inverlochy q2 2011

8/3/2019 Inverlochy Q2 2011

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Please see important disclosures at the end of this document. Page | 1

Q2 2011 Commentary

"Denial ain't just a river in Egypt."

-Mark Twain

Com m en t s Rega r d ing t he Recen t US Gove r nm en t Deb t Dow ngr ade & M ar ke t

Tu r m o i l

Augus t 22 , 2011

The markets have had a tumultuous few weeks to say the least. Even a cursory glance at

the economic and financial news over the last few months leaves any sentient being feelingdistinctly uncomfortable about the economic future. Nearly all global stock markets are


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negative on the year after registering respectable gains by the end of the second quarter.The current episode of turmoil is weighing heavily on the already bruised confidence of

consumers, businesses and investors which has resulted in a number of economic indicators

falling to recessionary levels. Investors have now suffered a full decade of what feels likeblind side hits the bursting of the tech bubble in 2000, a more than 50% melt-down in theS&P 500 in 2008, the 2010 Flash-Crash with a 10% intra-day plunge in US stocks and

now, 2011s August stock market debacle. Dealing with this unprecedented level ofuncertainty makes investing devilishly tricky. Investors are faced with the choice of earningalmost nothing on lower risk types of investments (short-term bonds, guaranteed deposits)or forced to take more risk than they are comfortable with stocks or corporate bonds just

for the prospect, not necessarily a guarantee, of higher returns.

The profusion of uncertainty makes the incredibly difficult task of forecasting the economic

future virtually impossible. In order to function in such an environment an investor needs aprocess to make objective decisions. Without a process in such an intractable investment

mosaic our emotional and behavioural biases often outweigh our more rational impulses.

This process should include a macro-economic framework that helps to understand thestructural economic, political and demographic problems facing most countries in thedeveloped world. Once the macro-economic environment is understood an investor can

focus on investment opportunities that are likely to thrive in such an environment. The

specific investment opportunities then need to be analyzed from the bottom up todetermine their investment merit. The bottom up analysis of a companys operating profitsand cash flow will remain the fundamental long term drivers of equity valuations, even in

todays less than hospitable economic environment. The probability of predicting marketmovements, especially in the short-term is very low. Conversely, the rate of success forobjectively reviewing macro-economic data combined with valuing the economics and

sustainability of a business is much higher.

What is causing the seemingly endless stream of bad economic news? I think it is

worthwhile revisiting some of the big picture issues that are making life so difficult forinvestors.

While the current amount of uncertainty facing investors seems like an impenetrable fog,when viewed through the prism of a macro-economic framework it becomes apparent the

issues facing the global economy are inexorably linked. Colossal and cascading governmentfiscal and monetary policy errors have resulted in egregious amounts of debt and currenciesthat have been seriously impaired in their ability to act as a store of wealth.


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A mans got to believe in something. I believe Ill have another drink.

-W.C. Fields

While President Obama was elected on a campaign slogan of Change We Can Believe In I

think most investors would currently side with the sentiment echoed above by W.C. Fields.

Really nothing has changed in terms of the geo-political or economic policies of the US sincePresident Obamas election. The current economic conditions are really just the re-

emergence of the same decade long problems that we last saw bubble to the surface duringthe summer of 2010 when markets wobbled and economists where running for the hills

calling for a double dip recession. The US Federal Reserve panicked around this time lastyear and announced their second round of quantitative easing, QE2, in response to financial

market weakness and worries about the general health of the economy. Both QE programs

launched by the Fed involved the monetization of debts, or said another way moneyprinting to the tune of about a combined $2.5 trillion. In Europe, policy makers hastily put

together a multi-hundred billion Euro bail-out package for Greece last spring. In both casespolicy makers never addressed the essence of the structural economic problems facing their

respective economies too much debt. In fact, in both cases, the underlying structuralproblems were only made worse.

In the summer of 2011 we are, once again, facing the consequences of decades ofunsustainable credit growth, government deficits and money printing. With very few


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exceptions policy makers around the globe have chosen to kick the proverbial can down theroad, usually while eyeing the next election, instead of making difficult decisions to correct

these issues. The behaviour of the financial markets in 2008 and again now emanates from

financial market participants starting to realize that the cost of kicking the can down theroad is going to be very expensive. Delaying the inevitable and necessary adjustment ofonce again living within our means will only make the adjustment more jarring when it

comes.

I don't make jokes. I just w atch the government and report the facts."

- Will Rogers

Ken Rogoff and Carmen Reinhart, the authors of This Time is Different: Eight Centuries of

Financial Folly, have studied the last 800 years of government financial policies and cameto the conclusion that, the ability of governments and investors to delude themselves,giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a

constant. Further, they came to the conclusion that even though policy makers and

governments improve over time they always are tempted to stretch the limits of what can

be achieved with various policies. History also shows that any highly indebted entity, be itan individual, company or government is dependent on the confidence of its creditors. As

we all know confidence is a particularly fickle human trait. As such, the authors go on toconclude, Economists do not have a terribly good idea of what kinds of events shiftconfidence and of how to concretely assess confidence vulnerability. What one does see,

again and again, in the history of financial crises is that when an accident is waiting to

happen, it eventually does. When countries become too deeply indebted, they are headedfor trouble. There is no question at this point that all major developed countries areheavily indebted (see chart earlier in this commentary) and that we have been seeing

warning signs for the last couple of years that trouble is headed our way.

While last years QE2 launched by the US Federal Reserve and the Greek bailout

orchestrated by the European authorities did temporarily goose economic activity they were

not successful at creating ongoing economic growth via the wealth effect of rising assetprices. People respond to changes in permanent levels of income, not to one-time cash

infusions, when making major spending or investment decisions. Wealth has always been

increased by creating long-term cash flows from productive investments, not just byincreasing debt levels or creating new units of a currency with a key board.

So while policy makers have been successful in fostering rampant speculation all they have

really achieved with the recent policy choices is impoverishing the world's poor throughcommodity price increases and punishing the risk averse and prudent savers with interest

rates that offer no prospect of a real return. Remember that real returns are what aninvestor earns above the rate of inflation. Clearly, when interest rates out to 10 years are

only around 2% per year and consumers are faced with mid-single digit (or higher)

increases in food and energy costs an investor is not earning a real return.

To reiterate, the pressing problem that needs to be addressed by global policy makers is the

restructuring of debts. Consumers are not purchasing less today because mortgage ratesare not low enough or because they dont have access to credit cards. It is because they

spent the last three decades incurring more debt than they can realistically afford to payback. Governments, in most countries around the world, have led the way in spending

more than what they conceivable collect from their respective tax payers. Consumers havesimply followed their governments lead.


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Common sense is not so common.

-Voltaire, French Philosopher and Writer (1694-1778)

The financial crisis of 2008 led to the first global recession since the great depression of the

1930s. It also left a gigantic mountain of debt that is acting as a powerful headwind

against the growth of the global economy. Is the debt situation really that bad?

According to Reinhart and Rogoff, as public debt in advanced countries reaches levels not

seen since the end of World War II, the urgency of taming deficits in order to stabilize andreduce outstanding debt as a percentage of gross domestic product increases. Not following

this common sense path will result in an economy that struggles to grow and produce newjobs. The Reinhart and Rogoff empirical research on the history of financial crises and the

relationship between growth and public liabilities supports the view that current debt

trajectories are a risk to long-term growth and stability, with many advanced economiesalready reaching or exceeding the important marker of 90 percent of GDP. What we have

been witnessing this summer in terms of volatile markets and suddenly weakeningeconomic growth would seem to support the authors findings.

The first chart below illustrates the debt of both the US Federal government and privatecreditors expressed as a percentage of GDP. The next chart is the debt of the Federal

government, again as a percentage of GDP. The empirical evidence shows, by either

measure, debts have reached a level where they will, at a minimum, weigh on economicgrowth and at worst case provide the tinder for another crisis.

Chart: U.S. Public & Private Debt as Percentage of GDP 1916-2009


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Chart: U.S. Debt as Percentage of GDP 1790-2009

What can global policy makers do to prevent another crisis and reinvigorate theireconomies? What choices are left, after we have incurred the debt and structurally

impaired our economies?

A recent McKinsey Global Institute Report, Debt and deleveraging: The global credit

bubble and its economic consequences studied the history of how over indebted economiesundertook the daunting process of reducing leverage. McKinsey looked at 45 prior episodesof deleveraging that have occurred since 1930. The deleveraging episodes that were

studied showed that these periods are lengthy and painful. According to McKinsey theperiods exhibited the following attributes:

The deleveraging periods last, on average six to seven years

Debt to GDP declined by an average of 25% GDP contracts in the initial years of the deleveraging but expands in the later years

Here are the observed methods that countries have used to extricate themselves from thetype of mess most developed countries now find themselves in:

4 ways to get out of the debt mess

i) belt-tightening,ii) high inflation,

iii) massive default,

iv) high GDP growth/productivity.

Clearly, after the fiasco of a debate about the US debt ceiling and controlling the deficit, the


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belt-tightening option is not currently in the cards. The political will simply does not exist tomeaningfully cut deficits by either cutting expenditures or raising taxes. In fact, the policy

actions of the last two or three decades would indicate that we should expect policy makers

to reach for option 2 (high inflation). A major misstep on the road to higher inflation maylead directly to option 3 (massive default). This misstep would result from either inflationaccelerating too quickly thereby causing a currency crash and loss of confidence in US policy

making or because reflation efforts are not robust enough and the US, and then globaleconomy by extension, falls into an uncontrollable deleveraging that also must end inwidespread defaults. Option four is simply wishful thinking due to the over indebtedconsumer and government sectors of the economy.

Alice: It w ould be so nice if something made sense for a change.

- Lewis Carroll, Alice in Wonderland (quote from the 1951 movie)

The continued emphasis on short-term fixes and bailouts has a high cost in the long run.These types of policies encourage, or are aimed at increasing debt levels, money printing

and speculation in financial assets and are temporary balm but end up becoming bombs as

they have been over used. Capital is misallocated as a result of improper market signalscreated by distorting risk levels and incentives that emphasize short-term gain orconsumption in favour of investment to produce long-term wealth.

Government finances throughout the Western world had limited ability to handle the extra

strain of deficit spending in response to the 2008 financial crisis as a result of decades ofdeficit spending to finance consumption related items. While a government response wasrequired by the time the financial crisis arrived, the time that was gained by providing thegovernment backstop should have been used to restructure the financial system, improve

the enforcement financial market regulations and address structural government budgetdeficits. Sadly, none of this was done.


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Throughout history, once governments make a series of such short-sighted choices oftenwhat follows next is a crisis of the sovereigns themselves. This occurs because the

government bailouts occur during periods of economic fragility and a private sector that is

already over indebted and trying to delever. In this situation the government ends up beingthe sole driver of credit growth, which modern economies require in order to expand. If acrisis of confidence then occurs at the sovereign level the financial system starts to make

some horrible creaking sounds much like a car with a failing engine. This is what we haveseen over the last year, starting with the periphery of the financials system (small countrieslike Greece, Portugal, Ireland) and more recently moving to the core of the financial system

with the US government debt downgrade and major cracks starting to form in core

European countries like Italy and France. Obviously the stakes are very high when a crisisof confidence develops at the government level. In the eyes of many types of investors,government debt is considered to be the risk free asset in our financial system. Because of

this fact even the threat of government defaults (as opposed to the default actuallyhappening) can result in major changes to investment behaviour.

Extending life support to the insolvent is a recurring mistake made by governmentsthroughout financial history. What often starts out as a relatively small crisis mushroomsinto something larger as misguided bailouts simply result in delaying a final reckoning much

larger than the original crisis. This lesson seems to go unlearnt because it is always more

politically expedient to bail out a troubled borrower than deal with the fall-out of a failurethat potentially costs voters their jobs and or savings. The temptation towards expediencyis amplified when a major financial institution or government is on the ropes as that may

lead to the contagion of other parts of an economy or trading partners. The temptation tointervene and bailout the unworthy using government funds and by money printing getsstronger in periods of significant economic weakness. So governments go down the same

road of failure bailout, cover-up and hope.

Doorknob: Read the directions and directly you w ill be directed in the rightdirection.

- Lewis Carroll, Alice in Wonderland (quote from the 1951 movie)

For over two decades now Federal Reserve monetary policy has been focused on attackingany and all economic or financial system weakness with a torrent of liquidity. This started

with the aggressive monetary ease that cut overnight interest rates to the incredibly low

level of 3% (Oh, the good old days of positive real returns) after the S&L crisis in order torecapitalize the banking system back in 1990. Since then money has always been made

abundant and cheap anytime the global economy or markets have a misstep. In the 1990swe experienced the Asian crisis, the blowing up of Long Term Capital Management and

Russias default. The Fed always responded with more liquidity. The global marketsbecame trained like dogs to expect that a crisis would precipitate more liquidity. This

asymmetrical policy bias is the fundamental reason for the current level of moral hazard

and the impaired ability of the markets to correctly price risk. The Federal Reserve aschaired by both Greenspan and Bernanke made it clear to the markets that the Fed would

not intervene to temper asset bubbles. Instead it would focus on aggressively mopping-up measures as asset markets faltered. Now we are faced with global markets that

recklessly expect any economic set-back to be met with an overpowering policy reactiondesigned to inflate asset prices further.

In the last three years we have seen central banking mopping up actions that have addedaround $5 trillion to central bank balance sheets. On top of this governments around the


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globe have guaranteed many trillions more of private sector debt. Too big to fail hasmigrated from a term associated with the largest banks to the creditworthiness of

governments themselves.

In the US mortgage finance has effectively been nationalized when Fannie Mae and Freddie

Mac became wards of the state. The Federal Housing Agency (FHA) has picked-up where

Fannie and Freddie left off insuring risky mortgage loans. Even with just a month of marketturbulence the financial markets are already begging for more government stimulus. Last

week, right on cue, President Obama asked his blue ribbon deficit cutting committee to

consider more deficit spending to help the economy! The Federal Reserve has alreadystarted down the road of additional monetary stimulus with their recent promise to robsavers of any interest for two more years.Oops, did I write that, I meant they promised to

keep interest rates at zero for two more years to help the economy. This is yet another

distortion of capital markets that will cause people to take yet more risk in order to earn apotential return via risky assets. The timing is perfectly awful, of course, as we may beentering a recession, a time when risky assets are likely to fall in value the most.

The European mess has spread from the periphery of small economic players to some of the

largest Italy and France. Financial market participants hope that the European leaderswill defend all the bad loans made to Greece, Portugal, Ireland, Spain, etc. by committingmore public funds. Markets are starting to grasp the intractable problems of European

Union finances. The abrupt end of cheap borrowing for a whole host of European countries,

most recently including Italy, is the belated recognition that severe structural debt andeconomic problems affect the current foundation of the Euro bloc.

We're all mad here.

Lewis Carroll, Alice in Wonderland (quote from the 1951 movie)

(Dedicated to the US Congress and Senate for their recent deft handling of the US debtceiling debate)

The recent beyond inept handling of the US debt ceiling issue helped illuminate the

vulnerability of the confidence that is required to underwrite the gigantic deficit spending

and liquidity of the US government debt market. Much like Greece the problems have beenfestering for years, decades really. So far the confidence in US government debt remainsbut Washingtons latest display of dysfunction is severely testing the confidence of

consumers, businesses, foreign governments and of course, investors.The take away of this review of sovereign debt history is that debt crises tend to follow a

common path. Problems mount over an extended period of time resulting in distortedmarkets that become incapable of adjusting in a rational way to significantly heightenedrisks. At some critical juncture however, the stresses become too much to bear

and markets react abruptly. Often the reaction is dramatic as we have seen in the case ofthe European debt markets this year.


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There is no subtler, no surer means of overturning the existing basis of society

than to debauch the currency. The process engages all the hidden fo rces of

economic law on the side of destruction, and does it in a manner which not oneman in a million is ab le to diagnose.

-John Maynard Keynes, British Economist

The Difference between Money and Currency

Given everything that I have written about in this commentary to this point it is worthwhilegoing on a small (I promise) tangent about what I perceive as the difference between

money and a currency. The distinction is not something very many people ever give amoments thought to even though they may work at jobs for 40 years, or longer, attemptingto build wealth and they use their countrys currency everyday of their adult life.

I have borrowed some of the material for this section from a commentary that I wrote lastyear, Why Own Gold? (The commentary is available on the www.inverlochycapital.comwebsite).

What is money? According to the online dictionary Wikipedia money is any object that

is generally accepted as payment for goods and services and repayment of debts The

main functions of money are: a medium of exchange; a unit of account; and a store ofvalue. In order for a modern economy to function there is a fundamental need for a

medium of exchange. Some early civilizations used pebbles or shells. Ive read that airplane

liquor bottles were used as a currency in the 1990s in Yugoslavia as a form of currencyduring their civil war, when the economy ceased to function. Barter is another form ofexchange but has obvious limitations as both a medium of exchange and a store of wealth.

Societies have always tried to organize themselves around the best monetary standard that

they could find. The Roman Empire used silver and many other monetary systems havebeen backed with gold. Paper money exchangeable for gold became available with theadvent of the paper printing process.

What is a currency? Here Wikipedia says In economics, currency refers to a generally

accepted medium of exchange. These are usually the coins and banknotes of a particular

government, which comprise the physical aspects of a nation's money supply. The otherpart of a nation's money supply consists of bank deposits (sometimes called depositmoney), ownership of which can be transferred by means of checks, debit cards, or other

forms of money transfer. Deposit money and currency are money in the sense that both areacceptable as a means of payment.

Notice that the definition of currency did not include the statement a store of value. Ibelieve that this is a very important distinction in a time of over indebted governments andentire economies for that matter. As I wrote earlier in this commentary, governments in

such a situation are more inclined to choose a path of inflation versus austerity to alleviatetheir debt loads.

So why do we tend to use these terms interchangeably? Mainly because the term currency,as it relates to money, evolved from an innovation which had occurred by 2000 BCaccording to Wikipedia. Originally money was a form of a receipt that represented grain

stored in granaries. This practice started in ancient Mesopotamia and then was adoptedin ancient Egypt. In this first stage of currency, metals such as copper, silver and gold were


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used to represent the stored value of the grains. In such a system the terms currency andmoney can be used interchangeably.

In todays financial system however our currencies are fiat based. In other words thecurrency only has value because a government declares it to represent value and to be legal

tender. As legal tender the currency must be accepted as payment for all debts.

I want to focus on the third function of money as defined by Wikipedia - a store of value.

Before the advent of paper money, currencies were commodity based. The value of anations or empires currency was linked to goods produced from land and labour. When

currencies were actual commodities such as grains or industrial metals (copper, tin, nickel,and zinc) it was impossible to counterfeit money. Money was linked to productive capacity.

When productive capacity grew then the available supply of currency grew. Even whenmoney was linked to a commodity you still had the right to trade it for the underlying item

of value on demand. This link provided a stable value for the money in terms of an item

that was considered by the society to represent wealth. Further, it ensured thatgovernments couldnt print money indiscriminately. The link between paper money andgold has been lost for many decades. In the case of the US dollar it was severed from gold

in two stages. During the Great Depression the US dollar was devalued relative to gold andindividuals were prohibited from holding gold. President Nixon made the final break in 1971when he ended the convertibility of US dollars for gold available to foreign countries as part

of the Bretton-Woods system. This created a world in which all currencies are fiat,

meaning they are not backed by gold or any other commodity. Therefore the supply isinfinite and governments are not limited by any natural force from creating more of thecurrency at will.

As any rational person would expect in a system that allows a government to create money

at will, a great deal of money has been printed since Nixon closed the gold window. This

would especially be the case in periods where money seemed hard to come by. Lets go tothe charts:


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Please see important disclosures at the

The chart above, courtesy of thbankers and politicians where s

from 1985 2008 having quad

During the financial crisis of 20base was increased from rough

The monetary base of a countrits coins, paper money in bankalso includes the reserves of co

Other measures of money in athe monetary base is smallestmost acceptable (or liquid) for

Components of US money supply (currency, M

The growth of the entire US m

base, M1 and M2 is over $9 trillmonetary base components asaccounts plus money market m

So even the mathematically chbeen created in the last three,grown dramatically since the 1

money is also higher. Howeve

end of this document.

e Federal Reserve Bank of St. Louis, shows tomewhat (not really!) constrained in their pri

rupled the US monetary base over the course

08 restraint was completely abandoned and tly $800 billion to almost $2.8 trillion.

s financial system is the highly liquid moneyvaults and currency circulating in the public.mmercial banks held at the central bank.

financial system are typically classified as levnd lowest M-level. Base money can be descof final payment.

and M2) since 1959 Wikipedia

ney supply, as represented by the componen

lion dollars. The money supply as defined bywell as the balances in checking, savings, moutual funds and certificates of deposit under

llenged can see that an enormous amount oten, thirty and even forty years. To be fair th60s in both real and nominal terms so the d

, it does not seem to be a stretch to say that

Page | 12

at the centralnting of money

of 22 years.

he monetary

comprised ofBase money

ls of M, whereibed as the

ts Monetary

M2 includes theney market100,000.

money hase economy hasemand for

the supply of


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newly minted base dollars has outstripped growth in the real economy over the last threeyears.

For further context on this matter consider that the ratio of M2 money to Base money in1985 was approximately 11xs. Currently that ratio is only 3.5xs. In a fractional reserve

banking system such as ours base money can grow to 10xs its original amount via banks

extending credit to their customers. That would place M2 at a theoretical level ofapproximately $27 trillion dollars. Now imagine an economy with the same amount of food,

energy and services, but with nearly three times the current total of money supply chasingthose items. How would the dollar be as a store of value in that scenario?

Substitute your lies fo r fact, I can see right through your plastic mac

-The Who, Substitute (1966)

Another way to parse the question of what is money is to delve further into the componentsthat are included in the definition of M2. Money market securities are really short-term

loans (one day to one year). Generally these types of securities are issued by high quality

borrowers such as governments and major corporations. Government treasury bills,commercial paper and short-term municipal paper all fall in this category. Money marketinvestments are generally held by investors looking for a safe place to park savings. This

type of investment is considered to be highly liquid and safe, basically a money substitute.

However, looking at our definition of money can these types of instruments really beconsidered money?

In normal times they meet the money/currency test of being highly liquid and are very

close to being a unit of account (money market mutual funds are normally priced at $1.00and dont move). In the short-term they can be considered a store of value. So far, sogood.

We cant forget the fact that these instruments are really loans though. All loans, even toquality governments and companies have some risk of default. This would indicate that as

a store of value they may or may not pass the test of what constitutes money. In times offinancial stress, such as 2008, the liquidity of such instruments can literally disappear. Insuch circumstances their value as a medium of exchange is also dissipated. Finally you

cant use a money market security or fund as legal tender. Close to legal tender, but first

you must sell the security or fund for actual currency. Therefore I would classify thisportion of the money supply as near money or money like as opposed to currency ormoney.

Being money like but actually being someone elses liability or debt in a time of excessive

leverage in the economy really makes this type of money substitute somewhat suspect.

What happens to this near money if everyone attempts to convert these short-term loansinto cash at the same time? All these loans must be sold to someone else for currency first.But, as we have seen in the charts above, the portion of the monetary base that is currency

is only a fraction of the overall money supply. This would imply the money like features ofthese types of holdings could prove to be fleeting in a period of deleveraging.

The issue of assigning money like qualities to near money was a major part of what causedthe 2008 financial crisis. Mortgage securities were given AAA ratings and treated as amoney substitute by investors as a result. When investors discovered, en masse, that there


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was nothing money like at all about many mortgages issued from 2003 2007 the value ofthese securities dropped precipitously. Food for thought when considering what really is

money as defined above.

The US dollar remains the worlds reserve currency and at the current time no other nation

or block of nations looks capable of taking over that role. However, the ability of the US

dollar to act as store of value will be severely tested when short-term interest ratesguarantee negative real returns for significant periods of time and the indebtedness of thegovernment continues to grow without any prospect of reducing the torrent of red ink.

The US dollar is not alone in this regard. The fiat currencies of all the major economies ofthe world suffer from many of the same issues. However, the US dollar is the reserve

currency of the global financial system and its value can have many repercussions on thefinancial systems of countries around the world.

Governments from time immemorial seem to have made a sport of debauching their

currencies in order to live beyond their means. Even as in the case below, where thecurrencies started out as solid silver:

In this example the currencies were debased by reducing the amount of valuable silver ineach coin in favour of much lower value base metals. Just a little more perspective on how

long governments have been kicking the can down the road!


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What do you know about gold, Moneypenny?

-James Bond line from the movie Goldfinger (1964)

Hold Gold!

The US dollar (and nearly all other fiat currencies for that matter) has lost a tremendous

amount of its purchasing power in the 40 years since the monetary system was untethered

from its connection to gold. In fact, the US dollar has lost over 80 percent of its purchasingpower when compared to gold in the last ten years. Gold, on the other hand, has beenconsidered as money for over 3,000 years and has maintained its purchasing power. Gold

retains its purchasing power because it meets all of the criteria for money that I outlined

earlier in this commentary. The fact that gold cannot be created by central banks like thefiat currencies in circulation today is an extremely compelling feature. Central banks are

being forced to print ever increasing amounts of currency to maintain the integrity of thefinancial system post the financial crisis. Allowing a rapid deleveraging would cause the

global financial system to seize and potentially fail. All of the actions of governments and

central banks since the financial crisis began indicate that they are willing to error on theside of excess money printing in order to prevent this from occurring.

Gold is an alternative form of money and currency that grows by only about 3% per year asnew supply is laboriously and expensively mined.

In more normal economic times short-term deposits in a currency pay a rate of interest that

is slightly above the prevailing rate of inflation. When this is the case fiat currencies can

function more like money because they are protecting the purchasing power of thecurrency. Currently that is far from being the case. With overnight deposits effectively at

0% and even 10 year government bonds yielding just over 2% it is basically impossible to

earn a no risk return on your money that is positive after factoring inflation. Thiscircumstance is not by accident. Global central banks have engineered this environment to

alleviate the staggering debt burdens their economies currently face. By having interestrates set this low, enormous amounts of debt can be relatively easily serviced interest

payments are very low. Further, periods when interest rates offer negative real returns (thereturn after accounting for inflation is less than zero) often experiencing rising inflation.

Inflation reduces the burden of the debt by making it smaller in real terms. The amount ofdebt owed stays constant but relative to the amount of money in circulation, asset prices

and income levels the debt has been diminished. The practice of setting interest ratesbelow the level of inflation and below any fair return has been referred to as financial

repression.

A great deal has been written about financial repression, including the recent paper byReinhart and Sbrancia, The Liquidation of Government Debt. The setting of interest ratesbelow the level that would be set by the market is a form of debt default that is far more

subtle than a government announcing that it wont be paying back its debts. In the periodpost World War II (1945 1980) most advanced economies had negative interest rates forapproximately half of the time. These negative interest rates helped governments to

stealthily reduce their debt to GDP ratios by an average of 3 4 percent per year. Over an

extended period governments were able to dramatically reduce their debt burdens.However, this financial repression was paid for on the backs of savers and investors in theform of lost purchasing power.


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INVESTMENT RECOMMENDATIONS

This investment environment is difficult, to say the least. The risks faced by the global

economy and financial system are obvious to those who chose to see them. However,staying true to ones investment process reduces the likelihood of an emotionally driven

investment decision which is often incorrect.

The first goal of Inverlochy Capital is to preserve our investors capital. This goal takesprecedence over short-term capital growth if we feel that current conditions indicate an

above-average risk of capital loss. When conditions warrant a more aggressive investmentstance to take advantage of strong risk-adjusted returns we will seize the opportunity.

Today however, there is a growing awareness by investors of the precarious financialposition which confronts many countries. This, unfortunately, is the case for much of the

developed world. In spite of these concerns, we continue to find investments that webelieve are attractive from a risk and reward stand point. Given the issues discussed in this

commentary we will remain cautious in terms of how much capital that we allocate to theseopportunities. An example of this is our now long standing call of investing in some of the

worlds highest quality companies such as Proctor & Gamble, Pepsico, Johnson & Johnson,etc. While we are of the opinion that these types of companies currently offer investors

attractive valuations, we are also cognizant of the fact corporate earnings are notoriously

difficult to forecast in an environment that contains the structural headwinds to economicgrowth that we find ourselves today. Hence, position sizes should be reduced to mitigate the

uncertainty.

At best the global economic recovery appears to be slowing dramatically. A worse casescenario is the global economic recovery falters completely. The United States, as made

clear by the debt ceiling debate, is currently politically incapable of dealing with many of thestructural economic issues it faces. The situation in Europe is serious, with potential global

economic ramifications. The Europeans are being forced to consider if their monetary union

can be taken to the next step of fiscal union. The twists and turns of such a debate are

bound to create significant volatility. We maintain that a defence first strategy isparamount at the current time.

As written about in our last quarterly commentary Inverlochy was of the opinion that riskyassets such as commodities, stocks and lower quality bonds may sell off through the

summer. That has most certainly happened. Further desperate government spending andmoney printing may create enough temporary relief for risky assets like stocks to rise.

However, inaction by governments and central banks will likely result in further weakness in

risky assets.

With the stock market correction we wrote about last quarter having commenced we areusing the opportunity to carefully increase equity exposure. If investor sentiment becomes

more negative and valuations improve further we will be prepared to commit more capital toequities and corporate bonds.

My investment recommendations are:

Cash

o The economic risks posed by the on-going sovereign debt concernsthroughout most developed world and other structural economic problemsrequires investors to hold higher than normal levels of cash. These concerns


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create headwinds that cap the upside opportunities in stocks from currentlevels. Increased holdings of cash dampen volatility and provide an option on

tomorrow. Even after the recent stock market correction most developed

market equities are priced for returns in the 5-7% range over the next 10years. At the bottom of several bear markets the expected 10 year returnswere as high as 20%. With this fact in mind, it should be clear that equities

have the potential for significantly more downside. A higher than normal cashallocation still is warranted. Holding cash does expose investors to currencydebasement and inflation risk. Inverlochy feels the risk to our investors cash

holdings is offset by our recommendation to hold gold.

Bonds

o With interest rates on 'safe' sovereign debt at or near zero at the short end,and in the US, expected to stay there for the next two years, short bonds

offer a negative real yield (meaning a yield below the rate of inflation). This isa compounding disaster for investors. Worse, we now know sovereign debtcan no longer be considered safe (recent events in Europe plus the US debt

downgrade). This means that on a risk-adjusted basis, the returns are even

more unattractive. Once again, we can thank Ben Bernanke et al for drivinginterest rates into punishingly low territory, forcing savers and investors toeither lose out to inflation or to take on more risk than they are being

rewarded for.o Longer term bonds currently offer very little in terms of risk versus reward.

US 10 year government bonds are now yielding approximately 2%. At this

yield they are risk, return free as opposed to a risk free return! Investors

should now be underweight longer-term government bonds.o Investors should hold the majority of their fixed income allocation in high-

quality bonds in the five-year or under maturity range. Individual bonds and

exchange traded funds (ETFs) that represent ownership in a large diversified

portfolio of quality short to medium term bonds are both acceptable ways tobuild fixed-income exposure.

Equities

o Invest in high-quality non-cyclical US equities that have a substantial portion

of their earnings and assets in countries with better currency fundamentals.We continue to hold Proctor and Gamble, Pepsico and Johnson & Johnson in

our accounts. These are premier organizations that pay very safe dividends

with higher yields than most government bonds. In the medium to long-termthese stocks are better mechanisms to protect wealth in this environmentthan long-term government bonds. After the recent pull-back in equity

markets, we are currently adding to our positions of high quality stocks.o The high quality consumer staple companies did well on a relative basis

during 1970 1980 period of inflation. Coca-Cola traded at a P/E of 48 in the'70s, Procter & Gamble was close to 40, even when the overall stock market

traded at a P/E of 15. These kinds of stocks can do well in emerging marketswhich are poised to continue growing at higher rates than most developedcountries.

o Canadian stocks give exposure to energy, base metals, precious metals and

even agricultural inputs. After their recent correction Canadian stocks are


18/19


more attractive and investors should cautiously add to existing positions.Further significant weakness in Canadian stocks should give investors

confidence to add to their positions more aggressively.

Gold and Precious Metal Equities

o Invest in gold and precious metal mining shares. Gold is starting to be

considered as an alternative currency and a true store of wealth by manyinvestors. Until developed country governments rediscover fiscal andmonetary sobriety this trend will continue. The long-term fundamentals for

gold are as strong as they have ever been. Over the medium to long-term theUS dollar will be devalued one way or another to restore competitiveness tothe US economy. Additionally, the US Congress and Senate have absolutely

no appetite for the hard decisions to help restructure the myriad of structural

economic problems. The longer the U.S. government delays addressing itsdebt issues, the causes of structural unemployment and the lax regulationthat was a major contributor of the financial crisis, the more attractive gold

will become. The final reason for holding gold is that it may be remonetized.

This means that it may used to back a major currency again in the future. Ifthat were to happen gold would have to be several times its current price to

adequately back the current number of dollars, Euros, Yen, etc. outstanding.

o Gold has responded smartly to the challenges faced by the global financial

system. We are not currently adding to our gold positions. We do continueto buy precious metal mining shares on weakness.

Thank you for your continued confidence and loyalty.

Regards,

W. Glen Morrison, CFA


19/19


IMPORTANT DISCLOSURES

Copyright 2011 Inverlochy Capital Ltd. & Inverlochy Capital LLC., (Inverlochy). All rights reserved. Thisreport is prepared for the use of Inverlochy clients, prospective clients and subscribers to this report andmay not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, withoutthe express written consent of Inverlochy. Any unauthorized use or disclosure is prohibited.

Inverlochy may own, buy, or sell, on behalf of its clients, securities of issuers that may be discussed in orimpacted by this report. As a result, readers should be aware that Inverlochy may have a conflict of interestthat could affect the objectivity of this report. This report should not be regarded by recipients as asubstitute for the exercise of their own judgment and readers are encouraged to seek independent, third-party research on any companies covered in or impacted by this report.

Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, tobuy or sell any securities or other financial instrument or any derivative related to such securities orinstruments (e.g., options, futures, warrants, and contracts for differences). This report is not intended toprovide personal investment advice and it does not take into account the specific investment objectives,financial situation and the particular needs of any specific person. Investors should seek financial adviceregarding the appropriateness of investing in financial instruments and implementing investment strategiesdiscussed or recommended in this report and should understand that statements regarding future prospectsmay not be realized. Any decision to purchase or subscribe for securities in any offering must be based

solely on existing public information on such security or the information in the prospectus or other offeringdocument issued in connection with such offering, and not on this report.

Investments in general and, derivatives, in particular, involve numerous risks, including, among others,market risk, counter-party default risk and liquidity risk. No security, financial instrument or derivative issuitable for all investors. In some cases, securities and other financial instruments may be difficult to valueor sell and reliable information about the value or risks related to the security or financial instrument may bedifficult to obtain. Investors should note that income from such securities and other financial instruments, ifany, may fluctuate and that price or value of such securities and instruments may rise or fall and, in somecases, investors may lose their entire principal investment. Past performance is not necessarily a guide tofuture performance. Levels and basis for taxation may change.

Foreign currency rates of exchange may adversely affect the value, price or income of any security orfinancial instrument mentioned in this report. Investors in such securities and instruments effectivelyassume currency risk.

Materials prepared by Inverlochy research personnel are based on public information. Investors shouldconsult their own legal advisers as to issues of law relating to the subject matter of this report.Any information relating to the tax status of financial instruments discussed herein is not intended to providetax advice or to be used by anyone to provide tax advice. Investors are urged to seek tax advice based ontheir particular circumstances from an independent tax professional.

The information herein (other than disclosure information relating to Inverlochy and its affiliates) wasobtained from various sources and Inverlochy does not guarantee its accuracy. This report may contain linksto third-party websites. Inverlochy is not responsible for the content of any third-party website or any linkedcontent contained in a third-party website. Content contained on such third-party websites is not part of thisreport and is not incorporated by reference into this report. The inclusion of a link in this report does notimply any endorsement by or any affiliation with Inverlochy

All opinions, projections and estimates constitute the judgment of the author as of the date of the report

and are subject to change without notice. Prices also are subject to change without notice. Inverlochy isunder no obligation to update this report and readers should therefore assume that Inverlochy will notupdate any fact, circumstance or opinion contained in this report.

Neither Inverlochy nor any director, officer or employee of Inverlochy accepts any liability whatsoever forany direct, indirect or consequential damages or losses arising from any use of this report or its contents.

inverlochy q2 2011

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