Agcapita Macro Update
October 2009


There has been considerable discussion recently about the
“paradox” of bonds and stocks and commodities going ...
Global Macro Update

Us FisCal DeFiCit

By the end of 2019, according to the administration’s                If you wer...
Global Macro Update (continued)

Global Macro Update (continued)

                                                                  2009) the index has ...
Global Macro Update (continued)

have allowed banks to delay reporting loan losses            intertwined worlds of pol...
Global Macro Update (continued)

though the debt has exploded, the interest for fiscal
2009 is down to “only” $383 bill...

                                  The information, opinions, estimates, projections and other materials
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Agcapita Oct Macro Briefing


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Agcapita is Canada's only RRSP and TFSA eligible farmland fund and is part of a family of funds with almost $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 Oct Macro Briefing

  1. 1. Agcapita Macro Update October 2009 1
  2. 2. Summary There has been considerable discussion recently about the “paradox” of bonds and stocks and commodities going up together - that the bond market is predicting a continuing recession via low interest rates and the stock market is predicting a recovery via high equity prices. Why is the bond market behaving so strangely in the face of a huge recovery stocks and commodities – surely one of these indicators must be wrong? Maybe, but perhaps there is an alternative interpretation that fits the facts. Markets always appear to act strangely to profit maximisers when non-profit maximisers are involved. I actually feel that the behavior of the sovereign debt market makes sense. Virtually every asset class is exhibiting the short-term effects of a massive monetary expansion. Once again assets that are liquid and traded - including LT sovereign debt – are rapidly “increasing” in price in nominal terms. Monetary authorities have expanded the global money supply aggressively allowing speculative activities to re-ignite via Contents investment and commercial banking intermediaries and at the same 2 US Fiscal Deficit time they are busy monetizing the rapidly expanding government 2 Failed Government Bond Auction debts - hence low interest rates and rapidly recovering equity prices. 2 US Sovereign Debt: When cross-correlations between assets classes are very high and 2 Unfunded Debt and Obligations positive we should always be asking ourselves whether we are in a 3 China Reducing Its Treasury period of liquidity/money printing induced euphoria. Duration Ultimately monetary authorities can control exchange rates or 3 Another US Bailout in the Wings? interest rates but not both. If they decide to sacrifice exchange 4 More Trouble on the Way in the rates for low interest rates then, in my opinion, inflation is sure to Banking System follow. 5 Hyperinflation – Quick Facts Kind Regards Stephen Johnston - Partner 1
  3. 3. Global Macro Update Us FisCal DeFiCit By the end of 2019, according to the administration’s If you were a foreign government, would you want to budget numbers, the US federal debt will reach increase your holdings of Treasury securities knowing $23.3 trillion—as compared to $11.9 trillion today. the U.S. government has no plans to balance its The U.S. federal debt was equal to 61.4% of GDP in budget during the next decade, let alone achieve a 1999, 70.2% of GDP in 2008 and is now projected surplus? to increase 90.4% in 2009 ultimately reaching 100% in 2011, after which the projected federal debt will FaileD Government BonD aUCtion continue to equal or exceed the US’s entire annual economic output through 2019. The Debt to GDP Latvia recently tried to raise US$17 million worth of ratio effectively measures a nation’s capacity to 6-month bonds. How likely is it that Latvia will default generate sufficient wealth to repay its creditors. The in the next six months? Unlikely, and yet the auction U.S. is thus on track to enter the ranks of those failed with no bids. When lenders lose confidence countries—Zimbabwe, Japan, Lebanon, Singapore, in a government’s ability to repay, the consequences Jamaica, Italy—with the highest government debt- can be swift and total - they refuse to lend it money. to-GDP ratio. In 2008, the U.S. ranked 23rd on the list—crossing the 100% threshold vaults the US into Us sovereiGn DeBt seventh place. Lenders are still willing to provide the US government 30 year financing at a 4% annual yield. For three Chart 1: Deeper in DeBt month funding they only charge the US government 0.066%. For a government heading into massive Budget surplus/deficit As percentage and prolonged fiscal deficits this seems somewhat (in billions) of GDP generous on the part of the markets. $500 5% surplus projections UnFUnDeD DeBt anD oBliGations deficit 0 The Obama Administration, unaware or ignoring the 500 -5 fact that the total unfunded debts and obligations of 1000 -10 the federal government have grown to nearly $120 trillion, continues to pursue a policy of massive fiscal 1500 -15 deficits. 2000 -20 1970s 1980s 1990s 2000s 2010s Source: OMB (historical); Committee for a Responsible Federal Budget, CBA (projections) 2
  4. 4. Global Macro Update (continued) another Us BailoUt in the WinGs? Chart 2: total U.s. DeBt as a perCent oF GDp A year ago the US government took over Fannie Mae and Freddie Mac to prevent them from failing. Now 1,200 1142 the Federal Housing Administration appears “destined 1012 1025 for a taxpayer bailout in the next 24 to 36 months” 1,000 according to Edward Pinto at a recent Congressional hearing. Edward Pinto, of course, is the former 800 chief credit officer for Fannie Mae so perhaps he is 600 speaking from experience. 400 311 FHA has managed to repeat all of Fannie and 263 Freddie’s mistakes – which of course was what was 200 hoped would happen. The FHA stepped in and 87 became a huge player in the mortgage loan markets 0 specifically to replace the crippled Fannie and Gross Federal, add; add; GSE add; SS/ add; Foreign add; Financial State & Local Household, Medicare held sector Freddie. The proof is in the data - FHA went from Gov’t Business insuring 6% of new mortgages in 2007 to over 21% Source: Federal Reserve Z 1, FHFA GSE Report 2008/ last year and accelerating in 2009. RGE Monitor, Richard W Fischer (“Storms on the Horizon,”, Dallas Fed 5/28/2008), Rather & Kittrell What does that portfolio look like? The FHA insures 5.4 million single-family home mortgages - most of which require only a 3.5% down payment - at a value of $675 billion. At the same time the FHA has China reDUCinG its treasUry DUration only $30 billion in capital – a 20-1 leverage level that How to start getting out of the dollar while not proved too much for some of the largest investment appearing to be getting out of the dollar? One way banks and insurance companies in the world. Of is to shorten the duration of your bond holdings or to course when you provide credit that the market will announce purchases of hard asset denominated in not, you suffer default rates that reflect the risk you dollars. This is exactly what is happening. China, for are taking on. FHA defaults rates are starting to instance, continues to accumulate Treasuries -- but increase rapidly. only short-term notes, not long-term bonds -- while buying up real assets like oil fields and iron ore mines. 3
  5. 5. Global Macro Update (continued) 2009) the index has recorded a 22% drop in value. Chart 3: loan portFolio DeFaUlt rate The quality of commercial real estate loans held by Default Rate banks is going to be seriously impaired soon. 2007 loans 30% 2006 loans 2008 loans 20 Chart 4: CommerCial real estate 2005 loans (% ChanGe) 10 25% 2004 loans 20% 15% 0 10% 1 2 3 4 Years since loans were made 0% -5% Source: FHA, The NY Times -10% -15% 1978 1980 1982 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 more troUBle on the Way in the BankinG system Source: NCREIF Commercial Real Estate Index data Over the last decade commercial real estate boomed. All over the globe developers borrowed trillions to build office towers, malls and industrial parks The magnitude of this problem will be as big as based in part on the belief that prices and rents the problem caused by loan losses on residential would rise for the foreseeable future. The National housing and as widely spread throughout the global Council of Real Estate Investment Fiduciaries banking system. Banks cannot continue to carry (NCREIF) is an association of institutional real estate these commercial real estate loans on their books at professionals. The NCREIF Property Index is a face value. Commercial borrowers cannot refinance quarterly time series composite total rate of return their loans if the property isn’t worth as much as measure of investment performance of a very large the debt. Trillions of dollars of commercial real pool of individual commercial real estate properties estate loans are coming due and the recession has acquired in the private market for investment caused occupancy levels and rents to fall and, with purposes only. The NCREIF index makes it clear that them, property values. The appearance that the one of the largest drops in US commercial real estate commercial real estate market has held up better values is currently underway and it is still the early than the residential market to date is an accounting innings. Over the last four quarters (3Q 2008-2Q fiction. The new mark-to-market accounting rules 4
  6. 6. Global Macro Update (continued) have allowed banks to delay reporting loan losses intertwined worlds of politics and economics with until their loans mature – rather than mark them to special attention given to money. In his most recent market. The rules also allow commercial real estate book, Monetary Regimes and Inflation: History, owners from reporting investment losses until they Economic and Political Relationships, Bernholz sell the property. The losses are still there and will analyzes the 12 largest episodes of hyperinflations begin to crystallize as loans fail to roll-over and - all of which were caused by financing huge owners go under. The stock prices of commercial public budget deficits through money creation. His property REITs should start to reflect these conclusion: the tipping point for hyperinflation occurs deteriorating fundamentals. REITS hold billions in when the government’s deficit exceeded 40% of its commercial property investments that will have to be expenditures. marked down. The banking sector will also suffer as the magnitude of these loan losses will be equal to or “According to the current Office of Management and perhaps even exceed the losses suffered from loans Budget (OMB) projections, US federal expenditures made to the residential real estate sector. are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010, with unified deficits of hyperinFlation – QUiCk FaCts $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to I want to quote a recent article by high profile financial 43.3% and 39.9% of expenditures in 2009 and 2010, analyst John Maudlin. Its makes fascinating reading. respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. “Killing the Goose” by John Mauldin “One has to ask whether the US reached the critical “Western democracies, communistic capitalists, and tipping point. Beyond the quantitative measurements Japanese deflationists are concurrently engaging in associated with government deficits and money what may be the largest, global financial experiment creation, there exists a qualitative aspect to such in history. Everywhere you turn, governments are a scenario that may be far more important. The running enormous fiscal deficits financed by printing qualitative perceptions of fiscal and monetary policies money. The greatest risk of these policies is that are impossible to control once confidence is lost. the quantitative easing will persist until the value of In fact, recent price action in metals, the dollar and the currency equals the actual cost of printing the commodities suggests that the market is already currency (which is just slightly above zero). anticipating the future.” “There have been 28 episodes of hyperinflation of Let me point out that the deficits for 2010 assume national economies in the 20th century, with 20 a rather robust recovery, and so they could turn occurring after 1980. Peter Bernholz (Professor out to be much worse, especially if unemployment Emeritus of Economics in the Center for Economics continues to rise and Congress decides (rightly) to and Business (WWZ) at the University of Basel, extend unemployment benefits. The interest on the Switzerland) has spent his career examining the national debt in fiscal 2008 was $451 billion. Even 5
  7. 7. Global Macro Update (continued) though the debt has exploded, the interest for fiscal 2009 is down to “only” $383 billion. My back-of-the- napkin estimate says that is over 20% of total 2009 tax receipts. I guess when you take interest rates to zero and really load up on short-term debt, it helps lower interest costs. The fiscal deficits are projected to be about 11% of nominal GDP, which is now roughly $14.3 trillion. The Congressional Budget Office currently projects that deficits will still be $1 trillion in ten years. Last spring I published as an Outside the Box a very important paper by Dr. Woody Brock on why you cannot grow government debt well above nominal GDP without causing severe disruptions to the overall economic system. I am going to reproduce just one table from that piece. Note that this was Woody’s worst-case assumption, adding 8% of GDP to the debt each year, and not the 11% we are experiencing today. The Congressional Budget Office projections are now even worse, and that assumes a very rosy 3% or more growth in the economy for the next five years. Under Woody’s scenario, the national debt would rise to $18 trillion by 2015, or well over 100% of GDP, depending on your growth assumptions.” 6
  8. 8. 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