How to profit from higher food prices

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Politicians have never been seen as a terribly useful bunch. There's an obscure PG Wodehouse poem called "The Parrot" in which the titular fowl drives the denizens of 20s clubland almost insane by incessantly chanting the phrase "Your Food Will Cost You More". The poem was satirical; the UK was suffering some food shortages at the time and the parrot was echoing the unhelpful response of many MPs.

But modern-day consumers may soon be equally sick of the same words. Buried in Thursday's inflation data was further evidence that inflation pressures are spreading, with food stores hiking their prices by 2% in the year to September.

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Any sign of higher food prices is rather worrying from an inflation point of view. Food may be non-core' to economists but it's fairly core to the consumer. If the price of most other goods rises, people can simply cut the amount that they buy. But that's not really an option with food unless, of course, the inflation is purely in caviar and champagne.

So if food bills rise sharply as a percentage of income, people start demanding more income to compensate. And thus you can find yourself on the slippery slope to a wage-price spiral - prices rise, causing people to demand more wages, which then forces companies to hike prices to compensate, and so on.

Whether this happens or not depends to some extent on why food prices are going up. So what are the reasons?

There are two obvious possibilities. One is that the added costs that producers and retailers have been suffering for a while such as energy costs are being passed on to the customers. Some people argue that if that's the case, it isn't really a problem: now that the oil price has eased off, so will energy costs and so after a lag will consumer prices.

We're not convinced by this upbeat outlook. Firstly, firms will do their best to make prices increases stick, even if their costs start falling again. Secondly, even if lower energy costs do feed back into food inflation probably as a result of competition between the supermarkets there will be a lag before this happens. And that lag could easily be enough time for inflation expectations to take hold and for people to start demanding more money from their employers, particularly with the key January pay round approaching.

The other possibility is even more worrying: that food commodity prices are primed to explode. In the last few months we've seen a very strong run up in agricultural commodity futures. Raw foodstuffs such as coffee, orange juice and most recently wheat have been hitting multi-year highs.

Here at MoneyWeek, we believe there could be a secular bull market in agricultural commodities over the next couple of decades. The root causes are the same as for the industrial commodity bull market that has already kicked off. As countries such as China and India become wealthier they will consume more, higher-quality foods.

Whether this agricultural boom is underway yet is uncertain. The recent price surges could be a response to supply shortages or they could be the impact of speculative money on exchanges.

Certainly there's some support for the supply shortages argument. The three commodities mentioned above all have supply risks over the next year or so. Fears of a frost in Florida have pushed up orange juice prices, while the dry season that Brazil has just experienced could severely cut next years' coffee crop if followed by a harsh winter. Meanwhile, drought and poor weather are threatening serious wheat shortfalls in some major producing countries.

But there's also evidence that speculators are piling into agricultural commodities in greater numbers. Given the amount of surplus liquidity in the world it would be amazing if they didn't; these funds feel compelled to chase after anything that moves.

Whatever the cause, there's a real risk that the parrot's refrain - 'Your food will cost you more' - will come true in the short term. If it's speculative money driving up prices, higher interest rates globally should bring prices down again quite quickly by drying up liquidity.

On the other hand, if it's a supply shortage, then it will take at least a year or two until new crops have grown and supply increases. Rate hikes do nothing to help that, but they may be necessary to restrain inflationary pressures elsewhere in the economy.

Of course, regardless of what's driving the current surge, rising demand for agricultural goods seems certain to push prices up further in the long-term - so it's well worth having some exposure to this trend. For more on investing in agricultural (or 'soft' commodities, you can read MoneyWeek's recent Roundtable on the topic, by clicking here: The best ways to invest in soft commodities.

And turning back to interest rates - they seem certain to rise before the end of the year. Friday's UK GDP figures have made a November hike a nigh-on sure thing. The first official estimate of third-quarter growth was scarcely blistering at 0.7%, but it came in above expectations. While stronger growth may sound encouraging, signs that the economy isn't slowing as quickly as expected suggest that rates should go higher.

However, there is one complication for the Bank of England much of the UK's economic growth recent years has been the result of our cheap credit-fuelled spending spree. People have been borrowing from their future to have a good time today, which means that our 'strong' growth has been borrowed too.

To bring the spending splurge to an end requires higher interest rates. But keeping rates at exactly the level that allows the credit bubble to deflate gently will be very tricky for the BoE.

And in fact, there may not be such a level. If rising inflation expectations take hold, then the Bank will be forced to combat the threat of inflation by keeping interest rates high even as the economy is slowing down.

And in any case, there's only so much debt that people can take on. You can't borrow money indefinitely - at some point, you reach the limit of your ability to pay, and either go bankrupt or cut your spending. Once this happens, the softest interest rates in the world can't persuade a person to take on more debt.

This mess may take a long time to unravel. But when it eventually does, the odds must be on a very hard landing.

Turning to the markets...

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The FTSE 100 ended the day just under one point lower, at 6,155, recovering from an afternoon slide. The day's biggest riser was Hammerson, on the back of positive broker comment. British Energy Group was the biggest faller once again, its share price sliding over 4.5% lower. For a full market report, see: London market close

Elsewhere in Europe, the Paris CAC-40 climbed 15 points to close at 5,375, boosted by strength amongst oil stocks including Total. In Frankfurt, the DAX-30 was 25 points higher at 6,202.

On Wall Street, the Dow Jones ended its winning streak, closing 9 points lower at 12,002, following a profits warning from Caterpillar. The Nasdaq was 1 point higher, at 2,342, as was the S&P 500 which ended the day at 1,368.

In Asia, the Nikkei up 137 points, at 16,788.

Crude oil futures fell again as traders waited to see whether Opec would follow through on its promise to cut production. Crude last traded at $58.81, whilst Brent spot was over 1% lower, at $56.87.

Spot gold last traded at $592 this morning.

And Intercontinental Hotels announced today that it is to pay £8m for a majority stake in a hotel venture with All Nippon airlines, boosting its presence in Japan. Shares in Intercontinental rose by as much as 0.5% in London this morning.

And our two recommended articles for today...

How will falling US consumer spending affect gold?

- Paul van Eeden examines past and current trends to suggest what the fallout from the US housing slump will be. Like most commentators, he believes it will put the brakes on consumer spending. To find out what this will mean for the price of gold- and other base metals - click here: How will falling US consumer spending affect gold?

Global economic growth: have we avoided a downturn?

- Financial markets have quickly tired of the slowdown play - the reacceleration bet is being priced back into asset markets. But is the lower price of oil - seen by many as the reason for more positive sentiment - all it's cracked up to be? Stephen Roach looks at whether now is the time to be optimistic: Global economic growth: have we avoided a downturn?