gather information on the quantities of what is being purchased so the CPI can be weighted towards more popular goods. For example, the price of food (13.98% of the CPI Index last month) holds more weight in the index than airline tickets (0.58% of the index).
Another method of measuring inflation is the Personal Consumption Expenditures (PCE) index. The Bureau of Economic Analysis (BEA) collects data on prices from the BLS, consumers, corporations, and quarterly GDP statistics. Since the PCE measures the change in prices for all items including those not paid out-of-pocket by consumers, this creates a different weighting system than the CPI. For example, the PCE index weighs health care costs twice as heavily as the CPI since households often do not pay the full cost of their healthcare. Though the Federal Reserve cites inflation using the PCE index, the CPI is often widely cited as it is generally more relevant to the general public.
The Current State of Inflation
In response to the COVID-19 pandemic, the federal government increased the U.S. money supply by $6 trillion. By materially changing how much United States currency circulates, this economic stimulus has resulted in higher inflation. The CPI rose to 6.2% in October, a rate of inflation that has not been higher in the past 30 years. The 0.9% rise in prices from September to October was also greater than government expectations. The PCE index has risen to 4.4%, and the index has increased every month since the spring of 2020.
With prices rising and purchasing power decreasing, people have taken notice. 88% of Americans are concerned about it, while 81% of investors state inflation is their top concern. More S&P 500 companies are mentioning inflation during their earnings calls than any time in the past decade. Although the Federal Reserve’s normal target for inflation is 2%, one in three institutional investors believe inflation will not normalize below 3% by the end of 2022. There’s also growing sentiment on whether the Federal Reserve’s practice of holding interest rates low for so long is the best idea, as the number of wealthy investors that strongly disagree with the Federal Reserve’s transitory approach to inflation more than doubled in the past month.
Should this much attention be given to inflation and its impact on investing? It depends on your portfolio, as inflation has impacted various asset classes differently in the past. Public companies reliant on labor, raw materials, or other variable costs have traditionally faced rising expenses during inflationary periods. Fixed-income bonds lose value as their coupon payments remain steady during periods of currency devaluation. Safer investments in cash or cash equivalents deteriorate in value through reduced purchasing power. Several various alternative assets have protected portfolios against rising prices in the past, with farmland emerging as a strong candidate worth considering to hedge against inflation.
How To Hedge Against Inflation With Farmland
Let’s take a closer look at why farmland has traditionally performed exceptionally well during periods of high inflation.
Positive Correlation to Inflation
Over the past several decades, farmland returns have moved in strong correlation with rising prices. Farmland has historically held a 70% correlation to the CPI and an almost 80% correlation with the Producer Price Index. Agriculture investments have also had a stronger relationship to inflation indexes than traditional investments. In the past, commodities had a stronger correlation to inflation than U.S. equities, international equities, bonds, real estate, and gold.
Real assets provide several unique benefits during inflationary periods. First, investment returns for real assets have historically been higher during these times. Real assets outperformed traditional assets from 2001 to 2020 during periods of higher inflation. Second, real assets have a history of nominal price growth over time. Since 1987, the nominal value of farmland has decreased year-over-year only once. Ignoring the impact of rising prices due to monetary supply, real assets had a tendency of preserving value over the past several decades.
The United States lost 11 million acres of arable farmland over the past two decades, and total international arable farmland is projected to decrease 250 million acres by 2050. As farmland continues to become more scarce, the asset class creates a natural inflation hedge that protects the value of the deflationary asset. Other fixed-quantity investments like precious metals or fixed supply cryptocurrencies claim the same argument: if the supply of an asset remains relatively stable or decreases, that asset may retain value simply because of its scarcity.
Investment Cash Flow
Farmland is unique as it has both an underlying asset in addition to operating income. Unlike long-term leases with fixed pricing in real estate, farmland operating income can fluctuate based on macroeconomic conditions. This has made farmland a tremendous investment during prior inflationary periods - as the cost to cultivate crops changes, commodity prices can change in response. Offerings through FarmTogether distribute this cash flow on a quarterly or annual cadence based on harvest sales schedules. After a modest 3.4% operating rate of return in 2020, commodity prices surged during most of 2021 - partially in response to the underlying cost of producing those commodities.
Comparison to Other Inflation Hedges
Gold has been a traditional method of hedging against inflation, commercial real estate shares many properties with farmland, and Bitcoin has emerged as a potential inflation hedge due to its limited supply. However, gold’s 16% correlation to the CPI shows it’s not as strong against inflation as one might think. Every industry of real estate was more volatile with a higher standard deviation over the past two decades. Bitcoin has an unproven history of battle price increases while also plagued with volatility.
Farmland continues to provide strong opportunities compared to each alternative. Between 1992 and 2020, farmland generated an average annual return of 11%. Farmland’s value can appreciate while simultaneously generating operating cash flow. Agriculture is vital for survival, and food will always be in demand. It’s also never been easier to invest in farmland due to FarmTogether’s online crowdfunding digital platform. In addition to all of these benefits, farmland has been one of the best hedges against inflation in the past. If inflation is on your mind and you’re worried about it adversely impacting your portfolio, consider the vast opportunities farmland through FarmTogether can offer.
Disclaimer: FarmTogether is not a registered broker-dealer, investment adviser or investment manager. FarmTogether does not provide tax, legal or investment advice. This material has been prepared for informational and educational purposes only. You should consult your own tax, legal and investment advisors before engaging in any transaction.
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