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Agcapita BriefingSeptember 2009

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Summary

Milton Friedman famously postulated “inflation is always and everywhere a monetary phenomenon”. To believe in deflation is to believe that the money supply will actually contract rather than the rate of growth merely slowing from historically high levels which is all that is happening currently. Rather than contract, I believe that there are two factors that will significantly increase the money supply in the medium term:

− Excess Bank Reserves: The global banking system has been flooded with cash that is currently accumulating on central bank balance sheets as “excess reserves”. Banks will obviously begin to lend again and through the multiplying effect of fractional reserve banking will significantly increase the money supply. If they do not do so voluntarily we expect them to come under government pressure to do so. I do not believe that the political will exists to extract these funds from the banking system. For example, the Swedish Central Bank recently cut nominal rates on excess reserves on deposit to NEGATIVE 0.25% in order to force banks to lend.

− Fiscal Deficits: Massive Keynesian style spending/deficits planned – current projections by the World Bank are that government deficits will accelerate to 9% of global GDP in 2009. Government is stepping in as borrower and spender of last resort.

Prior to 1971 when the US and the world went off the last remnant of the gold standard you could argue that there was at least some restraint on printing money. We have now arrived at a point in financial history where there appears to be no immediate restraint on money printing compounded by the fact that there is no stable (non-inflating) fiat currency with sufficient market size to act as a safe haven/competition and widespread belief amongst governments and central banks that inflation will actually be a good thing for the economy. The track record of the central banking community with respect to inflation/eroding the purchasing power of fiat currency is virtually perfect. The economist, Ludwig Von Mises once quipped “Government is the only institution that can take a valuable commodity like paper, and make it worthless by applying ink.”

CONTENTS

3 Energy Consumption Overview3 Global Oil Production - WEO4 Global Oil Production - EIA5 World Oil Peak When?5 Alberta Natural Gas6 Energy Consumption Quick Facts7 Rig Counts7 Saskatchewan Oil Quick Facts9 Food, Feed and Fuel Revisited10 Short History of Agriculture11 US Fiscal Deficit 12 Global Interest Rates13 Canadian Dollar13 Global Money Printing Update

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Its important to remember that inflation is not incidental to what the governments and central banks of the world have been doing during the crisis. They’re not saying, “Let’s bail out the banking system even if that is inflationary.” The banking system has been flooded with excess reserves with the expectation that these will be lent and the money supply increased. I would argue that the banking system is incentivized to create leverage and lending and so I can’t see that all this money sits on the sidelines indefinitely.

On top of the excess reserves parked in the system, the governments of the world are now effectively dictating that if the private sector will not or cannot borrow the reserves they have pushed into the banking system then they will borrow them. Hence we have fiscal deficits rapidly increasing across the globe. Canada is not immune from this type of inflationary activity. Timothy Lane, one of the deputy governors of the Bank of Canada has been floating the idea that the Bank of Canada should use quantitative easing to devalue the Canadian dollar. Mr. Lane said that a “persistently strong” Canadian dollar will reduce growth. However, quantitative easing would merely lower the purchasing power of Canadians through inflation as it devalued the Canadian dollar – where’s the benefit?

Does the Bank of Canada really believe you can devalue your way to prosperity? Ask any inflation stricken country about this theory. I believe that current Keynesian policies will achieve nothing more than corrosive inflation. What western economies need is more capital. Printing money does not create capital. Worse yet, low interest rates artificially stimulate speculation and consumption rather than savings. Ultimately, the inflation that money printing creates reduces the pool of available capital causing long lasting harm.

There are lots of complicated and opaque terms for what is being done - quantitative easing, liquidity, stimulus, bail-outs etc - but strip away the jargon and its simply printing money, borrowing money and spending money. If Milton Friedman, Ludwig Von Mises and history are any guide it should be inflationary.

On a different note we have added an energy section to the briefing for three key reasons:

− Energy and agriculture are increasingly intertwined with the expanding production of biofuels and large energy inputs required to maintain the yields in modern agriculture.

− Western Canadian oil production assets were being sold for over $70,000 per flowing barrel in late 2007, early 2008. Purchase prices have now fallen to around $20,000 per flowing barrel and less due to the credit crisis. At current oil prices, direct production purchases can generate extremely attractive cash flows for discriminating investors.

− The energy sector is part of the western Canadian secular bull market for commodities that is one of Agcapita’s central investment beliefs.

Kind RegardsStephen Johnston - Partner

Summary (continued)

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ENERGY CONSUMPTION OVERVIEW

In inflation adjusted terms, oil is materially below its 1981 peak. The current oil markets, however, are dramatically different from their 1980s counterparts. In 1981:− Global consumption was approximately 69 million

bopd− OPEC had approximately 10 million of spare

production capacity− Global production was increasing approximately

1% per annum − China consumed less than 2 million bopd or less

than 1 barrel/person/year − The US consumed 24 barrels/year/person

In 2008: − Global consumption is approximately 84 million

bopd− OPEC is estimated to have less than 3 million of

spare production capacity− Global production outside of OPEC is declining by

over 5% per annum − Data points to global peak oil underway− China is the second largest consumer of oil in

the world – 8 million bopd but still only 2 barrels/person/year

− The US consumes 24 barrels/year/person

Alberta and Saskatchewan have non-conventional oil reserves that rival Saudi Arabia – and conventional reserves of oil and gas that make them world-class producers. Oil production in Alberta was being sold for as much as $130,000 per flowing barrel in late 2007, early 2008. Purchase prices have now fallen to under $20,000 per flowing barrel. Junior producers are in extreme distress due to an inability to access either the debt or equity markets. This presents an

Energy Update

attractive window of opportunity to purchase oil and gas assets for competitive prices.

GLOBAL OIL PRODUCTION - WEO

In 2008 World Energy Outlook (“WEO”) analyzed approximately 800 fields accounting for ¾ of global reserves and more than 2/3 of global oil production. They came to the conclusion that decline rates are far higher than previously thought, between 6.7% and 8.6% a year. As result, they estimate that to maintain the current levels of oil production by 2030 the world would need to develop and produce 45 million barrels per day or approximately four new Saudi-Arabias. Simultaneously, they analyzed the large-scale projects

CHART 1: WORLD CRUDE OIL & LEASE CONDENSATE PRODUCTION,

INCLUDING CANADA OIL SANDS

MBD76

72

68

64

60

56

Source: EIA, en.wikipedia.org/wiki/Oil_Megaprojects, Tony Eriksen “ace” theoildrum.com

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Peak 1May 0574.24

Peak 2Dec 0574.16

Peak 3Jul 0874.82

May 09 70.8

IEA WEO 2008

Decline rate = 3.4% paDec 2010 to Dec 2012

Forecast

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that are planned globally (about 230) out to 2015. It takes five to ten years to produce oil from a new field. When the WEO added all the projects together (assuming all of them are able to locate financing in the current credit crunch) they will bring about 25 million barrels per day. However, because of the decline rates, the world will still be short of “at least” 12.5 million barrels per day before 2015. A recent report from the US Joint Forces Command supports the WEO calculations: “By 2012, surplus oil production capacity could entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10 million barrels per day.”

In 2009, Merrill Lynch also conducted a similar analysis and concluded that, “the world now needed to replace an amount of oil output equivalent to Saudi Arabia’s production every two years”. Yet oil production is already in an irreversible decline in at least 54 of the 65 most important producing countries and we currently consume between 4-5 barrels of oil for a single one discovered; an unsustainable situation.

GLOBAL OIL PRODUCTION - EIA

The Energy Information Administration (“EIA”) publishes an annual International Energy Outlook. Up until 2008, they were predicting growth in world oil supplies for the next two decades. The EIA makes its projections based on what its analysts call the “reference case” that is tied to an estimate of average economic growth.

In 2007 the EIA was predicting that world production of conventional liquids would be 107.5 million barrels per day in 2030 (up from 81.9 in 2005) coinciding with its prediction for world demand of

118 million barrels per day - 10.5 million barrels of unconventional liquids filled the shortfall. In 2009 the numbers deteriorated materially. Projected conventional production dropped from 107.5 million barrels per day of oil in 2030 in 2007, to 102.9 million barrels per day in 2008, to 93.1 million barrels per day in 2009. That’s a 13.4% reduction in conventional production in two years.

The 2009 EIA report assumed 13.5 million barrels per day of unconventional liquids by 2030 to fill the supply shortfall, including 5.9 million barrels per day in biofuels. To reach 5.9 million barrels per day of biofuels by 2030 would necessitate a huge diversion of cropland from food to energy with the strong possibility of increasing food prices and shortages.

The EIA reference case calls for USD$130/barrel oil in 2030. Assuming inflation rates of 5% over the projection period then this is only USD$ 46/barrel in real terms – i.e. the unlikely conclusion that real prices in 2030 will be lower than exist currently. Both inflation and demand growth could be much greater and according to other research the cost of oil could pass the USD$300/barrel mark if there is even a 15% shortfall in the supply. At a recent meeting of the All Party Parliamentary Group on Peak Oil, Toronto-based transport consultant Richard Gilbert revealed that while oil consumption is expected to increase by about a third by 2025 to more than 40 billion barrels a year, production will have fallen to less than 25 billion barrels a year. Gilbert quoted two different sets of research, highlighting the impact of a shortfall in crude supply: one states that a 15% shortfall in supply will lead to a 550% hike in the cost of a barrel of crude (and that’s based on the 2002 price of USD$50/barrel) and the other concludes that a 4% shortfall will result in a 177% increase.

Energy Update (continued)

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WORLD OIL PEAK WHEN?

The global recession has temporarily hidden a developing problem in the energy sector. As more and more countries are reaching their national peak oil outputs, the obvious question is when will world oil production peak. The concept that oil production will peak is not in dispute – rather the timing of this event. Predictions vary from it already having taken place to 2030 and beyond. Peak oil was first studied by M. King Hubbert. In 1956, he successfully predicted the 1971 US oil production peak by using a model based on cumulative oil discoveries, predicting it appears correctly, that oil production follows oil discoveries in the same bell shaped curve. To put current discoveries in perspective to current consumption - oil is now being consumed four to five times faster than it is being discovered.

World oil discovery peaked in mid 1960s. Since the oil production in the lower 48 states of US peaked about 40 years after the peaking of discovery, there are reasons to believe according to Hubbert’s theory the same thing could happen to world oil production.

ALBERTA NATURAL GAS

The Alberta economy is heavily exposed to natural gas prices rather than oil prices. While oil prices have been relatively strong, natural gas prices in Canada are at lows not seen since 2002. According to First Energy “The market is trying to rationalize all of the gas that is piling up and there are fewer and fewer places to put it. We expect that a $1 handle on prices will start becoming more common in the next few weeks,” said First Energy analyst Martin King. Inventory levels continue to build in Western Canada, at 492.46 billion cubic feet as of Aug. 23 2009. This exceeds the 489 billion cubic feet of existing storage capacity that according to King indicate that some

CHART 2: WORLD OIL DISCOVERY OVER 10-YEAR PERIODS

500

450

400

350

300

250

200

150

100

50

0

Source: ASPO March 2008

Billi

ons

of B

arre

ls

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030

Discovery Extrapolation

Energy Update (continued)

CHART 3: US NATURAL GAS STORAGE TREND

Billi

on C

ubic

Fee

t

3,6003,2002,8002,4002,0001,6001,2008004000

Aug

-07

Nov

-07

Feb-

08

May

-08

Aug

-08

Nov

-08

Feb-

09

May

-09

Aug

-09

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dormant storage sites have been reactivated. “At this stage, we still believe that shut-ins on the scale of 0.5 billion to 0.8 billion cubic feet per day may be needed for a short period of time for some kind of balance to be achieved in this market. If this does not occur, then protracted extreme price weakness is likely in store for the middle to late part of September to prices below $1 per gigajoule.” Storage levels are also high in the US as can be seen in Chart 3

Average prices at the AECO natural gas hub in Alberta dipped below CAD$2 recently. Natural gas prices have been on a downward spiral since the middle of 2008, driven by increased North American supply. The effect of this divergence between strong oil prices and weak natural gas prices can be seen graphically in Chart 4 of the ratio between the two. The oil/natural gas ratio is now trading at levels not seen in two decades.

ENERGY CONSUMPTION QUICK FACTS

− Internet: Contrary to popular belief, the internet consumes large amounts of energy. Author John Michael Greer explains: “The hardware of the internet, with its worldwide connections, its vast server farms, and its billions of interlinked home and business computers, probably counts as the largest infrastructure project ever created and deployed in a two decade period in history. The sheer amount of energy that’s been invested to create and sustain the internet beggars the imagination.” Recent estimates indicate the infrastructure necessary to support the internet consumes 10% of all the electricity produced in the United States and 5% globally.

− Automobiles: The construction of an average car consumes the energy equivalent of approximately 20 barrels (840 gallons) of oil. Ultimately, the construction of a car will consume an amount of fossil fuels equivalent to twice the car’s final weight. It’s also worth noting that the construction of an average car consumes almost 120,000 gallons of fresh water.

CHART 4: WTI CRUDE VERSUS NATURAL GAS RATIO (AUGUST 2009)

24.1423.0022.0021.0020.0019.0018.0017.0016.0015.0014.0013.0012.0011.0010.009.00

2004 2005 2006 2007 2008 2009 Monthly

8/1/2009(CLV9/NGV9)

Energy Update (continued)

Note: The shaded area indicates the range between the historical minimum and maximum values for the weekly series from 2004 through 2008. Source: Form EIA-912, “Weekly Underground Natural Gas Storage Report.”

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− Households: Home appliances are the world’s fastest-growing energy consumers after automobiles, accounting for 30 percent of industrial countries’ electricity consumption. Ninety percent of the energy consumed by an incandescent light bulb is given off as heat, while only 10 percent is converted to light.

RIG COUNTS

Baker Hughes has issued the rotary rig counts as a service to the petroleum industry since 1944, when Hughes Tool Company began weekly counts of US and Canadian drilling activity. Recent counts show a massive drop-off in activity in the oil and gas sector, particularly in North America. When the economy and demand starts to grow again this period of limited investment into production and development may create upward pressure on prices.

SASKATCHEWAN OIL QUICK FACTS

− Saskatchewan’s fi rst commercial crude oil discovery was made in 1944.

− Most of the major pools were discovered as a result of an intensive exploration effort in the mid-1950s and early 1960s.

− Saskatchewan is now the second largest oil producer in Canada after Alberta producing approximately 17 percent of total Canadian oil production.

CHART 6

ALBERTA SASKATCHEWAN MANITOBA

MONTANA

WYOMING

NORTHDAKOTA

SOUTHDAKOTA

Energy Update (continued)

CHART 5: RIG COUNTS

AreaLast Count

DateCount

Change from Last

Year

U.S. August 999 -1032

Canada August 184 -252

International July 974 -118

Source: Baker Hughes

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− Crude oil production in 2007 was 24.8 million cubic meters (156.1 million barrels).

− Cumulative oil production from Saskatchewan to December 31, 2007 was 745.0 million cubic meters (4.7 billion barrels).

− Remaining recoverable reserves at December 31, 2006 were estimated to be approximately 187.5 million cubic meters (1.2 billion barrels).

− Saskatchewan has an estimated 3.4 billion cubic meters (21.3 billion barrels) of heavy oil-in- place in the west-central region of the province.

− Saskatchewan set a record for land sale revenues of $1.12 billion in 2008, of which $916.5 million was spent in the southeast in the Bakken play.

− The Bakken formation — a light oil-bearing formation extending throughout the Williston Basin — is estimated to contain anywhere from 100 billion to 400 billion barrels of oil in place, one quarter of which is estimated to be located in Saskatchewan.

− Production from Saskatchewan’s portion of the Bakken has jumped from 950 barrels of oil per day (bopd) in October 2004 to 54,000 bopd in October 2008. As of December 2008, Bakken production exceeded 57,000 bopd.

− Saskatchewan’s oil production has steadily increased in the last eight years, after doubling between 1990 and 2000. By contrast, Alberta’s conventional (non-oilsands) production has steadily declined from 350 million barrels in 1995 to 191.6 million barrels in 2007.

Energy Update (continued)

CHART 7: BAKKEN OIL PRODUCTION

70

60

50

40

30

20

10

02003 2004 2005 2006 2007 2008

Well Count

700

600

500

400

300

200

100

0

Oil ProductionPer Well OIl Production

Oil Production per Well

Well Count

Oil Production

Source: Government of Saskatchewan

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FOOD, FEED AND FUEL REVISITED

As the world’s population grows, competition for food, water and energy will increase. Food and farmland prices will rise as a result.

According to John Beddington, the UK government’s chief scientific adviser, by 2030 “a whole series of events come together” to create the pre-conditions for a crisis:

− The world’s population will increase by 33%− Demand for food will increase by 50%− Demand for water will increase by 30%− Demand for energy will increase by 50%

Some of the problems reinforce each other, for example, agriculture consumes large amounts of

Agriculture Update

19501955

19601965

19701975

19801985

19901995

20002005

20102015

20202025

20302035

20402045

2050

CHART 8: POPULATION GROWTH, 1950-2050

Source: UN

10

8

6

4

2

0

Billion

Projected beyond 2008

Europe Africa Asia Latin America Northern America Oceania

Source: FAO

3500

3000

2500

2000

1500

1000

500

0

CHART 9: PROJECTED GROWTH IN FOOD PRODUCTION , 1960-2050

1662 1970 1980 1990 2000 2015 2030 2050

Million tonnes Total cereals Total meats

Projected data

water and energy. But Beddington also points to other drivers.− Urbanization: Not only is the world’s population

predicted to grow (until the middle of the century, at least) but more people are moving to cities. The growth of cities will accelerate the depletion of water resources as cities are more water intensive per capita.

− Income Growth: As people become wealthier their diets are change. The largest increase in meat consumption comes at income move up to USD$ 5,000 per year – a change that approximately 80% of the worlds population has yet to make.

− Biofuels: The more land is devoted to growing biofuels the less can be used for growing food.

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Agriculture Update (continued)

SHORT HISTORY OF AGRICULTURE

The history of modern agriculture comprises three distinct periods: − The Expansion Period (1600 to 1920): Increases

in food production during these three centuries came simply from putting more land into production; technological change played only a minor role.

− The Mechanization Period (1920 to 1970): In this half-century, technological advances issuing from cheap, abundant fossil-fuel energy resulted in a dramatic increase in productivity (output per worker hour). Meanwhile, farm machinery, pesticides, herbicides, irrigation, new hybrid crops, and synthetic fertilizers allowed for the doubling and tripling of crop production. Also during this time, U.S. Department of Agriculture policy began favoring larger farms (the average U.S. farm size grew from 100 acres in 1930 to almost 500 acres by 1990), and production for export.

− The Energy Period (1970-present): In recent decades, yield improvements have been primarily obtained with the application of increasing amounts of energy. At the same time the incremental productivity of this approach has been dropping – i.e. an ever-growing amount of energy is being expended to produce each extra bushel of yield from the overall system. In short, strategies that had recently produced dramatic increases in productivity became subject to the law of diminishing returns.

CHART 10: GLOBAL ENERGY DEMAND1980 – 2030

Source: IEA

20

15

10

5

01980 1990 2000 2010 2020 2030

Developed nations (OECD) Developing nations (non-OECD) World*

Projected from 2007

Million tonnes of oil equivalent

2005: Developing nations overtake developed nations

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US FISCAL DEFICIT

The U.S. federal budget deficit will run to $1.6 trillion this year, the Congressional Budget Office said yesterday, equal to 11.2% of GDP. That’s the biggest deficit since World War II. This is a pattern that is being repeated throughout the developed world – e.g. Britain will run a 11.6% deficit, and Japan a 10.3% deficit.

US government spending has climbed by US$700 billion, a 24 percent jump, for the biggest annual increase in more than half a decade. It is expected to aggregate to US$ 9 trillion in the next 10 years – a doubling of debt levels as can be seen in Chart 12.

Richard Russell recently wrote, “The US national debt is now over $11 trillion dollars. The interest on

our national debt is now $340 billion. This is about at 3.04% rate of interest. In ten years the Obama administration admits that they will add $9 trillion to the national debt. That would take it to $20 trillion. Let’s say that by some miracle the interest on the national debt in 10 years will still be 3.09%. That would mean that the interest on the national debt would be $618 billion a year or over one billion a day. No nation can hold up in the face of those kinds of expenses. Either the dollar would collapse or interest rates would go through the roof.”

As the current and cumulative US fiscal deficit grows the influence of the US’ creditors increases - the majority of these creditors are foreign, most notably China.

Global Macro Update

Source: Ned Davis Research

CHART 11: TOTAL CREDIT MARKET DEBT AS PERCENT OF US GDP

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

370350340330320310300290280270260250240230220210200190180170160150140130

3/31/2009 Debt = $52.904 Trillion3/31/2009 GDP = $14.090 Trillion

= 375.5% 100%

80%

60%

40%

CHART 12: US NATIONAL DEBT AS PERCENT OF GDP

Source: CBO

41%

82%

2008 2019

12

If and when purchasers of US sovereign debt become concerned about US debt levels they may pare back or even exit the market altogether raising interest rates. According to tax policy expert and Syracuse University professor Len Burman wrote in a recent op-ed titled “Catastrophic Budget Failure”. ”Taxes would rise to levels that would make a Scandinavian revolt. And the government would not be able to provide anything but the most basic public services. We would no longer be a great power (or even a mediocre one), and the social safety net would evaporate.”

GLOBAL INTEREST RATES

The major central banks of the world are continuing to pursue the strategy of monetary easing via historically low interest rates and quantitative easing.

There’s no sign yet that the US Fed will deviate from the strategy it has been pursuing for almost a year by making money virtually costless in nominal terms. Paul McCulley, who helps oversee the world’s biggest bond funds as a partner at Pacific Investment Management Co., expects the Fed will keep its target interest rate unchanged at zero to 0.25 percent into 2011.

Global Macro Update (continued)

CHART 13: CHINA – AMERICA’S BANKER

250

200

150

100

50

0

50

100

150

* Includes PBOC’s other foreign assets, CIC, and foreign assets of state banks; adjusted for currency gains/losses+Not marked to market

Source: Brad Setser & Arpana Pandey, Council on Foreign Relations

Quarterly figures, $bn Holdings of US assets, $bn

2004 05 06 07 08 09 2007 08 09

800

600

400

200

0

Increase in foreign-exchange reserves*

+-

“Hot-money” flows

Treasury bonds

Governmentagency bonds

Corporate bonds

Equities+

CHART 14: GLOBAL INTEREST RATES

Central BankInterest Rate (August

2009)

Bank of Canada 0.25%

Bank of England 0.5%

Bank of Japan 0.1%

European Central Bank 1%

Federal Reserve 0.25%

Swiss National Bank 0.25%

The Reserve Bank of Australia 3%

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CANADIAN DOLLAR

Timothy Lane, one of the deputy governors of the Bank of Canada (“BOC”) has been floating the idea that the Bank of Canada should use quantitative easing to devalue the Canadian dollar. Mr. Lane said that a “persistently strong” Canadian dollar would reduce growth. He attributed the Canadian dollar’s increase to the recovery of commodities prices and the weakening of the U.S. dollar - neither of which the BOC has any direct control over. Quantitative easing, a direct money-printing strategy would lower the purchasing power of Canadians through inflation as it devalued the Canadian dollar. Does the BOC really believe you can devalue your way to prosperity? Ask any inflation stricken country about this theory. Keynesian deficit and money printing economic policies are now being pursued globally on a scale without precedent. We believe that this will achieve nothing more than inflation. What western economies need is more capital. Printing money does not create capital. Worse yet low interest rates and cheap capital artificially stimulate speculation rather than saving and the inflation that money printing creates ultimately reduces the pool of available capital causing long lasting harm.

GLOBAL MONEY PRINTING UPDATE

The global cost of bailing out the financial sector to date amounts to around US$12-trillion. To put that in perspective it represents approximately one fifth of the world’s total annual economic output. On top of this overt subsidy to the financial sector, the G-20 governments are now committed to additional stimulus in the form of deficit spending, historically

Global Macro Update (continued)

low interest rates (as can be seen in part from Chart 14) and direct money printing in the form of the suitably obscure title of quantitative easing (“QE”).

The money injected into the financial system is what’s known in the central banking community as “high-powered liquidity” as its effect is multiplied greatly by the fractional reserve banking system. These funds are designed to re-inflate the asset markets – particularly it is hoped the stock and real-estate markets. Sample QE programs:

− Federal Reserve: The Fed is printing US$1.75-trillion in order to buy Treasury and mortgage backed bonds.

− Japan: The Bank of Japan is printing ¥1.8-trillion each month into the banking system - monetizing 50% of Tokyo’s budget deficit this year.

− UK: The Bank of England is printing £175-billion pounds to purchase distressed assets from banks – monetizing 66% of the UK’s budget deficit this year

− EU: The European Central Bank is printing €442-billion (US$613-billion) which it will inject into one-year money-market funds.

Our prediction is that this re-inflation effort will initially only serve to increase the nominal price of speculative assets – those that are directly accessible by the investment and commercial banking community while having little effect on the real economy. Eventually it will spread through the real economy creating significant consumer price inflation.

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While this inflationary program to save the banking sector has been underway in the developed world, China has been selling US dollar to increase its inventories of oil, metals, and other industrial staples and making direct investments in natural resource assets from Canada to Australia to secure supply. For example year on year China’s imports of:

− copper were up 160%; and − aluminum were up 1,600%.

As we wrote in the August briefing, in the first eight months of 2009, China’s vehicle sales have for the first time exceeded the US – increasing 29% to 8.33-million, while US vehicle sales decreased 28% to 7.1-million. Increased Chinese demand for iron-ore, steel, and rubber reflect this trend.

I would argue that gold and crude oil prices clearly reflect the G-20’s inflationary monetary policies – in particular manifested by an increasingly weaker US-dollar. The consensus seems to be building that the G-20 central bankers will not be increasing real interest rates or reversing their QE in the near-term. The Fed is explicitly signaling that it intends to leave monetary policy extremely accommodative for an extended period while at the same time paying lip service to inflation fighting and the much discussed “exit”. What are we supposed to make of Fed Chairman Ben Bernanke comments in July that “The Fed believes that a highly accommodative stance of monetary policy will be appropriate for an extended period,” while at the same time declaring “We will not allow the broad measures of money circulating in the economy to accelerate at a rapid rate that would eventually cause inflation.” This seems somewhat contradictory to me and indicative of a man who is

deliberately creating inflation but trying to keep the US’s increasingly restive foreign creditors happy at the same time. Ultimately, I believe this will prove to be a very difficult task.

In summary, I would argue that the large increase in the money supply that has taken place and that is planned will only serve to devalue the G-20 currencies and will not save the real economy – perhaps the devaluation will not be obvious relative the various currencies as they all are debased at the same rate but should become increasingly obvious versus hard assets.

Global Macro Update (continued)

#400, 2424 4th Street SWCalgary, Alberta T2S 2T4Canada

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