INVESTING IN A WORLD OF MACRO INSTABILITY

PRESENTATION STRUCTURE

1. The situation today 3

1.1 Weak growth 4

1.2 High debt levels 7

1.3 Inflationary pressures 8

1.4 Ineffective policies 9

2. What will happen 12

3. Investment opportunities 17

1. THE SITUATION TODAY

• Weak global growth even with extraordinary monetary and fiscal stimulus.

• Huge and rising debt levels, especially in the developed world.

• Inflationary pressures in the developing world.

• Lack of credible policy alternatives or global policy co-ordination.

There is no way to fix things without considerable pain.

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1.1 WEAK GROWTH

Divergence between reality and perception on global growth

2011 2012 2013 Comments

Dec 2012 Expectation Current

U.S. 1.8 2.8 2.0 1.6Expected to rise to 3%+ in 2014. Even the 1.6% number assumes inflation at less than 1%.

Europe 1.6 -0.2 0.4 -0.1 Will things get better after September?

China 9.3 7.8 8.1 7.5 Non government data suggest growth is more like 4%.

Japan -0.6 2.0 0.7 1.9The real surprise globally. But its growth could take away exports from others.

U.K. 1.0 0.3 1.1 1.0Inflation, of course, is assumed to fall distorting real growth estimates upwards.

Canada 2.5 1.7 2.0 1.7

Brazil 2.8 0.9 4.0 2.3

India 7.5 5.1 5.8 5.7Growth expectations seem to be ratcheting down recently to below 5%.

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Source: Bloomberg

1.1 WEAK GROWTH

• The IMF and World Bank have downgraded global growth significantly over the last four months, despite market views to the contrary.

• Anticipated growth in the U.S. has not met expectations for more than three years. Growth in the first half of 2013 is the weakest of the last three years.

• The U.S. real estate recovery is fueled entirely by cheap credit. First time homebuyers represent the smallest percentage of buyers in years.

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1.1 WEAK GROWTH

• Most of the problem countries in Europe are in a major economic depression. Unemployment and debt levels continue to climb. Social unrest and abandonment of the austerity demanded by EU authorities are more likely than a classic economic recovery.

• Official Chinese statistics may show only a moderate decline in growth to about 7%, but real economic metrics (electricity consumption, rail traffic) show annual increases below 4%.

• Most developing countries ex China have experienced sharp slowdowns in growth. Growth in their exports to the developed world do not suggest much growth in the latter either.

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1.2 HIGH DEBT LEVELS

Sources: Bloomberg, International Monetary Fund (IMF), Organization for Economic Co-Operation and Development (OECD) websites.

The ability to repay is questionable in some of the countries where the governments have no plans to turn around the situation.

CPISovereign

Debt/GDP (%) Comments

US 2.0 108.0GSE debt and unfunded Social Security and Medicare liabilities are not included.

Canada 1.3 87.0

Eurozone

Germany 1.9 80.0 Euro guarantees such as ESM funding not included.

Italy 1.2 130.0

Spain 1.8 92.0

UK 2.8 94.0Potential/Actual bank guarantees not included in debt. Bank exposures are several multiples of GDP

Japan 0.2 245.0Gross debt ratio. Adjusting for the considerable assets held by the government, Debt/GDP ratio declines to

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The developed world is saddled with huge levels of sovereign and private debt.This situation has only worsened over the last two years, even as inflation remains low.

1.3 INFLATIONARY PRESSURES APPARENT IN THE EMERGING WORLD

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Inflation now a significant political issue in many large developing nations.

CPISovereign

Debt/GDP (%) Comments

China 2.7 22.0Debt ratio does not include regional and local government debts. With these, Debt/GDP ratios should

Brazil 6.3 67.0

India 9.6 66.0

Russia 7.2 10.0

Mexico 4.3 42.0

Indonesia 5.6 22.8

Sources: Bloomberg, International Monetary Fund (IMF), Organization for Economic Co-Operation and Development (OECD) websites.

1.4 INEFFECTIVE POLICIES

• The developed world is facing a problem with fiscal deficits and debt sustainability. They need to adopt policies to live within their means.

• The developing world needs structural reforms to reduce inflation with a reorientation of growth away from exports to domestic consumption.

Policies being adopted are the opposite of what is required.

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1.4 INEFFECTIVE POLICIES – THE DEVELOPED WORLD

The operative approach in the developed world is “extend and pretend”. There is no long-term plan for growth being discussed or implemented.

• The U.S. continues to encourage borrowing and speculation with low rates and Quantitative Easing (QE). Higher asset prices seem to be the goal even though they have done little to create sustainable growth. Any serious tapering of QE is likely to prove devastating for asset prices, and possibly growth.

• The EU is attempting to delay the recognition of sovereign debt losses with bailouts and central bank promises. This is a form of disguised lending to the problem states in the region, all of which are seeing continued increases in their debt levels.

• Japan has done little to rein in spending and continues to rack up debt but has jumped on the QE bandwagon as well.

Price manipulation by policymakers has worked for a while, but is reaching its limits – the pretence of growth is no longer sufficient.

“You gotta know when to hold’em … know when to fold’em”*

*Source: Kenny Rogers “The Gambler”

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1.4 INEFFECTIVE POLICIES – THE EMERGING WORLD

The developing countries are continuing with pre-2008 policies despite sharply different conditions in the developed world.

• China continues to invest heavily to boost growth in export sectors with easy credit still available to local governments. These entities have proved to be value destroyers par excellence.

• Chinese consumption remains close to a record low as a percentage of GDP at 35.2%. Ample Chinese savings are being eroded by inflation and a lack of investment alternatives, fuelling continued real estate speculation.

• India has done little to improve its infrastructure and remove domestic bottlenecks. It faces a poor mix of weakening growth and high inflation. The government seems incapable of addressing these issues.

• Brazil’s exports have stagnated even as Chinese imports decimate their traditional manufacturing sectors. High domestic inflation is rendering the economy increasingly uncompetitive despite relatively high prices for commodity exports.

The developing world needs significant structural reform to reduce inflation and a change in policy priorities away from exports to domestic consumption. These have not been forthcoming.

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2. WHAT WILL HAPPEN

1) The European crisis will resume •Growth in the problem countries not likely to pick up.

•Unemployment still increasing.

•Political environment getting more dicey – Italy, Spain and Greece could all have governance issues after August.

•New global banking rules will require considerable reduction in Euro-wide bank balance sheets.

Sources: Bloomberg, Eurostat websites12

2) U.S. growth will not become sustainable

• Recent interest rate increases due to potential QE “tapering” have already started to affect housing market sentiment.

• Employment and income figures do not suggest a robust consumer backdrop.

• Little scope for fiscal stimulus. Even after sequestration and tax hikes, the U.S. fiscal deficit remains high, even compared to many of the problem nations in Europe.

• Continued uncertainty about global growth and U.S. monetary policy not likely to create huge investment growth.

2. WHAT WILL HAPPEN

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2. WHAT WILL HAPPEN

3) Japan will create inflation and export its excess capacity

• New government in Japan led by Prime Minister Shinzo Abe has a majority in both houses of the Diet and is also extremely popular.

• The Bank of Japan has committed to print money until inflation is created. It will succeed, very likely at the ultimate cost of the currency and/or the bond market.

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2. WHAT WILL HAPPEN

4) China will trade off some growth for a partial economic rebalancing

• A genuine debate is occurring in the government about efficacy of capital investment with government induced credit growth.

• Measures to boost consumer incomes and the standard of living are likely. These will mean a slowdown in the pace of investment and overall GDP growth.

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2. WHAT WILL HAPPEN

5) Emerging market turmoil will continue in the near-term, but a repeat of the 1994 or 1997 crises unlikely

• Problems in the developing world are not akin to earlier crisis periods. Most developing countries have much less foreign debt and have ample reserves.

• Tapering of U.S. asset purchases could ultimately reduce inflationary pressure on the developing countries.

• The recent deterioration in Current Account deficits has been less due to a lack of competitiveness and more because of economic weakness in the developed world.

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3. INVESTMENT OPPORTUNITIES

1. Japan

• Stay long Japanese equities: They provide an enviable combination of huge earnings growth potential (2Q 2013 earnings grew over 100%) and low valuations (Price/Book ratios less than one for many sectors).

• Short Japanese Government Bonds: With high domestic energy costs and a central bank printing money, 10-year yields at 0.80% are simply inadequate, especially given the high levels of debt.

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3. INVESTMENT OPPORTUNITIES

2. Europe

• Buy European fixed income: Anticipating a continuation of the European depression. The sell-off due to tapering concerns in bonds is not justifiable given Europe’s economic conditions.

• Short Euro credit: Especially in the banks and peripheral corporates. Depressions do not help balance sheets or debt servicing ability.

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3. INVESTMENT OPPORTUNITIES

3. U.S.• Buy U.S. Treasuries on weakness: 3%+ 10-year yields are not

sustainable given U.S. debt levels. Growth will suffer. The U.S. is looking more like Japan did in 1992, but markets do not believe that.

4. Emerging markets• Look to buy emerging market equities and debt on continued

weakness: Their fundamentals are still decent, especially in relation to the developed world.

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