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Abandoning a treacherous market | Karen Maley | Commentary | Business Spectator 3/09/10 2:46 PM

Commentary Comment

Abandoning a treacherous market


Karen Maley
Published 7:39 AM, 3 Sep 2010 Last update 10:00 AM, 3 Sep 2010

Anyone reading Paolo Pellegrini's farewell letter to investors hoping to find sweet, soothing
words about the challenges of investing will be disappointed. Instead, the high-profile hedge
fund manager has issued a grim warning of impending calamity.

A fortnight ago, Pellegrini – who rose to fame as the former Paulson & Co executive who
helped the firm make more than $3 billion by masterminding a bet on the US housing crash –
announced that he intended to wind down his hedge fund, PSQR Capital, and return money to
investors. The fund, which gained 40 per cent in 2008 and 62 per cent last year, fell by almost
11 percent in the first seven months of this year. The July rally was particularly harmful for
PSQR, causing the fund to drop almost 8 per cent.

In his latest report, Pellegrini points out that investors are caught in a tricky dilemma. They’ve
lost confidence in the rally that’s been fuelled over the past year and a half by massive fiscal
and monetary stimulus. At the same time, they can’t bring themselves to ignore the boost to
corporate earnings that’s largely the result of that same monetary and fiscal expansion. Even
worse, they know that governments may once again decide on extraordinary intervention. This
leaves investors trapped between risks to the upside, and risks to the downside. “Realising that
the positives are largely unsustainable, though, they stay ready to bolt for the exits at any
moment. The result is a particularly treacherous and volatile market,” he says.

But while Pellegrini concedes that buoyant corporate earnings could prop up the market for a
little while longer, “I remain convinced that the party has come to an end and equities will
retrace further.”

From his perspective, the big problem is the lack of aggregate demand, which is acting as a
dead-weight on the US economic recovery. The US government has boosted its spending to try
to fill the gap caused by the retrenchment in private sector spending. But it hasn’t addressed
what he sees as the basic structural problem in the economy – the declining share of national
income going to American workers.

“Since the 1970s, and most sharply since 2001, the US labour force’s share of the economic pie
shrank dramatically. The combination of technological advances and free trade suppressed the
purchasing power of an ever increasing proportion of American workers.”

Pellegrini points out that the share of GDP going to American workers fell from around 58 per
cent in 2001 to about 53 per cent in the first quarter of 2010. For a while, he says, the
consequences of this decline weren’t evident because American workers increased their
borrowings so that they could keep spending. “The increase in household borrowings, from a
range of 2.5 per cent–5 per cent of GDP in the 90s to approximately 7.5 per cent–10 per cent in
2002-2006, masked the economic and social consequences of this shift in income distribution.”

Had it not been for this surge in household borrowing, he says, “stagnant employee
compensation would have resulted in stagnant demand and stagnant GDP”. After all, consumer
spending does account for 70 per cent of the US economy.

According to Pellegrini, the US Federal Reserve – through policies such as keeping rates too
low for far too long as well as permitting unbridled lending and securitisation – engineered a
debt-bubble “solution” to ensure that the collapse of the internet bubble in 2000 did not result in
a lengthy period of zero or negative economic growth. But this only laid the groundwork for the
2008 financial crisis.

He says the debt bubble “avoided widespread personal hardships that would have generated
significant popular anger and perhaps forced major political, if not institutional changes, this

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Abandoning a treacherous market | Karen Maley | Commentary | Business Spectator 3/09/10 2:46 PM

expedient bought only a few years respite before crashing to a halt in 2008, when not only
compensation of employees continued to decline but household borrowings turned negative."

What’s more, the “debt bubble” enabled the US to conceal what Pellegrini calls its “inconvenient
twin realities of uncompetitiveness and gaping distributional imbalances”.

Even now, the US is delaying the day it must address these problems. “Postponing the political
resolution of the problem has only caused it to get bigger. Unfortunately, the US government is
continuing to dig the hole deeper, now with a coarser, less-efficient version that uses sovereign
borrowing in place of private debt to fill the demand deficit created by the labor force’s ongoing
income decline.”

The fundamental problem, he says, is that US workers’ compensation is still too weak to fuel an
economic recovery. “Four quarters into the recovery from the worst economic downturn since
the Great Depression, workers’ pay still lags. Even taking into account the boost to spending
power from private borrowing, the decline continues."

And while US government has stepped into the demand gap and borrowed huge amounts of
money in order to increase its spending, “the reality is that the exceptional amount of
government borrowing has failed to add up to final demand sufficient to spur economic activity
to anything approaching the cyclical upswings typical of post-war recoveries.”

Pellegrini concludes with a baneful warning that when markets finally recognise that government
stimulus has failed to produce a sustained recovery in private sector spending, the effect will be
violent.

“Failure to ignite self-sustaining economic activity means government is simply subsidising


current expenditure with unprecedented government outlays, racking up a bill that cannot be
repaid in full. That realisation will, in my opinion, hit markets soon and with powerful effect."

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