One of the discussion topics in the Q&A with President Clinton was the topic of food security, an area that he said could use more attention from the journalist/blogger community. In a follow-up post [see here], I'll discuss some of President Clinton's comments on this topic, but before I do that, I'd like to lay a better foundation by exploring the role of market speculation on food prices, and by extension food security, across the world. That's the focus of this post.
The key findings in this post, discussed in the ensuing sections, can be summarized as follows.
- Massive food price increases/bubbles were not unique to the 2000s but the recent price increases do appear to be unprecedented in modern history. Since the massive food price spike in the early 1970s, food prices experienced a long period of decline or relative stability until roughly late-2006, after which prices spiked. (Section I)
- The two huge spikes in food prices - in 2007-08 just before the darkest period of the Great Recession and since late 2010 during the ensuing recovery - have been accompanied by food-related riots or unrest in several countries across the world, some of which were part of the so-called Arab Spring. Addressing the cause of the price spikes is therefore paramount to maintaining stability in the world. (Section II)
- Recently published research shows that food price increases in the 2000s have been dominated by two factors - a secular shift upwards in the price baseline due to corn-to-ethanol fuel conversion (which reduces the supply of grains available for food consumption) and massive spikes tied to speculation in commodity markets. (Section III)
- An assessment of key market data indicates that the first food price spike in the 2007-2008 time period was fueled at least in part by money moving out of a collapsing housing market bubble looking for alternative safe-havens. However, since the depth of the Great Recession, food prices have become strongly correlated to the broad stock market. (Section IV)
- The strong positive correlation between commodity/food prices and stock markets since mid-2008 is historically anomalous and is suggestive that in the absence of alternative investments (e.g., housing), trillions of dollars are finding their way into commodity markets as primary investment options, not merely as a hedge against equities. (Section V)
Implications: The implications of the data presented in this post are fairly grave. For one thing, the criticality of appropriate regulation of commodities has likely increased even more during the recovery from the Great Recession than was the case during past recoveries. A world in which food or other essential commodities become not low-yielding hedge investments for businesses that are in the commodities sector and sometimes for outside entities like pension funds but mainstream speculative investment vehicles with returns equaling or exceeding equities - is a world that could become staggeringly more unstable and prone to crises. We therefore ought to invest enormous attention to solving this challenge.
The massive rise in food prices in recent years appears to be unprecedented as noted by Randall Wray at Credit Writedowns. Sharp food price increases are not unique to the 2000s - for example, there is evidence from the early 1970s that speculative bubbles were at least partly behind large commodity price increases at that time. However, since the early 1970s and prior to the second half of the last decade, the historical trend in food prices has generally been downward to flat, as can be seen from this chart published earlier this year in the report "Hungry for Justice - Fighting Starvation in an Age of Plenty" by the NGO aid organization Christian Aid.
In the past several years, there have been two massive food price spikes - in 2007-08 just before the darkest period of the Great Recession and since late 2010 during the ensuing recovery. Naturally, such steep increases in food prices could have major negative consequences. In a just-published paper - “The Food Crises and Political Instability in North Africa and the Middle East”, the authors M. Lagi, K. Z. Bertrand and Y. Bar-Yam illustrate the dependency between food prices and global instabilities using this chart:
Their entire paper is worth reading given they have also developed a model to predict food price thresholds that might result in future crises. We turn our attention, however, to what might be causing the price spikes.
There has been quite a bit of debate on the root causes for the recent food price increases. Another must-read paper, also published in Sep 2011 by M. Lagi, Yavni Bar-Yam, K.Z. Bertrand, Yaneer Bar-Yam provides us a great framework for exploring the various aspects of this debate - "The Food Crises: A Quantitative Model of Food Prices Including Speculators and Ethanol Conversion" (via Marion Nestle at Food Politics). Here is the abstract of the paper [bold text everywhere is my emphasis]:
Recent increases in basic food prices are severely impacting vulnerable populations worldwide. Proposed causes such as shortages of grain due to adverse weather, increasing meat consumption in China and India, conversion of corn to ethanol in the US, and investor speculation on commodity markets lead to widely differing implications for policy. A lack of clarity about which factors are responsible reinforces policy inaction. Here, for the first time, we construct a dynamic model that quantitatively agrees with food prices. The results show that the dominant causes of price increases are investor speculation and ethanol conversion. Models that just treat supply and demand are not consistent with the actual price dynamics. The two sharp peaks in 2007/2008 and 2010/2011 are specifically due to investor speculation, while an underlying trend is due to increasing demand from ethanol conversion. The model includes investor trend-following as well as shifting between commodities, equities and bonds to take advantage of increased expected returns. Claims that speculators cannot influence grain prices are shown to be invalid by direct analysis of price setting practices of granaries. Both causes of price increase, speculative investment and ethanol conversion, are promoted by recent regulatory changes—deregulation of the commodity markets, and policies promoting the conversion of corn to ethanol. Rapid action is needed to reduce the impacts of the price increases on global hunger.
These observations are partly summarized graphically in the chart below (from their paper). The findings are not entirely surprising given past discussions on the role of ethanol conversion and rampant commodity market speculation on food prices (tied in part to government subsidies and deregulation respectively, topics to which I will return in my next post), but they are quite significant given that the authors have been able to show quantitatively that these two factors can explain much of the food price increases over the last several years.
In the context of market speculation, the authors also compared the commodity price changes to the S&P 500 trend and observe that:
The increase in food prices coincided with the financial crisis and followed the decline of the housing and stock markets. An economic crisis would be expected to result in a decrease in commodity prices due to a drop in demand from lower overall economic activity. The observed counterintuitive increase in commodity prices can be understood from the behavior expected of investors in the aftermath of the collapse of the mortgage and stock markets: shifting assets to alternative investments, particularly the commodity futures market [133-135]. This creates a context for intermittent bubbles, where the prices increase due to the artificial demand of investment, and then crash due to their inconsistency with actual supply and demand, only to be followed by another increase at the next upward fluctuation.
Their observation that commodity prices continued to rise after declines in the housing and stock markets is worth discussing further. It's best illustrated using a couple of charts that I put together below (discussion follows the charts). Both charts show the FAO Food Price Index and the S&P/Case-Shiller Composite-20 Seasonally Adjusted Home Price Index (as a proxy for the housing market) between the time period of Jan 2000 and July 2011. The first chart is a line chart with time as the X-axis, the second chart is an X-Y chart with the Case-Shiller index as the X-axis and the FAO food price index in the Y-axis.
Here's an alternative view of the same data set:
The data from these charts suggest 5 distinct phases in the evolution of food prices in the last decade.
Phase 1: Early 2000 - Late 2006 when food prices were responding largely to supply/demand and ethanol conversion and were not strongly correlated to either the housing or stock markets
- During this phase, the housing market skyrocketed and the stock market went through a down period before regaining its footing & previous high and was not particularly well correlated to the food price index
Phase II: Late 2006 to Late 2007 when the stock market continued to rise but the housing market started to unwind rapidly, with the food price index starting its first abnormally rapid ascent
- The behavior of food prices during this phase is indicative that a large amount of the speculative investment from the housing market started to look for other investments and entered the commodity markets. It's certainly possible that some of the investment from the housing market also entered the stock market in this phase.
Phase III: Late 2007 to Mid 2008 when the housing market continued to plummet and the stock market started to decline, but the food price index continued its ascent, though not as rapidly as before
- For instance, although the DJIA hit a peak in Oct 2007, it declined roughly 15% until early June 2008. During this time, the FAO food price index increased roughly 18%. Hence for a period of several months after the stock market had peaked, food prices continued to increase, but at a slower rate than in the prior period.
Phase IV: Mid 2008 to Early 2009 when the housing market continued to decline and the stock market & food prices plummeted during the depths of the Great Recession
- Both the stock market and the food price index started to plummet at around the same time, even though the stock market peaked several months ahead of the food price index. Major stock market crashes are usually associated with or anticipate large growth rate cycle or business cycle downturns, when demand is exceeded by supply. Naturally, it would be more risky to pursue speculative bets on commodities during such periods due to the higher than expected probability that commodity prices are likely to fall during such downturns.
Phase V: Early 2009 to July 2011 when the housing market has been largely flat, while stocks & food prices rose rapidly
- Interestingly, the DJIA started its most recent sharp descent in July 2011, while the FAO food price index peaked in June 2011 and appears to have started a slight decline since then (data is only available until August 2011 as of the time of this writing). So, the FAO food price index appears to have correlated positively with the stock market since late 2008/early 2009.
The observations in Section IV raise two immediate questions in my mind.
(a) Is the recent positive correlation between the stock market and commodity prices unusual?
The answer is yes. Commodity investments were at one time considered to be an
alternative to fixed income investments as part of a portfolio that also
included sectors like real estate - see for example
this article. The returns were not expected to match the returns one might
expect in riskier equity markets. However, with the implosion of the housing
market, the concomitant discovery that massive returns are possible in
commodities and underlying fundamentals tied to demand, ethanol
conversion, and extreme climate events that could be exploited to drive
speculative excesses in commodities, there appears to have been a notable
change in the correlation between equities and commodities in recent years. An example is the chart below, reproduced from the paper - "What
Explains the Growth in Commodity Derivatives?" - by P. Basu and W. T. Gavin
published in Jan/Feb 2011.
As the authors point out:
Figure 6 reports a rolling correlation coefficient between total returns to investments in the Wilshire 5000 and the S&P GSCI using a 1-year window. The correlation is relatively small and generally not significantly different from zero until the onset of the financial crisis. During and following the crisis, the correlation is very large and positive.
(b) Is there enough money being pumped into the commodity markets to effect the kind of massive changes that we've seen in commodity prices in the last several years?
Again, the answer is YES. From the same Basu/Gavin paper, we have the following charts...this one:
And this one:
In some ways, this is a startling turn of events. As the authors note:
We offer two possible explanations for the surge in trading commodity derivatives. The first also explains the massive increase in trading of risky mortgage debt and all financial derivatives: Investors were searching for more substantial yields in an environment with very low returns paid on safe assets. This also explains why investors moved from real estate derivatives to commodity derivatives when the problems in the subprime market became apparent.
The second reason is a prevailing notion among institutional investors that commodity derivatives are an asset class that can be used to hedge equity risk, a notion we argue is mistaken. Even if the observed correlation between equity and commodity futures returns were reliably negative, it is likely that this negative correlation would be an equilibrium arbitrage phenomenon that should be expected in a world where no unexploited hedging profit opportunity exists. The rise in commodity derivative trading thus poses a challenge to asset-pricing theorists to explain in a well-articulated rational asset pricing model.
A lesson from the crisis is that regulators and policymakers should monitor financial innovations closely to learn whether they are being used to take excessive risks—that is, risks firms would not take if they were operating outside the government’s safety net. Under new regulations, the CFTC will collect information that should make trading in commodity derivatives more transparent. Banks argue that they need to use commodity derivatives to help customers manage risks. This may be true, but the recent experience in commodity futures did not reduce risks but exacerbated them just at the wrong time. The challenge to the government is to prevent too-big-to-fail firms from using current and yet invented derivatives to increase overall risk in the financial system.
I'll pick up the discussion on this topic further in my next post, that will also include President Clinton's comments on food security.