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ARTEMIS CAPITAL MANAGEMENT For Investment Professional Use. Not for Distribution Fall of the House of Money: Changes in Global Trade and Currency Exchange Council of Supply Chain Management Professionals – November 3, 2011 Christopher Cole, CFA 520 Broadway, Suite 350 Santa Monica, CA 90401 (310) 496-4526 phone (310) 496-4527 fax info@artemiscm.com

Fall of the House of Money 1. I NTRODUCTION TO C URRENCY D YNAMICS Global currency regime will likely face significant changes in the e nsuing decade Self-reinforcing cycle between Debtor-Developed and Emerging-Creditor nations likely to unravel – perhaps violently European crisis may tip us into a second global recession Global policy makers are out of stimulus options Dollar hegemony may be challenged in the future 1 Source: istockphoto.com

US Dollar has lost over 50% of its value since 1985 on a trade weighted basis 1. I NTRODUCTION TO C URRENCY D YNAMICS FRB Trade-Weighted Dollar is the Major Currency Index published by the Federal Reserve, with the USD weighted by respective merchandise trade volume against EUR, JPY, GBP, CHF, AUD, CAD 105 FRB Trade Weighted Dollar Index (1985 to Present) 95 85 75 65 55 45 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2 Source: Federal Reserve & Shadow Government Statistics

Global Currency Markets are like a Backwards Beauty Pageant 1. I NTRODUCTION TO C URRENCY D YNAMICS Like pageant contestants the value of one currency is judged in relationship to another currency However many contestants want to be the most ugly currency to gain advantage in international trade and to stimulate exports Fiat currencies are backed only by faith in a government –beauty is in the eye of the beholder Currencies are subject to laws of supply and demand Examples of Currency Pairs   $USD to GB Pound Aussie to Japanese Yen   CHF (Swiss Franc) to Euro $USD to Mexican Peso   $USD to Canadian Loony Chinese Renmembi to US Dollar 3

The value of a currency (in relationship to another) is driven by a variety of fundamental and 1. I NTRODUCTION TO C URRENCY D YNAMICS speculative factors including:   International Investment Flows Economic Data   Political Stability/Rule of Law/Taxes Monetary Policy   Geopolitical Events Interest Rates   Human Perception International Trade Flows Strong Currency Weak Currency +GDP growth Low GDP growth High Interest Rates Low Interest Hawkish Monetary Policy Loose Monetary Policy Low Government Debt to GDP High Government Debt to GDP Sound Political System Political Instability or War Rule of Law No rule of law / high taxes High Foreign Investment Low Foreign Investment Capital Inflows Lack of Capital Inflows High Current Account Balance More imports than exports 4

WORLD WAR €URRENCY 2. W ORLD W AR C URRENCY Countries are artificially devaluing their currencies to generate competitive trade advantages or to finance deficits United States  Ultra-loose monetary policy (ZIRP & Quantitative Easing)  Massive government deficits and high debt levels  Unsustainable fiscal spending and entitlements Japan  ZIRP and debt-GDP-ratios above 200%+  Japanese government intervened in foreign exchange markets for the 4 th time in over a year (selling yen and buying dollars & euros) China  Yuan is pegged to the dollar and estimated to be as much as 40% undervalued against the US dollar  China keeps buying dollars and “printing” Yuan to maintain this peg Switzerland  Swiss Franc was a popular safe haven appreciating +28% against the Euro and +50% against the dollar since 2003  SNB devalued Franc in September pegging it at 1.20x to the Euro Brazil  Central bank cuts interest rates twice in the last quarter despite highest inflation in six years 5

MASSIVE DEBT AND TRADE IMBALANCE 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE BETWEEN Emerging-creditor countries Debtor-developed countries …maintain growth w/o currency pegs … will need to DELEVERAGE despite slowdown in developed world   High debt Low debt   Low growth and inflation High growth & inflation   Bad demographics Positive demographics   Low interest rates Higher interest rates   Shrinking middle class Emerging middle class 7

Current Account Balance (exports minus imports of goods and services) 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE Debtor-Developed nations are net importers and Emerging-Creditor Nations are net exporters Source: IMF World Economic Outlook Database, April 2009 8

Debtor-Developed nations are massively OVERLEVERAGED 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE Nations with public debt above 90% of GDP (grey line) grow 1.3% per year slower than countries with lower debt ratios USA at 107% not including social security and Medicare 240 Government Debt to GDP % Developed Economies 220 United States 200 Japan Government Debt to GDP Ratio % 180 Greece Germany 160 Euro area 140 OECD Countries 120 100 80 60 40 20 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: OECD, statistic regarding GDP growth from “This Time is Different” by Carmen 9 Reinhart & Kenneth Rogoff

Relationship between Developed-Debtor and Emerging-Creditor Nation 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE Mechanics of Chinese Currency Peg People’s Bank of China $1 USD = approx 6.35 Yuan “print” Yuan Estimated at 15-40% undervalued to $USD Reinvest $3.2 tn excess reserves in: “buy” $USD US consumer buys $USD Chinese manufactured goods bought by US consumer 10

Yield% Yield (%) Source: Federal Reserve 10% 15% 20% 25% 10% 12% 14% 16% 18% 0% 5% 2% 4% 6% 8% Interest rates in the developed world are at generational lows fueling leveraged carry trades 1962 1962 1963 1963 1964 1964 1965 1965 1966 1966 1967 1967 1968 1968 1969 1969 1970 1970 1971 1971 1972 1972 1973 1973 1974 1974 1975 1975 1976 and increasing public and private debt 1976 1977 Rates have nowhere to go but up 1977 1978 1978 1979 1979 1980 1980 1981 1981 Effective Federal Funds Rate 1982 10 Year US Treasury Yield 1982 1983 (1961 to Present) 1983 (1961 to Present) 1984 1984 1985 1985 1986 1986 1987 1987 1988 1988 1989 1989 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1995 1996 1996 1997 1997 1998 1998 1999 1999 2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE 12

Global asset prices driven by the CARRY TRADE instead of economic fundamentals 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE End result is “RISK-ON” /“RISK OFF” dynamic Developed World Risk Assets + Emerging Economies Borrow at historically low Reinvest in Risk Assets! interest rates RISK ON! ↑ global stock prices ↑ commodities ↓ “safe haven currencies” like the USD or Yen RISK OFF! ↓ global stock prices ↓ commodities ↑ “safe haven currencies” like the USD or Yen 13

Basics of the Carry Trade 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE Japan Australia Yen = Safety Currency Aussie Dollar = Risk Currency 1 AUD = 81.15Yen Convert to 100 AUD and borrow 8,115 Yen @ 0.20% reinvest @ 5.60% + 5.40% of positive carry Keys risk is depreciation of the AUD against the YEN (due to economic weakness) “Safety” or “Funding” Currencies “Risk” Currencies Appreciate ↑ During Economic Weakness Depreciate ↓ During Economic Weakness US Dollar Australian Dollar Japanese Yen New Zealand Kiwi Swiss Franc (until recently) Brazilian Real 14

Excess global liquidity has arguably led to the most correlated period in the history of modern 3. G LOBAL T RADE I MBALANCES AND THE C ARRY T RADE markets rendering diversification futile (correlation measures the propensity for assets to move in-tandem) ASSET PRICE RISK = CURRENCY RISK Realized Correlation of 50 Largest Cap S&P 500 stocks Implied Correlation of S&P 500 Index 85 S&P 500 - 21 day Rolling Correlation Index (1 month rolling- 2005 to Present) 78 (12 month constant adjustement) 75 S&P 500 Index Implied Correlation 73 65 68 55 63 58 45 53 35 48 25 43 15 38 33 5 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Feb-05 Jun-05 Oct-05 Feb-06 Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 Feb-11 Jun-11 0.9 120 S&P 500 Sector Correlation Country ETF Correlation Ranked 21 day Realized Correlations of 50 LargeCap Stocks in SPX 0.75 (2005 to Present) 100 0.8 0.65 80 21 day Realized Correlation 0.7 60 0.55 0.6 40 0.45 20 0.5 0.35 0 0.4 0.25 -20 9/7/2011 (Highest Correlation at 0.82) -40 0.3 0.15 2008 Crash High (11/13/2008 - Correlation at 0.76) Bull Market Low (11/3/2006 - Correlation at 0.10) -60 0.05 0.2 Ranking (Lowest to Highest) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -80 1 101 201 301 401 501 601 701 801 901 1001 1101 1201 Source: Ivolatility & Artemis Capital Management LLC 15