When Convention Fails - Commentary & Strategy (October 2010)

7/31/2019 When Convention Fails - Commentary & Strategy (October 2010)

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www.bienvillecapital.com

COMMENTARY&PORTFOLIO STRATEGYOCTOBER2010

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

Since human psychology is slow to change, a broad economic move usually occurs in three stages. The first stagebegins when some unexpected event shatters an overdone psychological environment. Yet, while some people respond

immediately to this new lesson, most people, as they find it outside their past experience, do not believe it. They need

more evidencethat is, a second stage. Typically, the majority become convinced during the second stage and therefore

the psychological background changes. People begin to act differently, and their behavior soon affects the performance

of the economy. -D.A. Stoken, Cycles

WHEN CONVENTION FAILS

The Committee is prepared to provide additional

monetary accommodation through unconventional

measures if it proves necessary, so said Ben Bernanke,head honcho at the Federal Reserve, in a speech

delivered to his counterparts around the globe at this

years Federal Reserve Bank of Kansas City Economic

Symposium, a sort of annual love fest among central

bankers held in Jackson Hole, Wyoming.1

What was not addressed, notably, was why historys

greatest monetary and fiscal stimulus has resulted in a

macroeconomic dud, producing the weakest post-

recession recovery on record. Nor was the Chairman

compelled to explain why, despite things feeling

better, the foundation on which our economy resides is

considerably worsethat is, if were allowed to use the

absolute increase in system-wide debt as a barometer.

The

symposiums keynote address provided a preview of the

monetary gymnastics available to the Fed should the

economy fail to levitate to the satisfaction of its

Chairman. Despite anchoring interest rates firmly to the

floor and impregnating its balance sheet with

questionable assets, it seems a few tricks remain up thecentral bankers sleeve.

It is our opinion, if we may offer a conclusion before the

analysis, that further accommodation, to use

Bernankes own words, whether on the part of the Fed

or Congress, will have no lasting economic benefit.

Although it may succeed in artificially and temporarily

1 The Economic Outlook and Monetary Policy, Chairman Ben S. Bernanke, August 27, 2010

boosting asset prices,2

the underlying problems remain

structural, yet the proposed solutions cyclical. To reach

that conclusion one only needs to juxtapose the real yields

on bonds (near generational lows) with the price of gold (at

all-time highs).

It was nearly 80 years ago that Irving Fisher, author of The

Debt-Deflation Theory of Great Depressions, first suggested that

it is not under-consumption, over-production or over-

capacity that caused serious disturbances to the business

cycle. Rather, in the great booms and depressions, Fisher

continued, such factors, while important, played a

subordinate role as compared with two dominant factors,

namely over-indebtedness to start with and deflation following

soon after. Freeman Tilden, writing in his highly

prescient, The World in Debt, published in 1935, offered a

similar conclusion: There is one cause, and only one cause,

of all panics and depressions in the economic world. That

cause is debt.

Over-indebtedness is the dominant factor plaguing the

global recovery. Consumers, the engine of the US

economy, have been choking on it ever since real estate

prices stopped appreciating 10% per year. It is also over-

indebtedness that is acting as a cog in Bernanke & Co.s

monetary wheel, rendering his traditional policy levers

impotent.

To take a step back, hovering above the United States $14

trillion economy is $52 trillion of total credit market debt,

2 The S&P 500 increased nearly 9.0% from the day of Bernankes speech to September 30th.


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COMMENTARY&PORTFOLIO STRATEGY

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the highest on record in both absolute terms, as well as

relative to the income of the country. 3. Although this

ratio has been expanding nearly continuously since the

Baby Boomer generation came into the world, the vast

majority of the load was accumulated at a rapidly

increasing rate over the most recent decade (where

average annual gains of 4.0% GDP were outstripped by

debt growth of nearly 8.0%4

It is axiomatic that what follows periods of excessive

leveraging is deleveraging, a long held in-house theme

that seems to gain traction with each passing day.

Empirically, confirms the McKinsey Global Institute,

a long period of deleveraging nearly always follows amajor financial crisis. And in studying 45 such

episodes, the authors concluded that on average,

deleveraging scenarios last six to seven years and reduce

the debt-to-GDP by 25%.

). With debt growing twice

as fast as income, it is no wonder that asset prices

attempted to reach the moon. Earth, of course, is where

the financial crisis promptly restored them.

5

If the conjuring up of new dollars and credit is

inflationary, then by similar logic, their destruction

(either through repayment or default) must be

deflationary. But deflation is what the Chairman swore

would never happen here.

6

So that his audience could envision the knock-on effectsof the new strategy, Bernanke offered the following

mental illustration: Once short-term rates reach zero,

the Federal Reserves purchases of longer-term securities

And so with the traditional

monetary levers impaired, the Fed has improvised,focusing now on the size of its balance sheet and the

assets it stuffs on it. If Plan A was reducing interest

rates, which following a typical, run-of-the-mill recession

inspires borrowing and lending and therefore drives

economic activity, then it is Plan B that Bernanke has

migrated tothe Portfolio Rebalancing Channel, as

he euphemistically described it in Wyoming. We,

however, will refer to it as the Forcing Savers into

Risky Assets Stratagem.

3 Debt-to-GDP is approximately 360%, meaning 3.6 units of debt are required to create 1 unit of GDP.Off-balance sheet or unfunded liabilities are not included. Consumer debt is currently $13.5 trillion4 Grants Interest Rate Observer, March 20105Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences, McKinsey Global InstituteJanuary 20106Deflation Making Sure It Doesnt Happen Here, Ben S. Bernanke, November 21, 2002

affect financial decisions by changing the quantity and mix

of financial assets held by the public. Specifically, the Feds

strategy relies on the presumption that different financial

assets are not perfect substitutes in investors portfolios, so

that changes in the net supply of an asset available to

investors affect its yield and those of broadly similar assets.

Thus, our purchases of Treasury, agency debt, and agency

MBS likely both reduced the yields on those securities and

also pushed investors into holding other assets with similar

characteristics, such as credit risk and duration. To

translate into laymans jargon: by reducing the yield on cash

and short-duration bonds to virtually nothing, while

simultaneously eliminating the available supply of other

triple-A rated debt, quantitative easing forces investors into

riskier assets.

But we wonder, where, if anywhere, in his econometricmodel did Bernanke factor in the probability that investors

would not rebalance their portfolio into equities, but instead

to another asset that also yields nothingthat is, gold, the

so-called legacy monetary asset, which generally isnt

bought out of greed but rather out of fear?

Perusing Section 2a of the Federal Reserve Act a reader will

discover the mandate of the Federal Reserve. It reads,

The Board of Governors of the Federal Reserve System

and the Federal Open Market Committee shall maintain

long run growth of the monetary and credit aggregatescommensurate with the economy's long run potential to

increase production, so as to promote effectively the goals

of maximum employment, stable prices, and moderate

long-term interest rates.But by embarking on quantitativeeasing, and indirectly attempting to underwrite financial

markets, Bernanke, without a Congressional mandate, has

quietly added another targetthe price level of the S&P

500.

If Bernanke didnt already have a special place in his

predecessors heart, he must now. Appearing recently onMeet the Press, Alan Greenspan endorsed the Feds S&P

targeting strategy, predicting that if the stock market

continues higher it will do more to stimulate the economy

than any other measure, a back-handed reference to the

wealth effect. According to the wealth effect, when asset

bubbles are present, consumers consume and the output

and wealth of the country supposedly expands, so says the


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Bureau of Labor Statistics, the authoritarian on the

countrys GDP figures. But recognizing that no country

or consumer can spend their way to prosperity, is this

not, in reality, a form of incremental insolvency?

Somehow the critical difference between natural, credit-

less economic growth and consumption derived from

artificially-inflated asset prices still evades Greenspan.

Yet it doesnt require a PhD in economics to recognize

that the former is healthy and sustainable while the latter

simply the illusion of prosperity.

Of course, irrespective of its merits, the success of the

wealth effect is highly dependent on retail participation.

It is the individual that needs to see his 401k expand

before he dashes off to the mall in a state of euphoria.

But since the bottom fell out of the equity markets in

08, retail investors have largely eschewed stocks,preferring the safety of corporate bonds, cash and more

recently, gold. Twice burned in a decade and

disillusioned by intolerable volatility, the growth of a

mysterious force (i.e. high-frequency trading) and its

rumored impact on Mays flash crash, Joe Sixpack has

decided to sit this one out. What once seemed like a

mechanism to participate in good ole American

entrepreneurialism, equity markets now appear to be a

game where the odds are invariably stacked against him.

Which leads to the question, has the psychologicalbackground changed, as Dick Stoken predicted in the

opening quote? Possibly. If the tech bubble was strike

one, the bursting of the credit bubble was naturally strike

two (i.e. the second stage where behavior changes).

Unable to afford another whiff, the bat now rests firmly

on retail investors shoulders. Only when the fat pitch

comes will it be lifted. If so, the wealth effect may be no

more of a liquefier of growth than interest rates pegged

at zero.

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, reads the opening line from

Charles Kindlebergers Manias, Panics, and Crashes, a

seminal work that chronicles the history of the worlds

varied processions from boom to bust. Surprisingly, these

words were printed even before the most recent

pandemonium unfolded.7

Speaking on October 1st, William Dudley, Vice Chairman of

the Feds policy-setting Open Market Committee, boasted

on behalf of his colleagues that the Fed has tools that canprovide additional stimulus at costs that do not appear to

be prohibitive.

But emphasizing the early 1970s

as a start date was not accidental. For it clearly coincides

with President Nixons decision to sever the final link

between gold and the US dollar, launching the country into

a new monetary regime where the price of money and the

value of our currency would not be determined by the

market as a whole, but rather by a fallible, unelected few

(i.e. central bankers). Credit could be expanded and

contracted at their will. In essence, it was a grand leap

towards central planning. To date, their track record is

unimpressive.

8

Demosthenes, the Greek orator, once claimed that If you

do not know that confidence is the principal asset of a

business man, you do not know anything. Confidence is

what governments and central bankers attempt to create,

yet is what historically they have been complicit in

destroying.

To which we ask, precisely how are these

costs measured? How does one quantify the adverse

economic impact of general market and business

uncertainty, or the opportunity cost to capitalism when

investors, confused and fearful, allocate savings away from

productivity-enhancing businesses to socially unproductive

assets, such as gold, or worse, the bottom of their

mattresses? And more importantly, why, with the vast

amount of evidence pointing to the contrary, should we,

citizens and investors, trust the abilities of central bankers

to artfully and majestically command complex,

interconnected economies and markets?

Where all men think alike, no one thinks very much.

Walter Lippmann

7 Kindleberger passed away in 20038The Outlook, Policy Choices and Our Mandate, William C Dudley, October 1, 2010


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PORTFOLIO STRATEGY

"Investment decisions across many asset classes today

are tantamount to an educated guess on what the Fed

decides to do regarding QE. In the near-term this

trumps fundamentals, valuations and almost everythingelse. Thus the risk in the market is man-made, not freely

determined by the market. In general, this is not a good

thing because it may invite greater risks in the future."

Jim Caron, Morgan Stanley

Rarely is a Wall Street research note candid enough to

warrant reiteration, but we congratulate Jim Caron as his

recent piece honestly and succinctly summarizes the

quandary investors find themselves in.

Investing in a period of both heightened

macroeconomic and policy uncertainty presents

manifold challenges. Not only is it necessary to

anticipate probable economic and market outcomes, but

also the policy response and intervention (which today

are often without precedence) that will likely result from

them. Furthermore, positioning aggressively for any one

particular outcome could spell disaster should any other

unfold (e.g. assets that benefit in a deflationary backdrop

would perform miserably should inflation occur).

What is clear today is that Bernanke wants higher stock

prices, which he believes will drive consumption, as well

as a lower dollar, intended to boost exports while also

combating the current deflationary pressures. What

remains unclear is whether he will be able to engineer

either. Judging solely by the most proximate example,

Japan, the prospects for success are not encouraging.

Our base case outcome remains centered around a

prolonged deleveraging scenario resulting in below

average economic growth, structurally high

unemployment and unimpressive returns on traditional

asset classes, which are priced above fundamental

justification. Passive, buy-and-hold strategies are likely

to be as unprofitable as they were in the preceding

decade (unless were offered an opportunity to buy

cheaply, which we define as materially below average

multiples). Those historically reliant on this style of

investing will need to shift their focus to include tactical

opportunities around core positions, as well as hedged

strategies, such as long-short equities and event-specific

credit.

However, a double dip recession cannot be ruled out, 9

If a double dip were to occur, new lows for equities are a

real possibility. Not only will corporate profits come in

decidedly lower than expectations, but they will also be met

by materially lower PE multiples. In this scenario, cash and

high-quality bonds should provide a safe-haven as

deflationary pressures intensify, while additional stimulus

measures, despite the obvious diminishing impact, and thefear of outright debt monetization will likely cause the price

of gold to resemble that of a bottle rocket. We have

therefore tactically added to our gold exposure over the

course of the year with particular emphasis on gaining

levered upside exposure in the form of both gold-related

equities, as well as call option structures where

appropriate.

especially given the renewed pressures in the housing

market and lack of traction with employment. Global

imbalances remain unresolved, contributions from both

inventory rebuilding and fiscal stimulus are waning, while

private demand is largely dormant. All of which leaves the

economy highly susceptible to a systemic shock, whether it

be from Europe (where markets have recently chosen to

stick their heads into the proverbial sand), Japan, China, the

Middle East, or more simply, a decision by households to

increase deficient savings. One paradox of the Feds zerointerest rate policy is that it requires retirees and baby

boomers to save even more to make up for the lost interest

income they would otherwise receive.

10

A third potential outcome, and one that arguably poses the

most risk in terms of keeping up with the Jones, is an

asset-driven rally that temporarily transmits into the real

Gold remains inversely correlated with the

confidence in policymakers and positively correlated with

the size of the monetary base. Historically, it has

performed well when the real federal funds rate is below

2.0%, a level it will likely remain below for some time.

9 The OECD published a report analyzing 107 fiscal tightening scenarios. All but 26 experienced recessions10 Through September 30th, gold returned 19.3% year-to-date, while our gold equities position returned 25%since inception of the position on June 4, 2010


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economy, providing the appearance of a sustainable

expansion (i.e. the wealth effect). Under this outcome,

household debt levels will remain at record high levels as

the necessary adjustment process is shifted into the

future. The economy would show signs of

improvement, pressing the Fed to normalize monetary

policy, and therefore re-introduce the exit strategy

concerns surrounding the Feds bloated balance sheet. 11

In deleveraging scenarios, credit is removed from the

financial system, a process that is inherently deflationary.

Our historical appreciation of post-credit crises, rigorous

analysis of money supply

Fiscal policy would also need to be tightened, with

higher taxes serving as a governor on current and future

economic growth as capital will be reallocated from

productive sources in the private sector to the Treasury.

12 and bank credit provided theconvictionagainst consensusto hold an above-

average allocation to fixed income and credit throughout

the year, which has contributed nicely to portfolio

performance.13

Finally, we have recently re-doubled our research efforts

on China, attempting to more thoroughly understand theunderlying fundamentals of its economy and the various

transmission mechanisms of a potential hard landing.

Although its premature to present our view at length,

its quite possible that China is not the panacea to global

growth the investment community is relying on.

However, as yields have fallen, so has

the potential for attractive risk-adjusted returns. We

have therefore begun lightening traditional fixed income

exposures, shifting to more credit-specific opportunities

where complexity premiums still exit.

If you would like to hear more about our work on

China, or our views on any other topics, please dont

hesitate to call.

- Bienville Capital Management, LLC

ABOUT BIENVILLE

Bienville Capital Management, LLC is an SEC-registered

investment advisory firm offering sophisticated and

11 The Feds balance sheet has risen from ~5% of GDP to 16%. With another $1tn of QE, the balancesheet would rise to ~23%. This leverage, used to buy assets, will ultimately need to be removed12 M2, a broad measure of money supply, has been growing at its slowest rate in 15 years13 Through September 30th, our fixed income manager returned 9.8% year-to-date

customized investment solutions to high-net-worth and

institutional investors.

The members of the Bienville team have broad and

complimentary expertise in the investment business,

including over 100 years of collective experience in privatewealth 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

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Our clients include institutional investors, high-net worth

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When Convention Fails - Commentary & Strategy (October 2010)

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