Agcapita April 2010


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Agcapita is Canada's only RRSP and TFSA eligible farmland fund and is part of a family of funds with over $100 million in assets under management. Agcapita believes farmland is a safe investment, that supply is shrinking and that unprecedented demand for "food, feed and fuel" will continue to move crop prices higher over the long-term. Agcapita created the Farmland Investment Partnership to allow investors to add professionally managed farmland to their portfolios.

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Agcapita April 2010

  1. 1. Agcapita Update April 2010
  2. 2. Summary stag-then-flation… Will Rogers famously quipped, “It is difficult to make predictions, especially about the future”. Ignoring Mr. Rogers sage advice I will attempt to make some educated guesses about the future anyway, albeit with the assistance of some analysts far more prescient than I. The evidence from Kenneth Rogoff’s recent research is that in the three years following a financial crisis, on average, cumulative fiscal deficits almost double. We seem to be well along this path in the current crisis. Rogoff’s research also shows that how these deficits are financed is critical to the question of whether inflation ensues, whether you have a Japanese or an Argentinean style post-crisis experience. If Contents the deficits are funded from existing private sector savings (“belt- 3 Is the Financial Crisis Over – Are tightening” as Rogoff describes it) they are typically not inflationary – Our Governments Bankrupt Yet? e.g. Japan. If they are monetized by the central bank (the money is created) they are inflationary – e.g. Argentina. 4 Bail us Out with Printed Money and We’ll Fund Your Deficit Today, in one corner, we have the wholesale liquidation of mal- 5 Double Dip on its Way? What Will investments that have accumulated in virtually every segment of the Central Banks Do? the western economies from residential and commercial real estate 5 Is Anyone Going to be Able to down to the municipal bond markets. In the other corner, we have Pay for the Boomers’ Retirement? governments that are actively resisting this cleansing process as it threatens the solvency of the politically influential financial sector. 6 Moral Hazard and The Fallacy of the Safe Canadian Banking The result is that via bailouts and unprecedented fiscal deficits System private sector credit problems are being moved onto public sector 7 Interest Rates Versus Rollover – balance sheets – balance sheets that are already in precarious Pick Your Risk condition from past over-spending and unfunded future liabilities. 8 Surprise - AIG Took the Fed to the By nationalizing private sector losses governments around the globe Cleaners are seriously compounding their existing budget problems. 8 Banking Sector Back to Record According to research by Société Générale EU and US net Profits liabilities add up to around $135 trillion. That’s roughly four times 9 By 2012 Surplus Oil Production the capitalization of the world’s equity markets and forty times the Capacity Could Disappear cost of the 2008 financial crisis. The US plans to accumulate an 9 Oil Demand Back Past 2007 Peak additional $10 trillion in deficits over the next decade. 1
  3. 3. Summary (continued) These enormous numbers beg the question of how our governments plan to fill their funding gaps? Of course they will attempt to raise taxes, but it seems clear that they are going to resort to inflation as well. Inflation is more politically expedient as the apparent benefits are immediate while the all too real costs are delayed. To borrow yet again from Jens Parsson and his excellent book “Dying of Money”: “The government is free to incur any deficit and issue any amount of debt it may wish, so long as it is willing to draw purchasing power away from other borrowers and to tolerate the rise in interest rates which will result. The debt will create no inflation. Government deficits and government debt thus are not inflationary if they stand alone, but they never stand alone. The creation of government debt is practically always accompanied by an increase of money. Competing against private borrowers for a static supply of credit capital, a large government debt issue would drive interest rates upward, and high interest rates are anathema to a government. A large government debt issue simply could not be marketed without a large increase in the money supply. Therefore the government creates not only the debt but also the money with which to buy it. In addition, large government deficit expenditure tends to accelerate the velocity of money because the government spends its money more rapidly than cautious private spenders do. This combination of increased quantity and velocity of money, not the deficits, does the job, both for economic stimulation and for monetary inflation.” Now here is an attempt at one of those tricky predictions – will we see inflation or deflation over the next decade? I believe you can answer this question by considering the effect of the following factors: – Government Spending & Deficits – increasing – Regulation – increasing – Taxes – increasing – Money Supply – increasing Based on these factors I believe that rather than outright inflation or deflation we face stagflation in the developed world as further state expansion into the economy will reduce real growth while accelerating fiscal deficits combined with money supply expansions will lead to inflation. Low growth + high inflation = stagflation. Therefore, our investment thesis continues to be to gain long-term exposure to inflation hedging, income generating assets, with demonstrated linkages to emerging market growth – energy and agriculture remain our preferred sectors. 2
  4. 4. Agcapita Update (continued) is the finanCial Crisis over – are our governments Bankrupt Yet? Those believing the financial crisis is over are wrong. the capitalization of Datastream’s World equity index It has merely been transformed from a private sector of about $36tr, and forty times the cost of the 2008 to a public sector crisis. Dylan Grice, analyst at financial crisis. Our governments appear to be Société Générale, concludes that developed market insolvent. They’re liquid, so they can stay afloat governments are insolvent by any reasonable the way the Detroit auto companies did for years definition. Socgen’s estimates of capitalized net state despite being insolvent. But unlike the Detroit auto liabilities are shown in Chart 1 as the grey bars. companies, our governments’ debt doesn’t trade at distressed prices and as an effective option on According to Grice “I don’t see how our governments finding an escape from impending bankruptcy. I can pay these liabilities. EU and US net liabilities think they should. Such liabilities have historically add up to around $135tr alone. That’s four times crippled governments (and economies, and companies, and anyone else for that matter). And although governments usually default via inflation, our governments are short real goods and services (e.g. Chart 1: are our governments solvent earnings-linked pensions, health care), which they Official Net Debt, % GDP won’t be able to inflate away. This means there will Total net liabilities (on and off balance sheet), % GDP ultimately be even more pressure to inflate away 750% whatever they can.” Emphasis mine As Peter Bernholz notes in Monetary Regimes and 500% Inflation, “there has never occurred a hyperinflation in history which was not caused by a huge deficit of 250% the state.” The correlation between inflation and fiscal deficits is shown quite clearly by Hussman research set out in Chart 2. Obviously, we are in a period of 0% Germany Spain France Italy UK EU US Canada unprecedented deficit spending – highest levels as a percent of GDP since WWII and highest in absolute Source: SG Global Strategy, OECD, Fraser Institute, Agcapita terms in history of mankind. Will inflation follow? 3
  5. 5. Agcapita Update (continued) Chart 2: us federal spending vs. Cpi Chart 3: CommerCial Bank holdings - us government seCurities vs 16 12 CommerCial loans ($ Billions) 14 Billions of Dollars 10 $1,700 12 $1,600 8 Commercial and Industrial Loans 10 $1,500 $1,400 8 6 $1,300 Gov’t Securities $1,200 6 4 $1,100 4 $1,000 2 $900 2 $800 0 0 $700 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Federal Spending (4 year Growth) CPI Inflation (Right Scale) Source: Federal Reserve Source: Hussman funds Bail us out with printed moneY and we’ll However, according to David Goldman this has the fund Your defiCit effect of backing the Federal Reserve into a corner “Most of this reflects use of the carry trade by foreign At the time when foreign governments are slowing banks, or hedge funds, who are doing exactly what down their purchases of US treasuries US banks the American banks are doing: borrowing at 0.25% are increasing their purchases – putting the excess from central banks and lending it back to the US reserves lent to them by the Federal Reserve into government at 1% or 2%, depending how far out treasuries, rather than private sector loans (Gluskin the curve they go. The demand isn’t coming from Scheff’s David Rosenberg estimates that by February the oil exporters, who appear to be net sellers. On $740bn of bank credit had been withdrawn from the a geographic basis, the main buyers are “United commercial market since the start of the crisis). With Kingdom” and the “Caribbean,” that is, banks and zero cost money and a relatively steep yield curve this hedge funds. is a massive and profitable carry trade and a large, stealth subsidy to the banking sector – borrowing Raise rates and the carry trade comes crashing from the government short and lending to the down. And so does the Treasury market and the government long. mortgage market and the US economy. The Fed is 4
  6. 6. Agcapita Update (continued) stuck with loose money just as the Bank of Japan is anYone going to Be aBle to paY for the was during the 1990s, and for the same reasons.” Boomers’ retirement? douBle dip on its waY? what will the Are boomers merely misinformed or are they Central Banks do? willfully deluding themselves when it comes to their The Consumer Metrics Institute constructs an retirement prospects. index that tracks US consumption based on actual transactions for a range of major discretionary – ING’s minimum estimate of funds required for purchases such as cars, houses, durable goods, and retirement - $675,000 vacations. The ‘Daily Growth Index’ has predicted – Personal estimates of funds required for changes in U.S. GDP reasonably well to date and retirement by household income are set out in recently began to decline rapidly which may indicate Chart 5 – 46% of people surveyed thought less that growth could be about to slump – double dip on than $499,000 was adequate and 29% thought the way? Will even more QE follow? less $250,000 was adequate. Chart 4: dailY growth vs. Bea Chart 5: estimated reQuired savings for QuarterlY gdp retirement BY household inCome GDP Quarterly Monthly Avg. of Change Daily Growth Index All Workers Less than $35,000 50% 8% 8% $35,000-74,999 $75,000 or More 6% 6% Consumer Metrics GDP (Quarterly) Institute Growth Index 30% 4% 4% 29% 27% 26% 23% 24% Growth 20% 2% 2% 20% 17% 16% 14% 13% 13% 13% 13% 0% 0% 3% 3% 8% 8% 6% 5% 6% 4% -2% Contraction -2% -4% -4% Under $250,000- $500,000- $1,000,000- $1,500,000 Don’t know/Don’t $250,000 $499,000 $999,999 1,499,000 or more remember -6% -6% Source: Employee Benefit Research Institute -8% -8% Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar 2006 2007 2008 2009 2010 Source: Consumer Metrics Institute 5
  7. 7. Agcapita Update (continued) Clearly the majority of investors materially moral hazard and the fallaCY of the underestimate what they will need to retire. The safe Canadian Banking sYstem problem becomes worse as even given these low personal estimates, 31% of workers have saved Advocates of the Canadian banking system argue NOTHING for retirement. What this will mean for that Canada’s lack of bank failures is the result of poorly funded boomers and government pension conservative regulation combined with concentration plans over the next two decades remains to be seen in the sector. Yet despite an allegedly more restrictive - will the boomers demand that the government regulatory environment Canadian banks were actually make up the difference regardless of the economic more leveraged than well-run American commercial costs? banks. For example, at the end of 2008 according to research by Peter Boone and Simon Johnson: – JP Morgan leverage - 13 times Chart 6: workers who have saved – JP Morgan Tier 1 capital - 10.9% something for retirement – Royal Bank of Canada leverage - 23 times – Royal Bank of Canada Tier 1 capital - 9% Respondent Respondent and/or Spouse – Wells Fargo leverage - 11 times – Canada’s five largest banks average leverage - 19 78% 72% 75% times 69% 72% 71% 68% 69% 70% 69% 66% Given that Canadian banks were at least as leveraged and thinly capitalized as many of their bankrupt neighbors to the south, what prevented bank collapses in Canada during the crisis? According 57% 58% 74% 65% 67% 68% to Boone and Johnson, guarantees provided by the Canadian government. Over 50% of Canadian 1994 1995 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 mortgages are guaranteed by the government via the Canadian Mortgage and Housing Corporation Source: Employee Benefit Research Institute (“CMHC”) with a below market cost (state subsidized) to insure against default. The US, of course, had Fannie Mae and Freddie Mac, with predictable results as the moral hazard created by the implicit federal guarantee lead directly to their catastrophic participation in the sub-prime mortgage bubble. 6
  8. 8. Agcapita Update (continued) State guarantees have allowed Canadian banks to bonds have seen their best days” and is advising become the classic “too big to fail” organizations investors to buy the debt of countries such as and of course we have graphic evidence that “too Germany and Canada that have low deficits and big to fail” organizations are often on auto-pilot to higher- yielding corporate securities. The net effect of failure based on moral hazard. During the height this ongoing shift will be to increase US interest rates of the crisis, the CEO of Toronto Dominion openly and the cost of servicing the growing state debt. acknowledged the Canadian government “put” when he told investors “Maybe not explicitly, but what are To put the US problems into perspective, look at the the chances that TD Bank is not going to be bailed interest expense of the Federal Government. In 2009 out if it did something stupid?” Some examples of Federal debt increased significantly but at the same “too big to fail, but failed anyway”: time interest expense went down by approximately 15%. In contrast, the 2010 interest expense appears – Britain’s largest bank, the Royal Bank of Scotland, to be set to grow from $383 billion to $434 billion, a grew its balance sheet to around 1.7 times British 13% increase. GDP before it collapsed. – Ireland’s three largest banks’ grew their combined On September 30th 2009 the outstanding debt was balance sheets to around 2.5 times GDP before $12 trillion dollars with an effective average interest they collapsed. rate of 3.2%. If short rates return to the more normal 5% range and long rates return to the 7% range and Can Canadian banks resist the temptation to ignore the Treasury continues finance its needs at the short credit quality in the pursuit of state subsidized profits end of the curve (a strategy that reduces interest and scale? Ultimately, I believe Canadian banks rates but exposes the US government to extreme will be revealed to be the risk mis-pricing machines amounts of rollover risk) the average coupon would that virtually all state backed financial organizations likely rise to about 5.5% which would create an become. interest expense of around $780 billion with interest payments consuming approximately 2/3rds of the US interest rates versus rollover – piCk Federal budget. Your risk Going forward then the US Federal government Over the coming months of 2010 the US Treasury is faced with a serious dilemma – keep interest must refinance $1.8 trillion in maturing debt + interest payments from crippling the budget by funding from payments. “Concerns about the U.S. budget deficit the short end of the curve but then exposing the US are beginning to hurt the Treasury market” said Steve to the risks of a credit event caused by short duration Rodosky, head of Treasury and derivatives trading and the need to frequently rollover (refinance) large at bond giant Pacific Investment Management Co. percentages of its debt. (“Pimco”). Pimco’s Bill Gross said recently “[US] 7
  9. 9. Agcapita Update (continued) surprise - aig took the fed to the crisis, according to Jim Reid, a Deutsche Bank AG Cleaners strategist in London. Chart 8 tracks earnings of finance companies against earnings for non-finance It appears that a charitable interpretation of the companies. “It seems incredible that financials are transfer of the CDO bond portfolio from AIG to now scaling their 2006/2007 heights again,” Reid the Fed is government incompetence in the face wrote in a research note published yesterday. “The of a perceived emergency; the less charitable dramatic imbalances are re-occurring.” interpretation is that AIG took the Fed to the cleaners. According to David Merkel: – The average rating on the bonds in the portfolio is B-, with 61% rated CCC or lower. Below Chart 8: us finanCe seCtor profits BBB, loss rates turn up with significantly. For the vs. gdp portfolio to be B- rated on average, with 61% in billions CCC and below represents extremely poor credit 500 quality. Financial industry profits – 73% of the deals in the bonds originated between Non-financial industry profits Nominal U.S. gross domestic product 2005 and 2007, and 96% between 2004 and 400 2008. Arguably the 2003-2008 period represents the worst period for lax credit standards. 300 According to Merkel, it is extremely unlikely that the portfolio will ever exceed the $22 billion fair market 200 value ascribed to it by the Fed – i.e. the loss is permanent. 100 Banking seCtor BaCk to reCord profits Record low U.S. interest rates are boosting the 0 1970s 1980s 1990s 2000s profitability of the financial sector, creating the same kind of imbalances that fueled the credit Source: Deutsche Bank AG 8
  10. 10. Agcapita Update (continued) BY 2012 surplus oil produCtion CapaCitY oil demand BaCk past 2007 peak Could disappear Economic growth in the developing world, and According to the United States Joint Forces especially China, which reported first quarter growth Command (“USJFC”) annual report “By 2012, surplus of 11.9%, caused the IEA to up its estimate for 2010 oil production capacity could entirely disappear, and oil demand to a record high of 86.6 million barrels/day as early as 2015, the shortfall in output could reach - marginally higher than 2007 peak production level nearly 10 MBD.” The report points to growing energy that saw a peak oil price of US$147/barrel. Of course demand in the developing world, citing as an example much has changed since 2007, Western economies the huge potential for growth in car ownership in are still barely emerging from recession and are China, which currently has only 40 million vehicles saddled with massive public debt, so the growth compared to the 250 million in the USA. The USJFC estimate signals a shift in which the developing predicts that the coming oil supply gap will “at best... economies grow even without a recovery in their key lead to periods of harsh economic adjustment”. export markets. 9
  11. 11. disClaimer: The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Agcapita Partners LP (“AGCAPITA”) and its affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither AGCAPITA nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to AGCAPITA and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting AGCAPITA or its relevant affiliate directly. #400, 2424 4th street sw tel: +1.403.218.6506 Calgary, alberta t2s 2t4 fax: +1.403.266.1541 Canada