Inflation All Comes Down to the Crops

08/14/2012 11:15 am EST

Focus: COMMODITIES

John Stephenson

President and CEO, Stephenson & Company

It seems no matter how technologically advanced we become, the fact that we have to feed ourselves on crops that rely on vagaries of the weather is lost until the weather throws us a curve ball, observes John Stephenson of Strategic Investor.

Corn prices have surged 63% since mid-June, reaching an all-time high of $8.49 a bushel this past Friday, on the Chicago Board of Trade.

Soaring temperatures are feeding this recent rise in the price of corn. Production in the US, the world’s largest grower and exporter of the grain, will drop 13% to a six-year low after the hottest July since 1936 damaged fields in the Midwest. Crop conditions on August 5 were the worst since 1988, and 69% of the US Midwest was suffering with moderate to exceptional drought conditions, according to government reports.

This year’s corn harvest is expected to be just 10.78 billion bushels—down from 12.36 billion bushels in 2011. Dry weather in Russia and below-average monsoon rains in India are threatening to make the global grain situation a whole lot worse.

Rising grain prices impact not only the price of your daily bread, but also the cost of milk and meat. Soybeans, corn, and wheat are used for cattle and pig feed—therefore, any rise in grain prices directly affects beef and pork prices.

By some estimates, a 30% rise in grain prices translates into a 10% increase in livestock prices (with a three- to six-month lag). But even that may be underestimating the impact of grain prices on America's beef and poultry industries, considering that corn feed represents about two-thirds of the input costs for the beef industry alone.

While rising grain prices may be a good news story for grain farmers, they’re definitely a bad news story for ranchers and poultry producers.

A smaller corn crop may also increase costs for ethanol refiners such as Archer Daniels Midland (ADM) and Valero Energy (VLO), as well as meat producers such as Tyson Foods (TSN) and Smithfield (SFD), which buy the grain for feed. In the last quarter, Cargill cited lower beef-profit margins as contributing to an 82% drop in quarterly earnings.

Food prices in North America are likely to jump by 4% in 2013, but its unlikely that the rising grain prices will put much of a dent in the overall inflation rate. Helping to moderate the impact of rising corn prices this time around was an early wheat harvest in those US regions affected by the drought.

Back in 2008, the United States witnessed a similar rise in raw food prices, resulting in food inflation hitting 6.2%, but with the core inflation rate remaining largely unchanged. It’s likely the case that a short-term spike in food prices will have a minimal impact on US inflation, particularly since the global grain cushions are considerably better than they were in 2008.

But the impact of rising corn prices won't be as muted overseas, where rising grain prices will have a bigger impact on inflation. Recently, the United Nations reported the biggest gain in global food costs since 2009. As a result of the stress in the grain market, world cereal prices surged 17% in July, the most since February 2008, according to the UN’s Food and Agricultural Organization.

In China, the impact of surging grain prices may be a reason to curb monetary stimulus activity in China, since food is such a big component of Chinese CPI. The European Central Bank, unlike the Fed, does not focus on the trend in core prices, suggesting that monetary policy—and hence growth—in Europe may be affected by rising grain prices.

While we’re likely to see at least a temporary blip in our grocery bill, the investment implications are less clear. Rising corn prices are unlikely to impact the trend in the core inflation rate, so investors are cautioned to avoid classic inflation havens, such as gold, that tend to do well when inflation expectations are on the rise.

Instead, investors should look to the producers of fertilizers and the rising fortunes on the farm as savvy ways to play the bumper crop in grain prices.

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