June 2012 - Richard 'Jerry' Haworth: The believer is happy; the doubter is wise

At the core of the macro arguments today are the assumptions that governments can make a difference in the GDP level of a country either by monetary or fiscal intervention or stimulus. It is argued that when the private citizen does not deem it safe to put his money to work in the economy, the public citizen should and thereby dampen the down-leg of the business cycle. This would make total sense if governments had run a surplus previously and had a stock of capital to apply to the “situation”. It would even make sense if the country was under threat from a foreign power and it was deemed critical to the future wellbeing of the citizenry. Thus the government could borrow from the next generation i.e. 10-30 year bonds and repay once the crisis has passed. The situation we are currently facing has neither, it is merely deemed prudent by governments never to run low or negative GDP numbers.

Government thinking goes like this…

If GDP drops substantially, “goose” up the GDP by lowering interest rates and borrow more to spend more in order to get GDP up. If that fails and debt levels get too high and interest rates get to zero, monetise the debt and print more money driving up the price of goods to give an illusion of wealth, GDP growth and prosperity. If that fails because transaction velocity of money is falling faster than the mass of money is being added, just add more money “mass”, eventually you will turn the tide. This would work if the governments in question can add money willy-nilly until they stop the deleveraging.

Enter Europe, a loosely connected union with no ability to add “real” money supply and even if they did – to whom do they give the money?

If Europe succeeds in re-leveraging, the three legged stool of China, Europe and the US will stay upright. Nominal GDP will stay up but for the wrong reasons, inflation or stagflation will return. If Europe fails to re-lever, Europe, followed by the other two legs of the stool, and then emerging markets, will fall in to a deflationary spiral. That is unless China and the US can print enough money for themselves AND Europe.

The clear and present danger is that whatever path we move in, the acceleration along that path will increase until we face a potential extreme outcome; either extreme inflation/stagflation or extreme deflation.

We believe that volatility is a natural concomitant of either of these macro events and that our funds should benefit as a result.