“You may not be interested in global macroeconomics, but global macroeconomics is interested in you, your business, your family and your personal lives,” Dr. David Kohl said recently at the Professional Dairy Producers of Wisconsin (PDPW) Business Financial Decision-Making Conference. A professor emeritus of agricultural and applied economics at Virginia Tech, Kohl explained the new normal is black swans, volatility and extremes. In order to play the game of volatility, it is important to understand the conditions that will have an impact. He went on to highlight six key game-changers to watch as we enter a new year.
1. Black swans
Black swans are events that come as a surprise and have a major effect. Two of these on Kohl’s radar are the Middle East and cyber attacks.
Oil could increase to $200 a barrel very, very quickly if Iran and Israel break out, he said, resulting in $6 gasoline. Since 80 percent of a farm’s expenses are connected to oil, these will go up quickly as well. In addition, consumer behavioral economics kick in at $4 per gallon.
At this price point, people continue to buy gasoline but they don’t buy additional items in the store, which causes a ripple effect in the economy.
Cyber attacks have the ability to knock down electrical systems, computer systems, etc. A major event here could result in extreme volatility.
“I’m not saying it’s going to happen – but it can happen,” he said.
2. State of global economics
The BRICS (Brazil, Russia, India, China and South Africa) and the KIM-Ts (South Korea, Indonesia, Mexico and Turkey) are as big as the U.S. economy put together – but since 2000, they’ve represented half of the world’s growth.
These countries are what fueled the growth of U.S. grain demand. “Agriculture in rural America, your economic fortunes, are more tied to emerging nations than they are the U.S. economy,” Kohl said. “So goes those countries, so goes the health of the American dairy industry, because they demand grain. You’re competing against them.”
Three numbers to keep in mind are eight, five and three. Emerging nations growing at 8 percent growth rate or above result in heavy demand for corn, soybeans, wheat, oil, steel and copper. If the countries drop back to 5 percent growth, it will take 20 percent off the price of commodities.
If these nations grow at only 3 percent, it means officially they are in a recession, he said, noting an emerging nation doesn’t need a negative number to be in a recession. In this scenario, commodity markets could collapse to $3 corn, $50-per-barrel oil and soybeans in the single digits.
Currently the BRICS and KIM-Ts have a 4.6 percent growth rate. Because that is less than 5 percent, if weather patterns return to normal, commodity prices could decrease at a fast pace. “Don’t be surprised if, in the next five years, our grain industry goes into a negative margin very quickly,” Kohl said.
3. Watch weather patterns
“We would have had $3 to $4 corn this fall if we hadn’t had a drought in the Midwest and Russia,” Kohl said. “Mother Nature trumped us this time.”
Producers were urged to keep an eye on weather patterns in the southern hemisphere from now until February, and from then into March focus on the Midwest. If normal weather patterns occur, the price of corn could re-adjust to $3 to $4 a bushel.
However, Kohl cautioned, a back-to-back drought could mean a paradigm shift for the entire livestock industry.
4. Slowdown of world economy
Twelve of 17 European nations are in a recession. Unfortunately, Europe is China’s biggest customer – and if China isn’t selling products to Europe, it’s not going to buy products from rural America.
According to Kohl, the key to Europe in the next six months is to watch Germany. Angela Merkel, the chancellor of Germany, is coming up for re-election. She has held the euro currency together and, if she is not re-elected, the 35 percent chance of the euro breaking up gets much larger.
China has been growing at 10 percent for the past 30 years. A new leader will be installed soon and his critical issue in the next 10 years is to keep social control.
As the country is undergoing the biggest middle class transition the world has ever seen, the new leader, Xi Jinping, wants to know if the U.S. will be a dependable source of food, fiber and fuel. It is also securing its future in these areas by making investments in South America and Africa.
In terms of the U.S., this country is stalled on the edge of a fiscal cliff. As of the first of the year, the Bush tax cuts will be gone and approximately 2 million government workers will lose their jobs due to department cuts, Kohl said.
He warned not to get complacent on interest rates, noting an effective risk management plan covers revenue, costs and interest rates. Even though Ben Bernanke, chairman of the Federal Reserve, has said he is going to keep interest rates low until 2015, it may be out of his hands, Kohl mentioned. U.S. debt is at $16 trillion, 41 percent of which is financed with foreign money.
Bernanke has no control of these foreign creditors who may decide to keep their money or put it elsewhere. If that happens, interest rates will go up very fast.
China is the leading financier and a tough negotiator. The more money the U.S. borrows, the more negotiation power China gains. And, U.S. agriculture will be right in the cross-hairs of any trade war with China.
5. Super cycles
Since the start of the 1900s, there have been four super cycles. Each one was centered on heavy demand for agriculture, metals and oil. The current super cycle has lasted nine years, but Kohl warned it will most likely end between year 10 and 15.
One, or a combination, of the following factors could disrupt it: slowdown in the growth of global markets, ethanol, a stronger dollar, high interest rates or weather.
6. Land values
Land values are very cyclical, Kohl said. Corrections to today’s high prices will come, but they will be regional and local. This will also be the result of higher interest rates, a softening of the market, changes in ethanol and a stronger dollar.
There are cash buyers on the market, but 26 percent of buyers are using equity in their financing. A correction is very painful for equity buyers, he said.
Those also likely to get hit are the alpha dogs or the aggressively growing businesses that don’t have the discipline to hold liquidity and instead invest all of their profits into growth. When the cycle turns, these businesses go upside-down very quickly. Alpha dogs can also bring down other producers and agribusinesses in the fall-out, Kohl said.
What can you do?
When the game is changing, it is important to have your financial house in order, Kohl said.
“Companies that have longevity are good with cash,” he said. “Dormant cash is going to allow you to capitalize on opportunity.”
The bigger a farm becomes, the more it needs one to two months’ farm expenses in cash in the bank. Cash can help the business take advantage of discounts and risk-management strategies.
“Working capital and cash flow management are very critical,” Kohl said. “When you are profitable, you’ve got to store up some of that cushion so when that cycle goes against you, you’re going to be able to weather that cycle. Then you’re going to be able to hit the ground running out on the other side.”
Kohl said every business should have a working capital strategy. He likes to keep a working capital to revenue ratio at 33 percent and above.
He also suggested having a profit plan, because businesses can fall into an undisciplined pursuit of more. “Your biggest mistakes can be made in your profitable years,” Kohl said, noting a business is not as disciplined then as it is in the more challenging years.
When profits come to a business, he recommended using 60 percent to focus on efficiency and incremental growth, 30 percent to build working capital and manage taxes, 10 percent for family living.
His farm business also conducts a monthly and quarterly variance analysis where it looks at what was projected, what actually occurred and why there were deviations.
Did the numbers change due to macro economics or a poor management decision? Employees, as well as a team of advisers, are brought in on this discussion.
He did caution to be careful on the monthly analysis because it can vary quite a bit. That is why he also suggests a quarterly look at these reports.
Lastly, his business plan includes performing a SWOT – strengths, weaknesses, opportunities and threats – analysis and a review of accomplishments.
The important thing is to build a solid playbook to play through the changing game.
“You’ve got to keep extra cushion,” Kohl said. “You just can’t get out on the edge.” PD
