“This year, given all the changes and the excess supply of commodities, will probably be the hardest ever to figure out,” says Ann Duignan, U.S. machinery analyst and managing director of New York-based J.P. Morgan. “2017 is going to be a very interesting year.”
I was in the audience when Duignan addressed the United Equipment Dealers Assn. Convention in Louisville on February 14. She doesn’t fail to entertain, even as she jokes about her unique ability to deflate her audiences by the time she leaves the podium.
Her speech came just as we were realizing that dealers’ optimism (Ag Equipment Intelligence’s Dealer Sentiments Survey) was at a 33-month high. But then again, “risk awareness” is a big part of her job, as she guides institutional investors about the prospects of agricultural stocks for pension fund investments.
Her presentation to the dealers covered a lot of ground, too much to cover here, but there were several items that were worth sharing.
- Machinery Stocks High, But Not Because of Fundamentals — Machinery stocks are trading at very high P/E ratios. “Caterpillar is very expensive stock at 30 times forward earnings, like an Apple or high-growth stock,” she says. Despite the realities in ag, Deere is nearly as expensive. “Investors say they can’t buy CAT at 30 times, so they buy John Deere at these highs even though the fundamentals aren’t good.” The major line stocks are being pushed up by people like the Chinese, who believe in deflation trade in ag for the instrument, not because of the fundamentals, she says.
- Higher Equipment Costs Coming from Manufacturers — Countries like China are buying steel, aluminum and copper because they’re afraid their currency is going to devalue, she says. Plus there’s the acceleration of economic activity.
“The problem for you guys, as dealers, is that the steeper these commodity rises, the more likely that your OEMs will raise equipment prices,” Duignan says. “You’re potentially going to get squeezed. You know your farm customers are in no position to take on that higher price. This is going to get worse before it gets better. The better the economy goes, watch out — it’s going to drive these commodities up further and squeeze your profits.” Leasing, however, is a one way of getting around this, she says.
- Global Stocks Picture Skewed by Poor Production in South America — Noting that wheat, beans and corn have all been trending the wrong way, Duignan points out that even with the horrible crops (production was down 20%) in Brazil and Argentina, “We still had all of this [carryover].” She recalled a conference in Brazil where a speaker was asked how the inventory problem in agriculture could be fixed. Duignan remembers his answer: “If Australia had a big earthquake and sank.”
- Good news. The one piece of good news she shared was the crop insurance guarantees for corn. “It’s encouraging to see the $3.95 price for corn with crop insurance,” she says. But then she went on to say that also brings the risk of more corn acres planted.
Risk Factors with the New Administration
The most entertaining part of Duignan’s keynote was “What Could Go Wrong Under the Trump Administration” — a list of her musings that she said are not presently understood.
1. Strong dollar. Duignan says the damage to currency is already done because of the strength of the dollar vs. the peso. “The peso is the single most important currency for your customers.” Pointing out that Mexico is at the top of the importers of a long list of ag products and the U.S.’ third largest importer of ag products overall, she notes Mexico lost 20% of pricing power in the last month. Mexico already is saying, ‘Watch out U.S., we’ll make free trade agreements with Brazil and Argentina for ag.’ So they’ll spend it in South America. So even if there is not a trade war, they’re going to purchase from U.S. competitors.”
She points out that 15% of corn is exported today. “While we were building ethanol, we gave up the export market to Brazil and Argentina, and if we lose ethanol (the mandate expires in 2022), not only will we lose that market for corn, but the strong dollar will kill us.” She commented that ag would be wise to band together and launch a “no strong-dollar” campaign. Anyone see the American Petroleum Institute ads in the Super Bowl, a group that as she points out, HATES the ethanol mandate?
2.Immigration reform. “Ag is going to be particularly hit,” she says, citing recent conversations with farmers who say they cannot find U.S. laborers to pick potatoes, milk cows and perform other manual labor. “It will broadly hurts ag.”
3. China. She says that even agriculture doesn’t seem to grasp that China is sitting on 2 times as much corn in their grain bins as there is here in the U.S. “It’s old; it’s not good quality,” she says, “but if we get into trade wars, they’ll dump it on global market and settle for $1 bushel, 25 cents a bushel. They’ve done it before with cotton and actually corn, too. There is so much inventory they can get rid of.”
4. Tax changes. What do farmers hate most in life? The answer, she says, is taxes.
First, she wants the dealers to know that a new tax regime is going to void all holes that have given farmers an advantage. “There’ll be no deferring sales, no forward expense, etc. Farmers aren’t going to like a simple tax. The complexity is how they navigate through life.”
Second, is the border tax adjustment. “The dollar is going to go up, some say by as much as 25-30%. So if you think the dollar is strong now, watch out with the border tax changes. Others groups, like the garment and retail industries, are unifying against it, but not ag.” The interest expense deduction will also go with the border tax, she says.
5. FASB Leasing Ruling. Another big change is coming with the U.S. Financial Accounting Standards Board (FASB). “It’s going to change way of leases are accounted for. Leasing will need to be capitalized starting in 2019 for the lessee, and in 2018 for the lessor.” She adds: “If you’ve got to capitalize your leases, debt-to-equity will be worse and bankers won’t be happy.”
The FASB rule was put into motion many years ago, before Trump, with what may be very unintended consequences. “The intent was to ‘get at’ aircraft leasing and commercial real estate because those guys don’t carry the liability on balance sheets, because they lease everything,” she says. “This change was put in without any thought to ag, small business, dealerships, etc., but it’s done and in place. The only exemption is leases under one year.”
She worries the 1-year exemption may encourage combine rolling again. We all know how that turned out.
High Water Mark Indicator
Through her story telling, she also alerted me to a high-water mark conditions indicator that I’ll remember to test if/when that notion becomes relevant again one day (significant tax code changes may alter its usefulness).
“You know when your farmer is remodeling the wife’s kitchen that he’s bought all the equipment he could possibly buy.” She recalls that during an analyst farm tour in Iowa years ago, a farmer wanted to show off the new kitchen to the group, complete with marble countertops and an $8,000 espresso maker from Germany. “That’s when I said, ‘The cycle is over, downgrade the stocks,’” she says.