Farmland And The U.S. Debt Trap

Includes: MOO, PAGG
by: Pax Zoega

The latest monthly Market Outlook from Bill Gross (the manager of Pimco's $273bn Total Return bond fund) got a lot of traction in the blogosphere recently. His typically colourful language probably helped. He compares the United States' to a junkie:

When it comes to debt and to the prospects for future debt, the U.S. is no "clean dirty shirt." The U.S., in fact, is a serial offender, an addict whose habit extends beyond weed or cocaine and who frequently pleasures itself with budgetary crystal meth.

But there's also a serious message. As Gross points out, if you take the average of the forecasts from the Congressional Budget Office, the Bank of International Settlements and the IMF, the US needs a fiscal surplus equivalent to 11% of GDP to balance the books. Of course, the US is not doing this or anything near it. Even the much talked about "fiscal cliff" won't make a meaningful dent:

An 11% "fiscal gap" in terms of today's economy speaks to a combination of spending cuts and taxes of $1.6 trillion per year! To put that into perspective, CBO has calculated that the expiration of the Bush tax cuts and other provisions would only reduce the deficit by a little more than $200 billion.

Gross concludes with a rather sobering warning. What's interesting is if you substitute the first word (Unless) with the word "If", the sentence still works:

Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow and the dollar would inevitably decline.

In conclusion, the US is between a rock and hard place: if it doesn't get spending under control and/or raise taxes, it will be punished by markets. If it cuts and taxes enough to make a difference, the economy and tax receipts will shrink rapidly, spending on welfare for the unemployed will automatically increase, and the deficit will rise.

Damned if they do, damned if they don't: a classic debt trap. In the words of Mr. Gross, under such circumstances:

Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive within the "Ring of Fire."

Ideally, the very realest of assets, something whose supply is even more limited than gold, but that also offers a yield: farmland.

Owning the farmland asset directly would be the preferred strategy if long-term inflation is your primary concern. The reason farmland is such an effective inflation hedge is that, more often than not, food price inflation exceeds the headline inflation rate. The higher the headline rate, the more this will be the case. This is because when consumers' spending power is eroded, the ratio of discretionary to non-discretionary spending drops. A higher proportion of money in the economy is spent on food than other goods and services causing food prices to rise more quickly than other prices.

This rise in food prices is captured in farmland valuations because over the long term farm income to capital ratios remain constant. As agricultural commodity prices rise farmers are prepared to pay more for cropland. Although the relationship can sometimes appear less obvious in the short term (because of fluctuating input prices, weather events etc), over the long term the price of farmland will increase in direct proportion to the price of food. Thus, the rise in farmland values should exceed headline inflation over the long term.

Accessing the asset class directly can be challenging for investors, especially at smaller investment levels. There are two options. Investors with sufficient capital can acquire freehold ownership of farms. There are a number of Farmland investment advisory companies that acquire and manage farms on behalf of investors. Alternatively, there are funds that directly own freehold title to farms (but unfortunately many of these are also restricted to larger investors).

At lower investment levels, there are unfortunately almost no credible options for direct ownership. I've read many articles over the years talking about the investment merits of agriculture and they generally end with suggestions on a series of agricultural commodity ETFs for investors seeking exposure. Betting on short term fluctuations in the price of wheat has nothing to do with the long term fundamentals of growing food demand and restricted land supply. It is a bet on seasonal weather conditions in the wheat growing regions of the world, not on the growing Chinese middle class.

The next best thing to owning the farms themselves is to own the companies that benefit when the industry as a whole prospers. For diversified exposure, investors might look to ETFs that track agricultural indices. Examples are PowerShares Global Agriculture Portfolio (NASDAQ:PAGG) which tracks the NASDAQ OMX Global Agriculture Index and Market Vectors Agribusiness ETF (NYSEARCA:MOO) which tracks the DAXglobal Agribusiness Index.

A word of caution though: much as agricultural commodity ETFs are more correlated with crop production and weather patterns, agricultural equity ETFs are more correlated with equities than farmland values (as this chart shows). So if you buy agricultural indices now, then in the short term at least, you're buying the stock market more than you are farmland. Over the longer term, however, if you agree with the whole agricultural thesis, then it's reasonable to expect that these indices should outperform the overall equity indices (as this chart shows) in much the same way as farmland should outperform other assets (in particular, the value of money).

Disclosure: I 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.