Hard Truths

Paul Brodsky & Lee Quaintance run QB Partners, a private macro-oriented investment fund based in New York.


Outlook: As we look at the macroeconomic landscape at the onset of 2009 we see obvious negatives and not-so obvious positives for nominal asset prices. The negatives include:

• Almost unanimous deflationary expectations
• Tattered household balance sheets
• Almost no corporate growth visibility
• A higher cost of debt funding for most businesses
• An obliterated mortgage banking industry
• General pessimism among consumers and homeowners
• Heightened global military tensions, as energy exporting nations with nascent democracies struggle to maintain control while their economies contract

The lesser-recognized positives for nominal asset prices include:

• Trillions of new US dollars sitting latent in foreign reserve accounts that could be used to purchase assets at distressed prices
• Extraordinary amounts of inflation being generated by the Fed (and much more to come) – trillions of new dollars sitting latent on bank balance sheets waiting for the multiplier effect to turn them into up to 10 times that amount, leading to higher nominal prices for commodities, goods, services and financial assets
• US and European governments and central banks willing to act as “bad banks” so that their private sectors can maintain and/or enhance the nominal paper value of their assets
• The recent crash of commodity input costs and downward wage pressures, which should temporarily help businesses produce positive earnings at lower revenue levels
• US fiscal policymakers actively subsidizing home affordability and consumer recuperation
• A likely return to US–led global realpolitik, in which developed countries attempt to engage current and potential flashpoints in the developing world with diplomatic solutions.

If past is prologue, there are strong reasons to fade the notion that G7 economies are headed for a 1930s-type deflationary depression. Chief among them is that all economies of the world (via their respective central banks) issue fiat currencies, which means they can simply print money (inflate) to counteract organic deflationary pressures. This was not the case in the 1930s and it is precisely what global policymakers have begun to do.
As we look across the global investment landscape we see:

• Almost 0% “risk-free” global nominal rates of return (and therefore, substantially negative real rates), implying a dearth of risk capital at work in the markets
• Historically wide yield spreads across most tertiary bond markets (widest since the 1930s in many cases), implying; 1) a dearth of risk capital, 2) internal rates of return closer to risk-adjusted, inflation-adjusted equilibria, or 3) both
• Recently crashed global commodity prices, implying; 1) a dearth of risk capital relative to global demand, 2) global equilibrium pricing that better reflects sustainable global demand
• Generally weak US equity prices, implying; 1) a dearth of US dollar-denominated risk capital, 2) more sustainable corporate enterprise values and capital structures
• Weak US and European real estate prices, implying that previous high watermark values

We see both a reasonably-argued case for general pessimism – the continuance of declining fundamentals, and a reasonably-argued case for optimism – quickly improving commodity and equity markets (in nominal terms) that anticipate the end of poor fundamentals. The pessimistic case is obvious to all and markets either greatly or fully reflect that case. The optimistic case (in nominal terms) is less obvious, proven by generally declining prices of risk assets.

The graphs below provide very compelling clues as to the magnitude of the current problems and the substantial hurdles that must be overcome before current trends are reversed. The one immediately below plots the growth of broad US monetary aggregates and US nominal per capita GDP since 1968. It basically illustrates how much more US money and credit have grown than US output per capita.

It appears obvious that US output has been pulled higher in nominal terms by money and credit creation, and that without manufactured credit, US output/demand would have contracted. And if we are to use the strict definition of inflation (money stock growth), it becomes clear that US output has declined substantially in real (inflation-adjusted) terms. Will the markets acknowledge this nominal versus real disparity? (We discuss this in more detail later under “Hard Truths”.)


Looking forward, we feel strongly that the extreme money growth currently being administered by policymakers is the ultimate leading indicator of nominal US output/demand, which in turn is the key determinant for US equity prices and consumer sentiment. As is widely publicized, the problem with US money growth presently is that banks are not distributing it in the form of credit, which could then be used as collateral for increasing consumption and capital goods spending. So, even though we’re confident that nominal stock prices will be higher down the road, we haven’t a clue when this chain of events may gain traction. (We anticipate that banks, as publicly held profit-seeking entities, will most likely begin acquiring assets recently made cheap – and lending on them in a concentrated fashion – before beginning to extend credit to the broader public in a meaningful way. Wouldn’t you?)

It is also difficult to determine how effective easy monetary policy will be on US equity pricing. In the graph below we subtracted nominal per capita GDP growth from money growth. It shows in no uncertain terms the declining efficacy of inflationary US monetary policy on real US output growth. It is taking more and more dollars (monetary inflation) to produce a dollar in US output (this was evident even prior to the 2007/2008 credit bust).

We’ve argued repeatedly in favor of the inevitability of rising nominal prices of US dollar-based goods, services and asset prices because of the sensational monetary inflation currently underway and the inevitable money multiplier effect that will accompany it (see “A Modest Proposal” and “The Shadow Gold Price”). We’ve also argued in the past that once the reflation of nominal prices begins, we’d expect relatively un-levered assets and raw materials (precious metals and commodities) to outperform still leveraged assets (paper and real estate).

It is tempting to step away from that analysis when looking at these graphs – they make the Fed look desperate (given that substantial dollar and credit creation are coincident with output contraction presently). But we won’t step away from our central thesis. The incrementalism that has been exhibited by policymakers thus far has proven inadequate in real time. (You probably sensed that before you looked at these graphs.) We think there is a rising likelihood that the Fed will soon proclaim even more radical monetary inflation – far more radical than appears in these graphs.

Fundamentally, we reiterate our strong view that the US can’t grow or tax its way out of current and accelerating economic malaise that the credit de-leveraging has initiated. Policymakers know this. The only way out is to inflate away the value of US debt and inflate nominal wages by distributing new money and credit. They have begun to meaningfully debase the currency and we don’t expect them to stop until the US dollar has little purchasing power and/or they change the global monetary regime. Ultimately, we believe a coordinated global currency devaluation is the only possible resolution (consider it a form of pre-packaged bankruptcy of the global central banking industry).

It used to be theoretical that either US asset prices or the US dollar would have to be sacrificed. We now know the US dollar is being sacrificed. As Treasury and the Fed manufacture more and more money and credit out of thin air to prop up the US economy and domestic asset prices, global holders of US dollars will inevitably a) exchange their dollars for other currencies and move their wealth out of the US or b) de-link their currencies to the US dollar. This inevitability can’t be reversed unless and until the US exports more than it imports (runs a current account surplus, which is impossible given Triffin’s Dilemma), or until US assets become too cheap to resist for non-dollar holders. (The latter option would not impact sustainable US output, only the complexion of ownership of US assets.)

US policymakers have clearly chosen to sacrifice the US dollar, hoping (knowing?) that other monetary regimes will choose to sacrifice their currencies also. The grand assumption is that global monetary policymakers will choose to retain their implicit links to the US dollar. We don’t know whether US policymakers will be able to succeed in enforcing such a scorched earth policy on all fiat currencies, but we confidently assume that this is the plan.

It comes down to this: bank reserves and currency in float are to gold what growth in the broad monetary aggregates (credit) is to stocks and other leveraged assets. Banks don’t have to lend for gold to go to the moon (that’s the result of central banks printing money), yet banks do have to lend for stocks and other leveraged assets to recover.

We’ve arrived, we think, at the last hurrah. As we asserted last month, US policymakers currently think they can’t afford to overestimate the multiplier effect inherent in the fractional reserve banking system (underestimate monetary stimulation). The economy can continue to deteriorate as nominal asset prices stabilize and move higher. We think levels of US output growth, equity and real estate should stabilize and rise in nominal terms (and continue to fall substantially in real terms). We think prices of precious metals, commodities and the equity of businesses with sustainable pricing power should rise substantially more than other assets, and will be quite positive in nominal and real terms.

We’ve never been more confident in our long precious metals bias. US dollars and all other fiat currencies are being meaningfully devalued in absolute terms and relative to anything relatively scarce with inelastic demand.

We think our edge in 2009 will be a combination of: 1) our strong funding (we offered investors an opportunity to withdraw all their money on November 30 and less than 15% of capital was redeemed), and; 2) our strong conviction that we are fully invested in assets that will appreciate the most when the market tide turns (with or without the economic tide). We remain fully engaged and fully invested in our themes, and we are highly confident we will achieve our performance goals. We are betting on significant global inflation and we hope to make outsized returns from doing so.

Finally, we can’t help emphasizing the tired old, but entirely valid warning that appears on every document we produce: “Past performance may not be indicative of future returns.” Here here.

Hard Truths

When we’ve discussed what may appear to be morality issues within the US monetary system (and indict the system), our intentions should be obvious and twofold: 1) it is ethical to point out the natural and empirical inflationary impact of a paper currency and a fractional reserve banking system, and; 2) we aim to profit from our understanding of it. It is self-serving: that playbook alone should be enough to help us produce good returns over time, which should help us draw investors and build our business.

We debated whether to include the following discussion about personal responsibility in the markets – a topic usually left alone by investment managers. In the end we’ve included it because to think such thoughts and leave them out of our discussions would be inconsistent to our investment approach.
Our philosophy generally relies on fundamental value reconciliation, which in turn relies on an eventual migration “to the truth”. In the end we felt it would be disingenuous to consistently accuse policymakers of being irresponsible while ignoring the investment world’s failure to police itself (or even appear to care to). What’s good for the goose is good for the gander. An open discussion of all matters is best in the long run; whether it allows us to better understand future asset prices or the infrastructure through which we operate. It’s all connected. So, onward:

There’s no good defense of thieves that defraud investors, yet their guilt (proven or alleged) does not prove a corollary – that the victims of the fraud are innocent.

As managers of private, unregulated investment funds since 1996, it’s clear to us that an overwhelming majority of ostensibly sophisticated investors do not accept the personal burden of responsibility for managing their wealth. It is also obvious that most institutional investment intermediaries don’t know what to stress in their due diligence when judging the merits and risks of an investment program. And finally, it should be more than obvious to all that many (most?) hedge fund managers took their eye off the ball; they forgot (or didn’t care) that matched funding is the key to any sustainable business.

There is plenty of blame to go around but we would like to shine a harsh light on the segment few do – investors. Though it is their money and they can do with it as they choose, investors might want to begin considering that they should blame themselves – and only themselves – for losses (and feel free to credit only themselves for gains).

If a person with the means to defer consumption (the proper definition of “wealth”) opts to further better his or her lot by investing those means, then he or she should fully accept the risk of loss. The same is true of dedicated institutional investors. Rigid mandates and investment guidelines that weigh on fiduciaries overseeing those entities do not absolve them of responsibility during periods when markets “go off the ranch”. Those mandates and guidelines were created by people and they can be amended at any time if they don’t accommodate rare (yet inevitable) dangerous markets.

It seems too trite to say, but it is incumbent on all of us to understand where we’re placing our bets and what the downside is. The further removed investors of any stripe get from personally understanding the merits and risks of their investments, the less they should be surprised by losses and the less society should care about replacing those losses.

If that sounds unusually harsh, maybe it’s because our society has come to think that investing is saving. Of course, it is not. By saving we hope to have tomorrow the same magnitude of purchasing power we have today. Investing, on the other hand, is deploying a long-term time horizon to speculate on the direction of asset prices. We deserve losses – at least in the short-term – when we pay too much for our assets, and we deserve gains – at least in the long-term – when we buy our assets cheap. Otherwise, capitalism can’t work.

There is no denying the subjectivity and natural dynamism of markets and investing, and this is being proved to us presently. The more rigid one’s investment plan, the more likely it will produce negative surprises, which in turn will trigger unfortunate responses that compound those problems.
A good case in point is liquidity. When markets turn against us, the natural impulse of most investors is to flee. The focus turns to asset or fund liquidity, and, in the case of private funds, many investors tend to blame their fund managers for not providing immediate redemptions. We suspect that in the future there will be a natural tendency for investors and funds looking to attract investors to emphasize liberal redemption provisions – like those of mutual funds.

What a mistake that would be. Investors in the position to invest in private investment funds shouldn’t care that their outsourced investments are necessarily liquid. They should care more that their investment funds can maintain a matched book of assets and liabilities. Investors still do not seem to understand (or care) that market liquidity is a dynamic – not static – function, regardless of asset class. (We have no doubt that the most recent flight to liquidity – gimme Treasuries! – will eventually be another lesson for investors along these lines.)

When investment vehicles promise more liquidity down the road to appease the demands of investors mistaking speculation for demand deposits, we will raise our return expectations. (Our biggest error in 2008 was not taking the other side of excessive, mismatched leverage. It matters not what you own but who owns what you own, at least in the short run.)

There also seems to be a general consensus that traditional investment practices will prove adequate again once economic and market leverage is reduced. We couldn’t agree more that there was too much leverage, but we warn that nothing will be done about it in the future. Policymakers are working feverishly to try to replace the leverage that was vaporized naturally by the markets. They are trying to inflate the bubble again, not to place roadblocks up to prohibit it. If US and global government intervention in the markets does not change meaningfully (and regrettably we don’t think it will), investors might find that it’s in their best interest to accommodate that reality into their ongoing investment practices.

Profiting from hard realities (e.g. government intervention can work for us and against us simultaneously) is the true edge that private, independent investors and managers have over investors with rigid mandates that must or choose to remain fully invested in more or less the same assets as an index. We get to think for ourselves. Why else would anyone invest in legitimate hedge funds (with proper audits and a cogent plan for profiting)? Why else would anyone manage a hedge fund?

The Real Deal

Things don’t just happen, they happen just. We are not morally indignant at the uncanny parallels between the manner in which a scoundrel runs a Ponzi scheme and the manner in which the government runs, say, social security or bank bailouts. Our morality play knows no preferences – liberal nor conservative, progressive nor traditional, Keynesian nor Austrian. We may personally believe that certain economic philosophies serve the public-good better than others over the long stretch, but based on our parent’s good advice we aren’t proprietors of a philosophy shop or professional provocateurs. We manage an independent investment fund with the goal of doing better than most others so that our investors and we create more wealth relative to most others in society.
As we think we are well positioned for what has begun to occur in the markets, and as our view of things seems to be gaining guarded acquiescence on a daily basis, it serves our purpose to clarify and simplify the world as we see it. Here is the linear text of our broad vision:

The economy (US and global) is comprised of consumers, businesses, employers, employees and government. The first four components could comprise an economy on their own, but they tend to look to government systems such as the courts and regulatory bodies to be referees. Government inclusion into an economy would not be theoretically necessary if consumers, businesses, employers and employees were willing to look out for their own interests and suffer the consequences of their errors.

Pragmatically, however, most every society accepts government as a necessary participant, theoretically hoping to limit interventions during good times and accepting heavy-handed intervention during periods of adversity. Despite claims to the contrary, there are no truly “free-market” economies. So, if consumers, businesses, employers or employees want to improve their wealth by investing, they must assume there will be varying degrees of government intervention along the way and they must attempt to accurately estimate the magnitude and timing of it.

We believe – and this is not a theory to which Washington, Wall Street and most economists trained in the post-World War II Keynesian tradition generally subscribe – that government can, and indeed long ago became, the dominant force in the US and in global private sector economies (though most often it is unseen). Governments achieved this by taking control over money – that is, by creating, distributing and managing the peoples’ money, and then by enacting policies that force private parties to channel their money in ways governments find acceptable.

Treasury ministries and taxing authorities have come to control the terms of societies’ wealth through sweeping fiscal policy. Additionally (and far less apparent), private sector banks have ceded their independent authority to their central banks – private organizations usually owned by the largest banks themselves and with monopoly power to price and distribute money. This arrangement ensures that banking systems remain central to their economies and that money itself, not commerce, becomes the focal point of economies. (It also ensures that a few privileged large banks – the largest central bank shareholders – have extraordinary power over economies.)

Banks make their money by making a spread on the money they lend. With symbiotic assists from politicians – always looking for money to fund their legislative projects and campaigns, and from central bankers – continually brow-beaten by politicians, by commercial businesses relying on easy consumer credit for revenue growth, and by vocal private sector economists (usually working for Wall Street banks) providing constant chatter about how central banks should avoid (natural) economic contractions, banks are able to continually grow their balance sheets and, usually, their profitability.
This arrangement has been especially effective (and insidious to private sector wealth gatherers) since 1971, from whence all global money became un-tethered to gold and there became no limit on the amount of it that Treasury ministries could print and central banks could distribute. The US, the world’s largest economy that also prints and distributes the world’s reserve currency, has inflated its money stock so much that the purchasing power of each dollar has depreciated over 45% since then1 (and over 90% since 1913, when the Fed was established). This is why prices rise.

As you know, money is not necessarily a store of wealth. US dollars, and most of the world’s currencies whose values are judged in relative terms and are currently being inflated also by their central banks, have become merely means of exchange and units of accounts. They no longer have substantial store-of-wealth properties, and this has been borne out in the rational behavior of domestic holders of them. Americans, for example, no longer save their dollars.

Instead, Americans and individuals in many other lands with home currencies most closely tied to the US dollar generally use their money as collateral to borrow even more money with which to consume and invest. Money has become debt – literally (i.e. they are Federal Reserve Notes), and in practice (i.e. US debt overwhelms nominal US GDP and Income to such an extent that it must be repaid with money that does not yet exist.)

1 Shadow Government Statistics; CPI-U Alternate Series

Therefore, when economic adversity falls upon the global economy, Treasury ministries and central banks are compelled to create even more money so that the nominal levels of GDP, wages and assets can be prevented from declining, and so the real (inflation-adjusted) cost of the stuff that was bought with that money is reduced (the burden of outstanding debt is diminished relative to future wages and income). Yet this is not a sustainable global monetary regime, which further implies that the current global “economic business model” is unsustainable.

Here’s the rub: when the world judges value solely in nominal terms, the nominal prices of financial assets are not stores of wealth (i.e. deferred purchasing power). The faster the rate of money growth, the faster financial assets have to be turned over at a profit for them to retain their purchasing power. When financial asset prices stagnate or begin to decline, Treasury ministries and central banks (if they choose to save “the banking system”) must print that much more money and extend that much more credit, which in turn further dilutes the value of each money unit and the value of financial assets denominated in those money units.

So then, Treasury and the Fed are desperately trying presently to save the American economy and all its participants from an economic contraction in nominal terms while increasing their economic losses in real (inflation-adjusted) terms. You may decide for yourself if financial assets at current market prices reflect an acceptable barter value for things you will need and want in the future, once enough of the supporting debt of their underlying entities and their investors/sponsors is paid down.

In our view, there could be as much as $20 to $30 trillion that has to be manufactured out of thin air in the short term to generally equilibrate nominal real estate and financial asset prices, but that’s a guess ($55 to $75 trillion in private and public sector debt that must be devalued by 25% to 50%?). If we’re trying to precisely solve for the future nominal returns on US asset prices, we would need to have a good sense of just how much and how quickly the Fed will inflate the money supply. We can’t be that precise.

If we want to increase our future purchasing power relative to everyone out there still focused on nominal benchmarks (and that’s all investors should care about currently), then we would need to have a good sense only of whether the Fed will continue inflating the money supply (this we’re quite confident of) and invest in assets with lasting nominal pricing power or with supply growth below the rate money growth (relative global scarcity vis-à-vis paper currency).

The last point we’d like to make is that Treasury and the Fed can manufacture rising nominal US and global GDP simply by making money. Corporate revenues should rise in nominal terms, federal and local government tax receipts should rise in nominal terms, financial asset prices should rise in nominal terms. Unemployment should stop rising and maybe decline as nominal revenues of businesses rise. The reason for the likely success of policymakers in turning around the current economic slide is precisely because the world accepts nominal levels as their benchmarks and policymakers can unilaterally determine nominal levels through money supply growth.

This has been the true brilliance of the US economy, above all else. The US has enjoyed intergenerational productivity – and has avoided a lasting aristocracy – because each subsequent generation has had to work. Through its legislative initiatives and activist central bank (regardless of political party), the US has inflated away the real wealth of its people as nominal levels of output, wages (and debt) increase. Is this all a conspiracy? We doubt it is anymore, but we do recall the remark credited to Mayer Amschel Rothschild, the founder of the Rothschild banking dynasty; “give me control of a nation’s money and I care not who makes her laws.”

So we’re confident policymakers will succeed in avoiding a 1930 s style deflationary depression simply because they can manufacture (false) confidence. Everyone will be “a winner” again. Banks will lend and businesses, homeowners and consumers will start to borrow again once nominal levels of output and financial assets stabilize and nominal valuation ratios appear historically cheap. (Maybe stocks generally rise an average of 10% a year for five years? Commodities – and maybe certain bank stocks – generally rise an average of 15% – 25% a year? Maybe gold will be a five- or ten-bagger?)

We’re sure we’re wrong about their absolute magnitudes but we feel pretty confident about the relative value of each in real terms. The real winners among all the winners should be the gold bugs and the commodity bulls (and maybe the preferred banks).

We’re getting tired of beating this horse to death each month in our letters. Even though we’ll continue to invest this way (until circumstances or values change) we promise to write about other things. Lee makes a hell of a paella, and we’re sure his recipe would be very well received.


Lee & Paul


January 2009


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