COMMENTARY & PORTFOLIO STRATEGY
M. Cullen Thompson, CFA
Managing Partner & Chief Investment Officer firstname.lastname@example.org “The art of economics consists in looking not merely at the immediate but at the longer effects of any act of policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.” - Henry Hazlitt, Economics in One Lesson
“That government is best that governs least,” declared Thomas Payne, noted pamphleteer and co-Founding Father of the United States. What has been a long-standing libertarian belief has more recently been converted into an investable (and successful) investment strategy. The Congressional Effect Fund (ticker: CEFFX), launched in May 2008, is one of the more unique offerings available to everyday investors hoping to sidestep the pernicious effects of an incalcitrant Congress. But before diving in, a little background is deserved. It is no secret that Congress has had increasing difficulties balancing the nation’s books. Since 1961—a period spanning nearly half a century—in only five years did more money come in the front door than went out the back. 1 As the sea of red ink has risen, so has the country’s outstanding stock of debt. As the clock rolled over to 2011, America’s obligations reached a notorious milestone: $14 trillion—nearly triple the amount owed just over 10 short years ago when we cheered in the new millennium 2. Now closing in on 100% of the nation’s collective income, the accumulated liabilities equate to a non-negligible $126,900 per taxpayer—a virtual Mount Everest in the eyes of the average American when measured against his stagnant pre-tax income.
US Treasury Outstanding Debt (in billions, USD)
$15,000 $12,500 $10,000 $7,500 $5,000 $2,500 $Jan-44 Jan-50 Jan-56 Jan-62 Jan-68 Jan-74 Jan-80 Jan-86 Jan-92 Jan-98 Jan-04 Jan-10 Source: Bloomberg
Of course, these figures give no mention of the so-called offbalance sheet liabilities, principally the expanding entitlements of Social Security and Medicare, for which our legislators have conspicuously failed to provision for. Lumping the present value of those future cash outflows to the debts Congress admits to, and the tally comes to a knee-knocking $202 trillion 3—in essence, an arm, a leg and virtually every other body part of the forthcoming generation. “The American hegemon knows no limits, it seems, when it comes to spending other people’s money for their own consumption,” offers Bill Gross, founder and co-CIO of PIMCO, in the candid January edition of his monthly Investment Outlook. “Unlike Euroland or the United Kingdom, which appear to have gone on an extreme fiscal diet, the American answer to a bulging waistline is always mañana.” Seconding Gross’ thoughts, Kenneth Rogoff, author of This Time Is Different, and a recognized authoritarian on matters related to sovereign folly, suggested in the Financial Times on January 12th that “all the major regions remain trapped in post-crisis macroeconomic strategies that are either inconsistent, incoherent, or both. US budget policy is deliciously contradictory, cutting taxes while promising to balance the budget later, dramatically expanding entitlements while vowing to rein them in later. And because the dollar is so popular, the US is being sure to print lots of them.” Spending, it seems, is the nation’s new pastime. With the consumer driving over 70% of GDP, our elected officials can’t help but obsess over the shopping habits of their constituents. Nor can they resist the urge of tapping the public’s coffers in order to provide them with the necessary funds to do so. Given the amount of stimulus plowed into the economy in recent years, one has to wonder how we would’ve fared without it. Felix Zulauf, of Zulauf Asset Management, recently took the liberty of estimating that very hypothetical for Barron’s. Had the government abstained rather than indulged over the previous decade, in only two years would the economy have experienced growth at all (2001 and 2006). In 2009, Zulauf believes, the
The Congressional Budget Office recently raised its forecast for 2011’s budget deficit to $1.5 trillion The Federal Reserve is now the largest holder of US Treasury debt at an estimated $1.13 trillion, followed by China, Japan and the UK, per TIC
CBO Long-Term Budget Outlook – Alternative Scenario, June 2010
COMMENTARY & PORTFOLIO STRATEGY
economy would have contracted by 12.8%, followed by an 8.9% decline last year. When scrubbing through today’s economic statistics, a number of oddities and contradictions present themselves. Given the havoc caused by the Great Recession, combined with a 17% underemployment rate, it may not be surprising to learn that over 43 million Americans now rely on food stamps, or that 20% of incomes are derived from government transfer payments. But when these dismal realities are juxtaposed against retail sales, which are soon to pass their all-time, housing-inflated highs, the mind is easily boggled.
Total Adjusted Retail Sales (Less Food Services) (in USD)
It can only do this through higher yields. Thus, Ireland and perhaps now Greece can lead the way. For the Japanese it’s too late.” When that day—higher interest rates, that is—will come remains anyone’s guess. Today yields remain near generational lows while the collectively pro-stimulus Wall Street and financial media have undoubtedly assisted Congress and the Fed in pushing out the inevitable day of adjustment by disingenuously selling the “spend to prosperity” economic model to the American people. But as the economist Herb Stein once said, “if something cannot go on forever, it will stop.” To Eric Singer, founder of the Congressional Effect Fund, tomorrow is promised to no one. Protecting from the “cumulative effect of unintended adverse consequences on the US stock market from anticipated and actual Congressional legislative initiatives” is an immediate concern. With that belief, according to the fund’s website, he launched “the first mutual fund to explicitly seek to minimize investor exposure to potentially negative impact of new and proposed Congressional legislation.” The idea, however, was not simply a meritless, ideological reaction, but one based on hard-nosed, empirical research. Singer, a finance professor of some 25 years, discovered that over long periods of time the stock market performs dramatically better on days when Congress is out of session compared to days when it is in. To fulfill its mandate, the fund only utilizes two basic investment options: cash and the price return of the S&P 500 (apparently, the damage done by Congress is so great, the fund doesn’t even bother with dividends—traditionally a prominent source of returns for equities). Deciding between the two is even simpler. When Congress is in session, the fund sits comfortably in cash. When on recess, the boat is loaded with equities. Although it may seem as somewhat of a novelty product, the math is anything but. Since 1965—a period that roughly lines up with President Johnson’s entitlement-expanding ‘Great Society’— the performance of the S&P is heavily tilted in favor of keeping our elected officials at home on their respective sofas. On the days when Capitol Hill is vacated, the daily annualized price gain of the S&P 500 has been an astounding 16.0%. When Congress is busy improving the world: a paltry 0.9%. The differential, nearly 17.0% annually, represents a type of pseudo ‘alpha’ any hedge fund would be envious of. We wonder what the results would be if instead of cash, the fund hunkered down in gold. To date, Bienville has remained a passive, yet interested observer of the fund rather than an invested participant. Favoring valueminded strategies, it is hard to reconcile the fund’s approach with the proven one expounded by Graham & Dodd. One day, however, our hesitation may disappear.
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Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10
As much as we hate to speculate whether officials are knowingly trashing the public sector’s balance sheet and sacrificing what little remaining integrity the Fed has left just to keep us in the malls, it’s hard not to reach that conclusion. In fact, this past November, the very caretaker of the nation’s currency, Ben Bernanke, provided some insight into this question when he suggested that—thanks to his ultra loose monetary policy—“higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.” On the economic benefits of saving and investment, or the adverse consequences of today’s obsessive short-termism, he remains silent. According to Dylan Grice, SocGen’s piercingly insightful strategist, kicking the can down the proverbial road is not a rare strain of DNA specific to Americans, but rather all policymakers who naturally prefer quick fixes on the path of least resistance. Grice explains: “Behavioral psychology applies to central bankers, regulators and politicians as much as it does to investors. In promising to fiscally retrench tomorrow, finance ministers are exhibiting the behavioral phenomenon of overconfidence in their future self control.” So how, we all ask, do we gain the necessary self control needed to rediscover the necessary fiscal (and monetary) rectitude? Grice offers a prediction: “the bitter fiscal medicine required to stabilize debt levels won’t become more palatable today relative to tomorrow until the bond market makes it so.
COMMENTARY & PORTFOLIO STRATEGY
YEAR IN REVIEW The 4th quarter proved to be a good one for equities—the S&P 500 finished up 10.8% while MSCI World, a broader global market index, rose 9.1%. Contrarily, municipal bonds struggled considerably on the back of concerns regarding creditworthiness with the Barclays Muni Index falling 4.2%. The 1, 3, 5 and 10-year returns for the various indices, as well as their respective standard deviations are listed below.
Index S&P 500
products of the end of the cheap credit era. For this reason, it remains important to be aware of other former beneficiaries of cheap capital, especially those who became critically reliant on it. As history has shown, crises tend to move sequentially, generally beginning with the weakest link before moving further along the chain. As the credit bubble initially unraveled, subprime finance was most vulnerable as its Ponzi-style structure depended entirely on the further appreciation of housing prices. Once the additional credit required to support it disappeared, the result was the well-documented housing and banking collapse. As global liquidity subsequently seized up, the crisis migrated to the periphery economies of Europe where both the public and private sectors were previously able to load up on what are now unserviceable levels of debt. Despite numerous bailout attempts, the sovereign debt issues in Europe remain unresolved. And given the lack of global competitiveness of many of these countries, anything short of a debt restructuring will simply delay the inevitable. As for other candidates for concern, we offer two: Japan and China, both of which have also been significant beneficiaries of access to cheap money. For two decades Japan has been able to tap the plentiful savings of their citizens at below market interest rates in order to fund its hyperinflationary fiscal policy. However, with domestic savings now diminished relative to the country’s perennial budget deficits, the well is nearly dry. In addition to the world’s largest “stock” of outstanding debt, Japan now has an enormous “flow” problem—that is, they need an additional source of capital to fund ongoing deficits. We believe Japan will soon be required to either monetize these ongoing deficits (via the Bank of Japan) or tap international credit markets for external funding. Yet if they’re required to borrow at rates as low as 4.0%, interest expense alone will exceed the country’s tax revenues. For this reason, we believe a crisis will unfold in Japan—it’s not a question of if, but when. China has also been a beneficiary of cheap money, via net capital inflows, which result from three sources: its annual trade surplus, foreign direct investment and speculative inflows (i.e. hot money). And because it manages its currency to the US dollar, China imports the ultra loose monetary policy of the Federal Reserve. The result has been a dramatic expansion of both its money supply (up over 50% in the last two years alone) and credit, which are now creating intensifying inflationary pressures. Much of the foreign direct investment and speculative capital that flows into China does so on the expectation of continued high rates of growth, and more importantly, the eventual rebalancing of its economy from exports to domestic demand. We believe markets have vastly overestimated the probability of a smooth transition and have failed to make the important distinction
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1 Year 15.06%
Annualized 3 Year 5 Year -2.86%
10 Year 1.41%
Despite the impressive year-end result for equities, 2010 was anything but a smooth, linear advance. As the chart below illustrates, risk appetite oscillated violently over the course of the year as the market struggled to reconcile impressive corporate profitability with the bailout of Greece, May’s flash crash, spurts of economic growth followed by fears of doubledip, Ireland’s collapse, and finally, the combination of the Fed’s second round of quantitative easing and the unexpected tax cuts from the Obama administration. It wasn’t until the latter that equities moved aggressively higher (see adjacent chart).
S&P 500 Index (Percent Change)
20% 15% 10% 5% 0% -5% -10%
Jan 18 - Feb 8 - Apr 23 - May 7 - May 12 - May 26 - May 27 - June 1 - June 3 to June 7 June 18 July 2 - Aug 9 - Aug 30 - Nov 5 - Nov 16 Feb 8 Apr 23 May 7 May 12 May 26 May 27 June 1 June 3 June 7 - June 18 - July 2 Aug 9 Aug 30 Nov 5 Nov 16 Dec 31
Source: Bloomberg, Gluskin Sheff
PORTFOLIO STRATEGY Looking forward, not surprisingly, many of our themes remain unchanged, specifically our primary one, which is that 2007 marked the end of the 25-year secular credit bubble and that the crisis that resulted from its collapse was simply one symptom of a larger, yet unresolved problem—excessive debt. To be clear, the subprime and banking crisis was not the “event” itself, but rather one of the potentially many by-
COMMENTARY & PORTFOLIO STRATEGY
between high-quality and low-quality growth—the latter referring to China’s excessive reliance on infrastructure and exports, which appears to have resulted in a vast misallocation of capital. The immediate challenges and risks to the Chinese managed economic model are immense as the government struggles to maintain high rates of GDP, necessary to create jobs, while simultaneously containing the inflationary outcome, as well as the asset bubbles the very same policies inspired. Needless to say, it is a tall order. For this reason, over the near term, China is likely to be at the epicenter of the global economy. our position size given the wild swings in sentiment that accompany it, gold is likely to remain a core position for the medium term. To conclude, we hope that our investors will take comfort in the following thoughts: • We don’t believe the global economy is on a sustainable path of growth and are therefore skeptical over the medium-tolong term • Therefore, as stewards of your capital, as well as our own, we remain unwilling to posture portfolios in an overly aggressive manner. Our focus is on delivering positive returns with less downside potential • For the time being, we are likely to remain slightly underweight in our equity allocation, focusing on areas where risk does not appear to be underpriced. We remain intensely focused on the quality of the assets we buy and the price we (and our external managers) pay for them • Despite our cautious positioning, our portfolios have managed to deliver attractive, equity-like returns since the recovery began in 2009 with considerably less volatility. Tactical positioning and outperformance from our underlying managers have contributed materially • Given our positioning, we hope we are adequately prepared for any of the “grey swans” (i.e. potentially foreseeable events), as well as the unforeseeable, black ones. Additionally, we will continue to devote significant time and resources to uncovering them
In a sense, the financial crises marked a critical inflection point: either the world would rebalance to more sustainable sources of growth, or, on the back of stimulus, continue to pursue the logically flawed policies of asset and credit-driven growth—the very same policies which led to the crisis in the first place. It is now clear that the path of political least resistance was chosen. As a result, the global economy has become more imbalanced with 45% of growth derived from countries running fiscal deficits of greater than 10%. Additionally, central bankers around the globe are now targeting asset prices in order to drive consumption while the emerging economies in Asia have fallen back into the illusory comfort of export-led growth. With China, Japan and Germany—the world’s 2nd, 3rd and 4th largest economies— running perennial trade surpluses, the burden of global demand is placed squarely on the already over-indebted countries of the west, specifically, the US and Britain. Although the world today remains highly imbalanced, we are also careful not to underestimate the will of policymakers, or ignore the adept management and profitability of many highquality companies over the near term. We would not at all be surprised by a further increase in equity prices. Nonetheless, similar to banks in 2007, governments today rely more on access to capital markets to fund themselves than any time in history. Many countries in Europe are effectively insolvent, yet have avoided default as a result of recent liquidity (either provided by markets or from bailout vehicles and supranational entities). Liquidity, however, largely results from confidence. As confidence erodes, sovereign defaults will become more likely. Finally, the fiscal deflation necessary to cover both the onand-off-balance sheet liabilities around the world is politically impossible, which, combined with a hyper-expansionary Federal Reserve, provides a positive backdrop for gold, as well as other sound currencies. Although we may tactically alter
ORGANIZATIONAL UPDATE On the organizational front, we are happy to report that 2010 was a year of substantial progress for Bienville. On the client side, the firm selectively added a few new relationships. As a result, our assets under management are now approaching $300 million. We continue to travel extensively, expanding our network of contacts, as well as invest material resources in research in order to improve our idea generation and information flow. And finally, we are happy to announce that we have made an addition to the team. We welcome Blake Bennett to Bienville, who will join us in the New York office as an analyst. Blake, a graduate of Vanderbilt University, is highly motivated and will undoubtedly make a substantial contribution to our research process. We are fortunate to have him. We thank all of our clients for your support and feel blessed by the trust and freedom you place with us. - Bienville Capital Management, LLC
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COMMENTARY & PORTFOLIO STRATEGY
ABOUT BIENVILLE Bienville Capital Management, LLC is a research-focused, SEC-registered investment advisory firm offering sophisticated and customized investment solutions to highnet-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 alternative assets. 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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