Jeffrey Notaro's  Instablog

The economic theory behind monetary inflation is simple, by increasing the number of currency units in an economy well beyond its growth rate, the "nominal" price for physical assets must then adjust higher to compensate. The major reserve banks of the world have increased their respective money supplies way beyond the normal needs of their weak economies and way beyond anything ever seen before in advanced countries. The common reasoning why monetary inflation has not become a problem yet is because all the money has not flowed through the system. It sits on the bank's balance sheets for many well understood reasons: (1) banks are retrenching to allow time for their financial position and quality of loans to improve; (2) the public is dealing with underwater mortgages and high unemployment; (3) and corporations have plenty of cash and are wary of expanding. It will take a long time, but once enough bank and private debt is paid off or defaulted on, things will begin to get going again. Money will start to flow and monetary inflation could easily be a huge factor. Federal Reserve bankers seem sure they can remove these piles of recently printed cash before it gets sucked into the system to inflate prices. That is hard to imagine though when considering how big the increase in money supply has really been.

(click to enlarge)

Let's say they were able to remove this liquidity quickly, this would require aggressive actions by the reserve banks and would surely snuff out any nascent recovery in short order. Well aware of this, the Fed's of the world are going to lean towards less removing liquidity and more time for growth to take hold, which would then increase the risk of high levels of monetary inflation (Bernanke has already clearly said he will error to the side of growth before beginning to remove the expansionist measures). The depth of this current recession is severe enough that anything close to strong growth levels is many months if not years away. Nevertheless, it is prudent to hold investments now that are likely to be very good hedges against inflation rather than wait (especially ones with cash flow). Monetary inflation will probably come without warning and so fast it will be hard to act.

This brings us to farmland and whether it is a viable inflation hedge. The answer I suggest is yes, in fact, it may be one the best choices. Food and fuel inflation have already been having a bullish effect on farmland, extreme monetary inflation would carry an even bigger impact. Historically, farmland prices have statistically shown a high correlation with inflation, much more consistent than even gold. I compared the USDA's statistics for U.S. farmland prices, using the average change for Iowa, Indiana and Illinois since 1971, with the annual change in the CPI as the measure of inflation. There was a significant correlation (0.43) between farmland prices and the CPI, confirming what a number of other academic studies have found - that farmland has been a viable inflation hedge. The following table shows during periods of high inflation farmland has responded with even higher price gains.

Inflation comes in many forms. Food price inflation over the past decade can be directly tied to higher crop prices, which along with increasing emerging market demand, has been underpinning the current bull market in farmland prices. Considering monetary inflation, hard assets in general will appreciate to match the increased currency available in the system. Real estate is a basic hard asset, including both homes and farmland. Housing prices will have a tougher time responding to higher inflation for some time, given their oversupply and debt overhang. Farmland has no issues holding it back (other than maybe it is not starting from an especially cheap level). High inflation would probably bring higher interest rates; this will be a negative for home prices but less so for farmland prices since there is little leverage in the current makeup of farmland ownership.

In conclusion, the effects of mild monetary inflation on the already elevated prices for farmland would probably be modest, but excessive inflation would very likely carry farmland prices much higher. Given that the damage to one's portfolio from high inflation is so harsh, it is better to be safe than sorry and hold some protection now (especially important for retirees to consider). Houses could be a good choice in a few years, once they have had more time to digest their supply and debt issues; gold is volatile and earns no interest so only should be held in modest amounts; farmland is maybe the best choice since it has a very bullish case now anyway based on growing emerging market demand, plus it has a shown a high probability of protecting your wealth during extreme inflationary conditions.

In recent years, farmland has received a lot of attention as the most basic element in an increasingly stressed world food supply system. The recent market letter by Jeremy Grantham of GMO focused even more attention on what is likely to be long-term problem. In commodity related investing, when demand is greater than supply the price rises to adjust - farmland acts the same way, rising now to reflect the imbalance and adjustment taking place in all food commodities. Those that identified this situation early and were able to find a way to invest in farmland were rewarded by very large gains. Looking forward, I will argue farmland is still a very good investment, even at current price levels (though it will pay to seek out the locations with the best value).

There are three major factors that contribute to the value of farmland. (1) The most basic driver is farmer incomes. If a business is earning consistent profits, confident this success will continue, they will not hesitate to expand. In this case it means buying more land. Investors may be the ones paying the high prices at Iowa auctions, but farmers are scooping up everything else that makes strategic and economic sense for their operations. (2) Like any business with a balance sheet, leverage can be added to boost expansion. This was a big part of the 1980's rally in farmland prices but is not so much a factor now. (3) Even though many traders will deny it, money flow will tend to temporarily push up prices beyond the pure economics; this is true in stocks, commodities and even farmland. In the bigger picture though, there is sea change occurring in how farmland is owned; it is becoming an asset class with much greater institutional and retail participation. Let's look at each of these factors closer and also address how and where to purchase farmland at this stage of the bull market.

Farm incomes are the main driver of land values. Farms are more efficient now; they tend not to be as leveraged, labor intensive and are generally run more like a company. They are therefore in a much better position to take advantage of today's high crop prices. Look at this year's drought; many farmers will not produce any crop to speak of, yet proper use of insurance, government support and hedging has nearly eliminated severe business losses. There will continue to be seasonal swings in crop prices, but even the casual observer can see that food and grain prices are much higher on average now than a decade ago. The growth and quality of middle class diets around the emerging world has increased demand in a huge way and will continue to exert pressure on the system for years. Export markets are robust and offer plenty of profitable outlets for big producers. The opportunity for farmers to earn high incomes will continue for many years, which will support land prices.

Tied into farm incomes is the use of leverage. Today's ridiculously low interest rates would seem too good to pass up, but farmers in the U.S. apparently learned from their experience in the 80's when excessive use of bank borrowing was instrumental in pushing up land prices that ended in a big bust. Besides farmers not trying to borrow much, banks are still reeling from their own recent crisis and are not readily offering loans anyway. Looking at today's farm economics, it is regularly high crop prices that underpin farm profits. In 80's there were government price supports and export programs that kept prices artificially high, once these were removed prices dropped. Today is different; the demand from world emerging markets is real and will not disappear overnight. At some point interest rates will move higher, but the lack of high levels of borrowing and stable demand for farm products will greatly reduce the negative effect of leverage and interest rates on farmland prices.

The last big driver is rather new, money flow from investors. Institutions have expanded their appreciation for hard assets beyond timberland to include farmland. Retail investors are now seeing the opportunity too, but they have always had a tougher time finding avenues to access the market. This is where the permanent change will come; private placements offering direct investment opportunities will continue to expand and become more professional; some of these will evolve into private and then publicly traded REIT's. There is no reason why farmers need to own the vast tracks of land required for today's commercial operations. Leasing from investors instead of taking huge loans to buy land makes more business sense. Investors are attracted to the cash flow and a very direct way to invest in commodities and a hard asset. Prices will sometimes get temporarily distorted by excess money flow but the big picture points to a change in ownership structure. The bull market driven by growing world demand will support this change for a number of years to come.

Looking forward, investors in farmland at this stage of the bull market need to be more selective. Even though the long-term demand imbalances should continue to raise all boats for years to come, there are some markets where prices have gotten ahead of current conditions. Land in the big farm states in the U.S. Midwest are the obvious example; they are the easiest for investors to access and prices there are clearly in need of a correction (or some consolidation at least). Taking the extra leap to emerging market farmland is worth the effort. There are not as many options for the retail investor or even small institutions and family offices, but because these markets are not as easy to access is one reason why their prices are not as frothy. There is huge potential for the fertile Black Sea farmland belt in Eastern Europe to produce more food. Land consolidation, better infrastructure and larger more efficient farms will produce much more in time and thereby increase in value substantially. This region is my firm's area of expertise, but there are similar opportunities in Africa, South Asia, and Central and South America. When investing in farmland in the U.S. it might be practical to buy directly yourself, but in an emerging market a professionally managed fund or a large scale farming operation is much more advisable for obvious reasons. In making your selection, be sure your choice is well operated, reliable and has modest expenses. Farmland, especially in emerging market locations, should continue to be solid a addition to investment portfolios for years to come.