Paul Brodsky

An Adult Approach – II (Defining Relative Real Value)

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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.

BASENS

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.

Chart depicting US Monetary Base

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.)

Second chart depicting US Monetary Base

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:

Benchmarks

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 :)

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Copyright © 2012 · Lee Quaintance and Paul Brodsky of QB Asset Management

Published by kind permission of the authors.

No part of this document may be reproduced in any way without the written consent of QB Asset Management Company, LLC.

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