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librarium annual report 2013 Q1

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Horizon Scanning

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Contents
6 7 8 9

Introduction Status Report - Global Horizon Scanning


Global Horizon Scanning continued Global Horizon Scanning continued

10 Global Horizon Scanning continued 11

Status Report

11 Cyprus Debacle - Going off the cliff with offshore-banking - The story of banks 12 The story of the banks 13 The unraveling 14 The bigger picture 15 Does the Mass Media drive perceptions ? 16
continued

What is on the Horizon?

16 Japan & the UK at a cross-road? - Japan - The story of the ageing samurai reaching for the elusive fountain of youth 17 The story of the ageing samurai reaching for the elusive fountain of youth 18 Exporting false dawns 18 New Sheriff in town - meet Abenomics 19 New Sheriff in town - meet Abenomics 20 Graphs 21 Graphs 22 Graphs 23 Japan & the UK at a cross-road? - UK - Empire no more 24 Still looking for a recovery 25 Running out of gas 25 From longest period of expansion to triple dip recession 26 From longest period of expansion to triple dip recession 27 Lost in the maze? 27 The not so great GBP 27 Two archipelagos set for change? 28
continued continued continued

The Three-Legged Stool

28 Global Economy Review - Introduction 29 Introduction continued 29 Global manufacturing cools

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Contents
29 The fading growth benefits from stimulus, but for how long? 30 Weakness across all industries 30 Lack of global activity in key transport segments 31 The U.S. - The best house on a bad block? 32 The best house on a bad block? continued 33 U.S long term trends - wall of worry? 34 U.S long term trends - wall of worry? continued 35 Private deleveraging the ugly way 35 Trickle down economy? 35 Lower wages & higher cost of living 36 Past mal-investment An opportunity? 36 The least unattractive house on a bad block? 36 Still consuming Auto sales: U-turns & Down-turns 37 The EU - Sum of its parts? 38 Lost in that 19th Century feeling? 39 The road to shared prosperity? 39 The long-term trend Core nations 40 The long-term trend Core nations 41 The long-term trend Core nations 42 Germany - Introduction 43 Is Merkels economic machine beginning to show signs of neglect? 43 Germanys Choice 44 France - Introduction 45 Introduction
continued continued continued

45 Le retour a lancien regime 46 A civil service affair 46 Le Nationalism 47 Military might in Timbuktu? 48 Italy - Old, heavily indebted, structurally impaired and without leadership 49 Old, heavily indebted, structurally impaired and without leadership
continued

50 Reasons for protest? Italys long-run economic decline keeps getting worse 50 Italys debt/GDP: Highest since unification, other than wartime

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Contents
51 Spain - Introduction 52 A visual guide to the pain in Spain 53 A visual guide to the pain in Spain
continued

54 2013 unlucky for some 54 Construction & Real Estate sectors still in dire straits 54 Bad Bank(ia) 55 Captive bond buyers at the extremes 55 The second set of books - Al Capone style 56 Netherlands - Introduction 57 Dutch Decline? 57 Not looking so core 58 The Rest - Introduction 59 The scariest commodity during periods of plenty is the memory of past cycles 60 Investment

Implications

60 Custodial & Country Risk - Cypriot Take Away? - Introduction 61 A Powerpoint presentation too far 62 The source of much confusion and potentially lots and lots of lawsuits 63 Currency Risk - Introduction 63 Historical risks when mankind plays with the concept of money 64 The great U.S. equity markets disconnect? 65 Is the broad corporate reality a future of lower profits? 66 Is the broad corporate reality a future of lower profits? 67 Our
continued

core investment themes

67 Precious Metals - Physical Gold Ownership - What is the value of permanence 67 Value of permanence vs. the value of the ownership of a paper derivative 68 Central Banks continue to buy gold 68 Chinas ingrained understanding of the value of gold 69 Gold & Deflation 70 Are gold miners finally getting it right? 71 Agriculture & Fresh water - A look at Farmland vs RE/CRE 72 The water story 73 The water story
continued

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Contents
74 An interlinked world 74 The porcelain project 75 The porcelain project 75 Solutions required - all hands on deck 76 Energy - The U.S. - Leader in the great energy transformation? 77 The clear benefits so far 78 Energy - Driving towards a future of natural gas? 79 Changes in the global energy mix are under way 80 Changes in the global energy mix are under way 81 Energy - The LNG story 82 The future is floating 83 Shell Game - Forward thinking or boys with toys? 84 Our
continued

Summary

85 About 86 Disclaimer

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Introduction
The Librarium Associates Quarterly Review Series is a publication created by our team highlighting core global trends and projecting future paths on a geopolitical and macro economic level. We are constantly engaged in active horizon scanning while adhering to our belief that students of the lessons of history and permanent features such as geographic realities can provide superior insights. From these broad scenarios we work to identify investable trends and specific opportunities. We find that such a broad approach provides an early alarm system for risk management and an indicator of attractive price/value situations across asset classes. The intention of our research and the basic premise of this publication is to present rational perspectives based upon a diligent analysis of historical data. Through organizing the data logically, information is created. Through understanding and developing perspectives on the information, knowledge is generated. With knowledge, one can then start to make informed decisions. The most practical way to imagine the future is to question the expected, this is best done making use of what we call critical thinking - Critical thinking is the careful, deliberate determination of whether one should accept, reject or suspend judgment about a claim and the degree of confidence with which one accepts or rejects it. Critical thinking employs not only logic but a broad intellectual criteria such as the one outlined above. Critical thinking requires extensive experience in identifying the extent of ones own ignorance in a wide variety of subjects which is often captured in the following sentence; I thought I knew, but I merely believed. As J.F. Kennedy put it; Belief in myths allows the comfort of opinion without the discomfort of thought. Our aim is always to avoid this trap of the mind, when one attempts to look into the future one is better of exhibiting a more intellectually humble approach and challenge ones beliefs and opinions by asking the question; What if we took the opposite view? This leads to a more balanced set of insights in our view. The insights and opinions offered in this document are meant as a summary of events and our views not a conclusive or exhaustive overview or for that matter a specific investment recommendation. We hope it will offer some food for thought and that it can form the basis of conversations between our clients, interested parties and ourselves. Sincerely Yours, Mr. S.H. Sorensen Senior Associate Librarium Associates Ltd.

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Status Report

Global Horizon Scanning


The crisis is not over yet, not in the U.S. and not in Europe nor is it over for the key emerging economies, where perhaps it is just really getting started. Global economic activity, in the real economy not on central bank balance sheets, is grinding to lower and lower levels. It is not as dramatic as in 2008/09 but it is none the less bringing us to the same reality and this is happening on the back of unprecedented balance sheet expansion of the worlds key central banks. The graph below provides a visual representation of this trend.
Illustration 1 - World GDP *

Source: The Economist *Estimates based on 52 countries representing 90% of world GDP. Weighted by GDP at purchasing-power parity.

Even the normally pro-growth biased IMF has had to revise their outlook for the coming years, numbers which will no doubt have to be revised downward further as realities around the world set in. The illustration below shows the most challenged geographical segments with Europe on red alert.

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Global Horizon Scanning


Illustration 2 - World 2013 Growth Forecast Percent

Source: IMF

Slowing economic growth combined with increasing debt loads is not a recipe for success. Yet this is the exact situation we find ourselves in currently. As a person, a company or a government you are faced with challenges when dealing with a heavy debt burden that is not supported by a productive asset. If you can not increase the value and the income you are faced with only poor choices, default or if you are a government who has its own central bank you can use inflation as a subtler means of creating a wealth transfer from savers to debtors. The debt overhang is still there and its increasing every second.
Illustration 3 - Global Debt 2012

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Global Horizon Scanning


Illustration 4 - Bad Dynamics OECD fiscal situation - % of GDP

Source: JPM

Milton Friedman once quipped that; There is nothing as permanent as a temporary government program. This would appear true when looking through the government budgets of most OECD nations during the last 30 years and we believe when you take a look at central bank special measures instigated during the last 5 years you may be faced with the same reality. In the run-up to a debt crisis, bad debt tends to move to the highest level and may ultimately accumulate on the central banks balance sheets, provided the economy in question has its own currency. Excessive debt incurred by consumers, homeowners and businesses first moves to the banking system and corrupts its balance sheet. If, rightly or wrongly, the banking system isnt allowed to fail, bad debt is then transferred to the government via bailouts or implicit/explicit guarantees. When exacerbated by the burden of unfavourable demographics and several decades of proliferating welfare spending, it may overwhelm the governments debtcarrying capacity. Should financial markets become unwilling to refinance the government debt at rates acceptable to the government, central banks step in. They monetize government debt in the name of propping up the economy, creating jobs or weakening the currency to keep borrowing rates low and exports more competitive. The process whereby government or quasi-government debt is taken over by the central bank is called quantitative and qualitative easing. Many observers assume that, once bad debt is purchased by the central bank, the debt crisis is solved for good. The implicit assumption is that central banks have unlimited wealth at their disposal or can print unlimited wealth into existence. However, central banks can only create liquidity, not wealth. If printing money were equivalent to creating wealth, then mankind would not have to get up early on Monday mornings. Q.E. just transfers losses from the previous holders of the assets purchased by the central bank to the central bank itself. Up to a certain amount, the central bank absorbs these losses by sacrificing its equity and accumulated profits. But what happens once the central bank breaches this point? Inflation and high inflation would appear the logical answer. Historically, restructuring, inflation and financial repression has been part of the package as they all are measures that reduce your existing stock of debt but austerity must be a part as well as it stops you from adding further to the debt. There is no either-or. You need a combination of both to bring down the debt to a sustainable level.
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Global Horizon Scanning


Illustration 5 - Buyers of last resort keeps buying and buying Central bank balance sheets - % of GDP

Source: IMF, Reuters, UBS

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Status Report

The Cyprus Debacle Going off the cliff with offshore-banking


The Cypriot banking and wider financial sector had grown to unsustainable levels via a low-tax and low-compliance-hurdle formula which worked well during the heydays of globalization and financial cross-border activity. The banking sector, the government and the general population enjoyed the benefits of increased economic activity, rising tax revenues, easy credit and well paying jobs. This is in similar vain to what happened in Ireland, Iceland and to a degree in the U.K and U.S. where the Financial, Insurance & Real Estate segments (FIRE) all grew disproportionate to the general economy and through increased level of taxation and with a status of a provider of high paying jobs these sectors gained increased influence. The Cypriot situation was further enforced and complicated by the historic ties with Russia and its increasing role as a conduit in overseas transfers of this nations business and private individuals.

The story of the banks


The story is bigger and more nuanced than just pinning the blame for the collapse of the Cypriot banking system and the country itself on a few banks and individuals but Laiki and its management would appear to bear the burden of being the iceberg that sunk the vessel even if there where other factors involved. Mr. Spanodimos, the chief risk officer of Laiki Bank is quoted as stating in 2011 that; Our comfortable liquidity and capital position enables us to deepen selectively some highly profitable and highly promising client relationships. In short, they had so much liquidity that they had to invest it somewhere and given the regulators light touch, which gave the banks a clean bill of health through 2011, they bought Greek government debt and extended huge amounts of mortgage loans in Greece and Cyprus as well as loans to businesses and direct investment into expanding their reach in both nations.
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The Cyprus Debacle The story of the banks


For a while the Greek business was good, as the banks pursued this strategy. The 2006 annual report of Bank of Cyprus (BOC) speaks of its dynamic expansion in Greece and plans for more branches. By the time Greece began to teeter in late 2009, both BOC and Laiki were in deep. In July 2010, a pan-EU regulator conducted stress tests, both banks passed easily, with a total of Euro 572 million of surplus capital. The Central Bank of Cyprus declared deep satisfaction with the results, which it said demonstrate the ability of the domestic banking sector to withstand shocks under adverse scenarios. In 2010, after getting that all-clear, both banks also expanded their portfolios of soonto-be-toxic Greek government bonds. In February 2011, Laikis then-CEO, Mr. Bouloutas said were extremely comfortable with the banks capital levels which he predicted would rise as they turned out profits. He furthermore added that, We dont have any rush to strengthen them. Also that month Mr. Spanodimos, the risk officer, told analysts during a conference call that he did not think that Greek or Cypriot loans would go bad at an increasing clip. Around the same time, a top executive of BOC told analysts that the lender was selectively and cautiously expanding its business in Greece, and noted the banks position remains strong. In 2011, the European Banking Industry ordered more stress tests. Like the ones the previous year, they didnt contemplate losses on government bonds. The two main Cypriot banks where again found to have plenty of capital to withstand a deteriorating economic environment. Less than a week after the results came out, European leaders reached a deal for a new Greek bailout that included losses on Greek government bonds. That initial plan was never executed another plan, which saw even steeper losses, eventually was but now the specter of such losses were out in the open. Three months later, Laiki executives said they were racing to downsize their Greek government-bond holdings. Mr. Bouloutas told analysts in late November 2011 that the bank was seeing some customers pulling their deposits as a result of all this adverse publicity, but expressed confidence the trends would quickly stabilize. A week later, he resigned as CEO. That year, the banks realized huge losses on their Greek government bonds. Both were left with lower capital levels than Cypriot regulators required. BOC scaled back its lending to individuals and small businesses in Greece, but its loan portfolio there stood at about Euro 10 billion. Nearly 12% of the loans were classified as nonperforming. BOCs estimated deficit at that stage was Euro 1.56 billion and Laikis was Euro 1.97 billion. The banks had until June 2012 to come up with the new capital. They could not raise enough and where faced with increasingly deteriorating loan books which led them to the government who was unable to assist which in turn led to Cyprus needing a bailout.

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The Cyrpus Debacle The unravelling


Illustration 6 - Getting lost in Greece

Source: WSJ

On February 10th the FT referenced a confidential EU memo in an article, which pretty much foretold the events ahead with absolute precision. The article stated;
A radical new option for the financial rescue of Cyprus would force losses on uninsured depositors in Cypriot banks, as well as investors in the countrys sovereign bonds, according to a confidential memorandum prepared ahead of Mondays meeting of euro-zone finance ministers. The proposal for a bail-in of investors and depositors, and drastic shrinking of the Cypriot banking sector, is one of three options put forward as alternatives to a full-scale bailout. () By bailing-in uninsured bank depositors, it would also involve more foreign investors, especially from Russia, some of whom have used Cyprus as a tax haven in recent years. That would answer criticism from Berlin in particular, where politicians are calling for more drastic action to stop the island being used for money laundering and tax evasion. Labelled strictly confidential and distributed to euro-zone officials last week, the memo says the radical version of the plan including a haircut of 50% on sovereign bonds would shrink the Cypriot financial sector, now nearly eight timers larger than the islands economy, by about a third by 2015. Senior EU officials who have seen the document cautioned that imposing losses on bank depositors and a sovereign debt restructuring remain unlikely. Underlining the dissuasive language in the memo, they said that bailing in depositors was never considered in previous eurozone bailouts because of concern that it could lead to bank runs in other financially fragile countries.

Watching the subsequent chaotic process which followed - where all past judgments and common sense went out the window as the aptly named Mr. Panicos, head of the Cypriot Central Bank, and the newly elected government desperately tried to salvage the situation through backroom dealings with the EU and Russia one can not help but recognize that the process was extremely poorly handled by all involved. The 50% haircut on Cypriot sovereign debt, mentioned in the article, has not yet come to pass but as with Greece, give it time and considering the perilous economic and political situation on the island it will surely follow as the missing piece in the sustainability puzzle.

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The Cyprus Debacle The bigger picture


Cyprus significance was always going to stem more form the precedent it created than from its size. In choosing a relatively conventional good bank, bad bank model, the authorities have done much to alleviate the damage that would have been caused by an arbitrary tax on uninsured depositors. But the very success of the solution now being adopted seems likely to lead to its replication elsewhere. The Cyprus model has three key features, which highlight the effective elimination of many bondholders; supposed protections: Hasty implementation under national legislation: The rapid passage of national laws effectively re-writes existing bankruptcy legislation, reducing bondholders rights in the process. Even if bonds have been issued under UK or US law, this emphasis on the bankruptcy regime itself effectively dilutes and negates many of their protections. Application to all bonds by statute: Cyprus again demonstrates that, when backed into a corner, the authorities are willing to impose losses by statute on all bonds, even at senior level. Extremely low recoveries: The decision to move bonds to the bad bank, together with uninsured depositors and equity is likely to result in extremely large losses. Even if bonds are not actually converted outright into equity, as seems possible, the decision to protect not only insured deposits but also around Euro 9 billion in ECB ELA holdings - both of which are going to what is effectively the good bank is likely to result in near-zero recoveries. The authorities, with some disagreement, has been noisily voicing that Cyprus is unique. We disagree. The Cypriot banking sector was unusually large and yes, the complications related to the Russian depositor base are unlikely to feature elsewhere and losses for bondholders will likely be exacerbated by the unusually small portion of the capital structure they represent. But the similarities with other countries are far stronger than the differences. Almost all EU countries have banking systems that are outsized by global standards and which might prove difficult to save if they got into difficulty as the illustration below clearly highlights.
Illustration 7 - Bank assets to GDP by country (ratio) Note: Uses aggregated banking statistics for euro-zone countries

Source: Citi, Haver Analytics

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The Cyprus Debacle Does the mass media drive perceptions?


Lastly we found the broad response to the situation as almost as interesting as the situation itself. We have already covered the distorted perceptions, utter confusion and many missteps by the involved parties but how the world suddenly became engulfed in the events on a small island on the edges of Europe and how it subsequently moved onto other items of interest even as at the time of writing the process had not been completed with a potential vote to take place on the matter in Cyprus - highlights to us the fickle and through the rear view mirror tendencies of the mass media. The illustration below highlights this tendency.
Illustration 8 - Cyprus getting more coverage than AAPl & Germany combined Bloomberg Briefs

Source: Bloomberg

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What is on the horizon?

Japan & the UK at a cross-road?

Japan The story of the ageing samurai reaching for the elusive fountain of youth
A journey through Japans recent history From Meiji to Hiroshima to Pebble Beach to Deflation Ville to Fukushima and beyond. A rich nation, a strong army (Fukoku Kyohei) was the mantra of the reformers who in 1868 transformed Japan from an essentially agricultural country into a great industrial and military power. A new Japan, open to the world and keen to equal the West, was born on 3 January 1868, the day when imperial power was restored in the person of the Meiji emperor. The Meiji restoration initiated a radical process, motivated by a fierce desire for national independence and economic expansion to Western levels, founded on a strong industrial base, both civilian and military. Manufacturing output increased by a factor of thirty between 1878 and 1939. In 1968, exactly one century after the Meiji restoration, Japan overtook Germany and became the worlds third-largest economy after the U.S. and the Soviet Union. In the mean time, it had won wars resulting in the annexation of Taiwan, Korea and de facto, Manchuria. This in turn led to the invasion of China but culminated in Japans first ever defeat, in the Pacific War, and surrender in August 1945 to the U.S. Imperial Japans ambitions for hegemony in Asia had come to naught, the country lay in ruins and its economy was in tatters, with agricultural and industrial output running at barely a third of their pre-war level. The U.S. strategy was to turn its former enemy into an ally against the communist threat in the region. Just ten years after its defeat, the newly democratized country embarked on what has been called the Japanese miracle. The miracle refers to the high growth period (1955-73), when an average annual growth rate of 9.7% was sustained over eighteen years. Japanese GDP grew fivefold between 1955 and 1973 and doubled between 1974 and 1990.

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Japan The story of the ageing samurai reaching for the elusive fountain of youth
In 1974, a double whammy sent the economy into a savage recessionary spiral. The 1973 oil shock quadrupled oil prices and hit Japan at its most vulnerable point, energy dependence, while exports were undermined by the appreciation of the yen, which rose by over 30% in two years. Annual inflation rose to 25% in 1974 and a period of adjustment became necessary. Household savings financed budget stimulus packages, while the quest for energy efficiency brought about profound changes in production methods. Growth resumed at an annual rate of 4% until the end of the 1970s, by which time Japan was the worlds third-largest economy and exporter with 6.4% of the global market in 1980, compared with 2.1% in 1955. Japan was ready for the next phase of its expansion. Japans rise as a financial and technological power was almost symmetrical with the U.S.s decline, during the period from 1980 to 1989. Japan, the worlds largest creditor nation, was accumulating substantial foreign assets and running both a balance of payments and a budget surplus, while its financial institutions were expanding internationally. The U.S., now the worlds biggest debtor nation, was seeing its foreign debt rise sharply and running both a balance of payments and a budget deficit, while its financial institutions were retrenching. Tokyo overtook New York as the worlds biggest stock market in 1987, the worlds ten biggest banks in 1989 were all Japanese and they were responsible for 30% of all international lending. The 1980s were golden years, and by 1989 it looked as though nothing could halt Japans stellar ascension as an industrial, technological and financial power. The Plaza Accord of September 1985 enforced by the U.S. lead to the near doubling of the value of the yen against the USD between 1985 and 1987. This started the process of unravelling the last decades unsustainable practices. The bubble finally burst in 1990 and the ensuing collapse of the stock market and real estate prices, which had tripled since 1985, triggered a financial meltdown. The government used the twin levers of budget and monetary policy to deal with the problem. Ten stimulus plans followed in rapid succession over the ten-year period, at a total cost of USD 1 trillion, but they had such little effect that interest rates were cut to almost zero. Despite this shock treatment the recovery never came.

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Japan Exporting false dawns


There have been many false dawns in Japan during the last 20 years. Struggling with a combination of crushing debt and deadly demographics, Japans economy has stubbornly refused to make progress, despite numerous government efforts that range from currency devaluation to endless public works projects. The nasty reality for Japan is that its cost of inputs are rising at the same time demand for its goods continues to soften.

New Sheriff in town - meet Abenomics


Five years after staring into a political and personal abyss, Japanese Prime Minister Shinzo Abe is out to prove that the man who threw in the towel after barely a year in office has what it takes to survive as a long-term leader. Abe, whose 2006-2007 term as premier ended with his abrupt resignation after a year plagued by scandals, an election defeat and a gastro-intestinal ailment worsened by stress, won a rare second chance when his party surged to power in December 2012. The Abenomics as his new and radical policies have been named have yet to be fully implemented so far it has all been mainly talk. However, quarter one saw Abes chosen sidekick Mr. Kuroda take his place at the helm of the Bank of Japan (BOJ) earlier than normally and with some effect. A commitment to spending $100 billion in 15 months on more infrastructure seems to be out of the old playbook. Japan has already poured $2 trillion into concrete and steel since 1990 in a vain effort to resuscitate the economy, now in its fourth recession since 2000. Second on the to do list is the transformation of the BOJ, which Mr. Kuroda has been charged with, from a dusty bureaucratic institution to a fast-charging inflation crusader with impeccable controls and an uncanny ability to predict the future. Abe was already on the warpath during his election campaign and he made it clear that the BOJ will be directly subservient to the government during his rule. Abenomics will be build around a 2% annual inflation target and in order to create this in an economy which has spend the last 20 years in a deflationary spiral, a target for the doubling of the monetary base by the end of 2014 has been instituted. Japans monetary base already amounted to 12% of GDP in 2000, compared with figures of 6.9% for the euro-zone and 5.9% for the U.S. After Lehman Brothers collapsed and the global financial crisis took hold, the FED expanded the monetary base by 250%, the ECB by 57% and the BOE by 335% but Japan, where the Shirakawa BOJ had already been increasing the supply of base money, still had a larger monetary base relative to GDP. These proposed measures can only be described as an extreme experiment.

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Japan New Sheriff in town - meet Abenomics


Having read and enjoyed the excellent book; Lords of Finance by Liaquat Ahamed which describes the lives and actions of the heads of the worlds four key central banks from the late 1920s till after WWII I often find it interesting to compare these remarkable mens individual choices and enforced realities which led to those choices, with those of our current crop. Mr. Kuroda does appear the most Havensteinish of them all. Only time will tell if he, like Mr. Havenstein, finds himself on the slippery road of high inflation and its many destructive forces or whether he delivers 2% annual inflation year after year and in doing so awakes a Japanese giant from its slumber. What we do know at the end of the first quarter of 2013 is that Japans economy contracted in the fourth quarter and there are no real signs of an improvement at the time of writing this. Japans public debt will have expanded to 245% of GDP this year from 237% in 2012 according to the IMF. During 2012 Japans death rate crossed the birth rate and its demographic situation appears to have gone terminal with the oldest population of any OECD nation. The nation has lost its balance of trade surplus and the government has been running budget deficits for years. Japan is nearly barren of any large deposits of energy resources and in the aftermath of the Fukushima disaster Japan has become the worlds largest importer of LNG and is generally at the mercy of world markets in relation to most of its commodity needs which does not play well with the weak yen policy which has been embraced. Abe has also been forceful in his commitment to the expansion of the capabilities of the Japans Self-Defense Force (JSDF) and he has been vocal in the latest escalations surrounding the ownership of the Senkaku/Diaoyu/Tiaoyutai Islands. Get ready for some serious Kabuki theatre in the months ahead and as an investor you are going to want to stay away from yen and yen denominated assets. If you can borrow in yen and purchase productive assets in Canada, Switzerland, Norway or Australia you should be on to a good thing. The short side has already been very productive for investors including the talented Mr. Soros who seem to have come back to the kind of investing that he does best.

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Japan Graphs
Illustration 9 Japan growth abyss 1991-2011
Nominal GDP growth

Real GDP growth

US vs. Japanese corporate profits

Lost Decades

Source: JPM

Illustration 10 - Japans trade balance June 28, 1985 through December 31 2012

Source: Bloomberg

Illustration 11 - Japans birthrate June 28, 1985 through December 31 2012

Demographic headwinds

Source: Doubleline Capital

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Japan Graphs
Illustration 12 - Japan government debt to GDP

The banking & insurance sectors are heavily exposed.


Source: Ministry of Finance Japan

Illustration 13 - Japan government spending

Source: Ministry of Finance Japan

Illustration 14 - Japan: Shares of JGB Holdings at end-2010 percent

Source: BOJ

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Japan Graphs
Illustration 15 - Japanese Index vs. S&P 500 Growth of $1 December 29, 1989 through February 28, 2013

No wealth effect so far

Source: Bloomberg Note: Nikkei 225 Index Total Return = An index showing the average closing prices of 225 stocks on the Tokyo Stock Exchange. S&P 500 Index is a capitalization = weighted index of 500 stocks.

Illustration 16 - Kurodas BOJ seeks to overtake the FED and BOE

Flying too close to the sun?

Source: Nomura, Based on BOJ, FRB, ECB, BOE data Note: The estimate is based on the assumption that required reserves will increase by 3% a year and bank reserves constitute 88.8% of financial institutions current deposit holdings with the BOJ. The BOE has suspended reserve requirement in March 2009. The post-March figures are based the assumption that the original reserve requirement is applicable.

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What is on the horizon?

Japan & the UK at a cross-road?

UK Empire no more
During its heyday as the British Empire, the UK was the largest and most influential economy in the world. As the birthplace of the first Industrial Revolution during the 18th century, the UK ushered in what economic historians agree to be the most significant event in mankinds history. The UK was also able to be at the forefront of technological advances during this time, giving it a strong economic advantage over any country in the world which was furthermore expressed by the GBP acting as the worlds reserve currency. However as other countries began to catch up technologically wise, the UKs economy was also greatly affected by the two World Wars which subsequently led to the breaking up of its territorial empire. Though Britain and the empire emerged victorious from WWII, the effects of the conflict were profound, both at home and abroad. Much of Europe, a continent that had dominated the world for several centuries, was in ruins, and host to the armies of the U.S. and the Soviet Union, who now held the balance of global power. Britain was left essentially bankrupt, with insolvency only averted in 1946 after the negotiation of a loan from the U.S. This financial reality and the general wind of change ultimately meant that the British Empires days were numbered, and on the whole, Britain adopted a policy of relative peaceful disengagement from its colonies once stable, non-Communist governments were available to transfer power to. Between 1945 and 1965, the number of people under British rule outside the UK itself fell from 700 million to five million, three million of whom were in Hong Kong which has since been handed over to China. The UK spend the following years having to come to terms with its new reality economic and geopolitical. In 1976 the UK faced another severe financial crisis. The government was forced to apply to the IMF for a loan of $4 billion. The IMF insisted on deep cuts in public expenditure, greatly affecting economic and social policy.

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UK Still looking for a recovery


Today, the UK faces another struggle to recover from the 2008 financial crisis. Presently, the recovery has been the worst recovery on record as the illustration below shows.
Illustration 17 - Worst recovery in history Cumulative GDP change from peak

Source: ONS, OBR & NIESR

The UK, a leading trading power and financial center, is the third largest economy in Europe after Germany and France. Over the past two decades, the government has greatly reduced public ownership and contained the growth of social welfare programs comparatively to its peers within the EU. Agriculture is intensive, highly mechanized and efficient by European standards, producing about 60% of food needs with less than 2% of the labour force.

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UK Running out of gas


The UK has large coal, natural gas and oil resources, but its oil and natural gas reserves are declining rapidly and the UK became a net importer of energy in 2005. Services, particularly banking, insurance and business services, account by far for the largest proportion of GDP while industry continues to decline in importance.

From longest period of expansion to triple dip recession


After emerging from recession in 1992, Britains economy enjoyed the longest period of expansion on record during which time growth outpaced most of Western Europe. In 2008, however, the global financial crisis hit the economy particularly hard, due to the importance of its financial sector. Sharply declining home prices, high consumer debt and the global economic slowdown compounded Britains economic problems, pushing the economy into recession in the latter half of 2008 and prompting the then government led by Mr. Brown to implement a number of measures to stimulate the economy and stabilize the financial markets; these included nationalizing parts of the banking system, temporarily cutting taxes, suspending public sector borrowing rules and moving forward public spending on capital projects. Facing burgeoning public deficits and debt levels, in 2010 the Cameron-led coalition government initiated a five-year-austerity program, which aimed to lower Londons budget deficit from over 10% of GDP in 2010 to nearly 1% by 2015. In November 2011, Chancellor of the Exchequer George Osborne announced additional austerity measures through 2017 because of slower-than-expected economic growth and the impact of the euro-zone debt crisis. The government raised the value added tax from 17.8% to 20% in 2011. It has pledged to reduce the corporation tax rate to 21% by 2014. The Bank of England (BoE) implemented an asset purchase program of up to GBP375 billion as of Dec. 2012. In 2012, weak consumer spending and subdued business investment weighed on the economy. GDP feel 0.1% and the budget deficit remained stubbornly high at 7.7%. The Public debt has continued to increase. Since the beginning of 2011, the UKs monthly trade deficit has hit record levels of more than GBP 4 billion per month. Britains economy shrank more than expected at the end of 2012 with a North Sea oil production slump and lower factory output. The countrys GDP fell 0.3% in the fourth quarter according to the Office for National Statistics. Britains economy is now 3.3% smaller than its peak in Q1 2008, having recovered only about half the output lost during the financial crisis a worse performance than most other major economies.

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UK From longest period of expansion to triple dip recession


During Q1 2013, UK retail sales stagnated according to the Confederation of British Industry while disposable income also fell in the fourth quarter according to the statistics office. Manufacturing, as measured by the MARKIT survey, also continued its negative trend of below 50 readings. Last year was the worst since 2008 for retail store closures and retail job losses according to CBRE. According to Deloitte, the number of retailers that filed for administration a form of insolvency protection rose to 194 last year from 183 in 2011 and 165 in 2010. The largest 16 retail collapses accounted for 1,400 store closures. Britain has the most shopping space per capita in Europe according to CBRE. The currently shrinking store numbers represent a reversal of the previous decades opening binge, when retailers flush with cheap credit fought for new space amid tough planning constraints. According to real estate researcher LDC, the number of store closings is set to double this year. Even though the UK financial sector has already gone through serious surgery it is still not out of the woods. Dark clouds still hang over most of the banks in the form of potential penalties for past misconducts as well as an unknown new regulatory reality. Plus the BoEs Financial Policy Committee recently released a report highlighting that the UKs major banks has significant below-the-surface problems including bad loans, impaired assets not marked-to-market and hidden losses. All of this was enabled by the ENRON style accounting rules which where allowed directly after the bailing out of the sector in 2009 and has allowed the sector to appear in improving condition since. That perception may be in need of altering as according to the same report the UKs five biggest banks has undeclared losses of GBP 31.8 billion and if smaller banks and building societies are included you are looking at as much as GBP 60 billion. The report recommends that at least GBP 25 billion in fresh capital must be raised this year to start plugging the hole. The oversight of this process was handed over to the new, reassuringly named, Prudential Regulation Authority on April 1 from the less than convincing FSA.

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UK Lost in the maze?


All these aspects have collectively lead to the UK loosing its AAA rating from first Moodys and then Fitch. Fitchs decision was prompted in part by the Office for Budget Responsibility (OBR) that indicated that UK government debt will peak later and at a higher level than previously expected. Moodys analysis was focused on the weak prospects for economic growth which have thrown the governments deficit reduction strategy off course. The Cameron led government has been in choppy waters and the loss of the AAA rating was a particular challenge to Mr. Osborne who had painted himself as the prudent protector of Britains finances and its valued AAA rating when he first took the position as Chancellor of the Exchequer. Mr. Cameron also appears to have opened Pandoras box with his often fuzzy and listless strategy towards the EU. The governments focus on what it calls austerity has also led to animosity as the population is feeling the effects. It appears unlikely that the governments plans of largely eliminating the budget deficit in time for the elections scheduled for 2015 will be realized and without major changes one would have to consider the potential for a change in government and potentially a change in course in the future. To add further complexity to the picture Scotland has negotiated to have a referendum on the issue of independence from the UK in September 2014 Is a divorce after over two hundred years of co-habitation on the cards?

The not so great GBP


As an investor, if you had any long exposure to the GBP during Q1 of 2013 you experienced significant loss of purchasing power. The GBP had its biggest quarterly drop against the USD in more than four years. The GBP declined against all but two of its 16 major counterparts during the quarter including the Euro. The outlook would appear set for further deterioration in the years ahead.

Two archipelagos set for change?


For the two archipelagos (UK & Japan) on each side of Mr. Halford Mackinders socalled Euro-Asian-heartland - both obviously influenced by the U.S. are set for significant socio-economic changes in the future and the route would appear perilous. However both nations have in the full scope of history shown a high level of resilience and ability to change when it really matters. Furthermore the U.S. has a long-term strategic interest in keeping its closest allies in a conductive state, enabling it to manage its wider global strategic priorities.

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The Three-Legged Stool

Global Economy Review Introduction


The three major blocs of the developed world are careening toward a debt-fueled denouement that will play out over years rather than in a single moment in our opinion. As with most things in life there is no certain ending, there are multiple paths still available to Europe and especially the U.S., admittedly none of them are bright and carefree. There are very few paths available to Japan, as they have skipped too far down the yellow brick road of debt. None of Japans remaining paths would appear to have good endings. As we described in our last report, we see the emerging economies as potentially the most fragile. During Q1 2013 we saw a continued broad deterioration of the global economy with its related effects on all the different links and national and regional economies, as the charts below highlight. China, India, Russia and Brazil all continued to soften and all where faced with their individual choices in how to respond to the changing global landscape. Quarterly GDP in the G20 area grew by 0.5% in the fourth quarter of 2012 compared with 0.6% in the third quarter, according to preliminary estimates from the IMF. The aggregate G20 GDP growth rate however continues to mask diverging patterns across the worlds largest economies. Among the major seven countries, all European countries (Italy, Germany, France and the UK) experienced a GDP contraction in the last quarter of 2012. By contrast, the non-European major seven countries (Japan, U.S. & Canada) recorded broadly stable or positive growth rates in the fourth quarter of 2012. Among the remaining G20 economies, India, Mexico, South Korea, Brazil and South Africa recorded a higher growth in the fourth quarter of 2012 than in the previous quarter, while in Australia, Indonesia and China GDP growth remained broadly stable.

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Global Economy Review Introduction continued


Compared with the same quarter of 2011, GDP growth slowed to 2.4% in the fourth quarter of 2012 in the G20 area, with China recording the highest growth rate (7.9%) and Italy the largest contraction (minus 2.8%). For 2012 as a whole, GDP expanded by 2.8% in the G20 area, compared with 3.8% in 2011. As we have mentioned before we do not see official GDP figures as anything but a guiding number with its inherent challenges in terms of providing an exact representation of economic activity. We suggest that a broad representation of various inputs should be monitored, below is a series of indicators that broadly reflect that a negative trend has taken hold in the real global economy.

Global manufacturing cools


Illustration 18 - Markit PMI U.S., Euro Zone & China

Source: Markit & Reuters Note: A reading over 50 indicates expansion

The fading growth benefits from stimulus, but for how long?
Illustration 19 - Global Manufacturing PMI Index

Source: JPM

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Global Economy Review Weakness across all industries


Illustration 20 - Global all-industry activity Purchasing Managers Index

Source: JPM

Lack of global activity in key transport segments


Illustration 21 - Global air cargo traffic Freight-ton kilometers, YOY % change

Source: JPM

Illustration 22 - The Baltic Dry Index An indicator of global sea-trade activity

Source: Bloomberg

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The Three-Legged Stool

The U.S. The best house on a bad block?


The U.S. has the largest and most technologically powerful economy in the world, with a per capita GDP of $49,800. In this market-oriented economy, private individuals and business firms make most of the decisions and the federal and state governments buy needed goods and services predominantly in the private marketplace. U.S. business firms enjoy greater flexibility than their counterparts in Western Europe and Japan in decisions to expand capital plant, to lay off surplus workers and to develop new products. At the same time they face higher barriers to enter their rivals home markets than foreign firms face entering U.S. markets. U.S. are at or near the forefront in technological advances, especially in computers and in medical, aerospace, energy and military equipment. The onrush of technology largely explains the gradual development of a two-tier labour market in which those at the bottom lack the education and the professional/technical skills of those at the top and more and more fail to get comparable pay raises, health insurance coverage and other benefits. Since 1975, practically all the gains in household income have gone to the top 20% of households. Since 1996, dividends and capital gains in household income have grown faster than wages or any other category of after-tax income. Imported oil accounts for nearly 55% of U.S. consumption. Crude oil prices doubled between 2001 and 2006, the year home prices peaked, higher gasoline prices ate into consumers budgets and many individuals fell behind on their mortgage payments (many of these mortgages where given to people with little ability to service it). Oil prices climbed another 50% between 2006 and 2008 and bank foreclosures more than doubled in the same period. The sub-prime mortgage crisis, falling home prices, investment bank failures, tight credit and the global economic downturn pushed the U.S. into a recession by mid-2008. GDP contracted until the third quarter of 2009, making this the deepest and longest downturn since the Great Depression.

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The U.S. The best house on a bad block?


To help stabilize financial markets, in October 2008 the U.S. Congress established a $700 billion Troubled Asset Relief Program (TARP). The government used some of these funds to purchase equity in U.S. banks and industrial corporations, much of which had been returned to the government by early 2011. In January 2009 the U.S. Congress passed and President Obama signed a bill providing an additional $787 billion fiscal stimulus to be used over 10 years two-thirds on additional spending and one-third on tax cuts to create jobs and to help the economy recover. In 2010 and 2011, the federal budget deficit reached nearly 9% of GDP. In 2012 the federal government reduced the growth of spending and the deficit shrank to 7.6% of GDP. Wars in Iraq and Afghanistan required major shifts in national resources and from civilian to military purposes and contributed to the growth of the budget deficit and public debt. Through 2011, the direct costs of the wars totalled nearly $900 billion, according to U.S. government figures. U.S. revenues from taxes and other sources are lower, as a percentage of GDP, than those of most other countries. In 2010, President Obama signed into law the Patient Protection and Affordable Care Act, a health insurance reform that will extend coverage to an additional 32 million American citizens by 2016, through private health insurance for the general population and Medicaid for the impoverished. Total spending on health care public plus private rose from 9.0% of GDP in 1980 to 17.9% in 2010. In December 2012, the FED announced plans to purchase $85 billion per month of mortgage-backed and Treasury securities in an effort to hold down long-term interest rates, and to keep short term rates near zero until unemployment drops to 6.5% from the December rate of 7.8% or until inflation rises above 2.5%. Long-term problems include stagnation of wages for lower-income families, inadequate investment in deteriorating infrastructure, rapidly rising medical and pension costs of an aging population and sizable current account and budget deficits including significant budget shortages for state governments. For a further overview of the long-term challenges to the U.S. see the illustrations below. During Q1 we saw several down-ward revisions to U.S. economic figures for 2012, this appears to be a trend which is set to continue. Q1 factory and various industrial indicators slowed and hints at economic headwinds in 2013. The much heralded recovery remains slow, unsteady and not dynamic. The level of credit used in the past across all sectors is unlikely to reappear any time soon. Consumer confidence is moderate, business is hesitant to expand and Washington is failing to provide a clear and reliable setting. The immediate problems are worse elsewhere, allowing the U.S. to continue its role as the best house on a bad block.

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The U.S. U.S long term trends - wall of worry?


Illustration 23 - U.S. Government takeover of GDP

Source: usgovernmentspending.com

Illustration 24 - US tax policy and expenditures Percent of GDP

Source: JPM

Illustration 25 - U.S budget surplus Deficit in USD Bln

Source: Datastream

The public has two hopes, and government makes two promises - many benefits and no taxes. Hopes and promises, which being contradictory, can never be realized.

-Bastiat 1848
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The U.S. U.S long term trends - wall of worry?


Illustration 26 - The rising cost of debt

Source: Datastream

Illustration 27 - Overall US debt still remains elevated and the financial sector is still bloated

Source: FED, Haver

Illustration 28 - Public debt and unfunded obligations % of GDP from 1945

Source: Research Affiliates

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The U.S. Private deleveraging the ugly way


Illustration 29 New Delinquent Loans
USD Blns USD Blns

New Delinquent Student loans

Rising inequality

Source: NY FED

Trickle down economy?


Illustration 30 - Public debt and unfunded obligations % of GDP from 1945

Source: Bureau of Economic Analysis and GS

Lower wages & higher cost of living


Illustration 31 - Inflation comparison Inflation comparison (1978 Sept. 2012)

Source: dshort.com

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The U.S. Past mal-investment An opportunity?


Illustration 32 - U.S. Government takeover of GDP (1950 -2011)

Source: BCG Note: Net domestic fixed investments are fixed investments, purchases of residential and nonresidential structures and of equipment and software by private business, nonprofit institutions and governments minus consumption of fixed capital the decline in the value of the stock of fixed assets due to wear and tear, accidental damage and aging.

The least unattractive house on a bad block?


Illustration 33 - Annual working age population growth and projection US Vs. OECD

Source: GMO Note: Estimates are subject to numerous assumptions, risks and uncertainties which change over time and as such the forecasted segments are a provided as a guide only.

Still consuming Auto sales: U-turns & Down-turns


Illustration 34 - % of total population, 3 month moving average

Decline is relative

Source: BEW, Census Bureau, ECB, EuroStat

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The Three-Legged Stool

The EU Sum of its parts?


Below we have assessed the five largest economies in the EU in order to get a feel of the moving parts which will determine the future format of this crucial cog in the global economy. We will leave the reader to come to their own conclusions but it would appear that the sum of its parts is not a positive comparative number and one could argue whether the EU is more or less than its parts due to the institutions which have been implemented to act as the conduits of this project. What is certain is the fact that the involved nations and the EU overall is moving into uncertain and difficult times. As mentioned earlier, this will not be a situation that will resolve itself in the short-term but a saga working itself through the various stages at what will at times appear to be a snail-like pace and at others it will be like the events of a whole century has just rushed through in the matter of a few days. As the charts below highlight the problems are intractable, structural and requires time and strong leadership, both of which appear to be in short supply. Euro area unemployment, which rose to a fresh all time high of 12% during Q1 2013, has been rising constantly for 22 consecutive months the longest period for deteriorating unemployment since the early 1990s, which could be expected for a continent which has now reverted to 19th century growth rates as the illustration below highlights.

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The EU Lost in that 19th Century feeling?


Illustration 35 - Current long-term growth rates in France, Italy & Spain Change in 7-year real GDP, percent since 1820. WWI, WWII & Spanish Civil War excluded

France

1 2

France/Prussian war and impact of tarif reductions on French industry Great depression, worsened by delayed move by France to drop gold standard

Italy

Cumulative impact of 10-year Franco-Italian tarif war which resulted in a 60% decline in billetral trade

Spain

1 2 3

Overflow and exile of Queen Isabella II, collapse of railway boom and financial sector Currency, banking sector and stock market crisis, impact of New World grain invasion Pan-European banking crisis. Baring Brothers failure after Argentine govt default. Philomena epidemic arrives in Spain

Source: JPM

Illustration 36 - The largest post-WWII GDP declines

It happens slowly at first... then all at once. Everything feels normal then suddenly it is not.

Source: JPM

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The EU The road to shared prosperity?


Illustration 37 - Euro-Area joblessness rises to record 12 percent

Source: JPM

The long-term trend Core nations


Illustration 38 - Unemployment rate (%)

Source: Eurostat, Datastream, SG

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The EU The long-term trend Core nations


Illustration 39 - Generational discontent

There are no good options left

Source: Lighthouse

Illustration 40 - EU governments eating up a larger slice of the shrinking pie

Source: Lighthouse

Illustration 41 - How to do more with less

Source: Lighthouse

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The EU The long-term trend Core nations


Illustration 42 - Government spending outsized for the supporting economies

Source: Lighthouse

Illustration 43 - The Austerity never really gets started until the Troika arrives

Can we afford the cradle to grave government systems which we have promised ourselves?

Source: Lighthouse

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The Three-Legged Stool

EU - Sum of its parts?

Germany Introduction
The German economy the fifth largest economy in the world in PPP terms and Europes largest is a leading exporter of machinery, vehicles, chemicals and household equipment and benefits from a highly skilled labour force. Like its Western European neighbours, Germany faces significant demographic challenges to sustained long-term growth. Low fertility rates and declining net immigration are increasing pressure on the countrys social welfare system and necessitate structural reforms. Reforms launched by the government of Chancellor Gerhard Schroeder (1998-2005), deemed necessary to address chronically high unemployment and low average growth, contributed to strong growth in 2006 and 2007 and falling unemployment. These advances, as well as government subsidized reduced working schemes, help explain the relatively modest increase in unemployment during the 2008-09 recession the deepest since WWII and its decrease to 6.5% in 2012. GDP contracted 5.1% in 2009 but grew by 3.7% in 2010, and 3.0% in 2011, before dipping to 0.9% in 2012 a reflection of the worsening euro-zone financial crisis and the financial burden it places on Germany as well as falling demand for German exports. Stimulus and stabilization efforts initiated in 2008 and 2009 and tax cuts introduced in Chancellor Angela Merkels second term increased Germanys budget deficit to 3.3% in 2010, but it ran a balanced budget in 2012. A constitutional amendment approved in 2009 limits the federal government to structural deficits of no more than 0.35% of GDP per annum as of 2016. Following the March 2011 Fukushima nuclear disaster, Chancellor Merkel announced in May 2011 that eight of the countrys 17 nuclear power plants would be replaced with renewable energy. Before the shutdown of the eight reactors, Germany relied on nuclear power for 23% of its electricity generating capacity and 46% of its base-load electricity production.

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Germany Is Merkels economic machine beginning to show signs of neglect?


A plunge in exports drove a contraction in German GDP, highlighting the vulnerability of Europes largest economy to weakness in its euro-zone trading partners. Seasonally adjusted data from the Federal Statistics Office confirmed that German GDP shrank by 0.6% in the last three months of 2012 versus the previous quarter. Foreign trade deducted 0.8% from GDP while domestic demand added 0.2%. Investment in equipment has been falling for more than a year now and dropped 2% in the fourth quarter as firms spent less on machines, tools and vehicles.

Germanys Choice
The European crisis will enter a new phase this year that will expose Germanys limitations in managing the situation and intensify an ultimately irresolvable debate over who within the euro-zone the core or the periphery should bear the political, economic and social burden of the crisis. With parliamentary elections coming up this year, the German government is facing growing pressure to show German taxpayers that Berlin will manage the European crisis with a firm hand. At the same time, Germany must make concessions to deflect rising criticism from heavily indebted peripheral states that are now questioning the security of their bank deposits and are looking to France to champion their cause. France, facing rising unemployment at home, will identify with these states demands but will also have to choose its battles with Berlin wisely to avoid breaking the alliance that holds the European Union together.

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The Three-Legged Stool

EU - Sum of its parts?

France Introduction
The French economy is diversified across all sectors. The government has partially or fully privatized many large companies, including Air France, France Telecom, Renault and Thales. However the government maintains a strong presence in some sectors, particularly power, public transport and defense industries. With at least 79 million foreign tourists per year, France is the most visited country in the world and maintains the third-largest income in the world from tourism. Frances leaders remain committed to a capitalism in which they maintain social equity by means of laws, tax policies and social spending that reduce some income disparity and the impact of free markets on public health and welfare. Frances real GDP contracted 2.6% in 2009, but recovered somewhat in 2010 and 2011, before stagnating in 2012. The unemployment rate increased from 7.4% in 2008 and has remained above 9% per year since then. Lower-than-expected growth and increased unemployment have strained Frances public finances. The budget deficit rose sharply from 3.4% of GDP in 2008 to 7.5% of GDP in 2009 before improving to 4.5% of GDP in 2012, while Frances public debt rose from 68% of GDP to 89% over the same period. Under President Sarkozy, Paris implemented some austerity measures to bring the budget deficit under the 3% euro-zone ceiling by 2013 and to highlight Frances commitment to fiscal discipline at a time of intense financial market scrutiny of euro-zone debt. Socialist Party Candidate Francois Hollande won the May 2012 presidential election, after advocating pro-growth economic policies, the separation of banks traditional deposit taking and lending activities from more speculative businesses, increasing the top corporate and personal tax rates, and hiring an additional 60,000 teachers during his five-year-term.

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France Introduction
France ratified the EU fiscal stability treaty in October 2012 and Hollandes government had maintained Frances commitment to meeting the budget deficit target of 3% of GDP during 2013 even amid signs that economic growth will be lower than the governments forecast of 0.8%. However, during quarter one Hollandes government admitted that it would be unable to meet this target in 2013. Despite stagnant growth and fiscal challenges, Frances borrowing costs declined during the second half of 2012 to euro-era lows. The growth challenge for France is something we will have to watch, its not as bad as Italy, but as shown below, other than during wartime, this has been a very bad stretch for French growth. A period of no growth over 7 years in France is something seen more frequently during the 19th century. It was also seen during the 1930s when France struck to the gold standard longer than other countries did and paid a price. The same parallels between the gold standard in Europe in the 1930s and the binding constraint of todays currency union can be observed.

Le retour a lancien regime


Illustration 44 - Frances zero growth pace mirrors 19th century events Change in 7-year real French GDP, percent, since 1820

Source: Lighthouse

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France A civil service affair


France has economic problems that are particular to its political culture. While speculative excesses in Spain and Ireland were concentrated in an over-built, overgeared real estate sector, French exuberance was a civil affair. This out-of-control public sector machine used easy funding conditions through the 2000s to bolster the ranks of an already bloated bureaucracy the assumption was that such captive groups would vote for their ultimate paymasters come election time. According to some estimates France is the only country which has seen the public sector grow faster than the private sector in every year since 1987. The interesting thing is that the government share of GDP in France has relentlessly risen regardless of whether a right or a left leaning party was in power. Such has been the complete capture of the French economy by the bureaucracy that the public spending trend has remained unbroken. The share of French corporate profits in gross value is the smallest of the six major EU countries, and falling. While Germany has maintained its share of world exports, France has lost one third of its share since the Euro was launched. France is engulfed by a political and economic paralysis. The president has record low popularity, unemployment is making new highs and the tax czar appointed by Mr. Hollande recently had to resign after repeatedly lying about hiding Euro 600,000 in a Swiss bank account. The greater concern is that, nine months into his presidency, Mr. Hollande has still not revealed how he plans to find further savings. Until now, Hollande has chosen the path of least resistance by favoring tax hikes on business and the wealthy over spending freezes. But amid howls of protest that he risks scaring off investment and entrepreneurs, his government has committed to avoid further tax rises, meaning the only way from now on is chopping expenditure. This could turn Socialist allies, trade unions and the average person against him. In the words of Frances state finances watchdog the Court of Auditors; No reform that would bring significant savings beyond 2013 can as yet be identified. () new measures must be rapidly taken and clearly documented. For Hollande this may be a watershed moment, wringing an unprecedented Euro 38 billion of savings from public finances so far has been hard enough. But to go further he must cut into the flesh of French state spending, at 56% of output second only to Denmarks in the Western world. So far the markets and the other European nations have accepted Frances failings but for how long? What happens if France is faced with higher interest rates?

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France Le Nationalism
Nationalism is a strong force in French politics, and the ongoing European crisis may be nurturing its growth. The National Front, which represents French nationalism politically, fared better in the most recent presidential election than previous ones. Central to the partys platform is the notion that immigration is a threat to national identity and that the European Union has weakened the French economy. With high rates of immigration and with the European Union integrating further, the ideals espoused by the National Front may appear even more valid in the eyes of French voters. Already mainstream political parties are adopting some aspects of the National Fronts platform to reflect the partys growing popularity.

Military might in Timbuktu?


France has taken steps to showcase its relative military strength with campaigns in its old colonies in Africa. After a few botched events it decided to get deeply involved with the brewing conflict in Mali where an influx from the war in Libya of well-armed Taureg fighters pushed the balance of power in northern Mali in to the rebels favour. The northern section of Mali is the size of France and Spain combined, and its terrain is distinct from the southern half and blends in with the broader Sahel region. The countrys two halves are also relatively distinct ethnically and religiously. This means Bamako in the south has to project force into the north and occupy it to exert control, and for a poor country with limited abilities, this was a tenuous hold. The bolstered Taureg ranks fought an increasingly effective insurgency that triggered a military coup in the south and broke the army, which ceded the northern half of Mali. This was followed by a counter offensive from the Tauregs which was rapidly over running the southern part. This is when France decided to intervene with significant initial commitment. These operations where the first time Mr. Hollande ordered troops into action since he was elected. The operations, after some initial success, has ground to a halt with the French military having to dig in for the long-term as the promised replacement troops from the African ECOWAS has not been forthcoming and as the nature of the conflict has turned into a counter-insurgency effort in very rough terrain. It is hard to see an easy way for France to exit this commitment. France has limited direct interests I Mali itself, but the West African country is geographically centered in the heart of Frances former colonial empire. The unrest could be perceived to threaten its interests in the wider region which include energy resources in Algeria, uranium in Niger to fuel Frances robust nuclear sector and gold mining in Mauritania. France also has agrarian commercial interests in the region, including cotton in Mali and cocoa in the Ivory Coast. France currently has around 4,000 troops deployed in Mali with the related costs to be born by the state.

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The Three-Legged Stool

EU - Sum of its parts?

Italy Old, heavily indebted, structurally impaired and without leadership


Italy has a diversified industrial economy, which is divided into a developed industrial north, dominated by private companies, and a less-developed, highly subsidized, agricultural south, with high unemployment. The Italian economy is driven in large part by the manufacture of high-quality consumer goods produced by small and medium-sized enterprises, many of them family owned. Italy also has a sizable underground economy, which by some estimates accounts for as much as 17% of GDP. These activities are most common within the agriculture, construction and service sectors. Italy is the third-largest economy in the euro-zone, but its exceptionally high public debt and structural impediments to growth has rendered it vulnerable to scrutiny by financial markets. Public debt has increased steadily since 2007, topping 126% of GDP in 2012 and investor concerns about the broader euro-zone crisis at times have caused borrowing costs on sovereign government debt to rise to euro-era records. During the second half of 2011 the government passed a series of austerity packages to balance its budget and decrease its public debt. These measures included a hike in the value-added tax, pension reforms and cuts to public administration costs. The government also faces pressure from investors and European partners to sustain its recent efforts to address Italys long-standing structural impediments to growth, such as an inflexible labour market and widespread tax evasion. In 2012 economic growth and labour market conditions deteriorated, with growth at 2.8% and unemployment rising to nearly 11%. Although the government has undertaken several economic reform initiatives, in the longer-term Italys low fertility rate, productivity and foreign investment will increasingly strain its economy. Italys GDP is now 7% below its 2007 pre-crisis level. Leave the politics aside and you are still looking at testing times ahead.

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Italy Old, heavily indebted, structurally impaired and without leadership


Italys set of problems - the huge debt loads, soaring unemployment, and a growing social revolt against the new normal austerity status quo plus Italy has the second fastest aging population in the world, and the highest in Europe. makes it a serious piece of the equation, especially when its size as Europes third-largest economy is considered. By the end of 2012, Italy overtook Japan with the worst real GDP growth of all advanced economies since 1991. Spending cuts and tax increases passed by the outgoing Prime Minister, Mario Monti, helped Italy raise its primary surplus to 2.5% of GDP in 2012. However the economy contracted by 2.4% and interests on the debt rose last year by 10.7% and the budget deficit amounted to 3% of GDP. Other than wartime, the last few years in Italy have been the worst for growth since Italian unification in 1861. In Italy, the inconclusive February elections that led to a paralysed parliament will greatly complicate efforts by the traditional elites to form a government, and early elections cannot be ruled out. Italy will therefore experience political uncertainty during the next three months, with the popularity of the anti-establishment Five Star Movement enduring throughout this tumultuous political cycle. Italy has never been known for a highly functional governmental system but the current situation - where we have had a non-elected technocrat running the country since 2011 when Berlusconis government had to step down in less than ideal circumstances appears to be seriously dysfunctional. Now we have been left without a government since the February elections as the two main political blocs have been significantly weakened and the unpredictable Bebbe Grillos Five Star Movement proving unwilling to consider any form of compromises. At the time of writing there had been no solution and the elections for a new President to replace the outgoing Mr. Napolitano also looks to have come to an impasse. The Italian banking sector has also been under pressure with the Monte Paschi situation continuing to unravel. The bank is Italys third-largest bank and it already received Euro 1.9 billion in state aid in 2009. During quarter one they received another bailout of over Euro 4 billion in order to reach the capital requirements set by European regulators. The bank is also engulfed by investigations of its former managers who amongst other misdeeds allegedly engaged in some exotic derivatives deals which led to hidden losses. The bank has been around since 1472 so it has clearly navigated troubled waters before but it looks like it will find it difficult to turn this around.

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Italy Reasons for protest? Italys long-run economic decline keeps getting worse
Illustration 45 - Change in 7-year real Italian GDP, percent, since 1861 (Unification)

Source: JPM

Italys debt/GDP: Highest since unification, other than wartime


Illustration 46 - Gross general government debt GDP

Source: JPM

Illustration 47 - Getting older gracefully?

Source: JPM

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The Three-Legged Stool

EU - Sum of its parts?

Spain Introduction
After almost 15 years of above average GDP growth, the Spanish economy began to slow in late 2007 and entered into a recession in the second quarter of 2008. GDP contracted by 3.7% in 2009, ending a 16-year growth trend, and by another 0.3% in 2010, before expanding moderately in 2011, making Spain the last major economy to emerge from the global recession. The economy, however has once again fallen into recession as deleveraging in the private sector, fiscal consolidation, and continued high unemployment weigh on domestic demand and investment. The unemployment rate rose from a low of about 8% in 2007 to roughly 25% in 2012. The economic downturn has also hurt Spains public finances. The government budget deficit peaked at 11.2% of GDP in 2010 and the process to reduce this imbalance has been slow despite Madrids efforts to raise new tax revenue and cut spending. Spain reduced its budget deficit to 9.4% of GDP in 2011 and roughly 6.7%* of GDP in 2012, both above the 6.3% target agreed between Spain and the EU. Spains large budget deficit and poor economic growth prospects remain a source of concern for foreign investors, the governments ongoing efforts to cut spending and introduce flexibility into the labour markets are intended to assuage these concerns. The government is also taking steps to shore up the banking system. Their main step has been to manoeuvre for an EU bailout for its banks to the tune of $130 billion in order to recapitalize struggling banks exposed to the collapsed domestic construction and real estate sectors.
*Note: Even this number was later challenged as it does not include the costs associated with recapitalizing Spains banks. The European commissions estimate was much higher, at 10.2% of GDP because it included them.

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Spain A visual guide to the pain in Spain


Illustration 48 - Spains economic decline Percent change in 5-year real Spanish GDP, Since 1855

Source: JPM

Illustration 49 - Back to 1993 Spanish Industrial Output

Source: SG

Illustration 50 - Spains debt to GDP at levels not seen in over 100 years

Source: El Pais

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Spain A visual guide to the pain in Spain


Illustration 51 - Even with austerity the debt levels keep rising

Source: El Pais

Illustration 52 - Spains economic decline

Source: SG

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Spain 2013 unlucky for some


The beleaguered Prime Minister Mariano Rajoy had to admit that Spains economic output may shrink more in 2013 than the 0.5% he initially predicted. The IMF forecasts a 1.5% contraction. The year has not started well for the Spanish government, the central governments deficit for the first two months of the year widened to 2.22% of GDP from 1.95% last year. The government has been dragging their feet in submitting their budget plans through 2014 to the European Commission and several controversial revisions and some strong arming from Eurostat has been required. Unfortunately the bottom line is quite clear, the central governments interest bill surged 15% last year while tax receipts slumped 21 percent. The cost of servicing debt represented 30% of the taxes collected at the end of December, up from 20% a year earlier. This is a record level since records began. Mr. Rajoy also oversaw the breaking of another unfortunate record, Spains debtto-GDP has now reached levels not seen in over 100 years according to El Pais. Spanish debt levels rose at an alarming Euro 400 million per day in 2012 making it the largest annual increase in the nations history all the while proclaiming austerity. The last time levels of debt were this high relative to GDP Spain was recovering from war and the loss of its colonies.

Construction & Real Estate sectors still in dire straits


Its no shock that the Spanish housing market is in a horrible condition but hope has been, following the governments nationalization of various banks and the creation of the bad bank to soak up all the toxic assets that these banks had on their books, that a recovery could blossom. It appears not to be the case. Not only are bad loans rising at record rates with house prices remaining down over 40% but during quarter one of 2013, Reyal Urbis - a large RE/CRE developer - had to file for bankruptcy, making it the nations second largest bankruptcy ever.

Bad Bank(ia)
The Cypriot debacle kept the spotlight away from Spains own hair-cutting session. The Spanish government announced that it will impose heavy losses on investors at nationalized banks. The restructuring terms announced will impose losses of up to 61% at Spains largest nationalized banks. At Bankia, the largest of the institutions and the only one that is publicly traded, shareholders will be nearly wiped out and junior bondholders will lose around 30% of their original investment.

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Spain Captive bond buyers at the extremes


According to a recent article in the WSJ, Spain has quietly been tapping the countrys richest piggy bank, the Social Security Reserve Fund, as a buyer of last resort for Spanish government bonds, raising questions about the funds role as guarantor of future pension payouts. Now the scarcely noticed borrowing spree, carried out amid prolonged economic crisis is about to end, because there is little left to take. At least 90% of the Euro 65 billion fund has been invested in increasingly risky Spanish debt according to official figures (It was 55% in 2008) and the government has begun to withdraw cash for emergency payments. In addition, there are worries that Social Security reserves for paying future pensioners are running out much quicker than expected. In November, the government withdrew Euro 4 billion from the reserve fund to pay pensions, the second time in history it had withdrawn cash. The first time was in September, when it took Euro 3 billion to cover unspecified treasury needs. Spains continued use of those reserves to buy its own bonds appears to have violated a rule set by government decree that mandates their investment only in securities of high credit quality and a significant degree of liquidity. But with unemployment above 25% of the workforce and fewer wage earners paying in, the Social Security System is about Euro 3 billion in deficit according to government estimates. Not much left for social security.

The second set of books - Al Capone style


The government of Mr. Rajoy furthermore finds itself embroiled in a bribery scandal that could be straight out of a gangster movie or perhaps Uganda. One of Spains main newspapers published images of excerpts of almost two decades of handwritten accounts that it said were maintained by Peoples Party treasurers, showing donations from companies, mostly builders as well as regular payments of thousands of Euros to Mr. Rajoy and other party leaders. The Peoples Party has denied any improper conduct. Where there is smoke there is normally fire and one of the two former party treasures, Mr. Barcenas, was forced to step down as party treasurer in 2009 when judges began to investigate his possible involvement in alleged illegal payments and kickbacks to party officials from builders and other businesses that won government contracts. According to an article by Reuters, Mr. Barcenas deposited Euro 14 million into a new account at Dresdner Bank in Switzerland in 2005. When asked to explain how he had come by the money during the banks AML process, he told them that the funds came from his involvement with several Spanish and Argentine companies and from real estate and fine art deals. However most of the companies in question where either proven to be so-called shell companies, had gone out of business or they denied having any business dealings with Mr. Barcenas. At a time where most of the population is going through the effects of serious deleveraging and austerity measures which have led to one of the highest levels of unemployment in the EU, this is a matter that has led to social discontent and has significantly damaged the governments ability to govern and deal with the painful structural changes which must be pursued including dealing with the autonomous regions. 2013 will be a testing year for Spain and its current government.
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The Three-Legged Stool

EU - Sum of its parts?

Netherlands Introduction
The Dutch economy is the fifth-largest economy in the euro-zone and is noted for its stable industrial relations, moderate unemployment and inflation, a sizable trade surplus, and an important role as an European transportation hub. Industrial activity is predominantly in food processing, chemicals, petroleum refining, and electrical machinery. A highly mechanized agricultural sector employs 2% of the labour force but provides large surpluses for the food-processing industry and for exports. The Netherlands, along with 11 of its EU partners, began circulating the euro currency on 1 January 2002. After 26 years of uninterrupted economic growth, the Dutch economy highly dependent on an international financial sector and international trade contracted by 3.5% in 2009 as a result of the U.S. mortgage crisis. In 2008, the government nationalized two banks and injected billions of dollars of capital into other financial institutions, to prevent further deterioration of a crucial sector. The government also sought to boost the domestic economy by accelerating infrastructure programs, offering corporate tax breaks for employers to retain workers, and expanding export credit facilities. The stimulus programs and bank bail-outs, however resulted in a government budget deficit of 5.3% of GDP in 2010 that contrasted sharply with a surplus of 0.7% in 2008. The government of Prime Minister Mark Rutte began implementing fiscal consolidation measures in early 2011, mainly reductions in expenditures, which resulted in an improved budget deficit of 3.8& of GDP. In 2012 tax revenues dropped nearly 9% and GDP contracted. Although jobless claims continued to grow, the unemployment rate remained relatively low at 6.8%.

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Netherlands Dutch Decline?


Illustration 53 - Annual change in the Netherlands GDP

Source: CBS Statistics Netherlands Note: 2012 to 2014 Dutch Central Bank forecasts

Not looking so core


The Netherlands slid back into recession in the fourth quarter of 2012, as declines in investments and household consumption led to a second straight quarter of economic contraction according to official data from the Dutch Central Bank. Output in the Netherlands contracted by a quarterly 0.2% in the final three months of 2012, data from the national statistics bureau CBS showed. After shrinking by 0.9% in the third quarter, the Netherlands officially entered recession for the third time since 2009. The Netherlands is considered one of the stronger economies in the euro-zone, but its performance is lagging other core members of the bloc amid slowing exports and a persistent slump in the housing market. The economic contraction will likely drag on until the second half of 2013, according to several official forecasts. Falling house prices have caused an erosion of household wealth and this in turn has led to consumers cutting back their spending. Dutch households are among the most indebted in Europe due to their large mortgage debt. The fourth-quarter contraction was driven by a 5.2% year-on-year drop in investments and a 2.3% decline in household consumption, according to CBS. Exports did grow by 3.2% but from a low base.

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The Three-Legged Stool

The Rest Introduction


In our last report we focused on the five largest emerging economies, China, India, Russia and Brazil. We concluded that these economies, though all with some attractive dynamics, are more fragile than most market commentators believe. Furthermore with the interconnectedness of the global economy and considering that the U.S. and EU economies collectively makes up approximately two-thirds of the global economy and are in flux, one has to recognize that these economies are faced with a lot of uncertainty and they face them without the institutional frameworks that has so far enabled the U.S. and EU to bend but not break during the initial storms. It has been the case that for the past four years, that market participants have been uncritically thankful for the emerging markets. Set against what seemed like crippled developed countries, emerging market growth kept trade moving, commodities prices afloat and offered some attractive investment opportunities. We believe that, while growth still will be comparatively more dynamic than what we expect from most of the developed economies, serious downside potential exists in all of these economies and investors should not be blinded by fast growth and the illusion of easy profits.

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The Rest The scarcest commodity during periods of plenty is the memory of past cycles
Russia went through the so-called Ruble Crisis which on the 13th of August 1998 led to a collapse of the Russian stock, bond and currency markets. Annual yields on the ruble denominated bonds were more than 200%. The stock market had to be closed for 35 minutes as prices plummeted. When this happened, it was down 65% and from January to August 1998 the stock market lost 75% of its value. On the 17th of August 1998, the Russian government devalued the ruble, defaulted on domestic debt and declared a moratorium on payment to foreign creditors. Since Chinas era of reform and opening up began, the country has experienced three instances of large-scale public-finance problems. In the late 1970s, the country faced a debilitating fiscal deficit. In the 1990s its corporate sector was plagued by triangular debts (when a manufacturer that has not been paid for its product is unable to pay its suppliers, which in turn struggle to pay their suppliers). Later that decade, financial institutions were burdened by bad debts generated by state-owned enterprises. Chinas corporate and local government sectors are again looking fragile in our opinion, while the sovereign should be able to step into the breach and mop up the mess, it will still result in potentially dysfunctional financial markets and an official increase in the sovereigns debt burden. India is the most likely to default on its debts currently according to CDS rates and it has severe current problems. This is nothing new to India and veteran investors into this nation. In 1985, India started having balance of payments problems, by the end of 1990 it was in a serious economic crisis. The government was close to default, its central bank had refused new credit and foreign exchange reserves had been reduced to such a point that India could barely finance three weeks worth of imports. India had to airlift its gold reserves to pledge it with the IMF for a loan. Brazil has a varied economic history as we highlighted in our last report. It is worth noting that when Brazil had its first post-military-regime in March 1990 it was faced with imminent hyperinflation and a virtually bankrupt public sector. Furthermore in 1998 Brazil received a $41.5 billion IMF-led international support program. In January 1999, the Brazilian Central Bank announced it could no longer peg its currency to the USD and a serious devaluation followed. It is important to remember that only a couple of economic cycles ago these so called titans of growth were very poor developing nations with significant problems. A few skyscrapers and a financial center does not necessarily mean that there is a sustainable economy nor a liquid and transparent financial system with consideration for the protection of investors interests in place.

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Investment Implications

Custodial & Country Risk - Cypriot Take Away? Introduction


The Cyprus debacle which we discussed in our Status Report segment provided evidence of the importance of finding the right jurisdictions and custodial service providers. If the result of this unfortunate situation is that savers eyes are opened further to the basic risks involved with making choices as to where and with whom to safekeep ones savings, then something good will have come from it. It is a process we are constantly engaged in as we always consider the risk of loss of principal before considering the opportunity for yield. As Mr. Twain once put it; I am more concerned with the return of my capital than the return on my capital. High interests on deposits and zero percent tax and little administrative burden in an exotic place with a few years as a financial center is not always as attractive as it sounds. As with most things in life there is a trade-off and absolutely no free lunch when it comes to building wealth for the long-term. Will the so-called bail-ins, whereby losses are imposed on depositors, represent the modus operandi in the dealings with the ongoing solvency crisis in the state and financial sectors? Time will tell, but as an aside we must say that the concept whereby thinly capitalized government agencies purport to guarantee trillions in deposits with billions in capital has always been implausible as an insurance scheme. There would appear to be nothing reassuring about it in real terms. It is simply another unfunded government guarantee which in an age of insolvent states is being revealed. Any scheme that supposedly de-risks deposits without truly reflecting the cost of removing such risks is just a system that allows them to accumulate to unsustainable levels with predictable consequences as seen in Cyprus and throughout history. Trust but always verify...The importance of finding the right jurisdictions and the right custodial service provider.
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Custodial & Country risk - Cypriot take away? A Powerpoint presentation too far
Illustration 54 - Bank of Cyprus Group Presentation

Bank of Cyprus marketing materials The band on the Titanic played on.
Source: Bank of Cyprus Q3 2012

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Custodial & Country risk - Cypriot take away? The source of much confusion and potentially lots and lots of lawsuits
Illustration 55 - Mixed messages all around

Source: Zerohedge

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Investment Implications Currency Risk Introduction


Once you have found a set of solutions for your jurisdiction, custodial and banking services you will need to look at managing the currency risk aspects. As quarter one has shown, sitting in the wrong currencies can be seriously detrimental to your wealth. Savers with high exposure to the (not so) Great British Pound and the Japanese yen have felt a real loss in purchasing power during the last 3 months but USD and Euro focused savers have equally been exposed during the last 5 years. It is the curse of the fiat currency system and history is riddled with examples of this trend as the illustration below shows.

Historical risks when mankind plays with the concept of money


Illustration 56 -Exchange rate regimes and currency crises since the 1800s

Source: GoldMoney, Bordo and Landon Lane, Rutgers University, Temin, MIT, Simmons, Harvard University, Goldman Sachs Global ECS Research

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Investment Implications The great U.S. equity markets disconnect?


Illustration 57 - The DOW flying with the doves? Dow Jones Industrial Av. (Five Years)

Source: Bloomberg

Hope is a poor strategy but there appears to be a high level of hope involved in the predicted future earnings for the U.S. Around the world analysts are comfortable marking down expectations for U.K., European, Asian and Emerging Market nations but not so far in the U.S. It would appear to us that the U.S. will struggle to realize these hopeful expectations if the rest of the world is heading into negative territory.
Illustration 58 - High expectations for the US Stock Market A decoupling from reality?

Source: Reuters, CS

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The great U.S. equity markets disconnect? Is the broad corporate reality a future of lower profits?
In our opinion it is not uncertainty, as many observers claim, that is holding back corporate capital investment and employment - it is certainty that the future will not be like the last 20 or 30 years of relative balmy times. Tax revenues will have to rise in the future and the corporate sector has come under severe scrutiny as many of our largest companies pay little tax comparative with their real earnings. With increasingly desperate governments looking for income and reassessing their past arrangements with the global corporate sector it maybe a time where the double Irish and the Dutch sandwich gets taken off the menu. Furthermore corporations, such as Toyota and BP and the global financial industry, have been forced to deal with an increasing amount of penalties and settlements surely this is a trend that will not go away as it is a politically agreeable route. More of the future pension burden is also likely to be pushed onto the employer as governments tackle their gigantic un-funded liabilities. Most savings and efficiencies have been squeezed out during the last couple of years and businesses are now faced with the reality on the ground. It is a reality of slower global economic activity. From a value investors perspective, forecasting future earnings is a perilous task at the best of times, but broadly speaking it would appear that the trend is negative.
Illustration 59 - Considering the US fiscal situation how long can these balmy times go on? As of Feb. 2013

Source: Compustat, OECD, GS

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The great U.S. equity markets disconnect? Is the broad corporate reality a future of lower profits?
As discussed in our last report central banking special measures are not reflected in the real economy a disconnect is increasingly taking hold with the real economic activity broadly negative but with financial assets and equities especially behaving like we are in the midst of a period of strong sustainable global growth. Now we do not claim to know the future and even understanding current events in their totality can be a challenge but we do not see any real indication that we are in the midst of a strong sustainable scenario of global growth. The fundamentals underpinning the S&P500 would appear to be increasingly coming from one source and it is a source who makes decisions based on political priorities. The FEDs actions have inadvertently affected the broader financial markets and as the graph below indicates the S&P500 has been a strong beneficiary of the dovish actions.
Illustration 60 - FED magic?

Source: Bloomberg & Doubleline Capital

Illustration 61 - How long can the share buy backs, special dividends etc. go on at these levels?

Source: Compustat, GS Global ECS Research Note: As of April 1, 2013

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Our core investment themes

Precious Metals Physical Gold Ownership - What is the value of permanence


In our view, physical gold owned with direct title ownership is the ultimate currency and as such will always have a place in the currency segment of our portfolios. In times like the ones we are currently in it makes sense to have a more significant portion of this segment allocated to physical gold. In the long term gold endures, if confidence is increasingly lost in the fiat currencies, the bond markets and the institutions who underpin them, then gold is a safe haven - It will not necessarily protect you against a crash in the financial markets, as it showed in 2008. If many investors simultaneously need cash, they sell everything they have, including gold.

Value of permanence vs. the value of the ownership of a paper derivative


In our view there is a disconnect between the value of physical gold ownership and ownership of ETFs, gold futures and other derivatives which is that in essence all you get with these instruments is a paper promise and a vehicle to track the price of gold as to the market prices as expressed via markets like the U.S. Comex Market, which is by the nature of its operative format a highly leveraged system with little physical gold supporting the daily trading and common use of margins. This is obviously not a real market for physical gold but a paper derivative which is in our view only suitable for speculative positions and as such does not reflect the real attractions of holding physical gold. If you look at the sales of gold coins and bars via the worlds mints you will see record demand and central banks are increasingly adding to their gold reserves while downsizing their USD and Euro positions. Physical gold can not go broke and it has been used as money by mankind for millennia as such it is a superior proposition to debt based paper assets denominated in fiat currencies. It is hard to put a price on permanence, but it is worth a lot to us and our clients.
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Precious Metals Central Banks continue to buy gold


We discussed the increasing purchases of gold by the worlds central banks in our last review of the gold markets, during quarter one of 2013 we have had confirmation that this strong trend has continued as the illustration below shows. Russia was, according to Bloomberg, the worlds biggest gold buyer, its central bank having added 570 tons over the past decade. What is worth noting is the fact that China has not been reporting their position for a number of years, and as they are the worlds largest gold producer and as they have been importing significant amounts via Hong Kong on a consistent basis, one can only make an educated guess as to their actual position. According to some estimates China imported 834.5 tons during 2012, double the 431 tons imported in 2011. China last reported their official gold holdings as 1054 tons in 2009 according to the IMF.
Illustration 62 - Central banks have added to their gold holdings in increasing amounts. Thousand tons.

Source: IMF, CPM Group, Casey Research

Chinas ingrained understanding of the value of gold


The talented Mr. Felix Somary, who has been called one of the worlds greatest currency experts of his time, wrote the following in 1913; In Europe nobody would understand the Chinese mentality back then; Europe was at the peak of its power, full of confidence in the present and the future, amused at people who would reject bank notes and who would suspiciously put metal money on a scale to verify its weight. The consensus was that they were trailing us by five generations when the truth is, they were one generation ahead. They had experienced the fortune of billions on paper under Mongolian emperors war conquests and road construction and they had seen the bitter ending of it all. This experience had stayed with them throughout the centuries. How times change yet somehow stay the same when you look at the broad strokes. Is it the case that; it is just the same things happening to new people in a slightly modified version but driven by the same general behavioural patterns?
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Precious Metals Gold & Deflation


Gold is often talked about in connection with inflation and it is no doubt the environment where its strength is ultimately best reflected. However generally deflation is the prevailing current prior to periods of high inflation and it is the environment most of the world finds themselves in currently. We can highly recommend the excellent books; Monetary Regimes and Inflation by Mr. Bernholz and When money dies by Mr. Fergusson, for historic perspectives on these dynamics and the resulting behaviors. During periods of deflation, historically gold has outperformed, this is especially true relative to other commodities as illustrated by the graph below. It highlights the fact that gold, and to a lesser extent also silver, would record a clear increase in purchasing power during deflationary phases over a long time horizon.
Illustration 63 - Gold, silver and commodities in historical phases of deflation.

Source: Roy Jastram, The golden constant & Silver, the restless metal, Erste Group

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Precious Metals Are gold miners finally getting it right?


As discussed in our last report, gold remains a highly popular issue for discussion, but not a highly popular asset in portfolios. The underweighting of gold and the related miners by institutional investors is particularly profound. Institutions continue to hold only 0.15% of their assets in gold according to some estimates. We do not expect an imminent paradigm shift, this is practically impossible for regulatory reasons. But even a weighting of 2 to 3% in institutional portfolios would trigger enormous effects. The allocation of investment capital into gold mining shares is similarly insignificant. This could be about to change as the major gold mining companies have in recent years showed the kind of behaviours that could make them attractive to the institutional segment as well as to the average investor. The sector has no doubt disappointed in recent years as perceived opacity, lack of dividends and the general ills which have plagued the broader global mining industry over-expansion, over-valuations of purchases and a lack of focus on production and the bottom line have collectively left investors without the required level of conviction for a serious allocation to the sector. However we believe that the gold mining sector has a solid base. Although the pessimism is about as profound as three or four years ago, the fundamental shape of the gold industry is substantially healthier today than it was back then. Comparatively strong balance sheets, high free cash flows, a substantial increase in margins, low debt levels and rising dividends all speak in favour of the sector. The development in quarter one by Barrick Gold Corp. and Goldcorp inc. the two biggest producers by market value of providing more balance sheet clarity with the reporting of all-in sustaining costs for the first time was also an indication of the commitment to good practices. The measure averaged $941 an ounce between the two companies in the fourth quarter of 2012. That is 50% higher than the $626 average so-called cash cost they disclosed in the preceding three months. We see solid mining companies operating in politically stable regions as a great way to place a high-leverage bet on the long-term gold price, with an attractive risk/return profile. It is our opinion that the current, historically low valuations offer a good opportunity to invest in a selective range of these companies.

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Our core investment themes

Agriculture & Fresh water A look at Farmland vs RE/CRE


Illustration 64 - Farmland superior? Global capital growth (Annualized 2002-2010)

Source: Savills, Eurostat

In our last report we concluded that farm and forestry land offers a compelling proposition as a store of value, a cash-yielding asset and with a potential for capital gains. The illustration above from Savills highlights its relative performance vs. Commercial and Residential Real Estate (CRE & RRE). Farmland has clearly outperformed both. The level of farmland returns has been substantial in most geographical locations it has furthermore held up comparatively well in the U.S. who saw a well-documented collapse in RRE & CRE valuations during the covered period. We make the comparison between farmland and CRE/RRE with some reservation. Though farmland is often included in the real estate asset class, it is in our opinion more truly a hybrid of the real estate and commodity asset classes. Farmland values to a large degree are a derivative of agricultural commodity prices unlike RRE & CRE. This linkage in part, is the appeal of farmland investments as agricultural commodity demand fundamentals are robust and land prices remain relatively low. U.S. pension fund manager, TIAA-CREF, who have around $2.5 billion invested in farmland expects a continued return of 8 to 12% per year as global food demand increases.
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Agriculture & Fresh water The water story


Like oil in the 20th century, water could well be the essential commodity on which the 21st century will turn. Human beings have depended on access to water since the earliest days of civilization, but with over 7 billion people on the planet, exponentially expanding urbanization and development are driving demand like never before. According to research published by the World Resources Institute; Water use has been growing at more than twice the rate of population increase in the last century. They also predict that water use will increase by 50% between 2007 and 2025 in developing countries and 18% in developed ones. Will there be enough water for everyone, especially if the population continues to rise, as predicted, to 9 billion people by mid-century? We call it the Blue Planet for a reason and based on first impression we would appear to have plenty of water. The problem is, according to the Water Research Foundation, that 97.5% of the water is salty and of the 2.5% that is fresh, two-thirds of that is frozen. The illustration below offers a poignant visual insight as to the relative scarcity of fresh water. It shows the relative size of our water supply if it were all gathered together into a ball and superimposed on the globe. The larger ball represents all water (oceans, icecaps, glaciers, lakes, rivers, groundwater and water in the atmosphere. The smaller ball is the fresh water in the ground and in lakes, rivers etc. If you look real close you can see a tiny third ball which represents the fresh water in lakes and rivers. Two of the mightiest rivers on earth the Yellow River in China and the Colorado in the U.S and Mexico have been so depleted by cities, factories and farms that they barely reach the sea, as they have done for eons. This is a global problem.
Illustration 65 - Talk about scarcity

Source: USGS, globe illustration by J. Cook, Woods Hole Oceanographic Institution, A. Nieman

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Agriculture & Fresh water The water story


It would appear that we can handle peak oil - we find new supplies or new ways to get to marginal supplies and we develop alternatives it would appear that by the time we run out of financially viable oil supplies we will already have shifted to something else. But peak water is a different story. There are no new resources this really is a finite resource. With a problem of this magnitude, there is no such thing as a comprehensive solution. Instead, it will have to be addressed by chipping away at the problem in a number of ways, a process we have only just begun. With much water not located near our population centres, transportation will have to be a major part of the solution. With oil and gas, a complex system of pipelines, tankers and trucking fleets has been erected, because it has been profitable to do so. These commodities have a high intrinsic value. Water doesnt or at least it has not in most of the modern eras developed economies and thus delivery has been left almost entirely to gravity. Further, construction of pipelines for water that does not flow naturally means taking a vital resource from someone and giving it to someone else, a highly charged political and social issue. Conservation measures may help too at least in the developed world, though the typical lawn-watering restrictions will hardly make a dent. Real conservation will have to come from curtailing industrial uses like farming and oil extraction. Our primary inputs are increasingly interlinked as the illustration below shows.

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Agriculture & Fresh water An interlinked world


Illustration 66 - Our energy, agricultural and fresh water needs are interlinked

Source: Bain Macro Trends Group, 2011

However these are simply bandage solutions that can only forestall the inevitable without other advances to address the problems. Hopefully human innovation will again come up trumps after all it was wells and aqueducts that let civilization move inland from the riverbank, and irrigation that made communal farming scale, and sewers and pipes that turned villages into cities. Such innovation naturally represents a host of attractive investment opportunities. Given how much water we use today, there is little doubt that conservations sibling recycling is going to play a big role.

The porcelain project


Microfiltration systems are already very sophisticated and can produce recycled water that is near-distilled in quality. Large-scale production remains a challenge, as is the reluctance of people to drink something that was reclaimed from human waste or industrial runoff. Countries such as Yemen and Australia are already faced with difficult choices due to water scarcity. In South America several conflicts have erupted over water rights as the mining and farming industry competes with the local populations for freshwater supplies, and South America has more fresh water than any other region on earth, with 29% of the worlds reserves according to the United Nations Food & Agriculture Organization. The rub is that the water is not always where the best mineral or agricultural resources are located. Mines consume huge amounts of water to separate minerals from the rock. In Chile the worlds largest copper producer - it takes 28 litres of water to make 0.5 kilogram of copper.

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Agriculture & Fresh water Welcome to DESAL


Desalination is another potential game changer, in the Middle East desalinated water is often the core or at least half of the domestic supply and it has been widely used in the oil industry with Saudi ARAMCO leading the way for years. Again scaling it up at a quality suitable for human consumption in a cost efficient manner is the challenge. There has been significant changes in recent years with the official launch of the development of a large-scale desalination plant in Carlsbad, California, which will be the largest of its kind in the Western Hemisphere. When completed in 2016, the facility will create 54 million gallons of drinking water after drawing it from the salty Pacific Ocean. Posedion Resources Group who are behind the development also have plans for a similar size plant in Huntington Beach, California. When both are built, each will surpass in size the Tampa Bay reverse-osmosis desalination facility in Florida to become the largest seawater-purifying plant in the U.S. Desalination or in industry jargon; desal is not new, boiling seawater and collecting the condensate has been practiced by sailors for nearly two millennia. The same basic principle is employed today, although it has been refined into a procedure called multistage flash distillation in which the boiling is done at less than atmospheric pressure, thereby saving energy. This process accounts for 85% of all desalination worldwide. The remainder comes from reverse-osmosis which uses semi-permeable membranes and pressure to separate salts from water.

Solutions required - all hands on deck


Lockheed Martin Corp. the defence contractor better known for building jet fighters and lethal missiles recently discovered a way to slash the amount of energy needed to remove salt from seawater, potentially making it vastly cheaper to produce clean water. According to the engineer overseeing the project it will potentially provide a leap in the field of reverse-osmosis with the new filter being 500 times thinner than the best filter on the market today and a thousand times stronger resulting in giant energy savings. The new filter is called Perforene and work started in 2007 and it is due to be commercially available by 2015. Innovative solutions are being delivered which is of great importance as highlighted by a U.S. Intelligence report issued in 2012 which states; Between now and 2040, fresh water availability will not keep up with demand absent more effective management of water resources () Water problems will hinder the ability of key countries to produce food and generate electricity. We are faced with a great challenge and an equally great opportunity, an opportunity we can ill afford to pass or the words below of Mr. Ismail Serageldin of the World Bank will be realized; The wars of the 21st century will be fought over water.
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Our core investment themes

Energy The U.S. - Leader in the great energy transformation?


In our 2012 Annual Review & Outlook Report we discussed the strong developments in the U.S. energy sector and the benefits derived from a number of focused strategies especially in shale oil and gas and other innovative procedures to capture resources from unconventional sources. The alternative energy sector has also benefited with approximately $90 Billion being provided via various economic stimulus government funds during Obamas first term. He started his second term with a renewed focus on this sector and he announced the launch of a new initiative focused on continued research into alternative energy and the enhancement of U.S. energy resources. The U.S. seems to have grasped the opportunity represented by creating a viable and increasingly self-sufficient solution for the provision of increasing amounts of energy to meet demand at home and potentially abroad. The U.S. energy push has also represented itself in other places around the world with its traditional suppliers starting to feel the pinch from the new realities. Canada, Saudi Arabia, Mexico, Venezuela, Iraq and Nigeria The six biggest foreign suppliers to the U.S. of crude oil in 2012 all have to reassess their export strategies with Canada the currently most exposed due to a lack of alternative export channels and a need for an expansion of the current pipeline network to avoid bottlenecks. Europe must also be looking at the reality that U.S. households and business can increasingly access cheaper energy as the illustration below highlights. In a time where reviving, in some cases mortally wounded, economies is the political priority such a broad competitive advantage represents a major plus.

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Energy The clear benefits so far


Illustration 67 - Natural gas price divergence between US and Europe

Source: Bloomberg, SG

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Energy Driving towards a future of natural gas?


Illustration 68 - Cost for similar amounts of energy

Source: Bloomberg, SG

According to a study by Citigroup Inc. oil may reach a plateau worldwide by the end of the decade as cars, trucks, railroad engines and power plants increasingly use natural gas instead. As the illustration above highlights, U.S. prices for the fuels provide an economic incentive to make the switch. Crude oil is about four times more expensive than gas for a similar amount of energy, measured in British thermal units. The U.S. is already leading the way with others set to follow as gas becomes more plentiful and anti-pollution efforts intensify. China already has more than 40,000 trucks that run on liquefied gas and plans to put up thousands of service stations for these vehicles and passenger cars. In the U.S. a growing number of corporate and public-transport fleets use LNG or other forms of compressed natural gas. Canada, Russia and India are testing locomotives fueled by LNG. So is BNSF Railway Co., a unit of Warren Buffets Berkshire Hathaway, which said it would operate six LNG engines in 2013. Natural Gas may supplant oil as a fuel for generating electricity in the Middle East, India and Latin America. The shift may also be seen within international shipping and petrochemical companies. According to the report, greater fuel economy may combine with shifts towards gas to cause global demand to level off at about 91 million barrels a day. ExxonMobiles recent long term outlook also identified a trend towards natural gas, nuclear and the renewable segments as the illustrations below shows.

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Driving towards a future of natural gas? Changes in the global energy mix are under way
Illustration 69 - Significant changes underway

Source: ExxonMobile

Illustration 70 - The rise of natural gas

Source: ExxonMobile Note: *Wind and solar exclude costs for backup capacity & additional transmission

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Driving towards a future of natural gas? Changes in the global energy mix are under way
According to the same report, natural gas will be the fastest growing major fuel between now and 2040. The International Energy Agency (IEA) estimates that there is about 28,000 trillion cubic feet (TCF) of remainging natural gas resources across the globe. Experts believe this is enough natural gas to meet current demand levels for more than 200 years. Globally, unconventional gas makes up about 40% of the estimated remaining resources. In North America, unconventional production gas has a higher share accounting for about two-thirds as the illustration below highlights.
Illustration 71 - Abundant natural gas

Source: IEA, ExxonMobile

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Energy The LNG story


As natural gas gains favor over oil and coal because its cheaper and cleaner, nonOECD countries are expected to account for 80% of natural gas demand growth by 2035. The largest share of global gas demand comes from the power sector. China is set to double its LNG imports by 2015 as Beijing views gas as the foundation of its energy future over the next decade. Australia and Qatar will be the biggest suppliers of the current exporters. India is also set to double its regasification capacity by the end of 2015 as gas supplants liquid fuel demand. Global liquefaction capacity is set to to increase by 4.4% by 2015 and another 7.5% by 2020. The real potential game-changer will be if the U.S. moves to export its LNG with its fastly growing output capacity.
Illustration 72 - Cost for similar amounts of energy

Source: IEA, ExxonMobile

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The LNG story The future is floating


Liquefied natural gas (LNG) technology from LNG seaborne tankers and LNG trains to floating LNG facilities (FLNG) have quickly gone from concept to commercialization, opening up new possibilities and rendering the remote well, much less remote. Sector analysts say that FLNG terminals will become a major growth market within the next couple of years, as they offer more flexibility than stationary terminals. Liquefaction of natural gas is the process of super-cooling natural gas to minus 260 degrees Fahrenheit at which point it becomes much safer and easier to transport. After its been shipped to its destination, re-gasification plants at importing or receiving terminals return the fuel to a gaseous state. Floating LNG production, storage and offloading concepts are revolutionary because they have the ability to station a vessel directly over distant fields, removing the need for offshore pipelines and adding the advantage of mobility these floating facilities can be moved to a new location once existing fields are depleted. The advantages are comparable to the ones we discussed in last editions chapter on the Arctic and investment opportunities are again represented in the innovative, production and services segments. Floating liquefaction technology can bring additional LNG supply by accessing stranded gas reserves that were previously thought to be too remote, small or otherwise challenging for conventional land-based LNG development. More specifically, the advantages include: -Fast-track re-gasification for new LNG importers. -Lower upfront capital investment compared to onshore facilities. -Rising expense of onshore projects improves the cost differential in favor of FLNG. -Mobility/potential relocation to new fields. -Overcoming restrictions due to limited land availability. There are 10 existing Floating Storage and Re-gasification projects and an additional 8 under construction plus at least 30 other potential projects on the drawing board around the globe. Shell, Mobil and Statoil are developing large-scale FLNG projects in Australia, Nigeria and Namibia.

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The LNG story Shell Game - Forward thinking or boys with toys?
Shells most prized LNG project is its Prelude Floating Liquefied Natural Gas (FLNG) Project in Australia, which is moored some 200 kilometers out to sea and will produce gas from offshore fields and liquefy it onboard. The LNG, LPG and condensate produced will be stored in tanks in the hull of the facility. LNG and LPG carriers will moor alongside to offload the products. This vessel (See image below) will be six times bigger than the biggest aircraft carrier and will cost between $10.8 and $12.6 billion to build but it also means that Shell wont have to pay rising prices at Australias onshore LNG plants. The facility will produce about 3.6 million metric tons of LNG and 1.3 million tons of gas condensate a year. Shell furthermore holds an advantage as it has its own fleet of LNG tanker vessels so it does not incur the same processing and shipping costs. The cost of an LNG tanker more than doubled from 2010 to 2011. Shell is also gearing up for LNG exports from its North American terminal in Kitimat (British Columbia). Shell is also developing ideas for an LNG terminal in India, which would be the countrys first, and would handle LNG Imports from their Australian operations. Beyond Shell one can also look to some of the smaller independent owners and operators of LNG carriers. The field is driven by innovation and as such innovative companies who target this segment and can develop and scale their solutions represents an appealing proposition.
Illustration 73 - Mobile turn-key solution in LNG Shells flagship project

Source: Shell

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Our Summary

Continuing from our core observations from 2012, we have explored the challenges facing the two archipelagos on either side of Mr. Halford Mackinders EuroAsian heartland Japan and the UK. Plus we have added up the sum of the five key cogs of the euro-zone along with a broad overview of the U.S. and The Rest and the conclusions have to be that we are no where near a situation were the pieces of the sustainability puzzle are matching up. The worlds central banks have again been doing their outmost to extend some short-term protection to the global economy and its financial conduits but elected and unelected officials around the world appear unable to produce real solutions that are based on long-term sustainable foundations. The Q.E. medicine can only cover the realities for so long as it is not a cure but simply a local anesthetic which can dull the pain for a while. With Kuroda in place in the Abenomics team and Carney the Canadian not quite Conan the Barbarian - but the first foreigner to take charge of the Old lady of Threadneedle Street - the next couple of years should be interesting to observe unless you are sitting long these currencies. Will the German choice be to let Super Mario go to the next level or will he be stuck in the mud? Several of the emerging markets are still candidates for a hard landing and geopolitical stresses are increasing around the globe with resulting unpredictability and potential for dramatic paradigm changes. We recommend that you prepare for a storm, as to the old Chinese proverb; When the wind of change blows, some seek shelter others build windmills. We suggest that you do both.

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Librarium Associates About


Librarium Associates Ltd. is an independent research company focusing on global macro and geopolitical monitoring and analysis. We are committed to delivering distinctive insights on global trends enabling our partners and clients to make informed decisions in a changeable world. We offer global accredited investors such as asset managers, family offices and institutional investors with quarterly and annual publications providing an independent overview of global macro economic and geopolitical events and their implications on the world of investing. We also provide intra-monthly event driven insights as a part of our constant horizon scanning services. Our services can also be employed on a retained basis, providing the client direct & always confidential access to our team on an on-going basis allowing us to act as an independent sounding board for our clients ventures. Furthermore, we can also produce exclusive client commissioned stand-alone reports across a number of broad areas. We prefer to work with a relatively small and select group of active clients allowing us to provide them and their projects with our full attention and as such we operate a limited amount of such partnerships.

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Librarium Associates Disclaimer


The views expressed are opinions or our team through the period ending April 2013 and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and/or investment. The report includes forward looking statements. There can be no guarantee that any forward looking statements will be realized. Librarium Associates Ltd. undertakes no obligation to publicly update forward looking statements, whether as a result of new information, future events or otherwise. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that the investment strategies mentioned will work under all market conditions and each investor should evaluate the suitability of their investments for the long term and the compatibility of the ideas mentioned in this report with their existing investments and their investor profile. All Rights Reserved.

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