Protect your portfolio from rising food prices

This morning, we've heard that inflation in Britain remained stuck at 3.1% last month.

The Consumer Price Index rose at an annual rate of 3.1% in September, once again more than one percentage point above the Bank of England's central 2% target rate.

The Bank of course, isn't planning to raise rates. If anything, it wants to pump more money into the economy. And it's easy to see why the Bank's worried. Recent data on both retail sales and house prices has been pretty weak.

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Yet for now, despite the slowing economy, the prospect of lower prices seems a long way away. We can keep blaming inflation on 'temporary' factors such as tax-related price hikes, the weak pound, or rising oil prices. But these 'temporary' factors just don't seem to be going away.

And now we have another 'temporary' inflationary force to contend with soaring food prices.

What's causing rising food prices?

The price of grains has surged in the last week or so after the US Department of Agriculture (USDA) warned of "dramatically" lower supplies in its most recent monthly report.

The US is the biggest corn grower and exporter in the world. Earlier this year, all the talk was of record harvests and how the notion of a global food shortage was over-hyped. But since then, bad weather has hit production, while on a global basis, supply has been hit by problems in Russia and Ukraine.

Even so, traders were stunned when the USDA said that it expects US corn farmers to harvest about 12.7bn bushels in the 2010-11 'crop year' (the crop year starts in September). That was about 4% less than had been previously expected, reports the Financial Times. It also means that US corn stockpiles would drop to their lowest levels in nearly 15 years. Soybean and wheat production estimates were also cut.

Prices of various agricultural commodities have shot up as a result. The Reuters-Jefferies CRB commodities index is at a two-year high. Indeed, corn prices have risen by their maximum allowed daily limit on the Chicago Board of Trade for two sessions in a row now (if prices rise by a certain amount, trading is halted).

What's to blame for rising food prices? The answer, it seems, depends on your nationality, according to a Financial Times / Harris poll. If you're French, you blame 'speculators'. If you're British or American, you blame dodgy weather and bad government policies. Very few people questioned believe that it's all down to demand from emerging markets.

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You can see why the French want to blame those nasty 'speculators'. After all, the French are the ones who benefit the most from government intervention in the form of the Common Agricultural Policy. And you can see why the British would rather blame bad government policies as a key financial centre, we're among those who benefit most from commodity trading.

This is a pretty tangled argument. I don't have any easy answers. No one wants to believe that they are profiteering from starving poor people. And most commodity experts argue that betting on commodity prices rising has no more impact on the actual price of the underlying commodity than a bet on a horse influences whether it wins the race or not.

And if speculation really is to blame for higher food prices, then ultimately, it's our central banks who are responsible. They are the driving force behind speculators. Keep money cheap enough, and you drive investors into seeking ever-riskier assets in order to achieve 'real' returns. So as well as robbing savers, it may turn out that the Federal Reserve and the Bank of England are contributing to the global food crisis too.

However, as Dylan Grice of Socit Gnrale recently pointed out, it may be that we are seeing a genuine long-term shift in demand for grains. While issues such as the weather and export bans will obviously have short-term effects on prices, rising demand from emerging markets isn't going to go away.

Two consequences for investors to worry about

In any case, there are a number of knock-on effects for investors to worry about. For one thing, we're likely to see the price of food in supermarkets continue to rise. As well as pushing up the prices of basic foodstuffs, higher corn prices make it more expensive to feed animals for meat. That's bad news for meat producers who had already been hit by the spike in prices of 2007 and 2008. So at some point they'll have to pass those price rises on.

This will make life harder for Western central banks. And it'll make life a lot more expensive for hard-pressed consumers. It's worth remembering that the last time we saw a major commodity price spike like this, in 2008, it was followed rapidly by a big bust. Some pundits even go so far as to argue that the real culprit for the crash was rising oil prices, rather than sub-prime lending. We wouldn't go that far, but it's certainly fair to say that sharply rising living costs are the last thing that Western economies need right now.

What's it all mean? It's another reason to remain defensively positioned. We'll stick with blue-chip, dividend-paying equities the sort of stocks with pricing power and the capacity to withstand economic shocks. Food price inflation is good news for food retailers because it boosts sales and profit margins. Sainsbury (LSE:SBRY) is already doing well this latest news will boost it further.

And for longer-term plays on rising food prices, it's worth having exposure to companies that help increase farming productivity, such as fertiliser producers and others we've discussed in the past.

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