Prologue Capital Quarterly Letter - July 2011

July 18, 2011
The Burden Of Debt

It is payback time. The dominating force for developed economies this year is the continued unwinding of the credit bubble. History suggests that it will be the theme for some years to come. In this letter we discuss the impact from the deleveraging process on the United States, the Eurozone and the United Kingdom and its impact on markets. The Feeble American Recovery
"Some debts are fun when you are acquiring them, but none are fun when you set about retiring them." Ogden Nash, American poet
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This letter is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instruments. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Prologue Capital LLP is authorised and regulated by the Financial Services Authority.
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First, growth has been considerably weaker than it would otherwise be. Indeed, the economy is experiencing its weakest recovery since World War II. This is particularly noteworthy given the depth of the recession. Typically economic cycles display a certain degree of symmetry, i.e. the deeper the recession the faster the recovery. Obviously this is not the case this time around. Instead, the deepest recession since the Great Depression has been followed by the feeblest recovery. Thats right; no recovery has been this weak during the last eighty years.
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Whats spoiling the party is the non fun of paying back debt, aka deleveraging. This has affected the economic cycle in three distinct ways.
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The first half of the year wasnt fun but it was instructive. After displaying good momentum early in the year, the United States economy began to roll over in the second quarter as monetary and fiscal policy easings waned and various shocks, ranging from high energy prices to the Japanese earthquake, interrupted spending patterns and production chains. The outsized reaction to these changes shows that the recovery is not yet sustainable.
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The economy is currently growing at a yearly rate only marginally above the crucial two percent threshold. In the past, the economy has reached stall speed when growth has fallen below that pace, with the lack of momentum leading to subsequent recessions. This relationship has an impressive 100% hit ratio. If the growth rate flat-lines from here, i.e. remains at 2% quarter on quarter annualised, the economy will reach stall speed by the fourth quarter. That is currently not our base case but its probability is nevertheless significant.
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The economys new vulnerability will be a facet as long as the deleveraging process is ongoing. Unfortunately, that process still has years to play out. American consumers have reduced their debt burden for over three years, taking down the ratio of household debt to disposable income from a high of 130% to 114%. It is difficult to say exactly where that ratio should go but a good estimate is 85% which is the average during the 1990s, i.e. after financial deregulation and financial innovation in the 1980s and before the accelerated credit expansion that began at the turn of the millennium. At the current pace, it will take five years before the ratio reaches that level and this process has run its course.
Expansive fiscal and monetary policies have mitigated much of the impact from the deleveraging in the private sectors. Borrowing from governments allowed debt to be de facto transferred from private sector balance sheets to the public sector. Since the onset of the crisis in 2008, easy monetary policy has accommodated the servicing of existing debt burdens. This is now changing. Assuming no policy shifts, the fiscal drag will be around one percent per quarter for the rest of this year and throughout next. Meanwhile, the expansion of the Federal Reserves second quantitative easing programme ended last month. Going forward, the Fed will keep its balance sheet constant by reinvesting maturing debt, although purchases will decline from around $90bn per month to $20bn per month.
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Third, the economy has become more sensitive to external shocks. Shocks happen. They always have and they always will. In the past, the United States economy seemed particularly well equipped to handle shocks, largely thanks to the economys flexibility. The events this spring suggest that this is no longer the case. The main culprit is likely households increased sensitivity to higher energy prices due to weak aggregate income growth and diminished ability to use savings to smooth spending patterns.
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Second, monetary and fiscal policy easing have become less potent. Consider that GDP has expanded merely 5% since the trough two years ago, a disappointing result considering 500bps of rate cuts, $2trln of quantitative easing and a fiscal deficit that is now close to double digits.
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In sum, the picture for the United States is dire and there are no easy choices. The base case is a muddle through scenario that will play out over years. In that scenario the economy will at times accelerate but only for a few months at a time. Soft patches, like we saw last year and this spring, will be regular occurrences. In that environment rates will trend lower, punctuated at times by temporary increases. The core strategy will be geared towards carry trades but they need to be actively managed in order to navigate the rate spikes. The front to intermediate part of the Treasury curve should stay steep as long as deflationary risks do not materialise again. Swap spreads should continue to widen. The main risk scenario is a double dip. If that were to happen, the bull trend in Treasuries will accelerate. The curve will initially steepen but should later flatten as deflationary risks reemerge. Risk assets will sell off aggressively. The secondary risk scenario is that the economy accelerates on a sustainable basis. The Fed will then bring forward its
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The Federal Reserve will continue to facilitate the deleveraging process by keeping policy loose for a protracted period. Judging by Ben Bernankes press conference in June and testimony in July, the Fed is leaving the door open for both normalisation and further easing, a testament to the uncertainty of the outlook. Our work suggests that any normalisation is a long time off while further easing could happen later this year should the economy deteriorate in the second half. Our base case is for a very modest improvement in economic activity which will allow policy to remain on hold.
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An eventual budget deal will result in additional fiscal drag. It will be important for the near term outlook when that drag kicks in; the earlier the more concerning it is for the recovery. We would view any additional drag in 2012 as very poor news for the current recovery. It would be much more encouraging with a deal that included extension and expansion of the payroll tax cut with fiscal retrenchment delayed to 2013. That way the recovery would get another year to get on its feet.
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On the fiscal side there is a strong political desire to tighten policy more actively given the alarming size of the deficit, although there are significant divisions how that will be achieved. This issue has come to the forefront due to the debt ceiling that will be reached in early August. The situation is extremely fluid and the probability that there wont be a budget deal has increased. Rating agencies have recently warned that they will downgrade the United States should Republicans and Democrats fail to reach a credible agreement. That would be unprecedented and in our view highly damaging to the confidence in the Treasury market. This is especially so given the large share of foreign ownership of Treasuries. Our base case remains for a last minute deal, but we remain wary and are positioning the Funds Treasury exposure very carefully as a result.
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normalisation process. The market impact is straight forward for fixed income; the front end will sell off aggressively and the front to intermediate part of the Treasury curve will flatten dramatically. Swap spreads will tighten. We think the probability is very low for a scenario of this sort to play out this year.
The European Tragedy

How did you go bankrupt? Bill asked.
What brought it on?
Friends, said Mike. I had a lot of friends. False friends. Then I had creditors, too. Ernest Hemingway (The Sun Also Rises)
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In Prologues view, the European crisis has two underlying causes, one structural and one secular. 1. The Eurozone is an incomplete structure because it is not properly integrated politically. Consequently, it doesnt have the necessary checks and balances between countries that share a currency and allow free flow of goods, capital, labour and
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The crisis in the Eurozone periphery is now eighteen months old. During that time, European partners and the IMF has provided rescue packages for Greece, Ireland and Portugal totaling EUR 273bn while the ECB has bought EUR 70bn of debt and lent EUR 430bn to financial institutions. Despite these efforts, the crisis is going from bad to worse. Rather than contracting, the spreads of countries that have received assistance have trended higher, albeit with a lot of volatility. More troubling is that none of the rescue efforts so far have managed to ring fence the problem, with contagion spreading to Spain and Italy. If there is not a paradigm shift in policy responses, the contagion will likely not stop there. In that respect, it is important to keep in mind how much further the crisis could run. Although Greek, Irish and Portuguese spreads are at record wides (by a substantial margin), Italian and Spanish spreads are still well below their pre-convergence levels.
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Two ways, Mike said. Gradually and then suddenly.
services. The Stability and Growth Pact was supposed to fill that void but has proven to be wholly inadequate. 2. Furthermore, the creation of the Eurozone unfortunately coincided with the last phase of the secular global credit boom which contributed to excessive interest rate convergence. Both these factors resulted in large imbalances between Eurozone members. The financial crisis exposed these imbalances and the subsequent forced deleveraging process has made the situation untenable. For most of the past 18 months, policy makers have stubbornly viewed the situation as a liquidity crisis caused by irresponsible behaviour by a few smaller member states. Only recently does it appear that some, but not all, leaders in Europe recognise that the combination of an inadequate structural framework and excess credit resulted in a solvency crisis for these countries. The inadequate analysis of the problem invariably led to inadequate policy responses. These responses have popularly been described as kicking the can down the road strategies. The general perception is that they have bought time but nothing else. However, recent developments suggest that is too sanguine of a view. The inability to convincingly deal with the problem in first Greece and later Ireland and Portugal allowed the problem to fester and lead to subsequent contagion. With Italy now exposed, a more comprehensive solution is needed. What is required is a proactive approach that i) allows peripheral countries to achieve debt sustainability and ii) establish a structural framework that doesnt enable large intra Eurozone imbalances to build up again. There appears to be some progress on the first point, with various EU officials arguing for lower interest rates and longer maturities on emergency loans and enlargement of current rescue facilities. On its own it is not enough. To start with, the austerity programmes in the periphery need to be more focused on growth, while debt burdens need to be adjusted (i.e. written down). How to do that is an arduous process which so far has been too slow and too messy. Contagion spread surprisingly fast to Italy earlier this month, a development that will have far reaching consequences. Italys debt currently stands at EUR 1.5 trillion, which is more than all the peripheral debt combined, Spain included. Thus, Italy is simply too big to be absorbed in the current safety net. This point is accentuated by the fact that Italy is potentially on the hook for 18%, or EUR 80bn, of the EFSF program. Thus, the solutions which have been tried (unsuccessfully) to salvage peripheral countries are not adequate for Italy. If the market pressure on Italy intensifies, the Eurozone needs to come up with credible structural reform plans and fast. So far, the peripheral crisis has come in waves with progressively wider spreads. We believe that will continue to be the case. The end game is either a change of the composition of the Eurozone or deeper political, i.e. fiscal, integration. We strongly believe the latter has the higher probability. The road to that end point will no doubt be volatile and include financial calamities, including various forms of restructuring. From a secular perspective, the crisis has been extremely detrimental to peripheral countries. Unfortunately, this is inevitable. Even in a benign scenario, living standards have and will continue to be reduced in Greece, Ireland and Portugal. A similar development will take place in Spain and Italy but to a lesser degree. The crisis has also been detrimental to the economic cycle. The periphery has been in deep recession for some time. A newer development is that some of the larger economies
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are starting to be affected in a material way. This is most obvious in Italy and Spain, where leading indicators have plunged recently. The global soft patch may have had some effect but a much more likely force is the rapid tightening of financial conditions following plunging stock markets and soaring yields. The odds on bet now is that Italy will fall back into a recession later this year.
The Deflationary Triple Whammy in Old Blighty

My other piece of advice, Copperfield," said Mr. Micawber, "you know. Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds, ought and six, result misery. Charles Dickens (David Copperfield)
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The United Kingdoms government has whole heartedly embraced the Micawber principle and engaged in an ambitious, some would say fool hardy, path of fiscal retrenchment. According to OBR estimates, the cyclically adjusted fiscal deficit will be reduced by almost two percent per year over the next five years, resulting in a primary fiscal
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In conclusion, the situation in Europe has deteriorated noticeably in recent weeks. The peripheral, or structural, crisis have deepened and spread to larger economies. Spreads should continue to trade wider in a broad but volatile range. It is a challenge to monetise this view as any forceful policy initiative will, at least temporarily, work against the underlying trend. Thus, we continue to approach this situation tactically with a bias for further deterioration. Whats new is the worsening cyclical outlook. Until very recently the base case was for the Eurozone as a whole to continue to recover at a healthy rate. That has now changed and going forward our directional strategies in Europe will be biased towards lower rates. That said, any duration strategy will be impacted by peripheral developments so the cycle cannot be traded in isolation.
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Leading indicators suggest that growth is likely to decelerate in the rest of the Eurozone too, including Germany. The deceleration should be moderate in Northern countries but still noticeable. Meanwhile, inflation should peak in the third quarter (see the appendix for more details). This is not an environment conducive to further monetary tightening. Thus, we believe the outlook needs to not just stabilise but improve for the ECB to continue its tightening cycle in the fall. That said, we are conscious that the ECB is prone to over tighten and will listen carefully to ECBs rhetoric over the next two months.
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surplus by 2015. If executed according to plan, it would be the largest cut in real public spending since the 1950s. Meanwhile, debt reduction in the private sector is ongoing. UK household saw an explosive increase in debt levels throughout the nougthies with household debt to disposable income increasing from just over 100% to 167%. Since the credit bubble burst that ratio has declined to 150%. At the current pace it will take another eight years before it reaches (a still elevated) 100%.
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This triple whammy is having predictable negative effects on domestic demand which is already hit by the fastest decline in real disposable income since the 1970s. As a result, real household spending is on track to fall one percent this year. Consumer confidence, unsurprisingly, is well below its long term average.
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Accentuating the process is ongoing balance sheet repair from banks. Although they have increased their Tier 1 capital ratios from 8% in 2006 to 12%, bond spreads for banks remain high. This has motivated banks to shore up their capital ratios further. Consequently, bank lending is restrained and rates unusually high compared to funding costs.
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The economic weakness is not isolated to consumers. Construction spending is currently falling by almost three percent year on year while industrial production is contracting with around one percent. Whats particularly disturbing is the poor export performance of late. Some of it can be explained by weakness abroad but it is also likely due to British industrys inability to capitalise on the depreciation of the pound. Exports should improve over time if, as we expect, the pound remains weak. The recent weakness in activity is probably accentuated by special factors such as the royal wedding, higher energy prices and the Japanese earth quake. As these factors roll off, the weakness in the second quarter may be reversed. However, any improvement in the third quarter should be viewed as quarterly volatility as the underlying trend remains weak. Inflation should remain elevated until the fourth quarter of this year but should start to fall rapidly next year. The June inflation numbers, which showed significant deceleration in price increases of discretionary items support that view. Of course, this is highly contingent on energy and import prices. But the fact is that domestic demand is reaching a point where it cannot support accelerating price increases. We are increasingly confident that inflation will fall below the Bank of Englands 2% target in two years time. Looking ahead, fiscal policy should continue to exert a significant drag on the economy of about 1% per quarter. As the economy slows down further, the governments resolve will be tested to a greater degree than we have seen so far. Given the composition of the government, it is doubtful that it will manage to stay the course if the economy is not getting support elsewhere. That, however, is probably not an issue until next year at the earliest. One area of support will, in our view, come from monetary policy. Although inflation has been above the target for several years, we expect Mervyn King to keep rates at the current low level. Indeed, there is a significant probability that the Bank of England engages in a second round of quantitative easing. In sum, the deflationary forces are currently voracious in the United Kingdom and the economy is consequently weakening. Another round of quantitative easing has a reasonably high probability. This should affect curve shapes negatively and push swap spreads wider. It should also weigh on the currency. Our strategies over the rest of the summer will be geared toward these outcomes.
Concluding thoughts
The current macroeconomic dynamics are unprecedented in our life time. Individual countries have experienced large scale deleveraging, but no one active in todays markets has seen such massive deleveraging on a global scale before. Governments and monetary authorities will soon have to make difficult choices. If the incorrect ones are made, large parts of the global economy may tip into a crisis possibly more dangerous and far reaching than 2008. The stakes could hardly be higher. Fortunately that is not our base case although the scenario we foresee is hardly uplifting; that developed economies will muddle along at low growth rates as deleveraging weighs on growth rates for years to come. Real interest rates will have to remain abnormally low for a protracted time, possibly manipulated further by central banks desperate to counter the effects of fiscal prudence. Clearly that approach may have its own side effects on currencies and inflation which in turn will affect curve shapes and level of interest rates. This is a challenging time in for the global economy in general and developed economies in particular. Asset classes have been extremely highly correlated. While volatility has been elevated, this has made for a difficult trading environment. The challenges have been accentuated by the unorthodoxy of the economic cycle and evolving reaction functions
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from politicians and central bankers. We are confident the Fund will successfully manage its capital during the second half by sticking to our already proven trading framework, adhering to the analytical framework presented in this letter and relentlessly analyzing the evolving financial landscape. As markets rise and fall, opportunities often evolve and present themselves quite suddenly. Tenacity has never been more important. We will continue to position as aggressively as we see appropriate, recognizing that historical uncertainties have injected capriciousness and unpredictability into market movements and volatility. We remain focused on trading those that have reasonable risk versus reward characteristics, remembering that profitability must be pursued in the context of both capital preservation and prudent risk management.
Tomas Jelf Chief Economist
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We are confident that the Fund is well positioned to continue to take advantage of these opportunities and thank you for your continued support.
Appendix Prologues Inflation Profiles The United States We expect headline CPI inflation to remain close to current levels for the rest of the year. It should decline next year due to base effects. This assumes that oil prices do not increase much beyond the forwards. Our work suggests that core inflation will remain on a gradual upward trend, reaching 2.0% yoy at the turn end of this year. It is likely to moderate in early 2012 due to the large output gap and base effects. The core PCE profile has a similar shape to core CPI but is running two to three tenths below it. The Fed forecast is slightly below our profile around the turn of the year.
UnitedStates
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Apr11 Apr12 Jul11 Jul12 Oct11 Jan12
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Apr07 Apr08 Apr09 Apr10 Jul07 Jul08 Jul09 Jul10 Oct07 Oct08 Oct09 Oct10 Jan07 Jan08 Jan09 Jan10
Apr13
Oct12
Jul13
corePCE(Prologue)
coreCPI(Prologue)
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Nov Sep Jul
ECB(Q2)
FEDcorePCEforecasts(Jun11)
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Our work suggests that HICP will increase over the next few months due to near term pressures from unprocessed food and utilities. Positive base effects will accentuate the move and create a hump with a 3.0% peak in September-October. Inflation should then fall fairly quickly, reaching the ECB 2% target in the first quarter of next year. Core inflation should be on a moderate uptrend throughout this year and next provided the Eurozone does not fall back into recession.
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The Eurozone
EuroZone
May
May
Jan10
Jan11
Jan12
May
Mar
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Prologue
Mar
ECBtarget
Nov
Sep
Sep
Jul
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United Kingdom Our work suggests that headline CPI inflation will trend higher throughout the third quarter reaching a 5.0% peak in October. It should then fall rapidly in the fourth quarter and throughout next year. Provided our commodity assumptions are correct it should reach the MPC target by the end of next year, i.e. a quarter earlier than the Bank of England profile. The latest inflation data, which showed weaker prices for discretionary items, has increased the confidence in our profile.
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Prologue
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MPC(May 11)
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Core CPI excludes food and energy. Source: BLS.
UK CPI is the Consumer Price Index. Source: ONS. The index is compiled using the harmonized methodology developed for the purposes of measuring inflation across the EU. The reference period is set at 2005=100. We focus on core CPI defined as all items excluding energy, food, alcohol and tobacco.
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HICP is the Harmonised Index of consumer Prices. Source: Eurostat. The index reference period is set at 2005=100. We focus on core HICP defined as all items excluding energy, food, alcohol and tobacco.
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The core PCE price index (Price Index for Personal Consumption Expenditure) is the Feds preferred measure of inflation. Core PCE excludes food and energy. Source: BEA. The index reference period is set at 2005=100.
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CPI-U (US) is the Consumer Price Index for All Urban Consumers. Source: BLS. The index reference period is set at 198284=100.
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July 18, 2011

The Burden Of Debt

The European Tragedy

What brought it on?

Two ways, Mike said. Gradually and then suddenly.

The Deflationary Triple Whammy in Old Blighty

Tomas Jelf Chief Economist

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5

Core CPI excludes food and energy. Source: BLS.

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