Farmland: Cream of the inflation hedge crop?

Bottom line up top:

• Inflation’s hitting the high notes. Oklahoma!, Rodgers and Hammerstein’s 1943 musical, yielded a bounty of now-ingrained cultural references, including the expression “as high as an elephant’s eye.” Today, that analogy applies not only to tall cornstalks but also to inflation — which still looms above the 2% target set by numerous central banks. In the U.S., year-over-year headline inflation stands at 4.9% and 4.4%, as measured by the Consumer Price Index and Personal Consumption Expenditures Price Index, respectively. At this point, the Federal Reserve isn’t quite ready to let its higher-for-longer rate landscape lie fallow.
• Employment data is writing the score. What might make the Fed change its tune? More slack in the labor market. The number of open jobs and the availability of workers to fill them remains out of whack, putting upward pressure on wages, an important factor in the inflation equation. U.S. job openings increased to 10.1 million in April — far more than consensus expectations and nearly double the historical average. In contrast, the job quits rate declined for the second consecutive month. This metric typically leads wage growth by two to three quarters and may be a more useful gauge of labor market tightness.
  
  Weekly first-time unemployment claims have been moving sideways (Figure 1). For the most recent reporting week, they ticked up to 232,000 but were lower than forecast. Notable movement in one direction or the other could offer a clue as to the Fed’s next move.
  
  Monthly payrolls show a hot labor market that isn’t cooling fast enough for the Fed to consider rate cuts, but we could see a pause this month as the central bank takes time to interpret the data. Employers added a shockingly high 339,000 new jobs in May, while average hourly earnings rose 4.3% year-over-year, a tick lower than in April but still a healthy gain. One sign of weakness: The unemployment rate climbed to 3.7%.
• You can’t reap if you don’t sow. Despite labor market resilience and optimism amid last week’s deal to avert a U.S. government default, we still foresee a mild U.S. recession, although it’s likely been delayed from late 2023 until some time in 2024, as the growth-dampening effects of tight monetary policy work their way through the economy. In the meantime, with high inflation likely to persist, we think investors would be well-served by allocating to real assets that can provide meaningful inflation protection. Farmland could be a good place to start.

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Portfolio considerations

Real assets — historically an effective hedge against inflation — appear well-suited for the current backdrop. Many commodities, such as foodstuffs and raw materials, are components of inflation measurements. As their prices rise, so do the revenues and cash yields for real assets producing these commodities. Additionally, areas such as farmland and timber tend to be less affected by factors that cause day-to-day swings in stock and bond markets, offering a potential source of portfolio diversification.

Investors should consider how much to allocate to real assets, the ability of the asset class to generate attractive risk-adjusted returns and the overall correlations within a portfolio. Figure 2 compares the historical performance of a traditional portfolio consisting of stocks and bonds to portfolios that include real assets, including farmland. While adding farmland on its own significantly improved the historical Sharpe ratio (a measure of risk-adjusted return), other categories of real assets provided benefits as well. Our analysis showed that allocating 5% each to farmland, timber, real estate and infrastructure would have offered compelling results.

Lastly, in addition to hedging inflation, real assets can potentially enhance the defensive posture of a portfolio, making them worthy investment candidates in advance of a possible recession. Farmland and infrastructure, for example, provide basic necessities, so the demand for the goods and services they produce should be resilient in a weakening economic environment.

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