Keeping It Real - Interest Rates And Agriculture Investments

by: Deo de Jesus, CFA

Summary

Real assets enhance risk and return profiles of diversified portfolios.

Interest rate risk is a key source of portfolio correlation.

Understanding underlying sources of risk and returns is critical in ensuring portfolio benefit in a changing economic environment.

"I know it, when I see it."1

Unlike most other types of assets, real assets are assets you can see, even hear and touch. Real assets form an asset class that would appear intuitive, yet a precise definition remains elusive. In a survey of institutional investors, there was reasonable discrepancy on what investors believed constituted a real asset (Figure 1).2 One definition, which I use in this paper, is that a real asset is an asset that is independent from the variations in the value of money.

Real assets for portfolio diversification

This definition fits the primary rationale for investing in real assets, which is to provide diversification and enhance the risk-adjusted returns of investment portfolios.

An added benefit for many investors is that, the inflation-oriented characteristics of real assets are consistent with their inflation-linked liabilities.

However, there are a few practical reasons why asset owners may not have an allocation to real assets, or an under allocation. Economies of scale, governance and alignment, liquidity needs, management resources and comparative advantages of other investor types3 provide real barriers for institutional investors to access the sector.

These issues will be discussed later, with the purpose of this article being to outline the portfolio benefits of real assets and, more specifically, why agricultural real assets can best provide such benefits to institutional investors.

Real assets, interest rates and inflation

In recent years, low and negative global interest rates, and quantitative easing has supported asset prices. This has created a lower-return, higher-risk investment environment. As a consequence, investors have become increasingly interested in alternative asset classes such as real assets.

However, inflation remains low and indeed the prospect of deflation remains a concern for some countries, which raises questions on the efficacy of inflation-oriented investment strategies.

Jay Kloepfer of Callan observes that the best time to consider an inflation hedge is when the risk of higher inflation is low. He states, "hedging inflation now should be relatively cheap".4

But as we know, an inflation hedge can only be considered to be cheap if we can anticipate it will be worth more in the future. This means the risk of higher inflation in the future needs to be a probable prospect.

There may be underlying factors that may see the return of inflation in the medium term. The Bank of International Settlements (BIS) suggests demographic shifts may have provided a role in shaping current central bank policies and such shifts could provide the same role in increasing interest rates in the future. Specifically, BIS observed the relationship between the decline in the dependency ratio, being the ratio of workers to non-workers (i.e. children and the elderly) and lower interest rates.5

The thesis behind the observation is that dependants are a source of demand for goods and services, but by definition, are not sources of supply. As this ratio declines, the demand for consumption per capita decreases thereby increasing the savings ratio and placing downward pressure on interest rates. With baby boomers reaching retirement and low birth rates in developed economies, we may see a point of inflection in the dependency ratio, which may precipitate inflationary pressures, particularly when the participation rate begins to decline.

There are also political factors that may see a change in policy settings. Recently, ex-Federal Reserve Board member, Kevin Warsh openly questioned the sustainability of current central bank policies6 and the consequence of potential change in central bank policy has garnered investor examination.

Legendary bond fund investor Bill Gross opines that tangibility matters in this macro-economic policy environment:

"I don't like bonds; I don't like most stocks; I don't like private equity. Real assets such as land, gold and tangible plant and equipment at a discount are favoured asset categories."7

It is clear that in this environment, a return of capital, rather than a return on capital, is becoming a greater focus for investors.

Sources of risk and return

Despite the attractiveness of real assets at an asset-class level, it is important to remember the rationale behind investing in real assets in the first place: portfolio diversification and an inflation hedge.

The increase in correlation across asset classes through globalisation and during the global financial crisis8 led to investors investigating the underlying factors that drive risk and returns in certain alternative asset classes.9 The role of financial leverage in converging risk across different types of assets has already been demonstrated.10

More recently, with the potential end of the great bond yield moderation, investors are now debating the possible effect this may have on asset classes such as high-yield stocks, property and infrastructure.11

Recent comments on the current markets illustrate the risks:

"The premium that's been put on safe yield is at an extreme level"

- Andrew Sisson, Franklin Templeton Investments

"The market has had this unusual single thematic driving it the last six or seven years and that's been interest rates"

- Garth Rossler, Maple-Brown Abbott

Figure 2 illustrates the relationship of falling global yields, with the US Federal Funds Rate Target as a proxy for the price of global money, and the annual returns of various asset classes. In this graph, a negative correlation illustrates a stronger relationship between asset-class returns and lower interest rates.

What this graph illustrates is the continuation of the "Bernanke Put", whereby correlations across asset classes such as equities, property and fixed interest have all increased. The notable exceptions being Australian short duration government bonds and Australian broadacre agriculture. While exchange rates (and global differentials in cash rate) will have had an effect, the same conclusions can be drawn using Australian cash rate correlations.

Accordingly, it is critical that investors seeking to diversify their portfolios understand a real asset's underlying source of risk and return, and its correlation (or lack thereof) to the price of money.

In doing so, investors should ask themselves two
questions:

  1. How is economic value created by the asset class?
  2. What is the underlying duration?

Creating economic value

Value can be created in a number of ways. Property typically creates value through its proximity to population, jobs and other attractions. Accordingly, the sustainability of returns is based on the long-run changes to these factors.

With its government heritage, value in infrastructure is typically underpinned, at least initially, by a contractual undertaking. However, its long-run value is dependent on the underlying demand for the asset (e.g. traffic for roads, merchandise trade for ports, and centralized electricity production for energy grids). These are items that are difficult to substitute and which the asset owner can typically pass onto the consumer without incurring significant loss in market or market share.

Because of the stable and predictable cash flows that characterize these asset classes, typically debt is extensively used in property and infrastructure, which provides another source of returns. Accordingly, interest rate risk is a source of returns in these sectors. When combined with the long-term and relatively fixed nature of these cash flows (see duration discussion below), property and infrastructure have also been a beneficiary of the great moderation in bond yields.

By contrast, agriculture assets carry lower levels of debt, owing to the volatility of seasons and commodity markets and lack of diversification by typical asset owners. Accordingly, while interest rates have some effect, weather and commodity-price risk is perhaps a more significant contributor to value and returns in agricultural assets.

In later papers, we will explain how agricultural assets are valued, and we'll explore why the correlations of Australian agricultural assets with the global price of money have declined in recent years. However, for the purpose of this paper, it is safe to conclude that the factors that determine risk and returns in agriculture are different to factors that affect other asset classes. Understanding this is critical in ensuring that investors maximize the portfolio benefit of their real assets portfolio.

What is the underlying duration?

In the current economic environment, duration has critical importance for investors given the heightened asset price sensitivity at lower interest rates. For bonds, duration is determined at issuance when the term, interest rate, and mechanisms to change interest rates are determined. Duration can be measured reasonably precisely provided the coupon, interest rate and term are defined.

Measuring duration in other asset classes is more difficult given the variables are less precisely defined. However, forming a view on how assets behave under different interest rates is critical in measuring the portfolio benefits in the current environment.

Given the relationship between interest rates and inflation, an asset's ability to pass on inflation to its customers is an important factor in determining duration. In infrastructure, this is typically achieved by contractual terms that enable inflation to be passed on to the consumer. Some infrastructure assets are able to pass on rates that are greater than inflation in certain circumstances, typically under ratchet clauses. However, as this represents a reduction in correlation with inflation, it should be noted that such contractual arrangements may actually increase duration risk if the ratchet clause value is capitalized into the value of the asset.

As a commodity producer, individual participants in the agricultural sector are price takers rather than price makers, meaning the ability to pass on increases in price to their customers is limited. However, most land-based agricultural industries are remarkably flexible, creating products that have a stable demand profile. This means the industry as a whole, in the long-run, can pass inflation on to its customers.

When viewed from this perspective, we can begin to see why agricultural asset prices have been relatively stable and maintained their real value over a long period of time.

I know it when I see it

Ever since Richard Roll observed that a market portfolio is unobservable, determining the size of an allocation to real assets requires a sizable dose of art to go with the science.

This should not dissuade investors from investing in real assets. With the value of money becoming increasingly uncertain, real assets are proving to be attractive investments for long-term investors. The tangibility of real assets can provide investors with confidence that a return of capital can be achieved in the current uncertain economic environment.

However, real assets come in all shapes and sizes and are housed in structures, particularly with debt, that can change their risk profile and the portfolio benefits they provide. Understanding these factors is critical not only in selecting individual real assets but also setting the portfolio allocation as a whole.

The low correlation with other asset classes suggests an efficient portfolio should contain some allocation to the agricultural sector if the practical hurdles mentioned previously can be overcome. For those asset owners with the resources, making an effort to understand the agricultural sector provides an opportunity to add value to portfolios. Indeed, the lower correlation with other asset classes, means that an investment in agriculture could provide opportunity for asset owners to increase portfolio risk-adjusted returns with a lower number of managers.

In our next article, we will explain the different types of agricultural investments and where such investments fit within an investment portfolio.

Endnotes

  1. Justice Potter Stewart in US Supreme Court Case, Jacobellis v Ohio (1964) 378 US 184
  2. Deutsche Bank (2012) Real Assets: A sought-after investment in times of crisis, June 2012
  3. An example is the advantage that high-tax paying individuals and owner-occupiers have a comparative advantage to institutional investors with respect to residential property
  4. Kloepfer, J (2016) Real Assets Spotlight: Diversified Real Assets, Real Assets Reporter, Callan Investments Institute
  5. Juselius, M (2015) Can demography affect inflation and monetary policy? BIS Working Papers No. 485
  6. Warsh, K (2016) The Federal Reserve Needs New Thinking, The Wall Street Journal, 24 August 2016
  7. Gross, B (2016) Masters and Johnson Q&A, Monthly Investment Outlook, Janus Capital Group, August 2016
  8. Kolanovic, M (2011) Rise of Cross-Asset Correlations, J.P. Morgan
  9. Heaney, R et al (2012) Time-varying correlations between stock market returns and real estate returns, Journal of Empirical Finance, September 2012
  10. Choi, J et al (2011) The Volatility of a Firm's Assets and the Leverage Effect, AFA Atlanta Meetings 2010
  11. McKormick, D (2014) Dangers in chasing yield and returns, Select Asset Management
  12. Significant body of research but consider Baghestani, H (2016) Interest Rate Movements and US Consumers' Inflation Forecast Errors: Is There a Link?, Journal of Economics and Finance, pp 623-630; Zhang, J (2016) Macroeconomic News and the Real Interest Rate at the Zero Bound, Journal of Macroeconomics; Cochrane, J (2016) Do Higher Interest Rates Raise or Lower Inflation?, Chicago Booth School of Business
  13. Roll, R (1977) A Critique of the Asset Pricing Theory's Tests, Part I: On Past and Potential Testability of the Theory, Journal of Financial Economics, pp 129-176

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.