Investing in an Unbalanced World - CFA Society of Alabama (May 2011)

7/31/2019 Investing in an Unbalanced World - CFA Society of Alabama (May 2011)

1/10

www.bienvillecapital.com

COMMENTARY&PORTFOLIO STRATEGYMAY2011

M. Cullen Thompson, CFAManaging Partner & Chief Investment [email protected]

Adapted from a presentation to the CFA Society of Alabama on April 21, 2011, The Harbert Center, Birmingham, AL

INTRODUCTION

On behalf of Bienville Capital, I would first like to thank you

for hosting me. Its a privilege to be among peers. Our firm

always enjoys sharing our thoughts and ideas with friends in

the industry, believing that doing so will make us better

investors.

In order to give you a little context for todays discussion, I

would like to say a few words about our firms investment

process. What is fairly unique relative to our peers in the

investment advisory business is that one of the primaryfocuses at Bienville is on thematic, macroeconomic research.

Contrary to common perception, we believe that macro is

fundamental research. All of the issues we focus on revolve

around fundamental, rather than technical considerations.

The primary difference between some of the work we do

versus that of a security analyst is that we are applying our

analysis to the global economy, rather than specific businesses.

For much of the past 30 years, macroeconomic considerations

had taken a backseat in investors minds. We believe this was

largely the result of the relative tranquility that sort of fell over

the global economy beginning in the early 1980s.Nonetheless, given the vast imbalances alive today, an

awareness of the macro will remain an essential variable in the

investing equation.

In fact, Investing in an Unbalanced World has become

somewhat of a tagline at Bienville. Since were admittedly not

very good at delivering the so-called elevator speech, we felt

this at least suggestedto some degreewhat we attempt to

do as an investment firm.

Our process is both comprehensive and intense and involves a

number of outside strategists, consultants, economists, as well

as current and former policymakers. To the best of ourabilities, we attempt to understand the major forces impacting

the world, the potential outcomes, as well as the choices

policymakers are faced with. We leverage as many

relationships as possible, including the terrific work of many

of our underlying investment managers. However, in full

disclosure, with each passing year, we pay less attention to

Wall Street research. From my perspective and certainly with

a few notable exceptionsStreet research increasingly resembles

group-think, and as we all know, herd-like thinking offers little

value-add in the investing arena. Our focus is on the big

picturethe forest, not the trees. By contrast, organizations with

a predominant focus on business risk, rather than investment

excellence have a very difficult time being contrarian, as well as

making difficult portfolio decisions, both necessary preconditions

to successful investing. On the contrary, we deeply value many of

our independent research providers. Much of their work will be

reflected in this presentation.

Today, we will be spending a few minutes on some of the key

issues Bienville has been working on and discuss how we

integrate them into our portfolios. Although each topic deserves

its own distinct presentation, in the interest of time, I have tried

my best to aggregate them into one.

Our thematic views, which are constantly evolving, drive our

capital allocation process, including asset class decisions,

geographic preferences, as well as manager selection. Importantly,

these views help determine the amount of risk we are willingly to

take over the course of various periods. We allocate capital where

we believe valuations are favorable and avoid areas where they are

not.

The Graham & Dodd in me would like to tell you we singularly

define risk as the potential for permanent loss of capital,

however, its important to note that our firm predominantly

advises individuals and family offices. As the behavioral finance

field has demonstrated, we allas investorstend to respond

poorly to losses. As a result, our firm is cognizant of volatility.

By reducing some of the volatility inherent in investing, we hope

to minimize the opportunities to make poor decisions.

As for security selection, we rely almost exclusively on external,

value-oriented investment managers with an exceptional talent for

identifying long (and sometimes short) opportunities within the

equity or credit universe. I should also mention that we believe

that this talent cannot be discerned from quantitative screens or

Morningstar ratings. On the contrary, finding terrific managers is

a labor intensive process that also requires a qualitative

understanding of how a manager thinks and the investment

philosophy that drives decision-making.


2/10

COMMENTARY&PORTFOLIO STRATEGY

Page 2 of 10www.bienvillecapital.com

For us, a prerequisite for consideration is an intense,

fundamental approach and a concentrated portfolio. As the

adage goes, we want our managers best ideas, not their 80 th,

90th or 100th. Diversification is our job, not theirs. Ironically,

and despite traveling across the country, and to a lesser extent,

the world, Im pleased to say that two of our very talentedequity managers are based here in BirminghamCook &

Bynum and now Vulcan Value. We are grateful for the terrific

work they are doing for us.

Finally, although they may at times be profitable and even

offer uncorrelated returns, we abstain from investing in

quantitative, statistical or model-based strategies, particularly

those that rely on leverage. The know what you own

philosophy permeates our portfolios. By doing so, we sleep

better at night.

THE U.S.-AFISCALTRAP?To start, we ask the question, is the United States in a fiscal

trap? I should first mention that this is neither a simple

hypothetical question nor intended to be a statement of fact,

but rather a possibility that we think intensely about. But

before attempting to answer it, we first need to back up a bit.

A little background is warranted.

At the turn of the 21st century, private sector debt was

growing at a fast pacein fact, much faster than nominal

GDP growth. And specifically, the household sector was

leveraging up at a rapid rate. In fact, between 2003 and

2005a period spanning just three yearsmore mortgagedebt was accumulated in the United States than in the

previous two hundred. Wall Street, the intermediary of all this

debt creation, boomed, as did the assets bought with it. But

not surprisingly, with the collapse in prices and the onset of

the financial crisis, this household leveraging came to an

abrupt end. Deleveraging was to be expected, so we were

all told.

But as we now know, this is not how the narrative played out.

As has been the case over the past few decades, just as the

economy reached the point of a necessary creative destruction

process, the authorities intervened. Banks were determined

too big to fail and stimulus was called upon to underpin the

level of demand in the US economy. Levered speculators, by

and large, were saved.

Of course, fiscal stimulus simply transfers resources from

over-levered and credit-constrained borrowers to the credit-

worthy sovereign. According to academic theory, this makes

sense. Governments of triple-A rated countries can borrow at

lower interest rates than households, which allows for the

needed de-leveraging process to occur at a more digestible pace.

Unfortunately, to date, no system-level deleveraging has occurred.

If an analyst were to review the Federal Reserves Flow of Funds

data, they would notice these two obvious and disturbing trends:

first, the democratization of creditwhereby policy encouraged

that credit should become easier and easier to come byand thensecondly, the socialization of itthe process by which bad debts

were subsequently transferred to the public sectors balance sheet.

As of today, the very little debt reduction that has occurred at the

household level has been overwhelmed by the vast additions to

the public sector. For those who prefer metaphors, this is akin to

shuffling deck chairs around. Yes, it will buy a cyclical recovery,

as weve now witnessed. But as simple logic attests, you cannot

solve a debt crisis with more debt. All weve really done is

delayed the necessary adjustments.

Can this credit pyramiding last? Irving Fisher, the 20th century

authoritarian on debt deflations, taught us that major disturbances

in economic cycles occur from too much debt relative to the size

of the economy. And as logic would suggest, there are limitations

to governments backstopping the private sector.

Peter Bernholz, in his seminal book,Monetary Regimes and Inflation,

has demonstrated that deficit-to-expenditure ratios in excess of 40

percent (combined with monetization by the central bank) have

historically led to high and hyper-inflations. Recently, the US

crossed this alarming threshold. From Bernholzs analysis, two

especially noteworthy facts resonated: first, all hyperinflations in

history have occurred since 1914, which coincides with the global

movement towards discretionary monetary standards; andsecondly, all were caused by the financing of huge public deficits

through money creation by the central bank. 1

Unfortunately, the marginal benefit of all this debt is now

negligible, which is not at all surprising considering the economy

is already saturated with it. In fact, whereas between 1953 and

1984 each unit of additional debt generated 63 cents of economic

growth, today each new dollar of debt contributes only 7 cents to

GDP. This concept has been confirmed by Kenneth Rogoff andCarmen Reinhart who have demonstrated that once an economys

debt-to-GDP reaches 90 percent, growth noticeably suffers.

Other academics, such as Robert Barro have also argued that

once debt ratios surpass 60 percent, the government spending

multiplier turns negative, meaning that rather than contributing

positively to economic growth, additional deficit spending

Therefore, it

should not be taken lightly that the Fed is now the largest owner

of outstanding Treasuries or that, thanks to QE2, it has

purchased over 70 percent of recent supply.

1 One exception was France during the Revolution of 1789-96 when convertibility was suspended. Bernholzdefinition of hyperinflation is a rate of inflation of 50 percent per month


3/10



detracts from it. Although many of the technocrats in

Washington dont appear to fully comprehend this concept,

the private sector doesseeing bourgeoning deficits, the

business owner envisions higher taxes and less economic

stability. Confidence deteriorates and investment and hiring

understandably suffers.Now, much attention is given to where we standthat is, the

current fiscal deficit and outstanding stock of debt. Currently,

the Congress is haggling over raising the existing debt ceiling.

However, less focus goes into how difficult it will be to get the

governments finances back to more normal and sustainable

levels. To provide some perspective on the magnitude of the

necessary adjustments, in order to restore the governments

debt ratio to pre-crisis-levels by the year 2020, a change in the

primary budget balance of nearly 12 percent of GDP is

requiredthat is, from its current 10 percent deficit to a 2

percent surplus.

Unfortunately, Congress track record in balancing the

nations books is not particularly good. In the last 50 years, it

has occurred only 5 times. Regardless, the amount of fiscal

consolidation would be simply politically and socially

untenable. Ireland has implemented vicious austerity, and as a

result, its GDP has fallen by 25 percent. For comparisons

sake, the peak-to-trough decline of the US economy during

the recent crisis was 4 percent. A Congressman from Texas

once remarked that weve become a nation of financial

hypochondriacs. Ill let you decide.

So we all recognize things are bad. But everyone wants to

know, how do we get out of this mess? Unfortunately, were

not quite sure. What is certain, however, is it wont be easy.

It never is once an intertwined mess has been created.

To illustrate the difficulty, consider the budget deficits

between now and 2019 as estimated by the Congressional

Budget Office. The annual red ink is projected to add an

additional $9 trillion of government debt to the $14 trillion-

plus already outstanding. Of course, with debt comes a

costin the form of interest expensewhich thanks to the

maneuverings of the Federal Reserve is artificially depressed at

the moment. Nonetheless, at some point the Feds zero-

interest rate policy and large-scale asset purchases must end,paving the way for interest rates on Treasuries to rise, and

along with them, interest expense.

As you can imagine, off-setting some of the increased interest

expense will be some cuts in spending. However, even after

accounting for decreases in spending, and using the CBOs

optimistic expectations for economic growth and only modest

increases in interest rates, the net result is higher deficits. If

rates were to rise to their historical normsa more onerous

scenario versus the CBOsthe situation is even more explosive.

The all-important point is, in almost every conceivable scenario,

the net result appears to be higher deficits. We simply cant

reduce spending fast enough without risking a collapse in the

economy to offset the inevitable increased costs related to ourrising debt.

This is the potential fiscal trap, which leads us to wonder, can the

Fed ever leave its current zero-interest rate policy (i.e. ZIRP, or

the Zero Lower Bound)?

Kyle Bass of Hayman Capital Management, the highly resourceful

Dallas-based hedge fund, has described the process more directly:

When a heavily indebted nation pursues the ZLB to avoid

painful restructuring within its debt markets, the ZLB facilitates a

pursuit of aggressive Keynesianism that only perpetuates the

reliance on ZIRP. In other words, ZIRP is an inescapable trap.

Low rates resulting from Fed policy encourages more spendingand accumulation of debt, which in turn requires low interest

rates in order to ultimately service it. The bond market, which

historically has served as a warning indicator to free-spending

politicians, is currently overshadowed by the giant, non-economic

agent in the room (i.e. the Feds Treasury purchases).2

With complex situations, examples are often helpful. In this case,

Japan is the most proximate one. With its stock of debt now

approaching one quadrillion yen, interest expense alone

constitutes 25 percent of revenues, despite having the lowest

average cost of capital in world. If rates were to rise to levels as

low as 4.0 percent, interest expense will consume all of their tax

revenues. Japans outstanding stock of debt is so large that every

1 percent increase of their weighted average cost of capital nearly

equals 10 trillion yen in additional interest expense. Yet, the

central government only collects around 40 trillion yen in tax

revenues. After paying interest expense and escalating Social

Security expenditures, the Ministry of Finance hardly has any

revenues left over to fund the rest of the government, much less

roll over maturing debt. To do so, they rely on borrowing.

So what can be done? To reduce large public debt burdens, in

general, policymakers can:

Cut spending, but not too forcefully or domestic demandand tax revenues will plummet, exacerbating the situation

Implement supply-side reforms, which theoretically unleashGDP growth (and tax revenues) in excess of the rise in

interest expense. This, of course, was the template of the

Reagan administration. Unfortunately, for a number of

reasons, it cannot be repeated

2 The Fed is a non-economic agent because the purpose of its Treasury purchase program is not to earn aprofit on its holdings, but rather to manipulate interest rates


4/10



However, policymakers cannot:

Significantly increase the tax share of GDP. Despitevarying marginal tax rates, tax revenues have never

exceeded 20% of GDP

Excessively tax the rich, which in reality may raise around$100 billion (in the context of a $3.8 trillion budget). In

todays world, capital can move and wealthy individuals

and corporations have proven to be very good at avoiding

taxes. It recently came to light that GEs effective tax rate

is 3%, a real life example of imagination at work

Target inflation explicitlyexplicitly being theoperative word. Higher inflation would increase interest

expense, as well as rollover risk for the Treasurys

maturing debt. We recently learned from a senior official

that the Treasury Department has been lengthening the

average maturity of the countrys debt at the fastest rate

in history. However, it still remains only 59 monthsone of the shortest maturity profiles in the developed

worldsubjecting the government to considerable

rollover risk

In our opinion, whats likely to happen is a combination of a

few things: first, some cuts in spending. The Tea Party

members are demanding it. Secondly, we will have inflation,

but as much as possible will be in stealth form. Everyone in

this room is aware of the absurd subjectivity of the CPI

numbers. Thirdly, in a maneuver as equally, if not more

pernicious than inflation, we will likely see various forms of

financial repression, or forced measures to ensure the

governments interest rates remain low.

Financial repression has been a topic of discussion within

Bienville for some time. Quite simply, financial repression can

come in many varieties, including the forced buying of

Treasuries by pension funds, explicit interest rate caps, laws

deeming it illegal to hold gold for investment purposes, as well

as the introduction of capital controls to prevent money from

moving offshore. I should note that all of these have

occurred before either in the US or in other developed

markets. If 2008 taught us anything, it is to never

underestimate the will of government. Remember, less than

three years ago, short-selling was banned.

CHINAS DANGEROUS GAME

Despite the problems domestically, I believe China is the chief

flash point in the global economy, representing a possible

source for unanticipated, systemic risk. As we will discuss,

because of the way the world is currently organized, the US

and Chinese economies are inextricably linked. Therefore, the

policies pursued by both are of critical importance. In order to

explain why, allow me to first quickly revert back to the U.S.

economy, specifically how money flows through its various

sectors. What Im going to describe is a fairly simple equation,

yet it can be highly illuminating, providing insight into how the

world may be able to successfully rebalance.The equation is the national accounting identity. Now, bear in

mind, what Im referring to is not some arcane, abstract economic

theory but rather an accounting reality. Within every country,

there are three sectors: 1) the public sector, 2) the private sector,

including households and businesses, and finally, 3) the foreign

account, which is essentially the inverse of the current, or trade,

account. Importantly, the flows among the sectors must sum to

zero. Similar to the childhood game of hot potato, money can be

shuffled around, but it cannot leave the circle. Therefore, as

Charles Dumas of Lombard Street Research often remarks, one

sectors financial balance cannot be viewed in isolation as its

effects will be felt elsewhere.

Sectoral balancesthat is, how much a sector borrows or saves

represents a flow over time. Contrarily, outstanding balances

represent how much a sector owes, and therefore represents a

stock at a given moment in time. For example, the US

governments gross debt-to-GDP is currently approaching 100

percent. This is the stock of debt.

Presently, and using round numbers, the government sector is in

deficit to the tune of 10 percent of GDP, representing an annual

negative flow.3

CURRENT U.S.SECTORBALANCES

Secondly, the private sector is running a 7 percent

surplus, the result of balance sheet repair by households and

restraint by businesses. In conjunction, the net savings rate of the

country as a whole is negative. To compensate, we have the

foreign accountthe absolute value of the current account

which stands at around 3 percent of GDP, indicating that the

United States is importing capital from abroad.

Whats notable from the formula above is that both the private

and foreign sectors are currently funding the US government.

But importantly, the public sector cannot run deficits of 10

percent in perpetuity. Similar to the household sector, it must

also delever, shrinking its annual deficit. But as the math

demonstrates, both the private sector and public sector cannot

delever at the same time without the current account moving

3 The public sector includes the federal government, as well as state and localities. However, because statesand localities are required to balance their budgets, the effect here is negligible

Public + Private + Foreign = 0

-10.0 + 7.0 + 3.0 = 0


5/10



from deficit to surplus, a scenario that has not occurred in

over 30 years.

Now, in order to paint a picture of a more sustainable

situation, imagine that the public sector reduces its deficit to 3

percent of GDP, which is in line with the CBOs expectations

and sufficient to theoretically stabilize debt ratios at currentlevels. Next, according to Lombard Street, a more normal

private sector surplus is around 4 percent, which is the

combination of a 3 percent surplus for households and 1

percent for businesses, keeping in mind that businesses are

not formed to be savings vehicles. Again, because the sectoral

flows must equal zero, the rigidity of the math requires that

the current account moves toward a surplus. This is where

China enters the equation.

SUSTAINABLE SECTORBALANCES

Because of the existing currency regime in China, specifically

the yuan-dollar peg orchestrated in Beijing, the necessary

rebalancing of the US economy, as well as the global

economy, cannot happen. In order for the current account to

move to surplus, the US would need both lower imports and

higher exports. For that to occur Chinas exchange rate needs

to appreciate considerably, which to date, there has been no

tolerance for.

In fact, China has become increasingly addicted to both

exports and more recently, fixed asset investment (i.e. thebuilding of infrastructure-related projects) in order to drive

economic growth. Consumption, by contrast, has fallen as a

share of the overall economy for 20 years now.

Beginning in 2009, China unleashed a stimulus package of an

astronomical scale. Although the direction was intended, the

magnitude was not. Local government officials in China saw

an opportunity of essentially free reign to build anything they

wanted under the express intention of engineering growth. By

doing so, they also enriched themselves.

The result has been higher inflation. Yet policymakers have

yet to fully understand the problem. Most solely blame QE2while dismissing the 55 percent increase in the Chinese money

supply over the past two years. To combat it, theyve resorted

to liquidity measures and quantitative credit controls, which

are having significant distorting effects on the private sector.

Our sources relay to us there is simply no appetite for allowing

the currency to appreciate a meaningful amount or to loosen

capital controls. The former would hinder the export sector

while the later would diminish the Partys coveted control over

the banking system.

So Chinas economy remains deeply imbalanced. Their growth

model is also not sustainable, which simple math can illustrate.

And were not the only ones who think so. Just last fall, Premier

Wen Jiabao confessed that China lacks balance, coordinationand sustainable economic development. Ironically, however,

policymakers in China have been promising a rebalancing towards

a more consumption-oriented model for years. But given todays

precarious structure, I cant emphasize enough the difficulty of

this transition. Consumption simply cannot rise fast enough to

offset the necessary fall in investment in order to sustain the

current rates of growth.

So as long as China resists a significant appreciation of the yuan,

the US cannot rebalance to more sustainable trends. This is

precisely why China, and the policies it incorporates, remains at

the center of the global economy. Rather than allowing the worldto heal, Chinas currency peg is leading to another crisis. If

economics cannot resolve it, politics is ultimately likely to.

Finally, as for the question of a property bubble: anecdotally, a

consultant in Beijing recently informed us that his landlord is

attempting to sell his apartment for 70x gross annual rental

income. The down-payment alone would cost him 23 years of

rent. Rest assured, he is not bidding.

INFLATIONIS IT COMING?

The Bank can never go broke. If the Bank runs out of money, the Banker

may issue as much as needed by writing on ordinary paper.

- Monopoly, Official Game Rules

Before quickly diving into the inflation debate, I think its

necessary to first properly define it. Inflation is not too much

money chasing too few goods, as its so commonly described.

Inflation is simply too much money. Its a monetary

phenomenon, just as Milton Friedman said so. As a consequence

of the expansion of the currency, prices invariably rise. So

inflation is currency debasement. It erodes purchasing power.

Rising prices are a symptom of the disease, not the disease itself.

One other thing to keep in mind is that while inflation usuallyrefers to the increase in the amount of actual dollars in

circulation, we should not constrain our definition to physical

money. The expansion of credit counts too. So in essence,

anything that artificially increases aggregate demand for goods

and services is inflation.

Too much money can cause differing outcomes, including

higher consumer prices, stock market booms, real estate bubbles

and commodity price spikes. Although rising consumer prices are

Public + Private + Foreign = 0

-3.0 + 4.0 + -1.0 = 0


6/10



troublesome enoughits a tax for which the public has no

representationas weve learned twice now in the past

decade, asset price inflation can be far more dangerous.

Thats because not only are resources grossly misallocated, but

artificially inflated assets are often bought with leverage, which

comes with its own cost.As we will see shortly, inflation can also temporarily hide in

excessive productive capacity around the globe. For these

reasons, its too simplistic to singularly focus on the CPI as a

measure of inflation, irrespective of policymakers desire for

us to.

For the better part of 50 years, one way or another, weve

been printing too much money. In the 70s, the inflation

appeared in consumer and commodity prices, culminating in

the Great Inflation. But by the early 80s, a determined

Federal Reserve Chairman hiked the policy rate to 20 percent.

As a result, prices fell. Along with it came interest rates.Lower rates resulted in a lower cost of capital and therefore

increasing profits for businesses, which in turn encouraged

more investment in capacity. A virtuous cycled unfolded.

The global supply curve was pushed out to the right.

Regulatory burdens declined, globalization picked up its pace

and supply chains became more streamlined. It was the Great

Moderation, a truly serendipitous set of economic

circumstances. Nonetheless, there was still too much

moneythat is, if you were to consider the growth in total

credit market debt, where money was being created outside

the purview of the published money supply figures and

deployed into factories around the world.

To understand how consumer prices can fall despite excessive

money growth, consider the following framework as described

by Frank Byrd of Fielder Capital Management: if the amount

of money in circulation doubled, holding supply and demand

constant, prices should double. Thered be twice the money

chasing the same quantity of goods. But what if the money

supply doubled and the quantity of goods also doubled?

Holding demand constant, thered be no price inflation.

In Franks opinion, this is essentially what happened since

1982. Money supply grew dramatically, but production

capacity far outgrew consumption, so much so that it largelyanesthetized consumer prices from the currency inflation.

How does this relate to today? Supplyor capacityis

abundant while demand is being underpinned by government

transfer payments. Because demand has been temporarily

stabilized, albeit at an artificial level, some of the excess global

supply has yet to come off-line. But eventually, some of it will

be permanently shut. Protectionist rhetoric, high oil prices

and geopolitical uprisings only exacerbate this process. The

shuttering of this excess supplya magnificent disinflationary

force over the yearswill be inflationary. To date, central

bankers appear to be paying scant attention to the shrinking

supply side of the equation.

As an example, consider the employment picture. Commonperception is that high unemployment implies excess slack in the

labor force. Therefore, workers have no pricing power,

supposedly inhibiting the potential of a wage price spiral. But this

simple analysis overlooks two considerations. First, the

workforce in the United States is becoming increasingly

segmented by educational achievement. For those with college

degrees, the unemployment rate is relatively low while

participation rates are high, creating the potential for bottlenecks

to occur in the labor market despite the overall high levels of

unemployment.

Secondly, for the first time in its history, the US workforce hasmobilization issues. Imagine a viable candidate for a job

opportunity in Texas who is currently 25 percent underwater on

his mortgage in Arizona. He cannot move. Hes stuck collecting

unemployment benefitsfor 99 weeks at least. Therefore, the

theoretical supply of labor quality in Texas is less than the past,

which again, increases the risk of bottlenecks. NAIRUor the

non-accelerating rate of unemploymentcould be much higher

today than what the Feds models are currently estimating. These

issues are indeed structural. They cannot be resolved by counter-

cyclical policy and excessive monetary stimulus.

But employment is one of the Feds mandates and todays high

levels are providing cover for their current stance. Sources tell us

that Bernanke is deeply affected by the levels of unemployment

and at the height of the financial crisis quietly begged for fiscal

stimulus so that the burden of reflating the economy didnt fall

solely on the his shoulders. When looking at the numbers, its

easy to understand why. Today US nonfarm payrolls stand at a

little over 130 million, a level first reached at the end of 1999. So

in over a decade, the US economy has created zero net new

nonfarm payroll jobs. Yes, this is hard to believe. But its true.

As the population has continued to grow, the employment-to-

population ratio has dramatically deteriorated. And while the

BLS has ample latitude to tinker with the official unemploymentfigures, the employment-to-population ratio cannot be

manipulated. This is precisely what makes it a useful, unbiased

measure for whats actually occurring in the labor market.

Yet as we once again approach the Congressional debt limit,

austerity is supplanting fiscal spending as the theme of the day,

encouraging the Fed to continue its stimulative stance. So in an

attempt to alleviate the troubles with labor, the Fed has, once


7/10



again, set the price of money far too low. Unfortunately, we

dont seem to have learned the lessons of the past. As you can

see, whenever the Feds main policy ratethe federal funds

rateis held below nominal GDP growth for prolonged

periods of time, bad things inevitably happen.

When money is underpriced, resources are misallocated. Since1971, following the de-linking of the US dollar from gold, the

Fed has habitually made this error. The result was high

inflation in the 70s, followed by an equity market bubble in

the late 90s and a real estate bubble in the mid-2000s. Today,

stocks and bonds are once again rising, commodity and food

prices are going gangbusters and revolutions are popping up

all across the Middle East and Africa. How will it end this

time?

Oddly, many of the representatives at the Fed jump at the

opportunity to take credit for the rise in equity prices yet

refuse to accept responsibility for the concomitant increases in

commodity prices. I say oddly because both show an

uncannyand some would say unmistakable correlation to

the money supply. Core inflation, the most lagging of all

economic measures, is rising too, as are inflation expectations.

Other indicators, such as the ECRI Future Inflation Index and

the MIT Billion Price Index are climbing as well. And given

the recent performance of the US dollar, even relative to the

currencies of very troubled regions and countries (i.e. Europe,

UK and Japan), its clear that confidence in the worlds reserve

currency is waning. As confidence falls, velocity accelerates.

A reflection of the previous 30 years may provide some

indication why. Beginning with the Chairmanship of AlanGreenspan, the Fed has responded to every crisis, not matter

how big or small, with the same prescriptionby lowering

rates and providing additional liquidity. The result has been

serial booms and busts in asset and commodity prices.

In the olden days, central bankers were expected to protect

the value of the currency. Following the banking crisis of

1907, the political elite decided that the money supply should

become more elastic. Similar to an accordion, it should both

expand and contract consistent with the needs of the economy.

The Federal Reserve was born to facilitate this process. But

unfortunately, with the modern Fed, the supply of money only

expands. With the de-linking from gold in 1971, dollar-holders

lost an important governor on the central bank. As a result, wenow live in the age of inflation.

As we gather here today, central banks around the world employ

thousands of economists to assist in their desire to command the

complex, inter-related global economy. But despite their

increased payroll, their output has only gotten worse. Charles

Kindleberger, is his classic Manias, Panics and Crashes, remarked

that the years since the early 1970s are unprecedented in terms

of volatility in the prices of commodities, currencies, real estate

and stocks, and the frequency and severity of financial crises.

In the fall of 2010, to assist in their determination to boost the US

economy, and without Congressional approval, our monetaryauthorities appeared to have voluntarily added a third mandate to

their institutions missionthe price level of the S&P 500.

Historically, equity markets served as a quasi-barometer of

economic growth. Today they are a policy tool. And to be

perfectly candid, this is a frightening concept for a prudent

allocator of capital. If equity prices are a disproportionate part of

the economic equation, when does a small correction, ordinarily a

potential buying opportunity, become a self-fulfilling crisis?

So as you can imagine, we dont have a great deal of confidence in

central bankers. The fact is were too familiar with their track

records. Taking the punch bowl away is not their strong suit.

And given their current outsized balance sheets, the margin for

error is wider than ever. To be clear, its not that we believe them

to be bad people. Its just that they are human and therefore

fallible. They operate under the pretense of control, yet reality

proves time and again that no one knows what will happen next.

Control is an illusion. The Fed has no more ability to see into the

future than you or I, yet they set the price of money and

command economies as if they possess perfect foresight.

At present, the global economy is growing, inflation expectations

are climbing and commodity prices are booming. Yet the Feds

main policy rate is at zero and its balance sheet at all-time highs. I

should note that no mandead or alivehas ever managed abalance sheet the size of the Feds today. And importantly, none

of the voting FOMC memberseven those adamantly opposed

of the institutions actionshave ever faced a rising inflationary

environment. When the Great Inflation kicked into high gear in

1973, Bernanke was a 20-year old sophomore at Harvard.

So if youre still wondering which way the cards will fall in the

inflation versus deflation debate, consider the following. The Fed

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

Mar-71 Mar-74 Mar-77 Mar-80 Mar-83 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Mar-07 Mar-10

Federal Funds Rate less Nominal GDP(in %)

Source: Bloomberg


8/10



believes they have the tools to manage inflation, but not a

debt deflation. Thats a good place to start. Secondly,

Bernanke has told all of us, repeatedly, that deflation would

not happen here. We believe him.

CONCLUSION

The global economy remains deeply imbalanced. Presently,

the worlds 2nd, 3rd and 4th largest economies (China, Japan

and Germany) remain intent on maintaining large, annual

trade surpluses, partially supported through both apparent and

subtle exchange rate manipulation. But its important to note

that a trade surplus is nothing more than a deficiency of

domestic demand. Therefore, surplus countries rely on

excessive spendingand the resultant current account

deficitsby the likes of the US, UK and Spain. This was

always going to end poorly, and sure enough, it did. The

buyers of first and last resort no longer have the balance sheetor borrowing capacity to continue spending excessively. So in

a way, the financial crisis marked the end of the export-

focused growth model that many countries have relied on for

five decades. Going forward, a crucial determinant of the

outcome will be who the adjustments are forced upon. The

surplus countries must accept some responsibility and re-

orient their economies more towards domestic demand.

Otherwise, it will end badly for everyone.

On a more granular level, the US is in a precarious fiscal

position. All hope is not lost, but the adjustments will be

more difficult from here. Fiscal consolidation is a necessity.Either we will have it, or we wont. In the latter case,

policymakers risk a collapse in confidence in the US dollar.

Winston Churchill once remarked that the Americans will

always do the right thingafter theyve exhausted all the

alternatives.

We believe that Chinas growth model is unsustainable and as

a result, were anticipating either a soft or hard landing. Both

would likely have considerable knock-on effects to risk assets

in general and industrial commodities in particular. China

consumes close to 40 percent of the worlds industrial and

base metals production, nearly a quarter of soybeans and close

to 20 percent of wheat and corn output.

A rebalancing of the Chinese economy is, however, the

optimistic way out of this global mess. But again, it implies

lower Chinese economic growth in the near term, which we

believe there is little tolerance for. A side affect of QE is its

helping to accomplish the needed rebalancing by creating

inflation in China, raising its real effective exchange rate. Unit

labor costs in China are rising by double-digits while declining in

the US, evening the playing field some.

We believe that inflationwhen properly definedis already

here. For evidence, look no further than the Feds balance sheet,

which has risen from around 5% of GDP to approximately 20%.

Interestingly, it took the Fed 95 years from its inception in 1913to September 2008 to expand its balance sheet from zero to $1

trillion. Over the next 45 days, they added another trillion. With

QE2 were heading towards $3 trillion. We are in unchartered

territory.

I believe we are in the early stages of a period of considerable

monetary instability. If you could monetize the credibility of the

Federal Reserve, we would be short it. Instead, were long gold

a lot of it to be slightly more precise. The perfunctory 5 percent

allocation recommended by more-sanguine advisors doesnt cut it

in our opinion. Five percent is an after-thought. Its checking

the box, not protection.

Had you randomly polled Americans just five or so years ago, you

would have discovered that most were largely uninformed about

the nations finances. In fact, the vast majority believed that we

were the worlds largest creditor nation, rather than historys

greatest debtor. I recall this vividly because Washingtons fiscal

mismanagement was as much of a source of frustration for me

then as it is now. By contrast today, the average American is

knowledgeableand irate. Its front page news. And they

understand how the burden of future debt affects them.

By the same token, I believe most of us remain relatively unaware

of the history of money, what money really means andspecifically, the distorting actions of central banks. The subject is

complicated and Americans are busy. For the past 30 years or so,

theyve lacked a need or desire to concern themselves with

monetary policy. Its boring and confusing to most. But the

reality is, as a nation, we have regressed in terms of our

understanding of money. I believe this will soon change. I

believe society will soon once again think about what money is

and demand the stability of it. This discovery process is unlikely

to bode well for todays paper version.

We will also learn that central bankers are not bankers at all.

They are central planners. And we will come to understand thatyou cannot increase the quantity of money while also protecting

the quality of it.Money is unique. Unlike other items, abundant

supply is not a good thing. Murray Rothbard, the famed but far

too-often-forgotten free-market economist, once remarked that

once money is established, an increase in its supply offers no

social benefit.

The fact is, since 1880, or the end of the Civil War, monetary

regimes have lasted about a generation. Our current regimein


9/10



existence for not quite 40 yearsis arguably the worst. It has

allowed profound imbalances to build.

Today the US dollar is backed only by the political goodwill of

the Fed and Congress. Yet each day they endeavor to debase

it. For that reason alone, todays regime is more inflation

prone than any of the past.

Finally, we should all recognize that man has not solved the

business cycle. It remains an inherent part of capitalism.

Therefore, in the next few years, there will be another

recession. But notably, this reality is not modeled in

projections of our governments finances. The CBO assumes

tax revenues will climb in a consistent, linear fashion between

now and 2020. So when that inevitable day comes, will

policymakers do the right thing? As demonstrated in the last

crisis, it is governments that bail out banks. But who bails out

governments? In May 2010, as the Greek sovereign crisis

unfolded, Jean Claude Junker, the prime minister ofLuxembourg commented that We all know what to do, but

we dont know how to get re-elected once we have done it.

This doesnt inspire a great deal of confidence.

IMPLICATIONS FORINVESTING

Our focus at Bienville has been, and will continue to remain

on more flexible, unconstrained and skill-based strategies.

Reminiscent of the early stages of the mortgage crisis, we

dont believe the risks present today are fully acknowledged.

Within the equity space, many great businesses appear to betrading at fair, and in some cases, inexpensive prices. On the

contrary, among lower capitalization and more-speculative

companies, we have just witnessed the greatest junk rally since

1932. As a result, we are avoiding direct allocations to small

cap equities. While this has been a detractor of performance,

we believe it to be prudent from a risk perspective. If our

macro view is correct, smaller companies will suffer

disproportionately to the downside.

We particularly like more event-driven situations, which are

less correlated to the broad market. From a risk-return

perspective, its one of the areas where we get excited about

allocating capital. Unfortunately for some investors, these

strategies are harder to access.

With respect to fixed income, although we anticipated and

positioned for the deflation theme following the crisis, we no

longer believe the risk-reward is compelling. If economic

growth falters, driving interest rates lower, we are only likely

to witness more fiscal stimulus (or delayed austerity) and

almost certainly, more monetary stimulus. In fact, were not

sure QE ends anytime in the near future.

Within our various portfolios, we are able to reduce net exposure

through hedged strategies (e.g. long-short) as well as overlaying

individual protection when its attractive. This is not easy

however and does come with a cost in rising markets.

Were trying to avoid action biasthe desire to do something

at all timesin order to wait for better opportunities. This

requires patience on both our part, as well as our investors.

Patience, however, is in short supply when markets are rising.

Nonetheless, we believe this strategy will prove correct. Its

important to remember that just because we dont know when

something will happen, doesnt mean it wont. The potential fat

tail scenarios are very real, which at times can present attractive,

asymmetric opportunities.

We maintain substantial exposure to gold, which is one of the

longest holdings of Bienville clients. We acknowledge that gold

yields nothing and is speculative by nature. But the same

argument can be made of paper money. The critical difference is

that gold has retained its value for 2,500 years. No paper

currency has. Yes, the price of gold has risen. If that fact alone

concerns you, I encourage you to chart the monetary base.

Surprisingly to many, since the Nixon shock in August 1971,

which moved us to a fully-discretionary paper money regime, gold

has outperformed the Dow Jones Industrial Average. This is not

a suggestive statement on the acuity of corporate managements,

but rather a reflection of the degree of debasement by the dollars

overseers. Gold, as James Grant has said, is the reciprocal offaith in monetary arrangements. Today faith is declining.

Therefore gold is rising.

Finally, we remained concerned about pie chart (i.e. 60/40)

portfolios and the propensity to emphasize style boxes, both of

which are antiquated thinking in a new reality. Personally, I

shudder to think of the damage that would be done to pie chart

portfolios if the CPI unexpectedly sprang to life, taking interest

rates with it. I think its safe to say that it wouldnt be pretty.

Overall, in the ensuing years, we believe flexibility will be an

absolute necessity, but it requires difficult decisions and exposes

investment firms to business risk. Few organizations canstomach either. But as PIMCOs Bill Gross suggested in 2008,

investing is no longer childs play.


10/10



ABOUT BIENVILLE

Bienville Capital Management, LLC is a research-focused,

SEC-registered investment advisory firm offering

sophisticated and customized investment solutions to high-

net-worth individuals, family offices and institutionalinvestors.

The members of the Bienville team have broad and

complimentary expertise in the investment business, including

over 100 years of collective experience in private wealth

management, institutional investment management, trading,

investment banking and private equity. Bienville has

established a performance-driven culture focused on

delivering exceptional advice and service. We communicate

candidly and frequently with our clients in order to articulate

our views.

Bienville Capital Management, LLC has offices in New York,

NY and Mobile, AL.

DISCLAIMERS

Bienville Capital Management, LLC. (Bienville) is an SEC

registered investment adviser with its principal place of

business in the State of New York. Bienville and its

representatives are in compliance with the current notice filing

requirements imposed upon registered investment advisers by

those states in which Bienville maintains clients. Bienville may

only transact business in those states in which it is notice filed,

or qualifies for an exemption or exclusion from notice filingrequirements. This document is limited to the dissemination

of general information pertaining to its investment advisory

services. Any subsequent, direct communication by Bienville

with a prospective client shall be conducted by a

representative that is either registered or qualifies for an

exemption or exclusion from registration in the state where

the prospective client resides. For information pertaining to

the registration status of Bienville, please contact Bienville or

refer to the Investment Adviser Public Disclosure web site

(www.adviserinfo.sec.gov).

This document is confidential, intended only for the person towhom it has been provided, and under no circumstance may

be shown, transmitted or otherwise provided to any person

other than the authorized recipient. While all information in

this document is believed to be accurate, the General Partner

makes no express warranty as to its completeness or accuracy

and is not responsible for errors in the document.

This document contains general information that is not suitable

for everyone. The information contained herein should not be

construed as personalized investment advice. The views

expressed here are the current opinions of the author and not

necessarily those of Bienville Capital Management. The authors

opinions are subject to change without notice. There is noguarantee that the views and opinions expressed in this document

will come to pass. Investing in the stock market involves gains

and losses and may not be suitable for all investors. Information

presented herein is subject to change without notice and should

not be considered as a solicitation to buy or sell any security.

Past performance may not be indicative of future results and the

performance of a specific individual client account may vary

substantially from the foregoing general performance results.

Therefore, no current or prospective client should assume that

future performance will be profitable or equal the foregoing

results. Furthermore, different types of investments andmanagement styles involve varying degrees of risk and there can

be no assurance that any investment or investment style will be

profitable.

This document is not intended to be, nor should it be construed

or used as, an offer to sell or a solicitation of any offer to buy

securities of Bienville Capital Partners, LP. No offer or

solicitation may be made prior to the delivery of the Confidential

Private Offering Memorandum of the Fund. Securities of the

Fund shall not be offered or sold in any jurisdiction in which such

offer, solicitation or sale would be unlawful until the requirements

of the laws of such jurisdiction have been satisfied. Foradditional information about Bienville, including fees and

services, please see our disclosure statement as set forth on Form

ADV.

Investing in an Unbalanced World - CFA Society of Alabama (May 2011)

Documents

Transcript of Investing in an Unbalanced World - CFA Society of Alabama (May 2011)