While last year the green shoots of US inflation were labelled as merely transitory, now that it has increased 7% year on year for the first time since June 1982 to hit a 40-year high, it may be more than just ephemeral. 

The ongoing strain on supply chains, shortages of key products and tight labour markets are all contributing to higher costs for consumers. Add in the ubiquitous outbreaks of Omicron, and inflation is likely to persist for at least as long as the pandemic does.

Investors looking for an inflation hedge often view agricultural commodities and the farmland necessary to produce them, as prudent long-term options.

The hypothesis for investing in agriculture is, no pun intended, down-to-earth. Simply, with a growing global population, demand for food will continue to increase.

The Asset recently spoke to Melbourne-based Steve Jarrott, portfolio manager for diversified Agriculture at Warakirri Asset Management, on why agricultural products, as an asset class, are an increasingly important option for portfolio diversification and a tool to hedge against inflation.

The Asset: Historically does higher inflation lead to an increase in the value of agricultural/farmland assets, and if so why?

Steve Jarrot: Although the impacts of inflation on income yield in agriculture can vary, there is a clear trend that in periods of high inflation, values of farmland assets do increase at their highest rates. In the period between 1978 and 2019, farmland values in Australia increased at the highest rates during periods of high inflation and, in particular, when the CPI [consumer price index] has been above 4.2%.

Interest rates can also have a profound effect on property values across all sectors, including farmland, as higher interest rates increase the cost of finance and, in turn, reduce net operational returns. However, the impact of interest rates in agriculture is not as dramatic as that of inflation, which is more highly correlated to farmland capital returns than the RBA [Reserve Bank of Austalia] cash rate.

TA: Are publicly traded agriculture-based equities that also pay a dividend a practical way for investors to beat inflation?

SJ: Certainly, agriculture-based equities are one way to get exposure to the benefits of the asset class, and do so with good liquidity. However, investing in publicly traded agriculture-based equities carries with it the same general level of risk and volatility as the wider equity market.

For example, in the first half of 2020, an ASX listed Global Agriculture ETF with holdings in over 50 agriculture-focused companies across 10 jurisdictions, fell 45% as a result of broader equity sell off resulting from Covid-19.

Further to the potential volatility, there are limited options for investing in public agricultural companies on the ASX, for example. There are around 25 agriculture-related stocks listed on the ASX, which represent just over 1% of total listings.

Of these agriculture-related stocks, only a handful include real assets on their balance sheets, which means most would not benefit from any rise in real asset farmland values resulting from inflation or other contributory factors. Such businesses also commonly focus on particular crops or sub-sectors, limiting diversification options.

TA: Agriculture is exposed to risks from climate change. As extreme weather shocks worsen and become more frequent, do agricultural/farmland-related investments that are environmentally or environmental, social and governance ( ESG )-compliant become even more valuable?

SJ: There is strong evidence globally that increasing greenhouse gases are impacting climate and increasing climate variability. We accept the consensus of the international scientific community, and we do believe that strategies to address these risks, and enhance sustainability more broadly, make our investments stronger, more resilient and more profitable.

As climate variability increases, there is a stronger case to invest in greater regional diversification and real assets producing staple goods, providing that the risks of future climate change are known and well managed. This can be achieved through exposure to a well-balanced agricultural portfolio and an experienced investment team.   

When making investment allocations and completing asset due diligence, it is important to understand the regional impacts of climate variability, rainfall and temperature, and incorporate this knowledge into portfolio management and acquisition decisions. So ESG/environmental compliance is one thing, but skilled expertise that understands the local risks and opportunities of climate change is also critical.

TA: What effect has the global pandemic had on agricultural/farmland investment?

JS: The global pandemic has occurred during a period in which fixed-income and government bonds offer low returns. As such, agriculture/farmland has benefited from investors turning to alternatives, such as real assets, as solutions that can not only protect against inflation, but potentially benefit from an inflationary environment.

The agricultural/farmland sector remained relatively robust during the pandemic as identified by:

1.      Inelastic demand of food consumption – the unquestionable necessity of food has been further highlighted through the pandemic.

2.      Inelastic supply of assets – although productivity and efficiency can increase, ultimately the core elements of an agricultural investment ( farmland and water resources ) are finite and not something that can be manufactured or easily substituted. 

TA: When investors think of a hedge against inflation gold is often favoured. Between agriculture and farmland investing, which asset provides the best hedge?

SJ: In line with performance through historic events of economic stress, agricultural investment returns have been highly resilient through the pandemic. Although both options have their place, unlike the traditional inflation hedges, such as gold, farmland is also an income generating asset that can produce a reliable yield.

TA: With more agritech innovations and automation being deployed throughout the food supply chain will this lead to better margins for the agriculture/farmland sector?  

SJ: Agriculture is a much more sophisticated and less labour-intensive sector than it once was, and a continued focus on technology, operating efficiency and automation across the food supply chain is a key opportunity for this sector.

In an inflationary environment, high-cost goods and services can increase the cost of farm inputs, potentially squeezing margins unless revenue growth fully compensates for such extra costs. And upward cost pressures on labour would also be expected. A lower reliance on labour through automation has great potential to manage these risks and improve profitability generally.

And a focus on the automation of irrigation systems, machinery and processing has great potential to improve margins through risk management and a more efficient use of assets and input resources.  Examples like improved water efficiency, more targeted use of crop inputs and leaner supply chains, allow more to be produced from less and improve the sustainability of operations at the same time.

TA: Water is crucial to most agriculture and is increasingly becoming a limited resource. Is investing in water treatment and related industries another way to play the agriculture versus inflation theme?

SJ: Related to technology above, water as a resource is crucial. And, as such, we are consistently working to improve water use efficiency through advanced irrigation infrastructure and automation. As for water treatment or related industries, this is not core to Warakirri’s investment, and I am not in a strong position to provide insight.

TA: Where do you see the business of aquaculture fitting into agriculture investing?

SJ: There is increasing global demand for protein sourced from aquaculture, and this sector would be considered in a balanced agricultural portfolio.

TA: How and where can investors interested in agriculture or even farmland investment invest?  

SJ: Our Farmland Fund offers both domestic and offshore institutional investors a “core agricultural property” investment strategy that has been established to buy, develop and lease property to high-quality agricultural businesses as tenant partners, providing investors access to a diversified portfolio of investment-grade Australian agricultural assets with low volatility returns. 

The target assets for this strategy include the high-value sectors of horticulture ( nuts and fruit ), viticulture ( wine and table grapes ), irrigated row crop farmland assets and water entitlements.

For new prospective clients who are seeking to make allocations at lower scale, without the risk appetite or lead time required to build an extensive operating strategy, the product can achieve several levels of diversification from the outset, retains an attractive risk-return balance, and can provide a relatively simple and reliable exposure to the asset class.