COMMENTARY & PORTFOLIO STRATEGY

AUGUST 2011

M. Cullen Thompson, CFA
President & Chief Investment Officer cullen.thompson@bienvillecapital.com

“We can’t solve problems by using the same kind of thinking we used when we created them.” –Albert Einstein OUR FRAMEWORK
A framework is simply a method for processing information. In any endeavor, having a framework is important as it increases the likelihood of making better decisions. In financial markets, where information is not only constant, but also fast-moving, frameworks are vital. The framework we address below is instrumental to our current thinking, as well as in the construction of our secular themes. It serves as a guidepost for synthesizing incoming data, prioritizing our research agenda and anticipating policy responses. Importantly, it can often lead to views and positioning that are different from consensus. And because positioning directly affects performance, we believe it’s helpful for investors to fully understand our view. As discussed on many previous occasions, we believe the developed Western world is undergoing a process of deleveraging. In early 2008, at the onset of the crisis, this view was only considered to be a hypothesis—meaning there was no verifiable evidence to support it. However, as we analyze the data over the past three years, we believe, at this juncture, the deleveraging theme is virtually irrefutable. Consider the following, all of which are key factors in distinguishing between normal cycles and deleveraging scenarios:  The recovery since July 2009—the declared end of the recession—has been the weakest since 1921. In the first half of 2011, the US economy has grown at an annualized rate of 0.8%.1 By contrast, between World War II and 1990, postrecession recoveries averaged 6.8% annualized growth  Bank credit has failed to expand and households continue to reduce debt  Since the beginning of 2008, inflation-adjusted consumption has averaged just 0.5%, the slowest rate of growth in the postwar period All of this is of course despite a truly unprecedented fiscal and monetary response. Clearly something is awry. expansion, particularly in the household sector. However, in order to properly develop this theme, it’s helpful to quickly review the nature of credit, specifically focusing on why it is so important to officials, and secondly, why has it failed to increase. Over the past few decades credit has been used as a convenient expedient to economic growth, serving as a catalyst to household demand. Therefore, understanding credit cycles is critical in developing a view on future economic growth. Credit cycles can be bifurcated by orders of duration: short term (less than 10 years) and long-term (generally 50 – 75 years).2 Importantly, short-term cycles are heavily influenced by the actions of central banks. For example, by decreasing interest rates, central banks make additional levels of debt easier to carry. Also, lower interest rates usually have a positive effect on asset prices, which are often used as collateral. By contrast, as we’ll see below, central banks have little control over long-term credit cycles. To appreciate the nature of credit, imagine two parallel worlds: one without credit, whereby all transactions must be settled with actual money; and another where credit is readily available, allowing transactions to occur on the promise to pay money at a later date. In a credit-less world, the only way citizens can increase their consumption is through an increase in income, and the only way to increase collective incomes is for production to increase. For this reason, kick-starting a credit-less economy is challenging, particularly if at the onset, productive capacity exceeds the true demand of the economy (e.g. the US today). Generally, only after the painful but necessary process of discarding the excess supply does the economy reach new heights of prosperity. By contrast, in the credit-abundant world, individuals can simply borrow to increase their current consumption, which in turn, increases the aggregate—or total—demand of the economy. As a by-product, production will typically increase to reflect the new, incremental demand, which, in turn, drives incomes higher. For at least a while, a virtuous cycle ensues. What is noteworthy, however, is that the economy is no longer hostage to production and income growth. A willingness to take on more debt—via a pledge of either assets or future income—is all that is necessary to engineer consumption growth.

THE NATURE OF CREDIT
We believe that the inability of the US economy to stage a more robust and sustainable recovery is rooted in the lack of credit
1

As a result, the economy has failed to reach the 2007 pre-crisis peak

2

For more, see A Template for Understanding What is Going On by Ray Dalio

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COMMENTARY & PORTFOLIO STRATEGY
As you can imagine, this is precisely why elected officials publicly obsess over the availability of credit. Credit has a unique ability to mobilize a cyclical economic expansion. To be sure, this compulsion for credit is not limited to American politicians or even the modern bureaucrat. Reflecting on this in 1935, Freeman Tilden published A World in Debt where he suggested that “the whole progress of the legislative attitude toward the debtor, from the Roman republic to present day, has been steadily, though with occasional backward lapses, toward making debt easier to incur, lightening the burden of carrying and softening the consequences of default.” Nonetheless, we believe the process of “democratizing” credit— whereby borrowing is made more assessable to more people—has been a conscious attempt to paper over larger, more structural problems growing beneath the surface (e.g. education, healthcare, global competitiveness, stagnant incomes, etc.). We will come back to this subject below.
Commerical Bank Credit
$10,000 $9,500 $9,000 $8,500 $8,000 $7,500 $7,000 $6,500 $6,000 Jan-05 Jul-06 Jan-08 Jul-09 Jan-11

Source: Bloomberg

WHY HAS CREDIT FAILED TO EXPAND?
In 2009, Ray Dalio, founder of Bridgewater Associates, published A Template for Understanding What is Going On. In the article Dalio suggests that “the most fundamental requirement for credit creation to exist is that both borrowers and lenders must believe that the deal is good for them.” With that in mind, consider the circumstances of today. On one side of the equation, households—or borrowers—remain saturated with debt, which they are either defaulting on, or to a lesser extent, paying down (see table below). Importantly, this deleveraging process is not the result of irrational behavior, as is often suggested. Rather, it is a natural remedy for correcting a fundamental imbalance—the levels of debt households have previously accumulated are simply too high relative to the income needed to support it. Therefore, it cannot be reversed indefinitely through a transitory boost to confidence.
Credit Market Debt Outstanding (in $bn) Q1'10 Consumer Credit Home Mortgage Total
Source: Federal Reserve

Prior to the crisis, the private sector in the United States embarked on a multi-decade leveraging cycle. The collapse of this credit bubble has severed the traditional link with monetary policy, rendering it largely impotent. Therefore, despite increasing dosages of untested measures, it’s unlikely the Federal Reserve will be able to engineer a new credit cycle. Again, what is occurring is perfectly rational. It is how individuals and economies adjust to fundamental reality. Conversely, although additional monetary stimulus is unlikely to reverse today’s troubles, it can compound them. For instance, take the Federal Reserves’ questionable and intensely-debated decision to implement another round of quantitative easing in the fall of 2010— an action that had a notable impact on commodity prices. In the 12 months through July 22, wheat prices rose 16%, cattle and hog futures increased 21%, rice jumped 65% while sugar and corn futures skyrocketed, increasing 71% and 76%, respectively. These commodity price rises serve as an obvious and unavoidable tax on consumers, reducing income that could otherwise be directed towards debt repayment, consumption or savings. So if repairing balance sheets is a critical step to a sustainable recovery, QE2 was an impediment, not an accelerant. Not surprisingly, the economy has now slowed to levels that economists are euphemistically referring to as “stall speed.”

Q2'10 2,435 10,150 12,585

Q3'10 2,423 10,083 12,506

Q4'10 2,435 10,055 12,490

Q1'11 2,449 9,970 12,419

Cumulative Since Q4'09 (30) (372) (402)

MISDIAGNOSIS
As with any ailment, a proper diagnosis is crucial to reaching a cure. Otherwise, the tendency is to simply treat symptoms. In policy parlance, this tendency is commonly referred to as “kicking the can down the road,” the conscious and abject refusal to accept and confront reality. Since the onset of the financial crisis, we have feared that policymakers were either misdiagnosing the situation or refusing to accept reality. Therefore, they have repeatedly resorted to measures addressing symptoms, rather than the underlying structural problems. As a result, policymakers have wasted precious time and resources, arguably increasing the fragility of the system in the process. To be clear, this is true globally, not just in the US. For instance, in Europe, by failing to adequately address the insolvency of many of

2,454 10,207 12,661

On the other side of the coin, banks are struggling with existing loans. And because of the uncertain inflation outlook, they have difficulty in projecting whether new loans will be repaid with a “real return” that is sufficient to compensate for the credit risk undertaken. Compounding these problems is the uncertainty surrounding regulatory changes, which will affect bank capital requirements going forward. Therefore, it’s clear that borrowing and lending is a good deal for neither (i.e. borrowers nor lenders)—hence the lack of bank credit expansion since 2008.

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COMMENTARY & PORTFOLIO STRATEGY
the smaller peripheral countries, policymakers have allowed the crisis to metastasize, bringing Spain, and more frighteningly, Italy—the world’s third largest debtor nation—into the fold, threatening the viability of the European banking system.3 Looking further east, Japan has continued to run hyperinflationary fiscal deficits even as its ability to fund them domestically appears to be exhausted. In China, an implausible resistance to rebalancing its economy to more sustainable private demand, which would require a near-term slowing, has jeopardized the solvency of China’s local governments, as well as its banking system. Rarely does economics trump politics. Financial pain is never taken until markets force it. Below is a table that we refer to as the “Cumulative Effect of a Lack of Preemptive Leadership.” As you can see, our problems did not originate at the time sub-prime loans began to sour. The seeds were planted long ago. However, if we turn the clock back a little more than a decade—ignoring much of the day-to-day noise—and compare many important variables to today, a sobering picture emerges.
Financial & Commodity Markets S&P 500 Treasury 10-Year Yield US Dollar Index Oil Gold Corn Things We Want to Go Up Employment to Population Ratio Median Income (Inflation-Adjusted) US Private Sector Payroll (Non-Farm) Consumer Confidence Things We Want To Go Down Unemployment Rate Unemployment Rate (U-6) US Public Debt Outstanding (in millions) US Total Credit Market Debt (in millions) Gov't Transfer Payments (% of Average Income) Federal Reserve's Balance Sheet (in millions) China's Foreign Exchange Reserves (in millions) Annual Cost of Healthcare (Family of 4) Annual Cost of College Tuition (Public) Number of Pages in US Tax Code
Source: Bloomberg, CCH

Needless to say, understanding them is crucial in order to anticipate policy actions. Of the three, Keynesianism—originating from John Maynard Keynes—is perhaps the most well-known. According to Hoisington, disciples of this theory believe that “economic contractions are caused by an insufficiency of aggregate demand (or total spending).” To address this problem, policymakers resort to deficit, or stimulus, spending. Keynesian responses are not unfamiliar to Americans. Over the years, and upon every cyclical downturn, these knee-jerk responses have increased in both frequency and magnitude. In response to the most recent recession, government spending in the previous three years was $2.2 trillion more than the three years ending 2008. For this sum, we have bought ourselves anemic growth and witnessed the first downgrade of our nation’s credit rating, an embarrassing symbol of gross fiscal mismanagement. With the explicit focus on aggregate demand, a Keynesian response in the midst of a deleveraging scenario directs attention to the symptoms, rather than the over-arching structural problem. In essence, it confuses cause and effect. The Friedmanite view, derived from the economist Milton Friedman, and the theory that our current Federal Reserve Chairman subscribes to is that “protracted economic slumps are also caused by an insufficiency of aggregate demand, but are preventable or ameliorated by increasing the money stock.” Again, this is also a response we should recognize. Since September 2008 the monetary base in the United States has risen by 216%, from $850 billion to nearly $2.7 trillion. Despite this parabolic expansion, demand—or consumption—remains uncharacteristically weak as the household sector continues to delever. Neither the Keynesian nor Friedmanite response has been the panacea Americans were promised. This did not surprise Hoisington, who believes both responses are flawed because “both economic theories are consistent with the widely-held view that the economy experiences three to seven years of growth, followed by one to two years of decline. The slumps are worrisome, but not too daunting since two years lapse fairly quickly and then the economy is off to the races again. This normal business cycle framework has been the standard since World War II until now.” In other words, the two theories may be effective in dealing with recessions resulting from short-term credit cycles, but as we have now witnessed, Keynesian and Friedmanite responses are ineffective in reversing deleveraging scenarios, which are by-products of long-term credit cycles. By contrast, the Fisherian theory, derived from the Great Depression-era economist Irving Fisher, states that “an excessive buildup of debt relative to GDP is the key factor in causing major contractions, as opposed to the typical business cycle slumps.” The authors continue: “Only a time-consuming and difficult process of deleveraging corrects this economic circumstance. Symptoms of the excessive indebtedness are: weakness in aggregate demand; slow
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January 1, 2000 August 10, 2011 1,469 6.44% 101.87 $ $ $ 25.60 288 204.50 64% $ 52,388 130,572 141.7 4.0% 7.1% $ 5,776,091 $ 25,388,850 14.9% $ $ $ $ 668,906 154,680 8,250 7,322 48,960 $ $ $ $ 1,120 2.09% 74.74 105.68 1,805 688.50 58% 49,777 131,017 59.5 9.1% 16.1% $ 14,343,088 $ 52,603,830 20.4% $ 2,867,416 $ 3,197,490 $ $ 19,393 16,140 71,685

% Change -24% -68% -27% 313% 527% 237% -10% -5% 0% -58% 128% 127% 148% 107% 37% 329% 1967% 135% 120% 46%

THREE COMPETING THEORIES
In a recent investor letter, Van Hoisington and Lacy Hunt of Hoisington Investment Management neatly summarized three competing economic theories of the day: 1. 2. 3. the Keynesian, the Friedmanite, the Fisherian

As you can imagine, these theories are described as “competing” because they lead to drastically different policy responses.
3

Italy has more outstanding government debt than Greece, Ireland, Portugal and Spain combined

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COMMENTARY & PORTFOLIO STRATEGY
money growth; falling velocity; sustained underperformance of the labor markets; low levels of confidence; and possibly even a decline in the birth rate and household formation. In other words, the normal business cycle models of the Keynesian and Friedmanite theories are overwhelmed in such extreme, overindebted situations.” To judge the accuracy of this theory, consider the evidence to date: demand has been inordinately weak, broad money growth has been slow; the velocity of money has fallen; labor conditions have not improved (e.g. labor participation rates at 27-year lows); and consumer confidence remains at levels normally associated with recessions. Clearly, what we are experiencing is unlike a typical business cycle recovery. financial pain, the fiscal and monetary floodgates have been sprung wide. And although the United States may have lost its triple-A rating, for now it still retains its “magic credit card”—as Jim Grant lovingly refers to it—allowing our officials to lawfully print the very currency in which our debts are contracted. Who could resist?

WHAT DOES THIS MEAN?
If we can agree that the United States, as well as most of the developed Western world is currently engaged in a prolonged process of deleveraging, then it is important to also recognize that all episodes of deleveraging experience periods of cyclical recoveries—otherwise known as “bounces.” Intuitively, the larger the stimulus, the larger the bounce is likely to be. Not surprisingly, this leads many people to believe the situation has stabilized and that a new period of prosperity is around the corner. Occasionally, these bounces can fool even some of the most sophisticated and economically-literate professionals. Take for example the Federal Reserve, which is staffed with thousands of economists and has unparalleled access to economic data. In July 2009, as growth was believed to be reaching “escape velocity,” Ben Bernanke published an Op-Ed in the Wall Street Journal entitled The Fed’s Exit Strategy, outlining precisely what the title suggests. Yet only five weeks later, in a speech in Jackson Hole, Wyoming, he foreshadowed QE2. And just this week the Fed altered their policy language extending near zero percent interest rates until mid-2013, paving the way for QE3. Unfortunately, we don’t believe additional monetary stimulus will resolve much, if anything. Richard Fisher, Dallas Fed President and voting member of the FOMC apparently agrees, recently commenting that he believes the Fed is “out of ammunition.” If anything, zero-percent rates, QE3 or a modern version of “Operation Twist” is likely to lead to larger problems, particularly if they coincide with a collapse in confidence. In last quarter’s letter we included a chart illustrating the periods since 1970 where the Federal Reserve purposefully held interest rates below the rate of inflation (something that is becoming a habitual problem). In every instance, it ended badly. A wise and successful hedge fund manager in Texas once made a remark suggesting that “there is no path to salvation without pain.” Let’s hope policymakers will accept this reality before more damage is done. On the likelihood of that occurring, opinions vary. But what we do know is that in order to forestall today’s
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COMMENTARY & PORTFOLIO STRATEGY
ABOUT BIENVILLE
Bienville Capital Management, LLC is a research-focused, SECregistered investment advisory firm offering sophisticated and customized investment solutions to high-net-worth individuals, family offices 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 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 filing requirements. 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 to whom 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 author’s opinions are subject to change without notice. There is no guarantee 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 and management 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. For additional information about Bienville, including fees and services, please see our disclosure statement as set forth on Form ADV.

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