the broyhill letter (q1-11)

8/6/2019 The Broyhill Letter (Q1-11)

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T H E B R O Y H I L L L E T T E R

The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country and dogood service for his sovereign, is the jewel of the kingdom.

Sun Tzu, The Art of War

Executive Summary

Rather than the same old letter warning investors that most equity markets remain dangerously overvalued, that sentiment

on most measures is exceedingly optimistic, or that the cyclical rally in stocks (and the economic recovery for that matter)

is looking more extended at each passing month, we thought wed try something different this quarter. After spending a

weak in Edinburgh with Board members of local CFA Societies from around the globe, and hearing from another excel-

lent line-up of speakers at CFA Institutes 64th Annual Conference, its satisfying to step back and consider the big picture.

As such, this quarters Broyhill Letter will be a summary of what some of the industrys best and brightest had to say inScotland.

At every conference, no matter how enlightening the speakers, there is always at least one sleeper in the schedule. For

those that havent experienced a full week immersed deep into an investment conference, the sleeper in the schedule

provides you with the desperately needed opportunity to run back to your room for a quick powernap, ensuring that you

are well rested and capable of absorbing all of the information shared by the true headline speaker. This is considerably

important in Scotland where every evening reception consists of unlimited whisky tastings. But this years sleeper was

anything but. In fact, he was saluted by a standing ovation from the 1300 or 1400 members of the audience as he walked

off the stage. I, for one, am very glad I skipped that powernap.

The Sleeper

CFA Institutes agenda for the last day of the conference kicked off with Raghuram G. Rajan, author of Fault Lines and

concluded with Jim Rogers before lunch, with Sanusi Lamido Sanusi, Governor and Chairman of the Central Bank of

Nigeria sandwiched between. I imagined it was the perfect opportunity to rest up before soaking in all one could learn

from the investor that best called the long term commodity cycle and author of one of my favorite books of all time,

Investment Biker. Skipping that nap was easily the best decision I made in Edinburgh.

Sanusi Lamido Sanusi is the best thing to happen to central banking since Paul Volcker. There, I said it. I have never heard a

public official speak so openly about the fundamental truths behind the financial industry, let alone an official with former

ties to the banks themselves. Sanusi is recognized in the banking industry for his contribution towards developing a risk

management culture in the Nigerian banking sector. He was appointed Governor of the Central Bank of Nigeria in June

2009, in the middle of the financial crisis. In August 2009 Sanusi bailed out Afribank, Intercontinental Bank, Union Bank,

Oceanic Bank and Finbank and dismissed their chief executives. He said, We had to move in to send a strong signal that

such recklessness on the part of bank executives will no longer be tolerated. Many senior bank officials face charges thatinclude fraud, lending to fake companies, giving loans to companies they had a personal interest in and conspiring with

stockbrokers to boost share prices.

Go back and read that last paragraph again and contrast it with our own experience. How is it that not a single person

from the banking industry is in jail for their crimes? These were in fact crimes. Crimes against the public, yet many of the

same management teams which got us into this mess are either still running the banks, or worse, running our government!

Sanusi believes you need strong institutions and you need strong individuals to run these institutions. We have neither. He

believes the relationships between the banks and the government is just too cozy. He sees that Goldman Sachs alumni have

always been at the Treasury and The Fed, which arguably explains their behavior around the crisis in his view and my own.

Nigeria is not waiting around for regulators to tell them what to do. While Dodd Frank is watered down to a slap on the

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hand by bank lobbyists, Sanusi is moving forward today by separating commercial and investment banking and forcing the

banks to pay for the bailouts.

At the end of the day it is about values. Its about looking at character, said Sanusi. The banks are holding the money

of the general public. And theyre taking risks with the peoples money. It is my job to protect their money. This does

not sound like any central banker I have ever known! Its unfortunate that in the land of the free, we prefer to protect

our banks rather than our people. The Nigerian people are lucky to have such an admirable leader, watching over their

economy. His closing remarks included a quote from Sun Tzu If youre going to battle, make sure the ground you stand

on is strong. Sanusis take - If they cant bribe you and youre not afraid of them, they dont know how to deal with you.

Seems to me that the ground is getting stronger in Nigeria, and if Sanusi is able to accomplish even half of what he aims

to do, the Nigerian economy, already rich in resources, might just have quite a tailwind behind it.

The Big Reset

The articulate Jim Grant reminded us that up until 1935,

the US financial system did stand on firmer ground as the

stockholders of an individual bank got a capital call when

banks were under pressure. I suppose the only difference

today is that the capital call flows through Washington

before we ultimately foot the bill. Since the suspension

of dollar convertibility, according to Grant, the dollar has

been a derivative without an underlier. That said, there

may be upside surprises ahead for the dollar as it is not in

nearly as bad shape as the Euro. But neither one is a store

of value. We would agree with Grant on this call and arepositioned accordingly. We also find ourselves agreeing

with Grant on China, who claims that The Peoples Bank

is leveraged 1500 to 1. While we havent checked his math

on this one, it is obvious to us that there is significantly

more debt in the system than the low levels often quoted

by the street. Per Grant, In China, the party forces

the banks to lend to the SCEs but it cant seem to tell the

SCEs to pay the loans back.

Sharing our emerging concerns, CLSAs Russell Napier

gave an eye-opening presentation reviewing the unin-

tended consequences of US monetary policy. Accord-

ingly, the only thing Bernanke has accomplished with QE

is successfully scaring people out of the dollar. Most in-

vestors assume, hope, or pray that emerging markets will

sit back and accept this global rebalancing through infla-

tion. Instead, Napier believes we are building up to The

Great Reset as high inflation in emerging markets forces

independent monetary policy, causing an accelerated rate

of emerging market currency appreciation. China is fol-

lowing the Nixon playbook step by step on controlling

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inflation, but one day when China loses control of one of their economic variables - currency, capital controls, etc. - they

will go bankrupt. Its the biggest capital misallocation on the planet, according to Napier. Amen.

Napier was the rare strategist at CFA Institutes 2009 Annual Conference who was uber-bullish on equities. Today, he

warns that the target for the developed world is to deleverage in a slow and deliberate measure, which means credit growth

must be below GDP growth for the foreseeable future, which means fewer idiots getting rich. Additionally, overheating

emerging economies are bad for equity markets as it feeds through to inflation in the developed world. Inflation becomes

a big problem for equities north of four percent, according to Russell. He suggests it may be important because this

is when the Fed thinks its important.

Either way, we have created an insti-

tutional bias to hold capital in certain

asset classes despite the opportunities(or lack thereof) that are present. The

Cyclically Adjusted Price to Earnings

ratio (CAPE) predicts poor long term

returns, as we have written at length,

but very few people have a holding

period greater than three years. Napier

explains that historic peaks in CAPE

have been driven by new economies

but are always unsustainable. In fact, up

until 1995, a CAPE above 23 was not

sustainable. We stand at 24 today.

Where We Stand

Napier attributes the past two decades of

overvaluation to massive distortions in

the treasury market as money and credit

targeting changed the outlook for asset

prices. He believes that The Great Reset

will structurally alter the demand for trea-

suries at the same time that the retirement

of baby boomers creates issues of over-

supply. While we agree on most points,

I think he is early on the Treasury call,like so many others as 95% of investors

surveyed are bond bearish today. Even

Napier admits that with everyones port-

folios aligned for inflation, we are likely to

see a massive deflationary shockfirst And by his own measures, QE has failed in generating money or credit growth.

James Grant advised that Deflation is too little income chasing too much debt. A symptom of this disorder is falling

prices. This is precisely where we stand today. On this point, we found ourselves agreeing with David Blanchflower, Pro-

fessor of Economics at Dartmouth and former member of the Bank of Englands Monetary Policy Committee. As he

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explained, deflation is the thing that kept us up at night. Inflation was the fix. Well, we certainly got what we asked for!

But those focused on rising commodity prices fail to see the lack of similarities between today and the price shocks of the

70s. There is no evidence of second round effects. Wage growth is benign around the world.

Unlike certain members of our Federal Reserve who are 100% certain that they can control inflation, Blanchflower

openly admits that one of the problems with economic forecasting is you dont know where youre going. But its worse

than that. He also informs us that, You dont know where you are and you dont know where youve been! With that

comforting thought in mind, we can see that tightening too soon will have severe implications and as such, Blanchflower

thinks the ECB has made another fundamental mistake. The scary part is that even though authorities around the world

continue to make very optimistic growth assumptions, the real worry is that inflation is expected to remain well below nor-

mal (even under rosy growth forecasts) and deflation is likely to accelerate when growth disappoints. Blanchflower admits

that QE is a blunt instrument, but its the only game in town. We really didnt understand how it would work. The pointwas to raise asset prices and depreciate the currency. We need a strategy for growth, rather than one for lack of growth.

Perhaps we could learn a thing or two from our friends in Nigeria.

Popular Delusions

Weve been fans of Dylan Grices Popular Delusions for years. The free-thinking SoGen strategist regularly provides the

French banks clients with provocative ideas for protecting portfolios from the proverbial black swans and the more fre-

quent, and slightly more predictable grey swans. Per Grice, he works with investors to help them understand things that

might happen, rather than making absolute predictions of what will happen, so he fully understands the shortcomings

of economic forecasting highlighted by Blanchflower. From an investment perspective, the key in leveraging these grey

swans is finding cheap ways to hedge against them in other words, those few scenarios where the market has mispriced

the odds of a certain event occurring and where intense, independent research can tilt the odds away from the house.

According to Grice, there are a few

characteristics which are common place

among inflations historically - public fi-

nances under pressure; a government

which has committed to a level of

spending they cannot afford; and cen-

tral banks which have relinquished in-

dependence. We may be looking at one

such occasion today, as the mere size of

Japanese government debt makes Eu-

ropesfiscal problems look more similar

to a college freshman struggling to pay

down his first MBNA credit card. Japa-

nese tax revenues no longer cover the

bare necessities, social security spend-

ing now represents more than half of

tax revenues and interest expense as a

share of tax revenues is roughly 30%.

Grice calculates that a rise in interest

rates toward a level more consistent with its developed world peers call it three percent - would eat up half of Japanese

Government revenues. Japan must ultimately see a transfer of wealth from the private sector to the public sector and the

easiest way to accomplish this is through inflation. For a politician, its the best way to pass on blame, mainly because

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there is no bad guy. For investors, the best protec-

tion against a Japanese hyperinflation may be long-term,

out-of-the-money call options on the Nikkei as all nomi-

nal assets are revalued higher with spiking interest rates.

The folks at Soc Gen suggest that ten year call options

on Nikkei at 40,000 cost roughly 4% so hedging 10%

of your portfolios notional value would cost roughly 4

bps annually. Not too shabby, considering the outlook

for the island nation (and the upside during previous hy-

perinflations i.e. Israel). Napier seems to agree saying,

The Japanese Government will go bankrupt one day.

But it will be on page two of the FT.

Wall Street Revalued

Global stock markets are overvalued by Grices pre-

ferred measures. But interesting enough, he finds Japa-

nese equities looking cheap, as the Shiller PE for the

Topix now stands at 16x. More qualitatively, it feels as

though the international investment community has

given up on Japan and the market is severely under-

owned. Andrew Smithers, the brilliant British econo-

mist would tend to agree on both counts. By his count(and our own), there have been 4 times in history the

US market has been this overpriced, although we are

not nearly as overpriced as 29 and 00. Investors would

be well served to remember that when markets finally

do come down to fair value (and they always do) they

come down fast, but dont always stop at fair value -

they often overshoot. Conversely, he sees a great deal

of virtues in Japan and finds it absurdly impossible

that Japan is not the cheapest market in the world selling around book value. Accordingly, Japan is very likely to be the

best performing market over the next decade, with little in the way of downside risk according to the London-based

market observer If a market trading at book, falls 20% it would look very cheap. If the US fell 50% no one should be

surprised.

In addition to his work on stock market valuations, Smithers is one of few that fully understands the impact that excessive

debt has on an economy. He, like us, believes that private sector debt is the fundamental problem of the US economy as

it has increased eight-fold since 1945 as economic policies encouraged debt accumulation rather than discouraged it. Ac-

cordingly, The stupidest thing we do in the world today is subsidize interest on debt. The second is to rely on people who

got you into the mess to get you out of it. Rather than relying on the bubble squad to repeatedly bail us out, Smithers

stresses the importance of leaning against bubbles before they get too dangerous, as the cost of clean-up is very high.

Instead, we should be trying to make asset prices go down slowly rather than pushing them higher. Sort of like hedgehogs

making love - very slowly and very carefully.

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Long bull markets in commodities are normal in history. Most have lasted 15 or 20 years. This one doesnt have to. Rogers

believes this one will likely run longer and will ultimately end in a bubble. He points out that weve had no major oil fields

discovered since the 60s. And since politicians now know they can be reelected by printing money, you should still own

real assets rather than paper assets because money printing will debase currencies even if the economy doesnt get better.

Consequently, one of the reasons hes long cotton is because thats what money is made of!! Ben is not an economist.

Hes a money printer. Todays commodity bull market is simply supply and demand, according to Rogers. The market was

underinvested during the 80s and 90s. The predictable result - all major oil supplies are in decline. We should be expanding

capacity a decade into this cycle, but in 2008-2009 capacity additions were shelved so this cycle may last longer than normal.

Rogers pointed to the forced liquidation in commodities due to AIG and Lehman bankruptcies, where commodities only

went down for five months. He viewed this as artificial selling leading the bull to quickly resume. Historically, weve had

long periods where finance types captained the world, followed by periods led by real producers of goods. In 1958 we

graduated 5000 MBAs. Now we graduate over 200,000. Rogers advice, Think about becoming a farmer. Im pretty surehe was serious. Interestingly, the average farmer in the states is 58 years old. In 10 years they will be 68. This is a problem.

Rising prices will create crisis in the next decade. He asked the audience if we knew anyone that has gone into farming.

Surrounded by farms in Western North Carolina, I resisted the embarrassment of raising my hand.

Bottom Line

When questioned about risk, Rogers responded, The biggest long term risk to China is their water supply. If China

doesnt solve this, there is no China. We were pleased to hear this long-standing bull at least admit that risks do exist

around the China-driven commodity demand theme. Yet, we are still left wondering just how large a part rampant credit

growth has played in this storyline (this is a good time to revisit our first two charts). Throughout history, fear of short-

ages have resulted in excess orders and further buying in anticipation of price increases and restrained supply, confirming

expectations and promoting even more buying . . . a vicious self-feeding cycle.

Today, this dynamic is complicated by the context of a long term deleveraging process, where falling prices may well reveal

falling demand. In the past, massive inventory buying has given way to production cuts and inventory liquidation. Only

time will tell, but we were certainly happy to learn that at least near term, Rogers positioning is in line with our own think-

ing. He is short emerging market equities today as the region has been overexploited by MBAs for years. He is long dollars

given the extreme bearish sentiment. He is not short bonds right now because 95% of investors are bearish and hes been

investing long enough to know that when 95% of investors are bearish on anything, its not a good idea to follow the herd.

We would go one step further and make the wild suggestion that bonds (even at these levels) offer investors an attractive

hedge against renewed deflationary pressures in light of the sentiment above and todays obsession with long term infla-

tion risks.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The authors opinions

are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice

or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of

any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not

guaranteed.

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the broyhill letter (q1-11)

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