The Return of Economics

This quarter’s Newsletter is the result of a two month project I set myself to record my best guess of what is going to happen to the world economy.

1) Introduction: The Return of Economics

Like a lot of businessmen shocked out of complacency by the failure of Lehman and subsequent market crash in September/October I have been searching around for explanations. I am discovering that we neglected some basic rules of economics in our financial markets in the past 10 or 20 years, and these mistakes are coming home to roost. We are experiencing a forceful “Return of Economics”.

The document is long. If you do not have much time I recommend you read just the Overview in Section 2 and Investment Conclusions in Section 7.

I (again) attach Jeremy Grantham’s quarterly Newsletter to this email. Once again I think he summarises the investment climate well – far better than I could. My contribution is narrower – to try to dig into the actual ideas that drove monetary, fiscal and exchange rate policies. And to analyse the impact of those ideas on the market environments we will face.

Meanwhile we are still working on creating a new investment organisation. My thinking about the opportunity has become more general (not just agriculture) and more credit focused (lending rather than equity investing). Accordingly we are changing the name of the “work in progress” organisation we are creating from “Craigmore Resources” to “Craigmore Finance”.

It is unlikely we will seek capital from outside investors for at least six months. We don’t recommend that investors give us their precious cash just yet.

As noted I think that secure yield is going to be more interesting than equity risk in the environment we will face. I am therefore working on some ideas that would enable investors to take high cash flow returns, and some capital gains, from lending to corporate and infrastructure organisations.

2) Overview

In Section 3, “the Screaming Machine”, I try to understand the history of our present challenges. I trace the problems to a couple of big misunderstandings. Basically to the use of policy activism to eliminate the business cycle and encourage high leverage. The western economies built a “machine” that, in retrospect, we can now see was attempting to sustain an unsupportable equilibrium.

In Section 4 I identify an important fuel of that machine as the madly symbiotic relationship between the asset price inflation driven economies of the West and the export “success” driven economies of the East.

Section 5 predicts which segments of the world economy are likely to do relatively well, and which relatively poorly. I predict that, while few will prosper, it is the East that made the biggest mistakes, and that they will therefore suffer more than the West. In the West I predict, in line with the “Robin Hood Economy” theme of earlier newsletters, that consumer goods industries and wage-earners should do relatively well.

Section 6 makes some comments about building a disciplined investment process.

I conclude in Section 7 with some comments on why I believe it is still too early to invest in New Zealand land. But that, when we do, I now think we should invest via high yielding loans to farmers, with further upside from a link to increases in valuations of the farms. I think the land assets, purchased at low prices, will perform better than most through this crisis.

3) The “screaming machine” economy of the past 10 years

The key mistake of the US/UK policy environment of the past 10 years has been to “overcook” credit markets by, in particular, setting very low interest rates (around 1%) first in 98-99 then again in 02-03 (and of course approaching 0% now in 2009). It has now become clear that, at those sorts of interest rates, all sorts of mad-cap schemes seemed like a good idea. Hence a lot of over-leveraged investment bets (ranging from hedge fund investments to excessive housing investment) became widespread throughout in particular the financial and household sectors.

Looking back we can now see that the western economic policy consensus of the past 20 years was a gigantic attempt to ensure that risk taking would be rewarded. Central bankers, politicians, investment bankers, businessmen and households all conspired to ensure that, whenever there was a wobble in growth rates, central banks would intervene to lower interest rates and crank up the “machine” again.

In this environment cash was the worst possible investment. Prices of most assets doubled, and then doubled again during this period. Anybody who held onto cash was punished. People who purchased assets with (cheap) debt were richly rewarded.

With one important exception (we will talk about the savings mad governments of the East later) almost everybody came to feel that it was an acceptable risk to borrow money to purchase assets and that holdings of cash-at-the-bank was a bad idea. An extreme but widespread version of this belief was that capital gains could be counted on. Capital growth could be viewed as a legitimate way to expect to repay debt.

The system failed to let moderate sized recessions happen from time to time. And this became a formula for creation of an immensely dangerous “screaming machine”. In fact the Machine that caused the disaster we are currently experiencing.

So the question “do you believe in policy activism?” is a difficult one. My own belief is that, yes, we will need to use it over the next few years. But during that period we should never forget that it was inappropriately applied policy activism that was the main cause of the mess that we are in.

I agree with the monetarists that by the 1970s “Keynesian” expansionary economics had become over-used.  I had come to the view, as a student in the 1980s, that the one of the few things the “right” had done correctly in recent years was to kill off Keynesianism.

Then, like many young professionals starting out within the past 20 years, I put aside my former interest in macro-economic policymaking, and got on with building my career. As it happened this was as a credit markets trader and, later, information publisher. I guess I assumed that, with monetary responsibility now an “established principal” in the corridors of power, I could relax about the macro, and get on with the micro.

Sadly it turns out I could not have been more wrong. It turns out (and like most big mistakes this one was staring us all in the face but few of us noticed it) activism had not gone away at all. It just found a way to make itself so successful (inflation and unemployment were both low) that few noticed it was still being practised.

The Keynesians proved with the New Deal (and the Second and Korean Wars) that they could “crank up” the economy with fiscal stimulation. When this started flowing into inflation in the 1970s, the policy credibility of fiscal policy waned. Its use as a policy tool was trumped by management of the money supply. The Monetarists (or more precisely Paul Volker) proved interest rates could be used to manage economic aggregates. Rates were raised and activity was managed down (to eliminate inflation) in the 1980s. Rates were lowered to drive activity up again, to cure incipient recessions, in the early 1990s, in 1998 and in 2001.

However, even if its main tool changed, it turns out that activism did not go away. The Monetarists did not actually put the Keynesians to the sword as some of us had hoped and believed. No indeed, they merged! They formed a policy consensus which Krugman (a card carrying Keynesian) calls “The Keynesian Compact”. I prefer to call it Keynetarism.

You can read Krugman’s “Return of Depression Economics (2008)” if you want the details of how the former rivals made friends, but for our purposes it is sufficient to record that the Keynetarist leadership were very effective for a remarkably long period. They used BOTH fiscal and monetary policy to achieve their objectives: full employment and reasonable price stability.

Keynetarism had 15 “good” years (from 1992 to 2007). But was it sustainable?

Clearly not. The Keynetarist “machine” has just blown up. And the clear cause of the blow-up is excessive levels of leverage. What caused the leverage? The policy of always rewarding risk taking. Always lowering interest rates as soon as the economy slowed down.

Ben Bernake, the current chair of the Fed published a paper in 2004 called “The Great Moderation”. There he opined that on balance, it seemed likely that high quality economic policymaking (by people like his then boss Greenspan) was the main reason inflation and economic growth outcomes had been so good in recent years. The key weakness of his argument is that the “good” is defined only in terms of growth. He neglects to analyse the stability/sustainability of that growth.

The Keynetarist mistake was that they pursued just full employment and price stability in the medium term. They had no other aims. They neglected to analyse economic stability. The more right-wing of them (Greenspan) repeated again and again that was not their job. They outsourced it to the private sector!

The Greenspan-Bernake central bankers ignored ballooning credit availability and therefore rocketing asset prices. Amid this academically sanctioned complacency, and given the incentives to speculate which the policy environment had created, leverage exploded in most sectors of the economy (particularly the financial and household sectors).

But the crime was not committed “by” the policy establishment. They were merely its high priests. Most of the leaders of the entire Western economy were caught up in the myth. Managers, risk managers and directors of banks and other financial institutions were card carrying members of the religion of “no pain” economy. There was little debate on the matter. “Everybody” who mattered was in on the game. No doubt a few prudent souls (and e.g. short sellers of stocks etc) called warnings from the sidelines. But the main-stream western establishment did not question its own stability. The people who had done well in the recent environment and therefore been invested with power, the people who received invitations to Davos, did not doubt that Greenspan was a hero and that we were living in a brave, new, largely recession-proof world.

During this period financiers (sanctioned by some dubious modelling work by the ratings agencies and by models calibrated to data collected during the good years) financed assets mostly out of debt rather than equity. It was believed asset prices could not meaningfully fall. Most actors right down through the economy, in particular households and financial firms, made the mistake of ignoring the risk that at some point the credit bubble might deflate. That leverage might become so excessive that, as asset price inflation ran out, and cash flows became pinched, large institutions would begin to fail and the opposite cycle would begin to run. Asset markets are now failing and forcing bankruptcy of first the over-borrowed organisations (Lehman, AIG) and then, in turn, threatening the solvency of the banks that financed them. It is also threatening to flow through to the real economy as businesses fail to obtain financing.

Is it my basic conclusion that policy activism is OK in the bad times, but dangerous in the good times? I think so. I also think that things are going to need to get worse before the massive policy response can turn things around (hopefully in 2010 but, who knows, it could run much longer).

Before making some predictions about the actual policies that governments are likely to adopt to try to rediscover economic equilibrium we need to understand the international dimension of the problem. It turns out that the certain activities of the Eastern nations made the problems caused by Keynetarism significantly worse.

4) The fuel for the screaming machine: the mad symbiosis of the “Keynetarists of the West and the Mercantilists” of the East

It is well known that most healthy organisations and organisms have self correcting mechanisms. Think of the U.S. Constitution. Or the reflex that makes you vomit if you eat a poisonous substance.

It is generally assumed that a free market economy is self correcting. Why, therefore, did the free market in capital not “see through” the policy mistakes of the Keynetarists? Why did e.g. interest rates on risky lending not rocket up to correctly price risk and to choke off excessive borrowing? Clearly the bankers who invested in CDOs or lent to hedge funds or sub-prime mortgagees are now regretting it.

There are a number of answers to this question. Some relate the key topic of my career in finance hitherto – the pricing of credit instruments.  Itself correctly identified (by Keynes) as “the pricing of risk” and by Soros, again correctly, as the key determinant of almost most systemic movements in the prices of assets. This is a complex and as yet unsolved problem. All that is appropriate to say here is that credit markets generally do a bad job of pricing the risk of default and that they do a particularly bad job of pricing (and hedging) the sort of system-wide defaults that cascade through the system in a crisis. Indeed, far from pricing and attempting to hedge out systemic risk, banks and ratings agencies assume that it can be diversified away. Lo and behold, these same banks and ratings agencies have been at the core of a series of economic collapses. The credit markets are a series of self-inflicted wounds waiting to happen. And they happen generation after generation and nobody seems to learn.

(The current increase in government guarantees of the banking sector, and the likely interference by governments in lending decisions, will likely be instrumental in the next crash, when everybody suddenly notices them in 10 or 15 years time. They may well be the next “screaming machine”. However now is not the time to beg for, what I believe, which is that governments should stop messing around in the financial markets and let private enterprise run them. This is not a fashionable idea right now!).

Anyway, in the absence of discipline in the credit markets themselves, the more immediate answer to the question why private market interest rates in the aggregate did not rise to price risk correctly is that they could not. There was such a weight of savings coming out of the East that interest rates could not rise.

The wild “over-success” of the Keynetarist project in the West was a direct result of the large amount of reserve accumulation going on in the East.

Martin Wolf sets out why this happened in his excellent book “Fixing Global Finance” (2008). The export powerhouses of Asia; Japan and China (and Korea, Taiwan, India, Russia, Brazil) all sought systematically to “win” in the international battle for export markets. To make sure they did win they proceeded to fix the game. They managed their exchange rates to low levels, so that their export sectors would prosper. The result was massive export success and much lower levels of imports than would have otherwise been the case: i.e. enormous current account surpluses.

Most of these countries managed their exchange rates down (while at the same time avoiding inflation at home) by taking 100% of the surplus on the current account and to investing this in foreign financial claims. That way this cash was “sterilised” outside the domestic economy. It also (and this is why the mercantilist model is sometimes known as the “vendor financing” model of economic management) enabled the Keynetarist financial systems to have plenty of cheap cash to prop up consumption, thereby increasing demand for the vendors’ exports.

The policy makers of these countries did something which I would applaud a company director. They sought to make a profit.

But was this a wise policy for an economic policymaker of a sovereign country?

Well, the problem with running large surpluses is that you “force” somebody else to run a deficit. As Wolf points out, the balances of all international current accounts must sum to zero. And, if you push this hard enough (and the Chinese in particular have pushed it very hard, raising both exports and savings as a share of their GDP to an unprecedented 60%) you would, if you were in one economy with a common currency, bankrupt the country that you are forcing into the deficits.

China alone is left holding around USD 2 trillion of foreign reserves. These reserves are estimated to be 80% invested in US assets. If that is right then the claims of the Chinese state (even before we consider other Chinese entities) on America is USD 1,600 billion. If there are 160 mm wage-earners in American that is $10,000 for every household. At 5% interest rates around $500 per year for every wage-earner. For an economic actor within an economy this debt would be barely supportable. Added to the funds that the US owes to the Germans, the Japanese, the rest of the Asians, the Arabs, it would be clearly unsupportable.

However the folk lending to America (and to the rest of the West) made one crucial mistake. You cannot bankrupt a country by presenting them with claims denominated in their own currency. They will, logically, just print more money to meet your claim and deliver these to you.

This is the reason that Mercantilism, while a good set of principals for a company director, is a fundamentally flawed economic policy for a country.

I would go far as to say that, over-used as we can see has been the Keynetarist policy in the West, it is at least the beginnings of a thought-through macro-economic management policy. It was basically the right ideas, but over-enthusiastically applied.

The Mercantilist policies, on the other hand, seem to me ill-advised.

My prediction: the Mercantilist countries are going to (continue to) rapidly adjust to the failure of the Keynetarist expansion of their Western clients. Exports are already plummeting and will continue to fall. These falls will impose a far greater cost on the exporting country (idle capacity) than on the former importing country (those resources diverted elsewhere – likely into savings).

These countries are currently suffering massive deflations as they try to continue to prop up the USD. For that reason I expect the USD must, at some point fall. Right now these countries don’t know that the paradigm is broken and are continuing to try to “win” by buying the USD and selling their own currencies. They don’t know they have failed.

Mercantilism has come second to Keynetarism in a very poorly run race. Both are fundamentally flawed approaches, as they were applied, but Mercantilism has the added weakness of being a fundamentally flawed system, however applied.

So what is going to happen? The global economic pie is going to shrink. But some sections will shrink more than others. And how rapidly things shrink is going to depend on policy responses in, especially, America and China.

Predicting some aspects of those responses, and of the changing fortunes of various parts of the global economy, is the topic of my next section.

5) Predicting some major shifts in the terms of trade between economies and between sectors of economies.

So, what are policymakers going to do now?

Let us first analyse the global policy response. And then how the interplay between Eastern and Western systems is likely to impact that. And then how that is likely to play out in some terms of trade.

It is becoming clear that most economies are going to shrink significantly (i.e. we will experience extremely widespread recession and significant unemployment as well as further financial chaos). Basically the world economy is collapsing out of the unstable equilibrium of the “screaming machine”.

Keynes’ ignored long term has come back to haunt us.

In the face of this collapse there will be on-going government and private sector responses. The first round of these will include:

i) Fiscal responses: the U.S. will run an at least, $2 tn fiscal deficit this year – within a $13 tn economy. In fact if it over-runs, it might approach a remarkably large 20% of GDP.

ii) Consumer responses: savings rates everywhere will rise as the private sector builds resources against increased risk. Financial savings are rocketing up in the U.S. where they seem likely to rise from negligible levels to perhaps 10% of GBP – sufficient to finance a large part of their increased deficit if, as seems likely, these savings flow to government directed spending, rather than to the private sector.

iii) Regulatory responses. Large parts of the banking and other industries are likely to be nationalised. Government shareholders of banks will set about encouraging lending to domestic households and small businesses. This will cut off the flow of finance to countries without significant domestic banking systems (like New Zealand and a number of third world countries).

iv) Trade responses: as Western import demand falls the surpluses of the East are plummeting. The trade deficits of the west, in turn, are also shrinking.

v) Exchange rate responses: So far the rebalancing seems to be happening without major exchange rate moves. Foreign exchange values, in an age of likely massive monetary expansion, is a “ugliness competition”. Cash in any one of the major currencies seems unattractive given likely deficits and printing of money. Until that is, you look at the alternatives – the other currencies or equities or real estate. During the past three years the USD was weak as its problems became apparent earliest. And the EUR and JPY were strong. More recently as it became clear the U.S. is the more flexible and in many people’s view (including my own) better managed economy, the USD has become stronger. What is remarkable, however, is that, even in these circumstances, the U.S. is beginning to balance its current account deficit (down from 7% of GDP to forecast 3%). In the short term, therefore, I like the USD. In the medium term, however, given the massive Quantitative Easing that is in prospect in the U.S., I am bearish on the USD.

None of the above responses (fiscal, consumer, regulatory, trade, exchange rate) will, in my opinion, decisively break the cycle of “debt deflation” that was the core mechanism by which the previous boom came to an end. Why not? Well, as Grantham explains in the attached piece, none of these mechanisms do enough to remove the massive overhang of $24 trillion of debt sitting over the U.S. economy, and supported, by his calculations, by only $30 trillion of assets (down from $50 trillion). Nor the, by some calculations even larger, debt burdens sitting over the European and Japanese economies.

Other than allowing widespread bankruptcies the only way to “fix” the debt problem, and I am confident that the U.S. (and UK and New Zealand and other Western governments will and should do this) is to do something about the quantity of the debts. Either by legislative intervention in the market in debt contracts to change their value, relative to assets (I consider this unattractive and unlikely) or, much more logically and conveniently (you guessed this already dear reader) by “Quantitative Easing”. Printing of money. The massive expansion of Central Bank balance sheets as they buy bonds and other assets to inject cash into the private sector. Which bonds will they buy? Certainly most of the bonds that the executive arm of government is issuing to finance its increased deficits. Also bank bonds. Also securitisations. And also corporate bonds.

This policy response has the great advantages that
i) it directly addresses the markets that are broken – the credit markets. The government steps in to allow borrowers to re-finance debts – and, with low enough interest rates, this will encourage investment and, in time, drive reflation of asset prices.
ii) this policy has limited “costs”. As long as it is used in a time of deflation the government investment in credit markets will lead directly to increased jobs and national income, and will not, at least initially, drive inflation,
iii) there are no obvious limits on the use of this policy.The government of a country can print as much of its own currency as it wishes,
iv) the policy should be politically acceptable in the West. The relatively few voters with net cash-and-bond based savings in the West will be punished but they will be massively outnumbered by the larger number of voters who would like to see the economy reflated,
v) the gradual introduction of this policy, which of course is very unattractive to the Eastern holders of investments in Western currencies, gives the West the opportunity to put pressure on, especially China to raise its real exchange rate. The Chinese have already moved to do this by commencing a major domestic expansion (should drive domestic inflation and raise real exchange rates).

Of course as Tim Geithner noted in the very first economic policy announcement of the new presidency, it would actually be desirable (for both parties) for China to actually float its nominal exchange rate. You can bet that there is a furious negotiation, behind the scenes, about that topic right now. If I was involved in international economic policy negotiations there are few things that I would be more eager to see than that China would adopt a more realistic exchange rate policy. I would, if I was Larry Summers and Tim Geithner, be prepared to take a bit of flak at home by not publicly announcing such an expansionary monetary policy as I otherwise might, in order to offer the Chinese an incentive for good behaviour, an incentive to float their currency and remove one of the key underlying causes of global imbalances.

This is particularly true since the one great dis-advantage of Quantitative Easing is that it exacerbates the real exchange rate imbalance between West and East. Effectively it would, if carried out to an extreme, re-start the screaming machine.

If mercantilist Eastern countries continue to target constant nominal exchange rates by purchasing Western currencies (this may continue as the export sector tends to have massive influence in countries like Germany and Japan especially if they think western markets are going to recover under stimulus), and if deflation is therefore continuing particularly brutally in the East (this is happening, GDP is plummeting at 10% to 20% annual rates in the East, while falling at “only” around 2% to 8% in the West), then the cost competitiveness of Eastern export sectors will only get more extreme i.e. the global terms of trade imbalances will be exacerbated. Unless, of course, these countries’ nominal exchange rates were allowed to rise very significantly from current levels.

The “Screaming Machine” of excessive Credit Market expansion is, for the moment, broken. But in breaking it has put excruciating pressure on the imbalances of the Eastern mercantilists.

It seems to me that their current pain will only intensify until they see the error of their ways and adopt more balanced, less predatory economicy policies. However I am not an expert on the economies and politics of Japan, China, Germany. I don’t like what I see and I plan to avoid investments there. I know that many people are very optimistic about economic prospects for these regions. I would be interested to get their comments on my concerns.

The interplay between the “broken” economic model of the East, and the “sick” but in  my opinion not broken economic model of the West will be a key story of the next two to five years.

How will it play out? This is unclear. There are very gloomy predictions floating around of economic war and even of military friction/war. There are optimistic predictions out there of a rapid response of the Western economies to quantitative easing, of rebounding asset markets and the restoration of the old order (western importing and borrowing and eastern exporting and saving).

I don’t think that either extreme will ensue. Returning to the West, I expect these countries will suffer a bad recession but will use the massive printing of money (subsidies from the central bank to borrowers) to cushion the blows. It will not be a happy experience. Government will grow as a % of GDP and most people will feel worse off. Asset market returns will be, on average, poor, but return on assets i.e. yields will improve (this is the “Robin Hood economy” I talked of in earlier Newsletters).

Some asset markets will respond more readily to the monetary expansion and will do better. I believe this will include “defensive” sectors that are not in excess supply. This will include some soft commodities.

Some asset markets will do very poorly. “Transaction” service sectors such as investment banking and law have expanded massively for 20 years and will likely contract sharply. So will the specific commercial and residential real estate sectors that service them.

Credit markets will be (even more) nationalised than they are at present. It seems clear that we will have, in most countries, heavily socialised banking industries that will pursue state industrial objectives. This has always been the case in Germany, China and Japan. It will spread, unfortunately (because this is a very inefficient way to allocate capital) to many countries.

Places like New Zealand, which (wisely it turned out) outsourced its banking industry to Australia, may need to create local banks as it seems unlikely to me that Australian taxpayers will want their banks to do a lot of lending elsewhere in Asia, even to their close neighbours New Zealand. On the other hand it may be that the Reserve Bank of New Zealand can achieve Quantitative Easing by open market operations with the NZ operations of Australian banks. i.e. purchasing of NZD bonds issued by NZ banks and companies. We will monitor those developments as they play out. It will be interesting to see whether the great advantage New Zealand has in not having to bail out a banking industry continues to be an advantage as we discover we lack one (almost) altogether!

In summary I expect cash (e.g. USD) to do well for a while longer i.e. asset prices to continue to fall as we descend into the depths of this depression. For 20 years you could “not go wrong” owning assets. Until you did. Right now “you cannot go wrong owning cash”. Until, of course, that trend, too, turns around!

Eventually assets are going to be sufficiently cheap, and the prospect of inflation sufficiently frightening, that investors (like me) will return to the markets i.e. will invest.

Once that starts happening, and once cash flows to those assets (whether shares, farms, real estate, whatever) are under-pinned by fiscal and monetary expansion, we will be back in a Keynetarist world. And, once again, in that world, it will be a good idea to own high quality real assets rather than cash, and, indeed, to leverage the returns of those real assets by financing them with debt.

Final important point about property rights: it would be very logical for China and other Soverign Wealth Funds to greatly expand their purchase of Western real assets during this period. This began about two years ago and slowed down as the markets crashed (but note Chinalco purchase of large stake in Rio Tinto this month). It will resume at some point. In response it is likely the US and other countries will impose restrictions on foreign ownership of key assets at some time. This risk, of controls of capital flows, is one of the greatest risks facing the global economy in general, and Craigmore Investments strategy in particular. We will be monitoring these sort of asset expropriation risks” carefully. It may be that their risk greatly restricts the geographic spread of our investments – perhaps just to e.g. New Zealand, Australia, Canada and the UK.

6) Being disciplined in a world of Expectations

I did want to “headline” a likely wave of inflation in this Newsletter. It is too easy for the investing public, sated by wealth creation from years of Keynetarist excessive monetary expansion, to be beguiled into believing that, if we wait long enough, the government will (again) bail them out. I myself have been tempted, during this crisis, to believe that what I want to happen will happen. That asset prices will re-bound and that I did not need to re-adjust my traditional “long assets” portfolio. I, too, have been tempted to “hang in there” for the return of the good times. So far that has been just the wrong approach to this crisis. The people who have had a “good crisis” are those who have prudently reduced leverage i.e. who have sold assets as they have seen the crisis develop. At some point those people will be in a position to take their cash reserves and undrawn bank lines of credit and return to the asset markets. But that moment is not here yet.

Listening to e.g. CNBC it is remarkable how many people are looking for the next boom. For the moment to “go back into the markets”. There is too much optimism around. The moment to invest will be when average investors are a lot, lot more gloomy and despondent than they are now.

The main reason I am not prepared to predict inflation (and therefore not to move back into real assets just yet) is that, even as we do receive the inevitable “helicopter drops” of fiscal and monetary bonuses. I believe that, just as they did in Japan, citizens will save the gains; they will pay down debts and build up savings.

The turning point for the markets will be an unambiguous commitment to use as much Quantitative Easing as is necessary to resuscitate the economy, and to frighten cash out of banks into real assets.

One point already seems clear about investing in these markets: Distressed assets are trading much more cheaply than assets that are not distressed. Few organisations will be out there with fresh cash, and no legacy positions, investing during the depths of the current crisis. In order to tempt investors out of the safety of cash during a deflation we expect to be offered very compelling value. Normally only distressed sellers will be prepared to offer this.

7)  Investment opportunities in “mezzanine” financing of soft commodity assets

As you can see from the above sections I, like a lot of people, have been agonising about the right investment strategy for the current crisis.

A few principles are beginning to emerge. Craigmore Finance’s first investments should not be primarily about capital gains (that story is over for the moment). They should be about high levels of secure cash flow yield. They should be transparent claims on well defined assets in stable countries with careful attention to risks of capital controls. As you have seen I have a preference for the muddled but basically sound economic environments of the West rather than the “wrong” policies of the export obsessed countries. I will be seeking inflation protection i.e. real assets like farms or shares of businesses. I am seeking industries whose terms of trade mean they are likely to prosper, rather than decline even in a depression.

In short I am planning out a way to protect my family’s capital in this vicious, tumultuous environment, and, in time, to extend that facility to third party investors.

I am pretty confident that food demand should show good resilience, even in a down-turn, as long as you can invest in the “low cost producer” in each commodity. It looks as though, if present trends continue, one will be able to invest in very good yields in agricultural land as over-leveraged farmers sell farms at significant discounts to previous market values. And, meanwhile, as reasonable strength in soft commodity markets, augmented in our case by the weak NZD, keeps up the returns of those farms.

Musing on all of the above, in January, a light-bulb suddenly went on:

The “right” place for my family’s non-cash investments is to return to my roots: investing in credit risk i.e. bond and loan financing. With a particular focus on primary industries. We should not purchase the equity of businesses and take on management risk. Instead we should lend money to businesses ranking above their equity, but generally below the banks. Hence at a “mezzanine” level in the capital structures. We will partner up with top businessmen to purchase correctly priced businesses and infrastructure assets.

Probably starting in NZ and Australia since I know those best, but expanding to opportunities we discover in e.g. Canada and the UK when I move my family back to Oxfordshire from June 2009.

I have now looked at some valuations. I believe can currently see some opportunities offering 15% yields. As I identify them I will be investing in opportunities that offer yields of those magnitudes. I will keep you posted!

Sorry this has been such a long Newsletter. Keep in touch (feedback welcome!).

Until May,

Best regards,

Forbes.

GMO Quarterly letter – Obama and the Teflon Men, and Other Stories
GMO-Feb-09-Full-Newsletter Download the pdf (140 KB)