carlson capital Quarterly Letter

december 2016

black diamond thematic

Dear Investor,

Black Diamond Thematic, L.P. was up 9.27 percent net of fees in the fourth quarter of 2016, bringing year-to-date returns to 18.95
percent net of fees.

2016 was a successful year for the fund. The world goes through and endures cycles and at any given moment things might look
more or less difficult; however, in reality the song generally remains the same. In fact, it could be argued that we have enjoyed an
extended period of relative calm; a Peace Dividend that since the fall of the Berlin Wall, the end of the Cold War and the rise of the
BRICs, has kept on paying. The great civilizations since the beginning of time have lasted about two hundred years and they have
always followed (and undoubtedly progressed through) the same sequence: war to spiritual faith to courage to liberty to abundance
to complacency to apathy to dependence.

And from dependence back to war.

Not that we are predicting such a thing but we invest based on optionality and risk reward. A chart in the Financial Times in Novem-
ber was provocative.

Figure 1: Percentage Of People Who Say It Is “Essential” To Live In A Democracy

Source: Yascha Mounk and Roberto Stefan Foa, “The Signs of Democratic Deconsolidation,” Journal of Democracy | By The New York Times

People in the first world barely value democracy. Obviously, this is not strictly true but we certainly take it for granted. People born
in the 1930s in the midst of fascism and Nazism believed democracy to be “essential”. As we have moved away through the political
events of the last thirty years, the charts tells us that people have come to value democracy less and less until the 1980s cohort –
those people thirty-five and younger – for whom its relevance has abruptly plummeted to a frighteningly low level. This has occurred
with Quantitative Easing (zero rates), the faux-freedom enabled by the internet which has moved from superhighway utopianism
to FANG total corporate dominance and Kim Kardashian celebrityism. One could surmise that we have become a bunch of spoiled,
complacent self-centred “individuals” and have mispriced the risks of future inflation, volatility and loss of freedom. Older people in
the UK were blamed for Brexit and if it is true that people get a little more set in their ways and less liberal as they age, then it is also
true then that the greying of the population is a net negative to democracy.

1
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

In the context of this idea of complacency, the examples of the shift toward nationalism and against globalism (and globalization, for
they are different) are multiple and widespread and well, global. They range from extremes to democratic referendums. Brexit, UKIP,
the US election, Marine Le Pen’s “mondialisme,” the Freedom Party of Austria, Putin and Crimea, the populist Five Star Movement
in Italy and the building rhetoric and antipathy toward free trade (NAFTA, the EU, the WTO and Davos) come to mind. Islamic State
should only be mentioned in its own self-contained sentence.

The debate is no longer about left and right, socialism versus capitalism or big government versus laissez-faire. It is about the nation
state and the reassertion of control. Bretton Woods and the end of the gold standard, free trade, industrialization and demograph-
ics created a virtuous circle which led to Bretton Woods 2.0. This was a tacit agreement between China and the US where China
grew exponentially to produce cheap goods for Americans and in return bought US treasuries to keep rates low so that Americans
could take on even more leverage. Cheaply made goods including cars (a topical issue for the new President) were made available to
Americans with seemingly infinite prime and sub-prime credit.

Eight years after the Great Financial Crisis, the blowback has started which brings us to the impact of Border Adjustability and
perhaps the end of the Dollar Standard. The US Dollar has been the world’s reserve currency since World War II, but particularly
since 1971 when the world moved to pure fiat money (backed by nothing but good faith). A fiat money regime meant that sovereign
accounts were no longer zero-sum. Credit expansion could commence (on both sides of the trade, creditor and debtor) and with it
we would see waves of wealth creation, over indebtedness, capital misallocation, inflation and deflation, bubbles and crashes. Trump
wishes to put an end to the American deficit and pursue a current account surplus. The implications of this are dramatic.

The Fed (and the ECB) have been focused on the dual mandate of inflation and growth but less so or not at all on global credit. Dif-
ferent beneficiaries and victims – they always end up as victims in the end - have included Japan 1980, the Asean nations in the 1990s
and Southern (PIIGS) and Eastern Europe, China and Mexico in the 2000s. All along, low rates in the US have offered constant and
unerring support particularly for American equities. American industry and manufacturing jobs (not the stocks) were the victims as
the first world outsourced whatever it could in the quest for productivity. The result, however, is the rise and rise of Trump. For the
US to reduce corporate tax rates and incentivize manufacturing, US policymakers intend to tax imports and subsidize exports. This
reverses Bretton Woods 1.0 and 2.0 and will likely set off a trade war. If Trump does not support a border tax system then he will
advocate for a tariff. In either case, the US current account deficit will shrink causing the dollar to appreciate which will put pressure
on EM to raise interest rates aggressively to defend their currencies (not gradually as equity markets dislike less).

Worse still, corporations in those regions have built up US dollar denominated debt to manufacture and export goods to the US.
The BIS estimates this to be 10 trillion dollars. US rates will no longer remain low and in the short term the dollar will overshoot as
foreign corporations rush to pay down this debt. At the same time that paying down dollar debt becomes more expensive in local
currencies, their sales will be declining due to falling US demand. In the 1930s, nationalists were expansionists who coveted other
territories. That may still be the case with Putin, but Trump specifically wants to reassert control over his own country and much of
his support comes from those that want to go back to their own culture whatever they perceive that to be. It is an inward look. The
last big US backlash against immigration came during the Roaring Twenties, the last time that the foreign-born share of the popula-
tion stood as high as it is today, at thirteen percent. The 1930s saw a collapse in external credit involving Britain, the US and Ger-
many. Britain was losing its primacy, the US banned gold sales and aggressively recalled German loans causing a banking collapse…
and contributing to World War II.

This time last year, the combination of minor Chinese devaluations, an obsessive groupthink around secular stagnation, typical
seasonality, the first Fed hike and crashing commodity prices, meant that we spent much of our letter focusing on the coming low in
crude and why there was no chance of a recession. Today, on the back of Trump, expectations around the economy are the strongest
they have been in years. Commodity prices are parabolic, Bank of America stock is the new Facebook and inflation is apparently a
good thing. We have insisted for the last twelve months that inflation is coming, at first incipient, and then more rampant. Our view
on inflation has never really been about economic strength. We differentiate between the demand-pull and cost-push kind. The
output gap has essentially closed and the pushback against immigration will only make it worse so that wages, the true driver of 2

PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

inflation, are definitely rising. This is a labor supply issue not a demand one. Whilst we are sanguine on the economy, we believe
that real GDP growth will ebb and flow around two percent. Right now expectations are flowing. The Citigroup EM Economic Sur-
prise Index is at a peak.

Figure 2: Economic Surprises Are Highest In 5 Years

Source: Bloomberg

Based on rising commodity prices and the more than one hundred percent year-on-year increase in crude oil, also an (OPEC) sup-
ply issue, we expect inflation to rise quite sharply perhaps as high as five percent over the next year. Anytime over the last thirty
years that oil has risen one hundred percent year-on-year and long end interest rates are up one hundred percent year-on-year with
a strong dollar, the US economy has slowed down often into recession. It squeezes consumer real purchasing power, slows real
consumer spending at a time when export growth could slow given uncertainty over new, undecided policies and a less competitive
currency. This is a global phenomenon; Japan has an extremely low unemployment rate too. The Eurozone and UK CPIs are destined
to accelerate also.

Figure 3: Global CPI (IMF) Y/Y %

Source: Cornerstone Macro
3
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Far be it for us to call a meaningful slowdown having been defenders of the faith for so long, we repeat we look at optionality. Mar-
ket participants have shifted with extraordinary vigor out of deflationary, secular-stagnation convenience into cyclicality. It is not an
easy transition. Shifting from FANG-based investing to an increasingly volatile albeit still rising stock market has been a challenge
for the hedge fund community. The largest driver of our performance in 2016 came from owning US banks when the Fed was still
lowering the dots despite clear inflationary signs. For us it was truly the last subliminal cut. The optionality thereafter was uniquely to
the upside.

The last time that inflation accelerated was in 2010/2011 (also highly successful periods for the fund) and real global GDP decelerated
from six percent to three percent. Furthermore, as discussed last summer, the US had experienced five quarters of inventory dis-
accumulation which implied upside in the back half of the year. In the first quarter of 2017, we have seen much or all of that benefit
with inventory accumulation now contributing materially to GDP. In fact, in something of an optical illusion, everything seems tight
and the tighter it appears, the more intense the scramble for inventory despite no apparent acceleration in underlying demand. This
is the core of what we do and seek to identify. DRAM, NAND flash, iron ore, copper, steel, coal that was worthless a year ago are all
being hoarded.

Figure 4: Inventory Contribution To GDP Highest In 5 Years

Source: Bloomberg

With expectations of a new Trump-inspired cyclical story for the new economy fully baked into stocks, the merest deceleration from
any other factors cited here (inventory, seasonality, weather, crude, rates, inflation) could come as a shock to the new market posi-
tioning. Typically when the economy decelerates, as it does at some point every year, fears can extrapolate to a recession which will
of course be a total overreaction. We will be buyers again of the banks at such a point.

The reality of politics rather than its promise is already visible. During the campaign the Republican Party promised to roll back
Obamacare’s most disliked provisions like taxes used to fund the program and the individual mandate while keeping coverage
subsidized and affordable to those who had pre-existing conditions. This is impossible to do in the context of reconciliation which
requires that the Obamacare repeal be budget neutral in order to avoid the Senate filibuster. There are echoes of Brexit highlighting
the increasing trend of dis- and mis-information. Healthcare has always been a big research focus for us and if what we are observ-
ing occurs, we could be entering a period of extreme volatility in a large sector of the market. A failure to repeal Obamacare could
also significantly impair the likelihood of achieving the rest of the President’s agenda including tax reform and infrastructure stimu-
lus yet animal spirits continue. In other words, if the good stuff (lower taxes) that the market has already discounted gets pushed out
to an un-investable time horizon as a result of an Obamacare impasse, it is a problem.

December’s payroll report may be the template for 2017. New jobs added missed expectations while Average Hourly Earnings beat.
We cannot really pick on the data; the number of jobs added was still impressive but the economy is quickly running out of warm 4

PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

bodies to employ. This month, retail sales missed while the PPI beat. If the economy slows down against expectations it will have
little effect on the upward direction of inflation. The rationale of inflation was cost-push and supply side constraints not demand
side stimulus. Thus, we may be looking at the grisly spectacle of stagflation with the equity market on the highest cyclically adjusted
valuations ever.

We were very bearish on the bond market until the ten year reached 2.6 percent in mid-December. Bond yields can ultimately rise
much higher given the opening discussion in this letter, but we thought that a slowdown in the data against overly bullish expecta-
tions and an extreme short position in bonds could cause a retracement which has begun to happen. It is a feature of the new invest-
ment landscape that momentum investing is going to be problematic. Inflation causes volatility and trends will not hold but instead
oscillate. CFTC just released the latest positioning data. Despite the rally in bonds, the large latent speculative short position across
Treasury futures actually increased. Deutsche Bank estimates that the aggregate net short speculative position across Treasury
futures rose from sixty-nine billion dollars to seventy-four billion. This is an absolute record in US dollar terms since 1994 and this is
close to the historical extreme level seen in 2010 once adjusting for the aggregate open interest in ten year equivalents.

Figure 5: CFTC Positioning Data

Source: CFTC
5
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Trump could have said anything, anything at all, in his victory speech and the stock market was going to rise because the rotation
out of bonds had to go somewhere in the performance-chasing Season of Goodwill.

Consequently, in early December we began to rotate out of banks into parts of the market that had suffered from the bond market
sell-off. We moved long exposure into the Eurozone given the weakness in the currency (as a result of the strength in the dollar).
This included European and specifically Italian banks in front of the referendum. We have learned that every political deadline is a
buying opportunity whether expectations are bullish or bearish, but especially when they are bearish as they were in Italy. As yields
continued to rise we fully exited financial exposure and bought healthcare (pharma and biotech) and telecom. Amazingly, having
experienced a monotonic market where investors would pay absurd multiples for highly unproven growth, we have found really in-
teresting value in these sectors and more importantly we have been able to buy best-in-class stocks as opposed to the worst-in-class
cyclical stocks that former sworn-in secular stagnationists are now being forced into buying.

Of course, there is another way that bonds can rally and the economy can slow down that has nothing to do with any of the above. It
is both the nine hundred pound gorilla and the elephant in the room. China was on the cusp of despair exactly one year ago and as it
entered Chinese New Year it reversed, on a dime, its intended policy of reform. We are now experiencing the exact opposite setup
as 2016, when investors were universally negative, monetary and fiscal policy was setup to become even more stimulative than the
depths of the financial crisis, and the Fed had room to defer rate hikes for an entire year. With the Chinese government effectively
choosing currency stability over growth, the PBOC has outsourced monetary policy to the Fed at a time when the Fed is set to be-
come much more hawkish. We believe that China can ill afford tighter conditions with leverage levels set to become the highest in
the world after Japan by 2018. We expect an imminent growth slow down to force a devaluation that will allow the PBOC to regain
monetary independence.

Today investor positioning in commodities are at peak levels as evidenced by speculative interest in oil and copper at peak levels.

Figure 6: Speculative Interest In Commodities Are At Highs

Source: Bloomberg

Speculation in copper is almost out of control and commercial hedging has collapsed…

6
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Figure 7: Net Hedgers/Commercials and Net Large Speculators

Source: Bianco Research LLC

Monetary policy is tightening as interest rates in China have risen by almost one hundred basis points since the US election. Rising
interest rates have caused a slowdown in corporate bond issuance. We would expect that Chinese New Year starting on January 27th
will cause a further spike in rates.
Figure 8: Rising Interest Rates are Slowing Credit Growth

Source: Bloomberg
7
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Tighter monetary policy has consistently led to asset price deflation.

Figure 9: China’s Macro Policy Has Been Swinging Between Supporting Growth and Fighting Bubbles

Source: BofA Merrill Lynch Global Research, CEIC

The Chinese/US interest differential is the driver of the currency rate. Currently, Chinese one year rates are two hundred basis
points higher than in the US. Ultimately, we believe Chinese rates need to be significantly below the US rates.

Figure 10: China Interest Rates Need to Decline Causing FX Depreciation

Source: Bloomberg

Due to the pressure that rising interest rates will have on GDP given China’s leverage will reach three times GDP by 2018.

8
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Figure 11: China’s Interest Burdens (Total Interest Expense as a % of GDP)

Source: Deutsche Bank

Thus, if China remains committed to a stable currency, it means tighter economic policy and downside to data now that govern-
ment fixed-asset investment has begun to fall back to pre-February 2016 stimulus levels. The simplest way to observe this is through
Shanghai house prices, which have just turned negative.

Figure 12: Month-Over-Month Prices of Existing Homes: Shanghai

Source: Wall Street Journal
9
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

So politics and history feature heavily in our thinking as we begin the year. We see a variety of factors that could cause macro decel-
eration just at the moment when investors have been dragged kicking and screaming into cyclical positioning, a place in which they
are not truly comfortable. We further see much more dramatic risk from China. The combination offers attractive optionality to de-
fensive positioning that is now under owned and attractively priced. As it relates to the Trump rally, we could argue that there were
several drivers. The first was seasonality into year end. The second was the enforced bond-equity rotation which we suspect could
be over in the short term. Third, fourth and fifth would be policy themes: corporate tax reform, infrastructure spending and broad
deregulation. It was notable that in his first press conference there was no mention of any of these but rather unprompted criticism
of the pharmaceutical industry.

Setting aside intra-market rotations, we note that hedge funds are really long the market right now. Recent CFTC data showed large
US futures buying by hedge funds. Net futures positioning is now above the 80th percentile. Recent prime brokerage data showed
net leverage +6.5 percent above the trailing twelve month average and is now close to a twelve month high.

Figure 13: Hedge Fund Length in US Equity Futures (in $Billions)

Source: Goldman Sachs

Sentiment is bullish; inflation is deemed to be a good thing despite the points we have made here. The Merrill Lynch Survey shows
that we are in the euphoria stage:

10
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Figure 14: Global Risk-Love

Source: BofA Merrill Lynch Global Research, Bloomberg

Prior letters have been focused on the Fed and the implications of the rate hike cycle. These implications have not gone away, but
have perhaps been forgotten and the path will be difficult to reverse. Regardless of current opinion, the truth is that tightening
cycles almost always cause multiple contractions. The only exception was a six month period at the beginning of the chart below in
1987…

Figure 15: S&P 500 12M Prospective Price-Earning Ratio

Source: Minack Advisors

11
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Finally, we note that the market is rising on ever-decreasing breadth. In the second week of January when the averages made new
highs, only 3.5 percent of securities closed at a fifty-two-week high. This was one of the smallest readings in decades. The average
over one hundred years is almost fifty percent. The last two times breadth was this weak was in July 1999 and March 24, 2000.

Thus, the fund remains short. We produced a return of 18.95 percent net of all fees in 2016 despite averaging a short beta position of
34.5 percent on average throughout the year by capturing important rotations based on our macro analysis. This amounted to a 3.34
Sharpe ratio for the fourth quarter and 1.64 for the year. We see more of these alpha transitions to come going forward but expect
that we can also capture beta at some point in the first quarter of 2017. Volatility is here to stay and we also expect to be somewhat
volatile and accept it as a cost of doing business and will attempt to control risk as much as possible while expressing our views.

We cannot overstate the impact of a declining US trade deficit and this is why we spent a large part of the letter discussing it. If the
border adjustment mechanism is implemented as proposed we think it will cause a global depression and a major equity market
decline. It is still unclear whether it will happen but at the very least we expect that US trade policy will put downward pressure on
global growth. When this becomes apparent commodities will correct meaningfully and we will reinvest in inflation beneficiaries.
Until then we are short cyclicality with what we assess to be tremendous risk-reward optionality through semiconductors, industrials
and miners.

Regards,

Richard Maraviglia & Matt Barkoff
Portfolio Managers
Carlson Capital, L.P.

The views expressed above are exclusively those of Mr. Richard Maraviglia, Portfolio Manager, and Mr. Matthew Barkoff, Portfolio Manager, within the Eq-
uity L/S strategy at Carlson Capital, L.P. and are in no way intended to be considered investment advice. Mr. Maraviglia and Mr. Barkoff are also the Portfolio
Managers of the Black Diamond Thematic Fund, a top-down, thematic equity l/s fund launched in November 2011. Unless specifically indicated, this mes-
sage w/attachments (message) is not an offer to sell or solicitation of any investment products or other financial product or service, an official confirmation
of any transactions, or an official statement of Sender. This message w/attachments (message) is intended solely for the use of the intended recipient(s) and
may contain information that is privileged, confidential or proprietary. If you are not an intended recipient, please notify the sender, and then please delete or
destroy all copies and attachments, and be advised that any review or dissemination of, or the taking of any action in reliance on, the information contained
in or attached to this message is prohibited.
12
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com
carlson capital Quarterly Letter
december 2016

black diamond thematic

Important Disclosures
This confidential report is only intended for the recipient and may not be redistributed without the prior written consent of Carlson Capital, L.P. This report
is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Black Diamond Funds®
or other security. An investment in any Black Diamond Funds® is speculative and involves substantial risks. Additional information regarding the Black Dia-
mond Funds® listed herein, including fees, expenses and risks of investment, is contained in the offering memorandum and related documents, and should
be carefully reviewed. This document is qualified in its entirety by information contained in the offering memorandum and related documents. An offer or
solicitation of an investment in any Black Diamond Funds® will only be made pursuant to an offering memorandum. There can be no guarantee that any
Black Diamond Funds® will achieve their investment objectives. Portfolio characteristics and other information are provided as of the dates set forth herein.
Changes to the inputs or scenarios may alter outcomes. Current or future characteristics and other information may vary significantly from those provided
herein and Carlson Capital, L.P. undertakes no obligation to notify the recipient of any such variances. To the best of our knowledge and belief, the informa-
tion provided herein is true and accurate as of the date of this letter.

13
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. There is a possibility for loss as well as the
potential for profit when investing in the Black Diamond Funds® described herein. Net return information details
the fund’s Series “A” offering.
carlson capital l.p.
www.carlsoncapital.com