Vltava Fund letter for the third quarter ended September 30, 2016; “An Attempt At A Small Glance Into The Future.”

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Dear shareholders,

[drizzle]In the third quarter of 2016, the Fund’s NAV grew by 6.6%.

Vltava Fund

Vltava Fund – Prophecy at the stove

“Young man, have you ever seen a mine? It’s a hole in the ground, shafts going up and down and side to side. Now, a mine can be flooded, it can collapse, but no one can take it away!”

Every Czech knows this splendid excerpt from “The Visionary”, an absurdist one?act play by the great (albeit entirely fictional) Czech playwright Jára Cimrman. (We also know today, by the way, that even a mine can be taken away.) At the centre of the action, the farmer Hlavsa is foretelling the future from peering into a red?hot stove to the Prague coal baron Ptá?ek. We have often said to one another that it would not be a bad thing to have such a stove for reading financial markets. Although we unfortunately do not possess one, let us at least imagine what revelations we could expect to find there.

Revelation one: indebtedness

Every consideration as to long?term global development should probably start with a look at the key countries’ indebtedness. The following table shows the development of national debts as a proportion of GDP in major developed economies between 2006 and 2015.

The US, for example, had a national debt equal to 64.8% of GDP at the end of 2007, which in hindsight was the last relatively calm year before the Great Financial Crisis. A mere 2 years later, which is to say just after the crisis, the debt was one?third higher, at 87.1% of GDP. At the end of last year (i.e. after 6 more years of “economizing and saving”), the debt was higher by another one?fifth: 104.1% of GDP. In just 8 years from 2007, it grew by an incredible 61% and the debt continues to increase.

The development in other countries has been in the same direction. The most indebted by far is Japan, and debt is growing the fastest in Spain and in the UK. Only Germany slightly defies this trend. Although it, too, has a high debt, Germany’s debt is the lowest among those countries listed and it has been decreasing for several years (a question remains as to how much of a negative effect will occur due to the mass influx of immigrants). It is interesting that the unexpected crisis in 2008 increased the debts by an average 29%, and the following 6 years of economic expansion, low interest rates, and massive pro?growth stimuli brought another 29% rise. This is an incredibly alarming state of affairs. Debts have not been diminished successfully even under the relatively favourable economic conditions.

Vltava Fund

Vltava Fund

Why are debts a problem?

In the Czech Republic, we have heard politicians proclaim that “debts need not be repaid” and “there are sources enough”. But that is absolutely not the case. Long?term deficit operations and amassing debts is possible only until the market is no longer willing to finance it. Once the market’s willingness breaks, a swift end must follow. We need only go back to the book by Reinhart and Rogoff entitled This Time Is Different to be reminded of dozens of similar examples from history. The problem is that it is impossible to estimate beforehand at what level of indebtedness the market will lose confidence. Moreover, this level is not the same for every country. If the market is still able to tolerate Japan’s national debt at the level of 229% of GDP this does not mean that other states can count upon the same. Many countries in the past have been forced to declare bankruptcy with debts at only a fraction of that level. According to Reinhart and Rogoff, more than half of state defaults were at debt levels under 60% of GDP.

If we consider that national debt constitutes a substantial burden on state budgets, diminishing governments’ room to manoeuvre, pushing out private capital, suppressing economic growth, and raising the risk of potential insolvency, it is evident that debt and its size are potentially a great problem. The current debts of the major developed countries are simply too high, even leaving aside questions as to their immense future liabilities primarily for pensions and healthcare. These debts are not included into measures of the national debt – but they should be. Companies which have pension liabilities to their employees must state these on their balance sheets. They must measure and continuously finance these debts according to certain rules. If the same measures were to be applied to state finances, we would be shocked at how high are these debts. In many countries, their national debts would multiply several times over!

If you have masochistic inclinations, you can read the article by Jagadeesh Gokhale, formerly a senior fellow at the Cato Institute, entitled Measuring the Unfunded Obligations of European Countries. Gokhale has long been examining this problem, and according to his calculations the present value of future uncovered liabilities in the EU is on average 434% of GDP! Spain is the best off, at 244%, while Poland is in the worst shape with a figure of 1,550%! These numbers are downright terrifying. Moreover, those figures are from 2009. They will be even higher today, as the debts have continued to grow and the interest rates used to discount future liabilities are lower.

There can be no doubt that debts are too high and must be somehow reduced over time. So far, the only thing governments have to show for themselves is their endeavours to resolve the debt problem by amassing still more debt. Isn’t that great! It is as if an alcoholic can be treated by ever larger doses of alcohol. Warren Buffett at one point, probably with a bit of exaggeration, proposed to resolve the problem of swelling US indebtedness by enacting a law forbidding any politician who ever voted for a deficit budget from re?election. I would agree. That would solve a lot.

How to decrease debt?

The size of the debt relative to GDP can be reduced in essentially three ways. The first is by rapid economic growth. A briskly growing economy puts a smaller burden on the budget, and GDP can grow more rapidly than the debt. Thereby, the growth in debt relative to GDP can diminish. This is the ideal scenario, of course. Unfortunately, it is practically out of the question for most developed economies. If we look back to the previous table, we probably would not be surprised to see that the debt of the selected countries increased by 29% over the two worst crisis years. This could have been expected. An unpleasant finding, however, is that even though the global economy operated in a relatively favourable climate over the past 6 years, indebtedness has continued to grow relatively quickly.

Economic growth is still too slow to decrease debt all by itself. GDP growth in developed economies has been slower since

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