COMMENTARY & PORTFOLIO STRATEGY
M. Cullen Thompson, CFA
Managing Partner & Chief Investment Officer firstname.lastname@example.org
“Since human psychology is slow to change, a broad economic move usually occurs in three stages. The first stage begins 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 evidence—that 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 year’s Federal Reserve Bank of Kansas City Economic Symposium, a sort of annual love fest among central bankers held in Jackson Hole, Wyoming. 1 The symposium’s 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 the central banker’s sleeve. What was not addressed, notably, was why history’s greatest monetary and fiscal stimulus has resulted in a macroeconomic dud, producing the weakest postrecession recovery on record. Nor was the Chairman compelled to explain why, despite things “feeling better,” the foundation on which our economy resides is considerably worse—that is, if we’re allowed to use the absolute increase in system-wide debt as a barometer. It is our opinion, if we may offer a conclusion before the analysis, that further “accommodation,” to use Bernanke’s 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
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 overcapacity 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 overindebtedness 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,
The Economic Outlook and Monetary Policy, Chairman Ben S. Bernanke, August 27, 2010
The S&P 500 increased nearly 9.0% from the day of Bernanke’s speech to September 30th.
COMMENTARY & PORTFOLIO STRATEGY
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). 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. 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 a major 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%.” 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 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 to—the “Portfolio Rebalancing Channel,” as he euphemistically described it in Wyoming. We, however, will refer to it as the “Forcing Savers into Risky Assets Stratagem.” So that his audience could envision the knock-on effects of the new strategy, Bernanke offered the following mental illustration: “Once short-term rates reach zero, the Federal Reserve’s purchases of longer-term securities
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 trillion 4 Grant’s Interest Rate Observer, March 2010 5 Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences, McKinsey Global Institute January 2010 6 Deflation – Making Sure “It” Doesn’t 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 Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investor’s 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 layman’s 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 econometric model did Bernanke factor in the probability that investors would not rebalance their portfolio into equities, but instead to another asset that also yields nothing—that is, gold, the so-called legacy monetary asset, which generally isn’t 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 aggregates commensurate 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 quantitative easing, and indirectly attempting to underwrite financial markets, Bernanke, without a Congressional mandate, has quietly added another target—the price level of the S&P 500. If Bernanke didn’t already have a special place in his predecessor’s heart, he must now. Appearing recently on Meet the Press, Alan Greenspan endorsed the Fed’s 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 country’s 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, creditless economic growth and consumption derived from artificially-inflated asset prices still evades Greenspan. Yet it doesn’t 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 May’s 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 “psychological background” 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. varied processions from boom to bust. Surprisingly, these words were printed even before the most recent pandemonium unfolded. 7 But emphasizing the early 1970s as a start date was not accidental. For it clearly coincides with President Nixon’s 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. Speaking on October 1st, William Dudley, Vice Chairman of the Fed’s policy-setting Open Market Committee, boasted on behalf of his colleagues that the Fed has “tools that can provide additional stimulus at costs that do not appear to be prohibitive.” 8 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? 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.
“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 Kindleberger’s Manias, Panics, and Crashes, a seminal work that chronicles the history of the world’s
“Where all men think alike, no one thinks very much.” – Walter Lippmann
Kindleberger passed away in 2003 The 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 everything else. 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 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 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 Fed’s zero interest 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. 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 the fear 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. 10 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. 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
The OECD published a report analyzing 107 fiscal tightening scenarios. All but 26 experienced recessions 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
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 we’re offered an opportunity to buy cheaply, which we define as materially below average
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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 Fed’s bloated balance sheet. 11 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. 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 12 and bank credit provided the conviction—against consensus—to hold an aboveaverage allocation to fixed income and credit throughout the year, which has contributed nicely to portfolio performance. 13 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. Finally, we have recently re-doubled our research efforts on China, attempting to more thoroughly understand the underlying fundamentals of its economy and the various transmission mechanisms of a potential hard landing. Although it’s premature to present our view at length, it’s quite possible that China is not the panacea to global growth the investment community is relying on. If you would like to hear more about our work on China, or our views on any other topics, please don’t hesitate to call. - Bienville Capital Management, LLC ABOUT BIENVILLE Bienville Capital Management, LLC is an SEC-registered investment advisory firm offering sophisticated and
The Fed’s balance sheet has risen from ~5% of GDP to 16%. With another $1tn of QE, the balance sheet would rise to ~23%. This leverage, used to buy assets, will ultimately need to be removed M2, a broad measure of money supply, has been growing at its slowest rate in 15 years 13 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 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. Our clients include institutional investors, high-net worth individuals and family offices with complex needs, entrepreneurs and professionals. 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
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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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