CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE

Sound Advice 10th March 2009

DIVINE COMEDY

James Vinall – Senior Investment Officer

To understand the future, it is necessary to understand the past. The seeds of the current crisis can be found in

the Western world’s response to the collapse of Communism. Socialism was a nice ideal, but could not get past

inherent human selfishness (especially the greed of their leaders) and the premise of even distribution of existing

assets failed. Left leaning political parties (like the US Democrats and UK’s Labour) needed to find another way.

Bill Clinton noticed how true wealth was created for the average American after WWII through consumer credit

and hire purchase. This was the first time the general population was able to borrow and invest and the resulting

growth made the USA the superpower it is today.

After many years of “greed is good” excess at the hands of the Republicans and UK’s Conservatives, Clinton and

Blair stumbled on the laudable idea of social democracy, which promotes extensive credit to the poor to make

themselves rich. This created the asset boom of the late 1990’s, which had a hiccup in 2000 with the “Tech

Wreck” caused by massive corporate overinvestment. In 2001, George Bush and the Republicans took over and

restoring corporate growth was their priority to fuel economic expansion. To rescue the deeply indebted “USA

Inc”, Greenspan took US interest rates quickly down to 1% to transfer debt from companies to individuals and

zealously encouraged exuberant spending on borrowing. The resultant cheap money fuelled the greatest

worldwide asset boom ever seen. Bush got US corporate profits into record territory and Blair saw that “things

could only get better” for the average man. The banks were regulated, accounting tightened and risk

management systems deployed to guard against “Saving & Loans”, LTCM, Barings, Enron and Worldcom ever

happening again.

Unfortunately, AIG et al found a whacky wheeze of insuring banks all over the world against loan default which

meant they could lend to anyone as they would not carry the can if the debt was not serviced. These credit

default swaps and collateralised debt obligations increased money supply by 30% beyond what was normally

available using debt provisioning. The US government even used FannieMae and FreddieMac as state

sponsored lenders of last resort to people whose credit was so bad, even the banks wouldn’t lend to them. Debt

piled high and the social democrats celebrated engineering the greatest mass creation of wealth in the history of

the world.

The mistake was that bank regulators in the US, UK and Europe did not require banks to provision for bad debt if

that loan was being covered by some form of insurance. Politicians and central bankers basked in the warm glow

of never ending prosperity having banished the boom and bust cycle to annals of economic history.

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CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE

Sound Advice 10th March 2009

This was until, individuals and companies had borrowed

so much money that inter-bank risk was unsustainable

causing a systemic failure starting with Bear Stearns

mortgage hedge fund collapse on 5th August 2007. This

was followed by NorthernRock in the UK in Feb 2008,

Bear Stearns in March, and then FannieMae/FreddieMac,

Lehman, Merrill, AIG, Washington Mutual, Wachovia and

Fortis in September 2008.

Credit for all is a great idea, but, Greenspan, Bush, Brown

and Blair took it too far and it will take more than a

generation to pay back this “irrational exuberance”. Wide

sections of the population who have sampled the delights

of comparative wealth are not going to return to fiscal

purgatory quietly.

In the last week of February 2009, investors looked into the various stimulus packages and saw Dante’s version

of hell in the Divine Comedy and abandoned all hope as almost every asset class was sold in the rush for cash

(including gold). Funds need to meet redemptions and individuals have margin calls and the resulting selling is

throwing the babies out with the bath water.

This brings us to where we are now. Politicians have a choice to borrow and print unimaginably large sums to

spend their way out of deflation or throw companies and individuals to the wolves and let the phoenix rise from

the ashes. Having given consumer nirvana to the mass population in the great social democracy experiment,

politicians have no choice but to bail out the economy with stimulus packages, that will probably need to be three

times greater than those already announced with the subsequent effect on bond prices and currencies. We

believe the European banking system is on the brink of collapse, insurers are in free fall and will need a rescue

package in the following weeks.

China has been acting like a global department store credit card by lending money to Western consumers to

borrow and spend on their goods. China has the world largest current account surplus and foreign currency

reserves. However, both China and Japan are highly leveraged to the Western Consumer and their economies

have significantly collapsed because of belt tightening.

Japan has spent the last 19 years trying to stimulate domestic demand and the government now owes

US$132,300 for every worker (in a rapidly aging population) which will take more than a generation to pay back.

Japan’s economic future is very bleak as their export market has evaporated, corporate earnings are

disappearing and it has little ammunition left to develop their domestic market. The Nikkei 225 is currently at

7,086 which is down 82% from the ultimate peak of 38,915 on the 29th December 1989.

By contrast, China to said to own 10% of the US public debt and can use those funds to adjust from an exporter

nation to domestic growth. The overriding concern of the Chinese Communist Party and the seven-member

Politburo Standing Committee is to retain control over their vast and diverse population. China is very good at

learning from other people’s mistakes and successes. The fall of Communism in Russia taught them to closely

manage regional nationalism and avoid separatist escalation. China followed the Japanese export success

model by keeping their currency low by lending to the buyers of their goods and printing money at home. In

November, Premier Wen Jiabao announced a CNY4 trillion (US$586 billion) stimulus package which is probably

just the start as the 8% GDP growth target for this year was reaffirmed last month. In cultural sea-change,

Chinese Banks have embarked on a country wide consumer credit initiative to encourage the population to

borrow and spend, fuelling an asset price boom and driving up domestic demand. China is very aware of letting

Source: Adam Zyglis

CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE

Sound Advice 10th March 2009

China is now in the ascendant and is making the adjustment to a domestic led economy and buying valuable

distressed assets and companies at fire sale prices all over the world. China is not going to let America climb

back to the top of the fiscal pile using their money.

On 11th February 2009, Luo Ping, a director-general at the China Banking Regulatory Commission, said China

will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments

remain its “only option” in a perilous world. As we all know, things change and the key moment for the US$ will

be when the Chinese government decide to stop buying US Treasury bonds in order to stimulate their own

economy. That will signal the start of Asian dominance of global economics for the rest of this century, as the US,

UK and Europe take a generation to pay off their current debt.

Middle Eastern Sovereign Wealth Funds have already halted major purchases of US Treasuries as they cannot

see how the US$ can survive the economic measures required to put the economy back on track.

We have never had a financial crisis where every country in the world is profoundly affected at the same time.

This is the first global depression and it will take decades to fully recover.

Currencies

We have previously covered the debt levels of the leading economies and the extraordinarily high level of UK external debt, which is now to have been largely deleveraged by hedge funds and banks.

Country Public Sector

Net Debt

Public Debt per

Worker

GDP External Debt External Debt per

Worker

External Debt as a

% of GDP

UK $987 bil $33,616 $2.05 tril $8.45 tril $287,957 412%

USA $10.6 tril $73,611 $14.58 tril $13.63 tril $94,444 93%

Japan $8.4 tril $132,300 $6.0 tril $2.32 tril $36,825 39%

France $1.35 tril $48,300 $2.1 tril $4.58 tril $163,889 218%

Germany $1.86 tril $45,588 $3.65 tril $4.85 tril $118,978 133%

Source: BoE, ONS, US Fed, BdF, Bundesbank and MoF

Britain’s relatively low level of public sector net debt per worker at US$33.6k (compared to Japan @ US$132k) suggests that UK government has a vast amount of room to borrow and print more money to stimulate the UK economy which will not be good for sterling. Our greatest current concern is the Euro and the scale of bank lending. Peripheral Europe (Ireland, Portugal, Spain, Italy, Greece, Austria and the former Soviet states) have vast lending and fading economies. France and Germany do not have the political will to effectively help, even if they did have the cash (which they don’t) and the ECB has no established rescue mechanism. Current prospects for the EUR look worse than the USD and GBP. America and the UK are currently losing the battle of hearts and minds that they have conquered deflation and every asset class is being sold in a flight to cash. We recently discussed how governments fighting deflation need to throw irresponsibly large amounts of money at a failing economy to make saving worthless to have credible expectations to force people to borrow and spend. The US and UK have started printing money via quantitative easing to make money so cheap, it will eventually create inflation. The US and UK need much bigger and faster stimulus packages to inject “real” cash to create the perception of inflation coming soon. The heavily indebted Japanese government cannot borrow much more to stimulate domestic demand which should be good for the JPY against the US$ and GBP in the longer term.

CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE

Sound Advice 10th March 2009

The CHF is likely to be weaker as UBS have made a precedent of revealing 250 tax avoiding account holders to the USA IRS (previously it had to be criminal activity) with the DoJ saying another 17,000 need to be investigated. Switzerland’s safe haven status in now under threat (although where else can the money go?). Also 60% of all recent Polish mortgages are in CHF which has appreciated 50% against the Zloty in recent months and the chances of getting this money back anytime soon is slim. Another concern is that Swiss bank liabilities (that may require a bailout) significantly dwarf the Swiss National Bank reserves. Factor in the tacit connection to the EUR and Switzerland is not in a good place. We are currently seeing a large amount of asset sales and cash repatriation, especially from sterling. Short term the GBP, US$ and EUR pairs are likely to be volatile as it will be difficult to determine which currency will be perceived as weaker than the other at any given moment. The UK is a small country and if consumers significantly slow buying, the currency will become less important to exporters. The USD is the world’s reserve currency with a massive scale economy that will always be important. Longer term, regardless of the amount irresponsible fiscal stimulus from both sides of the pond, the US$ should outperform the GBP with exchange rates settling into a lower range between 1.1000 and 1.3000. In August 2005, China revealed the Renminbi currency (CNY) is fixed against a basket of world currencies that comprise the US$, the Euro, the Japanese ¥en, and the South Korean Won, with smaller weightings of UK Sterling, Thai Baht, Russian Ruble and the Canadian, Australian and Singaporean dollars. The weightings of the components within the basket are undisclosed, but analysis reveals the Japanese ¥en, Euro and Korean Won have a greater influence than the US$ . China’s CNY will probably continue its longer term appreciation against the US$, which supports holding Chinese domestic assets. Chart of US$/CNY since 2004 showing Aug 2005 start of the currency basket.

FX Recap Short term – stronger US$, and GBP and weaker CHF, EUR and JPY Longer term – stronger JPY, with US$ probably better than EUR, while CHF will be weaker and GBP weakest of all.

Commodities Gold has rallied strongly from a low of US$682 per ounce on 24 Oct 2008 to 1,006 on Friday 20

th Feb 2009 (up

47%). Since then Gold has fallen dramatically with a low of US$900.1 on the 4

th March 2009 before rallying to

US$945 on the 6th March 2009 and is

currently @ US$912. The selling is coming from Hedge funds meeting redemptions, individuals meeting margin calls in falling equity markets and general need for quick cash.

Source: Saxo Bank

CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE

Sound Advice 10th March 2009

Western Central banks printing money to finance ever increasing stimulus packages to fight deflation, mistrust of fiat (paper) money and financial irregularities/fraud should see gold appreciate significantly in the longer term. We believe Gold will rally past US$1,000 later this year and our model portfolio is already long @ US$934, with a further buying target @ US$893 per ounce. Another way to play gold is through the gold producing companies. The American stock exchange Gold Bugs Index comprises 15 gold mining companies that do not hedge their production past 18 months forward. That assumes that they are best exposed to movements in the gold price. See http://www.amex.com/othProd/prodInf/OpPiIndComp.jsp?Product_Symbol=HUI The Market Vectors Gold Miners Exchange Traded Fund (ETF), code GDX listed on the NYSE, comprises 32 gold mining companies of which the 15 components of the Gold Bugs Index comprise 79.73% of the ETF. See http://www.vaneck.com/index.cfm?cat=3192&cGroup=ETF&tkr=GDX&LN=3_02&rfl=/gdx. The correlation is very close. The graph below shows the relationship between Gold (in black) and the Gold Bugs Index (in blue - divided by 10 to make comparison easier) and the GDX ETF (in red). Gold stocks started collapsing in the end of September 2008 as funds sold any liquid issue to meet redemptions. This broke the long standing relationship between Gold and Gold producers which is slowly recovering. As we have covered in the FX section, a large portion of leveraged fund redemptions have taken place and Gold producers are climbing back to their long run relationship with Gold. The Gold producers were hit very hard by the price collapse from late September 2008 and have recovered considerably, but are still lagging 50% behind the previous relationship. Gold bottomed at US$682 per ounce on the 24

th October 2008 and has since rallied 33% to US$912. The Gold

Bugs Index bottomed on 20th Nov 2008 at 159.28 and is now up 72% at 275 and the GDX ETF bottomed on the

same day at US$17.59 and is up 79% at US$31.55.

The chart (above) shows that the Gold Bugs Index and the GDX used to trade above the Gold price and is now significantly below, despite recent appreciation. If the Gold producing stocks return to their previous relationship (if indiscriminate fund selling of equities subsides), the GDX should be at US$46 (up 45% from here) with Gold at US$912. If Gold rallies to 1,000 (up 9% from here) and the GDX ETF returns to parity, the implied price is in the order of US$50 (up 58% from here). The risk is this is an empirical, not implicit relationship and subject to macro money flows in equities rather than actual corporate value. Investors need to balance the downside risk in Gold producing stocks compared to Gold with the potential gain if the relation is re-established.

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Data Source:

Yahoo Finance

CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE

Sound Advice 10th March 2009

Demand destruction in oil, lower industrial production and the desperate need of foreign capital by all of the oil producers should conspire to keep crude low for a while, despite platitudes of production cuts.

Fixed Income Bond markets are dogged by Central Bank quantitative easing and the deleveraging of the 30% extra money supply created by default insurance lent out in good times by the banks that now needs traditional provisioning. The charts below show the US and UK central bank overnight rate and the yield of the 10 year government bonds revealing how low rates have been driven in the fight to provide liquidity.

10 year US Treasury yields bottomed at 2% on year end buying and still slightly higher, showing that investors who have been throwing in the towel and going to cash do not want to buy bonds in the face of quantitative easing. Government sponsored stimulus packages will fail in the long run unless they generate sufficient individual capital and savings to drive the economy forward. Governments are likely to follow the Robert Rubin’s (Clinton’s Treasury Secretary) path of taking new government borrowing under three years into the short end of the curve. Demand for longer term money from corporates is likely to push 10 year rates significantly higher as cash holders will demand extra compensation to discount quantitative easing, resulting in a steep yield curve. 10 year UK Gilt yield is 3.11%. The Euronext Long Gilt futures contract has a nominal coupon of 6% and a maturity between 8 years, 9 months and 13 years and the front month contract is trading @ 125.54%. If 10 year Gilt rates rise to 6% as we believe, the implied price of the front month Long Gilt futures contract should be in the region of 60% to 70%. 10 year US Treasury Note yield is 2.95%. The CBOT US Treasury Note futures contract also has a nominal coupon of 6% and a maturity between 6 years, 6 months to 10 years and the front month contract is trading @ 122.75%. If 10 year US Treasury Note rates rise to 6% as we believe, the implied price of the front month US Treasury Note futures contract should also be in the region of 60% to 70%. At some point in the near future, when governments and corporates are issuing bonds and traditional buyers are less conspicuous, we would suggest shorting long bond futures as a strategic position.

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Data Source: St Louis Federal Reserve Bank Data Source: Bank of England

CLEAR AS A VIEWS ON THE

Sound Advice

Equities

Equity markets look awful as investors are capitulating and getting out. of the major indices since the 9

th October 2007 when the S&P 500 had its ultimate peak at

The FTSE is the best performing market as it is ONLY down 48%. China is the worst performer being down 64%. Below is a chart of equity index performance crisis caused by overburdening debt. We can directly comp2000 and the S&P500 2007 pan out over the

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S&P500 down 57% IBEX35 down 55%

DAX down 55% CAC40 58%

FTSE/Xinhua China 25 down 62% Shanghai Comp down 64%

LEAR AS A BELLIEWS ON THE PAST, PRESENT AND FUTURE

10

look awful as investors are capitulating and getting out. The chart below shows the performance October 2007 when the S&P 500 had its ultimate peak at 1,565.

performing market as it is ONLY down 48%. China is the worst performer being down 64%.

a chart of equity index performance each day past the ultimate peak of the market during a financial crisis caused by overburdening debt. We can directly compare how Wall Street 1929, Japan 1989, NASDAQ

pan out over the subsequent days as Governments struggle to reflate economies.

IBEX35 down 55% FTSE100 down 48%

CAC40 58% Nikkei225 down 59%

Shanghai Comp down 64%

ELL UTURE

10th March 2009

The chart below shows the performance 1,565.

performing market as it is ONLY down 48%. China is the worst performer being down 64%.

the ultimate peak of the market during a financial are how Wall Street 1929, Japan 1989, NASDAQ

overnments struggle to reflate economies.

Data Source:

Yahoo Finance

Data Source:

Yahoo Finance

CLEAR AS A BELL VIEWS ON THE PAST, PRESENT AND FUTURE

Sound Advice 10th March 2009

Major equity indices look good value when compared to 2008 actual earnings. However corporate earnings are collapsing fast and no one really knows how bad the figures will be, although everyone agrees that analyst estimates are probably behind the curve. The FTSE is currently trading at 7 times 2008 earnings, estimates for 2009 earnings suggest the price earnings ratio (P/E) could be 22 and likely to get worse, which is not good value. The world is in crisis. The primary trend of equity indices is lower and if the markets follow the Dow Jones Industrial from 1929, technical support for the S&P500 is 400 and the FTSE100 at 2,000 over the next year. We are helping some trading clients to define buying targets for the expected countertrend rally in equity indices, but the scale and duration of such a rally is an unknown risk. We are also identifying “babies” that have been thrown out with the bath water for rapid recovery to fair value like Carrefour who have a 6% dividend yield at €23.90 per share and results out on Thursday 12

th March that are likely to be good.

Given our longer term view that equity markets still have further to fall, we would suggest taking a strategic short position on equity indices at a suitable point in the near future to benefit from the long, grinding slide lower over the next year.

Conclusion This financial crisis is taking us all through a Divine Comedy as investors have currently abandoned all hope within the Inferno; when we hit bottom we’ll be in Purgatory for quite a while before finally climbing back to Paradise many years from now. 16 months into this crisis, if we look at previous market disruptions, we are a long way from sorting out the mess and heading to recovery. We first saw “abandon all hope” selling in November and then again in the past week. We will probably see another round of final capitulation later this year as the stimulus packages fail to bring on inflation as fast as politicians, companies and individuals would like. We are helping traders to play the short term movements, but our longer term primary trends are strong Gold, weak equities, weak long term bond prices and a stronger JPY.

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