December 2014 Update

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OUTLOOK:We continue to inhabit an unprecedented global negative real interest rate world, even negative nominal rates in some cases.1 A quick survey around the globe reveals developed markets with nominal rates at multi-century lows.

As investors we must always step back and contemplate the abnormal global interest rate environment as risk assets are bid ever higher.

CHART 1: US BOND YIELDS

Source: Federal Reserve1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

18%

16%

14%

12%

10%

8%

6%

4%

2%

0%

CHART 2: UK BOND YIELDS

Source: BOE, Church House

1700 1720 1740 1760 1780 1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

15%

10%

5%

0%

CHART 3: GERMAN BOND YIELDS

Source: Global Financial Data

1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

15%

10%

5%

0%

In our worldview, negative real interest rates are a driver of mal-investment, capital destruction and asset bubbles.

In such an environment, we also believe our predisposition to hard asset investments remains sound. Economic laws and market forces are great levelers and while governments may try to immunize themselves from their operation in the end this is not possible. To quote George Wickersham - “These laws cannot be destroyed by governments, but often in the course of human history governments have been destroyed by them” 2

While sovereign bond yields remain low and public equity market returns are nothing short of spectacular our mandate is to think more broadly than next quarter. The artifice of central bank suppressed interest rates only supports nominal prices of accessible risk assets in the short to medium term, ultimately cash-flow triumphs and assets will re-price in real terms to reflect this fact. Current policies effectively result in the capital of savers being

Equicapita December Briefing

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Equicapita December Briefing (continued)

2008 2009 2010 2011 2012 2013

3600000

3300000

3000000

2700000

2400000

2100000

1800000

1500000

1200000

900000

Federal Reserve Balance Sheet S&P 500 Stock Price Index1800

1600

1400

1200

1000

800

600

400

200

0

CHART 4: FEDERAL RESERVE BALANCE SHEET VERSUS SP

0

5

10

15

20

25

30

35

40

45

50

1860 1880 1900 1920 1940 1960 1980 2000 2020

2000

1929

1901 25.78!

1966

CHART 5: SCHILLER CAPE E10 RATIOconsumed in order to provide what is believed to be the raw material of a rebirth of growth in the form of low interest rates. However this capital is largely being used by the financial sector for speculative activities hence the substantial increase in the value of even the riskiest assets without a corresponding recovery in the underlying real economy.

To this end, we believe that stock market prices are not being driven by fundamentals and do not reflect a recovering economy but rather: Central Banks: Federal Reserve’s balance sheet

is driving the markets - highly correlated to stock market price levels (see Chart 4)

Buybacks: Stock buybacks are at record levels even though stock prices are at record highs (see Chart 6)

Multiple Expansion: Cyclically adjusted price-to-earnings ratio (10 year average trailing PE) or “CAPE” – range of approximately 12x to 16x historically but is currently over 23x - going back 100 years, there have only been two higher readings: first in the late 1920s, before the Black Tuesday crash, and second in 1999, before the dot-com crash (see Chart 5)

2008 2009 2010 2011 2012 2013 2014

$180

$160

$140

$120

$100

$80

$60

$40

$20

$0

CHART 6: SP STOCK BUYBACKS BY QUARTER

Source: Capital IQ

We also believe that inflation is not subdued. The calculation method has merely been changed so that it now only measures a constantly declining quality of life given substitution effects and stripping out the costs of food and energy. One of the most less obvious techniques to hide inflation is what we call “shrinkflation” = where companies reduce the

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Equicapita December Briefing (continued)

CHART 8: OFFICIAL UNEMPLOYMENT (U3) VERSUS 1980S METHODOLOGY

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

25%

20%

15%

10%

5%

0%

Official (U3) ShadowStats

CHART 9: REAL BOND & EQUITY RETURNS VERSUS INFLATION RATE

Low 5% Next 15% Next 15% Next 15% Next 15% Next 15% Next 15% Top 5%

20

10

0

-10

-20

-30

Rate of return/inflation (%)

Real bond returns (%) Real equity returns (%) Inflation rate of at least (%)

20.2

11.26.8

11.95.2

11.4

3.410.8

2.87.0 5.2 1.8

-4.6

-23.2

-12.0

-2.6

-3.50.5 1.9 2.9 4.5

8.0

18

Source: 2012 Credit Suisse Global Investment Returns Yearbook

1982 1986 1990 1994 1998 2002 2006 2010 2014

15%

10%

5%

0%

-5%

SGS Alternate CPI, 1980-Based CPI-U

Year to Year Change. Through July 2014. (BLS, SGS)

CHART 7: CPI-U VERSUS 1980S METHODOLOGY

weight or size of an item without decreasing its price. See the examples of chocolate and orange juice containers below (1980s versus 2010s). Inflation is currently above 10% per year with a 10-year average above 7% pa (see Chart 7). To put this in perspective, that represents a 95% loss of purchasing power versus 20% loss under government numbers.

While it is true that the official unemployment rate is moderate and dropping, we do not believe it

is dropping because the economy is recovering. Unemployment rates are calculated using a different methodology from 1980s – if you use the 1980s method unemployment rate in the US is over 20% versus the posted 6% currently (see Chart 8).

If inflation is already high then it has consequences for the real returns of various asset classes. Part

of our investment thesis is that higher real returns and Sharpe ratios can be found in alternative asset classes and that current market conditions do not bode well for future public market bond and equity returns. The idea that public equities are useful inflation hedges is only the case in periods of deflation or low, stable inflation. When inflation begins to trend above 5% pa this breaks down and substantial real losses in both public equities and bonds accumulate (see Chart 9).

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Equicapita December Briefing (continued)

Real assets, producing goods with inelastic demand curves in sectors with leverage at or below historical averages, where possible with un-priced inflation hedging qualities are our preference. Over the next decade we believe such investments we return higher nominal and risk adjusted returns than bonds and equities.

Ultimately central banks have a Hobson’s Choice3 – they can control exchange rates/purchasing power or interest rates/asset prices but not both. Central banks are institutionally committed to lower interest

ENDNOTES:1 ECB has implemented negative 0.20% deposit rates for banks. In addition, Deutsche Skatbank has

announced that customers with over €500,000 on deposit as of November 1 will earn a negative interest rate of 0.25%.2 Wickersham Commission - May 1929 (full name National Commission on Law Observance and

Enforcement)3 Wikipedia: Hobson’s Choice is a free choice in which only one option is offered. As a person may refuse to

take that option, the choice is therefore between taking the option or not; “take it or leave it”.

rates and higher asset prices. The only realistic way for sovereign borrowers to repay debts is a de-facto default via money supply expansion that aligns with speculative capital interests and central bank policy. Therefore, the negative real interest rate environment is likely to continue for the foreseeable future, and so we continue to believe real assets with inflation hedging qualities in the form of inelastic demand curves (an example of an inelastic demand curves is water, energy and food) and soft linkage to commodity prices will generate superior returns.

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