David R. Kotok
August 11, 2012
Two expert agricultural economists joined this year’s gathering in Maine. Their expertise is worldwide. Each of them has years of experience forecasting various ag scenarios and resulting global impacts. One is chief economist of a major, worldwide trading company; the other is affiliated with a bank that is involved in agricultural lending.
We discussed corn, soybeans, and drought effects on world prices. We examined emerging economies, where food is a large component of the price index. We talked about how food spending drives the political constituencies in those countries. Bottom line: the geopolitical risk premium rises as food prices consume increasing amounts of household budgets.
The biggest take-away for me was the explanation that this decline in food production is likely to be a multi-year cycle. And this is not just one in one drought-stricken region of the world. The impact of food price increases is now global. Moreover, we have run down the inventory cushions.
Weather-induced price hikes are an exogenous shock, meaning that they are caused by factors from outside the system. Central bank monetary policy can do nothing about an outside shock. Central banks cannot grow corn. At a zero-bound policy interest rate, all the central bank can do is watch the price index climb above its targets. Any action it takes is likely to be counterproductive.
Governments often use fiscal policy to deal with food issues. Politicians act because they feel the heat from hungry constituents. In some cases, they implement food price controls that end up exacerbating shortages. In other cases there is turmoil in the streets, and it may lead to regime change, or at least the threat of regime change. But fiscal policy is constrained by large deficits in most OECD mature economies. Agree or not, we already see it being used as a subsidy in developing countries. The outcomes of fiscal response are questionable since they amount to a forced transfers payment.
The bottom line for me is to take this food price shock seriously. It flows beyond grain itself and into animal and energy feed stocks. It affects the rearing of the four-legged critters and the ubiquitous poultry found around the world.
Household budgets are impacted at many levels. That causes consumer retrenchment in other spending streams. This developing food price spike piles on top of the energy shock that is also underway.
In response, Cumberland Advisors is maintaining a cash reserve in our US ETF accounts. We have ratcheted back our exposure to the consumer discretionary sector. We expect food and energy costs to negatively impact household budgets in the mature economies of the world. In the frontier and emerging and developing nations, we expect food and energy costs to restrict household budgets severely.
A personal note: I recall conversations several years ago with the chief economist of the Central Bank of Zambia. I met with him while planning the Global Interdependence Center conference at Victoria Falls in Livingstone. A number of sub-Saharan African nations participated in that conference.
He described to me how the economy of his country was maize-based. He said, “Here I am trying to advise the governor of my central bank about what interest rate he should use for monetary policy. Half of my price index is being driven by rising corn prices.” At the time, Washington’s ethanol subsidy policy was creating those rising corn prices. He looked at me hard and said, “What would you do if you had to advise my governor on central bank policy?” The question had no clear answer, and left both of us perplexed.
Today we confront a similar but even more extreme issue. Ethanol mandates still exist, although a political attack on them is gaining momentum in Washington. The outright subsidies stopped after billions were wasted by our Congress and presidents (Bush and Obama), but the mandate continues. Washington is still causing corn to burn in automobiles. Meanwhile, Washington’s politicians starve hundreds of millions of people in the developing world.
Dear reader, this makes no sense and never has to this writer. But the reason the destructive policy persists is clear to me. Our American political system is corrupted by money, including contributions to politicians who put themselves ahead of most constituents and ahead of the lives of people around the world.
The shock this time is not due to an extreme subsidy. Yes, the subsidy is still there in the mandate. But this time the shock is weather, and nobody can control the weather. We may debate if it is anthropogenic but, alas, we cannot control it.
We may have only begun to experience the food price shocks and to see the steeper prices flow through to the entire food apparatus. Some models that we discussed in Maine indicate that corn could exceed $10 a bushel in a spike.
David R. Kotok, Chairman and Chief Investment Officer