Dough, a Deer

We had discussions last month with passive global investors including individuals, high net-worth families, institutions, and fund aggregators and allocators. Most shared a common theme: they had little conviction about future economic trends and asset values, and they were reluctant to express themselves forcefully in the markets. We also spoke with several active market operators including fund managers and position and prop traders. These traders and trend followers, up to their eyeballs in capital flows each day, do indeed have opinions, usually well reasoned yet almost always applied to the near term. Our sense is that market sponsorship is lacking conviction across the board. Very few investors are looking strategically across the valley and even fewer are positioning assets that way.

We also compared closely the stated intentions of policy makers with the policies they are actually prosecuting. There continues to be a substantial gap. We read others’ economic and market-based analyses of these intended policies — some of which made sense, much of which was illogical and self-serving, in our view. In our view, global monetary and fiscal policies are contingent and ad hoc, at best. Policy makers are behaving in a reactionary fashion, making it up as they go within the context of what measures may be politically acceptable at the moment. It is Kabuki Theatre. There is no grand design or proactive strategy among outside agents that market participants may follow to gain insights into future public policy or asset valuations. We, and you, are potentially as knowing as anyone about future events and we think it will pay to think for one’s self.

We scrubbed our own macroeconomic logic, scrutinized the markets, and re-ran our numbers. We think the gap separating our sense of macroeconomic and market outcomes from those commonly accepted among the majority of market participants (extrapolators) has rarely been wider. We characterize the current global economic environment as one with severe and unprecedented credit deflation in developed economies being combated by central banks with equally unprecedented monetary inflation. The net effect will be a substantial loss of purchasing power for holders of paper currencies and most financial assets denominated in them.
Nowhere in memory does the magnitude of this volatile combination imply a repeat, a rhyme or a reminiscence of any post-war economic cycle. Never before have global central banks had the power to inflate their currencies infinitely when massive credit contractions take hold. Most market participants, however, still seem to be ignoring the 1971 change in the Bretton Woods monetary regime, wherein central banks gained unilateral primacy in setting monetary conditions at the expense of more organic economic incentives. As a result, economies that now want to shrink to become sustainable again will not be allowed to do so by political establishments.

The vast majority of economists seem to be using econometric models that fail to capture the impact of vast money printing, and markets remain priced as though most investors are extrapolating past cycles forward. Market observers and participants do not seem to understand there is no such thing as goods, service and asset deflation in a world where central banks can, are, and will continue to, double, triple, quadruple their money supplies. Global investors, especially those in the developed world, seem to have split into two camps: the smaller camp (in numbers) is comprised of professional investors that are currently staying close to home (hugging indexes) or, in the case of “more aggressive” managers, trading quickly in and out of “risk assets” and cash. (One very large hedge fund manager bragged about taking all risk off in a month when they’re down 2 %. This sounds more like a very expensive savings account to us.) Such meaningless trading is providing the marginal pressure each day that forces prices of stocks and commodities higher or lower, and (inversely) dollar-denominated bonds and currencies lower or higher. The other camp, non-professionals, seems to have chosen simply not to participate in any major way in stocks and commodity markets for fear of volatility. The great irony is that index huggers and non-participants are taking far more risk than they know.

In a world defined by overtly debasing paper currencies, paper currency holders (in cash, money market funds or bonds) indeed may be ensuring they receive all their money back, but they are also ensuring that they receive less purchasing power back. Their cash and bonds may prove to be “money good” but in the end they will be left with bad money. And professional investors avoiding volatile periodic returns may think they are complying with their fiduciary responsibilities. They are not. Instead they are raising the probability of risk of loss to their constituents in real terms. While it is true that daily pricing in equities and commodities fall each day more than cash; and while it is true that commodities rise or fall more each day than equities sponsored mostly by dedicated long-only investors; it would be a mistake to assume the higher volatility within secularly up-trending commodity markets is an indication of greater risk. Rather, it is an indication of increasing awareness from more and more investors that paper currency-denominated financial assets offer negative real returns (nominal returns less monetary inflation). Higher volatility within up-trending markets is a good thing, not a manifestation of risk. It implies greater risk-adjusted opportunity. Investors wedded to stable monthly returns above all else are the ones that will be left holding the bag.

We think a growing number of global investors are joining previously third-world private wealth holders in migrating from “acceptable” portfolio constructions dominated by stocks and bonds (and now real estate) into far smaller real asset markets characterized by little or no debt encumbrances. Periodic volatility is a small toll early investors must pay when put in the context of massive current and future global currency debasement.

In short, unprecedented credit deflation and monetary inflation naturally engender a changing global monetary regime, yet the vast majority of market participants remain unwilling or unable to change their investment objectives and behavior. We believe paper currency-denominated cash and the majority of financial assets in developed markets will produce negative real rates of return over time. Further, we believe our real return objective keeps us free to position the Fund to exploit substantial secular market mis-pricings along these lines. We will continue to seek to increase our purchasing power vis-à-vis other market participants who are merely pursuing index or nominal alpha returns. (Or to put it another way, we will continue to seek to take advantage of “fiduciaries” being so “nominally” careful that they’ve become imprudent.) Accordingly, we continued to position assets more aggressively in February. We re-arranged some theme weightings, added new positions and let other positions go. We feel good about our book, strategically and tactically.

Brief Euro Thoughts

We think the immediate lesson to be learned from the current EU conundrum is that economic principles can’t be denied forever. We don’t mean to hit ‘em when they’re down by discussing the Euro’s structural flaws, but applying that term is nothing new for us. The Euro just happens to be even more overreaching in its construction than other currencies.

The notion that a common currency could be satisfactorily applied to a range of disparate economies with varied fiscal and tax policies throughout booms and busts seems a fundamental stretch. If one were to counter this claim by asserting all would have been okay had the PIIGS abided by the required Euro-compliant debt-to-GDP and deficit-to-GDP ratios, then we would have to argue in turn that the PIIGS: a) did not start from the same place as did stronger Euro economies in terms of productivity, current accounts and sustainable incomes; b) do not have economies comprised of the same revenue drivers and cost structures; and c) do not have perfectly similar political systems. At the very least these differences ensure staggered economic reactions to changes in global output and in turn varied and staggered political pressures to react to them. (The analogy that Greece is to the EU as California is to the US fails when we consider Greece still recognizes a discrete sovereign political system and California does not.)

A few weeks back we lunched with a senior economist at the Bundesbank who, while he was careful not to divulge how Germany planned to treat Greece, declared in no uncertain terms that “the Greeks had better get their act together quickly.” To be frank, we never thought the ultimate decision on Greece would be made by the Bundesbank or by any central banker – it is simply above their pay grade. The decision whether to help Greece roll its sovereign debt was always going to be made in the political sphere, more specifically by Merkel and Sarkozy (more specifically by German and French voters). The decision announced at the end of February to enlist German state-owned bank financing to save the day is clearly a temporary solution contingent upon the inability of disparate German voters to immediately link state-owned German banks holding Greek debt with their own obligations down the road. As long as Greek sovereign debt is not serviced by Greeks alone, German tax payers will be on the hook for Greek profligacy regardless of whether they write checks directly or whether they must later bail-out German banks that do.
There is nothing of value in stereotyping societal differences between Mediterranean cultures and those in more industrialized European economies, just as there are no economic lessons to be learned in distinguishing among peoples in Utah and the Bronx. The relevant distinction here is that all individual EU governments, including Greece and Germany, cannot have comprehensive domestic economic policies whereas a country with its own currency can (at least in theory). When Greece can’t roll over its debt, Frenchmen have no incentive to help. When California can’t roll over its debt, a US Federal agency can assume it, along with the debt of Detroit homeowners and the debt of large corporations owned by pension funds. Americans across all states might benefit from that federal agency.

German state-owned banks provide the same services to the German government as Fannie Mae and Freddie Mac now provide the US government. Unless all nations comprising the EU want to take ownership of German state-owned banks, the burden to continue subsidizing Greek labor unions will ultimately fall entirely on the backs of German citizens who will not receive benefits from the whole affair. We don’t see any way Merkel and Sarkozy can get away with keeping a 16 member Euro zone (unless they want to risk Les Miserable).

Ultimately it is not the rule of law or a fundamentally sounder economy that makes the US dollar a more stable currency than the Euro; it is the lack of incentives that exist for those holding Euros to adhere to its perpetuation. We have no great conviction about how to play this situation within the relative FX game. Obviously the Euro, as it stands, would appear to be weak vis-à-vis other currencies like the US dollar. However, if next month German state-owned banks and global bond investors step away from rolling over Greek debt, in turn causing expectations that the Euro zone will reduce its membership to 11 from 16, we could see the Euro as the world’s best fiat currency. (We are playing Euro FX weakness in a small way and all currencies’ weakness versus gold in a far bigger way.)
Fundamentals Show Opportunity
Growth in an economy’s Monetary Base (MB), (defined as currency in circulation and bank reserves), leads directly to an upward adjustment in the value of gold. The accompanying graph, which we print periodically and feel compelled to update, shows the Fed’s relentless printing of high-powered US dollars – money that may be further levered. As ridiculous as it may seem at first blush, the graph represents our best guess as to the magnitude of ultimate loss already baked into the US dollar’s purchasing power.

Most dollar holders don’t seem to know this yet. Investors seem to have chosen to wait before setting up for rising goods and service prices seen in popular consumer price baskets. What are they waiting for? Perhaps they are still equating output contraction with price declines? Or perhaps they are waiting for all those newly created dollars, and the 10x-plus claims those dollars will be multiplied to in the banking system, to begin chasing the relatively constant supply and demand equilibrium for global goods and services? Or, perhaps they believe the Fed will withdraw enough money and credit at just the right time to retard output growth?

We are not waiting to see if policy makers will successfully manage expectations for goods and service inflation. What they intend to do does not concern us. We think it is highly likely MB growth will continue on its parabolic path until consumer prices begin to rise. Indeed developing “a little” price inflation expectations must be the current, albeit unstated, policy objective. If policy makers are “successful” at stimulating the economy, they will not get a little price inflation; they will get a lot — record amounts — and they will not be able to do anything about it. Paper money will lose its purchasing power.

Gold is simply cash in a scarcer currency; wealth placed in an asset with a better future exchange rate; a legitimate store of current purchasing power; and possibly (probably) a legitimate store of increasing future purchasing power because so few own it today. It is looking more likely that there will be a sudden and equally parabolic shift in precious metals prices and their derivatives, just as we have begun to see in the Monetary Base graph above. The gold price has risen each year since the turn of the century. Have you ever seen a strong, secular bull market end without a blow off?

“A Meaningless & Intangible Social Construct”

“Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years. As the economy improves and credit losses become easier to size, banks will be able to build capital from earnings and outside investors, making them more able and willing to extend credit–in effect, allowing the low market interest rates to show through to the cost of capital for more borrowers. A more stable economic environment and greater availability of credit should contribute to the restoration of business and household confidence, further spurring spending.”
–Fed Vice Chairman Donald Kohn, October 13, 2009

Mr. Kohn, who has been at the Fed since 1970 and just announced his retirement, no doubt intended his remarks last fall to provide a reasonable roadmap for economic recovery – one that no reasonable person would dispute or be offended by. He would be wrong.

The accompanying graph shows US total bank credit (TBC), which we would argue is the secret sauce and leading indicator of the price of “risk assets”. In short, the increase in bank credit promotes leveraged investment in assets that promise a return in excess of the cost of that credit. The more bank credit in the system, the more financial asset borrowers reach for yield. All the credit chasing financial assets drives down their risk-adjusted returns. Eventually, asset bubbles burst and the credit remains. Then, credit values begin to decline as they are no longer collateralized by inflated assets. Mr. Kohn’s solution is to inflate another asset bubble.

As the graph shows, TBC is about $9 trillion presently, or over 4 times the Monetary Base. It has risen quite steadily over the last generation until just recently when it began to stumble. As Mr. Kohn shows clearly, public policy is to get TBC rising again, which will increase borrowing, money velocity, consumption, etcetera, etcetera, etcetera. What Mr. Kohn and others do not seem to understand is that they have lost control over their own banking systems. Despite its growth, TBC does not present a complete picture of dollar-based leverage. According to John Williams of Shadow Government Statistics, total US dollar denominated GAAP based obligations are about $71 trillion, or almost 8 times TBC and over 32 times the US Monetary Base. The US is one hell of a levered economy and US dollars seem to be, as our friends at “The Onion” joked, “just a meaningless and intangible social construct.”

What comprises the difference in $9 trillion TBC and $71 trillion total US dollar denominated GAAP based obligations? We don’t know for sure but we think we know where to look. According to Jim Rickard’s revealing interview in welling@weeden:

“The ratio of world financial assets to world GDP grew from 100% in 1980 to 200% in 1993 to 316% in 2005. Over the same period, the absolute level of global financial assets increased from $12 trillion to $140 trillion. The drivers of this exponential increase in scale are globalization, derivative products, and leverage. Globalization, we’ve talked about. Derivatives have grown even faster than the underlying financial assets, owing to improved technology in their structuring, pricing, and trading – and to the fact that the size of the derivatives market is not limited by the physical supply of any stock or commodity. It can theoretically achieve any size, since the underlying instrument is notional rather than actual. Thus, the total notional value of all swaps increased from $106 trillion to $531 trillion between 2002 and 2006. The notional value of equity derivatives increased from $2.5 trillion to $11.9 trillion over the same period while the notional value of credit default swaps increased from $2.2 trillion to $54.6 trillion.”

The numbers are daunting. Theoretically, if we wanted to completely settle dollar based claims versus dollars outstanding we would have to: a) increase the MB by 32 times; b) decrease credit by 32 times; or c) increase the MB and decrease credit until we found equilibrium. Of course, this is not really a fair analysis because aggregate US dollar-denominated debtors will never have to completely pay-off their debts, but it does indicate the magnitude of the leverage currently in the system and imply the difficulty with which this leverage can be paid down – and the difficulty with which even more credit will stimulate growth. Good riddance, Mr. Kohn, and don’t let the door hit you on the way out. (We know, meet the new boss; same as the old boss…)


If you accept the proposition that gold’s correlation lies with MB and stocks’ (as a proxy for risk assets) lies with TBC, as we do, then the two graphs above imply one should consider buying gold and selling equity. While the ratio is what matters for the pairs-trade, the nominal level of the numerator is what matters for the solvency of the banking system. In that sense, banks are agnostic towards the gold price unless a higher gold price ultimately flows through to a higher risk asset price (which, in time, we think it clearly will). Think of it this way: In good times (nominal asset price appreciation), banks enjoy robust lending conditions and therefore are the “money creators” (loans create deposits). In bad times (nominal asset price depreciation), banks suffer balance sheet pressures and therefore curtail lending. Under this scenario, the Fed is the money creator.

Mother Nature, being more powerful than even the Fed, applies the disciplinary constraint (a perceived upside limit on TBC/MB) in the modern monetary system that the gold standard did under former monetary regimes. Under the gold standard, however, MB was a constant so the ratio could only normalize from an inflated level via a contraction in TBC. As we discussed above, under our existing fiat currency system, the ratio can be normalized via a contraction in TBC, an expansion of MB or, a combination of the two. A $2.2 trillion MB has a long way to rise to meet $9 trillion TBC or $71 trillion total claims, even if they meet in the middle.

In the end this is nothing more than savers funding speculative bank lending, as it is the savers who foot the inflationary bill. Buy your Treasuries and be safe, if you like. We will fade you. Take “a little risk” if you dare by buying highly levered real estate or equity indexes. We will take the other side of your trade. Your investments may turn out to be “money good”, but in the end you will have bad money.

Lee & Paul

Paul Brodsky Lee Quaintance

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