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 U.S. gross debt peaked at 355% of GDP (see the remarkably gloomy article by Hayman, attached at the end of this commentary).

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% five years later amidst a blood-bath of bankruptcy and default. Borrowers in the U.S. (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 U.S. 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 U.S., 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 Melbourne notes that U.S. government debt increased by $800 billion in September and October alone. This is a pretty remarkably large number, as GBP in the U.S. 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 1970s. 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).


Who is going to win? The inflating governments or the de-leveraging private sector?

My heart says inflation. And that we will therefore have only a recession for the next few years. That is what we are all used to and I want to believe the past will continue into the future.

My head says, sorry, the governments would probably like a bit of inflation but deflation is happening right now (prices of everything are falling) and it may continue for a while yet. Maybe Hayman is right in his attached piece, $700 bn of support to the debt markets is a drop in the ocean when you have 70 times that amount of gross debt ($51 Trillion) in the U.S. economy.

If I was forced to say which of Stag-Deflation and Stag-Flation is the most likely I would answer, somewhat obliquely, “a Robin Hood economy”.

A Robin Hood economy has governments printing money, subsidizing and protecting industries to maintain GDP and prevent wages from falling, but meanwhile risky assets prices continuing to fall (in real terms even if not nominally) until the yields on assets offer returns those few entrepreneurs with remaining liquidity find attractive.


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)

Published: 1 October 2008