Basic Points

Existential Financial Risks

July 28, 2011

Published by Coxe Advisors LLP
Distributed by BMO Capital Markets

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Don Coxe THE COXE STRATEGY JOURNAL

Existential Financial Risks

July 28, 2011
published by

Coxe Advisors LLP Chicago, IL

THE COXE STRATEGY JOURNAL Existential Financial Risks
July 28, 2011

Coxe Advisors LLP. Author: Editor: 190 South LaSalle Street, 4th Floor Chicago, Illinois USA 60603

Donald Coxe dc@coxeadvisors.com Angela Trudeau at@coxeadvisors.com

312-461-5365 604-929-8791

Basic Points is published exclusively for BMO Financial Group and distributed by BMO Capital Markets Equity Research for clients of BMO Capital Markets, BMO Nesbitt Burns, BMO Harris Private Banking and Harris Private Bank. BMO Capital Markets Equity Research Manager, Publishing: Desktop Publishing and Distribution Coordinator Monica Shin monica.shin@bmo.com Anna Goduco anna.goduco@bmo.com

Existential Financial Risks OVERVIEW
When the next full-blown financial crisis afflicts the world, it will not resemble its predecessors, because it will come from an epidemic originating in the risk-free asset class in the Capital Asset Pricing Model—government bonds issued by traditionally credit-worthy nations. The "risk-free rate of return" is under attack from the political classes in Europe and the United States. No longer are stocks and corporate bonds the assets with relatively high endogenous risks and commensurate risk-adjusted expected returns: sovereign credits have become the epicenters of investor risk. Soon, many investors will be following the example of a successful hedge fund manager who announced recently that he is switching from trading in junk bonds to trading sovereign credits, because the opportunities are greater. Within the US Treasury market, that new risk is, at least for now, being priced only as the remote possibility of a short-term default, affecting longdated Treasurys, as the rest of the yield curve retains its haven status in an increasingly uncertain economy. Within the euro zone, the new world of fear-founded pricing for government bonds, and the debt paper and shares of the banks that hold them—is confined to those issued by the "peripheral nations"—the new euphemism for PIIGS. The euro is in the early stages of an existential crisis, in which solvency, liquidity, and politics lock themselves together in a downward spiral. This month we look at the Scared New World of investment pricing. We are not adjusting our cautious Recommended Asset Mixes. The global economy is slowing, and government is once again the problem and not the solution.

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Existential Financial Risks
The US Fiscal Crisis
Main Street's Fast-Growing Sense of Betrayal
Where have all the dollars gone? Main Street is wracked with nightmares of monstrous deficits that will end the sweet national dream—The American Dream. It feels betrayed by the political class. What happened, Americans ask, to the $900 billion of stimulus money that was supposed to end the recession? Why is unemployment rising again, instead of falling below the 8% target proclaimed as the return on those gigantic expenditures? This year’s deficit is an appalling $1.2 trillion, and, until recent weeks, the President was making no serious attempts to rein in future deficits. Last year he appointed a blue-ribbon, bipartisan advisory panel 1 on the nation’s fiscal crisis, headed by two wise elders—Erskine Bowles and Alan Simpson. In December, it issued a sobering, well-researched report showing what needed to be done to prevent the USA from sliding toward Grecian catastrophe. Its preamble included: Main Street... feels betrayed by the political class.

We cannot play games or put off hard choices any longer….Our challenge is clear and inescapable: America cannot be great if we go broke. The contagion of debt that began in Greece and continues to sweep through Europe shows us that no economy will be immune. If the US does not put its house in order, the reckoning will be sure and the devastation severe.

1

National Commission on Fiscal Responsibility and Reform, 2010

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It included a chart of the national debt as a percentage of GDP. It is currently 62%—up from just 33% in 2001. According to the Congressional Budget Office, it will exceed 100% by 2025 and reach 185% by 2035. The Commission projects that, if its proposals are accepted and enforced, the debt percentage could be below 60% by 2021 and actually decline in the following decades.
US Debt as a Percent of of GDP Figure 1: Debt as a PercentGDP

Poised outside this chamber are the denizens of darkness…

The Extended-Baseline Scenario generally assumes continuation of current law. The Alternative Fiscal Scenario Source: The Moment of Truth: Report of National Commission on Fiscal Responsibility and Reform, Dec. 2010 incorporates several changes to current law considered likely to happen, including the renewal of the 2001/2003 tax (CBO: income below $250,000 per year, continued Alternative Minimum Tax (AMT) patches, the continuation of the cuts onCongressional Budget Office) estate tax at 2009 levels, and continued Medicare “Doc Fixes.” The Alternative Fiscal Scenario also assumes discretionary spending grows with Gross Domestic Product (GDP) rather than to inflation over the next decade, that Alan does not increase forthright old former Senator from Wyoming, commented revenue Simpson, theas a percent of GDP after 2020, and that certain cost-reducing measures in the health reform legislation are unsuccessful in slowing cost growth after 2020.

The Looming Fiscal Crisis

at the release of their Report: “Poised outside this chamber are the denizens of darkness… those are the groups waiting out there in temples around the city, waiting to shred this baby to bits.”

Our nation of on an unsustainable fiscal path. Spending is rising and revenues are falling short, He was, is course, absolutely correct. requiring the government to borrow huge sums each year to make up the difference. We face staggering deficits.document wasspending was nearlyPresident of Gross Domestic Product This dramatic In 2010, federal praised by the 24 percent with his customary (GDP), the value of all goods and services produced in the economy. Only during World War II eloquence in what larger part of the economy. Tax revenues the at 15 percent of GDP was federal spending aturned out to be a modern version ofstoodAntonian Funeral this year, the lowest level sincehis best togap between spending and revenue ofthe budget Oration, because he did 1950. The bury the Report within days – its birth. deficit – was just under nine percent of GDP.

His State of the Union Address and his own Budget dealt with such themes

Since the last time high-speed trains, but offered no proposals and no sacrifices as investing in our budget was balanced in 2001, the federal debt has increased dramatically, rising from 33 percent of GDP to 62 percent of GDP in 2010. The escalation was to avert the fiscal train wreck slew of fiscally irresponsible policies, along with a deep driven in large part by two wars and a the Bowles-Simpson report had described as economic downturn. We have arrived at the was as if the Mayor of New Orleans, on inevitable absent major reforms. It moment of truth, and neither political party is without blame.

being warned of a coming monster hurricane, had told his supporters to Economic recovery will improve the deficit situation in the short run becauseBlues to will rise gather in the SuperDome for a major jazz festival: Sing the revenues drive as people go back to work, and money spent on the social safety net will decline as fewer away are Blow! people the forced to rely on it. But even after the economy recovers, federal spending is

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In contrast, House Republicans issued—and passed—a detailed road map showing the tough spending cuts that would be needed to prevent the national debt from exploding, and to protect Social Security and Medicare from imploding as the nation aged. The doleful document died in the Senate and the Republicans thereafter began to back away from demonstrations of fiscal responsibility—with the loudest voices coming from newly-elected members and aging firebrands who were demanding that the Party refuse to authorize any increase in the National Debt Ceiling. Orwell, thou shouldst be living at this hour. Michelle Bachmann, a Tea Party favorite, is front runner in the Iowa Republican polls. She has been wowing her audiences with a pledge to vote against any increase in the debt ceiling. This is, of course, the equivalent of telling homeowners whose house prices have fallen to refuse to make any further mortgage payments. An old and wise friend with a distinguished career in Canadian finance, who is accustomed to measured understatement, sent us a one-line email last week: "Has the entire US political class gone mad?" Michelle Bachmann may actually be following a proven formula to move from political long-shot to front-runner: In the midst of this unfolding fiasco we witnessed a TV clip of a splendidly calm and well-reasoned speech by a US Senator explaining why he was going to vote against an increase in the debt ceiling. He talked in terms of households having to control their spending and debts, and said Washington should be doing the same. He had to cast this vote, he assured us, to protect the nation's future for coming generations. It was then-Senator Barack Obama, explaining his "Nay" vote on the debt ceiling increase proposed by George W. Bush. (As one might expect, the only network that has carried this stirring summons to Franklinesque restraint was Fox News. We recalled having heard Obama deliver it back then, and falsely concluded that such an unserious legislator backed enthusiastically by the Far Left in his party could never defeat the serious Hillary Clinton for the Presidential nomination. His speech and vote, which apparently had the desired effect in the Democratic Presidential Primary, have now been resurrected by a candidate from the Far Right in an attempt to produce another political miracle.)

"Has the entire US political class gone mad?"

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When he finally realized a disaster loomed, Mr. Obama chose to demonize his Republican opponents as being more concerned about tax deductions for their corporate jets than saving the nation from catastrophe. He presented himself as the nation's savior against extremists and fools. But he declined to propose any specific budget cuts. The House Republican leadership has been under severe pressure from Tea Partiers and other frightened folk on Main Street ever since the election that carried them to power. All polls until mid-July had shown that—by a huge margin—Republican and independent voters were opposed to boosting the debt ceiling. They had succumbed to the homely analogies with overindebted householders who had been forced into tightening their belts and paying down their debts. Into this charged atmosphere stepped Larry Summers, never a man to shrink from controversy. Speaking on Bloomberg, he blasted Republicans opposed to raising the debt ceiling as "financial terrorists." Although Summers has not been widely renowned for his diplomacy and restraint, did he think this slander from such a high-profile Democratic Party figure would advance the negotiation process? In 1984, George Orwell gave us "The Memory Hole," the device Big Brother used to destroy any inconvenient information. Mr. Summers is not, thankfully, in position to create a national Memory Hole about Obama's previous stand of opposition to raising the debt ceiling, but he can rely on the media other than Fox not to remind voters.

A crucial minority of House Republicans disdains such backsliding on thrift and restraint.

The Debate
Polls show that voters have been closely divided on whether the debt ceiling should be lifted, but are strongly opposed to cutbacks on Social Security and Medicare. They want to cut back on waste, corruption and foreign aid, but lack puritan fervor for cutbacks in "good and necessary" government programs on which so many of them rely. Democrats recognize this seeming contradiction for what it is: endorsement for raising the ceiling so the Social Security checks can be issued and the soldiers paid. A crucial minority of House Republicans disdains such backsliding on thrift and restraint. They want a national tourniquet on government spending and they're prepared to fight the next election for that cause, even if they face impalement on their own fiscal swords. 6 July 2011
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The new (apocryphal) Republican restatement of Reaganism is that no taxes can ever be increased, which means the only course open is to close loopholes, slash dubious deductions and cut outdated expenditures—such as ethanol. (Yes, there actually is serious bipartisan discussion about addressing that most conspicuous form of waste, and some reform seems now inevitable. Ethanol will not, alas, get its fitting fate—the gas chamber—but it will be cut back. That surcease from stupidity would almost be worth a debt crisis.) The House Republicans also endorse a Balanced Budget Amendment to the Constitution. This is, alas, an exercise in gaseous emission and futility. Constitutional amendments are rare events, because the approval process is so daunting: Amendment requires a two-thirds supporting vote in both houses of Congress, and a yea vote from three-quarters of the states. The current Senate would certainly reject such an amendment, and the process of state-by-state ratification would take many years. The nation's debt crisis will not wait. Watching the TV addresses this week from the President and Speaker John Boehner, we saw again why Mr. Obama will likely win votes by blaming the Republicans if the debt ceiling isn’t raised on time. He was doing what he does best: speaking. He had obviously decided that he was going to use his personal and Presidential power to undermine the Republicans in voters' eyes—a great kick-off to the 2012 election. In forceful, unsmiling fashion, he denounced their opposition to a deal as being based in protection for the very rich. He presented himself as a reasonable moderate who has been trying for months to present proposals for a fair deal that will move the economy forward. He called on voters to phone Washington giving him support. (They did—forcing switchboard shutdowns—and polls showed that most viewers were convinced that Obama was reasonable and right, and the Republicans were mean-spirited and wrong. He won that instant popularity contest hands down—and Speaker Boehner knew it.) Mr. Boehner was workmanlike, but he failed to charm the electorate. To win what had become the debate, he could have responded to the President's attack on him and his party by saying, “Mr. President, you spent months demanding a 'clean' approval to raise the debt ceiling, insisting that no spending cuts be included. Now you say you have been presenting a wide range of cuts that many Democrats oppose. What budget proposals do you mean, Mr. President? The only numbers you've presented publicly were in your Budget, which was voted down 79 to zero in a Senate controlled by your own party. The Senate hasn’t approved any budget in more than two years.

Ethanol will not, alas, get its fitting fate—the gas chamber...

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Not once this year have you been specific about any high-profile spending programs you would cut. We have passed a debt ceiling protection bill with appropriate budget cuts. The ball has been in your court for months and you are blaming us for this crisis?” Mr. Boehner was probably non-confrontational because he realized how the President's tough speech would inflame his own caucus, and he didn't want to fuel their rage. Many independent observers from across the political spectrum have been upwardly revising their appraisal of a debt default since Mr. Obama reverted to his former class warfare stance. It certainly infuriated House Republicans, and Mr. Boehner was forced to withdraw his latest proposal to approve the debt ceiling increase because he no longer had enough support from his own party. As this is written, the Republicans cannot agree on a Plan B. The word in Washington is that the Fed and government departments have begun preparing their plans to deal with a default. Stock prices have been falling sharply as investors suddenly take "the unthinkable" seriously. This recalls Congress's rejection of the TARP legislation, which triggered a stock plunge. That plunge was enough to force Congress to a reconsideration, and TARP squeezed through. We hope the markets' demonstrated fears have the same result this time. However, TARP was a clear, fully-drafted proposal. No Republican proposal remains on the table after the Obama speech, and the Democratic-controlled Senate is struggling to reach agreement with the more-moderate caucus of Senate Republicans on some deal that might be presented to Mr. Boehner as a last-ditch deal he could try to get past his party's aroused fire-eaters. It seems that Congress, the President, and the Tea Partiers still think they have to answer only to America and not the world. A nation in debt to the world has no such independence. Congress and the White House should have acted on this much sooner—and mainly in private meetings. Baring all is an unsound strategy for married politicians tweeting young women, and for the leaders of a profligate nation that is borrowing 41 cents out of every dollar it spends.

Baring all is an unsound strategy for married politicians tweeting young women, and for the leaders of a profligate nation that is borrowing 41 cents out of every dollar it spends.

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However, investors cannot assume that a last-minute Perils of Pauline outcome that snatches solvency from destruction means that Treasurys will thereupon retain their status as the Premier Global Risk-Free Standard. That outcome would mean that the Capital Asset Pricing Model would remain as the basic mechanism for appraising investment risk and reward. Perhaps not…

The Risks to the #1-Ranked Global Risk-Free Asset
Treasurys could well have a somewhat deflowered look for many years: • Commentators have been discussing the "drama of the Treasury market" as default is discussed openly. The rating agencies—not known for their ability to predict ghastly financial events—have weighed in with a pricing of default—an event that would have been unthinkable even a year ago. One of the basic rules of drama comes from Chekhov: if there is a gun displayed in Act One, it will be used in Act Three. The big gun has been on display. If it remains unused through Act One, will it still loom large if, as a result of last-minute deal now, another Act is a mere six months away? Or has this drawn-out, mesmerizing default drama shown that the longer-term US fiscal situation is so problematic that Treasurys will have to be downgraded anyway? The agencies have suggested that is a likely outcome. A seemingly healthy person who survives an unexpected heart attack doesn't keep his low-risk life insurance rating. • Another QE round from the Fed to deal with unexpected financial market perturbations is rather like Banquo's ghost: it won't go away even if some influential people deny its possibility; if it comes, then Treasury yields will continue to be artificially suppressed—unless the dollar plunges anew and its foreign supporters decide they've had enough of devaluation. (Chairman Bernanke made no reference to any foreign risks when he told a House Committee that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.) • Treasury real yields are negative up to five years; Bill Gross is not alone in rejecting them as basic stores of value in an investment portfolio. We are somewhat sympathetic to the argument that no investor should be disconcerted by the warning about a Treasury downgrade from the rating agencies: after all, as the record shows, the agencies' distribution of Triple-A ratings during the real estate bubble was only marginally more restrained than Groupon's dissemination of its discount coupons. So why believe them now?

...the agencies' distribution of Triple-A ratings during the real estate bubble was only marginally more restrained than Groupon's dissemination of its discount coupons.

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We think there is a difference: the agencies were paid—handsomely—to give absurdly high ratings to perfumed products fashioned by PhDs whose backgrounds were mathematics and physics—not real estate bubbles. This is an uncritical acceptance of the concept of retroactive virginity. In contrast to their dealings with the Street, rating agencies don't (so far as we know) get paid to appraise Treasurys: those negative appraisals come gratis. We do not agree, as some captious critics have argued, and as some aggrieved plaintiffs in lawsuits have alleged, that the rating agencies were staffed almost wholly with idiots. The problem, we believe, was not in their intellectual power but in the incentive system under which they operated; it was as corrupting as the incentive bonus system for the biggies in the Wall Street firms they served. Both partners to the most appalling series of large-scale transactions in financial history were paid obscenely for their roles in creating financial obscenities. No such incentive system applies to their appraisal of Treasurys. Therefore, we take those appraisals seriously. When they work pro bono, they might actually be doing highly professional work. They just can't be trusted when they're paid to fulfill an absolutely essential role in helping investment banks to peddle complex investment products.

Treasurys should no longer be considered the risk-free dollar asset class.
There is some near-term measure of risk that the Treasury holder will not be paid interest or principal on time, but the Fed can print the money to pay the interest and principal eventually. But Treasurys backed—however tangentially—by that understanding of the last-resort to the printing press may no longer represent the unquestioned global standard of premier value. Various financial commentators and various Republican politicians have been assuring us that there could be a short-term national default, but Treasurys would get their Triple-A rating back as soon as the politicians came to their senses. This is an uncritical acceptance of the concept of retroactive virginity. It may, in fact, occur... and space travelers may in fact have visited Roswell... and the Cubs may in fact win the World Series.

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Apart from default risk due to political miscalculation, there is also some risk—however remote—that the holder of long-dated Treasurys may be forced—at some time in the future—to accept even longer-dated paper, or paper with lower yields than the investor has been earning. (This is in fact the scheme the Eurozone has imposed on banks holding Greek bonds, but critics point out that it resembles the scabrous deal Argentine inflicted on its creditors.)

Conclusion
Why accept an apparently subsidized yield for paper issued by an apparently dysfunctional government, backed by an increasingly dysfunctional economy? Investors can do better—and should. High-grade corporate bonds are the new normal—and their yields are routinely used by corporate pension funds to discount their liabilities. Leading Public pension funds, on the other hand, use the lofty projected returns in their versions of the Capital Asset Pricing Return, and they continue to use 8% as their assumed rates of return, and for discounting their liabilities; they will likely be the next class of investors to spawn disasters and taxpayer bailouts.

Why accept an apparently subsidized yield for paper issued by an apparently dysfunctional government, backed by an increasingly dysfunctional economy?

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The Eurozone Lurches From Crisis To Crisis
"What difference does it make what we do to control our deficit? Our rates rise click-by-click with Greece!"
Euro vs. US dollar January 1, 2004 to July 27, 2011
1.60 1.50 1.40 1.30 1.20 1.10 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 1.43

There Are No Answers. What Is The Question?
We thought of that classic exchange between Gertrude Stein and Alice B. Toklas during our recent visit to Spain. We spent two weeks in central Spain—mostly vacationing, returning back with even less optimism about the future of Spain—and of the euro—than when we wrote the previous issue of Basic Points. Spain is—need we say?—beautiful. And its people are polite, dignified and impressive. But they are sleepwalking through serious pain toward something much worse. The people and their newspapers have figured it out: being locked into the euro with Greece is not just insulting: it's downright dangerous... "What difference does it make what we do to control our deficit? Our rates rise click-by-click with Greece!" "What difference does it make whom we put in power? They're all corrupt and nobody has any answers." A young tour guide summed it up: "Capitalism has failed us. The banks created the financial crisis and they have to be supported by

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the taxpayers. We need to try something else, but what is it?" We could offer no contrary arguments. A mother of three children—one, a rebellious teenage boy, and two unemployed university graduate twenty-somethings told us, "I can't get my son to do his schoolwork. He says, 'What difference does it make? There are no jobs and there won't be any. I might as well have fun while I can'." [Youth unemployment is listed at 35% or 45%, depending on which statistic one believes.] The Spaniards' bitterness about their eurozone partners now extends to Germany, because of the sudden ban on their vegetable exports when an outbreak of a lethal strain of E. coli was blamed on the alleged low hygiene standards of Spanish gardeners. Financial losses for Spanish producers were enormous. It turned out that the culprit was sprouts from a German certified organic farm. As various American and British infectious disease experts had noted while the panic was spreading, the German authorities should have looked at sprout farms first, because sprouts are especially liable to be E.coli carriers. The Germans are compensating the Spanish, but the bitterness remains, because, Spaniards feel, the German response was rooted in Teutonic snobbishness about Spanish standards of cleanliness. We stayed at a hotel in Madrid located 100 meters from the public square used by the demonstrators against the government. The Spanish police managed the daily events superbly, checking all IDs, and showing an impressive display of weaponry—revolvers and nightsticks. The police were polite but firm, controlling all access to the square and ensuring that the demonstrations were peaceful. Spaniards aren't Greeks. But the nightly displays on European TV of anarchy and violence in Greece had a major impact on global investors' willingness to invest in debt issued by the other peaceful "peripherals"—or in the equities and paper issued by European banks, wherever headquartered, which had large "peripheral" exposure. The European Bank Authority provoked laughter amid last autumn's eurogloom; when it conducted stress tests on 91 large banks, and pronounced them strong, only to have five collapse within weeks when Ireland went down. This year, we were told, things would be different as the eurocrats went back to their drawing boards and came up with new, tougher stress tests. Ninety

...nightly displays on European TV of anarchy and violence in Greece had a major impact on global investors' willingness to invest in debt issued by the other peaceful "peripherals"

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banks participated, and the minimum strength for acceptance was 5% of Assets in Tier One Equity. The average was 8.9% and, after allowing for recent capital-raising, 8 banks fell below the acceptable level. In its section on exposure to Greek government debt, the good news was that two-thirds of the 98.2 bn euro exposure was held by Greek banks, with banks in Germany, France and Cyprus the largest holders. Contagion did not appear to be a significant problem. This report, as luck would have it, was issued six days before a crisis meeting of the leaders of the eurozone to avert a Greek default. The night before the meeting convened, Angela Merkel and Nicolas Sarkozy met for six hours to hammer out a deal that would avert a collapse and not arouse new rage among their own voters. The package was announced last Thursday. It is a near-total rejection of the sound, sensible, idealistic principles of the Maastricht Treaty. Some notable components: • The European Central Bank agreed to remove its ban on selective Greek default; • The European Financial Stability Facility (EFSF)—backed by the resources of the entire zone—has been given a new “flexible” role to prevent contagion; (flexible is the Orwellian locution for “craven abandonment of agreed-on principles.”); • The EFSF (which has a Triple-A rating from the rating services) will now have the right—nay the duty—to move in with loans for struggling states before they reach the full-blown crisis stage; • Most gallingly to hard-money believers in the financial-sound states, the maturity on rescue loans to Greece, Portugal and Ireland will be extended from 7.5 to 15 years, and the interest rates will be reduced from between 4.5% and 5.8%, to 3.5%. (Can anybody imagine a traditional Bundesbanker participating in those long-term loans at those rates? Two-year Greek bonds trading in open markets now yield more than 23%, but 15-year bonds will yield less than one-sixth as much. This is the magnificent new yield curve of the euro; presumably a 100-year Greek bond would yield .23 percent.) In sum, the euroleaders have agreed to jettison all the safeguards originally guaranteed to convince doubters in Germany and elsewhere that the entire membership would never be required to bail out weak members.

...a new “flexible” role to prevent contagion; (flexible is the Orwellian locution for “craven abandonment of agreed-on principles.”)

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The euro crisis is truly existential. As our readers know, we have long been euroskeptics because the euro is the first tradable currency to be backed by no government, no taxation system, no army and no navy; it is backed solely by a theory propounded by a prominent French eurocrat, Jacques Delors and other leftist elitists. When he outlined the proposal to the EU, Margaret Thatcher rejected it with her accustomed steeliness: "This is socialism by the back Delors." Like all the constitutions of France on which it was patterned, the euro pact has only rules for entrance. No exit. The European Central Bank is compelled by its rules to lend to banks against all sovereign europaper. Since the ECB has merely ten billion euros in equity, its financial condition risks becoming that of a large and impecunious Greek bank that is begging for a bailout. There is, of course, the International Monetary Fund, which became the euro's leading savior under the leadership of Dominique Strauss-Kahn. He had to vacate his chair under sensational circumstances; he was succeeded, as these things go in Europe, by another French elitist, the accomplished Christine Lagarde. It is now up to her and Jean-Claude Trichet to continue to coax and cajole the eurozone members into unanimous consent to what will be a never-ending series of aid packages, support packages and bailouts. The Germans are less and less happy with the plight of the “peripherals,” and are doubtless uncomfortable with France's control over the aid institutions. Karl-Otto Pohl, former head of the Bundesbank, and still a formidable figure on the Continent, recently told Spiegel that the euro is in trouble because the eurozone has been transformed into a transfer zone, with members sending aid to each other—in complete violation of the founding principles. Moreover, the European Central Bank is violating its constitution by making loans to member nations. He also noted that Greece should never have been admitted into the euro. We cite his views, because if you have a currency with no other backing than a theory and a set of rules, you have a serious problem when you violate those rules on majestic scale. The euro has lost its status as an elegant, eternal theory of financial stability, and is becoming just another bad European dream. It will exist—for as long as it manages to exist—as the currency equivalent of the room in Hell in Jean-Paul Sartre's famous existential play, No Exit. A man and two women enter the room singly and, upon realizing where they are, try to establish some basis for communication. The man falls

...if you have a currency with no other backing than a theory and a set of rules, you have a serious problem when you violate those rules on majestic scale.

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in love with one of the women, but she has a Lesbian attraction to the other woman—who rejects both her and the man. At that point, the door slams shut and they realize they will be each other's torturers through eternity. It was Sartre's sardonic view that Hell is eternal punishment in which we torture each other. In that sense, the existential risk to the euro from the acceptance of inevitable further bailouts of the defaulting three, and the likely future crises in Spain and Italy, are Sartresque: the euro is a locked room where countries are destined to torture each other in punishment of their sins.

...the likely future crises in Spain and Italy, are Sartresque: the euro is a locked room where countries are destined to torture each other in punishment of their sins.

Germany
What sin, you may ask, has Germany committed? It has been too good at what it does best. It is so efficient and successful that the eurozone has become, in effect, its privileged marketplace in which it profits by selling to partners, many of whom become more uncompetitive each year. In recent discussions with some knowledgeable observers, the following hypothesis emerged: When the Wall fell, Helmut Kohl made a strategic blunder: he agreed to swap good Deutschemarks even up for putrid ostmarks. Result: the reconstituted Deutscheland had a powerful, competitive West, and a weak, hopelessly uncompetitive East. Wages and benefit levels in East Germany were far too high to attract capital investment and launch the Marxist wasteland on the road to West German-style prosperity. (Prior to the Fall of the Wall, the sarcastic explanation of the Marxist Model was, "They pretend to pay us, and we pretend to work.") So the West Germans collectively sucked it up, and for a decade resisted wage increases and improvements in social programs for themselves, while pouring roughly $100 billion into the shambolic, socialist East. (As usual, the Western Left had it 100% wrong. J.K. Galbraith and other leading Western progressive economists pronounced East Germany a successful economy and society, right up to the Fall of the Wall, and top Western novelists like Günter Grass published endless streams of fiction that described West Germany in hideous terms. Indeed, West Berlin prior to the Fall was a city that had more true Marxists-per-capita than East Berlin—and they were being supported—in

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good socialist fashion—almost entirely from the output from the capitalists they reviled.) During that "lost German decade", Germany got virtually no financial help from its allies and EU "partners”, yet Germany continued in its role as paymaster for the Euroelites and their spending schemes. Then the new millennium dawned, and all the europartners were locked into sharing the same currency. No longer could weaker economies rely on their ability to ease their competitive problems with devaluations. There was no exit door. As a wise client remarked recently, the euro may have accomplished for Germany what the Hapsburgs and Hitler could not: near-total economic dominance of the Continent. As Germany’s trade surpluses with its europartners increased, its banks invested their depositors' savings in bonds issued by the other nations— particularly the weakest of the weak sisters—where a slight premium over bund yield was available. So they lent—on easy terms—the money to their partners to help them to bankrupt themselves. That Deutscheland seems to be über alles today would not have happened had West Germans not sacrificed for a decade to bail out their Eastern brethren. During those long years of sacrifice, the rest of Europe was enjoying the prosperity of the post-Cold War era and the technology boom. Wages rose faster than inflation. France cut the work-week from 40 hours to 35. Governments grew, and civil servants' pay and benefits grew even faster. Times were good. And those dull, dour Germans were still writing the checks that kept the EU afloat. None of the other countries' leaders seemed to notice that German wages weren't growing, but German competitiveness was. It didn't occur to them that they could be the new Philistines—laughing at Samson with his long hair and big muscles, not realizing that letting Samson loose when they were locked into a structure with no exits was a high-risk game. The euro is no longer just an elegant theory concocted by French intellectuals over glasses of premier grand cru wines (from vineyards subsidized through the 42% of the EU budget that went for agriculture). Because these intellectuals were socialists, the idea of the biggest member achieving sustained growth in industrial competitiveness within a single-currency environment was as unworthy of reflection or concern as recognizing that the Cold War had

...the euro may have accomplished for Germany what the Hapsburgs and Hitler could not: near-total economic dominance of the Continent.

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been won, not because of a sudden rush of Russian socialist good will, but because of the firm strategic and military leadership provided by their two premieres bêtes noires—Ronald Reagan and Margaret Thatcher. (They were not alone in their prejudices: Gorbachev won the Nobel Peace Prize for, in effect, losing the Cold War and Time named him Man of the Year after the Fall of the Wall.) The euro's bailout rules force the financially weakest economies within the free trade zone to austerity programs that shrink their GDPs. The debt/GDP ratio keeps deteriorating even as the restraints increase. This means that all those crisis meetings in which the Germans are asked to pony up more money to prevent some underachieving socialist economy from collapse are as effective in restoring sound economic growth as plowing the North Sea. Therefore, investors must face the reality that the weeks in which there is no eurocrisis to unsettle global stock markets will be succeeded by weeks of euroangst. There will be no return to the kind of euro-self-congratulation of the Lisbon Summit that was supposed to launch the eurozone on a drive to becoming "the most competitive knowledge-based economy in the world." No one imagined that within a decade of this declaration, Portugal would be bankrupt. Its one emblem of a knowledge-based economy was that its Premier's name at the time of the crisis was Sokrates. (That unfortunate Premier was, we understand, widely regarded as clueless. However, the original Socrates was famed for saying, “This only do I know: that I know nothing.”) The financial markets are Rhadamanthine in their judgments about the weaklings:
Ten-Year Bond Yield Changes Since January 2010 Greece Portugal Italy Spain In contrast: Germany 3% to 2.6% 5.9% 4% 3.6% 4% to to to to 17.9% 13.25% 5.6% 6.1%

...those crisis meetings in which the Germans are asked to pony up more money... are as effective in restoring sound economic growth as plowing the North Sea.

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ISI reports another unhappy statistic about the vitality of the eurozone: the MSCI Eurozone Equity Index is at the same level as 13 years ago. (The S&P is up 11% in the same period, and the TSX is up 18%.) ISI estimates combined GDP performance this year from the weaklings as falling 1.8%, whereas the rest of the eurozone is predicted to grow 1.9%. (That happens to be within one-tenth of one percent of what Bill Gross has long proclaimed as the New Normal Rate of Economic Growth. Great call.) The 2008 economic crisis originated in the US financial system with the toxic mortgage products. The next economic crisis—once the Treasury default problem is resolved— will originate in European banks stuffed with bad sovereign debts as more European economies weaken and the euro's core contradictions can no longer be denied. It may well spread to the US. Just as the collapse of those AAA-rated US mortgage products became a TransAtlantic horror story in 2007 because so many European banks had loaded up on malodorous mortgages issued by Wall Street, which, under Basel rules, required minimal capital allocations. (AAA is roughly at sovereign credit levels for Basel capital purposes.) This time, the backlash from an existential eurocrisis could become problematic for some big American money market funds that are heavily exposed to European bank paper. The Old World with the New Currency could—perhaps suddenly—become a new kind of challenge to the stability of the US financial system. It is unlikely the euro will survive for long. However, the IMF, ECB and new Continental acronym rescue packages could, at least in theory, defer the climax of the existential crisis for years. What could accelerate the crisis is European democracy. The elites created the euro and will muster all the mechanisms possible to keep it afloat. But, as recent state elections in Germany and the Finnish election demonstrate, ordinary voters are becoming more furious as they watch Greek rioters on their TVs—and more worried as they watch the contagion spreading to Spain and Italy.

Italy boasts (if that is the correct term) the third largest government debt market in the Western world.

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The most ominous recent development has been the run-up in yields on Italian bonds. Italy boasts (if that is the correct term) the third largest government debt market in the Western world. The sudden spat between Premier Berlusconi and his Finance Minister, Guido Tremonti, scared bond investors, and they ran to the exits. The successor to Jean-Claude Trichet as head of the ECB will be Mario Draghi, a respected Italian official. What is unclear is whether the ECB will be able to respond to an Italian crisis as easily as it has responded to squeals from other PIIGS if an Italian is the ECB's numero uno. Investors should not assume that the eurocrew will be able to patch the leaks in their sinking ship indefinitely. The list of severe Sovereign risks will grow—not disappear.

The list of severe Sovereign risks will grow—not disappear.

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There Goes The Sun
Another elegant theory that has been the basis for important policymaking is now at risk: the inevitability of terrible global warming unless governments everywhere impose costly, draconic controls. Two weeks ago, the University of East Anglia, the epicenter of the global warming research for the Copenhagen crisis conference, admitted publicly that there has been no demonstrated global warming for 14 years. Why? ...the collapse since 2007 in sunspot activity, after two centuries of robust activity, could mean the onset of a period of global cooling that might last for a century or more.

The Astronomers Challenge the Climatologists
We were, (we must admit), pleased last month when The Economist, which has been as adamant a campaigner for vast new controls and taxes to fight global warming as any mainstream publication, published a report on leading astronomers’ growing conviction that the collapse since 2007 in sunspot activity, after two centuries of robust activity, could mean the onset of a period of global cooling that might last for a century or more. Among the reports issued recently: 1. The University of Reading Space and Atmospheric Electricity Group in the Department of Meteorology's report is entitled “The solar influence on the probability of relatively cold UK winters in the future.” It reviews the records since 1659 of the Central England Temperature (CET) data series—“the world’s longest instrumental temperature record.” “The mean CET for December, January and February...for the recent relatively cold winters of 2008/9 and 2009/10 were 3.5°C and 3.53°C respectively whereas the mean value (+ or – one standard deviation) for the previous 20 winters had been 5.04° +/– 0.98°C.” The report discusses the close correlation between low sunspot activity and recorded periods of cooling over centuries. It goes on to note that “the current solar grand maximum was unusually long-lived and…it is due to end soon.” After reasserting that “the solar effect on the probability of relatively cold winters is that they are likely to increase in frequency in the next century,” it concludes with the necessary caveat that “anthropogenic global warming” might possibly offset this effect.

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2. The British journal Environment summed up that report in an article headlined, “Ice-skating on the Thames to make a comeback?" (Ice-skating was a very popular sport in London during the cold centuries.) It proceeds to quote NASA on the Maunder Minimum (1645-1715) “Although the observations were not as extensive as in later years, the Sun was in fact well observed during this time and this lack of sunspots is well documented. This period of solar inactivity also corresponds to a climatic period called the “Little Ice Age” when rivers that were normally ice-free, froze and snow fields remained year-round at lower altitudes…the connection between solar activity and terrestrial climate is an area of on-going research.” The author notes “However, many professional climate scientists do not believe that variations in the Sun have any significant effect on the Earth’s climate, and there is intense hostility to the idea from the Green movement.” 3. Scientists at the National Solar Observatory in Tucson make the case that the recent decline in solar activity may be no fluke: “A decrease in the sunspot magnetic field has been observed…this trend was seen to continue in observations of the first sunspots of the new solar Cycle 24 and extrapolating a linear projection to this trend would lead to only half the number of sunspots in Cycle 24 compared to Cycle 23, and imply virtually no sunspots in Cycle 25.” For the benefit of clients who are unfamiliar with sunspot records, we reproduce the latest chart of solar activity. (This chart comes from the website of an amateur astronomy enthusiast, www.SolarHam.com, who reproduces in user-friendly fashion—with attribution—NASA’s charts as part of a package of updates on solar observations.)

"...there is intense hostility to the idea from the Green movement.”

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Solar Cycle Progression - June 2011

...the sun went silent—zero spots—for the second longest period in two centuries in 2009.

Source: NOAA Space Weather Prediction Center, Boulder, Colorado. July 5, 2011.

What it shows: The new millennium began with a solar bang as monthly sunspot levels rose even above the frequently high scores of recent decades. (Each column is a year and each dot is the number of spots for a month.) Clients will recall that we began writing in 2007 about the possible end to the two-century pattern of enormously high sunspot activity after the [very cold] preceding centuries. Astronomers began to take serious notice that something big was unfolding when the sun went silent—zero spots—for the second longest period in two centuries in 2009. When the new sunspot cycle arrived, there was optimism that the sun would revert to its warm ways, and NASA and other agencies predicted that sunspot activity would climb swiftly back to the triple-digit range. Instead, spots only rose to a pitiful 25 during the first year, then seemed headed toward normal early this year before rolling over and falling anew. Those major reports that impressed even The Economist have been in agreement that a new era of minimal—or even zero—sunspot activity is upon us.

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This is the first time astronomers have entered the global climate debate. Astronomy is one of the oldest and most rigorous of the sciences. Climatology was, until quite recent times, the preserve of amateurs and the Farmer's Almanac, and it more closely resembles economics and other "social sciences." Since no weatherman is expected to give a completely accurate forecast covering even ten days, whereas an astronomer predicts the orbits of planets for millennia, the two fields of research are subject to hugely different standards of accepted accuracy. Climatology did not exist as a recognized field of research until late in the second century of very high sunspot activity that followed a long period of minimal or zero activity. Therefore, climatologists have taken the sun's output as an unchanging given. Those climatologists who attempt to learn about the history of the Earth's climate through dendrochronology (tree rings) and drill holes into glaciers never attempt to correlate past climate changes with evidence of changes in solar activity. That the world was roughly as warm a millennium ago as it is today does not seem to bother "climate change climatologists" one whit. They confidently assert that the increase in measured global temperatures in the past two centuries is due entirely to man-made emissions. That the source of all earthly energy has historically shown widely varying levels of output is, to them, irrelevant. In this—and perhaps only this—case, they are heirs to the Enlightenment credo: "Man is the measure of all things." Astronomers since Sir William Herschel, (the British astronomer who discovered Uranus and infra-red radiation), have noted a direct correlation between sunspot activity and the climate on Earth—and on crop production, because of the impact on the length of growing seasons in temperate zones. The debate between the Astronomers and Climatologists on climate change is about to begin. At this point, the two groups are speaking only to their own members. The economic and financial implications of the conflict between these two parallel areas of study are, of course, enormous. There are more politicians, "green industry" investors and climatologists than there are astronomers. We shall, of course, be hearing far more from the numerous and customarily activist climatologists than the relatively few, and customarily cautious, astronomers.

In this—and perhaps only this—case, they are heirs to the Enlightenment credo: "Man is the measure of all things."

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THE INVESTMENT ENVIRONMENT
1. Existential Risks for Sovereign Credits
Much of the history of Europe and its offshoots in the New World has been the conflict between the ruling, or sovereign class, and emerging political classes led by the educated and mercantile class. From Magna Carta through the English and American and French revolutions, the struggle was about who would have the power to legislate and rule. The names that made that history—such as Hampden, Cromwell, Locke, Washington, Adams, Jefferson, Madison, Lincoln, Condorcet, Voltaire, and Rousseau—are landmarks in western civilization. Since the advent of capital markets and industrial economies, government bonds of the leading industrial powers have generally been accorded the highest rank of investments—and other asset classes have been valued in relation to those risk-free assets. (Gold was, of course, the one asset that transcended national boundaries and banking systems, but that is another story for another time.) Outstanding debt can be classified by its issuer class: Home mortgages—primarily issued by the working and middle classes. Traditionally, home mortgages have been ranked as a riskfree asset class, with tiny default ratios. That changed in the US when politicians and Wall Street got together to create synthetic homeowners who were able to borrow beyond their means and beyond the value of their homes once that bubble-blowing process burst. Unsecured Consumer debt—bank loans and credit cards—much higher loss ratios and interest rates than secured home loans, but rarely a problem for the financial system because banks have extensive experience in monitoring their risks. Corporate Debt—issued by businesses, with risk levels extensively analyzed, and rarely a challenge to financial markets, because the largest borrowers tend to be cautiously managed, and their financial statements are widely scrutinized. Incentive systems for senior officers rarely promote excessive borrowing. Government Debt—issued by the political class. The relative risks between those last two asset classes are undergoing fundamental change. Non-junk non-financial corporate debt has experienced modest defaults, despite the recession. However, government debt issued in ...government bonds of the leading industrial powers have generally been accorded the highest rank of investments—and other asset classes have been valued in relation to those riskfree assets.

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the eurozone and the US faces the fallout from the systematic underpricing of entitlement programs over the decades. Politicians resisted leveling with voters about the combined impact of falling fertility rates and improved mortality rates on the costs of Social Security, Medicare and Medicaid on a rapidly aging population. (Even the success of the huge, sustained programs against cigarette smoking was never taken into account, except by state governments which happily issued debt based on future returns from successful litigation against tobacco companies.) Moreover, politicians until recently systematically refused to report the huge hidden costs of overgenerous public employee health and pension benefits. Result: aging economies with reduced economic growth rates and exploding government debts—now, and in updated projections for the future. If those worrisome projections are fairly costed, it will be a first for the political class. The supposed risk-free asset class of government debt now has, collectively, significantly greater endogenous risk than high or medium-grade corporate debts. The political class has—for decades—under-costed its vote-getting entitlement programs and, in recent years, over-estimated its revenues from taxes. The incentive system for politicians is skewed so as to punish candor about program costs and financial risks in favor of delivering goodies for voters. Already, 52% of voters pay no income tax and 70% of voters get more income from Washington than they pay in taxes. Any private business that had systematically misrepresented its financial affairs on similar scale would have gone bankrupt and its officers would have faced civil or even criminal prosecutions. Modern Portfolio Theory, The Capital Asset Pricing Model, the Efficient Frontier and related investment risk/reward concepts that began with the work of Harry Markowitz have been the basis of institutional portfolio construction for decades. At the root of these concepts is the Risk-Free Rate of Return—Treasurys for Americans, Gilts for Brits, and Bunds for Europeans. This concept was the basis of the Basel Accords, Paul Volcker's great contribution to global bank regulation. Banks would not be required to make capital allocations against their holdings ofacceptable sovereign credits, and would have to make only minimal allocations against their holdings of the rather small range of Triple-A-ranked private debt instruments. What the eurozone accomplished was to extend the risk-free concept to a wider range of euro sovereign debts, so that, in effect, smaller economies

The incentive system for politicians is skewed so as to punish candor about program costs and financial risks in favor of delivering goodies for voters.

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would benefit from the image of unshakable strength of Bunds and the bonds of other financially sound euromembers. The European Central Bank has routinely lent banks money against their holdings of bonds issued by any members. Pension funds have used European sovereign credits as risk-free assets in their calculations of their efficient frontiers for investing. After all, the politicians said, no European nation had defaulted in 40 years. That is no longer a defensible way to evaluate endogenous risk within institutional portfolios holding European sovereign credits other than Bunds and a few other seemingly bullet-proof bonds. A Treasury default or downgrade would threaten the entire process of efficient frontier calculations for American pension funds. Already, the evidence of the terrible deterioration in Washington's longer-term government liabilities has drawn response: one of the ratings services has indicated that a few leading corporate issuers—including Procter & Gamble—now have higher ratings than Treasurys. This opens a Pandora's Box for institutional investors—and for pension fund consultants.... And a new, troubling level of risk has entered the pension fund world.

This opens a Pandora's Box for institutional investors—and for pension fund consultants....

2. The Commodity Stock Outlook in an Uncertain Global Economy
(a) Agriculture
Corn July 28, 2010 to July 28, 2011
8.00 7.50 7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 6.91

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Existential Financial Risks
Soybeans July 28, 2010 to July 28, 2011
15.00

Recently, Glencore admitted that it had suggested to Putin that he should embargo wheat exports—in defiance of WTO rules.

14.00 13.00 12.00 11.00 10.00 9.00 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11

13.77

Jul-11

Wheat July 28, 2010 to July 28, 2011
9.00 8.50 8.00 7.50 7.00 6.50 6.00 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 7.11

Weather across the major grain-producing states in the midsection of the US has been wild this year—floods, tornadoes, droughts, and more recently, searing heat. In Eastern Europe and Russia, the weather has been very favorable. Proof that this should be a more reassuring year for global grain users: Vladimir Putin ended his embargo on wheat exports. (It will be recalled that it was his sudden imposition of an embargo on exports through the Black Sea that sent wheat prices soaring last fall. Recently, Glencore admitted that it had suggested to Putin that he should embargo wheat exports—in defiance of WTO rules. Glencore also disclosed it held significant wheat futures contracts at the time of its oh-so-helpful call.)

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Corn prices have been strong this year, but have fluctuated widely in response to US Department of Agriculture reports alternately expressing pessimism and optimism about this year's crops, and—to almost everyone’s amazement— conflicting reports about the size of corn carryovers. Those varying reports elicited an unusual denunciation from China, which complained that it failed to understand how carryover data could swing so wildly. At the moment, there is widespread agreement that this will be a near-record year for US corn production, and the world is breathing easier. We are pleased that the FAO's2 recently-proclaimed Global Food Challenge is unlikely to be upgraded to a new Global Food Crisis. Grain prices at these levels are enormously profitable for most farmers and the agriculture stocks have been firming. We remain very bullish on the outlook for agricultural stocks, (a stance we proclaimed in writing in the prospectus for the new Coxe Global Agribusiness Income Fund which was distributed this month and trades on the TSX, ticker symbol CAG.un. We express our gratitude to the many Canadians who supported the issue and hope that other investors will now consider it.)

Those varying reports elicited an unusual denunciation from China...

(b) Precious Metals
Gold January 1, 2006 to July 28, 2011
1,700 1,613.7 1,500 1,300 1,100 900 700 500 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

2

Food and Agriculture Organization of the United Nations

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Existential Financial Risks
Silver January 1, 2006 to July 28, 2011
60 50 40 30 20 10 0 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 39.76

KBW US Bank Index (BKX) relative to the S&P 500 July 1, 2006 to July 28, 2011
110 100 90 80 70 60 50 40 30 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 41.76

KBW US Regional Bank ETF (KRE) relative to the S&P 500 July 1, 2006 to July 28, 2011
105 95 85 75 65 55 45 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 49.71

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It would be hard to write a better script for a recommendation to buy Gold than (1) the crisis in the eurozone, (2) a possible US Debt Ceiling default, (3) strong oil prices, (4) weak economic news in the US and Europe, and (5) pitiful performance of bank stocks in the US and Europe. However, those same factors are near-surefire guarantees to jolt politicians and political activists in Europe and the US to rush to the rescue. Result: gold's near-term price action is hostage to political events, and speculators could be scaling back on bullion and gold stocks in coming days. As the commentary in this issue reveals, we are skeptical that quick fixes during crises will challenge the basic arguments for strong portfolio representation in gold, and, for the gutsy, silver. Volatility will continue as the rescue packages unfold, but long-term investors in gold will surely use selloffs to build their exposure. In none of our previous endorsements of gold and gold shares in this publication did we include a failure to increase the debt ceiling. But that has been the Page One story for a month. As the five-year charts show, gold is gradually becoming recognized as a necessary investment for those with wealth to conserve who do not assume that the political classes in the US and Europe will display sustained statesmanship. The events of recent weeks were, in the sweep of history, mere spastic twitches toward common sense and sustained restraint. Gold’s move through $1,500 an ounce was driven by tremendous participation from Chinese buyers. According to the World Gold Council, Chinese bullion demand was up five-fold last year, and China has supplanted India as the world’s largest buyer. But some of these new enthusiasts are taking profits as Chinese stock markets continue to wilt—according to the Financial Times. Although gold analysts will be watching these new world leaders closely, Chinese buying patterns will never be as important for gold and silver as they are for copper and iron ore. The move through $1,600 came after gold seemed to have lost momentum after breaking decisively through the “Big Number” of $1,500. Some analysts are warning that gold will need some proven outbreak of inflation to move up from these lofty levels. “What inflation?” these skeptics ask. When gold was steaming skyward in the 1970s, inflation was reaching double-digit levels across most of the OECD. Not this time.

The events of recent weeks were, in the sweep of history, mere spastic twitches toward common sense and sustained restraint.

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Despite record levels of money-printing and incredible buildups in government debt, and rising food and fuel prices, inflation remains benign and most central banks are able to maintain negative real interest rates to prevent renewed recession. Historically, negative real yields stimulate lusts among gold enthusiasts to tumescence. We believe that the gold rally is primarily driven by fear—not greed. Despite the trillions in bailouts, many major investment banks in the US and Europe continue to struggle under the weight of putrefying balance sheets. Gold is the exact inverse asset to bad mortgages and bad government bonds and the oft-derided love of gold is the exact inverse emotion to the misplaced greed of bad bankers.

Gold is the exact inverse asset to bad mortgages and bad government bonds...

(c) Oil and Gas
Crude Oil - West Texas Intermediate (WTI) July 28, 2010 to July 28, 2011
115 110 105 100 95 90 85 80 75 70 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 97.56

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Crude Oil - Brent July 28, 2010 to July 28, 2011
130 120 110 100 90 80 70 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11

118.18

We endorsed the International Energy Agency's call to release modest quantities of crude from Strategic Petroleum Reserves, because non-market fear factors were having undue influence on crude prices...

Natural Gas July 28, 2010 to July 28, 2011
5.0 4.8 4.6 4.4 4.2 4.0 3.8 3.6 3.4 3.2 3.0 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 4.24

The Arab Spring Fear Factor is fading in oil pricing. Libyan Light Crude still flows, despite the fighting. Bahrain's problems have not spread across the causeway to Saudi Arabia. We endorsed the International Energy Agency's call to release modest quantities of crude from Strategic Petroleum Reserves, because non-market fear factors were having undue influence on crude prices at a time of softening economic activity across much of the world.

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The biggest oil story of this year has been the sustained divergence between US crude oil (West Texas Intermediate, or WTI), priced at Cushing, Oklahoma, and Brent Crude, priced at the North Sea. For years, Brent traded at a discount. Now, it routinely trades at a premium of $17 to $20 a barrel, and some enthusiasts say the spread could widen to $50 a barrel. This massive differential means huge profits for some refiners who are able to buy WTI and sell refined products at the Brent-equivalent price. What was supposed to put a dent in this huge disparity is a new pipeline to bring oil from Alberta’s oil sands all the way to the huge refinery complexes in Houston. It needs approval from the federal government. As recently as a year ago, most investors viewed this as automatic. The pipeline would dramatically increase US energy security without having to drill in environmentally-significant areas like ANWR in Alaska. But some people in the Obama Administration, and many of its most prominent friends and financial backers regard “energy security” as being based on “green energy”—solar, ethanol, windmills, etc.—and not hydrocarbons. These people think Canada’s oil sands producers supply “dirty oil,” and they’re not just interested in ensuring that no new approvals are given to bring more of the hated liquids into the US. They’d like to roll back the imports already flowing to Cushing—and helping to drive down US gasoline prices. We have long credited the President with more sense than his most prominent friends display, and so we have long advised clients to be overweight shares of Canadian oil sands producers. Nowhere else, we have tirelessly proclaimed, can an investor find such long-duration reserves in a politically-friendly and reliable country. With the third-largest reserves of oil in the world the oil sands are something that Americans can count on for the rest of this century. Now, due to some spectacular bad luck, approval of the new Keystone L Pipeline from Alberta could be as hard to gain political approval as a new tax cut for the wealthy. The Environmental Protection Agency is looking into the case, under severe pressure from its activist allies, which pleases few believers in free markets and common sense. But Hillary Clinton is the key decisionmaker—which pleases many believers in free markets and common sense. The State Department is

...some people in the Obama Administration, and many of its most prominent friends and financial backers regard “energy security” as being based on “green energy”

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due to give its report on Keystone within a fortnight. The final decision rests with the President. What makes this final stage more problematic is that an old, small pipeline operated by Exxon Mobil recently leaked about 43,000 gallons of oil into the Yellowstone River. From the media coverage, this was the Exxon Valdes redux. Again, people recalled the supposed famous last words of the bibulous skipper of the Exxon Valdes: “No, damn it! I said Tanqueray on the rocks!” As the leader of the coalition battling the Keystone line exulted, “This kills Keystone!” Ne’er was a greenie happier with an oil spill. While this was going on, a court in Montana granted an envirogroup’s application to block the shipment of machinery across the state to an oil sands site in neighboring Alberta. We detail these doleful details because, for the first time since the oil sands came on stream, we realize that political risk may no just apply to oil producers in places such as Venezuela, Libya, the Democratic Republic of the Congo, and such other noted bastions of liberty and fair play. We’ll keep an eye on these unfolding events. For now, we’d just like to suggest that the Tea Party might want to propose legislation that anybody who tries to block the import of reliable sources of oil overland into the United States will not be permitted to fly into or out of any US airport, and that such persons’ automobile license renewal fees be raised to $5,000 a year. As for that other hydrocarbon… Much of the US is suffering from searing heat and air conditioners are operating at their maxima. Electricity plants using coal are, in general required to use natural gas for peak, heat-induced demands, so these should be the best of times for gas producers. Last winter was unusually cold, and that should certainly have been good for gas producers. The weather has been doing all it reasonably can to drive gas prices skyward. But all those shale drillers are doing the best they can to drive prices downward. US consumers, who have had little to cheer about, should be shouting ululations of joy about the sacrifices gas producers—and their stockholders—are enduring to make homeowners happy.

...the Tea Party might want to propose legislation that anybody who tries to block the import of reliable sources of oil overland into the United States will not be permitted to fly into or out of any US airport...

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Existential Financial Risks
Like any other hydrocarbon success story that promises low-coast, reliable energy, shale gas extraction costs are rising along with the number of lawsuits trying to keep it locked in the earth. The latest is a new one for us: lawsuits claiming shale gas has been causing earthquakes. We thought that, since the relatively recent era of human development when people learned that angry gods didn’t cause earthquakes or volcanic eruptions, the cause would always be assigned to seismic activity deep underground. Very deep. Jules Verne deep. But we are suitably respectful of the persistence of paranoia among extreme environmentalists, and the persistence of rapacity among plaintiffs' lawyers. One worrisome aspect of these lawsuits is that the next time a big quake hits Iran, Ahmadinejad could blame it on Israel's fast-developing oil ad gas industry—with potentially terrifying consequences.

...we are suitably respectful of the persistence of paranoia among extreme environmentalists, and the persistence of rapacity among plaintiffs' lawyers.

(d) Base Metals
Copper July 28, 2010 to July 28, 2011
4.80 4.60 4.40 4.20 4.00 3.80 3.60 3.40 3.20 3.00 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 4.47

How serious is the slowdown in China? We have been recommending an underweighting in the base metal stocks, partly because we didn't believe the consensus forecasts for good growth in the US economy, and we thought Europe would also disappoint, but mostly because China was obviously tightening because of (1) food and fuel inflation, and (2) a likely moderation in the furious rate of expansion of capex.

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Strikes at key copper mines and flooding problems for major Australian iron ore and coal mines have meant somewhat stronger metals prices than we expected—whereas we were bullish on oil, gold, and agricultural prices on their fundamentals. But, as BCA Research documents, Chinese annualized money supply growth has gone from the plus 50% range back in 2009, when the Middle Kingdom was doing its best to restart the global economy, to negative 10%—to restrain inflationary pressures. Similarly, Chinese auto sales growth on a year-overyear basis has plummeted from the 90% range to near-zero. There have been far too many housing starts—and far too few completions—in the past year, which means the credit squeeze is beginning to hurt. Chinese stock prices have been basically flat for 18 months—and the nation is suffering from food and fuel inflation. China and other leading emergent economies kept the global economy growing while the US and other OECD economies were struggling off the floor.

...Chinese auto sales growth on a yearover-year basis has plummeted from the 90% range to nearzero.

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Existential Financial Risks RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation Capital Markets Investments US Pension Funds
US Equities Foreign Equities: European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Commodities and Commodity Equities* Bonds: US Bonds Canadian Bonds International Bonds Inflation Hedged Bonds Cash Allocations 16 2 4 5 10 12 16 7 3 14 11 Change unch unch unch unch unch unch unch unch unch unch unch

Bond Durations
US Canada International Inflation Hedged Bonds Years 4.00 4.25 3.80 5.5 Change unch unch unch unch

Global Exposure to Commodity Equities
Agriculture Precious Metals Energy Base Metals & Steel
We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

33% 28% 24% 15%

Change unch unch unch unch

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Existential Financial Risks RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation Capital Markets Investments Canadian Pension Funds
Allocations Equities: Canadian Equities US Equities European Equities Japanese, Korean & Australian Equities Emerging Markets Commodities and Commodity Equities* Bonds: Canadian Bonds - Market Index-Related - Real-Return Bonds International Bonds Cash 16 5 2 6 8 12 Change unch unch unch unch unch unch

23 14 3 11

unch unch unch unch

Canadian investors should hedge their exposure to the US Dollar.

Bond Durations
US (Hedged) Canada: – Market Index-Related – Real-Return Bonds International Years 3.90 4.00 5.50 4.00 Change unch unch unch unch

Global Exposure to Commodity Equities
Agriculture Precious Metals Energy Base Metals & Steel
We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

33% 28% 24% 15 %

Change unch unch unch unch

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Existential Financial Risks INVESTMENT RECOMMENDATIONS
It’s time for those big new economies to take a pause—and it’s time for the OECD to get its act together. We have very high confidence in forecasting that China and some other important EMs will slow their hectic growth. This will be just a pause, to get domestic inflation and overbuilding under control, but it could prove painful for metal prices. We are going to press before the debt ceiling crisis is resolved, and are operating on the assumption that cooler heads will ultimately prevail. Therefore, we are assuming that by next week, investors can focus on the economy and opportunities in investment markets, and put politicians out of their minds…for a while. We devoted such space to discussing the events in Washington because, even after some last-minute rescue, there is little reason to believe that long-term investors can take US solvency for granted. The injuries to Treasury credibility as the risk-free asset class will, we fear, be enduring. 1. Emphasize high-quality corporate bonds in debt portfolios. Most major global equity indices will have trouble reaching recovery highs because of problems for banking and financial stocks from sovereign risk value impairments. Government is no longer—if it ever was—the solution. It is now the problem for many OECD economies—and for many institutional investment portfolios. The risk-free rate of return risks becoming the Cheshire cat for portfolio theory-based investment programs—slowly fading away, with no robust theory to replace it. 2. Continue to invest in high-quality Canadian assets, including banks and bonds. The fundamentals for the Canadian dollar remain favorable. The fundamentals for the American dollar remain bleak. Resist the urge to join the Chinese and overindebted Canadians in buying residential real estate in overheated markets. 3. Retain above-average exposure to gold and gold stocks. The scale of economic and financial risks continues to grow faster than any economy.

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4. Remain overweighted in global agricultural stocks, particularly the fertilizer and machinery companies. Farm incomes are outpacing economic growth in North America and in some South American countries. 5. Brazil has been the investors' favorite BRIC for several years. Apart from the economic overheating and the sky-high interest rates, its political situation has taken a turn for the worse since Lula retired. We think equity investors should resist the urge to take advantage of the Bovespa's pullback. Brazil has a long record of blowing its great advantages with political folly. History shouldn't repeat itself this time, but it might be prudent to wait and see. 6. Within the energy group, oil and coal remain favorable. BHP's purchase of a shale gas producer at a huge premium shows that long-term investors could be considering tip-toeing into leading natgas companies with long-duration reserves. 7. Base metal stocks are cheap—particularly the majors with long-duration reserves. They will probably get cheaper in the next 12 months. Continue to underweight the base metal stocks. 8. The falling dollar should continue to boost reported earnings for US multinational stocks. Although such earnings may be illusory and unrelated to corporate excellence, US investors can savor them at a time when domestic earnings gains will become harder to achieve. 9. Overweight Japan. Japanese stocks have completed their Triple Waterfall Crash, and are showing signs of a renaissance.

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