QBAMCO - An Adult Approach I and II

QB ASSET MANAGEMENT www.qbamco.com

1 See Important Disclosures at the end of this report.

Februar y 2012

An Adu lt Approach - I ( In vest ing in a Vu lgar Age)

If profanity is the weapon of the witless then how does one best describe something profane? Global policy makers are meddling in markets so that the economies they feel responsible for can achieve what seems to be a consensus objective of muddling through. A policy of meddling to muddle, if you will. Today’s meddling policy, broadly defined as manufacturing and distributing new base money, is a necessary follow-up to yesterday’s meddling policy, broadly defined as aggressively promoting when-issued base money (i.e. credit). In other words, policy makers must now rob Peter and Paul to pay Jamie, which is only slightly more acceptable than the previous policy of robbing Peter’s and Paul’s children to pay Lloyd. We have children, including young girls (sugar and spice and all that), but quite honestly the only apt response for this vulgar state of affairs is: “WTF?” The entire display of hubris among global economic policy makers is almost too repulsive to bear – even more so than the leap year sporting event commonly known as “letting Americans believe their plutocracy is a democracy” “The Great American Media Buy” the “U.S. Presidential Election”. To quote a headliner in this year’s quadrennial circus, it “is as close to despicable as anything (we) can imagine”. We are humble investors and it is not our occupation to sling judgmental Shinola. But it is undeniable that we exist, as do you, and therefore have a stake in the actions of fired-up world improvers oddly wired to believe unequivocally that motion is progress while demonstrating great finesse in assuring a minimum gets done. As you opened this piece not for a cynical (and increasingly trite) rant about the absurdities of contemporary authority but, we imagine, for a somewhat reasoned assessment of macroeconomic circumstances and how they may relate to makin’ money, we will try to calm our Tourette’s for a couple of thousand words. No guarantees, of course. It is the Currency, Stupid. Whether or not Greece will meet its debt obligations in March and beyond has little to do with Greek wherewithal and output. Everyone knows Greece is insolvent and cannot meet its March 20 payment. Nevertheless, bets are being made quite aggressively in the capital markets handicapping sovereign bailouts. As it stands today the debate surrounds how much to haircut Greek debt and through which entities the bailout would pass. Were Greece the only insolvent sovereign then most would think it would have already been bailed out. But the dubious balance sheets of other sovereigns like Portugal and Ireland (and Italy and Spain) demand that both sides, creditors holding Greek debt and solvent sovereigns like Germany ostensibly on the hook to pay them, try to find acceptable terms. The parties involved are not only negotiating about Greek debt. They are no doubt posturing for future negotiations as well. Many if not most Greek creditors, (and certainly the most active investors in negotiations), bought their bonds and CDS in the secondary market in anticipation of this workout. Both sides are concerned with establishing precedent. Whatever discount-to-par creditors take on the March 20 sovereign Greek debt payment would establish benchmark terms for other struggling Euro sovereigns as well. Thus, it is possible that the valuation of sovereign debt across all Euro nations will be established in relatively short order. This would conceivably indicate how much new currency the ECB would have to manufacture, which in turn would allow a more knowable valuation of the Euro vis-à-vis other major currencies. Perhaps this is why all those EURUSD shorts we keep hearing about have not succeeded in taking the Euro down? (And it still amazes us that media still do not understand that for every seller there is a buyer. Maybe they should learn to report which side, buyers or sellers, is most vociferous or has the shortest time horizon?) Nevertheless, we think ongoing currency exchange rates have been more or less accurately discounting the outcome and timing of the Greek debt workout, which in turn would establish a benchmark for sovereign debt haircuts across the Eurozone.



Strange too that public attention seems focused on the players rather than the process, as though it is a multi-front knife fight, a scatological war between politicians, taxpayers, hedge fund speculators, the ECB, IMF, and acronym-laden conduit vehicles. It is much simpler than that, in our view. The whole affair reduces to bond holders on one side and central banks on the other. After all, central banks are the only entities that can ultimately print the necessary money to service the debt and repay the creditors. The ECB, Fed, PBoC, BOJ, BOE, SNB, Bundesbank & Banque de France have the biggest stakes in exerting austerity on profligate societies because they manufacture the world’s benchmark currencies through which all wealth and power is commonly judged. As central banks enjoy unilateral monopoly power over manufacturing the world’s money with which to repay sovereign (and corporate and household) debt, they have omnipotent control over establishing terms over indebted societies. (For those arguing Plutocracy! here is the basis of your claim.) To be sure, central banks with insolvent sovereigns are the ones with the highest balance sheet growth rates. We thank James Bianco for the graph below showing the ECB’s balance sheet grew 44% over the last six months:

Source: James Bianco; “Living in a QE World”; January 27, 2012; posted at The Big Picture (http://www.ritholtz.com/blog/2012/01/living-in-a-qe-world/)

As everyone knows, the EU lacks fiscal unity which means the ECB is the focal point of intense public scrutiny when it comes to money printing for member nations. (As our friend Marshal Auerback informs, actual money printing is still done at the national central bank level, but the “orders” are placed by the ECB.) The problem for The Bank of Greece is that it must appeal to the ECB for help and the ECB is controlled by Germany, an economy in surplus. According to the BOG’s website, (http://www.bankofgreece.gr/Pages/en/Bank/default.aspx), it “is responsible for implementing the Eurosystem’s monetary policy in Greece and safeguarding the stability of the Greek financial system”. We note the BOG has no mandate to reverse an already destabilized EU or Greek financial system. The critical debt problems today are not just European, as most seem to believe. As we have written at length, the global monetary system is debt based and the amount of debt denominated in all currencies still dwarfs the actual amount of base money in the world. This leverage means that if global policy makers remain unwilling to de-lever the global monetary system by allowing debt to deteriorate, then they must de-lever it through continued base money creation (which shifts the debt to public accounts through the process of sovereign debt monetization).

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And so it shall be. All major central banks are manufacturing base money. (We must draw your attention to our friend Michael Panzner’s latest book, Modern Central Banking: Simplified, which is available on Amazon. You’ll laugh, you’ll cry…but mostly you’ll laugh.) The public debate has become how fast or slow central banks should print, not whether they should. (We argue they should just go ahead and get it over with! De-lever the system already!) The graph below shows global base money growth is a firmly established trend.

Source: James Bianco; “Living in a QE World”; January 27, 2012; posted at The Big Picture (http://www.ritholtz.com/blog/2012/01/living-in-a-qe-world/)

The Fed has our Back(side) In today’s global monetary system exchange rates are contingent upon popular confidence that equilibrium price levels can be agreed upon across currencies for goods, services and assets. Printing an excess of one particular currency would threaten the perception of that currency’s purchasing power value vis-à-vis other global currencies. It is okay, so believe overseers of the global banking system, for FX cross rates to fluctuate, but it is unacceptable for a major currency to fail. This would expose the dirty little secret that contemporary debt currencies cannot mathematically store purchasing power over time. Whether or not it is officially proclaimed “a failure”, the global monetary system is already failing in real terms. Anyone can see this in the costs of global goods, services and labor across all currencies, which are rising much faster than global demand, and in the long established trend of debt deflation. The problem for most investors today is that they no longer know how to invest with a real return objective. For forty years they have been taking the banking system at its word that the paper it produces stores value. Consider last month’s press conference held by Fed Chairman Ben Bernanke, in which he formally announced the Fed would target 2% inflation in the US. The Fed chose as its inflation benchmark the Personal Consumption Expenditures (PCE) index, calculated by the Bureau of Economic Analysis within the Commerce Department. Unlike the CPI, which is currently running at a 3% annual rate (even core CPI, which strips out food and energy prices, is running at 2.2%), the PCE was reported on January 30 to be running at 2.4% (1.8% core). Quick inspection of the PCE index (Bloomberg ticker “PCE DEFY” we kid you not!) shows it was “rebased to 2005” and that “to see this index with a base year as (of) 2000” we should “refer to the ticker PCE DEYO”.1

1 Bloomberg; PCE DEFY Index

Alas, Bloomberg did not have the data for base year 2000 when we tried.

http://www.ritholtz.com/blog/2012/01/living-in-a-qe-world/�



We are comforted that Chairman Bernanke and the Commerce Department are sanguine about something they are calling “inflation” not eating into the purchasing power of US dollars or into real returns on dollar-denominated assets. We would be happy to go along with the Fed except that we are investing to increase our future purchasing power and, frankly, we do not trust the Fed to watch out for our purchasing power. It seems obvious the Fed is not only changing policy by officially “targeting inflation”, (and framing the change as greater transparency which is in the public good), it is also shifting benchmarks to be able to better control the perception of low inflation so that it may manufacture more base money. Merriam-Webster defines profane as follows: “to treat (something sacred) with abuse, irreverence or contempt, or to debase by a wrong, unworthy or vulgar use”. We do not think measuring inflation should be considered sacred but we do think policy makers are deliberately, without ego or malice, managing monetary affairs as it suits the banking system. If by massaging the perception of inflation they are breaching the public trust and displaying contempt for laborers and unlevered savers, (not to mention investors), well then it is just business. WTF. Absolute Power Such economic manipulation is to be expected. Mr. Bernanke represents a power structure with deep roots that supports the general theory that those that control a nation’s money control the nation.

“Let me issue and control a Nation’s money and I care not who makes its laws. The few who can understand the system will be either so interested in its profits, or so dependent on its favours, that there will be no opposition from that class, while, on the other hand, that great body of people, mentally incapable of comprehending the tremendous advantage that Capital derives from the system, will bear its burden without complaint and, perhaps, without even suspecting that the system is inimical to their interests.” 2

- Mayer Amschel Rothschild, 1838

It is becoming increasingly obvious today within developed economies that ultimate power remains with the monopoly issuer of our fiat currencies, much as it has for centuries. Sometimes power must exert itself, as this 1819 discussion in the British Parliament shows: Commons Secret Committee: “In what line of business are you?” Nathan Rothschild: “Mostly in the foreign banking line.” Commons Secret Committee: “Have the goodness to state to the Committee in detail, what you

conceive would be the consequence of an obligation imposed upon the Bank (of England, which Rothschild owned) to resume cash payments at the expiration of a year from the present time?”

Nathan Rothschild: “I do not think it can be done without very great distress to this country; it

would do a great deal of mischief; we may not actually know ourselves what mischief it might cause.”

Commons Secret Committee: “Have the goodness to explain the nature of the mischief, and in what

way it would be produced?” Nathan Rothschild: “Money will be so very scarce, every article in this country will fall to such

an enormous extent, that many persons will be ruined.” Are we mad to compare old history with today’s monetary system? Well, let’s just say that nothing has changed in the structure of central banking and we have never been high on “this time is different” thinking. (We think even

2 Mayer Amschel Rothschild (1774-1812); written in a letter from London to Rothschild agents in New York; 1838.



Rogoff & Reinhart who wrote the wonderful book of the same title would instruct that private central banks maintain the same control over the monetary system today). So, we should expect central banks to manufacture mass quantities of currency to ensure bank system solvency. Knowing this in advance is an even bigger gift for unlevered real asset investors than Ben Bernanke’s gift to levered carry-trade investors by promising to keep US interest rates zero bound through 2014. We have not reached the end of history. Mankind evolves, as does capitalism and its many brands. But not that much. An objective look at our modern economic ecosystem shows clearly one unified global banking system that is actually made stronger by predictable, publicly aired tensions among competing political and economic theorists and practitioners. As long as lawmakers and we, the people that must obey them, continue quarrelling among ourselves, those that control money are free to do as they like. When the people revolt against the symbols of political power (storm the Bastille, storm the winter palace), then the people succeed in forcing those that control money to alter the political structure. Only when lawmakers take steps to limit bank system access to the nation’s resources by indenturing the factors of production (dumping tea overboard, storming the Eccles Building), can the nation’s capital shift back to the people. Today we have an oligopoly of central banks issuing the world’s baseless currencies and, by having successfully promoted substantial household and sovereign debt assumption, can now dictate resource allocation and fiscal policy terms. Against this power there is fragmentation -- (mostly) democratically elected officials overseeing republics of generally obedient populations. Lenin knew; “by continuing the process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens”. John Maynard Keynes himself agreed: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose”. We argue that indebted governments have ceded that power to banking systems without conscience or public accountability. If the global banking system has ultimate power over how global wealth is perceived, (as it does), and it is the only institution powerful enough to keep indebted governments in control of their societies, (which it is), then the only reasonable strategy for an independent investor is to think like a Rothschild. Don’t fight the Fed – bet on it. We will put more meat on the bones in a follow-up report, An Adult Approach II (Relative Real Value), and provide a truer sense of current and future US inflation and our sense of relative value within such an environment. Kind regards, Lee Quaintance & Paul Brodsky [email protected]

mailto:[email protected]�



FOR INFORMATIONAL PURPOSES ONLY THIS MATERIAL IS NOT AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO PURCHASE SECURITIES OF ANY KIND. THIS REPORT MAY CONTAIN FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. FORWARD-LOOKING STATEMENTS INVOLVE INHERENT RISKS AND UNCERTAINTIES, AND WE MIGHT NOT BE ABLE TO ACHIEVE THE PREDICTIONS, FORECASTS, PROJECTIONS AND OTHER OUTCOMES WE MAY DESCRIBE OR IMPLY. A NUMBER OF IMPORTANT FACTORS COULD CAUSE RESULTS TO DIFFER MATERIALLY FROM THE PLANS, OBJECTIVES, EXPECTATIONS, ESTIMATES AND INTENTIONS WE EXPRESS IN THESE FORWARD-LOOKING STATEMENTS. WE DO NOT INTEND TO UPDATE THESE FORWARD-LOOKING STATEMENTS EXCEPT AS MAY BE REQUIRED BY APPLICABLE LAWS. NO PART OF THIS DOCUMENT MAY BE REPRODUCED IN ANY WAY WITHOUT THE PRIOR WRITTEN CONSENT OF QB ASSET MANAGEMENT COMPANY LLC.



Februar y 2012

An Adu lt Approach – I I (Def in in g Re lat ive Real Va lue )

In our first installment of An Adult Approach, we attempted to scrub away some misconceptions related to inflation that are embedded in the contemporary economic and financial canon. We sought to raise doubt about the incentives of central banks to share the true loss of their currencies’ purchasing power with the public. When we began to write the follow-up, “Real Relative Value”, in which we apply a forward rate of inflation to current asset values, it quickly became clear that we were spending too much space discussing proper real value. So, this piece, which is now the second in a series of three (we think), will seek to provide a truer sense of money, inflation and real value today, all of which seem grossly misunderstood in the marketplace. Money & Banking (Cliff Notes) US dollars and all other world currencies today are not what most people think. The game starts when a central bank (on behalf of its sponsoring government) issues physical currency to you and me through its banking system. A bank can be a bank because it has already deposited assets that qualify as reserves at its central bank, not necessarily because it has deposits. Reserves are typically assets in the form of loans. The business of the bank is to issue credit, which is ultimately claims on physical currency, theoretically in an amount up to a level that does not breach its reserve ratio with its central bank.

The Monetary Base (a.k.a. base money) is physical currency in circulation and bank reserves held at the central bank. Everything else in the monetary system is credit, even including deposit balances held at banks by you and us beyond the amount of aggregate reserves. So then, modern banking systems are fractionally reserved (as is deposit insurance, which as far as we understand has de minimus reserves and zero physical currency).

Credit, regardless of who is contracted to receive it and pay it, is ultimately backed by the physical money printing ability of the central bank. If you go to the bank tomorrow and ask for $10 billion in C-Notes that you have on deposit, your banker will call its central bank, which will then debit your bank’s reserves held there. The central bank will then literally print the C-Notes and put them on an unmarked military cargo plane destined for your personal landing strip deliver the C-Notes to your bank where you can withdraw it. If your bank runs out of currency reserves held at the central bank, (because either depositors withdraw more than your bank has in reserve or because the value of your bank’s reserves depreciate in the marketplace), then your bank will ordinarily be subsumed by another fractionally reserved bank with enough reserves to make the new, larger entity properly reserved. The US banking system currently has almost $20 trillion in assets (held in the US and abroad). The US dollar monetary system is supported by about $2.7 trillion in total base money, about $1 trillion of which is physical currency in our pockets and about $1.7 trillion in bank reserves held at the Fed. (The ratios are about the same globally -- $95 trillion dollar equivalent bank assets and about $12 trillion in global base money.) Thus, the global banking system holds about 8.5% of its assets in reserve at global central banks to guard against the possibility that: a) you and we ask for our “money” back, and/or; b) the value of the assets it placed at central banks depreciates. We should not worry (nominally speaking, of course) if either (or both) of these events occurs because central banks can print all the money necessary to meet the demand for money. The good news is that everything else to be learned about modern money and banking is derivative (we mean that figuratively but feel free to apply it as you wish).



Inflation for Grown-Ups As we have argued, central banks and governments have great incentive to report inflation rates that do not fully capture the rate of purchasing power loss in the currencies they manufacture. If central banks and economic policy makers are not helpful to investors in providing reasonable inflation data, then it behooves investors to seek answers elsewhere. We believe a more accurate representation of manifest inflation may be found in Shadow Government Statistics’ Alternative 1980-based CPI Series1

(“SGS 1980 CPI”), which calculates the CPI based on the methodology employed prior to 1980. As the graph below shows, were the 1980 methodology still being used today by the Bureau of Labor Statistics then the CPI would show an annual inflation rate of 10.57% (blue line) as opposed to its current version running at 3% (red line).

As we discussed in An Adult Approach I, the perception of “3% inflation” is still too high for the Fed’s tastes and so last month it again announced its preferred inflation benchmark would be the PCE deflator, calculated by the Bureau of Economic Analysis (BEA) within the Commerce Department. We further expect that if/when the PCE deflator no longer provides a sufficiently low public perception of inflation, then the Fed’s thinking will evolve to the point of benchmarking nominal GDP targeting as its objective. After all, who, besides savers and pensioners, will care about 3% or 4% inflation when nominal output is running at 5% or 6%? (Never mind true inflation will be substantially higher than 2% or 4%.) Such sleight of hand rivals those of illusionists who make 747s disappear. There are real-world consequences when policy makers succumb to the perceived political imperatives of perverting economic data. The graph above provides a fascinating narrative that shows the practical inflationary impact on an economy. In July 2008 the annual inflation rate according to the SGS 1980 CPI peaked at 13.36%. This came just prior to the failure of Lehman Brothers, a credit event that acted as a deflationary catalyst for goods and service prices as well as a trigger for asset price declines. (After an economic lag, in July 2009 the SGS 1980 CPI dropped to a low of +5.4% and the BLS’s headline CPI dropped to -2.1%.) As we know, the Fed created new base money in the fall of 2008 for the benefit of its member banks (QE, asset purchases, swap and credit lines, etc). Over the three subsequent years banks used these new reserves to profit by buying cheapened assets for themselves, and to extend credit to worthy borrowers and levered buyers of liquid financial assets. Financial markets rebounded quickly. And as the graph above clearly shows, the prices goods and services also experienced a “V-bottom” in large part, we believe, because the new dilution in the USD and other global currencies gave incentive to global commodity manufacturers to demand more currency (higher prices). Commodity prices rebounded quickly and this flowed through to goods and service input costs. 1 http://www.shadowstats.com/alternate_data/inflation-charts

http://www.shadowstats.com/alternate_data/inflation-charts�



Regardless of how well it is measured, all inflation is not created equal. There is a big difference between the driver of consumer inflation and asset inflation. Changes in goods and service prices are ultimately determined over time by the growth or contraction of physical currency in float plus unreserved bank deposits (what Austrians call “checkbook money”). Changes in asset prices are ultimately determined in an over-levered monetary system by changes in the availability of credit. (After all, that’s why they call them financial markets.) Asset holders benefitted at the time of the 2008 base money inflation because the Fed deposited newly created reserves into the creditor banking system, re-funding banks and by extension their investors, and allowing investment asset prices to rebound. In fact, the growth of the permanent money stock and where it flowed since 2008 explains much about recent returns. The table immediately below shows how markets have performed in nominal terms since the Fed began substantially increasing US base money:

Nominal Returns

SGS-Alternative CPI 1980 Equiv

US Stocks

US Treasuries

Commodities

US Housing

Aug ‘08 - Jan ‘12

30.12%

10.38%

28.77%

20.27%

- 13.35%

Source: Shadow Government Statistics; BLS

S&P500 Total Return Index; Bloomberg

TLT Index; Bloomberg

RJ CRB Index; Bloomberg

Case Shiller Index; Bloomberg

And the table below shows real returns -- the nominal performance in the table above deflated for the SGS 1980 CPI, a more accurate measure of goods and service inflation:

Real Returns

SGS-Alternative CPI 1980 Equiv

US Stocks

US Treasuries

Commodities

US Housing

Aug ‘08 - Jan ‘12

30.12%

-19.74%

-1.35%

-9.85%

- 43.47%

Source: Shadow Government Statistics; BLS

S&P500 Total Return Index; Bloomberg

TLT Index; Bloomberg

RJ CRB Index; Bloomberg

Case Shiller Index; Bloomberg

According to the BLS, cumulative CPI has risen 3.6% since August 2008. However, the table above succinctly portrays what we believe American investors know intuitively -- since 2008 their asset values have not kept pace with accurately calculated goods and service inflation. In other words, US wealth and income has declined materially since 2008 in real terms regardless of popularly-accepted data to the contrary. (We are reminded of the Texas cad who indignantly demanded of his wife when she caught him in flagrante; “are you going to believe me or your lyin’ eyes!”) In short, asset holdings today are broadly perceived as a “savings pool” that will be exchangeable at current relative valuations for consumables tomorrow. This seems a faulty assumption. US output has been shrinking in real terms too. Since September 2008, cumulative GDP growth deflated for the cumulative SGS 1980 CPI has been -29.86%. This implies the US economy shrunk in real terms by almost 30% since the Lehman bankruptcy. Does such a startling figure resonate with you or do you find it hard to believe? Before you answer, please consider the current value of your consumption and investments in 2008 dollars. The BEA suggests real GDP since then has been +1.8%. This figure does not comport with our sense of output and pricing. It should not be considered acceptable to be in a profession – as a political economist, policy maker or investor – in which self-delusion has become a necessary requirement for success and perpetuating that delusion is harmful to the broad economy over time. Yes, but the “public good” you say? Ah, but for how long?



Inflation Perspectives As implied, expectations of future inflation in the general economy that drive consumption patterns, (should I consume now or later?), as portrayed by the CPI and PCE deflator, should theoretically correlate most tightly with physical currency in circulation; while expectations for the Dow Jones Industrial Average, home prices, college education costs, etc. (i.e. items sponsored with explicit or implicit leverage), should theoretically correlate most tightly with bank credit dynamics. Further, we think the common notion that prices of goods, services and assets are solely determined by a rise or fall in aggregate demand should be summarily dismissed in today’s environment. While it is true that increasing demand for goods, services and assets correlated with steady price increases from 1945 to 1971, it seems more accurate to attribute that dependable glide path to the forces behind it. Production and consumption shifted from the public sector to the private sector after World War II and there was very little private sector leverage at the onset of the peace in 1945. Monetary and credit policy makers after the War could afford to show restraint every now and then while still allowing the economy to grow and eventually recover with new credit accommodation. It also must be acknowledged that government spending and Fed money creation was hindered by the natural discipline of the gold-exchange standard under Bretton Woods, which greatly curtailed systemic leverage. Then, as we know, from 1981 to 2006 asset prices rose far more than goods and service prices. A decade after the demise of Bretton Woods in 1973, balance sheets remained comparatively unlevered. Additionally, the baby-boomer bulge in Western populations had incentive to begin saving for retirement. As interest rates began their long descent in 1981, savers gradually moved out on the risk spectrum, investing directly in equity markets, indirectly in derivatives and structured financial products, and finally in levered real estate. Their more speculative actions were further validated along the way in the real economy. Productivity soared, domestically and globally, as new technologies and innovation provided greater efficiencies. Finally, the fall of communism in the East provided a new, cheap global labor pool almost overnight. Throughout this golden age of investing from 1981 to 2006 there was also a great counter-factual at work: despite enormous productivity gains that would have otherwise greatly reduced prices of goods and services, easy monetary policies in developed economies led to ballooning balance sheets that stabilized the general price level (GPL). Global central banks led by the Fed did not stabilize goods and service prices by restricting credit, which would have tamped down price increases, but by promoting credit to levitate the price level. For the last thirty years economic policy makers have been in the business of promoting asset prices higher through easy credit. (It seems “stable prices” being the primary objective of all central banks demands they spike the punchbowl rather than take it away?) Within this environment, price increases for goods and services badly lagged price increases of assets bought with unreserved deposits or unreserved bank credit. As asset prices rose, collateral values backing potential consumer credit rose too -- a virtuous credit cycle. Neither of these two circumstances – reemerging economies re-building their infrastructures or a virtuous credit cycle -- exists today. Demand for goods and services in aging, highly-levered (i.e. “developed”) economies obviously remains intact but demand for assets has been largely replaced by the need to service and rollover debt. As these obligations come due, further pressures on asset prices should be expected. Cash on balance sheets is not net savings but, rather, quite literally encumbered credit held against obligations. To paraphrase Kyle Bass, most of the world is long things that are deflating and short things that are inflating -- long levered assets (directly or indirectly) and short the necessary credit needed to support their lifestyles and asset values. And so we think the leading indicator of inflation and real asset value today harkens back to the classic quip Milton Friedman made famous: inflation is always and everywhere a monetary phenomenon. What many monetarists like Friedman’s followers seem to have forgotten though is that the majority of what passes for money today is not money at all but rather unreserved bank credit that must someday be made whole at “par”. Otherwise it will simply vanish through repayment or default. While creating enough new money is easily achieved by central banks (without limit), there can be no “par” in real terms. There is only outstanding unreserved debt that must amortize.



Magnitude of the Problem Central bankers struck a match under the global economy in 1981 and it continues to burn. The match began to burn their fingers in 2008 when the process of “re-collateralizing” unreserved credit got underway.

The familiar graph above shows the increase in USD base money that began to de-lever the US banking system in 2008. Though we have written in the past about total dollar-denominated debt exceeding $50 trillion, all of that debt does not have to be paid down. (Most of it is fully-reserved because its creditors are not levered.) But there is an identifiable portion of dollar–denominated debt issued by highly levered creditors – banks. We believe the debt-to-money gap that must and will be greatly reconciled in short order is the ratio of bank assets to the monetary base. As the graph below shows, the US Monetary Base was only 13% of US Bank Assets on December 31, 2011.The banking system is the source of unreserved credit and is on the hook to use its collective balance sheet to be the transfer mechanism for economic stimulation through monetary policy. And as they have already demonstrated repeatedly, monetary policy makers feel the need to de-lever the banking system today so it may then extend credit to the rest of the economy tomorrow.



Of course, the US banking system is not alone. According to the Financial Stability Board, worldwide bank assets (including US bank assets) were approximately $95 trillion in October 2011 (USD terms). Meanwhile the IMF reported that as of December 2010 the global supply of base money was approximately $12 trillion (USD terms). These figures put the worldwide proportion of base money-to-bank leverage roughly in line with the US. Given: 1) the exorbitant leverage currently in the global banking system, 2) current negative real output growth in developed economies, 3) current negative real interest rates, 4) uniformly poor monetary, fiscal and demographic conditions across most developed economies, and 5) already wary populations beginning to get restless; we have difficulty imagining that global banks, labor, savers, politicians and investors will be able to endure current conditions much longer before demanding the financial reset button be pressed to complete bank de-levering. We provide the graph below merely to make it easier to conceptualize the nature of such a de-levering, as we see it. (This is not necessarily a prediction of timing or magnitude.) The takeaway is that base money (in the form of physical currency in circulation) and bank deposits will have to rise at a much steeper rate than bank assets until the banking system is more fully reserved. (At some point we think bank animal spirits will once again take over and we will have a new leveraging cycle.)

The graph above illustrates the forces behind a high-tech jubilee. The burden of repaying past systemic debt will have been greatly reduced through base money inflation, (that shifts the GPL higher, including revenues and wages), while the integrity of systemic debt remains intact (nominally). The integrity of the banking system will also remain intact, as would the creditworthiness of most debtors. So we anticipate the sum of physical currency and bank deposits to continue to rise to stimulate nominal GDP growth and the ratio of bank credit-to-base money to contract further. Will the lines meet or cross? We don’t believe so but we do think the gap will narrow substantially before bank assets can grow materially again. Thus, we expect the rate of change of the General Price Level to equal the rate of change of the sum of physical currency and bank credit LESS some accommodation for productivity gains. It is reasonable to expect:

1) A higher General Price Level 2) A CPI rate higher than the rate at which the GPL rises 3) Levered asset inflation rates that very likely will be nominally positive but negative in GPL terms and, even

more so in CPI terms



Relative Real Value Today Before we can project future asset prices according to our framework for future inflation, we must first re-price assets according to our sense of current real value, as indicated by a more accurate current inflation rate. For this we will use the SGS 1980 CPI, discussed above, which is presently 10.57%. To simplify matters we will assume an 11% inflation rate (we are more interested here in identifying the overall potential magnitude of change using our framework than identifying targets). The following tables adjust price and return levels of three major market benchmarks to reflect positive real returns in the current environment:

Treasury 10-Yr Note Current Adjusted Real Value Yield to Maturity 2.0% 12.0% Price Par 42.65 Price Change: -57.35%

S&P 500 Current Adjusted Real Value 2011 Earnings $97.00 $97.00 Earnings Yield 7.45% 12.0% Price 1345 808 Price Change: -39.92%

Residential Real Estate Current Adjusted Real Value Monthly $975 $975 30-Year Fixed Mortgage Rate 3.75% 13.00% Median Home Price $210,000 $88,133 Price Change: -58.03%

We must caution that the shocks above make many assumptions. However, the significant price declines capture mathematically the loss of value in the event asset levels adjust suddenly to reflect an inflation rate we believe to be more accurate. (We do not place a high likelihood on such a sudden event occurring.) Still, we believe such is the magnitude of general mispricing today in these asset classes when SGP CPI-U is indexed to produce contemporaneous real returns. In our next report, we will estimate future CPI given the inflationary operations we presume major central banks will embark upon. We will also seek to apply the substantial future inflation we envision to various asset classes, in absolute and relative terms. This month marks QBAMCO’s fifth anniversary and we have finally gotten clever enough to know what to call ourselves – a relative real value fund. We would be all set to try to market the fund except it seems few investors have a bid for such a thing. (Where is the “RRV” hedge fund bucket anyway?) Oh Well. What we lack in assets we make up for in a quantity of hope…and words. Kind regards, Lee Quaintance & Paul Brodsky [email protected]

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FOR INFORMATIONAL PURPOSES ONLY THIS MATERIAL IS NOT AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO PURCHASE SECURITIES OF ANY KIND. THIS REPORT MAY CONTAIN FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. FORWARD-LOOKING STATEMENTS INVOLVE INHERENT RISKS AND UNCERTAINTIES, AND WE MIGHT NOT BE ABLE TO ACHIEVE THE PREDICTIONS, FORECASTS, PROJECTIONS AND OTHER OUTCOMES WE MAY DESCRIBE OR IMPLY. A NUMBER OF IMPORTANT FACTORS COULD CAUSE RESULTS TO DIFFER MATERIALLY FROM THE PLANS, OBJECTIVES, EXPECTATIONS, ESTIMATES AND INTENTIONS WE EXPRESS IN THESE FORWARD-LOOKING STATEMENTS. WE DO NOT INTEND TO UPDATE THESE FORWARD-LOOKING STATEMENTS EXCEPT AS MAY BE REQUIRED BY APPLICABLE LAWS. NO PART OF THIS DOCUMENT MAY BE REPRODUCED IN ANY WAY WITHOUT THE PRIOR WRITTEN CONSENT OF QB ASSET MANAGEMENT COMPANY LLC.

QBAMCO - An Adult Approach I and II

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Transcript of QBAMCO - An Adult Approach I and II