STRATEGIC INVESTMENT CONFERENCE - DAY 1

May 3, 2012

If you have not read the notes of the first three presentations here are the links to Niall Ferguson on "Civilization", Dr. Woody Brock on "American Gridlock" and David Rosenberg from Gluskin Sheff. The last presentation I will report on from Day 1 of the conference is Dr. Lacy Hunt from Hoisington Research. Dr. Hunt was a previous member of the Federal Reserve board and is the Executive Vice President of Hoisington Investment Management who has run arguably one of the best performing bond funds over the past 25 years. With that I present the notes from Dr. Lacy Hunt.

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I want to begin by taking us back to the economic classroom. In any economic model there are two basic conditions - "Equilibrium" and "Transition"

For many years professors have drummed into students that equilibrium is the dominant condition and that transition occurs but it is generally smooth, unimportant and short. The commonest example is that of an airplane. When the airplane is on the tarmac it is at equilibrium. The takeoff and climb to altitude is the transition which is a generally short period relative to the overall trip. Once the plane reaches cruising altitude it is again back at equilibrium.

However, what we have learned is that equilibrium, in relation to economies, is very short. It is the transition periods that are long in nature. Economies consistently move towards equilibrium, achieve it temporarily, then began to transition again.

In the U.S. today, along with the rest of the world, we are currently engaged in "debt disequilibrium".

Currently, we simply have too much debt relative to GDP. This is not just a domestic problem. Excessive indebtedness is a global problem. Furthermore, as we take on consistently more debt, each additional increase in debt is becoming less effective, due to the law of diminishing returns, and eventually will produce a negative return. The reality is that for debt to be effective it must produce a positive return.

In the U.S. today the current debt to GDP ratio is roughly 360%. This is not the first time that debt to GDP has peaked. In 1875 the debt to GDP ratio peaked at 156.4% after the panic of 1873 following the collapse of the railroad boom. After that peak the economy remained in malaise for a very long period of time until the excess leverage was reduced. The process was repeated again in 1916 as debt to GDP hit 170.4%. This in turn led to the 1920-1921 depression where Federal spending was reduced by 50%, deleveraging happened very quickly and the economic cycle began to recover. However, this time the re-leveraging cycle quickly ensued in the roaring 20's which pushed debt to GDP to the next peak in 1933 at 299.8%.

Of course, the following gestation period and debt deleveraging cycle took a very long period of time as the psychological impact of the "Great Depression" changed behavior. It wasn't until 2003, 70 years later, before the debt to GDP ratio breached the 1933 peak at 301.4%. Debt since then has continued to soar rising another 80 points in 2009 to a peak of 382.8%. The debt deleveraging process has only just begun and if history is any guide it will be a very long and arduous process.

As stated previously by Dr. Woody Brock the addition of debt is acceptable as long as it produces a positive rate of return. Unfortunately, the U.S. has engaged in massive increases in the levels of debt but the average standard of living has not risen. The "debt disequilibrium" problem has now reached the point of producing negative impacts on the economy.

This is not just a domestic problem. It is a global problem. The Eurozone is at 450% of debt to GDP - which roughly 100 points higher than the US. The UK is at 470% and Japan is at 500% of debt to GDP.

Furthermore, Japan is the template of the US experience. This is not a popular view and is widely dismissed under various assumptions. However, Japan has done everything that the Keynesian and Freidmanite schools of thought have asked them to do. The results are not good. Yet, the current administration has failed to understand the consequences of those actions and have engaged upon the same path over the last decade.

The current debt problems occurred primarily between the years of 1998 to 2006. The issue that has yet to be realized is that you cannot solve a debt problem after the fact. It has to be resolved before it reaches critical mass.

In the early stages of a rising debt buildup it leads to both rising income and asset prices. It is in these early stages where actions should be taken to limit the debt buildup. However, since the corresponding increases in debt lead to a rise in incomes and asset prices - no one is willing to stop It The problem then becomes the crushing reality of declining prosperity as the negative ramification of excessive debt sets in.

"Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But when it is used imprudently and in excess, the result can be a disaster." Stephen Cecchetti

Let's take a look at the U.S. versus China

China:

• Debt To GDP = 16.3%
• Hidden Liabilities as % of GDP = 144%
• Total Debt and Hidden Liabilities as % of GDP = 160%
• PCE as % of GDP = 30%
• Investment as % of GDP = 70%
• China's growth target for 2012 = 7.5% - slowest in 22 years

U.S.

• Debt to GDP = 102%
• Hidden Liabilities as % of GDP = n/a
• Total Debt and Hidden Liabilities as % of GDP = 102%
• PCE as % of GDP = 71%
• Investment as % of GDP = 16%

China is an unsustainable model. The critical danger is their rapid deceleration in growth. While many people are looking at external factors to influence China's economy the reality is that the system can be disrupted purely by internal factors. It has clearly happened in the past.

4 Archetypes of the Deleveraging Process - McKinsey Global Study of 32 Countries.

There are only 4 major ways for a country to deleverage itself based on the study of 32 countries.

1. "Belt Tightening" — most common. (50% of countries studied)
2. "High Inflation" — (25% of countries)
3. Massive Default
4. Growing Out of Debt

Types 2-4 were relatively rare and occurred in conditions that are not present today in the mature economies. The record suggests that today's mature economies are most likely to deleverage through a belt tightening process as deflationary forces keep a lid on inflationary pressures even as currency printing increases.

The massive increase in debt in the U.S. economy over recent years is now having deleterious effects on the consumer. The personal savings rate is declining as consumer debt is being made available. In recent quarters we have seen huge increases in debt to fuel consumptive spending due to the stagnation of incomes and rising cost pressures.

What is very interesting to look at is the massive surge in student loan debt that is now becoming another concern. Student loans are increasing but not because there has been a sudden increase in the number of people attending colleges. The student loans have been going to fuel consumption.

If you want to know how weak the economy really is all you need to do is look at the 30-year bond. It is one of the best economic indicators available today. If economic conditions are robust then the yield will be rising and vice versa. What the current low levels of yield on 30 year bond is telling you is that the underlying economy is weak.

"The 30-year yield is not at these low levels DUE to the Federal Reserve; but in SPITE OF the Fed," Hunt said.

The actions of the Federal Reserve have continued to undermine the economy which is reflected by the low yield of the 30 year bond

The "cancerous" side effects of nonproductive debt are being reflected in real disposable incomes. Just over the last two years real disposable incomes slid from 5% in 2010 and -0.5% in 2012 on a 3-month percentage change at an annual rate basis.

This is critically important to understand. While the media remains focused on GDP it is the wrong measure by which to measure the economy. A truly growing economy leads to rises in prosperity. GDP does NOT measure prosperity — it measures spending. It is the measure of real personal incomes that measures prosperity. Prosperity MUST come from rising incomes.

GDP, on the other hand, can be distorted through government spending, which masks the effects of declining prosperity through weaker incomes. GDP does NOT lead to a increase in prosperity.

This brings us to the issues with various debt driven stimulus and liquidity programs. While they may have a short term positive effect they ultimately all have a diminishing rate of return over time. Take a look at the effect of the QE programs on the stock market.

• QE1 - stocks increase 36.4%
• QE2 - stock rise 24.1%
• Operation Twist (Stealth QE 3) - stocks gain 12.9%

While the liquidity interventions by the Fed have increased stock prices — it has also continued to create pressure on the average American by deteriorating prosperity.

The Velocity of Money

The velocity of money is at what speed is money moving through the economic system. The commonest measure is: GDP (nominal) = Money X Velocity

The velocity of money tells you the effectiveness of debt relative to the overall economy. From 1953 to 1980 the velocity of money was stable which was showing that the loans being made by banks to individuals and businesses were being put to productive uses. Today, as debt is taken on, it is no longer the case as additional bank lending produces little return. In other words there is relatively little return for each dollar lent.

The increases in debt without a productive return will ultimately lead to a larger proportion of government debt in the economy, versus private debt, with no relative increase in GDP. To put this into perspective - without changes to the current system government spending will reach 40% of GDP by 2050. This will not happen as the system will collapse long before then.

While we should be in the process of working off debt and deleveraging the system — in actuality we are doing the opposite and in 2013 we will be at 110% of debt to GDP.

To put this into an investment perspective let's take a look at "20 Year Periods With A Negative Risk Premium" A negative risk premium is when there is a negative return between the total return of stocks versus the total return of bonds. This will not be the first time this has happened.

• 1874-1894 = S4.4% in stocks vs. 5.4% in bonds = -1% equity risk premium
• 1928-1948 = 3.1% vs. 3.9% = -0.8% equity risk premium
• 1991-2011 = 7.8% vs. 8% = -0.2% equity risk premium

The bad news is that with the massive total increases in debt combined with the current policies being implemented under the current administration it is very likely that could extend the current 20 year cycle much longer. This has profound investment ramifications for individuals going forward.