The Broyhill Letter (Q2-11)

8/6/2019 The Broyhill Letter (Q2-11)

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T H E B R O Y H I L L L E T T E R “In summary, we nd that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclicallations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventthese, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this in turn, leads to attempts to liquidate; (5in turn, lead (unless counteracted by re ation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owshrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of betindicated by all nine factors; (8) the ways out are either laissez faire (bankruptcy) or scienti c medication (re ation), and re ation might just as well have been applied in the rst place.”

– Irving Fisher, The Debt De ation Theory of Great Depressions (1933)

“There is the possibility... that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute insense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority w

have lost effective control.” – John Maynard Keynes, The General Theory (1936)

Executive Summary

The essence of how our view differs from the consensus is that we believe the economies of the developed world areexperiencing an extended deleveraging process rather than recovering from a “garden variety” recession. In this two-partBroyhill Letter , we will explore the mechanics of a Deleveraging Process , which is best described as a unique economic envi-ronment that severely distorts typical market functioning. Government actions to date have largely focused on measuresintended to prevent this powerful de ationary force from spiraling out of control – Irving Fisher’s prescribed “re ation.”But government policies cannot halt this process. There are ceilings to debt growth and deleveraging must occur once the

burden becomes too large for the credit bubble to continue. Government actions have been “successful” to date, resulting in a slower pace of deleveraging and Averting Armageddon . But a slower pace also means that it will take an extended periodof time for households to rebuild balance sheets and until this process is complete, shrinking private sector debt levels

will retard spending and slow growth.

Reinhart and Rogoff demonstrated that severe nancial crises typically produce an acute disruption of economic activity.In the decade prior to a crisis, domestic credit as a percent of GDP climbs about 38 percent and external indebtednesssoars. Quite often, this leverage ratio continues to increase after the crisis as private sector debt is transferred onto publicsector balance sheets, despite the fact that a credit crunch is underway (this should sound familiar). During the ensuing Deleveraging Process , credit declines by an amount comparable to the surge after the crisis. However, deleveraging is oftendelayed and is a lengthy process lasting a full decade or even longer. Typically, the greater the unwillingness to write downnonperforming debts, the longer the deleveraging process is delayed. The decade that preceded the onset of the 2007 crisis ts the historic pattern. If deleveraging of private debt follows the tracks of previous crises as well, credit restraint will

damp employment and growth for some time to come. The unwinding of debt is far from complete

Balance Sheet Recession

In a “typical” economic cycle, growing demand eventually creates tightening capacity and causes in ationary pressures tobuild in the system. As central banks tighten monetary policy (i.e. raise rates), g rowth slows and recessions follow. Reces-sions relieve the system from building in ation, allowing the central banks to reduce rates and stimulate new lending andeconomic growth. That’s a “typical” cycle – ah, the good old days.

Whereas a garden variety recession is caused by in ation and excess inventory, a Balance Sheet Recession ocurs in the wakeof a debt- nanced asset bubble that leaves private sector balance sheets overleveraged and unable to service the growing

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wall of debt with existing cash ow. Hyman Minsky referred to these swings in the nancial system from stability to crisisas the Financial Instability Hypothesis . Minsky wrote, “...from time to time, capitalist economies exhibit in ations and debtde ations which seem to have the potential to spin out of control. In such processes, the economic system’s reactions toa movement of the economy amplify the movement – in ation feeds upon in ation and debt-de ation feeds upon debtde ation.” There is a very big difference between these two states. When everyone tries to save more and spend less, the

whole economy is suffocated by a lack of spenders – the so called Paradox of Thrift. When everyone focuses on minimiz-ing debt rather than maximizing pro ts, the net result is a saving surge that drives down income, price levels and interestrates. In most cases, the government becomes “the spender of last resort” as a consequence of the chronic lack of creditdemand.

Monetary policy works during a “typical” economic cycle, because lenders and borrowers respond to lower interest. Butduring a Balance Sheet Recession , reality runs counter to academic theory, which suggests that lower interest rates will generatean increase in borrowing. Conventional thinking lacks an understanding of debt dynamics. When a credit bubble nancedby borrowed money bursts, liabilities remain despite the collapse in asset prices. The rationale response is for the privatesector to pay down debt to a more manageable level – a level back in line with income and the ability to service that debt.If the private sector’s demand for funds with interest rates at zero is still declining, there is no reason to hope that mon-etary policy can generate a recovery. At the individual level, deleveraging occurs to repair balance sheets. But when mostof the private sector deleverages at the same time, bad things happen. The economy falls into Irving Fisher’s classic DebtDe ation where the mechanics of a normal economy break down:

“Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation,through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off , and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by re ation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in pro ts, which in a “capitalistic,” that is, a private-pro t society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9)Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

Borrowing & Binging

Over the past decade, US consumers have learneda very important lesson – at least, we hope. Wealthcreated by in ated asset prices is not trustworthy.Income growth is required to service the exces-sive debt left behind by previous bubbles. Incomegrowth is necessary because asset prices are proneto collapse, while debt bubbles stubbornly remainin place. Our work indicates that deleveraging islikely to continue until debts get back into align-ment with income. Despite massive (ongoing)foreclosures and curtailed credit lines, householddebt relative to income remains at a sky high 114%through early 2011. This ratio had never been


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above 100% until last decade. It peaked at 130%of disposable income in early 2008. The long term average is 75%.

The US economy remains extremely over-indebt-ed. The aggregate private debt to GDP ratio isnow 267%, versus the peak level of 298% achievedback in February 2009. With debt levels as high asthey are, the potential for further deleveraging stillexceeds the worst that the US experienced during the Great Depression. The risk is that the Desire

to Deleverage and the secular trend toward Pinching Pennies becomes so ingrained that consumers’ ap-petite for debt becomes permanently impairedeven after balance sheets are repaired. This Debt Rejection Syndrome was what triggered the Great Depression and kept interest rates from normalizing for three decades. It isquite possible that we experience a similar dynamic today. Consider that Japan is still dealing with its aversion to borrowing after two decades. With long term interest rates still hovering around one percent, signs of normalization are few and farbetween. If the structural weaknesses at home are not addressed quickly, we suspect many households will share the sameaversion for debt, and interest rates will remain remarkably low for a remarkably long time.

Enter Quantitative Queasing

Market forces are trying to correct the excesses created by a massive debt bubble blown over an entire generation. Gov-ernment policies can and have slowed the process. But they cannot stop it. The Fed can boost the monetary base all it

wants, but The Bernank cannot make overleveraged consumers borrow more. Reigniting animal spirits is easy when debtlevels are low, but reigniting them when debt levels are astronomical is much more dif cult, if at all possible. With Debt toGDP already at unprecedented levels, the chances of enticing the private sector to lever up are remote. Deleveraging mustoccur. Bernanke can publish Op-Eds singing the praises of Quantitative Easing all he wants, but he cannot force margin-

ally capitalized banks to lend to borrowers of questionable quality. The spike in excess re-serves indicates that banks aren’t lending. Inother words, the money isn’t owing into theeconomy. Something is broken.

As the monetary base has increased, the private sector has rationally chosen to hold ontothe extra cash. This is the hallmark of a clas-sic Liquidity Trap. With interest rates effec-tively at zero, there is little incentive to investsidelined cash for what equates to a minimalenhancement in yield. QE may or may not be“successful” in lowering interest rates. Butthe cost of money is not the issue here. Cred-it growth is no longer a function of interestrates. Interest rates are already low enoughthat a further decline toward zero is hardly

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likely to increase loan demand. Loan demand will in-crease when pro table opportunities arise. Not before.

And not until debt burdens are reduced to more nor-mal levels in relation to income. Until then, the privatesector will continue to deleverage.

Lessons from Japan

Few historical periods are relevant to today’s economiclandscape, as deleveraging processes are a “once in alifetime” occurrence. The two last credit bubbles in the

US were followed by The Panic of 1873 and the GreatDepression in 1933. Japan’s Lost Decade(s) providesthe most relevant experience outside of America. Ineach case, debt alone is not the culprit. Rather, the prob-lem is the credit-induced asset bubbles that predictably follow rapid increases in debt levels (China bulls shouldre-read this last sentence). The story always ends thesame. Obscenely elevated asset values ultimately col-lapse, leaving behind all of the debt used to nanceasset purchases. Multiple parallels exist between how

Japan and the US responded to their respective crises. The duration and magnitude of both the rise and thefall of house prices in these two countries are almostidentical.

Deleveraging in Japan lasted for decades. Why anyoneexpects quantitative easing in the US to be any moresuccessful than it was in Japan, is beyond us. Despitezero interest rates, any demand for credit has beendwarfed by debt repayments. Falling demand for credittranslates into falling aggregate demand until privatesector balance sheets are repaired and the private sec-tor is borrowing again. An expansion of the monetary base does little to prevent this powerful force, contrary to what economists read in text books today. We donot question the Fed’s ability to increase the supply of money in the economy or its desire to reduce the levelof interest rates. But neither of these factors repre-sents a constraint on economic growth today, so thereis no bene t to accomplishing them. Economists liketo describe this behavior as Pushing on a String . We think it’s tting.

The chart to the right from Dr. John Hussman, plotsthe velocity of the US monetary base against interestrates since 1947. Dr. Hussman explains that:

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“Few theoretical relationships in economics hold quite this well. Recall that a Keynesian liquidity trap occurs at the point when interest rates become so low that cash balances are passively held regardless of their size. The relationship betweeninterest rates and velocity therefore goes at at low interest rates, since increases in the money stock simply produce aproportional decline in velocity, without requiring any further decline in yields. Notice the cluster of observations whereinterest rates are zero? Those are the most recent data points.” Clearly monetary base expansions have little effect on GDP.

When the quantity of base money is increased, velocity falls in nearly direct proportion. The charts below compare thesame historical information for the US and Japan over the past two decades. The cluster of points at the bottom rightre ects the most recent domestic data.

Bottom Line

We believe that monetary policy and credit creation can have a profound effect on asset prices, often distorting economicreality. Financial asset prices can diverge from the real economy in the near-term, and often for longer than one wouldexpect, but cannot remain permanently divorced from economic fundamentals. That said, the current cycle in developedeconomies has proved to be far different from “post-war” economic cycles. This time around, the deepest post-war re-cession was followed by one of the weakest post-war recoveries (chart below). Moreover, that lackluster rebound camedespite unprecedented policy support. This suggests to us that the “vanilla” cycles of the post-war era may not be a very useful guide for what lies ahead. Comparable periods in history are rare, but if you look hard enough, you can nd them.

Japan continues to offer some important lessons in our view. During its lost decade(s), scal policy was the most effec-tive tool in generating recovery. Unfortunately,temporary recoveries (and stock market rallies)typically ended as scal support was removed (leftchart).

Governments like in ation because it leads thesheep into believing that things are better thanthey are. It is easy to mistake rising prices with in-creasing growth. It also helps the largest debtors(i.e. the government) pay down debt with freshly printed dollars. But unfortunately for the Fed, thetrajectory of in ation across the developed worldhas stubbornly followed the precedents of otherperiods characterized by long lasting slack .

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For the most part, big de cits and government debthave yielded low in ation, as growth proves to besub-par and the slack is absorbed only slowly. Recentreadings of core in ation suggest that we are just onecyclical downturn, or nancial accident, away fromoutright de ation. One of the key lessons investorsshould have learned from Japan’s lost decade(s) wasthat, however low bond yields seemed to be, they al-

ways fell lower alongside the business cycle (see chartto the right).

Quantitative easing is coming to an end, which im-plies tighter monetary policy. In 2012, developed world economies will face the rst signi cant removalof policy stimulus – like Japan so many times before(see chart to the right). Based on IMF estimates, the scal tightening will be the most severe since 1981.

That tightening contributed to the subsequent reces-sion. In 1937, it took only the end of quantitativeeasing and the tightening of scal policy to create ahard landing for the post-depression recovery and a50% decline in stock prices. It’s too early to call for acontraction in economic growth at this point but theodds are beginning to mount to the downside. And

given the probability of continued economic pres-sures driving demand for “risk free” assets, the likeli-hood of sustained upward pressure on bond yields islimited . . . at least for now. We’ll explore the implica-tions for investing during deleveraging processes inthe second portion of this quarter’s Broyhill Letter .

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The author’s opare subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investmenor a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sany security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable,

guaranteed.6


The Broyhill Letter (Q2-11)

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