PORTFOLIO STRATEGY UPDATE

APRIL 2013

M. Cullen Thompson, CFA

President & Chief Investment Officer cullen.thompson@bienvillecapital.com

Our Framework for Gold In evaluating gold, we consider the following: 1. 2. 3. 4. The Fundamental Case Should we own gold? If so, how should we size it? The Technical Backdrop How is gold currently trading? Where is the technical resistance and support? Sentiment How does the market currently feel about gold? Who is buying and selling? Portfolio Construction What is the risk of a major inflation or currency crisis? Is gold trading in a correlated or uncorrelated manner to the other assets in our portfolio? In what environments does owning gold enhance portfolio diversification? What does the symmetrythe upside vs. downsidelook like?

In periods of financial repression, similar to today, whereby interest rates are lowered to zero, owning gold is less of an opportunity cost. It can also serve as a prudent hedge to a portfolio of financial assets whose value can be printed away in real or inflation-adjusted terms. Historically, gold has performed well in environments of negative real interest rates, a reality we have experienced off and on since the turn of the century. In fact, from January 2000 through December 2012, golds cumulative return was 482.0%. This compares to the S&P 500s price return of -3.0%. However, since the price of gold peaked at $1,920 in September 2011, it traded poorly through the end of the first quarter of 2013. Reasons often cited were: The unwinding of investments in a number of safe haven assets, including the Swiss franc and Japanese yen following the ECBs stabilization of Europe The expectation that real interest rates would rise as the global economy seemingly improved, making gold a less attractive investment The expectation that the Federal Reserve would soon taper their asset purchases, exiting their quantitative easing program ahead of schedule

The Fundamental Case Because of differing views on what gold representsan investment or alternative currencythe fundamental case for gold is intensely debated among investors. We view gold as a currency, a role it has played for over 3,000 years. Only since 1971, a little over 40 years ago, when the US dollar was delinked from gold, has it been featured less prominently in the minds of investors. Unlike a bond that pays interest, a business that generates profits and cash flow, or a commodity with industrial use, golds value is tied directly to policymakersthat is, golds desirability is derived from its perception as a store of value. Market participants attempt to anticipate the future fiscal and monetary environment. Large and rising fiscal deficits introduce the prospect for rising inflation and central bank monetization. This inflation of the monetary base is an effective devaluation of the domestic currency. In such a scenario, similar to the environment that has existed since 2008, one could debate whether gold is actually rising or the currency is simply falling. Regardless, burgeoning deficits and hyperactive central banks have historically provided the fundamental justification for owning gold. Gold, as we have said, tends to be inversely correlated with the confidence in our elected and unelected officials.

Although we were aware of these views, and therefore understood why gold had been trading down, we disagreed with all of them. First, we believed Europe was only temporarily stabilized. Economic data has since deteriorated, particularly in France. We continue to view the Eurozone as highly fragile. Although Mario Draghi is a highly capable central banker, monetary policy is limited in solving Europes underlying fundamental imbalances. Second, as the global economy continues to delever, deflationary pressures remain, and both money and credit growththe transmission mechanism of monetary policyremain weak, especially in Europe. We therefore believe its unlikely central banks will allow interest rates to rise anytime soon, which would weaken demand for credit and possibly halt the nascent recovery in housing in the US. Although its always possible that inflation

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expectations become unanchored, causing interest rates to rise, such a scenario should prove positive for gold. Nonetheless, our base case view is that financial repression will remain with us for years to come. Loose monetary policy is the countervailing force to deleveragings deflationary pressures. Finally, we also view an early exit from QE by the Fed as a low probability. Although a number of Federal Reserve officials have recently made public their desire to taper asset purchases, our interpretation is that many of these comments may be nothing more than a warning shot targeted towards credit markets, where overheating is once again evident in certain areas. Since 2009 the Fed has been threatening an exit from their unconventional policy.1 But since Chairman Bernanke first authored an op-ed on the topic, the Federal Reserves balance sheet has increased by $1.22 trillion, or 61%. As the old adage goes, watch what they do, not what they say. What is not debatable, however, is that despite pervasive fears of money-printing, both inflation and inflation expectations have remained anchored in the US, as well as in other advanced economies.
Source: IMF

respect to gold, its the next few months we are concerned about. The Technical Backdrop As seen in the following chart, gold has been trading poorly of late. Its inability to rally on the back of several key macro developments has been both surprising and baffling.
Gold
$2,000 $1,750 $1,500

$1,250 $1,000 $750 $500 $250 $0 Aug-92

Aug-94

Aug-96

Aug-98

Aug-00

Aug-02

Aug-04

Aug-06

Aug-08

Aug-10

Aug-12

Source: Bloomberg

The key macroeconomic events that failed to catalyze gold include: Italy The most recent Parliamentary election in February left Italythe largest debtor nation in Europe and a core member of the EMUwithout a working government. Particularly concerning was the strong showing by the populist 5 Star Movement, a party with many members who have publicly called for debt repudiation and exit from the euro. Cyprus As part of the Cypriot bailout, initially both insured and uninsured bank deposits were to be haircut (i.e., confiscated). However, the plan was ultimately revised to only include uninsured deposits over 100,000. This is part of a policy shift in Brussels to move away from bailouts of debtor banks and governments and towards bail-ins, where equity holders, creditors and even depositors share losses in the Eurozone crisis. Such a decision increases the probability of capital flight across Europe and a destabilization of the European financial system. Slovenia

Therefore, with no fear of an imminent inflation, along with improving economic growth and a rising US dollar, the near term fundamental case for owning gold has become less attractive. And although it may not be evident from the negativity present in the news cycle, the fiscal situation is also improving. Our estimate for the current years budget deficit is around 4.0%, on par with nominal GDP growth. This would not only stabilize the debt/GDP ratio, but it also represents a substantial improvement over the past four years. Although the risk of a future inflationary episode remains, its unlikely to occur in the next few months. And with
The Feds Exit Strategy; Ben Bernanke; http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html
1

Slovenia is likely to be the sixth Eurozone government to request a bailout in order to cover the government's deficits and resolve its insolvent banks, likely continuing

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the trend of European bailouts to avoid sovereign defaults. Japan On April 4th, the Bank of Japan, under their new Governor, Haruhiko Kuroda, unveiled radical new monetary policy measures, including his intention to double the monetary base in Japan by the end of 2014. These policies are explicitly intended to create inflation in the Japanese economy. Such a large increase in liquidity will have considerable effects across the global economy. North Korea North Koreas new leader, Kim Jong Un, has increased his belligerence with all of his neighbors. This rhetoric, along with a nuclear bomb test and specific timelines for threats of force, has kept Asian investors on edge. Any of these individual events would suggest a rally in gold. But collectively, one would anticipate a powerful rally. That gold hardly moved was alarming, suggesting either a shocking degree of complacency or a declining desire to own gold as a safe haven. Regardless, it failed to act as a store of value. Sentiment Sentiment over the past few months has been persistently negative, which from a contrarian perspective is quite positive. Periods of exuberance are often followed by declines in gold, and times of pessimism frequently precede strong rallies.

(GLD) Gold ETF Shares Outstanding

500,000

450,000 400,000 350,000 300,000 250,000 200,000

150,000 100,000

50,000 0 Nov-04

Nov-06

Nov-08

Nov-10

Nov-12

Source: Bloomberg

Portfolio Construction The absence of visible and rising inflation, combined with the reduction of the federal budget deficit, the perception of an improving global economy and the anticipation of a normalization of the Feds current loose monetary policy, has clearly reduced the desire to own gold. Even in the presence of key events posing systemic risk, gold failed to rally, indicating something was awry. On Friday morning, gold broke key support levels at around $1,550, at which point we cut our holdings considerably. At the time we believed it could quickly fall into the low $1,300sthe next level of supporttriggering stop-loss targets of various institutional investors along the way. At that level, we may consider re-entering some positions. Gold has had a phenomenal run, rising for 12 consecutive years and contributing meaningfully to our portfolios (in terms of both return contribution and diversification in times of market stress). While it may be too early to call for the end of the structural bull market, the price action alone warrants a much smaller allocation. With long-term structural themes where we believe a sizable opportunity exists, it is never our intention to try to precisely time the various tops and bottoms.

Source: Hulbert Gold Sentiment Index

But whereas open futures contracts consistently swing from long to short, reflecting professional participants who trade tactically, steady trends in retail flows have recently collapsed. We believed the recent outflows by the retail community served as an important signal of investor disinterest in currently owning gold. With equity markets rallying, it seems gold became viewed as an opportunity cost.

Bienville prides itself on constructing a diversified portfolio of high-conviction themes and investments, and sizing them accordingly for our clients. Given the recent price action and evolving economic environment, we no longer have that conviction in gold. We intend to shift the proceeds to opportunities where we believe the symmetry is better (i.e., upside target vs. downside risk). As always, please feel free to call us with any questions.

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