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Agcapita Macro UpdateNovember 2009

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Summary

By virtue of more than a decade of low and often negative real interest rates coupled with increasingly rapid monetary growth, the economies of the developed world have been increasingly skewed towards consumption rather than production. Unfortunately, consumption is the destruction of capital – by definition it represents the diversion of resources from productive purposes. Both the private and public sectors have been indulging in this protracted debt fuelled consumption spree. Savings rates have plunged and fiscal deficits have expanded. Each year it requires a larger and larger amount of additional debt to create each additional unit of GDP – on the order of $4 of incremental debt to $1 of incremental GDP. Why? Because on average, we are incurring debts that do not create offsetting cash generating assets. At some point governments in the increasingly indebted, consumption oriented and aging economies of the west are going to be faced with an unpalatable set of options:

– Tax – Shrink – Default – Inflate

Not surprisingly, the governments of the world seem intent on continuing to inflate as they desperately force feed the markets consumption-oriented programs in place of stagnant private sector demand. An interesting fact is that for the last decade in the US, private sector job growth has been absent and all net job growth has been in government or state dependent sectors. We are facing massive “political inflation” as well as monetary inflation.

The problem arises that all state spending requires that capital is first taken out of the hands of the private sector via taxes, borrowing or inflation, then deployed in typically loss-making (capital destroying) activities. The net result is that the growing government spending and deficits are setting the stage for much greater problems in the future. Rather than allowing private sector savings to replenish the pool of capital our governments are going further into debt to finance policies that at best can only serve to pull future consumption into the present.

Contents

3 Monetary Authorities Ignoring Asset Inflation Again?

3 Banks’ Duration Challenge

3 US Federal Duration Challenge

4 US Federal Outlays

4 Do Gold Prices Signal Inflation?

6 30 Years of Western Consumption

6 Money Supply Growth = Inflation

6 Demographics are Destiny

7 Just How Fast is the Global Money Supply Growing?

8 Quick News

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To reiterate, what western economies need is more capital, not more consumption. There is no way to create capital other than through savings and hard work – a message to which our governments are reluctant to listen. Printing money seems alluringly easy at first, but it does not create capital, and worse, the inflation it creates ultimately causes long lasting harm to the production structure of the economy.

I believe that in the current expansionary monetary environment there are several important themes investors should consider:

1) Reduced Returns on Investments Tied to Developed Market Growth: If current trends continue I believe the western economies could be entering a period of low real growth if not outright stagnation as debt levels are reduced and the capital base rebuilt. If this is the case, investments that depend on developed market growth will be exposed to a reduced demand profile and therefore reduced returns on the whole.

2) Inflation: Real yield will continue to be scarce as governments seek to suppress interest rates at the expense of exchange rates. Arguably in such an environment inflation hedging investments should generate superior returns.

3) Higher Returns on Investments Tied to Developing Market Growth: While the developed markets seem poised for sub-trend growth, this does not appears to be the case for the developing markets – China in particular. With high savings rates, large domestic pools of capital and favorable demographics these markets appear to be in a period of sustained expansion. Of course for the foreseeable future, direct emerging market investments will continue to be volatile and carry significant and difficult to quantify political risk. We believe, therefore, that the better way to invest in emerging market growth is to invest in the things that emerging markets require – particularly commodities – but where the investment premise is expressed in politically stable parts of the world. For example, energy and agriculture in western Canada.

Regards

Stephen Johnston – Partner

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Global Macro Update

Monetary authorities ignoring asset inflation again?

The worlds monetary authorities are clearly ignoring the rapid reflation in risky liquid assets and focussing on CPI measures as their inflation yardsticks. The net result will be a growing disconnect between the speculative and real economies. This feels like a replay of the residential real estate bubble, where ostensibly low consumer inflation measures allowed central banks to ignore massive asset price inflation. Are we storing up another financial crisis as the real and speculative economies seem to be rapidly diverging again?

Banks’ Duration Challenge

The banking sector is facing a serious financing challenge ahead. They need to borrow larger amounts and at longer durations and they will be competing with the US government to do so (see USFederal Duration Challenge).

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Chart 1: average Maturity of MooDys rateD gloBal DeBt issuanCes

Deb

t Iss

ued

(US

D M

IL)

Avg Maturity Per YearMTN share of Total Wholesale Funding

3,000,000

2,500,000

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1,500,000

1,000,000

500,000

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Face Amount of Wholesale Funding IssuedSystem Average

Source: Moodys

“The average maturities of new debt issuance by Moody’s-rated banks around the world fell from 7.2 years to 4.7 years over the last five years,” according to the Financial Times - “the shortest average maturity on record. That means banks will face maturing debt of $10,000bn between now and the end of 2015, or $7,000bn by the end of 2012, according to Moody’s.” It was the mismatch between short-term financing and long-term loan portfolios that caused the banking system to collapse as underlying collateral values returned to historic norms. If the banking system cannot roll its financing requirements out to longer durations problems are sure to re-surface as commercial real estate comes under pressure over the next 24 months.

us feDeral Duration Challenge

The US government has an emerging duration problem in its borrowings states Bob English of the Precision Report, “A full 35% of the current Treasury debt portfolio ($2.5 trillion) matures by the end of FY2010 and must be rolled over, in addition to the new debt that must be issued to cover the estimated FY2010 deficit of $1.25 to $1.75 trillion.” Chris Rupkey, economist at Bank of Tokyo-Mitsubishi states that “the budget deficit, while not expanding, is still at levels unimaginable a few years ago,” … “With receipts on the weak side, the Treasury will have its work cut out for it when it comes to financing the government’s flood of red ink” particularly at longer durations.

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us feDeral outlays

This chart from the St Lois Federal Reserve provides a glaring visualization of the magnitude of the unfolding US government spending spree and the deficit it is fueling. The Federal deficit to GDP is at levels not seen since WWII and in absolute terms never seen before.

Do golD PriCes signal inflation?

Think about this quote from Greenspan at the May 18, 1993 Fed meeting. The market price of gold was increasing at the time and Greenspan, the then Chairman of the Federal Reserve, said: “I have one other issue I’d like to throw on the table. I hesitate to do it, but let me tell you some of the issues that are involved here. If we are dealing with psychology, then the thermometers one uses to measure it have an effect. I was raising the question on the side

Global Macro Update (continued)

Chart 2: feDeral net outlays versus feDeral reCeiPts

Source: St. Louis Federal Reserve (shaded areas indicate US recessions)

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with Governor Mullins of what would happen if the Treasury sold a little gold in this market. There’s an interesting question here because if the gold price broke in that context, the thermometer would not be just a measuring tool. It would basically affect the underlying psychology.” Greenspan was clearly advocating direct intervention in the gold market to reduce the traditional inflation signaling nature of gold. If gold prices are indeed managed (as far as possible) in a fashion akin to other exchange rates, when gold is appreciating in a large number of currencies is it time to pay attention? We believe gold’s recent behavior is signalling an ongoing attempt at simultaneous competitive devaluation (or global “race to the bottom”) as gold increases in relative value against most currencies - evidence that most governments are actively debasing their currencies. Gold recently moved to 8-month highs against the Euro, Swiss Franc and Canadian Dollar, it also moved to news records versus the Indian Rupee and Chinese Yuan.

Chart 3: gloBal golD inDex

Source: Bullion Vault

3002752502001751501251007550250

-25‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09

Gold in top 10 currencies (weighted by GDP)Gold in US Dollars

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According to BullionVault.org, the price of gold recently broke its previous high weighted against the world’s top 10 currencies by GDP and further that gold has beaten all other asset classes so far this decade. Central banks have been net sellers of gold for many years but this is changing.

Are global central banks, particularly those of the emerging economies that run large US$ current account surpluses beginning a move out of US$ reserves into gold? China, India and Russia all certainly have been increasing their holdings.

Global Macro Update (continued)

Chart 4: Central Bank golD reserves (thousanD tons)

Source: Globe and Mail

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Through Sept. 2009

Source: Bloomberg, Bureau of Labor Statistics, World Gold Council

Chart 6: golD reserves (tons, seP 2009)

United States 8,966Germany 3,757Int’l Monetary Fund* 3,326Italy 2,703France 2,695China 1,162Switzerland 1,147Japan 843Netherlands 675Russia 627India* 615European Central Bank 553

* Adjusted to reflect recent sale of 220 tones to India by the I.M.F.

$2,000 an ounce

1,500

1,000

500

unadjusted

Chart 5: golD inflation aDjusteD PriCe

‘75 ‘80 ‘85 ‘90 ‘95 ‘00 ‘05

Source: Bloomberg, Bureau of Labor Statistics, World Gold Council

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30 years of Western ConsuMPtion

The consistent trend over the last three decades has been decreasing bond yields.

US interest rates have been decreasing by approximately 1.0% every 4 years and as the price of money or debt becomes less expensive more is consumed. The steady interest rate decline is a product of a deliberate monetary policy that has driven consumption and on a larger scale driven asset prices as the financial sector intermediates increasingly profitable but risky speculative activities. What happens when this trend reverses?

Global Macro Update (continued)

Chart 7: us 30 year t-BonD yielD (nov 2009)

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Source: Stockcharts.com

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Constantly Decreasing Interest Rates

Money suPPly groWth = inflation

Chart 8 shows US money of zero maturity (“MZM”). MZM technically equals M2 plus all money market funds, minus time deposits and in essence measures the supply of financial assets redeemable at par on demand – a good reflection of overall US money supply. Do you see any deflation in this chart?

Chart 8: MZM Money stoCk

Source: St. Louis Federal Reserve (shaded areas indicate US recessions)

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DeMograPhiCs are Destiny

The 19th century belonged to the UK, the 20th century belonged to the US and it appears that the 21st century will belong to China. A consistent theme in the emergence of a new global power is a large and growing pool of domestic savings with a focus on investing in the capital base of the economy rather than increasing consumption and a population of young workers.

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The world’s western economies find themselves heavily in debt with deteriorating demographics. It has been said that “demographics are destiny’. Unfortunately, our governments are attempting to fix our problems by accelerating the very policies thatgot us into this mess in the first place.

Global Macro Update (continued)

The US federal funding gap is growing at rapid rate. Over the last 6 years:

– Unfunded obligations increased by approximately 50% from US$79 trillion

to US$114.7 trillion; but– Receipts increased by only approximately

12%.

Chart 9: us governMent oBligations (trillions of us$)

Valuation Date

Social Security

Unfunded Obligations

Medicare Trust Funds

A, B, D Unfunded

Obligations

Total Unfunded

ObligationsUS Debt

Column A Total

US Gov. Obligations

2009 $15.1 $88.9 $104.0 $10.7 $114.7

2008 $13.6 $85.6 $99.2 $9.2 $108.4

2007 $13.6 $74.3 $87.9 $8.6 $96.5

2006 $13.4 $70.5 $83.9 $8.1 $92.0

2005 $11.1 $68.1 $79.2 $7.6 $86.8

2004 $10.4 $61.6 $72 $7 $79.0

Source: Sprott Asset Management

The US government is now in the position of increasing its liabilities four times faster than its tax receipts. At some point governments in the increasingly indebted, consumption oriented and aging economies of the west are going to be faced with an unpalatable set of options:

–Tax - higher taxes are politically impractical in the face of stagnant growth–Shrink – reducing the size of government is

politically impractical in the face of large and influential state sectors

–Default - possible but inflation, at least initially, is much less noticeable

–Inflate – printing money is almost invariably the preferred option for cash strapped governments

The US Federal Reserve recently disclosed that it purchased half of the newly issued US Treasuries in the second quarter of this 2009, and of course it made these purchases with newly printed money - it appears “inflate” is the path that has been chosen.

just hoW fast is the gloBal Money suPPly groWing?

According to Mike Hewitt at Dollardaze.org the global money supply (M0) continues to grow rapidly. M0 is referred to as the monetary base, or narrow money and is composed of notes and coins in circulation and in bank vaults. M0 is the most conservative measure of money supply growth. Interestingly the largest currencies are growing at some of the most rapid rates showing that this is truly a global phenomenon and not an artifact of just US actions.

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Chart 10: y-o-y inCrease in M0 (us$ equivalent as of august 2009)

Country %us$

Billionsus$ Per Capita

US 10.50% $81 $268

EU 13.40% $126 $252

Australia 11.20% $4 $182

UK 8.40% $7 $111

Canada 6.80% $3 $96

S Korea 15.60% $4 $74

Mexico 14.90% $5 $43

China 11.50% $52 $39

Brazil 11.10% $5 $24

India 18.60% $23 $20

Source: Mike Hewitt Dollardaze.org, Agcapita estimates

quiCk neWs

November 12 - Bloomberg (Vincent Del Giudice): “The U.S. budget deficit widened in October from a year earlier, reaching a record for that month... The excess of spending over revenue widened to $176.4 billion last month, compared with a deficit of $155.5 billion in the same month a year earlier... Spending for October declined 2.7% from the same month a year earlier to $331.7 billion, and revenue and other income fell 17.9% to $135.3 billion... Individual income tax collections fell 29% to $61.2

billion in October from a year earlier, and corporate tax receipts last month were a negative $4.5 billion on the government’s books... Over the past week, the Treasury auctioned a record $81 billion in its quarterly sales of long-term debt. The Treasury’s debt-management director... told a meeting of bond market participants last week to anticipate another year of government debt sales of $1.5 trillion to $2 trillion...”

November 13 - Bloomberg (Bob Willis): “The trade deficit in the U.S. widened in September by the most in a decade, reflecting rising demand for imported oil and automobiles... The gap grew a larger-than-anticipated 18% to $36.5 billion, the highest level since January... Imports climbed 5.8%, the most since March 1993, to $168.4 billion. The figures reflected a $4.1 billion increase in imported oil as the cost of a barrel of crude climbed to the highest level since October 2008 and volumes also rose... Exports rose 2.9% to $132 billion, the most this year, propelled by sales of civilian aircraft, industrial machines and petroleum products.”

November 11 - Financial Times (Nicole Bullock): “Some of the same financial troubles that have pushed California toward economic disaster are wreaking havoc in nine other states and posing a threat to the nascent recovery, according to research... ‘California’s fiscal problems are in a league of their own,’ says Susan Urahn, managing director of the Pew Center on the States... ‘but the Golden State is hardly alone.’ Arizona, Florida, Illinois, Michigan, Nevada, New Jersey, Oregon, Rhode Island and Wisconsin join California as the most troubled US states... For residents, fiscal problems have meant

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higher taxes, layoffs of state workers, longer waits for public services, more crowded classrooms and less support for the poor.”

November 12 - Bloomberg (Darrell Preston): “U.S. states, which are closing $250 billion of budget deficits, will be forced to grapple with diminished revenue until at least 2012, a survey of fiscal officials found. The only thing that kept states from ‘draconian’ spending cuts has been $135 billion of funding under President Barack Obama’s economic stimulus package, according to a report from the National Governors Associations and the National Association of State Budget Officers. Revenue fell 7.5% in fiscal 2009, forcing states to close budget gaps of $72.7 billion. ‘These are the worst numbers we’ve ever seen,’ said Scott Pattison, executive director of the budget directors group... ‘States have been forced to lay off and furlough employees, raise taxes, drain rainy day funds and sharply cut state spending.’”

#400, 2424 4th street sWCalgary, alberta t2s 2t4Canada

DisClaiMer:

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