April 15, 2015

To the Friends of Neosho Capital,

It was a very good quarter for European equities markets in general despite the ongoing wrangling between the
Eurozone and Greece over the Greek bailout package. European markets have responded positively to their
version of Quantitative Easing (a $1.2 trillion bond buying program). European QE at present seems to be
having the intended effect on the Euro and the European bond market: the currency has dumped 20% of its
value against the Dollar and an increasing number of Euro bonds, sovereign and private, have negative yields.
Whether Euro QE will translate to sustained economic growth and substantial job creation remains to be seen
and is the subject of our commentary this month.
Things werent quite as rosy in Brazil and Russia with their economies heavily dependent on oil, gas, metals,
and other commodities. With falling prices, both economies are forecast to have negative GDP growth in 2015.
Furthermore, the leaders of both countries are facing major political issues at home. Brazilian and Russian
equities have been punished, and we have remained cautious and conservative in valuing securities in those
markets. In keeping with our sensitivity to leverage, we are avoiding companies that took on cheap Dollar debt
over the past 2-4 years, but may now be facing rising debt service as a result of their home currencies being
devalued against the Dollar (i.e. more Reals/Rubles needed to service the same amount of Dollar debt).
Valuations in those markets look very inexpensive, and we will invest in Brazilian and Russian equities as long
as the business fundamentals can hold up in a challenging environment.
We wont get into the business of speculating on oil prices, but we do believe the ample evidence in tanker
rentals, storage tanks, and pipelines that there is no shortage of global oil. Softness in oil and gas prices for the
next year or would not surprise us. Wall Street analysts expect the United States may run out of storage space
for crude oil very shortly. Presently the US has roughly 471 million barrels of oil in inventory, the highest level
since 1930.
ECB NIRP and QE: The Charge of the Monetary Light Brigade
Last quarter we focused on Japans monetary banzai charge in its battle against deflation and low growth, so
it is only fitting that this quarter we turn our attention towards Europe and the adoption by the European Central
Bank (ECB) of a negative interest rate policy (NIRP) to go along with its planned $1.2 trillion of bond
purchases. 1 Spoiler Alert: in keeping with our view on Japanese monetary efforts, likewise we believe the
Europeans are well-meaning, but misguided, in their efforts to solve demographic, cultural, and political
problems with massive monetary manipulations of exchange rates and securities markets.
In June of 2014, ECB President Draghi formally initiated NIRP by announcing that the ECB would pay -0.10%
on particular kinds of deposits which the ECB accepts from its member banks. In essence, European banks that
had excess reserves will now pay for the privilege to park those funds at the central bank, the first such move by
any of the major central banks in history. Denmark and Sweden were the first to dip their toes into NIRP back
in the 2010 timeframe. A Danish banker likened dealing with negative rates as learning to drive a car
1

Admittedly, the actual Light Brigade that rode into the Valley of Death during the Crimean War was British, and since Britain is
not part of the European Monetary Union, the reference is, strictly speaking, incorrect. But, the two events share the same illconceived fate.
Neosho Capital LLC
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backwards. Indeed, there is even such a thing as negative mortgage interest home loans in Denmark, if the
concept of negative deposit rates was not enough to boggle the economic mind.
Draghi followed this move up in March of this year by initiating Quantitative Easing via monthly sovereign
bond purchases of 60 billion until at least September 2016 (18 months), or roughly $1.2 trillion in total bond
purchases. 2 The scale of European QE is about 1/3 the size of the Japanese effort and 1/4 the size of the Feds
QE program. Given this gap in scale, it must be Mr. Draghis hope that negative interest rates (now with a
lower bound of -0.20%) will somehow catalyze or magnify the impact of its significantly smaller QE bond
purchasing program.
The two charts below, tracking the 2 and 10year European and US bond yields tell the tale of the tape as far as
Europes NIRPd and QEd interest rates go. For the typical 2 year sovereign bond in Europe you can expect to
pay 25 basis points each year for the privilege of owning a Euro-denominated government bond versus earning
about 50 basis points per annum owning its US equivalent. If you extend your timeframe to 10 years, you will

receive a whopping 0.19% of interest annually over the coming decade. The compound return of such an
investment, before transaction costs, will be 1.9% for the entire ten year period. Meanwhile almost 10 times
that amount of interest is available for those willing to take the perilous trip across the Atlantic to buy10 year
US government bonds. We find neither investment particularly compelling.
It is safe to say that nominal interest rates (i.e. quoted and advertised rates) have never been lower in the US,
Europe (including its German, French, Italian, and Dutch antecedents), the UK, Switzerland, and Japan going
back to the dawn of reliable information on such things, which can be 1900, 1850, or 1800, depending on the
country in question. This is undoubtedly a pivotal moment in global financial history, one that any long-term
participant will mark as they do the record high US Treasury yields of 1981, the Crash of 1987, the Dot Com
Bubble Burst of 2001, and the Lehman Crisis of 2008/9. These 5 major currencies easily account for 75% plus
2

The exact nature of these purchases is, at present, a closely held secret, though anonymous sources report that the first round of
purchases in March 2015 involved the bonds of Germany, France, Belgium, Spain and Italy.
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of global trade and wealth. Yes, there have been times of equivalently low real interest rates (the nominal rate
less inflation), but they generally were brief shocks caused by wars or their aftermaths. At the very least it
can be said that 99% of financial professionals working today have never seen such widespread, persistent,
purposeful suppression of the interest rate mechanism. 3
The assumed linkage between elevated securities market valuations, suppressed interest rates, and sustainable,
broad-based wealth creation is, at present, a wish masquerading as economic theory. While the Fed has tapered
its own bond purchasing, the Japanese remain mid-stream and the Europeans are just getting started. No one has
run a full cycle of Quantitative Easing, i.e. actively begun to shrink their balance sheets.
The Japanese have been plying super low, though not negative, interest rate policies for the past 15 years, and
have recently combined it with massive quantitative easing involving bonds, stocks, and real estate. Yet,
Japanese inflation remains at 0.2% and economic growth remains around 1% year on year, despite these
monetary efforts, which should give some pause to those advocating ZIRP or NIRP as the solution to European
or US economic ills.
Regardless of our skepticism, it is undeniable that Draghis twin monetary efforts (NIRP and QE) have had a
large impact on European securities prices and interest rates during the first quarter of 2015. The immediate
effects of these super-suppressed interest rates are not hard to spot on the two charts below in terms of their
effects on Euro/Dollar exchange rate, as well as European stock exchange prices. Un-coincidentally, the
Euro/Dollar exchange rate fell by about 20% while the MSCI Europe (stocks) Index increased 22% off its
January low to just a couple points off its all-time Euro-phoric/Tech Bubble high of 139 from those heady days
of the Year 2000.

In our modest survey of modern financial history for this commentary, we believe 1948 would have been the last year in the United
States that Federal Reserve and Federal Government policy were oriented to such intense interest rate suppression. Warren Buffett
would only have been 18 at the time, while his more senior partner, Charlie Munger, would have been 24. We cant think of any other
currently active financial professionals who would have been plying their trade in 1948, but we chose 99% as a precaution.
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This rise in securities valuations has hit the Euro bond markets hard and it is estimated that $3.6 trillion of Euro
Sovereign Debt is now trading at negative yields, representing roughly 16% of the total market. And each week
brings more and more bonds into that negative realm because some investors are compelled to buy and bid up
these money-losing investments due to portfolio constraints, index tracking requirements, capital reserve
requirements, or the belief that bond prices can continue to rise. Negative yields are particularly prevalent in
German, Dutch, and Finnish bonds, accounting for 30% of all such bonds currently outstanding.
To what end do these central banks hope to bring their monetarily adventuresome ways? The hope is that by
discouraging excess reserves at banks and driving down safe haven (short duration, high credit quality) bond
yields into negative territory that the prospective pain from loss of principal (which is what a negative interest
rates make certain) or the gain from pathetically meager interest payments will cause those in the unfortunate
position of having savings move into higher risk assets.
This, in turn, is supposed to ultimately drive down unemployment in Southern Europe and increase overall
prosperity across the Eurozone. Economists call this the Wealth Effect. In a nutshell, the Wealth Effect
predicts that an increase in nominal wealth via stock and bond prices will increase the general feelings of wealth
in their holders, who will then spend their increased wealth, thus increasing aggregate demand, which leads to
more jobs, more growth, and all sorts of desirable outcomes ensue.
At Neosho, we call this the Underwear Gnomes Effect in honor of the animated television series South Park
1998 episode Gnomes. We will try to preserve some portion of this commentarys dignity by not going into
too many details about this insightful cartoon, but suffice it to say that it involves a mysterious process whereby
the Gnomes steal childrens underwear and turn a profit in this nefarious scheme, as is seen in this PowerPoint
slide from the Gnomes business plan:

Likewise, the leap from higher securities prices to long-term and sustainable EU prosperity also leaves a big, fat
question mark in the middle of the PowerPoint slide that Mr. Draghi undoubtedly uses in his ECB presentations.
And we are confused as to how this Wealth/Underwear Gnome Effect (if we assume the big, fat question mark
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goes away) differs from the oft-derided trickle down economics of the Reagan Era. Are these securities
profits not supposed to have the same effect as the tax cuts of 1982 and 1986 in the US?
We see the ECBs efforts as a well-intentioned (nobody else seems to be taking charge), but ultimately futile
attempt for two reasons: it is misguided, like trying to unscrew a bolt with a hammer, and, even if monetary
policy was the solution, the wrench chosen by the ECB would be woefully small.
First, the ECBs monetary policy does not, and cannot, address the core demographic, political, and cultural
issues which lie at the core of the EUs current economic and existential ills. Japans monetary policy is being
asked to solve a problem that cannot be solved with money, namely the depopulation of Japan thanks to low
birth rates and the effects of a restrictive immigration policy. Likewise, the ECBs efforts to buy its way out
of fundamental flaws in the regulatory and political structure of the EU and its constituent states, in addition to
language, cultural, and educational differences, cannot succeed because monetary policy has zero long-term
effect on those underlying problems.
For example, imagine the US Federal Government without the power of direct taxation, depending upon the
States to upstream the amounts it requests, and with ambiguous powers over those same States. In a nutshell,
that is the E.U. It is the same state of affairs that afflicted the Articles of Confederation when the former
American Colonies first broke away from the Crown: the central government had all sorts of responsibilities,
but no real way to fund the work. Or, imagine an unemployed oil worker from Texas who only speaks Spanish
pondering a move to Minnesota, where there are many more jobs, but where they only speak Swedish. Intra-EU
labor mobility is severely hampered, not just by this language barrier, but by cultural norms and expectations
built up over hundreds of years.
Negative interest rates and aggressive bond purchases will not solve such political and cultural issues. They
may temporarily drive down sovereign interest rates lightening the interest component of the southern
Europeans indebtedness, but the principal repayments remain in force and are massive. European stock prices
have jumped smartly in the first quarter of 2015, but can they deliver the earnings growth needed to justify the
higher multiples they now enjoy?
Second, even if monetary policy could somehow turn stolen underwear into profits, er, spur job creation and
general economic growth, the scale of the ECBs effort is inadequate and the attempt looks half-hearted. The
EU and the US have roughly equal-sized GDPs about $16 trillion each, while Japan is a $6 trillion economy.
The Fed purchased around $3.6 trillion of market securities, the Japanese are targeting $3 trillion, while the
ECB is aiming to buy about $1.2 trillion.
GDP
Japan
ECU
USA

$6 trillion
$16 trillion
$16 trillion

Peak
Current
Unemployment Unemployment
5.6%
3.4%
10.9%
9.7%
10.0%
5.5%

QE
$3.0 trillion
$1.2 trillion
$3.6 trillion

QE/GDP
50%
6%
23%

The scale of the ECB intervention is undoubtedly constrained by the Germans, who as the largest contributor to
the Euro kitty, are not very keen on printing money, or its monetary equivalents, given that bad experience
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they had back in the early 1930s with hyperinflation. Which only further goes to demonstrate the seemingly
intractable EU political problems pointed out in our prior paragraphs.
Regardless of the various central bank follies underway, we will continue to focus on the fundamental
valuations of all our holdings and prospective holdings, European and otherwise, as the primary guiding light
for our investment strategy. There is always trouble on the macro front, but that the key is to avoid the disasters
by selecting less leveraged, more attractively valued enterprises with good global or regional diversification. 4
Sincerely,

Neosho Capital LLC

Past performance is no guarantee of future results and there can be no assurance that the results presented herein can be
achieved. Actual performance for client accounts may be materially lower than the results shown. Information provided reflects
Neoshos views as of the date of this presentation. Such views are subject to change at any point without notice. Neosho obtained
some of the information provided herein from third party sources believed to be reliable but it is not guaranteed and we are not
responsible for the consequences of any decisions or actions taken as a result of information provided in this presentation and does not
warrant or guarantee the accuracy or completeness of the information requested or displayed.. Information contained herein is for
informational purposes only and should not be considered a recommendation to buy or sell any securities. Nothing presented herein is
or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein.
Neosho has not taken into account the investment objectives, financial situation or particular needs of any individual investor. There is
a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying
degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor's
financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and
cannot eliminate the risk of investment losses. Any forward looking statements or forecasts are based on assumptions and actual
results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts
when making any investment decision.
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