THIRD QUAR TER 2011

THE BROYHILL LETTER

The length of this document defends it well against the risk of its being read. Winston Churchill

Executive Summary
European banks are woefully undercapitalized. In some cases, they are unwilling to raise capital at currently depressed share prices. In others, they are unable to nd dumb money to shore up their balance sheets. As a result, they are derisking the only way possible shrinking their loan books and selling assets. Deutsche Bank, for example, has warned that it might be impossible to raise capital from the markets in the current climate and indicated the bank would rather sell assets. Meanwhile, Commerzbank has said it will suspend new lending outside of its home market. Unfortunately, this expedited and coordinated deleveraging of the nancial system will have unintended consequences for the global economy, already on the brink of recession. Viewed through the eyes of a single bank, asset sales are a rationale decision. But what is rationale for an individual bank is disastrous in aggregate. Even looking at the announced plans to date, and ignoring the effects of other funding pressures that are signicant in themselves, there are simply not enough buyers for the magnitude of assets up for sale. Over 200 years ago, Adam Smith wrote, What is prudence in the conduct of every private family can scarce be folly in that of a great Kingdom. We would suggest that this is particularly applicable to the prudence of current day banks and the folly of the nancial system. Mervyn King, Governor of the Bank of England, recently summarized this problem in his Financial Stability Report: Many European governments are seeing the price of their bonds fall, undermining banks balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging. An erosion of condence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks balance sheets further. This spiral is characteristic of a systemic crisis.

Deleveraging - Eurostyle
In a frantic dash to recapitalize balance sheets, European banks are shrinking their loan books and selling assets. This plan will not work and in fact, if followed through will fail spectacularly as the potential deleveraging in the European banking system would make the US deleveraging look like a garage sale. According to BCA Research, European banks have $25 trillion of outstanding loans including roughly $5 trillion of direct loans internationally, which are prime candidates for asset sales. It seems that of this, emerging economies owe Europes banks $3.4 trillion, with $1.3 trillion lent to Eastern Europe. Given rising political pressures, it is likely banks choose to concentrate on their core business at home, at the expense of choking off credit to foreign borrowers. Non-core emerging market assets are likely to bear a disproportionate brunt of the selling, throwing a wrench into the ever-popular decoupling thesis. It appears to us that most investors underappreciate the intensity of the negative feedback loop between western world deleveraging and emerging nancial markets. Even ignoring the nancial linkages for the moment, the impact of increasing European austerity on domestic demand will translate into weaker external growth for emerging exporters in and of itself. Given the extent that these economies continue to rely on USD funding and credit from EU banks, an accelerated contraction in credit poses an even greater risk at the same time that growth is already rolling over. Central and Eastern European economies display the most obvious vulnerabilities, but a broad-based exit of European banks from Asia would pose signicant challenges in its own right.

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Negative Feedback Loops

Morgan Stanleys Cross-Asset Strategy team identies multiple stages of this negative feedback loop. In short, European bank deleveraging poses a great risk to the global economy due to historically high nancial interconnections. As economic growth contracts, heightened risk aversion may lead to capital outows from economies dependent upon foreign capital. These outows in turn limit any potential policy response exacerbating the economic deterioration and accelerating outows. George Soros refers to this phenomenon as a self-reinforcing process of disintegration. Wonderful. Lets ush out each of these components as it is extremely important to grasp the resulting impact on asset values.

Deleveraging by Eurozone banks is likely to approach 1.5 - 2.5 trillion over the next eighteen months, with over 500 billion at the expense of emerging economies. This process is accelerating as the broadening sovereign debt crisis has increased pressure on banks to raise capital and funding pressures continue to intensify despite coordinated liquidity provided by central banks. Asset sales are likely to be further expedited by the 1.7 trillion in term debt maturing through 2014 (chart above), of which 600 billion comes due next year, in addition to a front-end loaded sovereign debt calendar in 2012 (chart below). A severe credit crunch is now underway in Europe, with potential asset sales equivalent to as much as 20% of the regions GDP. Given the accelerated timeline illustrated below, it is not implausible that investors hoping for the typical Santa Clause rally get a handful of coal in their sovereign stockings in the form of a Greek default instead! This would not be without precedent as Mexico in 1994 and Argentina in 2001 chose the holiday season to announce their devaluations

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This deleveraging process is further complicated by the nancial interconnections which have grown sharply over the past decade, increasing the vulnerability to an external funding withdrawal. The pipes of the European nancial system are clogged, preventing the free ow of credit to the economy. European banks are no longer lending to each other, forcing the Fed to provide dollar liquidity at levels last seen before Lehmans failure.

Banks are parking funds with the ECB rather than lending to corporations at the same time they are almost entirely reliant on the central bank for their own funding. This is all too familiar to US bankers who were starved of credit in 2007-2008, when we last saw such coordinated liquidity provided by central banks. Liquidity wasnt the answer then and it is not the solution now.

Source: www.ritholtz.com/blog

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The challenge for investors is determining where the strains are likely to appear. Given the pressure in European funding aggravated by the massive deleveraging discussed above, we think credit squeezes are likely to emerge in the emerging world. Contrary to popular belief, most emerging economies still rely on dollar funding from developed markets, meaning systemic stress in western credit markets will ow through to the emerging world, where banks have a high proportion of foreign ownership and are heavily reliant on external funding as opposed to sticky deposits.

Importantly, Western European banks are by far the largest suppliers of global lending. For perspective, European banks outstanding claims to the developing world are twice as large as those of US or UK banks. Rapid credit growth to emerging markets, where lending grew almost 300% from 2000-2008, suggests that these assets are particularly susceptible to European bank deleveraging as political pressures at home make it unlikely banks will reduce lending domestically.

In addition to the direct linkages, a sharp rise in risk-aversion could lead to forced selling of risk assets and capital outows. We have discussed this issue regularly in recent months as it relates to the risk of capital ight in China (which continues to escalate). That said, the risk is far greater in many other emerging market economies. For this reason, we believe a number of these currencies are highly exposed to the current global deleveraging cycle. Half of the return from emerging
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bond funds - an increasingly popular hiding place among retail investors seeking higher yields - has historically come from currency appreciation. But emerging market currencies are extremely cyclical and no longer as cheap as they were a decade ago. As mom and pop scramble for liquidity, their exit notoriously shrinks, precisely when needed most. Small doors make big problems for large crowds. Widespread risk aversion in the last week of September, for example, led to the largest outows from the regions bond funds on record. As capital begins to ow out of emerging market economies, the nal stages of this negative feedback loop are determined by the capacity for policy response and the negative impact of ows back into developed markets. Recent weakness in emerging market currencies may limit policy options today, ultimately exacerbating the decline and accelerating outows. The self-reinforcing nature of this cycle would surely prompt a signicant headwind for the sole engine of global growth.

Few emerging economies suffer from the debt and decit issues plaguing the developed world, but we believe it is dangerous to assume that they are immune to the deepening debt crisis. Europe is the largest market for many emerging Asian exporters, but the economies of Eastern Europe boast the most obvious vulnerabilities to deleveraging by their western neighbors. The regions banks are heavily dependent on nancing from the largest banks in the Eurozone. Weaker export demand, reduced capital ows and deteriorating bank nancing conditions have the potential to create a severe headache for the region. As bank credit dries up, it is likely to put pressure on emerging market currencies reliant on foreign capital. Weakening currencies has the potential to reverse capital ows given extremely crowded investor positioning as the consensus has ocked to the relative safety of emerging market balance sheets in a world of western debt crises. Commodity producers are particularly exposed to weakening demand since any decline would be compounded by falling prices. The consensus view is that continued demand from China will prevent a steep fall in price despite deteriorating global nancial and economic conditions. This is inconsistent with past experience. We think there is a sizeable overhang here as the PIMCOs of the world hide out the ring of re in emerging market currencies. We suspect a shake-out is overdue.

Flight to Safety
Deposits are eeing EU banks, exacerbating funding issues. We just learned from a good friend that his family in Ireland has moved almost all of their net worth outside of the country rather than risk waking up one morning and having their wealth denominated in a weaker currency. We think it is notable that they decided to invest a large portion of their assets into US Dollars. This issue was initially limited to the weakest periphery countries, but recent stress has prompted outows from former core nations such as Italy. With banks now almost entirely reliant on the ECB for short-term nancing, declining deposits are increasingly worrisome. As this trend accelerates, do not be surprised if capital constraints are put in place to protect the banks (at the large expense of European tax payers).
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In the meantime, reserve funds from ofcial foreign accounts at the Fed have risen above the highs seen at the Lehman crisis, which is a reection of the steady loss of faith in commercial banks in Europe that are effectively shut off from anything but very short-term dollar funding. The biggest money market funds in the US have aggressively pulled funding from European banks, further squeezing access to precious dollar funding. FX Concepts, John Taylor, describes the signicance of these dollar shortages: As the worlds reserve currency funding global trade, the dollar declines when the global economy is expansive and rallies when a recession looms. This happens because negative business vibrations cause US banks and Euro banks, normally lending in dollars, to pull back their horns and reduce loans outstanding. The lack of new dollar loans and the repayment of outstanding loans cuts dollar liquidity and results in a shortage of the currency. This has made the dollar rally in every recession for the past thirty years. When reserve growth stops or even reverses, global growth stalls because there is a shortage of liquidity. A decline in reserves means dollars are scarce. There is a scramble for dollars because fast money is stuck in the vault. As the dollar rises, countries that had been gaining reserves start losing them and more importantly, start intervening to protect the value of their currencies, dropping their reserves sharply. Anecdotal reports imply reserves are dropping and emerging market countries are intervening heavily to support their currencies against the dollar. Every dollar spent this way is taken out of the global liquidity pool doing nothing but amplifying the future shortage of dollars. The system is inherently unstable as a declining dollar loosens monetary conditions when the world is growing and tightens conditions when the world enters a slowdown. The banks lend less money and a dollar shortage develops tightening monetary conditions and exacerbating the slump. The more the dollar strengthens, the worse it is as monetary conditions tighten signicantly and the banking system experiences credit losses.

The Ugly Contest

It is difcult for investors to question the long-term positive outlook for emerging markets, as the thesis has been veried by rising asset prices over the past decade. The challenge will be navigating around the growing cyclical risks in the near term. The divergence in US and global monetary policy was largely responsible for dollar weakness in 2006-2008 and again in 2009-2011. Now that global growth is slowing and ination has peaked, US policy and global policy have begun to converge, resulting in dollar strength. Note the performance of the dollar index last time global rates dropped precipitously. Speculators have been betting Source: Wolfe Trahan & Co. on the demise of the euro ever since the rst whiff of a Greek default. While investing with the consensus is not a protable long term strategy, it is worth noting that these speculators made similar wagers on the dollar in 2008 and 2010 . . . and were very right! The outlook for the global economy is quickly deteriorating today and relative prices of at currencies essentially boils down to Keynes ugly contest. During times of crisis, the most liquid asset will win every time. This means dollars
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today and even more so after Switzerland decided to peg the Swiss Franc to the Euro. There is one less safe haven in the world now. I think the market is going to be surprised by how high the dollar is going to trade against other at currencies, now that it has so little competition. Dollar strength, combined with broad-based emerging market weakness would hit the industrial commodity complex pretty hard. The marginal buyer of gold, on the other hand, has become less sensitive to moves in the dollar, resulting in lower correlations in price movements between the two with trust in global governments on the wane. Investors seeking protection from the proverbial printing press increasingly view the precious metal as the ultimate safe haven and store of value. Count us as part of this protection seeking group.

Bottom Line
In a recent IMF Working Paper titled, The Eurozone: How Banks and Sovereigns Came to be Joined at the Hip, the authors astutely warn that the combination of banking sector vulnerabilities uncovered by the crisis, weaker growth prospects, and high debt ratios could persist because they have the potential to reinforce each other. Fiscal problems have feedback effects and with the scal room for intervention much more limited, the Eurozone economies have moved to a new, more stressed regime from which there is no quick return. The probability of a wave of defaults has increased signicantly and rises the longer the crisis continues. Until policymakers are willing to address the structural imbalances in the global economy (i.e. restructure debt), investors should prepare themselves for a dangerous deleveraging around the corner. The alternative is a coordinated, massive reationary policy, which markets are begging Santa for this Christmas. In 2002, then Fed Governor Ben Bernanke concluded that, under a paper-money system, a determined government can always generate higher spending and hence positive ination via Milton Friedmans helicopter drop of money. It would be foolish to doubt central banks capacity to print money to paper over mountains of bad bank and sovereign debt. History suggests that all governments ultimately go down this road after exhausting austerity. The only question is how bad things get before they act. We suggest it is simply a matter of time before Helicopter Mario chooses the seemingly lesser of two evils. But be careful what you wish for as debt monetization comes with its own set of problems.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The authors opinions are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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