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COMMENTARY & PORTFOLIO STRATEGY

MAY 2011

M. Cullen Thompson, CFA

Managing Partner & Chief Investment Officer cullen.thompson@bienvillecapital.com

Adapted from a presentation to the CFA Society of Alabama on April 21, 2011, The Harbert Center, Birmingham, AL

INTRODUCTION
On behalf of Bienville Capital, I would first like to thank you for hosting me. Its a privilege to be among peers. Our firm always enjoys sharing our thoughts and ideas with friends in the industry, believing that doing so will make us better investors. In order to give you a little context for todays discussion, I would like to say a few words about our firms investment process. What is fairly unique relative to our peers in the investment advisory business is that one of the primary focuses at Bienville is on thematic, macroeconomic research. Contrary to common perception, we believe that macro is fundamental research. All of the issues we focus on revolve around fundamental, rather than technical considerations. The primary difference between some of the work we do versus that of a security analyst is that we are applying our analysis to the global economy, rather than specific businesses. For much of the past 30 years, macroeconomic considerations had taken a backseat in investors minds. We believe this was largely the result of the relative tranquility that sort of fell over the global economy beginning in the early 1980s. Nonetheless, given the vast imbalances alive today, an awareness of the macro will remain an essential variable in the investing equation. In fact, Investing in an Unbalanced World has become somewhat of a tagline at Bienville. Since were admittedly not very good at delivering the so-called elevator speech, we felt this at least suggestedto some degreewhat we attempt to do as an investment firm. Our process is both comprehensive and intense and involves a number of outside strategists, consultants, economists, as well as current and former policymakers. To the best of our abilities, we attempt to understand the major forces impacting the world, the potential outcomes, as well as the choices policymakers are faced with. We leverage as many relationships as possible, including the terrific work of many of our underlying investment managers. However, in full disclosure, with each passing year, we pay less attention to Wall Street research. From my perspective and certainly with

a few notable exceptionsStreet research increasingly resembles group-think, and as we all know, herd-like thinking offers little value-add in the investing arena. Our focus is on the big picturethe forest, not the trees. By contrast, organizations with a predominant focus on business risk, rather than investment excellence have a very difficult time being contrarian, as well as making difficult portfolio decisions, both necessary preconditions to successful investing. On the contrary, we deeply value many of our independent research providers. Much of their work will be reflected in this presentation. Today, we will be spending a few minutes on some of the key issues Bienville has been working on and discuss how we integrate them into our portfolios. Although each topic deserves its own distinct presentation, in the interest of time, I have tried my best to aggregate them into one. Our thematic views, which are constantly evolving, drive our capital allocation process, including asset class decisions, geographic preferences, as well as manager selection. Importantly, these views help determine the amount of risk we are willingly to take over the course of various periods. We allocate capital where we believe valuations are favorable and avoid areas where they are not. The Graham & Dodd in me would like to tell you we singularly define risk as the potential for permanent loss of capital, however, its important to note that our firm predominantly advises individuals and family offices. As the behavioral finance field has demonstrated, we allas investorstend to respond poorly to losses. As a result, our firm is cognizant of volatility. By reducing some of the volatility inherent in investing, we hope to minimize the opportunities to make poor decisions. As for security selection, we rely almost exclusively on external, value-oriented investment managers with an exceptional talent for identifying long (and sometimes short) opportunities within the equity or credit universe. I should also mention that we believe that this talent cannot be discerned from quantitative screens or Morningstar ratings. On the contrary, finding terrific managers is a labor intensive process that also requires a qualitative understanding of how a manager thinks and the investment philosophy that drives decision-making.

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For us, a prerequisite for consideration is an intense, fundamental approach and a concentrated portfolio. As the adage goes, we want our managers best ideas, not their 80th, 90th or 100th. Diversification is our job, not theirs. Ironically, and despite traveling across the country, and to a lesser extent, the world, Im pleased to say that two of our very talented equity managers are based here in BirminghamCook & Bynum and now Vulcan Value. We are grateful for the terrific work they are doing for us. Finally, although they may at times be profitable and even offer uncorrelated returns, we abstain from investing in quantitative, statistical or model-based strategies, particularly those that rely on leverage. The know what you own philosophy permeates our portfolios. By doing so, we sleep better at night. needed de-leveraging process to occur at a more digestible pace. Unfortunately, to date, no system-level deleveraging has occurred. If an analyst were to review the Federal Reserves Flow of Funds data, they would notice these two obvious and disturbing trends: first, the democratization of creditwhereby policy encouraged that credit should become easier and easier to come byand then secondly, the socialization of itthe process by which bad debts were subsequently transferred to the public sectors balance sheet. As of today, the very little debt reduction that has occurred at the household level has been overwhelmed by the vast additions to the public sector. For those who prefer metaphors, this is akin to shuffling deck chairs around. Yes, it will buy a cyclical recovery, as weve now witnessed. But as simple logic attests, you cannot solve a debt crisis with more debt. All weve really done is delayed the necessary adjustments. Can this credit pyramiding last? Irving Fisher, the 20th century authoritarian on debt deflations, taught us that major disturbances in economic cycles occur from too much debt relative to the size of the economy. And as logic would suggest, there are limitations to governments backstopping the private sector. Peter Bernholz, in his seminal book, Monetary Regimes and Inflation, has demonstrated that deficit-to-expenditure ratios in excess of 40 percent (combined with monetization by the central bank) have historically led to high and hyper-inflations. Recently, the US crossed this alarming threshold. From Bernholzs analysis, two especially noteworthy facts resonated: first, all hyperinflations in history have occurred since 1914, which coincides with the global movement towards discretionary monetary standards; and secondly, all were caused by the financing of huge public deficits through money creation by the central bank. 1 Therefore, it should not be taken lightly that the Fed is now the largest owner of outstanding Treasuries or that, thanks to QE2, it has purchased over 70 percent of recent supply. Unfortunately, the marginal benefit of all this debt is now negligible, which is not at all surprising considering the economy is already saturated with it. In fact, whereas between 1953 and 1984 each unit of additional debt generated 63 cents of economic growth, today each new dollar of debt contributes only 7 cents to GDP. This concept has been confirmed by Kenneth Rogoff and Carmen Reinhart who have demonstrated that once an economys debt-to-GDP reaches 90 percent, growth noticeably suffers. Other academics, such as Robert Barro have also argued that once debt ratios surpass 60 percent, the government spending multiplier turns negative, meaning that rather than contributing positively to economic growth, additional deficit spending
One exception was France during the Revolution of 1789-96 when convertibility was suspended. Bernholz definition of hyperinflation is a rate of inflation of 50 percent per month
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THE U.S. - A FISCAL TRAP?


To start, we ask the question, is the United States in a fiscal trap? I should first mention that this is neither a simple hypothetical question nor intended to be a statement of fact, but rather a possibility that we think intensely about. But before attempting to answer it, we first need to back up a bit. A little background is warranted. At the turn of the 21st century, private sector debt was growing at a fast pacein fact, much faster than nominal GDP growth. And specifically, the household sector was leveraging up at a rapid rate. In fact, between 2003 and 2005a period spanning just three yearsmore mortgage debt was accumulated in the United States than in the previous two hundred. Wall Street, the intermediary of all this debt creation, boomed, as did the assets bought with it. But not surprisingly, with the collapse in prices and the onset of the financial crisis, this household leveraging came to an abrupt end. Deleveraging was to be expected, so we were all told. But as we now know, this is not how the narrative played out. As has been the case over the past few decades, just as the economy reached the point of a necessary creative destruction process, the authorities intervened. Banks were determined too big to fail and stimulus was called upon to underpin the level of demand in the US economy. Levered speculators, by and large, were saved. Of course, fiscal stimulus simply transfers resources from over-levered and credit-constrained borrowers to the creditworthy sovereign. According to academic theory, this makes sense. Governments of triple-A rated countries can borrow at lower interest rates than households, which allows for the

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detracts from it. Although many of the technocrats in Washington dont appear to fully comprehend this concept, the private sector doesseeing bourgeoning deficits, the business owner envisions higher taxes and less economic stability. Confidence deteriorates and investment and hiring understandably suffers. Now, much attention is given to where we standthat is, the current fiscal deficit and outstanding stock of debt. Currently, the Congress is haggling over raising the existing debt ceiling. However, less focus goes into how difficult it will be to get the governments finances back to more normal and sustainable levels. To provide some perspective on the magnitude of the necessary adjustments, in order to restore the governments debt ratio to pre-crisis-levels by the year 2020, a change in the primary budget balance of nearly 12 percent of GDP is requiredthat is, from its current 10 percent deficit to a 2 percent surplus. Unfortunately, Congress track record in balancing the nations books is not particularly good. In the last 50 years, it has occurred only 5 times. Regardless, the amount of fiscal consolidation would be simply politically and socially untenable. Ireland has implemented vicious austerity, and as a result, its GDP has fallen by 25 percent. For comparisons sake, the peak-to-trough decline of the US economy during the recent crisis was 4 percent. A Congressman from Texas once remarked that weve become a nation of financial hypochondriacs. Ill let you decide. So we all recognize things are bad. But everyone wants to know, how do we get out of this mess? Unfortunately, were not quite sure. What is certain, however, is it wont be easy. It never is once an intertwined mess has been created. To illustrate the difficulty, consider the budget deficits between now and 2019 as estimated by the Congressional Budget Office. The annual red ink is projected to add an additional $9 trillion of government debt to the $14 trillionplus already outstanding. Of course, with debt comes a costin the form of interest expensewhich thanks to the maneuverings of the Federal Reserve is artificially depressed at the moment. Nonetheless, at some point the Feds zerointerest rate policy and large-scale asset purchases must end, paving the way for interest rates on Treasuries to rise, and along with them, interest expense. As you can imagine, off-setting some of the increased interest expense will be some cuts in spending. However, even after accounting for decreases in spending, and using the CBOs optimistic expectations for economic growth and only modest increases in interest rates, the net result is higher deficits. If rates were to rise to their historical normsa more onerous scenario versus the CBOsthe situation is even more explosive. The all-important point is, in almost every conceivable scenario, the net result appears to be higher deficits. We simply cant reduce spending fast enough without risking a collapse in the economy to offset the inevitable increased costs related to our rising debt. This is the potential fiscal trap, which leads us to wonder, can the Fed ever leave its current zero-interest rate policy (i.e. ZIRP, or the Zero Lower Bound)? Kyle Bass of Hayman Capital Management, the highly resourceful Dallas-based hedge fund, has described the process more directly: When a heavily indebted nation pursues the ZLB to avoid painful restructuring within its debt markets, the ZLB facilitates a pursuit of aggressive Keynesianism that only perpetuates the reliance on ZIRP. In other words, ZIRP is an inescapable trap. Low rates resulting from Fed policy encourages more spending and accumulation of debt, which in turn requires low interest rates in order to ultimately service it. The bond market, which historically has served as a warning indicator to free-spending politicians, is currently overshadowed by the giant, non-economic agent in the room (i.e. the Feds Treasury purchases). 2 With complex situations, examples are often helpful. In this case, Japan is the most proximate one. With its stock of debt now approaching one quadrillion yen, interest expense alone constitutes 25 percent of revenues, despite having the lowest average cost of capital in world. If rates were to rise to levels as low as 4.0 percent, interest expense will consume all of their tax revenues. Japans outstanding stock of debt is so large that every 1 percent increase of their weighted average cost of capital nearly equals 10 trillion yen in additional interest expense. Yet, the central government only collects around 40 trillion yen in tax revenues. After paying interest expense and escalating Social Security expenditures, the Ministry of Finance hardly has any revenues left over to fund the rest of the government, much less roll over maturing debt. To do so, they rely on borrowing. So what can be done? To reduce large public debt burdens, in general, policymakers can: Cut spending, but not too forcefully or domestic demand and tax revenues will plummet, exacerbating the situation Implement supply-side reforms, which theoretically unleash GDP growth (and tax revenues) in excess of the rise in interest expense. This, of course, was the template of the Reagan administration. Unfortunately, for a number of reasons, it cannot be repeated
The Fed is a non-economic agent because the purpose of its Treasury purchase program is not to earn a profit on its holdings, but rather to manipulate interest rates
2

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However, policymakers cannot: Significantly increase the tax share of GDP. Despite varying marginal tax rates, tax revenues have never exceeded 20% of GDP Excessively tax the rich, which in reality may raise around $100 billion (in the context of a $3.8 trillion budget). In todays world, capital can move and wealthy individuals and corporations have proven to be very good at avoiding taxes. It recently came to light that GEs effective tax rate is 3%, a real life example of imagination at work Target inflation explicitlyexplicitly being the operative word. Higher inflation would increase interest expense, as well as rollover risk for the Treasurys maturing debt. We recently learned from a senior official that the Treasury Department has been lengthening the average maturity of the countrys debt at the fastest rate in history. However, it still remains only 59 months one of the shortest maturity profiles in the developed worldsubjecting the government to considerable rollover risk In our opinion, whats likely to happen is a combination of a few things: first, some cuts in spending. The Tea Party members are demanding it. Secondly, we will have inflation, but as much as possible will be in stealth form. Everyone in this room is aware of the absurd subjectivity of the CPI numbers. Thirdly, in a maneuver as equally, if not more pernicious than inflation, we will likely see various forms of financial repression, or forced measures to ensure the governments interest rates remain low. Financial repression has been a topic of discussion within Bienville for some time. Quite simply, financial repression can come in many varieties, including the forced buying of Treasuries by pension funds, explicit interest rate caps, laws deeming it illegal to hold gold for investment purposes, as well as the introduction of capital controls to prevent money from moving offshore. I should note that all of these have occurred before either in the US or in other developed markets. If 2008 taught us anything, it is to never underestimate the will of government. Remember, less than three years ago, short-selling was banned. policies pursued by both are of critical importance. In order to explain why, allow me to first quickly revert back to the U.S. economy, specifically how money flows through its various sectors. What Im going to describe is a fairly simple equation, yet it can be highly illuminating, providing insight into how the world may be able to successfully rebalance. The equation is the national accounting identity. Now, bear in mind, what Im referring to is not some arcane, abstract economic theory but rather an accounting reality. Within every country, there are three sectors: 1) the public sector, 2) the private sector, including households and businesses, and finally, 3) the foreign account, which is essentially the inverse of the current, or trade, account. Importantly, the flows among the sectors must sum to zero. Similar to the childhood game of hot potato, money can be shuffled around, but it cannot leave the circle. Therefore, as Charles Dumas of Lombard Street Research often remarks, one sectors financial balance cannot be viewed in isolation as its effects will be felt elsewhere. Sectoral balancesthat is, how much a sector borrows or saves represents a flow over time. Contrarily, outstanding balances represent how much a sector owes, and therefore represents a stock at a given moment in time. For example, the US governments gross debt-to-GDP is currently approaching 100 percent. This is the stock of debt. Presently, and using round numbers, the government sector is in deficit to the tune of 10 percent of GDP, representing an annual negative flow. 3 Secondly, the private sector is running a 7 percent surplus, the result of balance sheet repair by households and restraint by businesses. In conjunction, the net savings rate of the country as a whole is negative. To compensate, we have the foreign accountthe absolute value of the current account which stands at around 3 percent of GDP, indicating that the United States is importing capital from abroad. CURRENT U.S. SECTOR BALANCES
Public -10.0 + + Private 7.0 + + Foreign 3.0 = = 0 0

CHINAS DANGEROUS GAME


Despite the problems domestically, I believe China is the chief flash point in the global economy, representing a possible source for unanticipated, systemic risk. As we will discuss, because of the way the world is currently organized, the US and Chinese economies are inextricably linked. Therefore, the

Whats notable from the formula above is that both the private and foreign sectors are currently funding the US government. But importantly, the public sector cannot run deficits of 10 percent in perpetuity. Similar to the household sector, it must also delever, shrinking its annual deficit. But as the math demonstrates, both the private sector and public sector cannot delever at the same time without the current account moving

The public sector includes the federal government, as well as state and localities. However, because states and localities are required to balance their budgets, the effect here is negligible
3

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from deficit to surplus, a scenario that has not occurred in over 30 years. Now, in order to paint a picture of a more sustainable situation, imagine that the public sector reduces its deficit to 3 percent of GDP, which is in line with the CBOs expectations and sufficient to theoretically stabilize debt ratios at current levels. Next, according to Lombard Street, a more normal private sector surplus is around 4 percent, which is the combination of a 3 percent surplus for households and 1 percent for businesses, keeping in mind that businesses are not formed to be savings vehicles. Again, because the sectoral flows must equal zero, the rigidity of the math requires that the current account moves toward a surplus. This is where China enters the equation. SUSTAINABLE SECTOR BALANCES
Public -3.0 + + Private 4.0 + + Foreign -1.0 = = 0 0

while the later would diminish the Partys coveted control over the banking system. So Chinas economy remains deeply imbalanced. Their growth model is also not sustainable, which simple math can illustrate. And were not the only ones who think so. Just last fall, Premier Wen Jiabao confessed that China lacks balance, coordination and sustainable economic development. Ironically, however, policymakers in China have been promising a rebalancing towards a more consumption-oriented model for years. But given todays precarious structure, I cant emphasize enough the difficulty of this transition. Consumption simply cannot rise fast enough to offset the necessary fall in investment in order to sustain the current rates of growth. So as long as China resists a significant appreciation of the yuan, the US cannot rebalance to more sustainable trends. This is precisely why China, and the policies it incorporates, remains at the center of the global economy. Rather than allowing the world to heal, Chinas currency peg is leading to another crisis. If economics cannot resolve it, politics is ultimately likely to. Finally, as for the question of a property bubble: anecdotally, a consultant in Beijing recently informed us that his landlord is attempting to sell his apartment for 70x gross annual rental income. The down-payment alone would cost him 23 years of rent. Rest assured, he is not bidding.

Because of the existing currency regime in China, specifically the yuan-dollar peg orchestrated in Beijing, the necessary rebalancing of the US economy, as well as the global economy, cannot happen. In order for the current account to move to surplus, the US would need both lower imports and higher exports. For that to occur Chinas exchange rate needs to appreciate considerably, which to date, there has been no tolerance for. In fact, China has become increasingly addicted to both exports and more recently, fixed asset investment (i.e. the building of infrastructure-related projects) in order to drive economic growth. Consumption, by contrast, has fallen as a share of the overall economy for 20 years now. Beginning in 2009, China unleashed a stimulus package of an astronomical scale. Although the direction was intended, the magnitude was not. Local government officials in China saw an opportunity of essentially free reign to build anything they wanted under the express intention of engineering growth. By doing so, they also enriched themselves. The result has been higher inflation. Yet policymakers have yet to fully understand the problem. Most solely blame QE2 while dismissing the 55 percent increase in the Chinese money supply over the past two years. To combat it, theyve resorted to liquidity measures and quantitative credit controls, which are having significant distorting effects on the private sector. Our sources relay to us there is simply no appetite for allowing the currency to appreciate a meaningful amount or to loosen capital controls. The former would hinder the export sector

INFLATION IS IT COMING?
The Bank can never go broke. If the Bank runs out of money, the Banker may issue as much as needed by writing on ordinary paper. - Monopoly, Official Game Rules Before quickly diving into the inflation debate, I think its necessary to first properly define it. Inflation is not too much money chasing too few goods, as its so commonly described. Inflation is simply too much money. Its a monetary phenomenon, just as Milton Friedman said so. As a consequence of the expansion of the currency, prices invariably rise. So inflation is currency debasement. It erodes purchasing power. Rising prices are a symptom of the disease, not the disease itself. One other thing to keep in mind is that while inflation usually refers to the increase in the amount of actual dollars in circulation, we should not constrain our definition to physical money. The expansion of credit counts too. So in essence, anything that artificially increases aggregate demand for goods and services is inflation. Too much money can cause differing outcomes, including higher consumer prices, stock market booms, real estate bubbles and commodity price spikes. Although rising consumer prices are
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troublesome enoughits a tax for which the public has no representationas weve learned twice now in the past decade, asset price inflation can be far more dangerous. Thats because not only are resources grossly misallocated, but artificially inflated assets are often bought with leverage, which comes with its own cost. As we will see shortly, inflation can also temporarily hide in excessive productive capacity around the globe. For these reasons, its too simplistic to singularly focus on the CPI as a measure of inflation, irrespective of policymakers desire for us to. For the better part of 50 years, one way or another, weve been printing too much money. In the 70s, the inflation appeared in consumer and commodity prices, culminating in the Great Inflation. But by the early 80s, a determined Federal Reserve Chairman hiked the policy rate to 20 percent. As a result, prices fell. Along with it came interest rates. Lower rates resulted in a lower cost of capital and therefore increasing profits for businesses, which in turn encouraged more investment in capacity. A virtuous cycled unfolded. The global supply curve was pushed out to the right. Regulatory burdens declined, globalization picked up its pace and supply chains became more streamlined. It was the Great Moderation, a truly serendipitous set of economic circumstances. Nonetheless, there was still too much moneythat is, if you were to consider the growth in total credit market debt, where money was being created outside the purview of the published money supply figures and deployed into factories around the world. To understand how consumer prices can fall despite excessive money growth, consider the following framework as described by Frank Byrd of Fielder Capital Management: if the amount of money in circulation doubled, holding supply and demand constant, prices should double. Thered be twice the money chasing the same quantity of goods. But what if the money supply doubled and the quantity of goods also doubled? Holding demand constant, thered be no price inflation. In Franks opinion, this is essentially what happened since 1982. Money supply grew dramatically, but production capacity far outgrew consumption, so much so that it largely anesthetized consumer prices from the currency inflation. How does this relate to today? Supplyor capacityis abundant while demand is being underpinned by government transfer payments. Because demand has been temporarily stabilized, albeit at an artificial level, some of the excess global supply has yet to come off-line. But eventually, some of it will be permanently shut. Protectionist rhetoric, high oil prices and geopolitical uprisings only exacerbate this process. The shuttering of this excess supplya magnificent disinflationary force over the yearswill be inflationary. To date, central bankers appear to be paying scant attention to the shrinking supply side of the equation. As an example, consider the employment picture. Common perception is that high unemployment implies excess slack in the labor force. Therefore, workers have no pricing power, supposedly inhibiting the potential of a wage price spiral. But this simple analysis overlooks two considerations. First, the workforce in the United States is becoming increasingly segmented by educational achievement. For those with college degrees, the unemployment rate is relatively low while participation rates are high, creating the potential for bottlenecks to occur in the labor market despite the overall high levels of unemployment. Secondly, for the first time in its history, the US workforce has mobilization issues. Imagine a viable candidate for a job opportunity in Texas who is currently 25 percent underwater on his mortgage in Arizona. He cannot move. Hes stuck collecting unemployment benefitsfor 99 weeks at least. Therefore, the theoretical supply of labor quality in Texas is less than the past, which again, increases the risk of bottlenecks. NAIRUor the non-accelerating rate of unemploymentcould be much higher today than what the Feds models are currently estimating. These issues are indeed structural. They cannot be resolved by countercyclical policy and excessive monetary stimulus. But employment is one of the Feds mandates and todays high levels are providing cover for their current stance. Sources tell us that Bernanke is deeply affected by the levels of unemployment and at the height of the financial crisis quietly begged for fiscal stimulus so that the burden of reflating the economy didnt fall solely on the his shoulders. When looking at the numbers, its easy to understand why. Today US nonfarm payrolls stand at a little over 130 million, a level first reached at the end of 1999. So in over a decade, the US economy has created zero net new nonfarm payroll jobs. Yes, this is hard to believe. But its true. As the population has continued to grow, the employment-topopulation ratio has dramatically deteriorated. And while the BLS has ample latitude to tinker with the official unemployment figures, the employment-to-population ratio cannot be manipulated. This is precisely what makes it a useful, unbiased measure for whats actually occurring in the labor market. Yet as we once again approach the Congressional debt limit, austerity is supplanting fiscal spending as the theme of the day, encouraging the Fed to continue its stimulative stance. So in an attempt to alleviate the troubles with labor, the Fed has, once

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again, set the price of money far too low. Unfortunately, we dont seem to have learned the lessons of the past. As you can see, whenever the Feds main policy ratethe federal funds rateis held below nominal GDP growth for prolonged periods of time, bad things inevitably happen.
Federal Funds Rate less Nominal GDP (in %)
20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 Mar-71 Mar-74 Mar-77 Mar-80 Mar-83 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Mar-07 Mar-10

Source: Bloomberg

become more elastic. Similar to an accordion, it should both expand and contract consistent with the needs of the economy. The Federal Reserve was born to facilitate this process. But unfortunately, with the modern Fed, the supply of money only expands. With the de-linking from gold in 1971, dollar-holders lost an important governor on the central bank. As a result, we now live in the age of inflation. As we gather here today, central banks around the world employ thousands of economists to assist in their desire to command the complex, inter-related global economy. But despite their increased payroll, their output has only gotten worse. Charles Kindleberger, is his classic Manias, Panics and Crashes, remarked that the years since the early 1970s are unprecedented in terms of volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises. In the fall of 2010, to assist in their determination to boost the US economy, and without Congressional approval, our monetary authorities appeared to have voluntarily added a third mandate to their institutions missionthe price level of the S&P 500. Historically, equity markets served as a quasi-barometer of economic growth. Today they are a policy tool. And to be perfectly candid, this is a frightening concept for a prudent allocator of capital. If equity prices are a disproportionate part of the economic equation, when does a small correction, ordinarily a potential buying opportunity, become a self-fulfilling crisis? So as you can imagine, we dont have a great deal of confidence in central bankers. The fact is were too familiar with their track records. Taking the punch bowl away is not their strong suit. And given their current outsized balance sheets, the margin for error is wider than ever. To be clear, its not that we believe them to be bad people. Its just that they are human and therefore fallible. They operate under the pretense of control, yet reality proves time and again that no one knows what will happen next. Control is an illusion. The Fed has no more ability to see into the future than you or I, yet they set the price of money and command economies as if they possess perfect foresight. At present, the global economy is growing, inflation expectations are climbing and commodity prices are booming. Yet the Feds main policy rate is at zero and its balance sheet at all-time highs. I should note that no mandead or alivehas ever managed a balance sheet the size of the Feds today. And importantly, none of the voting FOMC memberseven those adamantly opposed of the institutions actionshave ever faced a rising inflationary environment. When the Great Inflation kicked into high gear in 1973, Bernanke was a 20-year old sophomore at Harvard. So if youre still wondering which way the cards will fall in the inflation versus deflation debate, consider the following. The Fed
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When money is underpriced, resources are misallocated. Since 1971, following the de-linking of the US dollar from gold, the Fed has habitually made this error. The result was high inflation in the 70s, followed by an equity market bubble in the late 90s and a real estate bubble in the mid-2000s. Today, stocks and bonds are once again rising, commodity and food prices are going gangbusters and revolutions are popping up all across the Middle East and Africa. How will it end this time? Oddly, many of the representatives at the Fed jump at the opportunity to take credit for the rise in equity prices yet refuse to accept responsibility for the concomitant increases in commodity prices. I say oddly because both show an uncannyand some would say unmistakable correlation to the money supply. Core inflation, the most lagging of all economic measures, is rising too, as are inflation expectations. Other indicators, such as the ECRI Future Inflation Index and the MIT Billion Price Index are climbing as well. And given the recent performance of the US dollar, even relative to the currencies of very troubled regions and countries (i.e. Europe, UK and Japan), its clear that confidence in the worlds reserve currency is waning. As confidence falls, velocity accelerates. A reflection of the previous 30 years may provide some indication why. Beginning with the Chairmanship of Alan Greenspan, the Fed has responded to every crisis, not matter how big or small, with the same prescriptionby lowering rates and providing additional liquidity. The result has been serial booms and busts in asset and commodity prices. In the olden days, central bankers were expected to protect the value of the currency. Following the banking crisis of 1907, the political elite decided that the money supply should

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believes they have the tools to manage inflation, but not a debt deflation. Thats a good place to start. Secondly, Bernanke has told all of us, repeatedly, that deflation would not happen here. We believe him. labor costs in China are rising by double-digits while declining in the US, evening the playing field some. We believe that inflationwhen properly definedis already here. For evidence, look no further than the Feds balance sheet, which has risen from around 5% of GDP to approximately 20%. Interestingly, it took the Fed 95 years from its inception in 1913 to September 2008 to expand its balance sheet from zero to $1 trillion. Over the next 45 days, they added another trillion. With QE2 were heading towards $3 trillion. We are in unchartered territory. I believe we are in the early stages of a period of considerable monetary instability. If you could monetize the credibility of the Federal Reserve, we would be short it. Instead, were long gold a lot of it to be slightly more precise. The perfunctory 5 percent allocation recommended by more-sanguine advisors doesnt cut it in our opinion. Five percent is an after-thought. Its checking the box, not protection. Had you randomly polled Americans just five or so years ago, you would have discovered that most were largely uninformed about the nations finances. In fact, the vast majority believed that we were the worlds largest creditor nation, rather than historys greatest debtor. I recall this vividly because Washingtons fiscal mismanagement was as much of a source of frustration for me then as it is now. By contrast today, the average American is knowledgeableand irate. Its front page news. And they understand how the burden of future debt affects them. By the same token, I believe most of us remain relatively unaware of the history of money, what money really means and specifically, the distorting actions of central banks. The subject is complicated and Americans are busy. For the past 30 years or so, theyve lacked a need or desire to concern themselves with monetary policy. Its boring and confusing to most. But the reality is, as a nation, we have regressed in terms of our understanding of money. I believe this will soon change. I believe society will soon once again think about what money is and demand the stability of it. This discovery process is unlikely to bode well for todays paper version. We will also learn that central bankers are not bankers at all. They are central planners. And we will come to understand that you cannot increase the quantity of money while also protecting the quality of it. Money is unique. Unlike other items, abundant supply is not a good thing. Murray Rothbard, the famed but far too-often-forgotten free-market economist, once remarked that once money is established, an increase in its supply offers no social benefit. The fact is, since 1880, or the end of the Civil War, monetary regimes have lasted about a generation. Our current regimein
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CONCLUSION
The global economy remains deeply imbalanced. Presently, the worlds 2nd, 3rd and 4th largest economies (China, Japan and Germany) remain intent on maintaining large, annual trade surpluses, partially supported through both apparent and subtle exchange rate manipulation. But its important to note that a trade surplus is nothing more than a deficiency of domestic demand. Therefore, surplus countries rely on excessive spendingand the resultant current account deficitsby the likes of the US, UK and Spain. This was always going to end poorly, and sure enough, it did. The buyers of first and last resort no longer have the balance sheet or borrowing capacity to continue spending excessively. So in a way, the financial crisis marked the end of the exportfocused growth model that many countries have relied on for five decades. Going forward, a crucial determinant of the outcome will be who the adjustments are forced upon. The surplus countries must accept some responsibility and reorient their economies more towards domestic demand. Otherwise, it will end badly for everyone. On a more granular level, the US is in a precarious fiscal position. All hope is not lost, but the adjustments will be more difficult from here. Fiscal consolidation is a necessity. Either we will have it, or we wont. In the latter case, policymakers risk a collapse in confidence in the US dollar. Winston Churchill once remarked that the Americans will always do the right thingafter theyve exhausted all the alternatives. We believe that Chinas growth model is unsustainable and as a result, were anticipating either a soft or hard landing. Both would likely have considerable knock-on effects to risk assets in general and industrial commodities in particular. China consumes close to 40 percent of the worlds industrial and base metals production, nearly a quarter of soybeans and close to 20 percent of wheat and corn output. A rebalancing of the Chinese economy is, however, the optimistic way out of this global mess. But again, it implies lower Chinese economic growth in the near term, which we believe there is little tolerance for. A side affect of QE is its helping to accomplish the needed rebalancing by creating inflation in China, raising its real effective exchange rate. Unit

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existence for not quite 40 yearsis arguably the worst. It has allowed profound imbalances to build. Today the US dollar is backed only by the political goodwill of the Fed and Congress. Yet each day they endeavor to debase it. For that reason alone, todays regime is more inflation prone than any of the past. Finally, we should all recognize that man has not solved the business cycle. It remains an inherent part of capitalism. Therefore, in the next few years, there will be another recession. But notably, this reality is not modeled in projections of our governments finances. The CBO assumes tax revenues will climb in a consistent, linear fashion between now and 2020. So when that inevitable day comes, will policymakers do the right thing? As demonstrated in the last crisis, it is governments that bail out banks. But who bails out governments? In May 2010, as the Greek sovereign crisis unfolded, Jean Claude Junker, the prime minister of Luxembourg commented that We all know what to do, but we dont know how to get re-elected once we have done it. This doesnt inspire a great deal of confidence. almost certainly, more monetary stimulus. sure QE ends anytime in the near future. In fact, were not

Within our various portfolios, we are able to reduce net exposure through hedged strategies (e.g. long-short) as well as overlaying individual protection when its attractive. This is not easy however and does come with a cost in rising markets. Were trying to avoid action biasthe desire to do something at all timesin order to wait for better opportunities. This requires patience on both our part, as well as our investors. Patience, however, is in short supply when markets are rising. Nonetheless, we believe this strategy will prove correct. Its important to remember that just because we dont know when something will happen, doesnt mean it wont. The potential fat tail scenarios are very real, which at times can present attractive, asymmetric opportunities. We maintain substantial exposure to gold, which is one of the longest holdings of Bienville clients. We acknowledge that gold yields nothing and is speculative by nature. But the same argument can be made of paper money. The critical difference is that gold has retained its value for 2,500 years. No paper currency has. Yes, the price of gold has risen. If that fact alone concerns you, I encourage you to chart the monetary base. Surprisingly to many, since the Nixon shock in August 1971, which moved us to a fully-discretionary paper money regime, gold has outperformed the Dow Jones Industrial Average. This is not a suggestive statement on the acuity of corporate managements, but rather a reflection of the degree of debasement by the dollars overseers. Gold, as James Grant has said, is the reciprocal of faith in monetary arrangements. Today faith is declining. Therefore gold is rising. Finally, we remained concerned about pie chart (i.e. 60/40) portfolios and the propensity to emphasize style boxes, both of which are antiquated thinking in a new reality. Personally, I shudder to think of the damage that would be done to pie chart portfolios if the CPI unexpectedly sprang to life, taking interest rates with it. I think its safe to say that it wouldnt be pretty. Overall, in the ensuing years, we believe flexibility will be an absolute necessity, but it requires difficult decisions and exposes investment firms to business risk. Few organizations can stomach either. But as PIMCOs Bill Gross suggested in 2008, investing is no longer childs play.

IMPLICATIONS FOR INVESTING


Our focus at Bienville has been, and will continue to remain on more flexible, unconstrained and skill-based strategies. Reminiscent of the early stages of the mortgage crisis, we dont believe the risks present today are fully acknowledged. Within the equity space, many great businesses appear to be trading at fair, and in some cases, inexpensive prices. On the contrary, among lower capitalization and more-speculative companies, we have just witnessed the greatest junk rally since 1932. As a result, we are avoiding direct allocations to small cap equities. While this has been a detractor of performance, we believe it to be prudent from a risk perspective. If our macro view is correct, smaller companies will suffer disproportionately to the downside. We particularly like more event-driven situations, which are less correlated to the broad market. From a risk-return perspective, its one of the areas where we get excited about allocating capital. Unfortunately for some investors, these strategies are harder to access. With respect to fixed income, although we anticipated and positioned for the deflation theme following the crisis, we no longer believe the risk-reward is compelling. If economic growth falters, driving interest rates lower, we are only likely to witness more fiscal stimulus (or delayed austerity) and

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COMMENTARY & PORTFOLIO STRATEGY


ABOUT BIENVILLE
Bienville Capital Management, LLC is a research-focused, SEC-registered investment advisory firm offering sophisticated and customized investment solutions to highnet-worth individuals, family offices and institutional investors. The members of the Bienville team have broad and complimentary expertise in the investment business, including over 100 years of collective experience in private wealth management, institutional investment management, trading, investment banking and private equity. Bienville has established a performance-driven culture focused on delivering exceptional advice and service. We communicate candidly and frequently with our clients in order to articulate our views. Bienville Capital Management, LLC has offices in New York, NY and Mobile, AL. This document contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. The views expressed here are the current opinions of the author and not necessarily those of Bienville Capital Management. The authors opinions are subject to change without notice. There is no guarantee that the views and opinions expressed in this document will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Past performance may not be indicative of future results and the performance of a specific individual client account may vary substantially from the foregoing general performance results. Therefore, no current or prospective client should assume that future performance will be profitable or equal the foregoing results. Furthermore, different types of investments and management styles involve varying degrees of risk and there can be no assurance that any investment or investment style will be profitable. This document is not intended to be, nor should it be construed or used as, an offer to sell or a solicitation of any offer to buy securities of Bienville Capital Partners, LP. No offer or solicitation may be made prior to the delivery of the Confidential Private Offering Memorandum of the Fund. Securities of the Fund shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. For additional information about Bienville, including fees and services, please see our disclosure statement as set forth on Form ADV.

DISCLAIMERS
Bienville Capital Management, LLC. (Bienville) is an SEC registered investment adviser with its principal place of business in the State of New York. Bienville and its representatives are in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which Bienville maintains clients. Bienville may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This document is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Bienville with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Bienville, please contact Bienville or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). This document is confidential, intended only for the person to whom it has been provided, and under no circumstance may be shown, transmitted or otherwise provided to any person other than the authorized recipient. While all information in this document is believed to be accurate, the General Partner makes no express warranty as to its completeness or accuracy and is not responsible for errors in the document.

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