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.
Canadian farmland has a long track record of producing steady, equity-like returns that are uncorrelated with the ups and downs of other financial assets. Bonnefield’s research has shown that long-term farmland returns are highly correlated with, and are primarily a function of, the long-term improvement in the productive capacity of farmland. Simply put, as crop yields have improved over time, and as farm operations have become more efficient through consolidation and technical improvements, the “earnings power” of the underlying farmland itself has increased, leading to an increase in both farmland values and farmland rents.
An analogy is to think of farmland like shares in a public company. If the productivity of a company improves, one would expect its profits to improve and the price of its shares to increase accordingly. But if, in management’s drive to improve the company’s productivity and profitability, they take on too much debt or weaken the company’s financial liquidity, then its profitability (and, therefore, share price) is put at risk.
The same is true of farmland. If the farm sector’s debt load were to increase to the point where farmers’ financial liquidity deteriorates substantially, farmland prices and rents would potentially be at risk. Such was the case in the early 1980’s when a debt boom coincided with declining crop prices and skyrocketing interest rates, resulting in a rare period of widespread farmland price declines.
So the obvious question is: How financially sound are Canadian farmers? Most farmers rely on debt to capitalize their operations. Are they sufficiently liquid to withstand a period of crop price stagnation and/or interest rate increases? Are we potentially at risk of a 1980’s-style farm crisis?
Statistics Canada’s most recent Farm Financial Survey suggests that the clear majority of Canadian farmers are in sound financial shape.
Recent analysis by Farm Credit Canada concluded that in 2015, 82% of Canada’s grain and oilseed producers had debt-to-equity ratios of less than 0.3. 77% of vegetable producers and 63% of potato producers had similarly low debt levels. More importantly, Canadian farmers appear well positioned to continue to service those debt levels as indicated by healthy debt-service ratios (net income divided by annual debt service payments). More than 2/3rds of all grain, oilseed, vegetable and potato producers in Canada had debt service ratios greater than 2.5, the result of several years of strong cash receipts and low interest rates.
FCC’s analysis also 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, with the grain and oilseed sector especially strong at 3.6. To put this in perspective, FCC considers a farmer’s financial liquidity to be adequate if they have a current ratio of 1.5 and most Canadian farmers have current ratios well in excess of these levels.
The healthy financial liquidity of the Canadian farm sector stands in contrast to that of US farmers who, according to FCC, have experienced a decline in their current ratio from 2.87 in 2012 to 1.55 in 2016. Unlike their US counterparts, Canadian farmers have been insulated to some degree from lower corn and soy prices by a favorable USD/CAD exchange rate and a more diversified mix of crops (especially canola and pulses, the prices for which continue to be strong).
Indeed, Statistics Canada released figures in late November showing that Canadian farm revenues (“farm cash receipts”) for the first 9 months of 2017 were up 3.3% versus the same period in 2016.This increase is the 7th year in a row in which Canadian farmers have experienced year-over-year increases in revenues. Moreover, Canadian farm profits, as measured by realized net farm income, were up 4.2% in 2016, the 6th such increase in the past seven years.
The bottom line is that we are reassured by Statistics Canada’s most recent Farm Financial Survey showing that the clear majority of Canadian farmers, particularly grain, oilseed, potato and vegetable producers (the sectors that Bonnefield focuses on) are in sound financial shape.
The Liberal government’s proposed tax changes will likely cause the greatest destruction of wealth for Canadian farm families since the 1980s farm crisis. But unlike the crisis of the 1980s, from which farmers eventually recovered, the proposed changes are a permanent, structural change that will cause a drop in farmers’ income and net worth from which there will be no recovery.
Finance Minister Morneau and Prime Minister Trudeau have said that the proposed tax changes are aimed at wealthy Canadians who use “tax loopholes” to unfairly pay less tax than “middle class” workers. But the legitimate small business tax planning tools, which the Liberals plan to change, have been used for decades by small business entrepreneurs in all sectors across Canada to help manage and mitigate the financial risks associated with starting, building and selling their businesses.
The implications of these changes for all small business entrepreneurs are huge, but given the unique nature of farming, the impact on Canadian farm families will be especially severe. Farming, more so than most other businesses, rely on the entire family’s participation and support to succeed. Children, spouses and extended family members typically support the farm business, whether directly in the farm’s operations, or indirectly in unpaid, but essential ways. Canadian farm families typically incorporate as small businesses to enable them to efficiently share the income from their farm operations among family members. But the proposed tax changes will severely restrict a farmer’s ability to split income among family members, even though the reality for most farmers is that the entire extended family participates in one way or another in supporting the business.
Moreover, for most farm families, their primary (and sometimes sole) source of wealth for their retirement is their land. Because of the capital-intensive nature of farming and the volatility of most farm incomes, farmers often do not have significant other sources of retirement savings such as TFSAs, RRSPs and investment savings. By incorporating as small businesses, and having multiple family members as shareholders, farmers have been able to use legitimate tax planning tools to maximize capital gains exemptions and reduce the tax burden when it comes time to sell the farm to finance their retirement. The proposed tax changes will eliminate farmers’ ability to use multiple capital gain exemptions and will thereby dramatically reduce their retirement savings.
The extent of this pending wealth reduction for farmers is hard to estimate and is based on individual circumstances, but it is not hard to imagine that for a typical farm family like those we deal with every day at Bonnefield, the proposed tax changes could destroy a third, maybe even half, of the wealth they have accumulated over their career through land price appreciation.
Bizarrely, the proposed tax changes will make it far more advantageous from a tax perspective for a farmer to sell their business to a large conglomerate, rather than sell the farm to the next generation and keep it in the family. The 2016 census showed that the average farmer in Canada was 55 years old. So, over the next decade a substantial portion of Canadian farms are going to change hands.
At Bonnefield we often work with young farmers to help them finance the transition of their parent’s farm and expand their operations. The proposed tax changes will dramatically reduce the amount of after-tax cash available to retiring farmers and make it harder to transition the farm to the next generation.
For anyone concerned about the disappearance of family farms in Canada, the pending tax changes are a looming disaster.
Everyone agrees that tax fairness is an essential principle for a civil democratic society like Canada. But one’s tax burden should not only be proportionate to one’s income. It should also take into account the risk and sacrifice entrepreneurs incur to earn their income, as well as the benefit to society that results from their entrepreneurial spirit. Canadian farmers represent the best of that entrepreneurialism and risk taking, and all Canadians benefit from a thriving agricultural sector.
I urge you to contact Minister Morneau, Prime Minister Trudeau and your local MP and urge them to stop these ill-conceived, disastrous tax changes.
The volatile weather expeienced across Canada so far during the 2017 growing season has, once again, reiterated the need for a well-diversified farmland portfolio amidst unpredictable and challenging farming conditions. At the time of writing this blog, there are more than 150 wildfires burning throughout the interior of British Columbia due to abnormally dry weather and forcing over 6,000 people from their homes. In Saskatchewan over 60% of the province’s topsoil is considered short or very short of proper moisture levels. Meanwhile in Ontario, accumulated rainfall to date is 4 times that of 2016. The Maritimes have had relatively normal conditions so far this season.
The dry conditions in the prairies made for ideal seeding conditions but continued dryness will, with the exception of irrigated areas in southern Alberta, likely depress yields across much of the west in 2017. The rains in SW Ontario that delayed planting show little sign of abating, however, progressive farmers using good management techniques should expereince reasonably good yields.
Challenging growing seasons such as these also highlight the benefit of partnering with top-grade farmers who use progressive practices and sophisticated agrology analysis in their farm management techniques. We are seeing dramatic differences in the fortunes of farmers across the country between those who use excellent management techniques and those who do not. The former are experiencing average-to-good yields at this point in the season, while many others are seeing poor yields.
The revenue impact to Canadian farmers from a rebounding Canadian dollar has largely been offset by stronger agricultural commodity prices across the board and global demand for Canadian-based crops such as canola and lentils remains strong.
While Canadian farmers are facing challenges this growing season, most are coping reasonably well and maintain a bright outlook for years to come. Sadly, recent news from abroad is not so positive for farmers elsewhere.
Drought conditions have returned to the US Plains and parts of California
FAO reported that 19.4% of China’s arable land is contaminated
A study released by MIT predicts that much of South Asia – home to a fifth of the world’s population – will be too hot for food production and human survival by the end of the current century.
Against this backdrop, investing in a widely-diversified portfolio of farmland in Canada – a politically stable country whose ag sector is expected to be a net beneficiary of climate change – looks very attractive indeed.
English 
French