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May 2010
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December 2009

Dear Friends and Colleagues,
We have now launched our first two Funds. At the moment they are capitalised just with family money. From Jan-Feb we will be able to accommodate outside investors.

They are:
1) Craigmore Sustainables NV. This Fund invests in green projects. Initially growing forests in New Zealand for carbon sequestration. In time we expect to expand to forests in other regions and Renewable Energy projects.

2) Craigmore Credit NV. This Fund invests in yield ñ primarily bonds. Most of the bonds are under our own management but in some sectors we outsource management to carefully selected fund managers.

The Elworthy family trust is capitalising EUR 10 mm into the Funds. A further EUR 5 mm of commitments from cornerstone investors have been received and we expect to be in a position to take in these investors in Jan-Feb. We have not started marketing to outside investors but when we launch this (target January-March) we hope to then grow Funds under management toward our year-end 2010 target of EUR 50 mm.

Of the two funds the Credit Fund is more liquid ñ investors will be able to request redemptions on quarterly dates. Since the Sustainables Fund invests in private equity Investors will be ìlocked inî for two years. After that they can request liquidity semi-annually.

Returns on the carbon forestry projects look good. And one has the satisfaction of knowing, even if we have (further) volatility in the carbon market, we have lumber values to protect capital.

Both Funds target returns to investors of at least 12% per annum, after fees. We believe that in some years we will be able to generate significantly higher returns. For example in 2009 the predecessor entity of Craigmore Credit has generated a simple return, March to November, of over 70%. 2009 was an exceptional year for credit investing. However we believe these tightening trends (improvement in risky bond valuations) have another 12 months to run. The re-pricing of Carbon assets and liabilities as the authorities progressively ìcarboniseî the world economy has much longer to run. We expect generous returns from that strategy for rather longer.

If you would like more information on either Fund please have a look at www.craigmore.com. Or email me for e.g. track record information or a presentation on the Funds at .

I have been doing some thinking about the powerful but unfair and unsustainable ways that modern western economies work. I record these musings in the postscript below.

We will be here in Oxfordshire for Christmas. I hope you have a wonderful holiday season,
Kind regards, Forbes.

Postscript:

Modern Economies: Where are our Pyramids?

One of the most thought provoking lines in Keynesí General Theory is the question why the Egyptians were able to maintain a stable civilisation for 2,000 years. Keynes believed the answer lay in two activities: Construction of the Pyramids and the search for precious metals (Gold etc). Why? Because, unlike most goods, the pursuit of these articles does ìnot stale with abundanceî. You cannot get too much of religion (the Pyramids) or of Gold. The Egyptian gold rushes, one assumes, like our nineteenth century discoveries, led to inflation and full employment. Keynes, like Bernanke today, believed full employment and inflation was a much better thing than unemployment and deflation.

Keynes was referring to ancient Egyptís solution to the problem of surplus capacity (unemployment of resources) in a highly productive economy. Egypt had its Nile agriculture. What about us though? Global resource sharing, specialisation and innovation under a market economy make us wealthier still. Where are our Pyramids?

The theme to which Keynes returns again and again in his writing is that Economies are not like households and firms. These players (us as individuals) suffer from scarcity of resources. Their main problem is efficiency ñ how to make scarce resources go further. Rich, highly productive societies as a whole have a very different problem. A problem of excess, rather than of scarcity. These societies (our society as a whole) attains such high levels of production that they become unstably rich. I often think this when driving around the motorways in the UK. Every second or third car is a GBP 25,000 German marvel of engineering. We attain levels of wealth that seem giddily high, and, it is true, when a shock occurs, we all panic about it. We all, simultaneously, conclude we were living beyond our means. We retrench. That is what happened last year. As Jeremy Grantham points out, the world was not any less wealthy in terms of goods and services on offer (potential GDP). It just felt a lot less wealthy since we all, in a nasty feedback loop, decided to consume at a lower rate, and thereby lowered aggregate consumption.

Anyway, back to the Pyramids, it is highly pointless for a Robinson Crusoe to build pyramids, or to mine gold. He is the ultimate household faced with scarcity. He needed to do productive things.

Our society, on the other hand, has more than enough productivity to live well. We need ìhigher orderî things, with high ìincome elasticityî, on which to vent our creative energies (or, more precisely, our competitive search for status).

Keynesí only partly ironic point is that, with goods like sexy-state-religions (the Pyramids), the less useful they are, the more likely it is they will keep being demanded and produced, no matter how much comes forth.

What then are our Pyramids today? Clearly the fashion industry. Probably holiday travel and other forms of leisure expenditure. Definitely housing. Our smarter and smarter and more prestigious houses are, for sure, our societiesí totems. Our higher order infinite elasticity means of expressing ourselves. Our Pyramids.

These activities are, then, suitable high elasticity explanations/expressions of the remarkable level of wealth in our economy today. How do the authorities regulate the building of these ìPyramidsî, and, indeed, influence who gets to build them?

Here I would argue that banking in particular, and finance in general, has become, in the west, our greatest pyramid builder.

The endless moving around of money is, in itself, a largely pointless activity. But, because it is financially lucrative it is massively pursued. Why do our governments allow a pointless activity to be so lucrative?

The answer, and we partly have Keynes himself to thank for this, is that the banking sector, and in particular the credit markets (the market in bonds) is used by the authorities (our modern Pharonic court) to pump up the economy whenever it is down (the equivalent, after seeing unemployed Egyptians on street corners, of ordering e.g. a Pyramid or two to be built/torn down/moved/whatever). Our fund did not make 70% odd this year because we outwitted the market. Oh no. It made 70% because the authorities wanted to pump up the entire (wholesale) capital market. We were just experienced enough bond traders to know a banking system reflation when we saw one. We invested in bank subordinated bonds back in March 09 in order to play our pre-destined part in the reflationary process.

Crazy though it seems to me (and it must seem even crazier to those not bond traders) the above system does seem to have worked. Keynesí legacy has, it seems, ìfixedî the problems of boom and bust that marred so many lives before he came along. The world has paid a price in nouveau riche bond traders fanning out to fill their pre-destined roles creating employment on mansions in the Cotswolds (and numerous other places), but, maybe, it has been a price worth paying. After all somebody had to be the transmission mechanism, the Pyramid builders.

Right from the time of publication of the General Therory Keynesí critics have complained about his subversion of the marketsí natural tendancies. Subverting the marketís desire to reach its own equilibrium can work for a while, but, his critics argue, in the long, run, are we not storing up an even bigger crash?

Keynes standard response to this point was that ìin the long run we are all deadî. Well, is that long run now coming?

I am not qualified to judge whether the price of Keynesianism has been worth paying. It appears to have worked remarkably well for a long time, but during that time some truly frightening excesses have built up (of consumption, of leverage, of reliance on a pumped up banking sector, of inequality).

I do however have a much more immediate and unambiguous complaint about Keynesian management, at least as it is currently implemented. And this is something I donít think Keynes could have foreseen.

We have only discovered in the past 10 or 20 years that man-made climate change is likely to either disastrously raise the temperature of the planet, or, alternately, force us to massively scale down our use of fossil fuels, i.e. massively change the energy basis of our economy.

Keynesian reflation as currently conducted urges massive fiscal and, in particular, monetary / credit expansion at the time of unemployment in order to reflate the economy. Put simply, it is an invocation not to save, but to consume. This is not the pathway climate scientists would urge us down.

Conversely the path the climate scientists are urging us down (to create a ruthless carbon cartel and squeeze the hell out of the use of carbon i.e. organise a massive energy terms of trade shock) is exactly the pathway our macro-economists DO NOT want to see occur. Energy shocks have been the undoing of Keynesian reflations before (in 1973, in 1979 and arguably in 2007). They undermine reflations.

So. Expect the emerging consensus at government level behind a Western / Chinese alliance around a carbon cartel to come into direct conflict with the traditional economics community (and the business community who also donít like energy shocks ñ they are not good for stock prices).

Who is right? What is the right thing to do? Well I think the answer is clear. We need to take Keynes insight about the Pyramids and modify it so that our Pyramids are no longer fancy houses and cars. Instead (and fortunately, my sense is that Larry Summers and team understand this answer), we need to shift our Pyramids (our surplus) onto the environment. We need to devote the amazingly creative and productive capacity of modern capitalism to correctly solving the biggest problem it has ever faced ñ environmental destruction. This is a massively high elasticity destination for our productive surplus. It is also a most worthy destination.



September 2009

Dear Friends and Colleagues,
The crisis that broke last Sept-Nov was a big shock. I was long of property assets with the first round of cash from CMA. I felt wrong-footed by the subsequent turn-down in markets. My Newsletters since record my attempt to I recover my economic sense of balance. I sought to have a “good crisis”.

As I managed to work out by the final paragraphs of my (tortuous) Feb 2009 Newsletter my investment strategy since that date has been to “return to my roots” by investing in defensive but high yielding bonds and other yield producing assets. We focused on perpetual bonds issued by banks (and insurance companies). We judged this sector would recover with government support of the banking system (very low rates interest rates are a licence for the banks to make money). We also purchased some blue chip equities with high dividend yields.

These trades worked well. Our trust securities portfolio is generating cash flow yields at an annual rate above 10%. Capital gains of over 20% since an average entry date of May mean the Portfolio is actually up 27% in four months – an annualised rate of about 90%. We won’t be able to keep up that rate but, absent any major bank defaults (extremely unlikely now with government support) a very satisfactory annual return is achievable. This remains a good opportunity to profit from the panic of 2008.

As a result of this reasonable successful trading (admittedly in very favourable circumstances) I am feeling better than I did last October.

So much for the good news. My next task is to apologise for my bearish comments on equity prices in my June Newsletter. Although a sell-off in June-July made me feel wise for a time the big rally in late July through September proved me spectacularly wrong.

It is no excuse that I was not alone in this view. 90% of professional investors spent the past six months underweight equities. We were all wrong. Equities have stormed off their lows. As they should have. Looking back, they were cheap and, unlike in 1929,  this time the authorities moved decisively to save the banking system and to re-start the global economy. I got the printing of money and selective support for the finance sector right (this was the rationale for purchase of capital bonds issued by the financials). However I missed the positive effect that massive fiscal and monetary expansion would have on the wider economy and therefore stock market.

The lesson for me is to avoid making predictions about stock markets. I am a fixed income guy. Stick with what you know!

I might have been wiser about the action in the equity markets had I read George Soros' latest book, “The Crash of 2008” earlier in the crisis. Soros reminds us that social organisations like economies are reflexive. One should closely monitor the second order effects of market prices and actions.

A Soros analysis might be: First Lehman blew, then markets and prices broke down. This engendered massive government support to the economy. This, in turn, enabled credit and securities markets to recover.

The traditional securities pricing paradigm is to analyse the risk (especially the state of the economy) and to position oneself accordingly. The Soros paradigm looks at the two way interaction between finance and the real economy. The real economy can drive securities valuations up or down. But actions in the financial space (especially credit expansion) can also act on valuations of real assets. 

Keynes correctly identified the urge of investors to run into cash (waiting for deflation) as their major and malign contribution to slumps. He named this behaviour “liquidity preference”. The past six months has been “liquidity preference in reverse”. Investors were (and to some extent still are) caught up in a sentiment where fear and greed, normally balanced, both urged them (us) onto the short side of the market. Into “safe” cash. We are now being expertly “squeezed” out of our liquidity preference by the major central banks, acting in concert. Keynes would be proud.

Where to from here? While taking care to avoid any predictions about equity markets (!) I remain bullish on credit markets. I continue to think this is a once in a lifetime opportunity to purchase great bonds. Hence I am accelerating the launch of recently re-named Craigmore Investments. This is the right time to launch a yield intermediary. I hope to have it up and trading before Christmas.

Until December!

Warm regards,
Forbes.

PS. A quick comment on Global Warming: I received a lot of reader mail, mostly from farmers in NZ who are apparently, to a man, adamant that Global Warming is a myth. Sadly, dear farming colleagues, (and I wish you were right, I would prefer our planet was safe from harm), I think you are being bamboozled. I have yet to read a book or indeed academic research that in any way re-assures me we are not staring down the barrel of an climate disaster. The most supposedly comforting book I have read on the topic is “Climate of Extremes, Global Warming Science they don’t want you to know” by Patrick Michaels and Robert Balling (from the US Cato Institute). These experts have received significant funds from Exxon Mobil and are well known climate change “deniers”. Despite the implied promise in the title that climate change is not happening the authors’ actual argument is 1) climate change is happening, 2) it is man-made, 3) it will in time melt the ice-caps if left unchecked. Their great insight is that the IPCC was wrong to imply the ice-caps might melt within 200 years – raising sea levels 7 metres and flooding 1/5 of humanity. They cite some pretty convincing evidence that they will not melt until a date between 200 and 1,000 years from now. Their main point is therefore not a scientific one, but an ethical one. They contend that fossil fuels are too central to our current way of life for it to be a valid decision to tax carbon usage now, and lower present GDP etc. They argue it would be wiser to keep trucking along as we are and simply use the extra time to adjust our life-styles (to a world without ice caps and a lot more sea). I thought a lot about the supposedly comforting nature of this book (it is well reviewed on Amazon by the denier community). I have now decided the book is, ironically, the strongest argument I have yet read for actually doing something about climate change. A couple of well fed looking Americans don’t have the right to assert we are OK to destroy the environment on this precious planet. Ever. Not in 50 or 100 years. But also not in 500 years.

I would be interested to hear from any readers who agree with Michaels and Patrick? I.e. I’d like to hear your logic / moral argument arguing e.g. that IF we were to accept that we are cooking the planet but it might take longer than some thought, THEN this actually gives us the right to go ahead and leave the gas on.

In case you think this is just hot air about hot air Craigmore Farming Co now has a contract to acquire one property for planting of trees for carbon sequestration, and we bidding on another. I will let you know how these progress. As we get comfortable with these investments (which appear to offer high returns on investment) we may decide to devote some of the capital of Craigmore Finance to investing in them.

By the way if you would like to review and maybe make some suggestions about the new Craigmore Fianance organisation do let me know. I will send you a draft business plan. I would be grateful to discuss.

Dear Friends, Colleagues and Potential Investors,

Craigmore Finance

The business I am thinking of creating is continuing to evolve. It now looks more like a lender than a specialist resources investor. See www.craigmore.com for a sketch of what “Craigmore Finance” may become.

Through a re-flation, darkly

The massive government intervention in markets has borne fruit. Crucially the wholesale credit markets are operating again. They led us into depths, and they are now leading us out.

It feels as though we narrowly escaped a re-run of the 1930’s. But where does that leave us? Logically in the 1970s. A period where excesses built up during the long boom of the ‘50s and ‘60s came to their end.

The years after ‘73 were a period of chronic government deficits, huge amounts of government debt and very accommodative monetary policy. As goods prices rose central bankers were forced to let interest rates rise. But they rose too slowly to choke off inflation.

A re-run of the 1970’s would be a good scenario for commodities, and for ownership of assets acquired cheaply in the nadir of the crash and financed by debt (provided asset earnings are of sufficient quality to cover interest costs). Stock markets performed less well in the ‘70’s as inflation squeezed profit margins. Stock market investors do not like high interest rates.

I repeat my assertion from my Feb Newsletter (see craigmore.com); in a world where mercantilist nations are rigging currencies and where, partly as a result, imbalances in Western countries have become unsustainable, re-flation is the right thing to do. We in the west are quantitatively easing our currencies – to, among other things, expose the false economy the mercantilists have been practicing.

Will we succeed? On balance I think we will. i.e. I expect the west will gradually inflate its way out of its massive imbalances. Despite a period of low growth or, indeed, a possible Japanese style recession, I expect the policies will save the Western economies in roughly their present form i.e. without a collapse of too many of their existing industries.

Savers and the middle and professional classes will, however, be collateral damage. They will be punished by inflation and taxes and a return to more interventionist styles of government. Put simply, their wealth and income will be confiscated in order to shore up the solvency of borrowers – including governments.

A happier by-product of re-flation is it will build wealth of those leveraged asset holders who are able to remain solvent.

However, given the many years of deleveraging that we probably need to experience, the 70’s is only one scenario, and probably a best case one. There remains a significant risk of policy failure. A rapid boom could take off, and turn into a very unstable hyper-inflation. Or, perhaps more likely, it is possible that capital markets may revolt. That savers (including the Eastern export oriented economies) may withdraw their capital and force interest rates up. This would drive us back into severe crisis. In that scenario the boot would be on the other foot. Savers (and mercantilist nations) would be the only liquid show in town and would “win” big time – purchasing cheap assets amidst widespread restructurings. Borrowers, including sovereigns, would be humbled.

I think hyperinflation is unlikely. There is just too much unemployment in the economy. There are no candidate sectors ready and able to get into “boom” mode. A return of deflation is a more significant risk to my “long stagflation” prediction. It would be a nightmare, and it could happen. It is indeed actually happening in US sub-prime and auto’s. We will discuss below that it may be about to happen to the more leveraged dairy farmers in New Zealand.

Have “a bob each way”

Because the “best” prospect is probably a stagflation, and the next most likely is a deflation, I am, accordingly, refreshing my advice from my October Newsletter (also on craigmore.com);  to “have a bob each way”. Have some cash positive real assets, in defensive sectors, to participate in the inflationary (likely stagflationary) scenario that is most likely. Have some moderate levels of financial leverage against those assets. But keep some dry powder, such as liquid fixed income assets, or undrawn lines of credit, so that you have a buffer in place. So that you can be an acquirer of assets in a resumption of the melt-down, not a seller.

Agricultural Land

The market in land in New Zealand is still trending down. My pick is most classes of land in NZ will bottom out at around 50% of their peak valuations. NI sheep and beef assets are already most of the way there and may soon find their bottom as red meat prices turn up nicely.

As an example, last month we were bid slightly more than we paid in 2008 for the Te Moata business (we bought it at the July nadir of the red-meat commodity price cycle). We decided to turn the bid down. The property is generating good cash flow returns. Call me uncreative but, when it came down to it, I could not think of a better place to have capital than in a King Country sheep farm. 

Meanwhile, in NZ’s largest and most leveraged agricultural sector, the farming of dairy cows, the USD price of exports remain 60% below their 2008 highs. If this continues, and if the NZD continues to be strong (up about 30% from its lows) then a number of NZ dairy farmers who purchased at high land prices will be insolvent. This could be as much as 20% of NZ’s largest export industry. It could be NZ’s own “South Pacific Sub-Prime”.

Keep in mind, however, the NZ dairy industry is actually a world leading converter of solar energy and water into food. In time, as the commodity market adjusts up, and land prices adjust down, NZ dairy farming should revert to its traditional high returns on equity. As always the timing of the entry point into the asset class will be the key determinant of returns.

Until September,

Warm regards,
Forbes

Now back in the UK and still on

P.S. Climate change research

I am currently doing a lot of reading about climate change. I reviewed Amazon for the best reviewed writers on the subject. They range from Climate Change alarmists (Tim Flannery, Hansen, Sir Nicholas Stern, the IPCC) to writers who either deny the phenomena or even believe it is abating. Most of this “denier” material is published by experts from a network of US corporate funded research organizations.

There are also some writers who accept that it is happening but who believe it does not warrant global efforts to mitigate greenhouse gases. I am almost finished a very carefully written book (called “Climate of Extremes”) by Patrick Michaels and Robert Balling which accepts CO2 is causing temperatures to rise but argues we should live with this rather than doing anything about it. My preliminary conclusion is these characters, who are also financed by US corporations, are spinning a line of wishful thinking. I will figure out why I think that, and report back.

I would be interested to get your views or references to research on the topic. A number of NZ farmers have assured me that global warming is not happening. I would be more than eager to receive research material or references from these farmers, or anybody else.     

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”.

This Quarter’s Newletter 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. Please email me with any comments at . 

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 6 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 1970’s “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 US 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 CDO’s 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 US 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 US 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 US 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 US 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 US, 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 US 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 bankruptcy’s the only way to “fix” the debt problem, and I am confident that the US (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, iv) 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 2 to 5 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 2 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 click here to download pdf (140KB)

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November 2008

Dear Friends and colleagues,

Last month I wrote a long Newsletter about the battle between inflation and deflation. My heart (and experience) believed that inflation should prevail and encouraged me to (still) own assets. My head told me that deflation is in full force and is going to beat inflation in most economies and that therefore one would be wise to sell assets, and hold cash. I promised I would report back this month on the special case of asset values in commodity currency countries like NZ. I also introduced the concept of a "Robin Hood Economy". Where (real) asset prices are falling relative to yields. I.e. P/E ratios and most other financial valuation ratios are falling.

This month the newsletter will be mercifully short, partly because it is being written in the lounge of Heathrow Airport. My thinking on the situation facing any economy has not changed. I still think, on balance, asset prices will (continue to) fall in the short term. But I do worry about a burst of inflation in the medium and long term from massive government deficit spending, asset market intervention and failure to sterilise this money creation i.e. failure to "mop up" the liquidity through issue of government bonds.

My feelings about the likely prevalence of deflation over inflation are summarised, by way of background, in the first 3 slides of the attached presentation which I gave to the Strategic Link agribusiness discussion group in mid-month.

What have I concluded specifically w.r.t. asset prices in NZ? A brief version of my conclusion is: 1) NZ is a commodity exporting country whose currency has traditionally traded in line with the prices of our export commodities, 2) Countries like NZ, like all world economies right now (and also like all sectors within those economies, some of which are likely to do worse than others), face either a very bad slump, or, in the best case, a "Robin Hood Economy" where cash flows are reasonable, but real values of assets fall, 3) The NZ export sector is fortunate that its currency can depreciate to keep its export prices attractive, 4) Falls in international commodity prices PLUS the dearth of candidates willing to lend to fund NZ's currency account deficit means that the NZD is likely to continue to fall, 5) This, in turn, means that a Robin Hood economy is more likely than a slump for most sectors of the NZ farming industry. In fact, for NZD based investors in NZ farmland, reasonably decent cash flows, falling land values and a likely "window" where interest rates are low will present attractive buying opportunities in the medium term.

Investors not based in NZD may be less enthusiastic about the above opportunity (since it is predicated on the NZD continuing to tank). Even investors who are based in NZD would be wise, in my opinion, to continue to wait for asset prices to soften further.

The above logic is spelt out in somewhat more detail in the second section (5 slides) of the attached presentation.

I also attach the October quarterly Newsletter from Jeremy Grantham of GMO. Grantham is, along with Buffett, one of the great investors of our age and I thought some of you might like to read his summary of what we can learn from the current crisis. If you want to get the benefit of Grantham’s research and humour each quarter then have a look at www.gmo.com/America.

I am trying to listen to logic (my head) and not just my heart i.e. I am currently more inclined to sell assets than purchase them. I therefore I continue to think this is not the right time to recommend that you invest in land via Craigmore Finance.

Added to the above, the decision by the NZ National Party to delay implementation of NZ’s greenhouse gas emission trading scheme also puts on hold one of the investment themes of Craigmore Resources.

You can see, dear readers, that I am still waiting for the moment to advise to you invest. Until that moment arrives I will down-grade the Craigmore Finance newsletter from Monthly to Quarterly. You will hear from me before the end of February.

In the meantime have a wonderful Christmas!

Kind regards,
Forbes Elworthy

GMO Quarterly letter - Reaping the Whirlwind click here to download pdf (604KB)

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October 2008

Dear Friends and colleagues,

This month I explore prospects for the main world financial and asset markets.

Next month I will try to figure out what this means for investors in a “commodity currency country” like NZ or Australia.

My unsurprising conclusion this month is that we don’t know what the future will hold. It could be inflationary (when you should own real assets) or deflationary (when you should own e.g. bank deposits). Given this investors are wise to “have a bob each way”. But we should try to avoid having too much debt.

A quick note on the “status” of the Fund:

Since I launched Craigmore Resources in August some of you have very kindly indicated you may consider investing. I have not followed up with you as I feel the environment is still too uncertain, and asset prices still too likely to fall, for me to want to encourage you. Thus far our family trust is the only investor. I plan to keep it like that until such time as I can clearly see opportunities that I am very confident will deliver the 15% return target I have for the Fund. At that time any existing assets will be marked to their then market value using an independent valuation.

“A bob each way and try not to owe the bookmaker too much.”

The banks and individuals of the western economies have taken on levels of debt that cannot be supported by the incomes in those economies. E.g. in the US gross debt peaked at 355% of GDP (see the remarkably gloomy article by Hayman, attached).

I am not sure whether “gross” debt is a very meaningful comparison as, in a sophisticated modern economy a lot of debt is back-to-back through an intermediary. Nevertheless the number is clearly too high, just as it was in 1930 when the same ratio peaked at 260% of GDP before falling to 160% 5 years later amidst a blood-bath of bankruptcy and default. Borrowers in the US (and I suspect also NZ and Australia) have been borrowing to pay the interest, and have been caught out.

The ratio of debt to GDP in the US and also in highly indebted populations like NZ, Australia and Britain needs to shrink (if not to WW2 levels then one would imagine but by, lets guess, 20% or so). This is already happening. Almost all private sector lending to new clients has recently ceased in most economies including the US, Britain and NZ. New debt is not being issued. Banks are trying to shrink their bloated balance sheets (see table of the amazing levels of leverage of most large banks: often 50 units of debt for every 1 unit of equity, in the same article by Hayman).

How will the ratio of debt to GDP shrink? Well, either goods and asset inflation needs to be achieved in order to grow nominal GDP and enable borrowers to generate cash and sell assets to pay down debt, or the amount of debt needs to shrink through defaults and bankruptcies in order to create a more sustainable economy.

Either way, as we wake up from the party of the last 20 years, we are poorer. Either way the level of consumption in our economies, relative to our productivity and work (relative to GDP) is going to shrink. This is why we will have a recession in the next few years. Inflation or deflation.

By the way recent actions transferring the debts from the balance sheet of the banks to the balance sheet of governments did not in itself shrink the ratio. This was a skillful piece of moving the deck chairs around and it was successful in preventing an immediate fall into widespread bankruptcies in the wholesale financial markets which would have almost certainly led to (more) widespread defaults on debts. That some debt owed by households and corporations and banks is now effectively owed to governments does not in itself answer the key question we have set ourselves to answer today, will the “ratio problem” be solved via inflation, or via deflation, or via a mixture of the two? The debt is still there, unsustainably large, and it is still owed by the borrower households and businesses and banks to the lenders (increasingly governments and government backed banks).

We now need to figure out whether governments will monetize the debts. Two things need to happen for monetization (inflation) to occur. The first is that governments need to print money to finance their subsidies to credit and other markets. (And not “sterilize” it by financing it with government bonds). The second thing is that populations need to go out and spend this printed money not just save it.

The article published yesterday by and copied below from Dan Denning at “The Daily Reckoning” in Melborne notes that US government debt increased by $800 billion in September and October alone. This is a pretty remarkably large number, as GBP in the US is $13 trillion. They have also cut rates to 1% in what I judge is an attempt to frighten savers back into the asset markets. This behavior looks like the behavior of a government that is determined, at all costs, to shock the markets out of an otherwise inevitable deflation. To encourage people to purchase shares and other assets.

Some brave souls have moved back into equity markets and the inter-bank credit markets are improving with the support of government guarantees. Despite this progress, however, banks (who are all trying to de-leverage) remain reluctant to lend other than to the best credits.

Who is going to win the battle? Do we face a “Japanese” future with de-leveraging of risky businesses, deflation, sale of assets, and everybody holding what cash they have on deposit in government guaranteed bank deposits yielding 1%?

Or are the governments going to “win”. Are people with savings going to reject lending to the US (or any other) government at 1%? And, instead, move their cash into other assets such as equities and property, and, maybe even move cash between currencies in expectation they will do better elsewhere?

Nobody knows the answer. However my own feeling is that our friends at the Daily Reckoning are right to conclude there is a significant chance that the governments will print so much money that there will be a distrust of low interest rate currencies of recession countries. In order to borrow governments (and individuals) would need to pay MUCH higher interest rates than they are at the moment.

That would be, roughly, a return to the stag-flation of the 1970’s. The bottom left hand quadrant of the table below. A good time to have real assets and a moderate amount of debt, but not too much as rates paid would be much higher than asset cash flows.

There is also a risk that as private sector lenders demand repayment assets continue to be sold throughout economies and deflation ensues. Sadly this is going on already. However, given governments will do almost anything to prevent a Global Depression occurring it seems likely that, if we do have deflation, this will be a “low interest rate Japanese style Stag Deflation, not a Global Deflation.

I would almost go so far as to say that, the more likely a Global Depression becomes, the more likely it is that governments open the monetary floodgates and chase deposits out of the banks with a burst of inflation (an inflation led by the rising wages of government and other employees paid with government subsidies and credits).

Clearly we are a good bit of the way through the process of creating a Robin Hood economy. House prices and stock prices have already fallen sharply. Land prices are likely to soften significantly (perhaps less so in NZ where the currency has taken the pressure – more on this next month). Wages have not dropped.

As assets become attractive (and in the land asset class I currently think we have minimum three months to wait; and maybe one or two years) we will by then be very aware that Robin Hood has paid us a visit and it will be time for capitalism and optimism to pop up their heads again.

That time is not yet here in the resources market but when it comes I will be buying more assets. I will be helped in knowing that moment by seeing when return targets for the Fund are reached.

The returns I think we should target are cash flow yields on real assets of 5% to 7.5% with commodity/product marked at prices at the low point of its possible cycle and expectation of creating another 5% to 7.5% of value per year through management of the asset (normally through land-use change). I.e. I think we should be aiming to generate a total return of 10% to 15% before any leverage.

In the meantime I am concluding the right portfolio is “a bob each each way”. Some capital in real assets. Some in cash. And, in either category, trying to avoid having too much leverage.

Best regards,
Forbes Elworthy

Hayman Advisors Letter - What's Next? Click here to download pdf (227KB)

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September 2008

This month I will give a brief analysis of the impact of the Sept 2008 Financial Crisis on farming, and in turn the strategy of the new fund

1) A crisis spreading even to NZ

The significant deterioration of wholesale financing markets is currently spreading to New Zealand. As a debtor nation we are in the process of tightening our belts. Our current account deficit has already fallen from 10% to around 6% of GDP and will need to fall further as there are few enough lenders out there willing to finance NZ borrowers. The NZ urban sector, which expanded massively in recent years on the back of a high dollar, cheap imports and free credit, is contracting. The NZD has moved sharply lower (from USD 0.80 at its peak to USD 0.67 at time of writing) and interest rates are falling. Both these developments are good for our export oriented, debt financed farming sector and I anticipate that agricultural cash flows in NZ should improve as a result. However, and this is very significant for our new fund, it now appears that the prices paid for farmland, despite these improvements, will fall.

2) Why is it likely that prices of NZ farmland will now fall?

There are two reasons:

The first is that banks are cutting back on lending. It is rumoured that two of the four largest agricultural lending banks have quietly decided in the past few days not to advance ANY new farm financing loans. This extraordinary move (I guess the last time this happened in NZ was in the Great Depression) is not primarily because farming is doing badly. Rather it is because these banks need to improve their balance sheets; to either raise capital or lower assets. And for these Australian owned banks one of the easiest ways to improve those ratios is to cease (new) lending in a couple of off-shore islands called New Zealand.

The second reason prices of farmland in NZ looks likely to soften is that, although red meat commodity prices are moving up as predicted in last month’s Newsletter, Dairy commodity prices have fallen sharply in the past 6 weeks. We have seen a sharp fall to (a still satisfactory) price of around USD 3,000 per ton of skim milk powder from remarkably elevated prices that peaked at around USD 5,000 i.e. international Dairy commodity prices are down around 40% down in USD terms. Though the pain has been cushioned for NZ farmers by the fall of the NZD against the USD the kiwis are still about 10% worse off from last season to this (prices were not at USD 5,000 last year … that is a more recent peak). The fact Fonterra, the giant farmer-owned NZ dairy co-op that is involved in 50% of the international trade in Dairy products, has been forced to write down 70% of the value of their investment in San Lu, a scandal affected Chinese milk distributor has not helped. Fonterra have lowered their forecast pay-out for the 08-09 season from the $7.90 per kg of milk solids they paid last year to a forecast of $6.60 per kg. NZD 6.60 is still a very good pay-out for farmers whose costs in most cases hover around $4 per kg (enabling them to generate operating profits of NZD 2,000 to 3,000 per ha – still a substantial yield). However some of the more over-leveraged dairy farmers could well find themselves needing to sell their farms in coming months. We are already seeing some properties coming to market in an effort to beat the rush.


3) How does these negative factors for the price of land affect our Strategy?

Across all sectors, for those people fortunate enough to have free capital available, capital preservation is currently the key objective. The current environment is one in which the right strategy is to cut costs, to simplify businesses, to locate a bank that is solid and to hold your cash there in a bank account or term deposit.

It is true that agricultural returns look like they will do ok, and farm prices look like they will fall, however there is no hurry to invest. In a time of crisis attractive investments can be had by (those few) players who have cash to spend. We aim to be one of those investors.

In keeping with this strategy we have pulled out of the purchase of the dry-land property mentioned in the last Newsletter. Te Moata Station, our first purchase, is reasonably well positioned as its current output (red meat) is turning up (prices for red meat remain 40% higher than the same time last year). We have had good spring growing conditions up there on the west coast of the North Island and the stock values (purchased in winter on a drought market) are now trading up nicely. I am confident that Te Moata is going to perform well in cash flow terms. Could we purchase the same property cheaper in a few months? Quite possibly, given the bank lending situation and the possibility there may be forced sellers (at the present time the market in land has ground to a complete halt – nobody is buying or selling). However I don’t believe a fall in the land value of Te Moata would offset the rise in value of the stock and returns from sale of produce.

We are looking closely at carbon sink opportunities at Te Moata and elsewhere now that New Zealand has passed (in mid September) its Emissions Trading Scheme legislation – the first in the world to include both Green House Gas emissions from ruminant animals and the carbon sequestration value of forestry. Our strategy on Carbon Sequestration will be the subject of a subsequent newsletter but the basic summary is that trees can sequester remarkably high quantities of carbon (30+ tonnes of Carbon per ha per year on good land), that good operators in this space are likely to make high returns, but that at the same time we need to tread carefully as this is a new and therefore risky market.

In summary, other than working hard on our sheep, beef and tree strategies at Te Moata, Craigmore Resources will now go into a “capital preservation” mode. We will wait for yields to rise, and only commit capital to particularly high quality projects. We expect that some of these are going to become available at attractive valuations.

I am confident that the medium and long term case for improvement in the terms of trade of food and other products of the land remains intact. It follows that, provided we invest wisely, investments in productive capacity of land will out-perform “average” investments in coming years.

Until October I wish you all well in this very challenging environment (and would be glad to get your views on any matter raised).


IWMI - Water - the Forgotten Crisis click here to download pdf (69.3KB)

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August 2008

Dear Investors and Potential Investors in Craigmore Resources Fund,

For the period I led CMA I wrote a monthly report of the progress of the company. I plan to do the same thing for investors and potential investors in Craigmore Resources.

This document is intended only for people who are not "competitors". As long as you are not planning to become involved in raising capital* to invest in land then you are welcome to become a subscriber to the Newsletter. Also if you have friends to you think would like to follow this resources venture please send this on to them and copy me so that I can put them on the email circulation list. If the emails are getting “too much” just let me know and I will take you off.

This month I first write generally about resource investments in the global context and then go on to outline the specific investment strategy of Craigmore Resources.


i) Resource Investments in the Global Context

The key determinants of any market are demand, supply and technological change. For 120 years these factors have driven down global relative prices (the “terms of trade”) of the produce of the land. Why? Well my pioneering ancestors have a bit to do with it. Australasia and Africa were colonized by Europeans in the nineteenth century. By the 1870’s steam shipping and railways (into e.g. the American mid-west) meant that the abundant agricultural land of these regions could be used to grow grain, wool, and meat for rich markets such as Europe. Supply exceeded demand and, with increasing productivity in agriculture, demand never really caught up (no matter how rich you are, or how cheap food is, you can only eat a certain amount of food each day). Food, having absorbed 25% to 50% of household incomes 120 years ago, fell to perhaps 5% of household incomes. A "glut" or inventory of 200 to 300 days of global demand for food hung over the market, dampening down any short term price action from shortages.

All of this has changed in the past two years. China, a net exporter of foodstuffs until last year, has become an importer. The diet of the new rich economies is shifting in favor of (resource intensive) protein foods. According to the Financial Times food inventories have fallen massively to currently only around 40 days of food inventory to feed the world.

Supply and innovation (including the activities of organizations like Craigmore Resources to raise levels of production from the land) is of course responding. However the food market has very “steep” demand and supply curves. Small changes in quantities (supplied or demanded) can have massive impacts on price. The net result is it appears that the 120 years of real term price declines in the produce of the land is now decisively over.

Amid all the “chaos” it appears that there are three major factors increasing demand for output from land, and one major force which is curtaining land productivity.

The three major factors driving up “demand” for the produce of the land are:

i. Increased wealth in emerging markets.
The demand for food in general, and protein in particular, from especially China and India, is already creating shortages of foodstuffs like dairy products. This is going to be an on-going trend and require enormous increases in international availability of grains plus protein products like dairy and meat. Recently the Japanese, aware of food shortages, have tried to negotiate two year dairy supply contracts with Fonterra, the NZ farmer owned co-op that controls a significant part of the international trade in dairy products. They have not been able to secure the contract. They have been out-bid and out-negotiated by China.

ii. Biofuels.
One of the greatest agricultural assets on earth is the deep soils and reliable rainfalls of the American mid-west. The "Maize belt". One third of the production of maize in this region has recently been diverted to production of bio-fuels (Financial Times report). Similar switches in land use are occurring in Europe (rape seed), in Brazil (sugar cane) and in China. It is clear that especially maize based Biofuels are not particularly "efficient" in their energy usage. However their centrality in American energy planning, where they are viewed primarily as an energy security tool (not as an efficiency tool) and their massive support from the American agricultural lobby mean that it unlikely they will be phased out any time soon.

iii. Carbon Sequestration.
The process of photosynthesis absorbs CO2 and produces Oxygen. With a global market in CO2 emerging farms like "Te Moata Station" recently purchased by Craigmore Resources look like they will earn a significantly higher yield sequestering CO2 rather than their present use (in this case growing sheep and beef). Te Moata should be able to sustainably sequester around 20 tonnes of CO2 per ha per year. The price of carbon in international markets is around EUR 30 per tonne. Hence around EUR 600 per ha per year gross yield, perhaps 500 after costs. Te Moata cost us around EUR 2,500 per ha. A 20% annual yield looks attractive compared with its current yield from production of meat and wool of around 3% to 4% per year. As understanding of the carbon market becomes more widespread in New Zealand (it is currently in its infancy) we expect these calculations will lead investors to revalue the lower value, remoter parts of high rainfall NZ hill country (the land that grew podocarp forest before it was cleared 100 years ago). We expect this process to drive a doubling or tripling in the value of NZ land like Te Moata. i.e. it might attain perhaps EUR 7,500 per ha – in line with the price of land of comparable productivity in less remote, less mountainous parts of New Zealand.

The key factor reducing the supply/productivity of land is desertification. The spread of shortages of natural water. Australia, in particular, is suffering from a significant reduction in available productivity of dry-land soils as rainfall becomes more variable. This is made worst by a fall in supply of available irrigation water. This is also occurring in other regions of the world (a related paper from the International Water Management Institute is attached).

The above 4 trends each began "in earnest" only 3 or 4 years ago. However the world has only woken up to shortages of “soft commodities” in the past 6 to 12 months because the price effect was masked by the market’s absorption of the previous excess inventories.

Agricultural price increases began when prices of wheat and dairy products doubled 12 months ago. The price of rice, stable for many years, doubled in the last 6 months.

The prices of red meats and pork have only begun to move in the past 3 months. Prior to that a very significant "cull" of stock in Australia (resulting from the drought) and in the US (as farmers shifted resources into bio-fuels and out of beef) meant that red meat prices and pork were actually rather depressed.

This counter-intuitive market behavior is called the "hog cycle" and suggests that red meat and pork prices should recover sharply over the coming period as the market incentivizes farmers to re-build lost breeding flocks and, in turn, produce the young stock (calves, lambs and young pigs) which are the primary source of meat proteins when the market is in equilibrium. Prices of sheep-meats and beef in New Zealand have been depressed for the past 2 years as a result of the cull of maternal stock and resultant excess supply of red meat globally. However they rose approximately 40% in the past 2 months. I expect this is the beginning of a very significant upturn in the international price of meat proteins.

Clearly higher prices for agricultural commodities will elicit a supply response. Farmers will strive to convert marginal land and to irrigate dry-land in order to produce more. Scientists will (continue to) develop new and more productive cultivars. We do not yet know for sure whether, once again, agriculture will produce more than the (affluent) world can eat as a result of these supply responses. My view is, however, that it cannot. That marginal land, much as it might be socially desirable it be brought into production of cheap food, is going to primarily be used to produce bio-fuels and carbon sequestration i.e. trees. Just look at the Te Moata example above. To compete with growing trees to sequester carbon the prices of Te Moata’s current meat and wool production would need to approximately treble. That, in turn, would approximately treble the price of agricultural land in Craigmore Resource’s portfolio. And this is at world prices for carbon of EUR 30 per tonne. Many people expect that carbon will need to trade closer to EUR 100 per tonne before behavior is significantly changed.

Biology meanwhile, can only work within nature, not over-leap it, and therefore productivity can only increase at perhaps 1% to 2% per year, not the 5% odd that is needed to meet food, bio-fuel and carbon sequestration forecasts. They are not making any more land. Or water.

So much for the (generally favorable) international market in the produce of the land. What is Craigmore Resources’ strategy?

At the outset at 90% to 95% of Craigmore Resources’ capital will be invested in land. The remainder will be invested in “infrastructure projects”. E.g. a dam to bring water onto dry-land we have purchased for irrigation. Or perhaps a hydro project or a wind power project (NZ has very strong winds such that wind projects in the right areas can be economic in NZ even without government subsidies).

In time I expect we will raise the proportion of “project risks” in CR’s capital base. In the meantime we feel that investors will benefit, for the next few years, simply from the high levels of price rises in agricultural land that we expect, and from the land-use change that we will be working to achieve on our properties. As a new equilibrium is reached in prices for the produce of the land, and therefore in land prices, we would expect to then need to “work harder” to make the consistently good returns that we are targeting for our investors.

I expect Craigmore Resources to make a return of at least 10% every year for investors, and to make 30% in some good years when our larger projects come to fruition. As a result I target an average compound return of at least 15% per year, after fees. Many of you will know that an investment yielding 15% per year for 5 years will double in value over that period. That is our aim.

Leverage (debt) will be restricted to no more than 50% of the value of assets.

It is likely that we will focus on New Zealand in early years, as we see significant opportunities there and the legal and agricultural infrastructure environment is first rate. In time, however, I expect we will expand the portfolio internationally. There are opportunities to take cutting edge New Zealand farming techniques and apply them in other countries (including e.g. feeding American dairy cows on pasture, in the field, rather than the expensive practice, which is “normal” in the USA, of feeding them harvested grain in a barn).

New Zealand is a small and entrepreneurial country with a volatile currency. The Fund will therefore give non-NZD investors some exposure to fluctuations in the NZD. Generally however these should be hedged by the export nature of NZ land-based production. Commodities, internationally, are generally priced in USD and, as the NZD falls, the value of farmland in NZ rises. For example the NZD has depreciated about 15% against the USD in the past 2 months (from 20 year highs). I view this as a buying opportunity for NZ assets. New Zealand is a country of four million people with the land resources to feed 60 mm and I view this sell-off (relating primarily to falling interest rates in NZ as an over-heated urban sector goes into recession) as a buying opportunity.

New Zealand has a curious law which means that foreigners may not own land in NZ. Or at least, if like Shania Twain who recently purchased an iconic sheep station in NZ, they really want it, they must apply to the “Overseas Investment Commission” for permission. A process which takes about 5 months. During this period the local, kiwi buyers will normally have found a way to “slip in front of” any foreigner other than those prepared to pay “top of the market”.

In order to avoid these challenges the first Craigmore Resources Fund will be NZ owned, which is to say it will take in no more than 25% of its capital from outside New Zealand. Potential investors located in foreign parts will nevertheless be allocated up to 25% of the first CR Fund.
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The Fund will contract management of the portfolio to a new management company I am setting up called "Craigmore Resource Advisors". I am building up a team of experienced agricultural experts to help us source and decide upon the best investments and to negotiate e.g. terms on which land can be leased to farmers.

Many aspects of the Craigmore Resources structure are still being finalized. Also please understand that, if you wanted to invest in Craigmore Resources, we would need to ensure that we complied with the securities laws of your relevant jurisdiction. It is important to keep in mind this Newsletter is not an invitation to invest, rather an information document for anybody interested in the progress of the Fund.


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