Vol 1/15, 1 December 2010


“Capital” means different things to different people in different contexts. Homeowners think of capital as their net savings. Investors think of it as funds available to invest. Financial risk managers think of it as the maximum loss that can be sustained. But what, exactly, do these savings, investible funds and risks represent? Ultimately, all financial wealth represents some sort of claim on some real, productive asset. In aggregate, these real assets are a claim on the capital stock of the entire economy, that is, total current and future productive potential. Yet many economists, including the current Chairman of the US Federal Reserve, seem to think that, as paper wealth increases, so does economic growth when, in fact, trying to grow an economy by inflating paper wealth actually destroys the capital stock! The result: A lower standard of living.

This edition of the Amphora Report marks the end of our first year of publication. We take this opportunity to review the topics we have covered to date and how our thinking on these has evolved in recent months. We believe most topics remain relevant for 2011 and possibly beyond.
A CAPITAL PARADOX What, exactly, is economic capital? It is the productive potential of the economy, the ability to make things that people need and want to consume. But unlike paper, capital does not grow on trees. Capital itself must first be produced, in the form of capital goods. Let’ s start from the beginning: We all need to consume food. Few of us produce our own. So we need to purchase food with our earnings. When we go to the supermarket and purchase a trolley of food, we are purchasing the output of a mind-bogglingly complex productive process. To highlight just a few aspects of this, consider: · Arable land requires regular attention to remain productive, including irrigation, soil and fertiliser treatments; · Irrigation is only partially provided by natural rainfall and drainage. An increasing portion is provided by some mechanical means, eg wells, pumps, aqueducts, desalinisation, etc; · Soil and fertiliser treatments are overwhelmingly produced in factories requiring substantial energy input; · Farm machinery must also be produced in factories and properly maintained thereafter; · Wells, pumps, aqueducts, desalination plants, fertiliser and farm machinery factories themselves don’t just exist; they too need to be manufactured and, thereafter, regularly maintained with suitable equipment, which must itself be manufactured

and maintained with suitable equipment, and so on. Now why would someone go to the trouble of manufacturing suitable equipment for making suitable equipment for maintaining a factory which is full of suitable equipment for producing fertiliser, which is then packaged and transported using suitable logistical equipment requiring regular maintenance using suitable equipment to a farm when it is loaded on to a tractor (requiring regular maintenance using suitable equipment), which was manufactured in a factory full of suitable equipment which was itself manufactured in another factory full of suitable equipment... ? Well, as with all economic activity, someone must believe that they will make a fair profit by engaging in some aspect of this process above, or else they wouldn’ t do so. But do you see the complexity? How on earth can anyone just sit back, survey all these various stages of production and possibly know how each and every step should work, much less what sort of profit should be expected? Well, no one can. (This is one intuitive way of understanding why command economies are horribly inefficient, even assuming that everyone is competent, is trying their best and no one is corrupt, three assumptions that are at odds with historical experience and, as such, highly suspect.) But if no one understands how this process works, then how does it work at all? Simple: The division of labour. At every stage of every productive process, either within a firm or between firms, there is


for whatever reason. however. Building a home costs money. to the depreciation of the capital stock. or less.THE AMPHORA REPORT Vol 1/15. it is a write off. what. the more these are used by the government. Don’ t be surprised when you look around and see the crumbling infrastructure. or. Maintaining the home once built costs money. As such. discouraging savings. the greater the potential depreciation and therefore the greater the maintenance required to prevent it. nevertheless there are people who are willing to step up where they think they see an opportunity and invest their savings in capital goods of some kind. even for something as basic as foodstuffs. there are only two ways in which the existing capital stock can be properly maintained: With either a higher private savings rate. Now that we understand how complicated economic production is in a modern economy. Now why is this important? Consider: The larger the capital stock. And as it is strictly limited to functioning. discouraging investment. Once created. LOWERING THE POTENTIAL ECONOMIC GROWTH RATE! And what if this state of affairs lasts for years? THE CAPITAL STOCK IS GOING TO DEPRECIATE DRAMATICALLY. the financial assets which are claims on the present and future productive value of the capital stock–net of depreciation of course– rise in value to the point that the holders thereof feel themselves “richer ” and neglect to save? What if. electrical grids and power plants. eventually to the point of becoming unproductive. It is the most highly leveraged. in perceptions and confidence can have a huge impact. both creating and maintaining a capital stock requires savings. it is a harsh economic reality. exactly. factories. in taxes. from which they are reasonably confident they will earn a respectable return. roads. in regulations. Even though no one can conceive of each and every detail in a highly complex production chain as that described above. No savings. Now what happens if there IS no savings? What if. not just indirectly. In a great paradox. although asset prices can rise indefinitely and infinitely in nominal terms–for example if the purchasing power of the currency is constantly and exponentially declining–they can only rise sustainably in real terms if the underlying economic value of the capital stock continues to grow. So the capital stock originates in savings. So the maintenance also originates in savings. LOWERING THE STANDARD OF LIVING! Don’ t be fooled into thinking that the capital stock is unlimited. the less they are available for private sector uses. such that there is little incentive to save? What if. if the tax burden rises? The answer to that is obvious. there is naturally little in the way of resources available to maintain the existing capital stock. let ’s consider how the capital stock comes into existence in the first place. Without maintenance. structure and health of the capital stock. All real capital depreciates. and the return on savings artificially low. they will continue to work accordingly. of course. we should all have an interest in growing the capital stock over time. we know this is correct. thereby making it even less attractive to save? Well. Is the private sector going to save more. the home will depreciate to the point of being rendered uninhabitable. TO THE POINT WHERE MUCH OF IT BECOMES A WRITE-OFF. And if the government then uses that dollar to bail out insolvent financial enterprises or to fund consumption–say to provide entitlement benefits of some kind–rather than for investment.amphora-alpha. most sensitive. sold for scrap or otherwise recycled. For each dollar in savings that the government takes for itself to fund its deficit it is taking one dollar away– at present prices–from private always someone to perform each specific task. And don’ t be fooled into thinking that somehow higher taxes would help. refineries. on the size. Beyond that point. the central bank starts directly and artificially propping up asset prices by buying securities. Finally. vehicles. over time. the capital stock needs to be maintained. even. for example. If we spend all our income on day-to-day consumption of food and clothing. As long as those participating continue to believe that they receive fair compensation for their contribution. The slightest changes in interest rates. for the government to redirect existing entitlement spending– consumption–toward infrastructure instead. as in our example above. the central bank holds interest rates artificially low. machines. Yet the larger the capital stock. no growth in the capital stock. in response to an unusually prolonged slump in economic activity. without which the capital stock will depreciate. the capital stock will eventually depreciate to the point where it is no longer able to perform the functions for which it was originally intended. most easily distorted part of the economy. is going to happen to the capital stock? IT IS GOING TO DEPRECIATE. guess what? Amidst artificial disincentives to save and asset price distortions that make people feel “ richer”. Intuitively. someone is going to come along who believes that they can make a reasonable profit by using their savings to provide maintenance on the existing capital stock. much less expand it. be it buildings. 02 . 1 December 2010 www. Who is going to provide this maintenance? In much the same way as capital comes into existence in the first place. With asset prices artificially high. either to be abandoned. So-called “crowding out” of capital is not just a financial theory. then the government is contributing directly. doing their part to make a highly complex productive process a sustainable reality. arable land. rather than saving up for occasional home maintenance. Returning to the economy. No. the higher the productive capacity of the economy. alternatively. It is anything but. presumably a result of higher after-tax interest rates. economically viable capital goods.

could possibly succeed at preventing a dramatic relative economic decline of the US in the coming years. is going to continue in 2011. many of which are investing heavily in infrastructure and other capital stock. is a clear demonstration of relative US decline. That is the unseen “cost ” of propping up failed financial institutions and preventing a natural. far beyond what anyone in Washington. as policymakers have resorted to ever more desperate means to get their economies going. What follows below is a list of all topics. it is unrealistic to expect that Mr Volcker. or anyone else for that matter. the issuer of the world’ s reserve currency. Our thinking on this topic has not changed one bit. including both a brief summary and an update of our thinking for 2011. we believe that investors should be particularly wary of currencies as stores of value and should seek ways to preserve wealth outside of cash. These countries include the US. Paul Volcker is tasked with restoring global confidence in the US dollar and economy generally. 03 . contributing directly to a reduction in savings. to an accelerating depreciation of the capital stock. its real wealth. although quite possibly at a slower pace than in recent months. the precious metals. underperformance in real. ultimately. It is destroying. for most if not all traditional financial assets. Given current global economic conditions. to a decline in the potential growth rate.THE AMPHORA REPORT Vol 1/15. Now. 1 December 2010 www. as in 1979. to a reduction in the standard of living. and all fiat currencies for that matter. even worse. To do so would require fundamental economic reform of vast scope. We would expect this outperformance to continue in 2011 although it might well be less pronounced. occasionally abruptly in a sharp decline or. the nation’ s capital stock. not just in dollars but in most currencies. salutary reorganisation and rebuilding of the capital stock. There is no serious talk of fundamental economic reform. including the growing lack of fiscal discipline IS MONEY A STORE OF VALUE? VOL 1/2 We generally take it for granted that cash in a government-guaranteed bank deposit account is a risk-free store of value. by stealth. as we expect. DC is willing to seriously consider or debate. dollar is likely to lose its pre-eminent reserve currency status in the coming years. the FROM “DARTH” TO “CZAR ” VOLCKER? VOL 1/1 Imagine that.amphora-alpha. But is it? The fact is that the dollar. in which deficit reduction was an important topic. even following the elections. many of which overlap in some way. The Fed has not merely demonstrated that it is incompetent as the chief financial regulator and that it is increasingly pathological in its pursuit of inflation at all costs. or something else entirely? 2010 THEMES IN REVIEW In the prior 14 editions of the Amphora Report this year we have covered nearly 30 topics. The outperformance this year of emerging market economies. tend to lose purchasing power over time. in a hyperinflation. including the historical cash substitutes. notwithstanding the best of intensions. the Fed has embarked on an increasingly radical monetary course which does nothing to restore confidence in the the policies which the Fed has implemented to artificially prop up asset prices and stimulate economic activity are. in the event that the global economy slows somewhat. and. We believe that. It is not surprising that. What binds them all into a coherent set is our view that the economic policies being implemented in nearly all major countries are not just unsustainable but in some cases outright reckless. the pile of rubble which once was arguably the greatest ever accumulation of capital in world history will be reflected in crumbling real financial asset values. If anything. The result is bound to be a period of global economic and financial market turmoil and. When the smoke clears. Meanwhile. our conclusions seem largely vindicated by recent developments in Washington. demonstrated by the extension of tax cuts and unemployment benefits. By implication. in fact. currencies in general have declined in value relative to commodities this year. We are confident that this trend of rising commodities prices. do you want to be holding those assets. purchasing-power adjusted terms.

so the old saw goes. but the strength was in fact quite broad-based and demonstrates both good demand from the more dynamic emerging markets but also. in this topic we explore how. this could be supportive of the euro.THE AMPHORA REPORT Vol 1/15. Well try telling that to the US government. does not have a great deal going for it. Meanwhile. which has just decided to accelerate the ongoing deterioration in its finances Commodities have outperformed this year.32 today. But don’t forget the brewing debt crisis in state and local governments either. at 1. The sovereign debt crisis that began in Greece earlier this year has spread to Ireland. the overall tax base and fiscal and current account balances. In sinister dialectical fashion. success is far from assured and some sort of debt restructuring is probably inevitable. including liquid commodities. There were some supply issues at times. While we are not particularly optimistic for the economic future of the euro-area which. when evaluated according to the size of the public sector. that global inflationary pressures are rising. As such. In any case. in particular with grains and certain other agricultural commodities. However. where necessary. investors should consider increasing their allocations to alternative investments. the FINANCIAL CRISES AND NEWTON’S THIRD LAW | VOL 1/3 Policymakers tend to react to financial crises in ways that contribute to an even greater crisis down the road. This demonstrates that the euro-area can respond positively to market pressures. Indeed. 1 December 2010 www. most probably for a variety of reasons. you had better first stop digging. 04 . governments are desperately trying to reduce deficits in return for financial assistance from France and Germany and also temporary funding support from the European Central Bank (ECB). restructured. In all four countries. the powers assumed and mistakes made by policymakers tend to grow with each crisis. we nevertheless think it is important to make a fair comparison between the euro-area and the US. SIR? VOL 1/2 As diversification is rightly considered to be the only “free-lunch” in economics. We believe that Germany and France will not come to Greece’s rescue absent a dramatic fiscal consolidation. In time. with a broad tax cut extension as well as extended unemployment benefits. in a world of both low interest rates and high uncertainty. the legacy of multiple asset bubbles and busts.amphora-alpha. is essentially at the same level it was when the crisis broke in April this year. EUR/USD exchange rate. policymakers continue to dig an ever deeper hole. the Greek crisis has kicked off a round of general euro-area fiscal consolidation. the US economy in aggregate. the Fed has embarked on another round of monetary expansion. If you are stuck in a hole. as financial assets are increasingly highly correlated with each other–a consequence of artificial monetary stimulus– diversification through financial assets alone is unusually limited. While Greece is certainly trying to reduce its deficit. California. however. New York and Illinois are all at risk and collectively are of comparable economic size to the entire euro-area periphery. Rather than get out of the way and let the economy restructure and rebuild in a natural. HOW MUCH FREE LUNCH WOULD YOU LIKE. bears a far greater similarity to the euro-area periphery than to the core. investors should be inclined to seek rather more diversification than would ordinarily be the case. notwithstanding the ongoing and widening crisis. Portugal and Spain. thereby ensuring that future crises become progressively more severe. importantly. This is yet another example of policymakers contributing to an even greater crisis down the road. This requires investors to look at the overall US fiscal situation. the reactions of policymakers and regulators are consistently disproportionate to the actions of financial markets. THE REAL LESSON OF THE GREEK DEBT CRISIS | VOL 1/2 Greece now finds itself under attack from the financial markets and unable to refinance its debt. absent Germany and a few other pockets of regional strength. undistorted fashion by allowing asset prices to adjust lower to more sustainable levels and banks and corporations to be sensibly downsized and. which continues to deteriorate amidst federal tax cut and unemployment benefit extensions. While 2011 may not be as good a year for commodities as 2010– in part because there are signs that emerging market demand is now cooling–we nevertheless expect investors to continue to seek diversification in alternative assets. Indeed.

As much of China is still a subsistence economy. rather than in absolute terms. In financial markets. Fed Chairman Bernanke made explicit that monetary stimulus was likely to support the stock market which. China and India have both recently raised interest rates.THE AMPHORA REPORT Vol 1/15. Additional fiscal and monetary stimulus in the US is most probably going to contribute to still more inflationary pressure in China and other more dynamic economies around the world. senior executives chose instead to focus on short-term profitability: A healthy balance sheet became of secondary importance to a healthy income statement which. was likely to stimulate economic activity. food price inflation would most likely turn into wage inflation. But if asset prices are distorted. this topic becomes more relevant as the US Fed becomes increasingly desperate in its desire to stimulate economic activity. in a recent op-ed published in the Washington Post. this would also push up prices in the US. the risks they were taking but were unwilling to confront the short-term. Brazil and South Korea are taxing foreign capital flows. 05 . All other measures of value are ultimately subjective to the individual rather than objective in the marketplace. These trends are likely to continue in 2011 and will contribute to “stagflationary” conditions in the US. as the US imports a huge amount from China. rising global commodities prices implied that Chinese inflation was likely to increase further. including in China. as things only have an identifiable. as policymakers will see to it that in the event of yet another crisis. If a central bank sets interest rates at an artificial level. Recent developments in Ireland should serve as an example of what happens to a country that underwrites the risks of its financial sector. justified healthy bonuses. a part. with potentially severe economic consequences. However. China is just one of many countries which is now taking action to cool growth and keep prices under control. are resources being misallocated? We believe so. Chinese inflation has continued to rise all year. Indeed. well prior to the great financial crisis of 2008. with the consequence of systematically underestimating risk. Events this year have done nothing in our opinion to change this. The moral hazard of the system has grown. The spike in food prices over the summer has played HOW WOULD EINSTEIN VALUE FINANCIAL ASSETS? VOL 1/5 With this brief topic we presented the idea that assets can only be valued relative to other assets. partnership-based industry. These misallocations will only increase in 2011 as more and more artificially stimulus is thrown at the economy. in turn. asset prices will become distorted and resources WHY FINANCIAL GENIUS FAILS | VOL 1/3 Believe it or not. But rather than take appropriate action to protect their firms with sensible risk management policies. to be sure. While highly theoretical. it is now widely believed that US financial asset prices are distorted in some way by Fed policy actions. the taxpayer comes to the rescue. 1 December 2010 www. but the underlying pressures were already in place. as China is a huge importer of raw materials. which in turn would push up prices for Chinese manufactured goods generally and possibly lead China to revalue its currency versus the dollar. Einstein showed that the speed of light was the only constant against the universe against which all else could be measured. Those firms already too big to fail in 2008 are now even bigger. Now that the industry has been bailed out and has returned to profitability–at least for a brief time–another important lesson has been learned: The more risks you take. Previously considered a fringe view. It is increasingly clear that most if not all financial executives were aware of IS CHINA BEING TAKEN FOR A RIDE? VOL 1/4 Back in the spring we noticed that inflation rates were picking up just about everywhere. bonus-driven culture which had come to dominate a once conservative. quantifiable value if they are exchanged for something else. Eventually. Indeed. the better. the only constant is the time value of money. The seeds of the next crisis have been sown. Much has been written this year about how the risk management culture on Wall Street was a key ingredient to the crisis of 2008. as represented by the term structure of interest rates.amphora-alpha. it was widely known among the educated financial elite that the standard risk management models and methods used by the major banks were woefully inadequate. of course.

The REAR-VIEW MIRROR MYOPIA | VOL 1/6 The dramatic rise in the price of gold in recent years finally began to receive attention in the mainstream financial press in 2010. It merely changed form. or other forms of “ paper” gold. futures. In general. not only in dollar terms but also in that of most global currencies. Where others observe a series of separate crises. When public authorities stepped in to prevent a further deleveraging of the financial system. much commentary has suggested that gold may now be in a “bubble”. only in sovereign form. It may have taken a number of months but the financial markets finally figured out that the debt was still there. we see a continuum. far below historical averages. gold does look expensive when compared to financial assets. As recent moves to add additional stimulus to the US economy are likely to reinforce existing distortions in asset prices. sovereign and US state and municipal debt markets. But rather than analyse the fundamental reasons behind this trend. where prices are generally lower. we expect these trends. 1 December 2010 www. they issued more of their own and also raised expectations for future issuance. In doing so. 06 . Yet central banks continue to expand their balance sheets. It is obvious that this is THE ASSET-PRICING IMPLICATIONS OF THE GREAT BAILOUT | VOL 1/5 Moving from theory and into practice. value assets and underweight nominal vs. through some combination of debt default and currency devaluation. Gold continues to feature as a popular topic in the mainstream financial press. to focus only on the past 20 years is to demonstrate severe rear-view mirror myopia. These debts are going to be devalued either by inflation or some form of default. investors should be particularly concerned about recent developments in euro-area and US state and municipal debt markets. the government stepped in and guaranteed not just deposits but the complete liabilities of its entire banking system. The risks of devaluation and/or default continue to increase. This sort of debt “ shell game” is being played over much of the world and will not end until there is a proper deleveraging of the global financial system.THE AMPHORA REPORT Vol 1/15. Certainly the rally in gold has gone a long way and a growing number of investors have no doubt acquired some position in the metal. either as physical bullion or via ETFs. and sovereign debt crises are spreading. Also. with the exception of the No. In this context. we find that the assets for which values are most likely distorted to the upside are those with relatively uncertain and long-dated cash flows. in general. has never left the system but rather has moved from place to place. once originated in the form of debt. In this regard. financial risk of bad lending decisions. in some cases dramatically so. we expect the gold price to continue to rise in 2011. although probably at a more gradual rate following the rather dramatic developments in recent months. real assets such as commodities have outperformed nominal quite substantially in the second half of the year. to continue in 2011. We have a long way to go yet. But let ’s put this in perspective: According to the World Gold Council. Investors should therefore be underweight growth vs. Ireland is a clear example of this. asset prices in general have risen in value. Since we wrote this edition. ranging from US subprime mortgage debt to euroarea sovereign debt. When looking at the past 20 years or so. we investigate in detail just how we believe asset prices are being distorted by various forms of economic stimulus. The great financial crisis of 2008 never ended. the total value of investment gold is only some 2% of the total value of global financial assets.amphora-alpha. No realistic real growth assumption would allow this debt to be paid pack at its present value. real assets. they explicitly or implicitly assumed responsibility for much of the debt that was collapsing in value. although it still receives far less attention than traditional financial assets. But given that the risks of a general global sovereign debt and fiat currency crisis are without doubt the highest they have been for many decades. aggressively in the case of the US Fed. as back when the banks were at risk of failure.

Silver rose by around twice as much. in 2010. is the dollar a sensible benchmark? Should investors measure their wealth and performance in dollars or in some other unit of account? We believe that the answers to these questions have become increasingly obvious as this year has progressed. At times gold was the outperformer amongst commodities. now that the Fed is purchasing Treasuries in an attempt to prop up assets and also to place downward pressure on the dollar. This topic is really just a corollary to that above. yet during the summer agricultural commodities were the top performers and. Investment idiots are made to look like geniuses if measured against a chronically devaluing benchmark. terms. 2010 provides ample evidence of this. if your benchmark unit of account is the Zimbabwe dollar. On the contrary. what does this really tell us? Did stock markets perform well or not? Did they rise in terms of purchasing power? Stock markets do appear to have risen with respect to price inflation. But this was not due to positive economic developments in Zimbabwe. this does not imply that gold is going to outperform all other real assets. No major stock market performed in such spectacular fashion during this time. you have made outrageous profits during the past few years almost regardless of your choice of investment. There are no doubt those out there who think they are able to pick the best asset at any point in time but we are of the opinion that holding a broad. As we enter 2011. We expect others to come to a similar conclusion in 2011. Certain rare earth minerals multiplied their value several times over. As such. the Zimbabwe stock market was a fantastic investment over the past decade. beginning in September. But then valuations don’ t look as attractive as before. well-diversified portfolio of liquid commodities is a better answer to the dilemma posed by global debt default and devaluation IS GOLD ALL THAT GLITTERS? VOL 1/6 Notwithstanding the view above. we suggest that investors consider measuring their performance in ways that reference more stable benchmarks than the dollar. 1 December 2010 www. In particularly good months it rose by several hundreds of percent. Money is meant to function. that the gold price is likely to continue to rise in 2011. Yes. While we would not presume to debate anyone touting the wealth-preserving properties of gold through the ages. it is important for serious WHEN IS A RISING STOCK MARKET ACTUALLY FALLING? VOL 1/7 In domestic currency terms. among other things. either due to inflation or deflation. nothing has changed our thinking in this regard. most stock markets have risen this year in dollar role in any defensive investment strategy. looking forward into 2011. In any case. But if the dollar is no longer a sensible benchmark. it was reflective of the severe hyperinflation that was taking place. it stands to basic economic reason that diversification should always play a prominent THE BENCHMARK IS IN THE EYE OF THE BEHOLDER |VOL 1/7 How do we measure wealth? In some unit of account. For example. The dollar is no longer an appropriate benchmark. as a unit of account. Well. investors to choose a benchmark which is not and can not be deliberately devalued. this distorts the way in which real wealth is measured. gold was far from the top performer. In some years it rose more than tenfold in value. which will give comfort to some.THE AMPHORA REPORT Vol 1/15. as did coffee. silver began to surge. Cotton doubled in value.amphora-alpha. the denominator for any given asset value. But if the purchasing power of a currency is unstable. up about 30%. Indeed. 07 .

at increasing cost.THE AMPHORA REPORT Vol 1/15. the Fed itself. Treasury supply is going up. in part because so many Treasury investors are essentially nondiscretionary and will buy comparable amounts at any price absent fundamental changes in their mandates. can have severe. Well. policymakers frequently speak and act as if there is not only a free lunch. this is merely going to draw growth away from the future. It had already become clear by mid-summer that various countries. The recent spike in Treasury yields may be an indication that investors are beginning to price in some combination of higher US deficits and inflation THERE MAY BE NO FREE THE REAL ECONOMIC HORROR SHOW | VOL 1/7 As it becomes increasingly evident that the US economic recovery is not self-sustaining. Curiously. We look at who buys Treasury securities and why. as we think the Fed will soon grow concerned that a higher level of yields will quickly derail the weak economic recovery. as the public sector is growing rapidly relative to the private. were the economy fundamentally healthy. Nevertheless. As such. debt crises had already forced governments’ hands toward dramatic fiscal tightening. the Fed can frighten speculators into refraining from shorting Treasuries with credible threats to purchase more as yields rise. around that time. in future. in the event. Among other developments. but the recent decisions to launch QE2 and also extend tax breaks and unemployment benefits demonstrate that the US economy remains in a perilous situation that will only become more so as Treasury yields rise. financial risks disappear and that attempts to do so. notably the UK and Germany. THE NEW CONUNDRUM OF LOW TREASURY YIELDS | VOL 1/7 It remains our view that the US is headed for some sort of debt crisis during the coming 1-2 years. we explore what this implies for the future.amphora-alpha. the Fed would feel otherwise. not a single one of the recommendations has received serious consideration in Washington. as demonstrated by recent policy actions elsewhere. 08 . with QE2 underway. We doubt that this is the beginning of an adjustment in US Treasury yields higher to more normal levels. unintended consequences. the US has chosen to implement even more aggressive fiscal stimulus by extending both tax cuts and unemployment benefits. given its free market traditions. were increasingly opposed to using fiscal expansion to fight the deleveraging in credit markets and associated economic weakness. BUT IS THERE A MAGIC WAND? VOL 1/8 While common sense informs us that you can’t get something for nothing. Indeed. why aren’t Treasury bond yields higher if the deficit is about to explode on the upside? The answer to this apparent conundrum is surprisingly straightforward: supply and demand. that the tax base is shrinking even as the government debt burden increases. with the understanding that President Obama would most probably consider implementing at least a few of the recommendations. but rather is going to require additional stimulus at some point. It is reassuring to think so but contemporary developments suggest otherwise. But investors will eventually see through such deception and the results will be sudden and. We are likely to see more attempts at using accounting tricks or other “smoke and mirrors” to disguise the true nature and scale of the debt problem in 2011. Moreover. 1 December 2010 www. interest expense is already rising. even though growth in 2011 may be artificially supported. Yes. but that they possess a magic wand that can reduce and/or eliminate economic and financial risk. with Treasury yields having spiked a full percentage point in recent weeks. and we find that a substantial portion of the market is held by non-discretionary buyers. One key implication is that. But if we are alone in this view. Of course. In other countries. the various euroarea sovereign debt crises demonstrate that policymakers do not have a magic wand to make including Greece and Ireland. including of course central banks and. yields still remain extremely low in a historical comparison. the work of the bipartisan US “deficit panel” was well underway. It is true that. the US is bucking a global trend toward fiscal austerity. This implies a lower future potential growth rate and lower standard of living. Instead. but so is demand. unexpected. such as in Ireland for example. for those who disagree with our thinking in this regard.

growing frustration in Germany. however remote.THE AMPHORA REPORT Vol 1/15. prop up the stock market and increase both economic activity and employment. but to many. causing a general. the crises to date are likely to escalate and spread into additional euro-area countries. Maintaining portfolio diversification in these conditions requires investors to increase their holdings of alternative assets. in particular commodities. global credit crisis perhaps as large as that catalysed by the Lehman Brothers bankruptcy in Q4 2008. roughly corresponds to the amount of new Treasury issuance expected during the period. 1 December 2010 www. will reconsider its commitment to the bail-out framework agreed with other EU states in May. The Jackson Hole Symposium and other such Fed policy forums used to be the primary way in which the Fed communicated its strategic thinking on monetary policy to a wider audience. we see ample evidence today that the Fed has become pathological. commodities are. unintended consequences of past and possible future actions suggests that US monetary policy is becoming increasingly pathological. resulting perhaps in another bailout for Wall Street at taxpayer expense? With reckless disregard for the growing costs of everexpanding monetary stimulus. indicates what Mr Bernanke may be planning for the future. As financial markets bid up the financing costs of one weak euro-area sovereign after another. the Fed now goes straight to the public. many commentators in Germany think that the existing arrangements are not only not in Germany’ s interest but are blatantly unconstitutional. While we believe that European Monetary Union (EMU) is going to continue in some form. No longer. In both cases. Chairman Bernanke published an op-ed in the Washington Post and has also been interviewed on the popular news IS THE GERMAN EAGLE A GREY SWAN? VOL 1/9 While the several sovereign debt crises in the euroarea have taken markets largely by surprise–thus leading them to be labeled as unforecastable. we see DIVERSIFICATION IN A WORLD OF DEFAULT AND DEVALUATION | VOL 1/9 With all financial assets ultimately containing some risk of bankruptcy or default. the Fed is likely to consider increasingly radical means to provide additional monetary stimulus. Fighting an increasingly poor public image. 09 . Indeed. We accept that they are programme. which by nature cannot default. but at what cost? A sharply weaker dollar? Sharply higher price inflation? Another asset bubble which ends in other bust. a sensibly diversified basket of liquid commodities should continue to outperform a traditional portfolio of financial assets. as we enter 2011 we believe it is increasingly likely that much existing euro-area sovereign debt is going to be restructured in some way and that member countries will continue to follow tight fiscal policies. stimulate investment. as the US economy weakens again. Alan Blinder. as long as governments and central banks continue to resist the natural credit risk deleveraging process. In time. But these swings are not driven by changing perceptions of credit risk. Recently.amphora-alpha. perhaps just incidentally. “Black Swan” events–we see a potentially much greater risk ahead. this should be positive for the euro. The Fed’s chronic inability to address the negative. If so. Looking forward to 2011. he has been attempting to explain the Fed’ s recent decision to purchase some $600bn of Treasuries in the coming months which. When all manner of financial assets. not only equities but also supposedly investment-grade corporate bonds and even sovereign bonds are at growing risk of default or currency devaluation. The reasoning above may seem obvious to some. “speculative” investments. that Germany. by their very nature. diversification benefits across global financial assets are at historic lows. subject to occasionally highly volatile price swings from time to IS THE FED BECOMING PATHOLOGICAL? VOL 1/8 Bernanke’s recent speech at the Kansas City Fed’s annual Jackson Hole Symposium indicates that. Bernanke denies that this is equivalent to “printing money”–although that is really a matter of semantics–and also claims that this policy will reduce borrowing costs. He may be right for a time. The bailout arrangements hastily arranged earlier this year are subject to renegotiation. then investors need to look elsewhere for an alternative. at some point. 60 Minutes. and with currencies in general no longer providing reliable stores of value in a world of weak financial systems and deteriorating government finances. A recent editorial by Bernanke’s friend and former colleague.

notwithstanding signs of moderating economic BEGUN. It may be too early to expect such a large move in 2011. such as in the 1970s and 1930s. much weaker dollar. Russia and Vietnam. among several other countries. 2011 may not be as strong a year for commodities as 2010 however. but you never know. much of this liquidity will leak out into the global economy. Is this due to constrained supply or simply a weaker dollar? We find these explanations inadequate because commodity prices are rising in all currencies and relative to both stocks and bonds. India. Amidst structurally high unemployment. implying higher commodity prices. THE CURRENCY WARS HAVE | VOL 1/10 For years. This is highly unusual and suggests that investor preferences have shifted in favour of commodities for some reason.amphora-alpha. most of the trends described have remained in place. such as the Baltic Dry Shipping Index. although other indicators. as the dollar has been strong recently yet commodity prices continue to rise in nearly all currencies. most probably contributing to a further rise in global commodities prices in 2011. Brazil. have taken specific actions this year to either weaken their currencies or control capital flows in some way. But Japan’s unilateral intervention in the foreign exchange market in September represents the opening of a new front in an escalating global currency war. even amidst relatively weak economic growth. Even if accompanied by business and jobs-friendly tax and regulatory policies. should the US continue to create liquidity to stimulate growth. But that implies a much. But as the US dollar is the global reserve currency. the US has been pressuring China to allow its currency to appreciate. 1 December 2010 www. Indeed. the US economy can only return to sustainable growth when incomes catch up to existing asset prices. But how far would the dollar need to fall to push wages up by enough to bring incomes into line with current asset prices? While still an immensely wealthy country by any reasonable measure. Japan. the US economy has become THE MYSTERY OF RISING COMMODITY PRICES | VOL 1/11 In recent months. This may indicate a pickup in China. But why? We believe we know the solution to this mystery. Absent substantial real income growth– which has in fact been stagnant for decades–the US has no choice but to devalue the dollar to the point where US unit labour costs catch up the elevated level of asset prices. with the notable exception of late that crude oil prices have been rising along with others. This requires substantial wage inflation. as long as the Fed continues to add dollar liquidity to the economy. Yet a massive debt has been run up which now needs to be serviced. increasingly unproductive in recent years. Many financial commentators now refer to a currency “ war” being underway between the US and WHEN ONLY A MUCH WEAKER DOLLAR WILL DO | VOL 1/10 Absent widespread asset price deflation and debt restructuring that would be resisted at all costs by the US Fed and Treasury. suggest that activity is more or less stable. it is important to note that commodity price strength is broad-based and is not merely the result of a weak dollar. some of it is going to flow into commodities as a sensible hedge against currency devaluation and debt default. but that it just one front in a wider and broadening conflict. this event may be the trigger which sets off a series of similar actions elsewhere. Regardless. global commodity prices ranging from precious metals to grains to cotton have risen dramatically. global industrial demand. 10 . Since we wrote this topic. Past episodes of global currency devaluation. As discussed in various other topics this year. have always led to increases in global commodity prices. the only way to generate wage inflation is via a weaker dollar. a 25-40% devaluation from the current trade-weighted level is probably required. South Korea.THE AMPHORA REPORT Vol 1/15. as global industrial demand may begin to cool.

they find ever more elaborate ways of deceiving their parents. 11 . With Ron Paul. we may already the economy to the Fed. the last time the US economy was mired in stagflation.amphora-alpha. assuming the Chairmanship of the House Monetary Affairs Subcommittee next year. that in fact the US economy may already have entered a “stagflationary” situation not unlike the late 1970s. the CPI calculation methodology has changed dramatically through the years. relations between the government and the Fed are more strained today than at any time since the early 1980s. It might result in a scaling back of planned Treasury bond purchases. Beginning next year. whenPaul Volcker came under fire for raising interest rates in the middle of a major recession. The Fed may not be pleased with this development. However. However. higher oil and import prices generally. As a product which must be purchased and consumed on FROM STAGNATION TO STAGFLATION | VOL 1/12 US CPI has been trending lower amidst a stagnating US economy. only to be caught out time and again. notwithstanding broad unemployment in the double-digits. Yet the Congress has now extended tax cuts and unemployment benefits. a daily basis. This is why the recent surge in global food prices is so significant. as a teenager. then you find that the current rate of overall CPI is over 8% y/y and rising. but Chairman Bernanke did just that earlier this year. a noted Fed critic. this situation is likely to worsen in 2011. Many economic commentators have speculated that the US might find itself in a stagflationary situation as a result of a weaker dollar. In 2011. Also. wheat and soyabean prices all near recent highs. rather than take responsibility. food prices are holding these gains. following a long childhood. for those on low incomes. While the Fed claims that inflation is undesirably low. yet with a weak jobs market and high unemployment. when he said that the Congress should focus on getting the deficit under control and leave GUESS WHAT ’S COMING TO DINNER: INFLATION! | VOL 1/12 The surge in global food prices will soon arrive on the dinner table. consumers are acutely aware of it THE FED’S TEENAGE TEMPER TANTRUM | VOL 1/11 When a young child is caught in a lie. with corn. the Fed has now entered its teenage years. It is highly unusual for the Fed to offer opinions about US government economic policy. for example. a look behind the headline economic data and across some financial market developments reveals a disturbing picture. they deny it. they give up trying to deceive and begin simply to blame their parents for their transgressions. they are referring to the current rate of core price inflation. if CPI is measured in the same way in which it was in the 1970s. actions which will increase the deficit. 1 December 2010 www. if you look behind the headline economic data. We argue that. far more inflationary picture implied by rising wage demands in developing countries. Food price inflation is a dangerous animal. the acrimony is all but certain to continue in 2011. to focus on the direct inflationary impact of higher food prices alone is to miss the bigger. much less criticise it. Finally. it will gradually transform into a more general manufactured goods price inflation the world over. it can threaten their basic health and that of their family. As pipeline price inflation is still on the way. be there.THE AMPHORA REPORT Vol 1/15. And so far. Indeed. As they grow. But regardless. which excludes food and energy. consumers in most developed economies will discover to their surprise that “food” price inflation is creeping into an astonishingly wide variety of consumer goods. Recent statements by Federal Reserve officials suggest that. This spells danger for financial asset prices. as food price inflation feeds into wage pressures in emerging markets.

does the Fed have to celebrate.THE AMPHORA REPORT Vol 1/15. this is highly unlikely to change current US or global economic and financial market trends. However. however. there is really nothing to update other than to say that we still don’t believe that the US is as attractive a place to do business as it used to be. As this topic was a parable. who now control the House of Representatives. and that absent rational economic calculation and a certain degree of passionate risk-taking. But what. If you want to understand economics. But why? Is the Fed incompetent? Is it poorly designed? Does it have the wrong mandate? We are pleased to learn that Ron Paul will be Charing the US House Monetary Affairs Subcommittee next year as he is likely to ask these questions. they do nevertheless reinforce our ultimate conclusion in this topic. you need first understand two things: That the human condition of one of scarcity and uncertainty. 12 . not done a particularly good job at promoting financial stability. Indeed. 2011 may be the year that we begin to get some answers. which translates somewhat inelegantly into English as: “The more things change. Our assessment of the US political outlook following the recent mid-term elections was not THE TALE OF ANDRÉ PRENNER. off the cost of Georgia. which is that the US government is not going to be able to address its deficit during the coming two years. rather than an economic or investment PLUS ÇA CHANGE (PLUS C’EST LA MÊME CHOSE) | VOL 1/13 This past week provided an excellent example of this old French saying. We doubt we are the only ones surprised by this. and perhaps beyond.amphora-alpha. And no. exactly. the more they stay the same”. with obvious consequences for future economic growth. 1 December 2010 www. The US mid-term elections may have resulted. Did anyone make the connection between his name and the themes in the story? Hint: Adopt a gentle French accent and speak the name softly as one long word. We expected complete gridlock. We would like to draw readers’ attention to the protagonist’s name. But notwithstanding some grand headlines in the press. the deficit is now going to be commensurately larger in 2011 and 2012. as expected. to promote financial stability? What can we say? More and more observers are coming to the inevitable conclusion that the Fed has entirely correct. as it was created. where a secret meeting took place to lay the political foundations for what would become the Federal Reserve System. we take a brief pause from our normal economic and financial market commentary with this tale of common sense economic calculation and action. A PARABLE FOR OUR TIMES | VOL 1/13 In this edition. we do not believe that the world is any more complex than we present it here. nor at protecting the purchasing power of the dollar through the years. ostensibly. nothing good can ever come of it. while these actions may not qualify as gridlock. A CENTURY OF MONEY MISCHIEF | VOL 1/14 The US Fed recently celebrated the centennial of its founding at a historic hotel on Jekyll Island. in a large victory for the Republicans. yet there has already been agreement to extend both tax cuts and unemployment benefits.

Best Wishes to all for a happy and prosperous 2011. AMPHORA: A lateral-handled. But now the sovereigns themselves. This can occur either through default or currency devaluation. ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. That credit risk will be reduced in the end. and under no circumstances shall we be liable for any direct or indirect losses. Prior to joining DB in 2007. 13 . We attempted to pull many previous threads into this topic. The credit risk. With few exceptions. All express or implied warranties or representations are excluded to the fullest extent permissible by law. which looks at the debt crisis from the investor’s perspective.butler@amphora-alpha. as the global debt crisis heats up and the sea of debt rises. John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London.amphora-alpha. Whether a home is lost to foreclosure. there could be much additional damage indeed. there is simply too much credit risk in the sea and they want it reduced. Well. tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities. We wish all of our readers a pleasant and festive holiday season. 2011 will be yet another year in which policymakers struggle to prevent such an implied deleveraging. where he was responsible for the development and marketing of proprietary. must be reduced. it is instructive to step back and look at the entire sea of debt. where he and his team were voted #1 in the Institutional Investor research THE RISING SEA OF DEBT | VOL 1/14 As yet another wave of crisis rolls across the global financial markets. JOHN BUTLER john. investment products or other financial instruments. are toppling over. one way or the other. This report is produced by us in the United Kingdom and we make no representation that any material contained in this report is appropriate for any other jurisdiction. Nothing in this report shall be deemed to constitute financial or other professional advice in any way. DISCLAIMER: The information. They want less credit risk and they are going to find a way to reduce it. a factory to corporate bankruptcy. These terms are governed by the laws of England and W ales and you agree that the English courts shall have exclusive jurisdiction in any dispute. costs or expenses nor for any loss of profit that results from the content of this report or any material in it or website links or references embedded within it. Judging by the experience of 2008-10. quantitative strategies. it eventually yet suddenly swamps those living close to the shore. New York and Germany. one by one like John Butler has 18 years’ experience in the global financial industry. politicians presumed this could be summarily accomplished with sovereign bailouts. or both are lost to the sea. free from the relentless doom and gloom of the Amphora Report. rising temperatures result in rising sea levels. All rights reserved. He is a regular contributor to various financial publications and websites and also an occasional speaker at investment conferences. through some combination of default and currency devaluation. 1 December 2010 www. What forms of fiscal and monetary stimulus are we yet to see? How will investors react? We don’t presume to know the specifics but what we do know is that increasingly arbitrary attempts to prevent financial markets doing what they know they must do are going to fail. As is postulated by global warming theory. At first. having worked for European and US investment banks in London. The only question is how much additional economic damage will be unnecessarily caused along the way. makes little difference to the holders of the debt that is defaulted on. policymakers appear to prefer the latter. © Amphora Capital LLP.THE AMPHORA REPORT Vol 1/15. sovereign and all. From an investor’s point of view. Prior to launching the Amphora Commodities Alpha Fund he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London. Amphora Capital is registered in England and Wales under the number OC345497.

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