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Food Costs Could Crimp Global Growth

Daniel M. Harrison

The global market's recovery from the Asia-led swoon faces a challenge that's not on most investors' radar screens -- but is on their dinner plates.

Over the past year, the price of corn has doubled, grain prices have surged 70%, soybean prices have risen 27%, and inflation in confectionary materials is running at a 12-year high, up nearly 10%. In addition, the price of animal feed has gone up by 18%, and after falling most of last year, fertilizer has inched back up 5% in the past three months.

The massive price surges have resulted in the cost of global finished consumer foods rising 10% in the last year and baked goods gaining in nine out the past 10 months. These latent inflationary pressures may be more significant than many realize, some say.

"Markets have got so excited recently over U.S. inflationary figures, but we have to be concerned about using one set of figures for the global economy," says Justin Urquhart-Stewart, a director of global investor Seven Investment Management in London. "It's not a sensible method of running any investment plan."

The concerns over exported inflationary pressures generally and the recent drive in food prices specifically is important because it suggests that the attitude of the Federal Reserve last Wednesday about inflation may have been too casual, say market commentators, particularly those in the U.K. and Asia.

The reason for this round of food price inflation is a growing urban middle class in emerging-market countries and increased mandates for the use of clean fuels such as ethanol, which is made from corn of sugar cane.

While shareholders in emerging-market ETFs such as the FTSE Xinhua 25 Index (FXI Quote), the MSCI Emerging Markets Index (EEM Quote), the iShares Brazil (EWZ Quote), and the iShares Taiwan (EWT Quote) have enjoyed substantial gains in the past year, the increased consumption that is fueling such economies' growth is also raising costs globally.

For example, while Pakistan's ministry of finance announced last week that consumer price index-based inflation was down on the year ended Feb. 28 from 8.05% to 7.4%, even the country's efforts to tighten monetary policy couldn't keep food inflation from surging 2.7% over the last year to 10.3%.

Furthermore, after years of keeping global inflation down with its masses of cheap labor, China is now beginning to export inflation with its growth, says Urquhart-Stewart. "Over the past years, China has net absorbed inflation with its deflation," he says. "China is now exporting inflationary pressure, and costs are no longer falling."

One main way it is exporting that inflation is in food products.

Just as the slump in China's Shanghai Composite Index in February had repercussions in the U.S. markets, so too might this export of inflation.

"Food inflation charts are pretty disturbing and will doubtless see further increases move through into the U.S. CPI and PPI," says an internal research memo issued to traders at J.M. Finn in London on March 16. "Do note that the key component driving Chinese inflation is the food side of their calculations. It is very hard to see how [second-half 2007] sees inflation tailing off within China as some notable commentators say they expect."

From an investment perspective, food manufacturers such as General Mills (GIS Quote), Kellogg (K Quote) and Tyson Foods (TSN Quote) may be some of the hardest hit by the hike in food prices.

"All food manufacturers are making price adjustments," General Mills Chairman and CEO Steve Sanger said in an interview with Dow Jones Newswires last week. "We're no exception to that."

In Mexico, manufacturers have already started to feel the pain of the inflation, with political consequences. In January, Mexico's President Felipe Calderon was forced to impose a price cap on tortillas of 35 cents a pound, after thousands stormed Mexico City's Central Square in protest of the massive rise in recent prices of tortillas.

Tortillas are a staple in the diets of most Mexicans and a key component of the Mexican economy. The price cap, which is 40% more than the price for tortillas only three months ago, is still generating political tension in the country. The hike in tortilla prices is believed to be a result of the demand for corn ethanol, generated by President Bush's recommendations for a fourfold increase in the use of the substance in his new "cleaner energy" initiative.

Another way manufacturers may pass on the price increases to consumers is in reducing the size of the packages of their products, many say. The rise in prices of sugar and corn may also force companies such as Coca-Cola (KO Quote) and Pepsi (PEP Quote) to lift prices in soft drinks and snacks.

Conversely, big food retailers such as Wal-Mart Stores (WMT Quote), Kroger (KR Quote), Costco (COST Quote) and Albertsons have been winners in the past year. Their ability to weather decreased margins vs. smaller traditional retailers while still keeping costs low gives them increasing prominence in the food retail market, writes Ephraim Leibtag, an analyst from the U.S. Department of Agriculture, in a December research report.

In clean fuels, next year the EU has stipulated that 6% of all diesel fuel produced in Europe must be biodiesel, as opposed to the current level of 2%. The demand for biodiesel has seen a rush in public listings of biodiesel producers on London's Alternative Investment Market, as well as hefty returns for shareholders. But such policy is putting pressure on countries that supply the vegetable components used to make the clean fuel.

The Philippines has voiced concern recently that it will be unable to meet demand for copra, a substance produced from coconuts that is used in the fuel. Such supply shortages would also put more pressure on food prices.