Research Note Hancock Agricultural Investment Group

Transcription

1 Research Note Hancock Agricultural Investment Group An Investment Outlook for Institutional Farmland Investors Cody Dahl, Ph.D. Senior Agricultural Economist The strong sustained performance of farmland assets over the past decade in a period of turbulent and uneven global economic growth suggests farmland investments can help diversify traditional investor portfolios. A key benefit of farmland assets is that the risks inherent in production agriculture are distinctly different from the risk profile in nonagricultural sectors of the economy. Many institutional investors, however, are hesitant to add farmland to their portfolios because they do not fully understand the dynamics of the asset class. Many investors are concerned about the recent large increases in farmland capital values and are asking, What happens next? This research note provides investors with a short-, medium-, and long-term outlook for U.S. farmland investments. Before addressing the outlook for agriculture investments, I will review some of the key drivers underlying today s markets for agricultural commodities. First, agriculture production in the U.S. has a strong export orientation. Between 2000 and 2010, the U.S. sold, on average, approximately 70 percent of its cotton, 50 percent of its wheat and rice, 40 percent of its soybeans, and 18 percent of its corn to foreign buyers. For permanent crops, in the period 2008 to 2010, approximately 61 percent of pistachios, 58 percent of almonds, and 58 percent of walnuts were exported. The strong relationship between agricultural exports and U.S. farm income suggests the future profitability of the agricultural sector will continue to depend upon foreign demand. Second, farmland prices are rationally responding to strong farm income expectations and the low opportunity cost of capital. Figure 1 demonstrates how farm income from HAIG s row crop properties continues to outpace the 10-year Treasury constant maturity rate. The income return from row crops has held steady since 2006, despite robust increases in the per acre price of farmland. In fact, income returns have increased every year since 2009, while Treasury rates have decreased every year. Given that foreign demand for U.S. agricultural exports is expected to remain strong, investors are rationally bidding up the price of farmland to levels justified by the income return. Figure 1 HAIG Row Crop Returns and the 10-Year Treasury: 1991 to % 15% 12% 9% 6% 3% 0% -3% Capital Rate of Return Income Rate of Return 10-Year Treasury Constant Maturity Rate Hancock Agricultural Investment Group Research Note (Continued on page 2)

2 An Investment Outlook for Institutional Farmland Investors (Continued from page 1) Short-term Outlook In December 2012, policymakers at the Federal Reserve Bank (FED) indicated they will maintain a near zero federal funds rate as long as the rate of unemployment remains above 6.5 percent, the projected rate of inflation through 2014 remains below 2.5 percent, and the longer term expectation of inflation appears anchored. These actions will prevent a major appreciation in the value of the dollar in the short-term. A weak dollar supports U.S. agricultural exports because foreign consumers can purchase relatively more U.S. goods for a given unit of their currency. The supply of agriculture goods is relatively fixed in the short-term. Therefore, U.S. dollar-denominated commodity prices will need to remain high to ration demand and should support grower margins in the short-term. Given the low opportunity cost of capital, participants in the farmland market will continue to purchase row and permanent cropland for its income yield. In general, farmland capital and income returns should remain strong in the short-term. A few caveats are in order for the short-term. First, slower economic growth in China and other developing countries could result in weaker demand for U.S. agricultural exports. Second, while supply is relatively fixed in the short-term, if multiple growing regions simultaneously have banner harvests, then expanded world supplies of agricultural commodities could chill world prices and compress grower margins. Third, an increase in interest rates and a strengthening of the dollar could occur if the FED decides to halt its open-ended asset purchase program. Agriculture policy could also impact the outlook for farmland assets in the short-term. Legislators in Washington have yet to enact a Farm Bill, and market participants currently expect crop insurance to replace direct payments for program crops. In addition, on January 31, 2013, the Environmental Protection Agency increased its proposed volume mandate for cellulosic biofuel to 14 million gallons in 2013 and 16 million gallons by The renewable fuel standards support demand for corn and crop insurance provides a measure of safety for producers. Although unlikely, a reduction of support for either of these initiatives could adversely affect the performance of farmland investments. HAIG expects a continuation of the current low interest rate environment to continue to support agricultural exports in the short-term. Strong agricultural exports will support farm income, helping to maintain or increase the aggregate price of U.S. farmland in the short-term. Primary Factors Affecting U.S. Farmland Investments in the Short-Term (0-2 years) ( ) Economic slowdown in China or other developing countries ( ) Banner harvest in multiple growing regions increases supplies ( ) Policymakers at the FED halt the current open-ended asset purchase program ( ) Agriculture policy reduces support for program crops (+) Policymakers at the FED maintain a near zero federal funds rate (+) Weather shocks result in poor global yields and low world supplies (Continued on page 3) 2

3 An Investment Outlook for Institutional Farmland Investors (Continued from page 2) Medium-term Outlook Inflation will be a primary factor affecting the performance of farmland investments in the medium term. Inflation reduces the real interest rate, lowering the rate at which landowners discount future farm income and effectively boosting the present value of farmland. An inflationary environment can cause the dollar to depreciate, which would be favorable for agriculture exports and farm income. Figure 2 portrays how farmland investments have performed during periods of low, medium, and high inflation. In general, farmland assets perform well during inflationary periods. However, if policymakers at the FED decide to combat inflation, then the resultant higher real interest rate should attract capital to the U.S., causing the dollar to appreciate, and placing negative pressure on agricultural exports and farm income. The continuing sovereign debt problems in the euro zone could destabilize the global economy in the medium-term. Investors tend to acquire safe haven assets denominated in U.S. dollars during risky periods, which may put upward pressure on the value of the U.S. dollar. Thus, the quantity of U.S. agricultural exports could indirectly be pinched if a country leaves the euro zone. Fiscal austerity programs in the euro zone might also have a small direct negative effect on U.S. farmland investments because the U.S. exports a small amount of agriculture goods to the euro zone. However, the indirect effects could potentially be larger, because exports from developing countries account for over 28 percent of the value of euro zone imports. If austerity programs cause euro zone members to import less from developing countries, then the reduced economic activity in the developing countries will likely result in imports of fewer agricultural goods from the U.S. The old adage, high prices cure high prices could come to fruition in the medium-term as investors outside of developed countries are motivated to make better use of existing farmland or bring new areas into production. However, high costs associated with poor transportation infrastructure in rural areas will in many cases limit the feasibility of expanding production in these developing countries. HAIG expects foreign demand from developing countries to keep pace with additional global supplies in the medium-term. In addition, the value of the U.S. dollar should remain relatively weak for the duration of the medium -term, supporting agriculture exports and farm income. Primary Factors Affecting U.S. Farmland Investments in the Medium-Term (3-5 years) ( ) Policymakers at the FED raise real interest rates to combat inflation ( ) One or more countries exit the euro zone ( ) Large new areas come into production in response to high commodity prices (+) Inflation reduces real interest rates (+) Poor infrastrure in developing countires prevents new areas from coming into production Figure 2 U.S. Farmland Returns during Periods of Low, Medium, and High Inflation: 1970 to 2012, average total annual returns 15.1% CPI Farmland Returns 10.1% 8.7% 7.7% 2.0% 3.5% Low Medium High Source: Morning Star Inflation, Ibbotson Associates U.S. Farmland ( , discontinued), NCREIF Farmland Index ( ) Continued on page 4) 3

4 An Investment Outlook for Institutional Farmland Investors (Continued from page 3) Long-term Outlook The long-run outlook for U.S. farmland investments largely depends on the continuation of an upward trajectory for the wealth of low- and middle-income nations, and on investment in the improved productivity of foreign agricultural producers. Demand Considerations Seven billion people currently inhabit the earth and the World Bank estimates the number will rise to 9.2 billion by The Food and Agriculture Organization of the United Nations recently undertook a global assessment of land and water resources to analyze threats to food security and sustainable development. The results suggest agricultural producers must increase global food production 70 percent to meet the future demand for food. Specifically, producers must generate an additional 1.1 billion tons of cereals and 221 million tons of livestock products. The world will require approximately 4.78 billion tons of cereals and 1.13 billion tons of livestock products in 2050 (FAO). The growth in global demand for food largely depends on the wealth and number of consumers in developing countries because consumers in low- and middle-income countries spend a higher proportion of their income on food relative to consumers in high-income countries. In particular, economic growth in India would greatly enhance the outlook for U.S. farmland investments. India currently restricts trade in agricultural goods to protect its large population of rural farmers. In the long-term, the prospects of export-led economic growth should compel India to reduce these restrictions. Supply Considerations The legal, political, and economic institutions outside of the developed world will largely determine the supply of food in the long-term. These institutions must create an environment that is conducive for economic and social development, and such development will likely require investment capital from outside the agriculture sector, and perhaps even from outside the country. Therefore, agricultural oriented countries such as Argentina, Brazil, China, India, Indonesia, Mexico, Nigeria, Russia, and the Ukraine must strengthen property rights and patent laws and reduce red-tape bureaucracy to attract the investment capital these countries need to enhance crop yields and expand production areas. The strength of the U.S. legal system, the historical performance of the U.S. economy, and the infrastructure supporting the marketing and transporting of U.S. agriculture goods should continue to provide a competitive advantage to U.S. producers in the long-term. Primary Factors Affecting U.S. Farmland Investments in the Long-Term (6 or more years) ( ) Large new areas come into production in response to high commodity prices ( ) Institutions outside of the developed world facilitate increases in agricultural productivity (+) Population growth in developing countries increases demand for U.S. agriculture exports (+) Red tape hampers the development of transportation infrastructure in developing countries (Continued on page 5) 4

5 An Investment Outlook for Institutional Farmland Investors (Continued from page 4) Conclusion The recent strong performance of farmland assets in the wake of an uneven global economy underscores the difference between the agricultural and the nonagricultural sectors of the U.S. economy and suggests farmland investments can help diversify traditional investor portfolios. Many interrelated factors will determine the future performance of farmland investments. In the near term, government policy could reduce the demand for ethanol and potentially decrease the price of corn and soybeans. Inflationary pressure could compel policymakers at the FED to increase interest rates, which would exert downward pressure on the price of farmland. Of the many factors upon which the price of farmland depends, the growing demand for food by consumers in developing countries is the primary determinant in the long-term. The strength of institutions in the U.S. should continue to provide U.S. farmland investors with appealing risk-adjusted returns. Citations FAO (2011) The State of the World's Land and Water Resources for Food and Agriculture, Food and Agriculture Organization of the United Nations Disclaimers on Forward Looking Statements Hancock Agricultural Investment Group ( HAIG ) is a division of Hancock Natural Resource Group, Inc., headquartered in Boston, MA, a registered investment adviser and wholly-owned, indirect subsidiary of Manulife Financial Corporation of Toronto, Canada. The information provided herein is not an offer to sell, or a solicitation of an offer to buy any security, investment product or service. This document may contain forward-looking statements and information. Forward-looking statements are related to possible or expected future, and not past, events. These statements may be identified by words such as expects, looks forward to, anticipates, intends, plans, believes, seeks, estimates, will, project or words of similar meaning. Such statements are based on our current expectations exclusively as of the date of this document and certain assumptions, and are, therefore, subject to certain risks and uncertainties. A variety of factors, many of which are beyond Hancock Agricultural Investment Group s control, may affect performance and results, and could cause the actual performance and results of investments to be materially different from any future performance or results that may be expressed or implied by such forward-looking statements. Hancock Agricultural Investment Group, an operating division of Hancock Natural Resource Group, Inc., hereby disclaims all liability for any loss or damage suffered due to the use of any information or statements contained herein. 5