Accord Update

April 2010
Summary

Stag-then-flation…

Will Rogers famously quipped, “It is difficult to make predictions,

especially about the future”. Ignoring Mr. Rogers sage advice I will
attempt to make some educated guesses about the future anyway,
albeit with the assistance of some analysts far more prescient than I.

The evidence from Kenneth Rogoff’s recent research is that in the

three years following a financial crisis, on average, cumulative fiscal
deficits almost double. We seem to be well along this path in the
current crisis.

Rogoff’s research also shows that how these deficits are financed
is critical to the question of whether inflation ensues, whether you
have a Japanese or an Argentinean style post-crisis experience. If Contents
the deficits are funded from existing private sector savings (“belt-
3 Is the Financial Crisis Over – Are
tightening” as Rogoff describes it) they are typically not inflationary –
Our Governments Bankrupt Yet?
e.g. Japan. If they are monetized by the central bank (the money is
created) they are inflationary – e.g. Argentina. 4 Bail us Out with Printed Money
and We’ll Fund Your Deficit
Today, in one corner, we have the wholesale liquidation of mal- 5 Double Dip on its Way? What Will
investments that have accumulated in virtually every segment of the Central Banks Do?
the western economies from residential and commercial real estate
5 Is Anyone Going to be Able to
down to the municipal bond markets. In the other corner, we have
Pay for the Boomers’ Retirement?
governments that are actively resisting this cleansing process as it
threatens the solvency of the politically influential financial sector. 6 Moral Hazard and The Fallacy
of the Safe Canadian Banking
The result is that via bailouts and unprecedented fiscal deficits System
private sector credit problems are being moved onto public sector 7 Interest Rates Versus Rollover –
balance sheets – balance sheets that are already in precarious Pick Your Risk
condition from past over-spending and unfunded future liabilities.
8 Surprise - AIG Took the Fed to the
By nationalizing private sector losses governments around the globe
Cleaners
are seriously compounding their existing budget problems.
8 Banking Sector Back to Record
According to research by Société Générale EU and US net Profits
liabilities add up to around $135 trillion. That’s roughly four times 9 By 2012 Surplus Oil Production
the capitalization of the world’s equity markets and forty times the Capacity Could Disappear
cost of the 2008 financial crisis. The US plans to accumulate an
9 Oil Demand Back Past 2007 Peak
additional $10 trillion in deficits over the next decade.

1
Summary (continued)

These enormous numbers beg the question of how our governments plan to fill their funding gaps? Of course
they will attempt to raise taxes, but it seems clear that they are going to resort to inflation as well. Inflation is
more politically expedient as the apparent benefits are immediate while the all too real costs are delayed.

To borrow yet again from Jens Parsson and his excellent book “Dying of Money”:

“The government is free to incur any deficit and issue any amount of debt it may wish, so long as it is willing
to draw purchasing power away from other borrowers and to tolerate the rise in interest rates which will result.
The debt will create no inflation.

Government deficits and government debt thus are not inflationary if they stand alone, but they never
stand alone. The creation of government debt is practically always accompanied by an increase of money.
Competing against private borrowers for a static supply of credit capital, a large government debt issue would
drive interest rates upward, and high interest rates are anathema to a government.

A large government debt issue simply could not be marketed without a large increase in the money supply.
Therefore the government creates not only the debt but also the money with which to buy it. In addition, large
government deficit expenditure tends to accelerate the velocity of money because the government spends its
money more rapidly than cautious private spenders do. This combination of increased quantity and velocity of
money, not the deficits, does the job, both for economic stimulation and for monetary inflation.”

Now here is an attempt at one of those tricky predictions – will we see inflation or deflation over the next
decade? I believe you can answer this question by considering the effect of the following factors:

– Government Spending & Deficits – increasing

– Regulation – increasing
– Taxes – increasing
– Money Supply – increasing

Based on these factors I believe that rather than outright inflation or deflation we face stagflation in the
developed world as further state expansion into the economy will reduce real growth while accelerating fiscal
deficits combined with money supply expansions will lead to inflation. Low growth + high inflation = stagflation.

Therefore, our investment thesis continues to be to gain long-term exposure to inflation hedging, income
generating assets, with demonstrated linkages to emerging market growth – energy and agriculture remain our
preferred sectors.

2
Accord Update (continued)

Is the Financial Crisis Over – Are Our

Governments Bankrupt Yet?

Those believing the financial crisis is over are wrong. the capitalization of Datastream’s World equity index
It has merely been transformed from a private sector of about $36tr, and forty times the cost of the 2008
to a public sector crisis. Dylan Grice, analyst at financial crisis. Our governments appear to be
Société Générale, concludes that developed market insolvent. They’re liquid, so they can stay afloat
governments are insolvent by any reasonable the way the Detroit auto companies did for years
definition. Socgen’s estimates of capitalized net state despite being insolvent. But unlike the Detroit auto
liabilities are shown in Chart 1 as the grey bars. companies, our governments’ debt doesn’t trade
at distressed prices and as an effective option on
According to Grice “I don’t see how our governments finding an escape from impending bankruptcy. I
can pay these liabilities. EU and US net liabilities think they should. Such liabilities have historically
add up to around $135tr alone. That’s four times crippled governments (and economies, and
companies, and anyone else for that matter). And
although governments usually default via inflation, our
governments are short real goods and services (e.g.
Chart 1: Are Our Governments Solvent
earnings-linked pensions, health care), which they
Official Net Debt, % GDP
won’t be able to inflate away. This means there will
Total net liabilities (on and off balance sheet), % GDP ultimately be even more pressure to inflate away
750% whatever they can.” Emphasis mine

As Peter Bernholz notes in Monetary Regimes and

500%
Inflation, “there has never occurred a hyperinflation
in history which was not caused by a huge deficit of
250% the state.” The correlation between inflation and fiscal
deficits is shown quite clearly by Hussman research
set out in Chart 2. Obviously, we are in a period of
0%
Germany Spain France Italy UK EU US Canada
unprecedented deficit spending – highest levels as a
percent of GDP since WWII and highest in absolute
Source: SG Global Strategy, OECD, Fraser Institute, Agcapita terms in history of mankind. Will inflation follow?

3
Accord Update (continued)

Chart 2: US Federal Spending vs. CPI Chart 3: Commercial Bank Holdings

- US Government Securities vs
16 12 Commercial Loans ($ billions)
14 Billions of Dollars
10
12 $1,700
8 $1,600
10 Commercial and Industrial Loans
$1,500
$1,400
8 6
$1,300
Gov’t Securities
6 $1,200
4
$1,100
4
$1,000
2 $900
2
$800
0 0 $700
1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Federal Spending (4 year Growth) CPI Inflation (Right Scale) Source: Federal Reserve
Source: Hussman funds

Bail us Out with Printed Money and We’ll However, according to David Goldman this has the
Fund Your Deficit effect of backing the Federal Reserve into a corner
“Most of this reflects use of the carry trade by foreign
At the time when foreign governments are slowing banks, or hedge funds, who are doing exactly what
down their purchases of US treasuries US banks the American banks are doing: borrowing at 0.25%
are increasing their purchases – putting the excess from central banks and lending it back to the US
reserves lent to them by the Federal Reserve into government at 1% or 2%, depending how far out
treasuries, rather than private sector loans (Gluskin the curve they go. The demand isn’t coming from
Scheff’s David Rosenberg estimates that by February the oil exporters, who appear to be net sellers. On
$740bn of bank credit had been withdrawn from the a geographic basis, the main buyers are “United
commercial market since the start of the crisis). With Kingdom” and the “Caribbean,” that is, banks and
zero cost money and a relatively steep yield curve this hedge funds.
is a massive and profitable carry trade and a large,
stealth subsidy to the banking sector – borrowing Raise rates and the carry trade comes crashing
from the government short and lending to the down. And so does the Treasury market and the
government long. mortgage market and the US economy. The Fed is

4
Accord Update (continued)

stuck with loose money just as the Bank of Japan Is Anyone Going to be Able to Pay for the
was during the 1990s, and for the same reasons.” Boomers’ Retirement?

Are boomers merely misinformed or are they

Double Dip on its Way? What Will the willfully deluding themselves when it comes to their
Central Banks Do? retirement prospects.
The Consumer Metrics Institute constructs an
index that tracks US consumption based on actual – ING’s minimum estimate of funds required for
transactions for a range of major discretionary retirement - $675,000
purchases such as cars, houses, durable goods, and – Personal estimates of funds required for
vacations. The ‘Daily Growth Index’ has predicted retirement by household income are set out in
changes in U.S. GDP reasonably well to date and Chart 5 – 46% of people surveyed thought less
recently began to decline rapidly which may indicate than $499,000 was adequate and 29% thought
that growth could be about to slump – double dip on less $250,000 was adequate.
the way? Will even more QE follow?

Chart 4: Daily Growth vs. BEA Chart 5: Estimated Required Savings for
Quarterly GDP Retirement by Household Income
GDP Quarterly Monthly Avg. of
Change Daily Growth Index All Workers Less than $35,000
50%
8% 8% $35,000-74,999 $75,000 or More

6% 6%
Consumer Metrics
GDP (Quarterly)
Institute Growth Index 30%
4% 4% 29%
27% 26%
23% 24%
Growth 20%
2% 2% 20%
17% 16%
14%
13% 13% 13% 13%
0% 0% 3% 3%
8% 8%
6%
5% 6% 4%
-2% Contraction
-2%

-4% -4% Under $250,000- $500,000- $1,000,000- $1,500,000 Don’t know/Don’t

$250,000 $499,000 $999,999 1,499,000 or more remember

-6% -6%
Source: Employee Benefit Research Institute
-8% -8%
Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar
2006 2007 2008 2009 2010
Source: Consumer Metrics Institute

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Accord Update (continued)

Clearly the majority of investors materially Moral Hazard and The Fallacy of the
underestimate what they will need to retire. The Safe Canadian Banking System
problem becomes worse as even given these low
personal estimates, 31% of workers have saved Advocates of the Canadian banking system argue
NOTHING for retirement. What this will mean for that Canada’s lack of bank failures is the result of
poorly funded boomers and government pension conservative regulation combined with concentration
plans over the next two decades remains to be seen in the sector.  Yet despite an allegedly more restrictive
- will the boomers demand that the government regulatory environment Canadian banks were actually
make up the difference regardless of the economic more leveraged than well-run American commercial
costs? banks.  For example, at the end of 2008 according to
research by Peter Boone and Simon Johnson:

– JP Morgan leverage - 13 times

Chart 6: Workers who have saved – JP Morgan Tier 1 capital - 10.9%
something for retirement – Royal Bank of Canada leverage - 23 times
– Royal Bank of Canada Tier 1 capital - 9%
Respondent Respondent and/or Spouse – Wells Fargo leverage - 11 times
– Canada’s five largest banks average leverage - 19
78%
72%
75% times
69% 72% 71% 68% 69% 70% 69%
66%

Given that Canadian banks were at least as leveraged

and thinly capitalized as many of their bankrupt
neighbors to the south, what prevented bank
collapses in Canada during the crisis?  According
57% 58% 74% 65% 67% 68%
to Boone and Johnson, guarantees provided by
the Canadian government.  Over 50% of Canadian
1994 1995 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
mortgages are guaranteed by the government via
the Canadian Mortgage and Housing Corporation
Source: Employee Benefit Research Institute (“CMHC”) with a below market cost (state subsidized)
to insure against default.  The US, of course, had
Fannie Mae and Freddie Mac, with predictable
results as the moral hazard created by the implicit
federal guarantee lead directly to their catastrophic
participation in the sub-prime mortgage bubble.

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Accord Update (continued)
State guarantees have allowed Canadian banks to
become the classic “too big to fail” organizations
and of course we have graphic evidence that “too
big to fail” organizations are often on auto-pilot to
failure based on moral hazard.  During the height
of the crisis, the CEO of Toronto Dominion openly
acknowledged the Canadian government “put” when
he told investors “Maybe not explicitly, but what are
the chances that TD Bank is not going to be bailed
out if it did something stupid?”  Some examples of
“too big to fail, but failed anyway”:
– Britain’s largest bank, the Royal Bank of Scotland,
grew its balance sheet to around 1.7 times British
GDP before it collapsed. 
– Ireland’s three largest banks’ grew their combined
balance sheets to around 2.5 times GDP before
they collapsed.  rate of 3.2%. If short rates return to the more normal
Can Canadian banks resist the temptation to ignore
credit quality in the pursuit of state subsidized profits
and scale? Ultimately, I believe Canadian banks
will be revealed to be the risk mis-pricing machines
that virtually all state backed financial organizations
become.
Interest Rates Versus Rollover – Pick
Your Risk
Over the coming months of 2010 the US Treasury
must refinance $1.8 trillion in maturing debt + interest
payments. “Concerns about the U.S. budget deficit
are beginning to hurt the Treasury market” said Steve
Rodosky, head of Treasury and derivatives trading
at bond giant Pacific Investment Management Co.
(“Pimco”). Pimco’s Bill Gross said recently “[US]
bonds have seen their best days” and is advising
investors to buy the debt of countries such as
Germany and Canada that have low deficits and
higher- yielding corporate securities. The net effect of
this ongoing shift will be to increase US interest rates
and the cost of servicing the growing state debt.
To put the US problems into perspective, look at the
interest expense of the Federal Government. In 2009
Federal debt increased significantly but at the same
time interest expense went down by approximately
15%. In contrast, the 2010 interest expense appears
to be set to grow from $383 billion to $434 billion, a
13% increase.
On September 30th 2009 the outstanding debt was
$12 trillion dollars with an effective average interest
5% range and long rates return to the 7% range and
the Treasury continues finance its needs at the short
end of the curve (a strategy that reduces interest
rates but exposes the US government to extreme
amounts of rollover risk) the average coupon would
likely rise to about 5.5% which would create an
interest expense of around $780 billion with interest
payments consuming approximately 2/3rds of the US
Federal budget.
Going forward then the US Federal government
is faced with a serious dilemma – keep interest
payments from crippling the budget by funding from
the short end of the curve but then exposing the US
to the risks of a credit event caused by short duration
and the need to frequently rollover (refinance) large
percentages of its debt.
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Accord Update (continued)

Surprise - AIG Took the Fed to the
Cleaners
It appears that a charitable interpretation of the
transfer of the CDO bond portfolio from AIG to
the Fed is government incompetence in the face
of a perceived emergency; the less charitable
interpretation is that AIG took the Fed to the cleaners. 
According to David Merkel:
crisis, according to Jim Reid, a Deutsche Bank AG
strategist in London. Chart 8 tracks earnings of
finance companies against earnings for non-finance
companies. “It seems incredible that financials are
now scaling their 2006/2007 heights again,” Reid
wrote in a research note published yesterday. “The
dramatic imbalances are re-occurring.”

– The average rating on the bonds in the portfolio

is B-, with 61% rated CCC or lower.  Below Chart 8: US Finance Sector Profits
BBB, loss rates turn up with significantly.  For the vs. GDP
portfolio to be B- rated on average, with 61% in billions
CCC and below represents extremely poor credit 500
quality. Financial industry profits
– 73% of the deals in the bonds originated between Non-financial industry profits
Nominal U.S. gross domestic product
2005 and 2007, and 96% between 2004 and 400
2008. Arguably the 2003-2008 period represents
the worst period for lax credit standards.
300
According to Merkel, it is extremely unlikely that the
portfolio will ever exceed the $22 billion fair market
200
value ascribed to it by the Fed – i.e. the loss is
permanent.
  100
Banking Sector Back to Record Profits

Record low U.S. interest rates are boosting the 0

1970s 1980s 1990s 2000s
profitability of the financial sector, creating the
same kind of imbalances that fueled the credit Source: Deutsche Bank AG

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Accord Update (continued)
By 2012 Surplus Oil Production Capacity
Could Disappear
According to the United States Joint Forces
Command (“USJFC”) annual report “By 2012, surplus
oil production capacity could entirely disappear, and
as early as 2015, the shortfall in output could reach
nearly 10 MBD.” The report points to growing energy
demand in the developing world, citing as an example
the huge potential for growth in car ownership in
China, which currently has only 40 million vehicles
compared to the 250 million in the USA. The USJFC
predicts that the coming oil supply gap will “at best...
lead to periods of harsh economic adjustment”.
Oil Demand Back Past 2007 Peak
Economic growth in the developing world, and
especially China, which reported first quarter growth
of 11.9%, caused the IEA to up its estimate for 2010
oil demand to a record high of 86.6 million barrels/day
- marginally higher than 2007 peak production level
that saw a peak oil price of US$147/barrel. Of course
much has changed since 2007, Western economies
are still barely emerging from recession and are
saddled with massive public debt, so the growth
estimate signals a shift in which the developing
economies grow even without a recovery in their key
export markets.
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