Agcapita January 2010 Economy Briefing

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Agcapita Macro UpdateJanuary 2010

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Summary

DEMOGRAPHICS ARE DESTINY

The 19th century belonged to the UK, the 20th century belonged to the US and it appears that the 21st century may belong to China. A consistent theme in the emergence of a new global power is a young population with a large and growing pool of domestic savings and a focus on investing in the capital base of the economy rather than consumption. The world’s western economies find themselves heavily in debt with deteriorating demographics (our populations are aging and our birth rates are low) and economies skewed towards consumption. We are accruing ever-greater liabilities to cover vast social, medical and retirement programs that we currently do not have the workers or more importantly the high growth economies to pay for. It has been said that “demographics are destiny’. Unfortunately, rather than face these issues, our governments are attempting to fix our manifest problems by accelerating the consumption friendly policies that were largely responsible for getting us into this situation in the first place. As an example of this, the US Federal funding gap is growing rapidly. Over the last six years:

– unfunded obligations increased approximately 50% from US$79 trillion to US$114.7 trillion; but

– revenue rose approximately 12%.

The US government is now in the position of increasing its liabilities four times faster than its tax receipts. This is a trend being repeated throughout the developed world. The US Federal Reserve recently disclosed that it purchased half of the newly issued US Treasuries in the second quarter of 2009 – all of which would have been purchased with newly created money – direct debt monetization.

Investors must be alive to the growing divergence between the economies of the west and those in the emerging world and position themselves accordingly. We believe that the way to benefit from long-term Chinese growth is to invest in what China needs in politically stable parts of the world. That gives you the best of

CONTENTS

1 Demographics Are Destiny3 Forty Percent of US Corporate

Profits From Finance!4 America’s Current Export –

Inflation4 How Can this End Well?4 ZIRP and Commodity Prices –

Is There A Link?5 Money Velocity Increasing6 Interest on US Debt6 US Residential Housing Sector

– Losses Now Nationalized?7 Private Sector Growth is

Absent in the US7 US Bailout Cost7 Equity and House Price

Declines – Over?7 Government Fiscal Deficits Will

Continue to Worsen8 Top 10 Points for Canadian

Limited Partnership Investors 9 Quick News Review

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both options – first world political risk and transparency combined with emerging world growth rates. Clearly a category that fits this description is commodity investment in western Canada–Agriculture–Energy

And to a lesser degree commodity linked investment in western Canada:–Businesses that service the commodity sector–Businesses and sectors that benefit from general population/

economic growth in Western Canada

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Global Macro Update

FORTY PERCENT OF US CORPORATE PROFITS FROM FINANCE!

Given the rapid reflation of the prices of speculative assets and the collapse of risk premiums, the ongoing money printing efforts in the developed world are having limited effect outside of the “finance economy”. It is estimated that up to 40% of US corporate profits are generated by the finance sector – largely from speculative activities. Corporate profits attributable to the finance sector were effectively stable until the 1970s when the growth in the US money supply turned sharply higher on a sustained basis. Given the finance sector’s intimate relationship with the US Federal Government and the Federal Reserve banking system it is not surprising that the newly printed money has flowed into and through the finance sector acting as a wholesale subsidy that drove corporate profits, compensation and speculation.

Despite widespread belief to the contrary, government intervention into broad swathes of the economy to support “too big to fail” companies or more accurately to prevent capital destroying business activity from being eliminated to the benefit of the entire economy is not a positive for future growth. There is an economic truism that whatever you subsidize you get more of – hence by subsidizing failure we are ensuring bigger failures in the future and worst of all penalizing well run businesses. The firms that were prudently managed leading up to the crisis should have benefited from the demise of their poorly run competitors – in a free economy capital would have flowed to the profitable businesses rather than the loss making ones. The fact that this didn’t happen creates a perverse “if you can’t beat’em, join’em” mentality with respect to risky and imprudent business practices.

QUICK FACTS

China US

GDP: $4.3 trillion – increased a total of 430% in last 10 years

GDP: $14.2 trillion - increased a total of 18% (real terms) in last 10 years and added ZERO private sector jobs

20% percent of economy in state sector 30% percent of economy in state sector

Consumer demand is 35 per cent of GDP Consumer demand is 70 per cent of GDP

Savings rate is 40 percent of household disposable income (one of the highest in the world)

Savings rate is 6 percent of household disposable income

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Global Macro Update (continued)

CHART 3: 2009 CRB INDEX CONSTITUENT RETURNS

Source: Reuters

Wheat -11.46% Nat Gas -0.89%

-30 0 30 60 90 120 150

Live Cattle 0.15%Corn 1.72% Soybeans 6.97% Lean Hogs 7.84% Coffee 21% Gold 22.91% Cocoa 23.41% Aluminium 44.81% Silver 48.5% Heating Oil 50.73% Cotton 54.22% Nickel 58.33% Crude 77.94% Orange Juice 88.25% RBOB 102% Sugar 128.19% Copper 138.38%

AMERICA’S CURRENT EXPORT – INFLATION

The US zero-interest rate policy (“ZIRP”) has lead to sustained efforts to cause currency devaluations on the part of its trading partners. The idea is that if they weaken their currencies, domestic producers will be able to maintain market share in the US. The net result is that the US is effectively exporting inflation to its global trading partners.

HOW CAN THIS END WELL?

Often a picture is worth a thousand words…

The rebound in commodity prices was lead by oil copper and sugar (see Chart 3) as China’s demand continued to grow even in the face of the global recession.

ZIRP AND COMMODITY PRICES – IS THERE A LINK?

The CRB Index of 19 raw materials increased 23 percent in 2009 as can be seen in Chart 2 – this represents the largest annual increase since 1979 – the last period of highly inflationary monetary policy.

550

500

450

400

350

300

250

200

150

100

50

CHART 2: CRB SPOT INDEX (1967 = 100)

1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007

Source: Commodity Research Bureau

1895 1910 1925 1940 1955 1970 1985 2000 2015

400,000

200,000

0

-200,000

-400,000

-600,000

-800,000

-1,000,000

-1,200,000

-1,400,000

-1,600,000

(Milli

ons

of D

olla

rs)

CHART 1: FEDERAL SURPLUS OR DEFICIT (USD$ BILLIONS)

Source: St. Louis Federal Reserve, White House – Office of Management and Budget (shaded areas indicate recessions)

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CHART 5: CAPACITY UTILIZATION (PERCENT OF CAPACITY)

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

90

85

80

75

70

65

(Per

cent

of C

apac

ity)

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

CHART 6: MZM VELOCITY (DARK BLUE) V. US GDP % GROWTH (LIGHT BLUE)

Source: St. Louis Federal Reserve

2.4

2.2

2.0

1.8

1.6

1.4

MZM

Vel

ocity

GD

P G

row

th c

urre

nt te

rms10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

-2.0%

-4.0%

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Jun-

03

Jun-

04

Jun-

05

Jun-

06

Jun-

07

Jun-

08

Jun-

09

Interestingly, the rebound in the CRB index is mirrored by another powerful upward surge in US base money supply (M0) after its initial doubling in late 2008, early 2009.

MONEY VELOCITY INCREASING

For those who are adherents of the money velocity theory of economic activity, the velocity of MZM is

increasing after it started falling in the first quarter of 2007 - six quarters before economic growth slumped. The recent increase in MZM velocity may point to increased economic activity, the question then becomes whether it will be sustained as can be seen in the capacity utilization numbers.

CHART 7: ESTIMATED US INTEREST PAYMENTS

Source: GAO

$800 in billions

700

600

500

400

300

200

2010 2019

2,400

2,000

1,600

1,200

800

400

0

-400

(Billi

ons

of D

olla

rs)

CHART 4: US M0 (US$ BILLIONS)


1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

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4,0003,6003,2002,8002,4002,0001,6001,200

800400

0-400

(Billi

ons

of D

olla

rs)


1940 1950 1960 1970 1980 1990 2000 2010

CHART 8: REAL ESTATE LOAN AT COMMERCIAL BANKS (US$ BILLIONS)

Further increases in this velocity are considered by many as an essential precursor for sustained economic growth.

INTEREST ON US DEBT

More than half of the $9 trillion in debt the US Federal government is expected to build up over the next decade will be incurred to pay interest charges - US$4.8 trillion.

In 2015 $533 billion in interest payments will be equal to a third of the federal income taxes expected to be paid that year – obviously a dangerous trend given that longer term interest rates can be expected increase from their currently historically low levels. The other issue for the US is that the duration of its borrowing is rather short – in simple terms that means the US federal government must constantly refinances its existing debt in addition to borrowing more to fund ongoing deficits. The magnitude of this issue is shown in that the US Treasury estimated in November 2009 that “approximately 40 percent of the debt will need to be refinanced in less than one year.” This shortened duration leaves the US quickly exposed to any increases in borrowing costs demanded by the markets.

US RESIDENTIAL HOUSING SECTOR – LOSSES NOW NATIONALIZED?

The US automobile industry has been nationalized, the banking sector has been nationalized, medical care has been nationalized and now the residential housing sector has been nationalized. With the

Treasury department’s recent announcement that it will provide unlimited backing to Freddie Mae and Fannie Mac these two organizations now underwrite almost 80% of all new mortgage lending in the US – de facto nationalizing of the market, a market that represents:

– $14.6 trillion in total U.S. mortgage debt outstanding

–$8.9 trillion in total U.S. mortgage-related securities.

–$7.5 trillion in pooled mortgages, of which about $5 trillion is securitized or guaranteed by Freddie Mae, Fannie Mac or FHA

Charts 8 & 9 show that while most mortgage lenders have been withdrawing from the US residential housing market, Freddie and Fannie loan books are exploding.

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Source: Washington Post

CHART 10: US JOB GROWTH BY DECADE

1 2 3 4 5 6 7 8 9 10

0

0%

38%

Year in Decade

1940s 72.0% unavailable

1960s 53.1% 44%

1970s 38.1% 28%

1950s 51.3% unavailable1980s 34.9% 42%

1990s 38.6% 58%

2000s 17.8% -4%

% change in gross domestic

productBy decade,

inflation adjusted

% change in household net

worthBy decade,

inflation adjusted

PRIVATE SECTOR GROWTH IS ABSENT IN THE US

Private sector has actually shed jobs in the last decade and generated very little in inflation adjusted GDP growth – hence the nagging feeling in the middle class that they are not getting ahead. Unfortunately the same cannot be said for the US government that continues to grow relentlessly.

US BAILOUT COST

Despite the varied and often conflicting reports about the total cost of the US bailouts – when all the programs are taken into account the cost is approximately US$14 trillion. Given the pre-bailout money supply of the US was around US$ 15 trillion this represents a truly staggering amount of money.

EQUITY AND HOUSE PRICE DECLINES – OVER?

Research (Aftermath of Financial Crisis, Reinhart and Rogoff, 2008) shows that the average real decline in equity and house prices following a banking crisis is 56% and 35% over 3.4 years and 6 years respectively. If this historical average holds, and arguably the current crisis far exceeds virtually all the others over the past 100 years, then both house and equity prices will fall much farther in real terms.

GOVERNMENT FISCAL DEFICITS WILL CONTINUE TO WORSEN

Research shows that even with the current dramatic deterioration in G7 government finances we can expect worse to come (Aftermath of Financial Crisis, Reinhart and Rogoff, 2008). Over the course of the typical banking crisis government debt levels rise an


200180160140120100

80604020

0-20

(Billi

ons

of D

olla

rs)


1975 1980 1985 1990 1995 2000 2005 2010

CHART 9: TOTAL FEDERAL GOVERNMENT AND SALLIE MAE CONSUMER LOANS

(US$ BILLIONS)

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average of 86 percent in the three years following. The buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century. The question that will inevitably arise is that if investment demand is not present for the huge debt issuances that this will entail, will the worlds central banks revert to monetizing their governments’ debts – or in simple terms printing the money.

TOP 10 POINTS FOR CANADIAN LIMITED PARTNERSHIP INVESTORS

Investors in private limited partnerships are faced with a wide range of offerings – from classic private equity vehicles to real estate development projects. Here are some simple criteria to help you make your decisions about what private LPs to consider for their RRSP portfolio this year.

1. Experienced management team – A significant number of investment teams have NO experience in fund management or even in the sector in which they are investing your capital. Work with teams that have a track record at both the investment management level and at the operational level – there is NO substitute for a track record of successful investment and operation in the business area by the team you are trusting to act on your behalf.

2. Clear investment premise – The investment premise should be based on sound fundamental analysis that is simple to understand and clearly laid out in the presentation. Avoid momentum-based investments where the core rationale is effectively that “everyone else is doing it”. To quote Sir John Templeton - “It is impossible to

produce a superior performance unless you do something different from the majority...”

3. Tax efficient structure – Tax can have a major effect on your returns. Make sure that all reasonable and credible steps have been taken by the management team to manage tax obligations.

4. Audited financial statements – Management must provide annual audited financial statements. A past failure to do so should act as a red flag.

5. Regular operational reporting – Management must be open and available to answer your questions about the business.

6. Clearly defined hold period – Make sure that the hold period is clearly defined and cannot be arbitrarily changed or extended by the management team. You need to know how long your investment will be committed and exactly when you can expect repayment.

7. No non-arms length transactions – Situation where the management team acquires the target assets first and then sells them to the fund for an upfront profit. Even if disclosed in the offering documents this is a poor practice and creates a mismatch between the economic interests of the management team and the interests of the investors.

8. No acquisition fees - Fees where the management team gets paid a portion of all capital deployed. This creates a mismatch between the economic interests of the management team and the interests of the investors, as acquisition fees are not tied to returns.

9. No fee escalation – Management fees should not be tied to appraised or calculated asset value that is an unrealized gain. The only valuations that matter are the purchase price and the sale price.


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Management should receive the bulk of their fees based on gains that are actually realized for investors.

10. Incentives reward ACHEIVED performance – Favor investments where the manager makes the bulk of his return only when you make a return. This fee structure is commonly referred to as “success based”. Lifts, acquisition fees, escalating annual management fees are not success based.

QUICK NEWS REVIEW

Venezuela Devalues: “Shouting “buy, buy, the world is going to die,” Venezuelans went on a frantic shopping spree on Saturday following a sharp currency devaluation that is expected to drive up prices. President Hugo Chavez announced a dual system for the fixed rate Bolivar Friday night while much of the country was watching a baseball game. “I’ve been lining up for two hours outside to buy a television and two speakers because by Monday everything is bound to be double the current price,” said Miguel Gonzalez, a 56-year-old engineer

standing in the tropical sun outside a popular store. The government acknowledges prices will rise after the devaluation, but say the upward trend will be more gradual. State run television and radio stations avoided using the word “devaluation,” preferring the word “adjustment.” One pro-Chavez radio station responded to critics of the measure by playing a popular Argentine song called “Imbecile.” With oil crowding out other sectors of the economy, Venezuela heavily relies on imports for consumer goods, leaving it subject to big price swings depending on the exchange rate. Older Venezuelans are accustomed to sharp losses in the value of their money, with numerous devaluations and currency regimes over the last three decades of economic turmoil. Inflation, the highest in the Americas, at 25 percent last year, reached 103 percent in 1996 after a previous president lifted exchange and price controls. Chavez’s high-spending policies during an oil bonanza fueled a massive consumer boom and fast growth that shuddered to a halt when oil prices plunged a year ago. The sharp drop in oil revenues also undermined the Bolivar and made a devaluation inevitable at some point.” Source: Reuters Jan 2010


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Economy & Finance

Agcapita January 2010 Economy Briefing