2011 09 27 CLSA - David Roche

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This memorandum is based upon information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned herein.

This memorandum is provided solely for the information of pro fessional investors who are expect ed to make their own investment decisions without undue reliance on this memorandum and save for any liability o r obligations under the Financial Services Act 1986 and/or

the rules of the Securities and Futures Authority Limited. Independent Strateg y Limited accepts no liability whatsoever for any direct or consequential loss arising from any use of this memorandum and its contents. It may not be circulated to or used by private investors for

any purpose whatsoever. This memorandum may not be reproduced, distributed or published by any recipient for any purpose.

David Roche October 2011

INDEPENDENT

STRATEGY

‘ if ’

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INDEPENDENT

STRATEGY

The great plurality

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INDEPENDENT

STRATEGYFigure 1Ifs – the great plurality

3

When outcomes have no normallydistributed probabilities of occurring

from the certainty of the known knowns to the

unquantifiable uncertainty of the knownunknowns and the of the unknown unknowns

The plurality of outcomes

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INDEPENDENT

STRATEGYFigure 4Distribution of deadly conflicts according to the number ofpeople killed

6

0

100

200

300

400

500

600

0.02 0.07 0.2 0.1 0.2 0.9 1.1 6 7 10 20 120 130

Fatalities (m)

No of

conflicts

Distribution is not normal bell curve

but a power law: double the no of

deaths and wars become four times

less common. The power law impliesthat when a war starts out, there is

no indication of how big it will come

(unlike human height distribution)

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INDEPENDENT

STRATEGYFigure 5Probability distribution for fluctuations in S&P-500 index

7

0

2

4

6

8

10

12

-20 -15 -10 -5 0 5 10 15 20

Normal Levy* Actual

Variation

P r o b a b i l i t y

* A Levy flight distribution is arandom distribution punctuated by

occasional big leaps ie 'fat tails' -fluctuations in stock market arecloser to the Levy flight distributionthan a normal distribution

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INDEPENDENT

STRATEGYFigure 6Knightian uncertainty

8

In his seminal work, Risk, Uncertainty, and Profit , economist Frank Knight(1921) established the important distinction between risk and uncertainty:

“ Uncertainty is.. radically distinct from risk. Risk means a quantity susceptible of measurement… a measurable uncertainty. that’s far

different from an immeasurable uncertainty ”

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INDEPENDENT

STRATEGY

Global sovereign debt crisis

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INDEPENDENT

STRATEGY

Derivatives 4%

Bond Debt 79%

BankLending

65%

PowerMoney

4%

Derivatives 173%

Bond Debt 141%

BankLending74%

PowerMoney

6%

Derivatives 125%

Bond Debt141%

BankLending

64%

PowerMoney11%

Figure 7The liquidity pyramid: the measure of global liquidity (% of GDP)

Note: * counterparty risk value

1990152%

2007394%

2011341%

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INDEPENDENT

STRATEGYFigure 8Global private credit and sovereign debt ($ trn)

11

0

20

40

60

80

100

120140

160

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Private credit Public debt

$41trn

$100 trn

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INDEPENDENT

STRATEGY

12

Figure 9Credit explosion

A: OECD – private credit and public debt ($ trn) B: OECD credit (% of GDP)

C: OECD credit (as % of real GDP) D: OECD: annual change in credit (%)

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Private credit Sovereign debt

Recession Recession

EM crisis

0

50

100

150

200

250

300

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11Private credit Sovereign debt

120%

48%190%

92%

100

140

180

220

260

300

340

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Private credit Sovereign debt

132%

53%210%

101%

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INDEPENDENT

STRATEGY

Note: * includes US, Germany and Japan.

Real 10 yr BY CPI inflation Nominal 10 yr BY Average real 10 yr BY

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

Q 2 1 9 8 1

Q 2 1 9 8 2

Q 2 1 9 8 3

Q 2 1 9 8 4

Q 2 1 9 8 5

Q 2 1 9 8 6

Q 2 1 9 8 7

Q 2 1 9 8 8

Q 2 1 9 8 9

Q 2 1 9 9 0

Q 2 1 9 9 1

Q 2 1 9 9 2

Q 2 1 9 9 3

Q 2 1 9 9 4

Q 2 1 9 9 5

Q 2 1 9 9 6

Q 2 1 9 9 7

Q 2 1 9 9 8

Q 2 1 9 9 9

Q 2 2 0 0 0

Q 2 2 0 0 1

Q 2 2 0 0 2

Q 2 2 0 0 3

Q 2 2 0 0 4

Q 2 2 0 0 5

Q 2 2 0 0 6

3.7%

1.6%

Figure 10OECD* CPI inflation and ten-year bond yield (%)

13

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INDEPENDENT

STRATEGY

14

Figure 11US non-financial debt (% of GDP) and national savings rate(% of GDP)

100.0

120.0

140.0

160.0

180.0

200.0

220.0

240.0

1 9 5 2

1 9 5 4

1 9 5 6

1 9 5 8

1 9 6 0

1 9 6 2

1 9 6 4

1 9 6 6

1 9 6 8

1 9 7 0

1 9 7 2

1 9 7 4

1 9 7 6

1 9 7 8

1 9 8 0

1 9 8 2

1 9 8 4

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

12.0

14.0

16.0

18.0

20.0

22.0

24.0

Credit - LHS Nat sav rate - RHS

128%139%

225%20.7%

19.7%

13.4%

GDP = 3.0% p.a.

GDP = 3.6% p.a.

Post-war decades

INDEPENDENT

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INDEPENDENT

STRATEGYFigure 12Global sovereign debt crisis

15

• Interest costs higher than growth

• Debt ratio above 90% of GDP (60% in EMs)

• Negative primary budget balance

• Current account deficit

• High foreign ownership of debt

• Shallow domestic bond market and short maturity of debt

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INDEPENDENT

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INDEPENDENT

STRATEGYFigure 14Net government debt and structural budget deficits,2010 (% of GDP)

17

-40

-20

0

20

4060

80

100

120

140

-2 0 2 4 6 8 10 12

Aus

Bel

Swe

Swz

Ita

Jap

US

UK

Gre

Ire

Spa

FraPor

Eur

Neth

Den

Ger

! DANGER ZONE !

EMU Export bloc

EMU Austerity blocOther

Structural deficit/GDP

N e t d e b t / G D P

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INDEPENDENT

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INDEPENDENT

STRATEGY

• Sovereign debt no longer risk free. No risk free rate for valuation of financialassets.

• Fiscal policy neutralized as sovereign debt no longer safe haven. Less refluxof capital to sovereign bonds in crises to help finance fiscal deficit spending.Fiscal debt and spending already too high.

• Monetary policy integrated with fiscal policy to prevent market pricing ofsovereign debt risk. Transfer of volatility from price-rigged to market pricedassets.

• Sovereign debt backstop to financial system discredited making banks more

risky and capital more expensive.

Fig 16A: The New Risk Paradigm - DM’s:

INDEPENDENT

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INDEPENDENT

STRATEGY

• Accumulation of DM sovereign bonds as international reserves makes forsolvency and liquidity risk as big as historical foreign debt risks.

• Threat to export growth model due to deleveraging in DM’s.

Fig 16B: The New Risk Paradigm - EM’s:

INDEPENDENT

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INDEPENDENT

STRATEGYFigure 17Three IFs and fat tails

21

NORMAL

UNCERTAIN

Ice age Long grind Halcyon days


%

INDEPENDENT

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22

P r o b a b i l i t y %

NORMAL

UNCERTAIN


INDEPENDENT

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23

P r o b

a b i l i t y %

NORMAL

UNCERTAIN

Halcyon daysLong grindIce age

INDEPENDENT

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STRATEGY

2

The Bedrocks:

• Death of Disinflation

• Emerging Market Model

INDEPENDENT

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STRATEGYFigure 18Bedrocks: the death of disinflation

25

HISTORY FUTURE

• Globalisation of labour supply • Slowing EM labour supply

• Tough central bank policy • Easy monetary policy

• More regulation;Government intervention

• Supply-side reform

• Maturing hi-tech markets• Hi-tech revolution

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INDEPENDENT

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STRATEGYFigure 20Bedrocks: the emerging market model

27

HISTORY FUTURE

Export-led growth Economic models based on domesticdemand

High savings, high

investment

Falling savings, rising consumption

and wages in national income

Plentiful young labour Increasingly old, scarce and moreexpensive labour

Low costs, capitalinflows

Less recycling and away from $ assets

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INDEPENDENT

STRATEGYFigure 23

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STRATEGYFigure 23Credit boom

30

A: Cumulative change in central bankassets and broad money 07-10 (%)

0

20

40

60

80

100

120

140

CB assets Broad money

DM EM

B: Change in credit/GDP from long-term trends (% pts)

0

5

10

15

20

25

Turk Bra China Indo Russ

Worry point as defined

by Basel Committee

C: Cumulative change in property prices 2006-10(%)

0

5

10

15

20

25

30

35

40

Indo Kor Mex China Russ

206!

INDEPENDENT

STRATEGYFigure 24

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STRATEGYFigure 24EM risk

31

A: EM-DM CDS differential B: BRIC real policy rate (%) and relative to realgrowth (% pts)

50

100

150

200

250

300

350

400

N o v - 0

8

J a n - 0

9

M a r - 0

9

M a y - 0

9

J u l - 0

9

S e p - 0

9

N o v - 0

9

J a n - 1

0

M a r - 1

0

M a y - 1

0

J u l - 1

0

S e p - 1

0

N o v - 1

0

J a n - 1

1

M a r - 1

1

M a y - 1

1

J u l - 1

1

* EM CDS is average of top seven EM

sovereign issuers; DM is average of top

four DM sovereign issuers

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

A u g - 0 7

D e c - 0 7

A

p r - 0 8

A u g - 0 8

D e c - 0 8

A

p r - 0 9

A u g - 0 9

D e c - 0 9

A

p r - 1 0

A u g - 1 0

D e c - 1 0

A

p r - 1 1

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

Real pol icy rate - LHS Less real growth - RHS

INDEPENDENT

STRATEGY

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STRATEGY

3

Investment wrap

INDEPENDENT

STRATEGYFi A

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STRATEGYFigure 25AThree IFs and fat tails

33

NORMAL

UNCERTAIN



%

INDEPENDENT

STRATEGYFigure 25B

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STRATEGYFigure 25BThree IFs and fat tails

34

Ice age Long grind

P r o b a

b i l i t y %

Halcyon days

NORMAL

UNCERTAIN

INDEPENDENT

STRATEGYFigure 26

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STRATEGY

The uncertain outcomes

35

Death of disinflation

New paradigms for EMs

US: end of empire

Global sovereigndebt crisis


Deflation:govt bonds and gold;

safe-havencurrencies

4-6% inflation:high-yield equities,

safe-havencurrencies

8-10% inflation:commodities, gold,growth stocks, EM

equities

Deflation: new EMmodel postponed – out of EM assets

Gradual move to newEM model: buy EM

consumer stocks and

Rmb; short EM debt

New EM modelwithin five years:buy EM equities

Deflation: hastenedcollapse of US power – out of US assets

except for govt bonds

End of US$ asreserve currency:

short US$ and fragileEMs

High US externaldeficit financed by

foreigners:buy US assets

Deflation: out ofbanks and cyclical

stocks

Contagion: out ofUS, UK and Japan

govt debt

Debt yields rise:stay out of govt debt

INDEPENDENT

STRATEGYFigure 27

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STRATEGYFigure 27Asset Allocation

36

There are gains under most outcomes

Short term: halcyon days

Medium term: grind

Long term: ice age

LONGS: Selected EMU sovereign debt (Ireland);index linked bonds; gold; euro, NZ$, S$, CHF

SHORTS: Sovereign debt; soft and hard commodities; US$

NEUTRAL: core blue chip high dividend yield equities.

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INDEPENDENT

STRATEGY

Contact details

Guido Manca or John Armstrong

Tel: +44 20 77304965Email: [email protected]

INDEPENDENT

STRATEGY

mailto:[email protected]

mailto:[email protected]

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Appendix

INDEPENDENT

STRATEGY

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3

The euro: sovereign debt,

banking and currency crises

INDEPENDENT

STRATEGYFigure A1

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The fiscal

4

Figure 1B: Net public debt to governmentrevenues (%), 2011

Figure 1D: Gross national s avings by sector (%of GDP), 2011

Figure 1C: Primary budget balance (2011) and thatrequired to stabilise debt at current level (% pts ofGDP)

Figure 1A: Public sector debt to GDP (%), 2011

87100

229

67 72

128

0

50

100

150

200

250

Eur US Jap

Gross debt Net debt

150

231

386

0

50

100

150

200

250

300

350400

450

Eur US Jap

-1.7

-8.6-9.0

-0.3

-1.8

-0.8

-10

-9

-8

-7

-6

-5-4

-3

-2

-1

0

Eur Jap US

Prim budg bal Req prim bal

5.4

11.5

6

9.0

10.823.3

-2.1 -4.0-3.1

19.2

25.3

12.3

-10

-5

0

5

10

15

20

25

30

35

US Eur Jap

Gov

Corp

House

Total

INDEPENDENT

STRATEGYFigure A2

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Figure A2Government debt held abroad (% of total debt outstanding), 2010

41

3229

7

0

5

10

15

20

25

30

35

US Eur Jap

INDEPENDENT

STRATEGYFigure A3

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Bank exposure

4

Figure 3B: Bank lending by sector (% of GDP), 2011

Figure 3D: Bank leverage (x) and equity to assetratio (%), 2011

Figure 3C: Bank exposure to PIIGS sovereign andbank debt (€bn ), 2011

Figure 3A: Total national gross debt by sector(% of GDP), 2011

91

72

74

76

142

138

97

148

188

100

87

229

0 100 200 300 400 500 600 700

US

Eur

Jap

Household Non-Fin Corp Financials Public sector

63

56

30

29

71

60

8

12

76

0 50 100 150 200

US

Eur

Jap

Households Corporate Government

75

115

18 22

116

72

43 33

0

20

40

60

80

100

120

140

160

180

200

Ger Fra US UK

Sov Bank

INDEPENDENT

STRATEGYFigure A4

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Figure A4Bank wholesale funding as share of total liabilities (%), 2010

43

0

5

10

15

20

2530

35

40

45

50

Jap US Eur

€10trn

€3.7trn

€11.6trn

INDEPENDENT

STRATEGYFigure A5

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gBank rollovers in 2012, % of total debt

44

5

7

9

11

13

15

17

1921

Ire Spa Por Neth Ita Ger Fra Aus Bel Gre UK

€21bn€88bn

€17bn €95bn

€142bn €227bn€182bn

€163bn

€34bn

€8bn

€3bn

Total Eurozone debt

rollover in 2012 = €795bn,

or 16% of total bank debt

`

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INDEPENDENT

STRATEGYFigure A7Growth and bailouts

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Growth and bailouts

4

Figure 7B: Required net trade contribution (%pts of GDP) to achieve growth rate

Figure 7D: EFSF (only) cost of bailing out thePIIGS through 2014 (€ bn)

Figure 7C: Funding for Eurozone governments (€bn)

Figure 7A: Required nominal GDP growth rate tostabilise govt debt ratio and 2011 rate (%)

3.0 3.3

3.8 4.04.4 4.5

1.3

-3.0

0.5

4.0

2.1

-1.1

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Ita Gre Ire Bel Spa Por

Req nom GDP rate 2011 rate

0.40.5

0.6

0.8 0.9

1.5

0.3

-0.3

-1.1

0.1

-0.5

0.7

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Bel Ita Spa Por Gre Ire

Req Ave 02-07

440

142

432

922

1022

0

200

400

600

800

1000

1200

EFSF Existing bailouts Add Spain Add Spa+Ita Add Spa+Ita+Bel

110

390

216

0

50

100

150

200

250

300

350

400

450

Asset purchases* Liquidity provision** Bailouts

* ECB's SMP

** ECB collateral holdings

*** IMF/EFSF/EFSM bailouts

1.6% of Eurozone GDP



INDEPENDENT

STRATEGYFigure A8Gross public debt and contingent liabilities of key EMU

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Gross public debt and contingent liabilities of key EMUstates if EFSF tripled in size (% of GDP), 2011

47

0

50

100

150

200

250

300

Ita Bel Ger Fra Spa Neth Fin

Pro rata Joint & Several

483%

800%

INDEPENDENT

STRATEGYFigure A9

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EFSF capacity as share of requirements (%)

48

% share

Spa+Ita req funding to end 2012 54

Spa+Ita req funding to 2014 30

Bank recap cost on sovereign default 22

Total PIIGS debt 10

EFSF capacity relative to weekly ECB SMP funding 33 weeks

INDEPENDENT

STRATEGYFigure A10

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The euro debt crisis

49

The options

Fiscal integration and economic reform

Monetise and underwrite fiscally EMU state debt

Reconstitute the euro (Treaty changes to allow weak EMU states

to leave or be expelled)

Abolish the euro (birth of new Super-DM euro?)

International funding initiative coupled with IMF governed reformof PIIGs

2011 09 27 CLSA - David Roche

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