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 1930s. 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 1970s 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 ‘70s as inflation squeezed profit margins. Stock market investors do not like high interest rates.

I repeat my assertion from my Feb Commentary (see; 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 de-leveraging that we probably need to experience, the ’70s 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 U.S. sub-prime and autos. 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;  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. N.I. 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,


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 U.S. corporate funded research organisations.

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 U.S. 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.

Published: 1 June 2009