This piece originally appeared in the Strategic Planning Group, as a Supplement exclusively for Members. It has been edited for content.So recently, the New York Observer ran one of its snooty, fawning pieces about hedgies in New York.
|“So you’ll give me 2% of your money up front, |
then 20% of any winnings,
plus you’ll eat all the losses on my bad bets:
Isn’t that a great deal I’m giving you?”
That sharp-toothed rodent cunning was on display in the Observer story: These hedgies were boasting about buying farmland left and right, as a hedge against inflation.
So: Is farmland worth buying as a hedge against inflation?
This is a reasonable question.
Bottom line, the answer is: No.
The reason, however, is worth examining in some detail, because insofar as farmland is concerned, there would be a period of time when it is a clever investment, and then a point after which it would be a terrible investment. And as with everything in life, the dividing line between the terribly clever and the terribly stupid is as smeared and undefined as roadkill on an Interstate.
First off, farmlands produce agricultural commodities—which in an inflationary scenario would rise drastically in price. Thus one would think that owning farmland would be akin to owning a gold mine: A sure-fire hedge against inflation.
However, there are three caveats to this line of argumentation: One, farmlands—like any other bit of real estate—is dependent on credit. Two, the business of farming is cash-intensive, and requires sure-fire lines of credit in order to eke out razor-thin margins. And three, unlike industrial commodities or precious metals, agricultural commodities can spoil if they are not consumed; not all agriculturals spoil, of course, but enough that it affects the entire commodity class.
From the first two caveats, we can see how credit is such a key component in farmlands as an asset class, and farming as a business.
Therefore, if credit is restricted or cut—another banking crisis, say, or a sudden upswing in interest rates brought on by higher inflation—farmers cannot afford to buy the feed and equipment necessary to farm their land. This is an age-old problem that affects farmers even in good times. In a very high-inflation environment, credit would be severely restricted, if not cut off altogether, as banks and lending institutions would not want to give out loans: After all, inflation—not to mention high- or hyperinflation—eviscerates them.
And of course, as we saw in the SPG Hyperinflation Scenario, real estate prices fall—dramatically—during periods of high or hyperinflation, precisely because mortgage loans evaporate, and thus there are far fewer qualified buyers, which thus forces sellers to lower real estate prices even as inflation is making prices rise in commodities, necessities and consumables.
The third caveat—that agricultural commodities spoil if they are not consumed—is the reason so many farmers during high-inflation or hyperinflationary events do not plant crops. This makes complete sense, once you stop and think about it.
As prices for gasoline and other consumables necessary for farming rise, farmers do not have the cash to pay for these ever-rising expenses. So they don’t: They decide not to farm as much as they could, because they don’t have the cash for these higher production costs, or can’t afford the usurious interest rates being charged. The farmers are acting out of self-interest: They realize that it is better not to make money than to lose money.
(This, by the way, is how ever-rising rates of inflation become self-reinforcing among agricultural commodities: Prices rise, making it too expensive to plant crops, making prices rise some more.)
Even if the farmers were to go against their financial self-interest and sow these crops they can’t afford to harvest, once they somehow manage to harvest the crop, it is likely that they will not be able to send them to market. The reason is, transportation and other marketing costs in a high-inflation or hyperinflationary environment would have made it prohibitively expensive.
Thus the harvested crops would sit and rot, never reaching the market while hyperinflation is raging.
So from a farmer’s perspective, planting and harvesting and trying to bring to market a crop makes no sense—better to save money, and hope for better times later.
This model of what happens to crops and farmland presupposes that high-inflation or hyperinflation have already arrived. But what of the lead-up to the hyperinflationary event?
This is an interesting situation: As inflation rises—but is still moderate, i.e. below 20% per year—agricultural commodities are an excellent hedge against inflation. Speculative anticipation that inflation will send food prices up makes market participants head for agros and bid up their prices.
The same with farmlands—market speculators go shopping for farmlands—
—and hence we have the New York Observer story, right on schedule.
Now, this speculation in farmlands will pump up, then blow off. When? When inflation trips over and becomes serious. As I demonstrated in the Scenario via-à-vis industrial commodities, certain commodities rise during the run-up in inflation—then dive as hyperinflation trips up higher.
Thus you can think of the following graph as illustrative of the prices of farmlands during a run-up to hyperinflation:
As inflation rises, farmland prices not only rise in lockstep—they outpace inflation, until a tipping point, where they then fall drastically because of the aforementioned reasons.
The Observer piece is well worth reading, because of what it indicates: Not only do sophisticated market participants anticipate high inflation, they are already moving into assets which they think will beat inflation.
These hedge funds will indeed look clever as inflation rises—but they will look exceedingly foolish if and when inflation turns abruptly higher, and leaves them holding the bag.
In and of itself, the bet on farmlands is not un-clever. The trick is timing: When is the moment to get out of farmlands?
Answer: Before high-inflation chokes off credit.
If you want more from where this came from, check out the Strategic Planning Group’s Preview Page.