The Absolute Return Letter

July 2009

Make Sure You Get This One Right

“You can’t beat deflation in a credit-based system.”

Robert Prechter

The great debate As investors we are faced with the consequences of our decisions every
single day; however, as my old mentor at Goldman Sachs frequently
reminded me, in your life time, you won’t have to get more than a
handful of key decisions correct - everything else is just noise. One of
those defining moments came about in August 1979 when inflation was
out of control and global stock markets were being punished. Paul
Volcker was handed the keys to the executive office at the Fed. The rest
is history.
Now, fast forward to July 2009 and we (and that includes you, dear
reader!) are faced with another one of those ‘make or break’ decisions
which will effectively determine returns over the next many years. The
question is a very simple one:
Are we facing a deflationary spiral1 or will the monetary and fiscal
stimulus ultimately create (hyper) inflation?
Unfortunately, the answer is less straightforward. There is no question
that, in a cash based economy, printing money (or ‘quantitative easing’
as it is named these days) is inflationary. But what actually happens
when credit is destroyed at a faster rate than our central banks can
print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has
been no shortage of finger pointing and the hedge fund industry, which has
always had an uncanny ability to be at the wrong place at the wrong time,
has yet again been at the centre of attention. And politicians, keen to divert
attention away from themselves as the true culprits of the crisis through
years of regulatory neglect, have been quick at picking up the baton.
Admittedly, the hedge fund industry is guilty of many stupid things over
the years, but blaming it for the credit crisis is beyond pathetic and the
suggestion that increased regulation of the hedge fund industry is going to
prevent future crises is outrageously naïve.
If you prohibit private investors from investing in hedge funds which on
average use 1.5-2 times leverage but permit the same investors to invest in
banks which use 25 times leverage and which are for all intents and
purposes bankrupt, then you either don’t understand the world of finance
or you don’t want to understand. Shame on those who fall for cheap tactics.

1 See chart 5 for a definition.

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 Let’s begin by setting the macro-economic frame for the discussion. I
have been quite bearish for a while, suspecting that the growing
optimism which has characterised the last few months would
eventually fade again as reality began to sink in that this is no ordinary
recession and that ‘less bad’ doesn’t necessarily translate into a quick
recovery. I still believe there is a good chance of enjoying one, maybe
two, positive quarters later this year or early next; however, a crisis of
this magnitude doesn’t suddenly fade into obscurity, just because the
economy no longer shrinks at an annual rate of 6-8%.
The return of the boom & bust Going forward, not only will economic growth disappoint, but the
economic cycles will become more volatile again (see chart 1) with
several boom/bust cycles packed into the next couple of decades. This
is a natural consequence of the Anglo-Saxon consumer-driven growth
model having been bankrupted. Growing consumer spending over the
past 30 years led to rapidly expanding service and financial sectors
both of which will now contract for years to come as overcapacity forces
players to downsize.

Chart 1: US GDP Growth Volatility

Source: Reserve Bank of Dallas

This will again lead to higher corporate earnings volatility which will
almost certainly drive P/E ratios lower, making conditions even trickier
for equity investors. At the bottom of every major bear market in the
last 200 years, P/E ratios have been below 10. As you can see from
chart 2 overleaf, few countries are there yet. The next decade is
therefore not likely to be a ‘buy and hold’ market for equity investors.
The combination of low economic growth and pressure on valuations
will create severe headwinds. The most likely way to make money in
equities will be through more active trading.
Japan all over again? So now, two years into this crisis, where do we stand and where do we
go from here? History offers limited guidance, as we have never
experienced the bursting of a bubble of this magnitude before. The
closest thing is the collapse of the Japanese credit bubble around 1990.
As the Japanese have since learned, recovering from a deflated credit
bubble is a long and very painful affair.
Governments and central banks on both sides of the Atlantic are
pursuing a strategy of buying time, hoping that a recovery in economic
conditions will allow our banking industry to re-build its capital base.
The Japanese pursued a similar strategy back in the early 1990s. It

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 failed miserably and set the country back many years in its recovery
effort. Ironically, the Japanese approach was almost universally
condemned as hopelessly inadequate. It is funny how you always know
better how to fix other people’s problems than your own. A little bit like
raising children, I suppose.

Chart 2: P/E Ratios in Various Countries

Source: Bespoke Investment Group

Another lesson learned from Japan is that once you get caught up in a
deflationary spiral, it is exceedingly hard to escape from its grip. The
Japanese authorities have used every trick in the book to reflate the
economy over the past two decades. The results have been poor to say
the least: Interest rates near zero (failed), quantitative easing (failed),
public spending (failed), numerous attempts to drive down the value of
the yen (failed); the list is long and makes for painful reading.
The liquidity trap We are effectively caught in a liquidity trap. The Bank of England, the
European Central Bank and the Federal Reserve have all flooded their
banking system with enormous amounts of liquidity in recent months
but what has happened? Instead of providing liquidity to private and
corporate borrowers as the central banks would like to see, banks have
taken the opportunity to repair their balance sheets. For quantitative
easing to be inflationary it requires that the liquidity provided to the
market by the central bank is put to work, i.e. lenders must lend and
borrowers must borrow. If one or the other is not playing along, then
inflation will not happen.

Chart 3: Broad Money versus Narrow Money

Source: BCA Research

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 This is illustrated in chart 3 which measures the growth in the US
monetary base less the growth in M2. As you can see, the broader
measure of money supply (M2) cannot keep up with the growth in the
liquidity provided by the Fed. In Europe the situation is broadly
similar.
There is another way of assessing the inflationary risk. If one compares
the total amount of credit destruction so far (about $14 trillion in the
US alone) to the amount spent by the Treasury and the Fed on
monetization and fiscal stimulus ($2 trillion), it is obvious that there is
still a sizeable gap between the capital lost and the new capital
provided2.
The output gap If we instead move our attention to the real economy, a similar picture
emerges. One of the best leading indicators of inflation is the so-called
output gap, which measures how much actual GDP is running below
potential GDP (assuming full capacity utilisation). It is highly unlikely
for inflation to accelerate during a period where the output gap is as
high as it currently is (see chart 4). Theoretically, if you believe in a V-
shaped recession, the output gap can be reduced significantly over a
relatively short period of time, but that is not our central forecast for
the next few years.

Chart 4: Output Gap & Capacity Utilization

Source: BCA Research

The deflationary spiral I can already hear some of you asking the perfectly valid question: How
can you possibly suggest that deflation will prevail when commodity
prices are likely to rise further as a result of seemingly endless demand

2 http://seekingalpha.com/article/145904-hyperinflation-trade-looking-crowded

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 from emerging economies? Won’t rising energy prices ensure a healthy
dose of inflation, effectively protecting us from the evils of the
deflationary spiral (see chart 6)?

Chart 5: The Deflationary Spiral

Source: zerohedge.com

Good question - counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be
deflationary so long as demand for such commodities is relatively
inelastic, which is usually the case for basic necessities such as heating
oil, petrol, food, etc. The logic is the following: As commodity prices
rise, money earmarked for other items goes towards meeting the higher
commodity price and consumers are essentially forced to re-allocate
their spending budget. This causes falling demand for discretionary
items and can in extreme cases lead to deflation. We only have to go
back to 2008 for the latest example of a commodity price induced
deflationary cycle.
A price increase on a price inelastic commodity is effectively a tax hike.
The only difference is that, in the case of the 2008 spike in energy
prices, the money didn’t go towards plugging holes in the public
finances but was instead spent on English football clubs (well, not all of
it, but I am sure you get the point) which have become the latest ‘must
have’ amongst the super-rich in the Middle East.
For all those reasons, I am becoming increasingly convinced that the
ultimate outcome of this crisis will turn out to be deflation – not
inflation. Inflation may eventually become a problem, but that is
something to worry about several years from now. The Japanese have
pursued an aggressive monetary and fiscal policy for almost 20 years
now, and they are still nowhere.
Interest rates on the rise So why are interest rates creeping up at the long end? Part of it is due
to the sheer supply of government debt scheduled for the next few
years which spooks many investors (including us). And the fact that the
rising supply is accompanied by deteriorating credit quality is a factor
as well. But countries such as Australia and Canada, which only suffer
modest fiscal deficits, have experienced rising rates as well, so it cannot
be the only explanation.
Maybe the answer is to be found in the safe haven argument. When
much of the world was staring into the abyss back in Q4 last year,
government bonds were considered one of the few safe assets around
and that drove down yields. Now, with the appetite for risk on the

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 increase again, money is flowing out of government bonds and into
riskier assets.
Perhaps there are more inflationists out there than I thought. Several
high profile investors have been quite vocal recently about the
inevitability of inflation. Such statements made in public by some of
the industry’s leading lights remind me of one of the oldest tricks in the
book which I was introduced to many moons ago when I was still
young and wet behind the ears. ‘Get long and get loud’ it is called; it is
widely practised and only marginally immoral. Nevertheless, when
famous investors make such statements, it affects markets.
Make sure you get it right The point I really want to make is that the inflation v. deflation story is
the single biggest investment story right now and being on the right
side of that trade will effectively secure your investment returns for
years to come. If I am wrong and inflation spikes, you want to load
your portfolio with index linked government bonds (also known as
TIPS for our American readers), gold and other commodities,
commodity related stocks as well as property.
If deflation prevails, all you have to do is to look towards Japan and see
what has done well over the past 20 years. Not much! You cannot even
assume that bonds will do well. Recessions are bullish for long dated
government bonds but a collapse of the entire credit system is not. The
reason is simple - with the bursting of the credit bubble comes drastic
monetary and fiscal action. Central banks print money and
governments spend money as if there is no tomorrow, and all bets are
off. Equities will do relatively poorly as will property prices. But
equities will not go down in a straight line. The market will offer plenty
of trading opportunities which must be taken advantage of, if you want
to secure a decent return.
All in all, deflation is ugly and not conducive to attractive investment
returns. It is also not what governments want and need right now. With
a mountain of debt hitting the streets of Europe and America over the
next few years, as the cost of fixing the credit and banking crisis is
financed, one can make a strong case for rising inflation actually being
the favoured outcome if you look at it from the government’s point of
view. The problem, as the Japanese can attest to, is that deflation is
excruciatingly difficult to get rid of, once it has become entrenched. I
am in no doubt which of the two evils I would prefer, but we may not
have the luxury of choosing our own destiny.
Focus on volatility trades So where does all that leave us? Our good friend and business partner,
John Mauldin, has just put the finishing touches to a new accredited
letter which will be published in the next day or two. In his letter, John
makes the point that markets are likely to remain volatile for quite a
while yet. On a personal note I will add that if my worst fears are
proven correct and we have to fight a bout of deflation, the authorities
will have no choice but to try and provoke price increases through
aggressive policy measures. Otherwise entire countries could be
bankrupted as they suffocate in their own debt. Whether it will work is
a different story.
Such a struggle for supremacy between deflationary and inflationary
forces will only add to the volatility predicted by John and give rise to
an investment environment which is very unlike the one we have seen
during the past 20-30 years. You need strategies in your portfolio
which thrive on volatility, and they are certainly not the same strategies
as those held by most investors today.

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We are currently preparing the launch of a new single manager fund
which is designed to thrive on volatility. It is also operating in markets
as far detached from the world of equities as you can imagine, so the
correlation to equities will almost certainly be low. If you are based in
Europe, Africa or Asia and want to learn more about this new product
or if you wish to receive John’s letter3 when it is published, just drop us
a note and you will hear from us. In the meantime, join me and wish
for a bit if inflation. It is clearly the lesser of two evils.
Niels C. Jensen
© 2002-2009 Absolute Return Partners LLP. All rights reserved.

This material has been prepared by Absolute Return Partners LLP ("ARP"). ARP is
authorised and regulated by the Financial Services Authority. It is provided for information
purposes, is intended for your use only and does not constitute an invitation or offer to
subscribe for or purchase any of the products or services mentioned. The information
provided is not intended to provide a sufficient basis on which to make an investment
decision. Information and opinions presented in this material have been obtained or derived
from sources believed by ARP to be reliable, but ARP makes no representation as to their
accuracy or completeness. ARP accepts no liability for any loss arising from the use of this
material. The results referred to in this document are not a guide to the future performance
of ARP. The value of investments can go down as well as up and the implementation of the
approach described does not guarantee positive performance. Any reference to potential
asset allocation and potential returns do not represent and should not be interpreted as
projections.

3 If you have already signed up as an Accredited Investor on John Mauldin’s website,

you will receive his new letter automatically.

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Absolute Return Partners
Absolute Return Partners LLP is a London based private partnership. We provide independent asset
management and investment advisory services globally to institutional as well as private investors, charities,
foundations and trusts.
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believe that we can achieve this through a disciplined risk management approach and an investment process
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Absolute Return Letter Contributors

Niels C. Jensen njensen@arpllp.com tel. +44 20 8939 2901
Jan Vilhelmsen jvilhelmsen@arpllp.com tel. +44 20 8939 2902
Nick Rees nrees@arpllp.com tel. +44 20 8939 2903
Robert Dawson rdawson@arpllp.com tel: +44 20 8939 2904
Tricia Ward tward@arpllp.com tel: +44 20 8939 2906

The ARP Structural Alpha Portfolio

as at 31st May, 2009:

Commodities
Relative Volatility Trading (RV)
Value Arbitrage 3.9% Corporate Lending
Arbitrage 6.9% 25.2%
3.0%
Managed Futures
5.2%

Power Trading
4.7%

Life
Insurance
7.3%

ILS (Non-Life)
6.7%
ILS (Life)
Project Finance
5.6%
6.6%
Credit Opportunities
Legal Real Media & Trade Finance
8.2%
Finance Estate Ent. 10.5%
2.4% Finance Finance
2.4% 1.4%