Strategic Research FebRuARy 11, 2011 MARK O. LAPOLLA, CFA WWW.KNIGHT.COM 404.736.2431 | [email protected] The Final Chapter of The Old Story Nevertheless, like me in 1958, investors refused to see the ground shifting beneath them, even though the environment was no longer what they knew and thought they understood. Like me, they were walking into a trap where the responses were not what they had anticipated. Like me, they were headed toward big surprises for which they had no preparation. It has been said that good forecasters have a good sense of history. I suppose that is true. But the best lesson from the past is to forget it before it shoves you into trouble — and remember that surprises and ruptures surely lurk ahead. Peter L. Bernstein, (1919-2009) on the Financial Crisis “To Botch A Forecast, Rely on Past Experience” The New York Times; December 30, 2007 Refer to important disclosures at the end of this document. Knight Capital Americas, L.P. Strategic Research We believe that the credit crash of 2007—2008 ended a 75-year Consumer Credit Super Cycle in the developed world, and that government policy actions— particularly in China and the United States—and the market responses to them, have pushed the cyclical and structural terms of global trade past their tipping points. Thus, we believe that the consensus global growth story is ending, and so too, the gilded age of the Emerging Markets. The global economy will fully enter into a generational transformation requiring the painful maturation of the developing world, the end of entitlements based democracy in the developed world, and the hopeful renaissance of U.S. economic and geopolitical leadership. Knight Capital Americas, L.P. 2 Strategic Research Say It Ain’t So Surely the endgame is upon us. Higher commodity prices will fuel inflation and materially higher interest rates. And necessarily, this will precipitate a collapse in the dollar and threaten the fiscal sustainability of the United States. Moreover, if prevailing economic and financial theory are to be believed, then all these statements are true and the implications quite troubling. But, the prevailing orthodoxy is NOT to be believed, nor the de facto conclusions which they imply. With the presumption of a broadening economic rates; but in a startling divergence from economic in the dollar and threaten the fiscal sustainability of recovery around the world, the global financial theory, it did not. the United States? And if so, wasn’t the leader of markets are once again focused on rising In his now famous speech given in April 2005, Ben the Communist Party of China, Hu Jintao, correct commodity prices, the global growth story and the Bernanke offered an explanation for why long-term when he declared at the G20 summit this past present risk that economic and foreign exchange interest rates stayed low. It wasn’t excess consumption November, “We are the masters now.”? imbalances will trigger the end game of the that fueled the current account imbalance; rather, If prevailing economic and financial theory are to “Sovereign Debt Crisis” leading to higher interest it was a “global savings glut”—primarily in Asia— be believed, the resounding answer to all these rates, currency debasement, and the possibility of which by extension (we are being facetious here) questions is, “yes.” But the prevailing orthodoxy is hyper-inflation. forced the United States to consume more in order NOT to be believed, nor the de facto conclusions And such is the nearly uniform consensus around the to absorb the excess savings of our trading partners. which they imply. world. The storyline goes something like this: But causal clarity is not important to the story line. And this is the rub—and the ambitious Profligate developed world nations—most What is, however, is the entrenched belief that “we” (foolhardy?) challenge of this publication: to particularly the United States—have recklessly and are dependent upon “them” for economic balance present our views in a simple and approachable irresponsibly adhered to expansive monetary policies and survival. form that efficiently challenges the orthodox and regulatory regimes to support undisciplined And nothing has changed. Today, the Federal Reserve consensus, and at a minimum, will serve as fiscal spending and gross “excess consumption” by is proceeding apace with QE2, U.S. budget deficits the foundation for spirited dialogue going the household sector. ensure an ongoing ramp-up of accumulated debt, forward. In turn, as a matter of accounting identity, domestic and stock and commodity prices have skyrocketed. To accomplish this, we have chosen to minimize dis-savings had to be balanced by foreign savings; Inflation is breaking out across the emerging world, verbiage and maximize illustrations; and on namely, the purchases of Government debt the December UK Retail Price Index of inflation (4.8%) balance, to keep the logical flow going without obligations by “rich nations” flush with trade doubled wage growth, and German unions—citing succumbing to tedious—and in all likelihood— surpluses and excess foreign exchange reserves. rising inflation—are pushed for higher wages at the unconvincing detail. Ultimately, our objective European Union Summit. This dynamic led to an ever-widening current account with this publication—as with all our work—is to deficit which drove the exchange rate of the dollar Surely the endgame is upon us. Higher commodity apply experience, common sense, and intuition to down and should have resulted in higher interest prices will fuel inflation and materially higher interest uncover powerful investment themes obscured by rates. And necessarily, won’t this precipitate a collapse the fallacies of conventional thinking. Knight Capital Americas, L.P. 3 Strategic Research The Gist “To understand reality is not the same as to know about outward events. It is to perceive the essential nature of things. The best-informed man is not necessarily the wisest. Indeed there is a danger that precisely in the multiplicity of his knowledge he will lose sight of what is essential. But on the other hand, knowledge of an apparently trivial detail quite often makes it possible to see into the depth of things. And so the wise man will seek to acquire the best possible knowledge about events, but always without becoming dependent upon this knowledge.” Dietrich Bonhoeffer, Lutheran Minister Knight Capital Americas, L.P. Strategic Research Executive Summary It is our contention that the current levels of supported and cheered by the political establishment to its cyclical end. Moreover, we believe that the unemployment are structural, and likely understate (who have historically retained power through the consensus view on U.S. monetary policy and the the magnitude of dislocation across the workforce. extension of benefit,) as well as the financial sector impact that accumulated debt, persistent budget It was Keynes who first wrote of “technological whose power and sway upon the affairs of the world and trade deficits will have on interest rates, unemployment” back in the days when machine was crested at unimaginable heights. inflation, and the dollar, is wrong. replacing man at a furious rate. At the same time, the world was growing fond Our view remains that stable/growing cash flow Today, we believe the U.S. economy is suffering of the rising emerging markets; in some cases streams denominated in U.S. dollars are the most from the cumulative effect of a different type of laden with resources, in most cases laden with attractive assets in the world. We believe that technological unemployment; in this case, the rapidly inexpensive labor, and in all cases, laden with unlevered cash on cash returns will once again diminishing value of “average” human capital within large populations hungry for higher standards become the measure of “value.” a society where IP (intellectual property) is the driver of living. This of course implied an insatiable By design, this publication does not delve into of marginal productivity and profit. demand for commodities and all the elements tactical concerns, sector weights, or security As a result, labor has been steadily losing its power, necessary for massive infrastructure development; selection. It is our hope that by providing clarity on and with it, wage growth. Thus, we view the housing and ultimately, of course, explosive demand for pivotal macro issues, this work will be applicable boom and bust in the context of a society desperately branded goods from the developed world. to all investors and those concerned with the trying to extend lifestyle gains to a workforce desiring It is our contention that the emerging market allocation of assets over the coming decade. to live far above what their economic value justifies. story—which has now blossomed into the Listed below are some key takeaways from our Needless to say, this was an outcome broadly “global growth thesis”—has matured and come work. BBThe U.S. Labor Market Is Structurally Broken BBMonetary Policy Cannot Create Inflation BBConsumer Credit Is Dead BBThe U.S. Current Account Deficit Is a Non-Issue BBThe “Recovery” Is Just a Stabilization BBThe Fed Anchors and “Controls” Rates BBNominal GDP Will Remain Anemic for Years BBThe U.S. Is Fiscally Sustainable BBCorporate Profitability and Main Street Economics Are Uncoupled BBInterest Rates Will Remain Low BB Corporate Margins Will Not Revert Back to Their Long-Term Mean BBThe Euro Will Survive, but the Dollar Standard Will Grow Stronger BBRising Commodity Prices Are Deflationary in the Developed World BBNominal Is All That Really Matters BBSustaining Inflation in the U.S. Will Not Be Possible for Years BBThe Global Growth Story Is Over: and China Is the Linchpin BBThe Global Terms of Trade Are Past Their Tipping Point BBFood Is More Important than Oil Knight Capital Americas, L.P.