THE AMPHORA REPORT

Vol 1/15, 1 December 2010 www.amphora-alpha.com

IN THIS EDITION

A CAPITAL PARADOX
Capital means different things to different people in different contexts. Homeowners think of capital as their net savings. Investors think of it as funds available to invest. Financial risk managers think of it as the maximum loss that can be sustained. But what, exactly, do these savings, investible funds and risks represent? Ultimately, all financial wealth represents some sort of claim on some real, productive asset. In aggregate, these real assets are a claim on the capital stock of the entire economy, that is, total current and future productive potential. Yet many economists, including the current Chairman of the US Federal Reserve, seem to think that, as paper wealth increases, so does economic growth when, in fact, trying to grow an economy by inflating paper wealth actually destroys the capital stock! The result: A lower standard of living.

2010 THEMES IN REVIEW

This edition of the Amphora Report marks the end of our first year of publication. We take this opportunity to review the topics we have covered to date and how our thinking on these has evolved in recent months. We believe most topics remain relevant for 2011 and possibly beyond.
A CAPITAL PARADOX What, exactly, is economic capital? It is the productive potential of the economy, the ability to make things that people need and want to consume. But unlike paper, capital does not grow on trees. Capital itself must first be produced, in the form of capital goods. Let s start from the beginning: We all need to consume food. Few of us produce our own. So we need to purchase food with our earnings. When we go to the supermarket and purchase a trolley of food, we are purchasing the output of a mind-bogglingly complex productive process. To highlight just a few aspects of this, consider: Arable land requires regular attention to remain productive, including irrigation, soil and fertiliser treatments; Irrigation is only partially provided by natural rainfall and drainage. An increasing portion is provided by some mechanical means, eg wells, pumps, aqueducts, desalinisation, etc; Soil and fertiliser treatments are overwhelmingly produced in factories requiring substantial energy input; Farm machinery must also be produced in factories and properly maintained thereafter; Wells, pumps, aqueducts, desalination plants, fertiliser and farm machinery factories themselves dont just exist; they too need to be manufactured and, thereafter, regularly maintained with suitable equipment, which must itself be manufactured

and maintained with suitable equipment, and so on. Now why would someone go to the trouble of manufacturing suitable equipment for making suitable equipment for maintaining a factory which is full of suitable equipment for producing fertiliser, which is then packaged and transported using suitable logistical equipment requiring regular maintenance using suitable equipment to a farm when it is loaded on to a tractor (requiring regular maintenance using suitable equipment), which was manufactured in a factory full of suitable equipment which was itself manufactured in another factory full of suitable equipment... ? Well, as with all economic activity, someone must believe that they will make a fair profit by engaging in some aspect of this process above, or else they wouldn t do so. But do you see the complexity? How on earth can anyone just sit back, survey all these various stages of production and possibly know how each and every step should work, much less what sort of profit should be expected? Well, no one can. (This is one intuitive way of understanding why command economies are horribly inefficient, even assuming that everyone is competent, is trying their best and no one is corrupt, three assumptions that are at odds with historical experience and, as such, highly suspect.) But if no one understands how this process works, then how does it work at all? Simple: The division of labour. At every stage of every productive process, either within a firm or between firms, there is

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always someone to perform each specific task. As long as those participating continue to believe that they receive fair compensation for their contribution, they will continue to work accordingly, doing their part to make a highly complex productive process a sustainable reality. Now that we understand how complicated economic production is in a modern economy, even for something as basic as foodstuffs, let s consider how the capital stock comes into existence in the first place. Even though no one can conceive of each and every detail in a highly complex production chain as that described above, nevertheless there are people who are willing to step up where they think they see an opportunity and invest their savings in capital goods of some kind, from which they are reasonably confident they will earn a respectable return. So the capital stock originates in savings. No savings, no growth in the capital stock. Once created, however, the capital stock needs to be maintained. All real capital depreciates, be it buildings, factories, machines, roads, vehicles, refineries, electrical grids and power plants, even, as in our example above, arable land. Without maintenance, the capital stock will eventually depreciate to the point where it is no longer able to perform the functions for which it was originally intended. Beyond that point, it is a write off, either to be abandoned, sold for scrap or otherwise recycled. Now why is this important? Consider: The larger the capital stock, the higher the productive capacity of the economy. As such, we should all have an interest in growing the capital stock over time. Yet the larger the capital stock, the greater the potential depreciation and therefore the greater the maintenance required to prevent it. Who is going to provide this maintenance? In much the same way as capital comes into existence in the first place, someone is going to come along who believes that they can make a reasonable profit by using their savings to provide maintenance on the existing capital stock. So the maintenance also originates in savings, without which the capital stock will depreciate, eventually to the point of becoming unproductive. Intuitively, of course, we know this is correct. Building a home costs money. Maintaining the home once built costs money. If we spend all our income on day-to-day consumption of food and clothing, rather than saving up for occasional home maintenance, the home will depreciate to the point of being rendered uninhabitable. Returning to the economy, both creating and maintaining a capital stock requires savings. Now what happens if there IS no savings? What if, for example, the financial assets which are claims on the present and future productive value of the capital stocknet of depreciation of course rise in value to the point that the holders thereof feel themselves richer and neglect to save? What if, for whatever

reason, the central bank holds interest rates artificially low, such that there is little incentive to save? What if, in response to an unusually prolonged slump in economic activity, the central bank starts directly and artificially propping up asset prices by buying securities, thereby making it even less attractive to save? Well, guess what? Amidst artificial disincentives to save and asset price distortions that make people feel richer, what, exactly, is going to happen to the capital stock? IT IS GOING TO DEPRECIATE, LOWERING THE POTENTIAL ECONOMIC GROWTH RATE! And what if this state of affairs lasts for years? THE CAPITAL STOCK IS GOING TO DEPRECIATE DRAMATICALLY, TO THE POINT WHERE MUCH OF IT BECOMES A WRITE-OFF, LOWERING THE STANDARD OF LIVING! Don t be fooled into thinking that the capital stock is unlimited. It is anything but. It is the most highly leveraged, most sensitive, most easily distorted part of the economy. The slightest changes in interest rates, in taxes, in regulations, in perceptions and confidence can have a huge impact, over time, on the size, structure and health of the capital stock. And as it is strictly limited to functioning, economically viable capital goods, the more these are used by the government, the less they are available for private sector uses. So-called crowding out of capital is not just a financial theory; it is a harsh economic reality. For each dollar in savings that the government takes for itself to fund its deficit it is taking one dollar away at present pricesfrom private savings. And if the government then uses that dollar to bail out insolvent financial enterprises or to fund consumptionsay to provide entitlement benefits of some kindrather than for investment, then the government is contributing directly, not just indirectly, to the depreciation of the capital stock. Don t be surprised when you look around and see the crumbling infrastructure. With asset prices artificially high, discouraging investment, and the return on savings artificially low, discouraging savings, there is naturally little in the way of resources available to maintain the existing capital stock, much less expand it. And don t be fooled into thinking that somehow higher taxes would help. Is the private sector going to save more, or less, if the tax burden rises? The answer to that is obvious. No, there are only two ways in which the existing capital stock can be properly maintained: With either a higher private savings rate, presumably a result of higher after-tax interest rates; or, alternatively, for the government to redirect existing entitlement spending consumptiontoward infrastructure instead. Finally, although asset prices can rise indefinitely and infinitely in nominal termsfor example if the purchasing power of the currency is constantly and exponentially decliningthey can only rise sustainably in real terms if the underlying economic value of the capital stock continues to grow. In a great paradox,

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the policies which the Fed has implemented to artificially prop up asset prices and stimulate economic activity are, in fact, contributing directly to a reduction in savings; to an accelerating depreciation of the capital stock; to a decline in the potential growth rate; and, ultimately, to a reduction in the standard of living. That is the unseen cost of propping up failed financial institutions and preventing a natural, salutary reorganisation and rebuilding of the capital stock.

The Fed has not merely demonstrated that it is incompetent as the chief financial regulator and that it is increasingly pathological in its pursuit of inflation at all costs. It is destroying, by stealth, the nation s capital stock, its real wealth. When the smoke clears, the pile of rubble which once was arguably the greatest ever accumulation of capital in world history will be reflected in crumbling real financial asset values. Now, do you want to be holding those assets, or something else entirely?

2010 THEMES IN REVIEW

In the prior 14 editions of the Amphora Report this year we have covered nearly 30 topics, many of which overlap in some way. What binds them all into a coherent set is our view that the economic policies being implemented in nearly all major countries are not just unsustainable but in some cases outright reckless. These countries include the US, the issuer of the world s reserve currency. By implication, the FROM DARTH TO CZAR VOLCKER? VOL 1/1 Imagine that, as in 1979, Paul Volcker is tasked with restoring global confidence in the US dollar and economy generally. We believe that, notwithstanding the best of intensions, it is unrealistic to expect that Mr Volcker, or anyone else for that matter, could possibly succeed at preventing a dramatic relative economic decline of the US in the coming years. To do so would require fundamental economic reform of vast scope, far beyond what anyone in Washington, DC is willing to seriously consider or debate. Our thinking on this topic has not changed one bit. If anything, our conclusions seem largely vindicated by recent developments in Washington, including the growing lack of fiscal discipline IS MONEY A STORE OF VALUE? VOL 1/2 We generally take it for granted that cash in a government-guaranteed bank deposit account is a risk-free store of value. But is it? The fact is that the dollar, and all fiat currencies for that matter, tend to lose purchasing power over time, occasionally abruptly in a sharp decline or, even worse, in a hyperinflation. Given current global economic conditions, we believe that investors should be particularly wary of currencies as stores of value and should seek ways to preserve wealth outside of cash. dollar is likely to lose its pre-eminent reserve currency status in the coming years. The result is bound to be a period of global economic and financial market turmoil and, for most if not all traditional financial assets, underperformance in real, purchasing-power adjusted terms. What follows below is a list of all topics, including both a brief summary and an update of our thinking for 2011.

demonstrated by the extension of tax cuts and unemployment benefits. There is no serious talk of fundamental economic reform, even following the elections, in which deficit reduction was an important topic. Meanwhile, the Fed has embarked on an increasingly radical monetary course which does nothing to restore confidence in the dollar. The outperformance this year of emerging market economies, many of which are investing heavily in infrastructure and other capital stock, is a clear demonstration of relative US decline. We would expect this outperformance to continue in 2011 although it might well be less pronounced.

It is not surprising that, as policymakers have resorted to ever more desperate means to get their economies going, currencies in general have declined in value relative to commodities this year, including the historical cash substitutes, the precious metals. We are confident that this trend of rising commodities prices, not just in dollars but in most currencies, is going to continue in 2011, although quite possibly at a slower pace than in recent months, in the event that the global economy slows somewhat, as we expect.

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HOW MUCH FREE LUNCH WOULD YOU LIKE, SIR? VOL 1/2 As diversification is rightly considered to be the only free-lunch in economics, in this topic we explore how, in a world of both low interest rates and high uncertainty, investors should be inclined to seek rather more diversification than would ordinarily be the case. However, as financial assets are increasingly highly correlated with each othera consequence of artificial monetary stimulus diversification through financial assets alone is unusually limited. As such, investors should consider increasing their allocations to alternative investments, including liquid commodities. THE REAL LESSON OF THE GREEK DEBT CRISIS | VOL 1/2 Greece now finds itself under attack from the financial markets and unable to refinance its debt. We believe that Germany and France will not come to Greeces rescue absent a dramatic fiscal consolidation. While Greece is certainly trying to reduce its deficit, success is far from assured and some sort of debt restructuring is probably inevitable. In any case, the Greek crisis has kicked off a round of general euro-area fiscal consolidation. This demonstrates that the euro-area can respond positively to market pressures. In time, this could be supportive of the euro. The sovereign debt crisis that began in Greece earlier this year has spread to Ireland, Portugal and Spain. In all four countries, governments are desperately trying to reduce deficits in return for financial assistance from France and Germany and also temporary funding support from the European Central Bank (ECB). Interestingly, however, notwithstanding the ongoing and widening crisis, the FINANCIAL CRISES AND NEWTONS THIRD LAW | VOL 1/3 Policymakers tend to react to financial crises in ways that contribute to an even greater crisis down the road. Indeed, the reactions of policymakers and regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, thereby ensuring that future crises become progressively more severe. If you are stuck in a hole, so the old saw goes, you had better first stop digging. Well try telling that to the US government, which has just decided to accelerate the ongoing deterioration in its finances

Commodities have outperformed this year, most probably for a variety of reasons. There were some supply issues at times, in particular with grains and certain other agricultural commodities, but the strength was in fact quite broad-based and demonstrates both good demand from the more dynamic emerging markets but also, importantly, that global inflationary pressures are rising. While 2011 may not be as good a year for commodities as 2010 in part because there are signs that emerging market demand is now coolingwe nevertheless expect investors to continue to seek diversification in alternative assets.

EUR/USD exchange rate, at 1.32 today, is essentially at the same level it was when the crisis broke in April this year. While we are not particularly optimistic for the economic future of the euro-area which, absent Germany and a few other pockets of regional strength, does not have a great deal going for it, we nevertheless think it is important to make a fair comparison between the euro-area and the US. This requires investors to look at the overall US fiscal situation, which continues to deteriorate amidst federal tax cut and unemployment benefit extensions. But dont forget the brewing debt crisis in state and local governments either. California, New York and Illinois are all at risk and collectively are of comparable economic size to the entire euro-area periphery. Indeed, the US economy in aggregate, when evaluated according to the size of the public sector, the overall tax base and fiscal and current account balances, bears a far greater similarity to the euro-area periphery than to the core.

with a broad tax cut extension as well as extended unemployment benefits. Meanwhile, the Fed has embarked on another round of monetary expansion. This is yet another example of policymakers contributing to an even greater crisis down the road. Rather than get out of the way and let the economy restructure and rebuild in a natural, undistorted fashion by allowing asset prices to adjust lower to more sustainable levels and banks and corporations to be sensibly downsized and, where necessary, restructured, policymakers continue to dig an ever deeper hole, the legacy of multiple asset bubbles and busts.

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WHY FINANCIAL GENIUS FAILS | VOL 1/3 Believe it or not, well prior to the great financial crisis of 2008, it was widely known among the educated financial elite that the standard risk management models and methods used by the major banks were woefully inadequate, with the consequence of systematically underestimating risk. But rather than take appropriate action to protect their firms with sensible risk management policies, senior executives chose instead to focus on short-term profitability: A healthy balance sheet became of secondary importance to a healthy income statement which, of course, justified healthy bonuses. Much has been written this year about how the risk management culture on Wall Street was a key ingredient to the crisis of 2008. It is increasingly clear that most if not all financial executives were aware of IS CHINA BEING TAKEN FOR A RIDE? VOL 1/4 Back in the spring we noticed that inflation rates were picking up just about everywhere, including in China. However, as China is a huge importer of raw materials, rising global commodities prices implied that Chinese inflation was likely to increase further. As much of China is still a subsistence economy, food price inflation would most likely turn into wage inflation, which in turn would push up prices for Chinese manufactured goods generally and possibly lead China to revalue its currency versus the dollar. Eventually, as the US imports a huge amount from China, this would also push up prices in the US. Chinese inflation has continued to rise all year. The spike in food prices over the summer has played HOW WOULD EINSTEIN VALUE FINANCIAL ASSETS? VOL 1/5 With this brief topic we presented the idea that assets can only be valued relative to other assets, rather than in absolute terms, as things only have an identifiable, quantifiable value if they are exchanged for something else. All other measures of value are ultimately subjective to the individual rather than objective in the marketplace. Einstein showed that the speed of light was the only constant against the universe against which all else could be measured. In financial markets, the only constant is the time value of money, as represented by the term structure of interest rates. If a central bank sets interest rates at an artificial level, asset prices will become distorted and resources misallocated, with potentially severe economic consequences.

the risks they were taking but were unwilling to confront the short-term, bonus-driven culture which had come to dominate a once conservative, partnership-based industry. Now that the industry has been bailed out and has returned to profitabilityat least for a brief timeanother important lesson has been learned: The more risks you take, the better, as policymakers will see to it that in the event of yet another crisis, the taxpayer comes to the rescue. Events this year have done nothing in our opinion to change this. Those firms already too big to fail in 2008 are now even bigger. The moral hazard of the system has grown. The seeds of the next crisis have been sown. Recent developments in Ireland should serve as an example of what happens to a country that underwrites the risks of its financial sector.

a part, to be sure, but the underlying pressures were already in place. Additional fiscal and monetary stimulus in the US is most probably going to contribute to still more inflationary pressure in China and other more dynamic economies around the world. Indeed, China is just one of many countries which is now taking action to cool growth and keep prices under control. China and India have both recently raised interest rates. Brazil and South Korea are taxing foreign capital flows. These trends are likely to continue in 2011 and will contribute to stagflationary conditions in the US.

While highly theoretical, this topic becomes more relevant as the US Fed becomes increasingly desperate in its desire to stimulate economic activity. Previously considered a fringe view, it is now widely believed that US financial asset prices are distorted in some way by Fed policy actions. Indeed, in a recent op-ed published in the Washington Post, Fed Chairman Bernanke made explicit that monetary stimulus was likely to support the stock market which, in turn, was likely to stimulate economic activity. But if asset prices are distorted, are resources being misallocated? We believe so. These misallocations will only increase in 2011 as more and more artificially stimulus is thrown at the economy.

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THE ASSET-PRICING IMPLICATIONS OF THE GREAT BAILOUT | VOL 1/5 Moving from theory and into practice, we investigate in detail just how we believe asset prices are being distorted by various forms of economic stimulus. In general, we find that the assets for which values are most likely distorted to the upside are those with relatively uncertain and long-dated cash flows. Investors should therefore be underweight growth vs. value assets and underweight nominal vs. real assets. In this regard, investors should be particularly concerned about recent developments in euro-area and US state and municipal debt markets. Since we wrote this edition, asset prices in general have risen in value, with the exception of the No. The great financial crisis of 2008 never ended. It merely changed form. When public authorities stepped in to prevent a further deleveraging of the financial system, they explicitly or implicitly assumed responsibility for much of the debt that was collapsing in value. In doing so, they issued more of their own and also raised expectations for future issuance. It is obvious that this is unsustainable. No realistic real growth assumption would allow this debt to be paid pack at its present value. These debts are going to be devalued either by inflation or some form of default. Where others observe a series of separate crises, ranging from US subprime mortgage debt to euroarea sovereign debt, we see a continuum. The REAR-VIEW MIRROR MYOPIA | VOL 1/6 The dramatic rise in the price of gold in recent years finally began to receive attention in the mainstream financial press in 2010. But rather than analyse the fundamental reasons behind this trend, much commentary has suggested that gold may now be in a bubble. When looking at the past 20 years or so, gold does look expensive when compared to financial assets. But given that the risks of a general global sovereign debt and fiat currency crisis are without doubt the highest they have been for many decades, to focus only on the past 20 years is to demonstrate severe rear-view mirror myopia. Gold continues to feature as a popular topic in the mainstream financial press, although it still receives far less attention than traditional financial assets.

sovereign and US state and municipal debt markets, where prices are generally lower, in some cases dramatically so. Also, real assets such as commodities have outperformed nominal quite substantially in the second half of the year. As recent moves to add additional stimulus to the US economy are likely to reinforce existing distortions in asset prices, we expect these trends, in general, to continue in 2011, although probably at a more gradual rate following the rather dramatic developments in recent months.

financial risk of bad lending decisions, once originated in the form of debt, has never left the system but rather has moved from place to place. Ireland is a clear example of this, as back when the banks were at risk of failure, the government stepped in and guaranteed not just deposits but the complete liabilities of its entire banking system. It may have taken a number of months but the financial markets finally figured out that the debt was still there, only in sovereign form. This sort of debt shell game is being played over much of the world and will not end until there is a proper deleveraging of the global financial system, through some combination of debt default and currency devaluation. We have a long way to go yet.

Certainly the rally in gold has gone a long way and a growing number of investors have no doubt acquired some position in the metal, either as physical bullion or via ETFs, futures, or other forms of paper gold. But let s put this in perspective: According to the World Gold Council, the total value of investment gold is only some 2% of the total value of global financial assets, far below historical averages. Yet central banks continue to expand their balance sheets, aggressively in the case of the US Fed, and sovereign debt crises are spreading. The risks of devaluation and/or default continue to increase. In this context, we expect the gold price to continue to rise in 2011, not only in dollar terms but also in that of most global currencies.

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IS GOLD ALL THAT GLITTERS? VOL 1/6 Notwithstanding the view above, that the gold price is likely to continue to rise in 2011, this does not imply that gold is going to outperform all other real assets. Indeed, in 2010, up about 30%, gold was far from the top performer. Silver rose by around twice as much, as did coffee. Cotton doubled in value. Certain rare earth minerals multiplied their value several times over. While we would not presume to debate anyone touting the wealth-preserving properties of gold through the ages, it stands to basic economic reason that diversification should always play a prominent THE BENCHMARK IS IN THE EYE OF THE BEHOLDER |VOL 1/7 How do we measure wealth? In some unit of account. Money is meant to function, among other things, as a unit of account, the denominator for any given asset value. But if the purchasing power of a currency is unstable, either due to inflation or deflation, this distorts the way in which real wealth is measured. For example, if your benchmark unit of account is the Zimbabwe dollar, you have made outrageous profits during the past few years almost regardless of your choice of investment. Investment idiots are made to look like geniuses if measured against a chronically devaluing benchmark. As such, it is important for serious WHEN IS A RISING STOCK MARKET ACTUALLY FALLING? VOL 1/7 In domestic currency terms, the Zimbabwe stock market was a fantastic investment over the past decade. In some years it rose more than tenfold in value. In particularly good months it rose by several hundreds of percent. No major stock market performed in such spectacular fashion during this time. But this was not due to positive economic developments in Zimbabwe. On the contrary, it was reflective of the severe hyperinflation that was taking place. This topic is really just a corollary to that above. Yes, most stock markets have risen this year in dollar

role in any defensive investment strategy. 2010 provides ample evidence of this. At times gold was the outperformer amongst commodities, yet during the summer agricultural commodities were the top performers and, beginning in September, silver began to surge. There are no doubt those out there who think they are able to pick the best asset at any point in time but we are of the opinion that holding a broad, well-diversified portfolio of liquid commodities is a better answer to the dilemma posed by global debt default and devaluation risks. As we enter 2011, nothing has changed our thinking in this regard.

investors to choose a benchmark which is not and can not be deliberately devalued. Well, now that the Fed is purchasing Treasuries in an attempt to prop up assets and also to place downward pressure on the dollar, is the dollar a sensible benchmark? Should investors measure their wealth and performance in dollars or in some other unit of account? We believe that the answers to these questions have become increasingly obvious as this year has progressed. The dollar is no longer an appropriate benchmark. We expect others to come to a similar conclusion in 2011.

terms. But if the dollar is no longer a sensible benchmark, what does this really tell us? Did stock markets perform well or not? Did they rise in terms of purchasing power? Stock markets do appear to have risen with respect to price inflation, which will give comfort to some. But then valuations don t look as attractive as before. In any case, looking forward into 2011, we suggest that investors consider measuring their performance in ways that reference more stable benchmarks than the dollar.

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THE REAL ECONOMIC HORROR SHOW | VOL 1/7 As it becomes increasingly evident that the US economic recovery is not self-sustaining, but rather is going to require additional stimulus at some point, we explore what this implies for the future. One key implication is that, as the public sector is growing rapidly relative to the private, that the tax base is shrinking even as the government debt burden increases. This implies a lower future potential growth rate and lower standard of living. Curiously, given its free market traditions, the US is bucking a global trend toward fiscal austerity, as demonstrated by recent policy actions elsewhere. It had already become clear by mid-summer that various countries, notably the UK and Germany, were increasingly opposed to using fiscal expansion to fight the deleveraging in credit markets and associated economic weakness. In other countries, THE NEW CONUNDRUM OF LOW TREASURY YIELDS | VOL 1/7 It remains our view that the US is headed for some sort of debt crisis during the coming 1-2 years. But if we are alone in this view, why arent Treasury bond yields higher if the deficit is about to explode on the upside? The answer to this apparent conundrum is surprisingly straightforward: supply and demand. Yes, Treasury supply is going up, but so is demand. We look at who buys Treasury securities and why, and we find that a substantial portion of the market is held by non-discretionary buyers, including of course central banks and, with QE2 underway, the Fed itself. Moreover, the Fed can frighten speculators into refraining from shorting Treasuries with credible threats to purchase more as yields rise. The recent spike in Treasury yields may be an indication that investors are beginning to price in some combination of higher US deficits and inflation THERE MAY BE NO FREE LUNCH, BUT IS THERE A MAGIC WAND? VOL 1/8 While common sense informs us that you cant get something for nothing, policymakers frequently speak and act as if there is not only a free lunch, but that they possess a magic wand that can reduce and/or eliminate economic and financial risk. It is reassuring to think so but contemporary developments suggest otherwise. Among other developments, the various euroarea sovereign debt crises demonstrate that policymakers do not have a magic wand to make

including Greece and Ireland, debt crises had already forced governments hands toward dramatic fiscal tightening. It is true that, around that time, the work of the bipartisan US deficit panel was well underway, with the understanding that President Obama would most probably consider implementing at least a few of the recommendations. Well, in the event, not a single one of the recommendations has received serious consideration in Washington. Instead, the US has chosen to implement even more aggressive fiscal stimulus by extending both tax cuts and unemployment benefits. As such, even though growth in 2011 may be artificially supported, this is merely going to draw growth away from the future, at increasing cost. Indeed, with Treasury yields having spiked a full percentage point in recent weeks, interest expense is already rising.

in future. Nevertheless, yields still remain extremely low in a historical comparison, in part because so many Treasury investors are essentially nondiscretionary and will buy comparable amounts at any price absent fundamental changes in their mandates. We doubt that this is the beginning of an adjustment in US Treasury yields higher to more normal levels, as we think the Fed will soon grow concerned that a higher level of yields will quickly derail the weak economic recovery. Of course, were the economy fundamentally healthy, the Fed would feel otherwise, but the recent decisions to launch QE2 and also extend tax breaks and unemployment benefits demonstrate that the US economy remains in a perilous situation that will only become more so as Treasury yields rise.

financial risks disappear and that attempts to do so, such as in Ireland for example, can have severe, unintended consequences. We are likely to see more attempts at using accounting tricks or other smoke and mirrors to disguise the true nature and scale of the debt problem in 2011. But investors will eventually see through such deception and the results will be sudden and, for those who disagree with our thinking in this regard, unexpected.

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IS THE FED BECOMING PATHOLOGICAL? VOL 1/8 Bernankes recent speech at the Kansas City Feds annual Jackson Hole Symposium indicates that, as the US economy weakens again, the Fed is likely to consider increasingly radical means to provide additional monetary stimulus. A recent editorial by Bernankes friend and former colleague, Alan Blinder, indicates what Mr Bernanke may be planning for the future. The Feds chronic inability to address the negative, unintended consequences of past and possible future actions suggests that US monetary policy is becoming increasingly pathological. The Jackson Hole Symposium and other such Fed policy forums used to be the primary way in which the Fed communicated its strategic thinking on monetary policy to a wider audience. No longer. Fighting an increasingly poor public image, the Fed now goes straight to the public. Recently, Chairman Bernanke published an op-ed in the Washington Post and has also been interviewed on the popular news IS THE GERMAN EAGLE A GREY SWAN? VOL 1/9 While the several sovereign debt crises in the euroarea have taken markets largely by surprisethus leading them to be labeled as unforecastable, Black Swan eventswe see a potentially much greater risk ahead, that Germany, at some point, will reconsider its commitment to the bail-out framework agreed with other EU states in May. If so, the crises to date are likely to escalate and spread into additional euro-area countries, causing a general, global credit crisis perhaps as large as that catalysed by the Lehman Brothers bankruptcy in Q4 2008. As financial markets bid up the financing costs of one weak euro-area sovereign after another, we see DIVERSIFICATION IN A WORLD OF DEFAULT AND DEVALUATION | VOL 1/9 With all financial assets ultimately containing some risk of bankruptcy or default, however remote, and with currencies in general no longer providing reliable stores of value in a world of weak financial systems and deteriorating government finances, diversification benefits across global financial assets are at historic lows. Maintaining portfolio diversification in these conditions requires investors to increase their holdings of alternative assets, in particular commodities, which by nature cannot default. The reasoning above may seem obvious to some, but to many, commodities are, by their very nature, speculative investments. We accept that they are

programme, 60 Minutes. In both cases, he has been attempting to explain the Fed s recent decision to purchase some $600bn of Treasuries in the coming months which, perhaps just incidentally, roughly corresponds to the amount of new Treasury issuance expected during the period. Bernanke denies that this is equivalent to printing moneyalthough that is really a matter of semanticsand also claims that this policy will reduce borrowing costs, stimulate investment, prop up the stock market and increase both economic activity and employment. He may be right for a time, but at what cost? A sharply weaker dollar? Sharply higher price inflation? Another asset bubble which ends in other bust, resulting perhaps in another bailout for Wall Street at taxpayer expense? With reckless disregard for the growing costs of everexpanding monetary stimulus, we see ample evidence today that the Fed has become pathological.

growing frustration in Germany. The bailout arrangements hastily arranged earlier this year are subject to renegotiation. Indeed, many commentators in Germany think that the existing arrangements are not only not in Germany s interest but are blatantly unconstitutional. While we believe that European Monetary Union (EMU) is going to continue in some form, as we enter 2011 we believe it is increasingly likely that much existing euro-area sovereign debt is going to be restructured in some way and that member countries will continue to follow tight fiscal policies. In time, this should be positive for the euro.

subject to occasionally highly volatile price swings from time to time. But these swings are not driven by changing perceptions of credit risk. When all manner of financial assets, not only equities but also supposedly investment-grade corporate bonds and even sovereign bonds are at growing risk of default or currency devaluation, then investors need to look elsewhere for an alternative. Looking forward to 2011, as long as governments and central banks continue to resist the natural credit risk deleveraging process, a sensibly diversified basket of liquid commodities should continue to outperform a traditional portfolio of financial assets.

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BEGUN, THE CURRENCY WARS HAVE | VOL 1/10 For years, the US has been pressuring China to allow its currency to appreciate. But Japans unilateral intervention in the foreign exchange market in September represents the opening of a new front in an escalating global currency war. Indeed, this event may be the trigger which sets off a series of similar actions elsewhere. Past episodes of global currency devaluation, such as in the 1970s and 1930s, have always led to increases in global commodity prices, even amidst relatively weak economic growth. Many financial commentators now refer to a currency war being underway between the US and WHEN ONLY A MUCH WEAKER DOLLAR WILL DO | VOL 1/10 Absent widespread asset price deflation and debt restructuring that would be resisted at all costs by the US Fed and Treasury, the US economy can only return to sustainable growth when incomes catch up to existing asset prices. This requires substantial wage inflation. Amidst structurally high unemployment, the only way to generate wage inflation is via a weaker dollar, implying higher commodity prices. But how far would the dollar need to fall to push wages up by enough to bring incomes into line with current asset prices? While still an immensely wealthy country by any reasonable measure, the US economy has become THE MYSTERY OF RISING COMMODITY PRICES | VOL 1/11 In recent months, global commodity prices ranging from precious metals to grains to cotton have risen dramatically, notwithstanding signs of moderating economic activity. Is this due to constrained supply or simply a weaker dollar? We find these explanations inadequate because commodity prices are rising in all currencies and relative to both stocks and bonds. This is highly unusual and suggests that investor preferences have shifted in favour of commodities for some reason. But why? We believe we know the solution to this mystery. Since we wrote this topic, most of the trends described have remained in place, with the notable exception of late that crude oil prices have been rising along with others. This may indicate a pickup in

China, but that it just one front in a wider and broadening conflict. Japan, South Korea, Brazil, India, Russia and Vietnam, among several other countries, have taken specific actions this year to either weaken their currencies or control capital flows in some way. But as the US dollar is the global reserve currency, should the US continue to create liquidity to stimulate growth, much of this liquidity will leak out into the global economy, most probably contributing to a further rise in global commodities prices in 2011.

increasingly unproductive in recent years. Yet a massive debt has been run up which now needs to be serviced. Absent substantial real income growth which has in fact been stagnant for decadesthe US has no choice but to devalue the dollar to the point where US unit labour costs catch up the elevated level of asset prices. But that implies a much, much weaker dollar. Even if accompanied by business and jobs-friendly tax and regulatory policies, a 25-40% devaluation from the current trade-weighted level is probably required. It may be too early to expect such a large move in 2011, but you never know.

global industrial demand, although other indicators, such as the Baltic Dry Shipping Index, suggest that activity is more or less stable. Regardless, it is important to note that commodity price strength is broad-based and is not merely the result of a weak dollar, as the dollar has been strong recently yet commodity prices continue to rise in nearly all currencies. As discussed in various other topics this year, as long as the Fed continues to add dollar liquidity to the economy, some of it is going to flow into commodities as a sensible hedge against currency devaluation and debt default. 2011 may not be as strong a year for commodities as 2010 however, as global industrial demand may begin to cool.

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THE FEDS TEENAGE TEMPER TANTRUM | VOL 1/11 When a young child is caught in a lie, they deny it. As they grow, they find ever more elaborate ways of deceiving their parents, only to be caught out time and again. Finally, as a teenager, they give up trying to deceive and begin simply to blame their parents for their transgressions, rather than take responsibility. Recent statements by Federal Reserve officials suggest that, following a long childhood, the Fed has now entered its teenage years. It is highly unusual for the Fed to offer opinions about US government economic policy, much less criticise it, but Chairman Bernanke did just that earlier this year, when he said that the Congress should focus on getting the deficit under control and leave GUESS WHAT S COMING TO DINNER: INFLATION! | VOL 1/12 The surge in global food prices will soon arrive on the dinner table. However, to focus on the direct inflationary impact of higher food prices alone is to miss the bigger, far more inflationary picture implied by rising wage demands in developing countries. Beginning next year, consumers in most developed economies will discover to their surprise that food price inflation is creeping into an astonishingly wide variety of consumer goods. Food price inflation is a dangerous animal. As a product which must be purchased and consumed on FROM STAGNATION TO STAGFLATION | VOL 1/12 US CPI has been trending lower amidst a stagnating US economy. However, a look behind the headline economic data and across some financial market developments reveals a disturbing picture, that in fact the US economy may already have entered a stagflationary situation not unlike the late 1970s. This spells danger for financial asset prices. Many economic commentators have speculated that the US might find itself in a stagflationary situation as a result of a weaker dollar, higher oil and import prices generally, yet with a weak jobs market and high unemployment. We argue that, if you look behind the headline economic data, we may already

the economy to the Fed. Yet the Congress has now extended tax cuts and unemployment benefits, actions which will increase the deficit. The Fed may not be pleased with this development. It might result in a scaling back of planned Treasury bond purchases. But regardless, relations between the government and the Fed are more strained today than at any time since the early 1980s, whenPaul Volcker came under fire for raising interest rates in the middle of a major recession. With Ron Paul, a noted Fed critic, assuming the Chairmanship of the House Monetary Affairs Subcommittee next year, the acrimony is all but certain to continue in 2011.

a daily basis, consumers are acutely aware of it and, for those on low incomes, it can threaten their basic health and that of their family. This is why the recent surge in global food prices is so significant. And so far, food prices are holding these gains, with corn, wheat and soyabean prices all near recent highs. In 2011, as food price inflation feeds into wage pressures in emerging markets, it will gradually transform into a more general manufactured goods price inflation the world over.

be there. While the Fed claims that inflation is undesirably low, they are referring to the current rate of core price inflation, which excludes food and energy. Also, the CPI calculation methodology has changed dramatically through the years. Indeed, if CPI is measured in the same way in which it was in the 1970s, for example, the last time the US economy was mired in stagflation, then you find that the current rate of overall CPI is over 8% y/y and rising, notwithstanding broad unemployment in the double-digits. As pipeline price inflation is still on the way, this situation is likely to worsen in 2011.

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PLUS A CHANGE (PLUS CEST LA MME CHOSE) | VOL 1/13 This past week provided an excellent example of this old French saying, which translates somewhat inelegantly into English as: The more things change, the more they stay the same. The US mid-term elections may have resulted, as expected, in a large victory for the Republicans, who now control the House of Representatives. But notwithstanding some grand headlines in the press, this is highly unlikely to change current US or global economic and financial market trends. Our assessment of the US political outlook following the recent mid-term elections was not THE TALE OF ANDR PRENNER, A PARABLE FOR OUR TIMES | VOL 1/13 In this edition, we take a brief pause from our normal economic and financial market commentary with this tale of common sense economic calculation and action. And no, we do not believe that the world is any more complex than we present it here. If you want to understand economics, you need first understand two things: That the human condition of one of scarcity and uncertainty; and that absent rational economic calculation and a certain degree of passionate risk-taking, nothing good can ever come of it. A CENTURY OF MONEY MISCHIEF | VOL 1/14 The US Fed recently celebrated the centennial of its founding at a historic hotel on Jekyll Island, off the cost of Georgia, where a secret meeting took place to lay the political foundations for what would become the Federal Reserve System. But what, exactly, does the Fed have to celebrate, as it was created, ostensibly, to promote financial stability? What can we say? More and more observers are coming to the inevitable conclusion that the Fed has

entirely correct. We expected complete gridlock, yet there has already been agreement to extend both tax cuts and unemployment benefits. We doubt we are the only ones surprised by this. However, while these actions may not qualify as gridlock, they do nevertheless reinforce our ultimate conclusion in this topic, which is that the US government is not going to be able to address its deficit during the coming two years. Indeed, the deficit is now going to be commensurately larger in 2011 and 2012, and perhaps beyond.

As this topic was a parable, rather than an economic or investment analysis, there is really nothing to update other than to say that we still dont believe that the US is as attractive a place to do business as it used to be, with obvious consequences for future economic growth. We would like to draw readers attention to the protagonists name, however. Did anyone make the connection between his name and the themes in the story? Hint: Adopt a gentle French accent and speak the name softly as one long word.

not done a particularly good job at promoting financial stability, nor at protecting the purchasing power of the dollar through the years. But why? Is the Fed incompetent? Is it poorly designed? Does it have the wrong mandate? We are pleased to learn that Ron Paul will be Charing the US House Monetary Affairs Subcommittee next year as he is likely to ask these questions. 2011 may be the year that we begin to get some answers.

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THE RISING SEA OF DEBT | VOL 1/14 As yet another wave of crisis rolls across the global financial markets, it is instructive to step back and look at the entire sea of debt. As is postulated by global warming theory, rising temperatures result in rising sea levels. Well, as the global debt crisis heats up and the sea of debt rises, it eventually yet suddenly swamps those living close to the shore. Whether a home is lost to foreclosure, a factory to corporate bankruptcy, or both are lost to the sea, makes little difference to the holders of the debt that is defaulted on. From an investors point of view, there is simply too much credit risk in the sea and they want it reduced. At first, politicians presumed this could be summarily accomplished with sovereign bailouts. But now the sovereigns themselves, one by one like dominoes, are toppling over. The credit risk, sovereign and all, must be reduced. This can occur either through default or currency devaluation. With few exceptions, policymakers appear to prefer the latter.

We attempted to pull many previous threads into this topic, which looks at the debt crisis from the investors perspective. They want less credit risk and they are going to find a way to reduce it, one way or the other. 2011 will be yet another year in which policymakers struggle to prevent such an implied deleveraging. What forms of fiscal and monetary stimulus are we yet to see? How will investors react? We dont presume to know the specifics but what we do know is that increasingly arbitrary attempts to prevent financial markets doing what they know they must do are going to fail. That credit risk will be reduced in the end, through some combination of default and currency devaluation. The only question is how much additional economic damage will be unnecessarily caused along the way. Judging by the experience of 2008-10, there could be much additional damage indeed.

We wish all of our readers a pleasant and festive holiday season, free from the relentless doom and gloom of the Amphora Report. Best Wishes to all for a happy and prosperous 2011.

AMPHORA: A lateral-handled, ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean.
JOHN BUTLER john.butler@amphora-alpha.com John Butler has 18 years experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to launching the Amphora Commodities Alpha Fund he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is a regular contributor to various financial publications and websites and also an occasional speaker at investment conferences.
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