Note: this article first appeared in PEI Agri Investor February 13, 2018 www.agriinvestor.com
US farmers have had a tough time since 2013 when net farm incomes reached a record $135.6 billion after a stunning increase of 82% in just 4 years. Since those heady days, US net farm incomes have been in decline, and the USDA recently predicted further declines in 2018 – to levels not seen since 2006.
North of the boarder, the story has been very different. Canadian net farm cash receipts have enjoyed an 8-year run of continuous increases. Since 2013, net cash receipts have increased 27% in Canada, even as they have declined by 28% in the US.
DIFFERING FORTUNES – Canadian vs US Farm Profits (2000 = 100)
Sources: USDA – Net Farm Income; and Statistics Canada – Net Cash Receipts
It is a testament to the attractiveness of farmland as an investment asset, that US farmland values have not declined significantly since 2013, despite big declines in farm incomes. Farmers, after all, don’t react to short-term commodity price swings by selling land that is the cornerstone of their long-term business. According to USDA figures, average cropland values across the US are largely unchanged since 2014. In Canada, however, steadily increasing farm incomes have led to steadily increasing farmland values since 2014, in line with long-term historic averages of 6% to 8% per year.
Several years of belt tightening have deteriorated the balance sheets of many US farms, whereas most Canadian farms have maintained low debt levels and good liquidity. Farm Credit Canada (“FCC”) recently concluded that the “overall liquidity position of Canadian agriculture is strong”. The average current ratio (current assets divided by current liabilities) of all Canadian farmers was 3.0 in 2015 (the latest year for which figures are available), with the grain and oilseed sector especially strong at 3.6. By comparison, US farmers have experienced a decline in their current ratio from 2.87 in 2012 to 1.55 in 2016, according to FCC.
So, what explains the differing fortunes of US farmers and their Canadian cousins?
Exchange rates are a big factor. Declining corn and soy prices since 2013 coincided with a surging US dollar – a double whammy for US farmers. In Canadian dollar terms, corn and soy prices have not deteriorated to the same extent.
But beyond exchange rates there are important structural differences that have given Canadian farmers a significant advantage. Most investors don’t realize, for example, the extent to which the fortunes of US farmers are determined by just two crops – corn and soy. A stunning 55% of all US farmland – an area the size of France – is annually seeded to just those two crops. By contrast only 13% of Canadian farmland typically grows corn or soy each year in Canada. Far more Canadian farmland is used to produce crops which are not widely grown in the US, and which continue to enjoy strong demand (and prices) on world markets, such as canola and lentils. The result is a Canadian agriculture sector with a more evenly diversified mix of products that makes it better positioned to withstand declines in prices for any single crop.
Even within the corn sector Canadian farmers appear to have an economic advantage over many US producers. Using corn planting budgets and prevailing yield data from USDA and OMAFRA, we estimate Southwest Ontario corn producers have a 32% economic advantage over producers nearby in the US Mid-West, owing primarily to differences in land and input prices in local currency terms. Economic advantages like those can mean the difference between a profit and a loss when corn prices are low – like now.
Will the fortunes of Canadian and US farmers continue to diverge? In the short-term, corn and soy prices will determine the answer. But in the longer-term, Canuck farmers have some powerful structural advantages that should help them continue to prosper. Unlike most US farmers, Canadian farmers will see net benefits from a changing climate. While most US farmers are facing increasing heat and drought, Canadian farmers will benefit from more heat units, a longer growing season and access to plentiful stores of clean, renewable water. Most importantly, Canadian farmers are world leaders in sustainability. The Economist Intelligence Unit’s 2017 Sustainability Index, ranked Canada’s primary producers 2nd only to Germany, and 1st amongst the world’s major exporters. By comparison, the US ag sector ranked 19th behind the likes of China and Ethiopia. In an increasingly hot, polluted and dry world, sustainability will be the most important competitive advantage any farmer can have.
The current market environment is creating a dilemma for investors. On one hand, the economic picture remains bright: corporate earnings appear strong, unemployment is low and inflation, while rising, remains benign. On the other hand, warning signs abound:
We are in the midst of one of the longest bull markets in history: stock markets have enjoyed a 10-year upward run with few interruptions.
Stock prices, by almost any measure, are more expensive than they have been at any time in history other than just before the 2001 “Dot Com” crash.
Bond yields are rising, and interest rates are headed up (which is bad for stock prices).
Individual debts are at all-time highs and, more worryingly, margin debt (debt borrowed to buys stocks) is at unprecedented levels.
Bitcoin, blockchain and cannabis stocks are clearly in speculative bubbles.
Geo-political and international trade uncertainties abound, and (to put it mildly), the response of world leaders to any potential shock cannot be predicted.
In the last 34 years we have experienced five significant bull-market runs, four of which ended in large stock market declines or crashes. The first began in 1984 and ended on Black Monday in October 1987. The second started in 1994 and ended with the Asian Flu currency crisis in September 1998. The third began in late 1998 and ended in the Dot Com bust of 2001. The fourth started in March 2003 and ended with the Global Banking Crisis of 2008, and the fifth began in March 2009 and has continued until today, more or less uninterrupted for much of the past decade.
Just how exceptional has our current bull market been? Figure 1 provides some context. The previous 4 market cycles lasted an average of 29 months and saw the S&P 500 rise by an average of 97%. In comparison, our current bull market run has, so far, lasted an incredible 107 months and seen the S&P 500 rise by 354%
Figure 1: our current bull run is the longest in decades…
Figure 2: …and it takes a long time to recover after long bull runs
As Figure 2 indicates, it typically takes a long time to recover losses incurred in stock market crashes that have followed long bull runs. In the previous four cycles, the recovery period (ie. the length of time it took to fully recover the losses incurred from market declines) lasted 77% as long as the preceding bull market run – an average of 43 months. Recoveries from the Dot Com and Global Financial Crisis took significantly longer – 81 and 65 months respectively.
Simply put, it took between 5.5 and 6.7 years for investors to make up the losses they incurred in the previous two stock market declines.
What conclusions can we draw from these historic patterns?
We are surely in the latter stages of one of the longest bull markets in history, and the longer it goes on, the greater the risk of a significant decline.
At current equity valuations, future market gains will, almost certainly, be less than those of recent years and with interest rates increasing, bond returns are likely to decrease from recent levels as well.
As the prospect of further returns diminish, market risk is increasing – creating a poor risk/return outlook for both stocks and bonds.
Figure 3 illustrates how the current risk/return pattern has significantly changed from the past few decades. Using historic annual returns since 1990 for the S&P 500 and 10-year Treasury Bonds (all figures in US dollars without currency conversion into CAD), we estimated the stock-and-bond portfolio mix that would have produced a similar 10% total return as that generated by Canadian farmland over the same period.
During the 1990s, it was possible to replicate farmland’s 10% total return (through capital appreciation plus dividends and interest) by investing 39% of one’s assets in 10-Year Treasury Bonds and 61% in the S&P 500. Moreover, this strategy required no debt leverage and had a modest level of volatility at 11.6%
The Dot Com bust of the early 2000s created an entirely different story for investors during that decade. The only way an investor could have generated a 10% return from 2000 to 2010 would have been to put all of one’s portfolio into Treasury Bonds, lever it by 300% and buy the S&P with the proceeds of the debt leverage. No sane investor would have done this, and even if they had, they would have experienced a ridiculous level of volatility (69%).
The Goldilocks bull market run that we have experienced since 2010 changed the portfolio mix again. Declining interest rates and strong stock returns meant that an investor could have put 76% of their portfolio in Treasury Bonds and just 24% in the S&P 500 and still generated a 10% total return with a volatility of just 8.2%
Figure 3: portfolio mix required to match Canadian farmland’s long-term total return of 10%
This historic what-if analysis puts the changing risk/return environment in perspective. Looking forward, however, is trickier. 2018 consensus estimates for the S&P 500 and bond returns, suggest that, in the current environment, one would need to put 88% of their portfolio in the S&P and just 12% in bonds to generate an anticipated return of 10% in the coming year. But this assumes that we do not experience a significant market correction in 2018, and, as I have argued above, the likelihood of a significant correction occurring is increasing with each passing month. Clearly, the classic portfolio of 60% equities and 40% bonds no longer generates an attractive risk/return for investors.
So, what is a prudent investor to do? Moving to cash is the obvious option for capital preservation, but at the cost of low-or-no real returns. How can one protect their capital while still generating an acceptable long-term return?
Increased market and geo-political risks for future stock and bond returns, stand in stark contrast to the prospects for continued steady returns to owning Canadian farmland, all of the core investment themes for which remain intact:
a growing global population, significant portions of which face serious food insecurity;
a changing climate that is benefiting Canadian farmers and challenging most other food producing regions of the world;
plentiful access to water for food production in Canada while much of the world faces drought, water shortages and water quality challenges; and
Canadian farmland prices that have not increased significantly relative to Canadian farm earnings (in contrast to rising valuation metrics for public equities).
Is Bonnefield predicting an imminent market collapse? Certainly not. We are neither skilled enough nor smart enough to call a stock market top.
There is no doubt, however, that the lessons of history and the precarious risk/return profile of current markets are clear signals to investors seeking capital preservation and steady returns: now is the most important time in recent memory to rebalance away from public markets into alternatives like Canadian farmland – a proven steady performer, with low volatility and bright prospects for continued steady returns.
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