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Bridgewater Associates: My Ruminations - November 2006


Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater® Daily Observations November 20, 2006 © 2006 Bridgewater Associates, Inc. (203) 226-3030 Ray Dalio Bob Elliott My Ruminations by Ray Dalio As you know, we position ourselves for major market moves not wiggles, so I’m going to focus on the major moves. The last few months’ market movements have been in the opposite direction of their longer-term trends, contrary to the fundamentals (I believe) and, by implication, contrary to our positions. So we’ve given back the gains that were posted during the first half of the year and are essentially flat on the year. In a nutshell, our notable positions are as follows: • Moderately short global bonds and long short maturities. • Short Euroland and US bonds, and long Japan and Canada. • Moderately long most emerging market currencies vs. developed. • Strongly long the Chinese RMB. • Moderately long the JPY/USD and JPY/EUR. • Neutral on global equities; moderately long Australia and UK relative to Euroland stocks. • Moderately long commodities. When we go long or short our bets are relative to that which is discounted in the markets. So let’s start by looking at what is discounted. That’s shown below. Australia Canada Euroland Japan U.K. U.S. Avg One-year change in short rates 0.2% -0.1% 0.3% 0.5% 0.2% -0.4% 0.1% 10-year Real Yield 2.4% 1.8% 1.6% 1.1% 1.4% 2.3% 1.8% 10-year breakeven inflation rate 3.1% 2.4% 2.1% 0.7% 3.0% 2.3% 2.6% One-year analyst earnings growth Long-term analyst earnings growth Implied real earnings growth rate 10% 9% -1.3% 14% 13% -0.7% 10% 7% -1.7% 10% 13% -0.4% 8% 9% -2.3% 11% 12% 0.3% 10% 11% -0.7% 10-year chg in real FX vs. USD 0% 6% 7% 15% 10% 6% 10-year chg in nom. FX vs. USD -10% 6% 10% 35% 1% 8% So, there’s not much of a tightening built in on average in the industrialized countries - the average is 0.1 percent with some tightening in Euroland and Japan and some easing here discounted. As shown, there is about 40 basis points of easing built into the US short rate so that if the Fed was to essentially remain neutral, and we actually think that the Fed will tighten during that period, then it would be profitable to be short that market. Real yields are only 1.8% on Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17, U.S. code). 1 Bridgewater ® Daily Observations 2/7/2007
  • 2. average, with the highest being 2.3% in the US; we think those numbers are too low. The breakeven inflation rate is around 2.6% on average (with individual countries shown), which we also consider a bit low in relation to what’s likely. When looking at the term structure of rates, the bond yield essentially equals the real yield plus the breakeven inflation rate (risk premiums aside). So from this perspective, we think nominal bond yields are generally fundamentally low and we expect a more material rise in the real yield plus a bit of a rise in the breakeven yield. We believe that bond yields are artificially low for reasons pertaining to who’s buying, what quantities, and why (which we’ll get into later in this report) and that most, though not all, of what is making yields too low are of a transitory nature that will lead to yields being too high when they change. Equities, from a value perspective, are generally moderately attractive. If you look at the implied real earnings growth rates, there’s not much in the way of real earnings growth that’s discounted, so we would say that equities are modestly to moderately attractive if you were to just look at their expected returns relative to bond yields. But, since we expect that bond yields are going to rise, that’s going to be a negative for stocks despite the fact they’ll be relatively cheap. Further, regarding purchases and sales, institutional portfolios are being restructured in a way that is negative for equities. So, on balance, we are relatively neutral. Recent Market Action: Minor Corrections in Longer-term Trends The charts that follow first show the market action since the start of July and then show the longer-term movement (typically back to 1960) to put the recent movements in perspective. The recent period is then shown in the circled area on the long-term chart. As shown in the first chart, over this short-term period, U.S. 10-year T-bond yields fell from about 5.4% to somewhere a little bit above 4.6%. Then go to the long-term chart and see the dip which I’ve circled. As you can see, it’s a small downward wiggle in an uptrend. Bond Yields 4.6% 4.8% 5.0% 5.2% 5.4% 3.7% 3.8% 3.9% 4.0% 4.1% 4.2% US (left axis) Euroland (right axis) Japan + 2% (right axis) 11/18 11/11 11/4 10/28 10/21 10/14 10/7 9/30 9/23 9/16 9/9 9/2 8/26 8/19 8/12 8/5 7/29 7/22 7/15 7/8 7/1 2 Bridgewater ® Daily Observations 2/7/2007
  • 3. US 10yr Yield 18% 15% 12% 9% 6% 3% 0% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 A lot of people, perhaps a consensus, are focusing on this dip in bond yields and think we’re in a new environment of slower growth. I think that they are overweighing the recent movement because people tend to over exaggerate the importance of wiggles, not because of the fundamentals. The next set of charts show equity prices for the major markets. As shown, they rose by about 10% from their lows and had a retracement of the declines from their roughly 2000 peaks back up to those peaks. Equity Prices 8% 3% -2% -7% US Euroland Japan -12% 7/1 7/15 7/29 8/12 8/26 9/9 9/23 10/7 10/21 11/4 11/18 US Stocks (ln) Japanese Stocks (ln) 400% 350% 300% 250% 200% 150% 100% 50% 0% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 3 Bridgewater ® Daily Observations 2/7/2007
  • 4. The next chart shows the dollar’s move since early July, which was modestly up. With that dollar strength, there’s a growing view that we are in a stronger dollar environment. Again, I draw your attention to the chart at the bottom, particularly the circled area in the context of the longer-term movement. Once again, you can see that the recent movement has been an insignificant wiggle. In fact, the dollar has been in a range since about 2004 as you can see from the longer-term chart. US Dollar 7/1 7/15 7/29 8/12 8/26 9/9 9/23 10/7 10/21 11/4 11/18 USD/EUR 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 The next set of charts shows oil and commodity markets. As shown, for the last few months or so, oil has declined (while many other commodities such as metals are up). With that decline, there has been a change in psychology from bullish to bearish with the consensus believing that we are past the commodity problem and past the oil problem. And again, as shown in the longer- term chart, these declines were insignificant wiggles. 1.22 1.24 1.26 1.28 1.30 1.32 110 111 112 113 114 115 116 117 118 119 120 EUR/USD (inverted) JPY/USD Stronger dollar Weaker dollar 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 Stronger US Dollar Weaker US Dollar 4 Bridgewater ® Daily Observations 2/7/2007
  • 5. Oil CRB 85 80 75 70 65 60 55 6/1 6/15 6/29 7/13 7/27 8/10 8/24 9/7 9/21 10/5 10/19 11/2 11/16 Oil (ln) CRB (ln) 4.0 1.5 3.5 1.3 3.0 1.1 2.5 0.9 2.0 0.7 1.5 0.5 1.0 0.3 0.5 0.1 0.0 -0.1 -0.5 -0.3 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 I believe that there’s a very strong tendency for people to exaggerate the importance of recent events and recent performance. I think it’s human nature. You turn on the television and whatever’s on the news seems more important at the time than in retrospect. Probably the greatest mistake in investing is exaggerating the importance of, and extrapolating, what’s happened lately. I think that that’s what’s been happening over the last three to six months has substantially changed the psychologies and positions of a lot of people in the direction of betting these recent wiggles will continue. The recent market action also conveys the leverage bubble hasn’t yet popped, even though the housing bubble is deflating. The chart below shows our “crisis indicator” which converts the market action into an index of markets that reflect the discounting of improving economic conditions and the rewards of leveraging when it rises, and deteriorating economic conditions and the penalties of leveraging when it declines. Said differently, when the line rises, liquidity is typically plentiful and borrowing cash to buy assets and invest in businesses is being rewarded. Over the past few years, there has been a lot of leveraging (i.e., borrowing of cash to essentially bet that the line on this chart won’t fall), especially in the household and financial sectors. For example, a lot of private equity money has been buying assets at 6, 8, or 10 times multiples to yield 10% to 15%, and financing it with debt that has a 5 or 6% interest rate. That sort of tapping of liquidity to buy assets that are widely believed to have higher expected returns than the cost of debt is behind the mortgage picture, the corporate picture and, most importantly, the financial sector’s picture. Crises are usually caused when the cash flows thrown off by those assets don’t cover the debt service costs, and asset prices fall, which is reflected in declines in the line in this 400 395 390 385 380 375 370 365 360 5 Bridgewater ® Daily Observations 2/7/2007
  • 6. chart. As shown in this chart, a mini-tremor occurred in May-June, but it has passed and been long forgotten. Excess Liquidity/Crisis Indicator 25% 30% 35% 40% 45% 50% 55% 11/3/06 10/3/06 9/3/06 8/3/06 7/3/06 6/3/06 5/3/06 4/3/06 3/3/06 2/3/06 1/3/06 12/3/05 11/3/05 10/3/05 As shown in that chart and as you probably recall, in May/June, we had a liquidity scare that led to a large plunge in asset returns and had a significant negative effect on hedge fund returns (because they have a systematic bias to benefit from low credit spreads, low liquidity premiums and rising asset values). In our opinion, there are structural reasons to believe that this behavior will occur in the future, probably more forcefully and probably within the next couple years (with the risks being relatively small over the near-term and increasing at an increasing rate at more distant points in time). So, I want to emphasize that we’d be shocked if the housing bubble deflating turned into anything approaching a recession. In fact, though we expect a big problem in a couple of years, we expect just a minor hiccup in growth (less than the 1967 growth recession) followed by a pickup in growth and greater tightening (like that which occurred in 1968­ 69). Our reasoning follows: The Three Major Drivers As you know, we believe that there are three major forces that have been, and will continue to be, the main drivers of the global economy and the global markets. They are: 1) The economic/market cycle: There is a “typical” economic/market cycle that’s important to understand as a reference point from which one might consider how each particular cycle is different. In a nutshell, typically when coming out of a recession, we see fast growth in demand that, at some point, creates tightness of capacity causing inflation pressures to build, leading to central banks tightening and recessions to follow. Late in expansions, balancing inflation and growth becomes increasingly difficult for central bankers compared to early in expansions. Also, global markets tend to behave in sync and global economies are positively correlated (though less so than their markets). That’s the norm and virtually all cycles have roughly followed this script. In our opinion, we’re in a relatively typical economic/market cycle and we are entering the late stage of that cycle when it will become increasingly difficult for the Fed to balance growth and inflation. While this cycle, as with all cycles, is not identical to the typical cycle, the most important differences this time around are due to the other two major drivers. 2) Debt: The debt influence is unique in two respects. First, there is an exceptionally high level of debt globally, especially dollar denominated debt. 6 Bridgewater ® Daily Observations 2/7/2007
  • 7. The US household and global financial sectors have leveraged up a lot. That high level of debt has implications in that it makes the U.S. economy and the world economy more interest rate sensitive than normal. That is because debt burdens essentially equal interest rates times debts, so when debt levels are at higher levels (as they are now), it takes smaller interest rate changes to affect debt service burdens and in turn the economy. Second, an extraordinarily large percentage of that debt is being bought and held by foreign investors, particularly government foreign investors, for reasons having nothing to do with the economics of owning that debt. So, U.S. interest rates (particularly bond yields) are now lower and the dollar is now higher than they would be if these loans weren’t made or if this lending goes away. We project the borrowing requirements of the U.S. (and other dollar denominated borrowers) to rise at the same time as we project the desire to lend by these foreign investors to fall, so we expect upward pressure on interest rates and/or downward pressure on the dollar. Further, if this occurs, it will make the Fed’s trade off between inflation and growth more acute at the same time as the cyclical forces are also making it more acute. We expect this influence, like the cyclical influence, to unfold gradually at first and at an increasing pace over the next two to three years. 3) “The China” and “Productivity” Factors. While China is the most important country to substantially increase the global supply and lower the price of labor, and to increase the demands for commodities, there are of course others (e.g. India) following a similar dynamic. But, for simplicity, I am dubbing this “the China Factor.” Related to this “China Factor,” in lowering the price and the demand for labor in developed countries (because labor in these countries competes with labor in developed countries) are productivity gains that are happening everywhere. This improvement in productivity comes a) partially from the globalization, increased supply and cheap prices of labor markets (e.g., “productivity” as measured in the cost of a unit of output, not just in the hours it takes to make it, is higher in the U.S. because of cheaper labor in the U.S., largely because of competition from China), b) partially from efficiency gains due to inventions, capital expenditures and cleverness and c) partially from the changing complexion of the economy (i.e., because those industries that are accounting for an increasing share of GDP require less labor per unit of GDP). As a result of these forces, labor’s share of the income pie is shrinking (especially in developed countries) relative to capital’s share (e.g., corporate profits) and commodities’ share. So, in a nutshell, the world’s supply of labor quadrupled over the last 20 years or so, which created a cheap labor market and disinflationary productivity gains globally as China and other emerging countries with cheap labor became giant manufacturing machines by combining their cheap labor with the newest plant and equipment in the world (provided by capitalists) and commodity imports. These countries are so efficient that their exports are outstripping their imports and, together with their capital inflows, they are having enormous balance of payments surpluses. If governments didn’t intervene and free market forces drove things, the imbalances would disappear via China (etc.) spending and importing more rather than by increasing reserves and the markets would bring this about via their currencies appreciating and/or their interest rates falling relative to interest rates in deficit countries. However, because they don’t want their exchange rates to rise, they’re forced to buy U.S. dollar denominated bonds, defacto motivating Americans to buy houses and to over consume (especially imported goods) by keeping U.S. interest rates artificially low and the dollar artificially high. This dynamic is also causing these countries’ monetary policies to be easier than they’d like, which is causing their economies to be stronger than desired, which is contributing to faster economic growth and 7 Bridgewater ® Daily Observations 2/7/2007
  • 8. higher commodity prices, thus pushing the global economy’s movement deeper into the late-cycle stage of the expansion. It is in the interest of these countries to tighten their monetary policies to restrain growth, but doing so would only increase their balance of payments surpluses and their lending to dollar denominated borrowers. So, to have the domestic and balance of payments conditions that they desire, it is in their interest to have both their interest rates and their currencies rise. As with the two previously described influences, we expect the pace of the movement in this direction to be gradual at first and to pickup progressively as time passes. To help put this dynamic in perspective, I believe that the period in history that is most analogous to the present is 1967/69, after the Fed’s first leg of tightening, around the time of the pause in growth that was followed by the last leg up in growth and the next tightening that led to the 1970 recession and the breakup of the Bretton Woods monetary system. Then, as now, there was an enormous increase in dollar denominated debt purchased by the surplus countries in order to help maintain the fixed exchange rate and because the dollar was the world’s reserve currency leading other countries who were not trying to fix their currencies to buy dollar debt (like commodity exporters are doing now). Then Japan, and to a lesser extent Germany, were very competitive at the then existing exchange rates, for much the same reason as China and other cheap labor, high productivity growth countries are cheap today, so they ran large balance of payments surpluses. When foreign investors demanded U.S. bonds in exchange for foreign currency liquidity which Americans used to buy foreign goods and services, it tends to keep interest rates artificially low and makes it easier for the Fed to balance inflation and growth pressures; when foreign holders of U.S. debt want to slow their purchases of U.S bonds and convert their bonds into purchasing power it tends to cause interest rates to be artificially high and makes the Fed’s balancing act more difficult. A large foreign debt is essentially either latent inflation or latent credit problems. That is because, when bond holders turn their bonds in for cash and then take that cash to spend it, the central bank either has to increase the amount of cash/liquidity to meet these demands in order to sustain growth (which is inflationary) or not increase the money supply to meet these demands in order to curtail inflation (which is when a liquidity crisis ensues). That’s why, when foreign investors bond buying slows or turns into selling, the Fed’s trade off between growth and inflation becomes more acute. To be clear, we don’t think that this is imminent. Both current economic conditions and the market action are not consistent with it now happening. Remember that the dollar’s devaluation occurred following the 1970 recession and such devaluations typically occur when central banks are faced with the choice between fighting inflation and currency weakness and fighting economic weakness at the same time. This happens when capital is moving out of the country and out of the long end of the credit markets, causing long rates to rise relative to short rates, the dollar to decline and inflation hedge assets to rise. So, while the dollar denominated debt is a large and a latent risk, I don’t see it as an immanent risk. I do, however, expect the trends of the markets and economic conditions to be in this direction, so these risks do affect our current positioning. Let’s look at each of these three drivers a bit more closely. 1) The Economic/Market Cycle: The chart below shows what the typical economic/market cycle looks like to us. 8 Bridgewater ® Daily Observations 2/7/2007
  • 9. As mentioned, in our opinion, the economic market cycle is moving into the late cycle phase, which is initially bullish for inflation hedge assets, and is bearish for bonds and later for equities. And we think that the risks to these markets and the economy will increase substantially over the next two or three years. To convey why, we will show some charts that illustrate where we are in the economic cycle. First chart shows the GDP gap in the developed world; it’s a measure of slack in the economy for the developed countries. As you can see, it is relatively high, though not as high as it was in 2000. You know what the 2000 environment was like. It’s also not quite as high as it was in 1990. You might remember what 1988-90 was like. Both of those environments were environments of tightenings that were followed by recessions. In a cyclical sense, we are where we were in 1999, 1988, 1978 and 1972 – i.e., at the beginning of a tightening and one or three years before the recession. 9 Bridgewater ® Daily Observations 2/7/2007
  • 10. Developed World GDP Gap -6% -4% -2% 0% 2% 4% 70 73 76 79 82 85 88 91 94 97 00 03 06 The unemployment rate shown below shows a similar picture against previous unemployment rates. This is inverted, so a higher number represents a lower unemployment rate. You can see that the unemployment rate is at its lowest levels since 2000 and 1990. Developed World Unemployment Rate (inverted) 2% 4% 6% 8% 70 73 76 79 82 85 88 91 94 97 00 03 06 The next chart shows a) Bridgewater’s gauge of “slack” which is a combination gauge of GDP gap, capacity utilization (in maroon) and b) CPI inflation (the blue line), so you can see the relationship between them. As you can see, when that maroon line is above zero, inflation tends to rise. Observe 1988 to 1990, which we consider to be analogous; also see 1998-2000, which we also consider to be similar. Though the current level of capacity constraints is not yet as great as existed at the most severe points during these times, it is consistent with the levels that produced higher inflation. In a nutshell, I’m just saying that capacity is moderately tight so that above trend growth from here will, all else being equal, produce faster increases in inflation. So, cyclical forces should motivate the Fed to make sure that growth stays in the vicinity of 3% or less, all else being equal. Of course, all else is not equal. 10 Bridgewater ® Daily Observations 2/7/2007
  • 11. US GDP Gap, Capacity Util. + Unemployment vs. 10yr Avg CPI Y/Y 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 The world is growing at a faster pace than the U.S. The next chart shows world GDP growth. As you can see, it has been relatively strong. Emerging countries’ growth rates have been particularly strong. So we’re looking at relatively good growth in the developed countries and strong growth in emerging countries, so relatively strong growth overall. In our globalized economy, in which there is global competition for resources, global growth rates affect each country’s inflation rate nearly as much as the domestic growth rate. World Real GDP Growth (GDPWeighted Y/Y Change) 70 73 76 79 82 85 88 91 94 97 00 03 06 Emerging CountryReal GDP Growth (GDP-weighted, Y/Y change) 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 0% 2% 4% 6% 8% 10% 12% 14% 16% -4 -3 -2 -1 0 1 2 Cyclical pressures havetransitioned from deflationaryto neutral,andarenowmoving to inflationary. -2% 0% 2% 4% 6% 8% *55 countries 0% 2% 4% 6% 8% 10% 11 Bridgewater ® Daily Observations 2/7/2007
  • 12. Global growth is uniquely broad-based. The chart below shows the percentage of countries that have positive real GDP growth rates. As shown, 100% of the economies are growing. One has to go back to 1969 to find the last time that happened. % of Countries with Positive YoY Real GDP Growth* 100% 95% 90% 85% 80% 75% 70% * 58 Countries 65% 60% 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 In the next chart, we plotted the U.S. bond yield, the U.S. CPI plus a constant and the U.S. core CPI plus a constant in order to help convey the relationships between these three things going back to 1960. As shown, all three have been rising since 2003. Also note that bond yields are now the lowest in relation to these inflation measures that they have been since 1980. We think that either bond yields will rise or inflation will decline, and we don’t think inflation will decline. More precisely, we believe that the core rate of inflation (which is more of an influence on the bond market) will rise and the CPI will fall over the next few months, and that both inflation rates will start rising in 2Q-07. 10 Year Yield Overall CPI + Constant Core CPI + Constant 20% Core inflation describes bond yield with 20% less error than overall inflation 15% 10% 5% 0% 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 To help conceptualize inflation, we break it into its three most important drivers which we think are domestically produced items, rents and imported items. The relative size of these influences is shown in the table below. Rents and primarily domestically produced goods and services each count for a bit over 40% and imported goods and services account for about 17%. Domestically produced goods and services are primarily affected by domestic labor costs. 12 Bridgewater ® Daily Observations 2/7/2007
  • 13. % of Core CPI Rents 42.8% Primarily Domestic Goods and Services 40.2% Primarily Imported Goods 16.9% These three inflation rates are shown below. Rents US Labor Sensitive Importable Goods 14% 12% 10% 8% 6% 4% 2% 0% -2% 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 The next chart shows various measures of labor costs. As shown, they are all rising at brisk paces and are at the high end of the range of the last 20 years, except for the ECI. We expect these upward trends to continue at the same time as productivity growth will slow. Unit Labor Costs Y/Y Compensation per Hour Y/Y ECI Y/Y Hourly Earnings Y/Y 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 Developed countries, especially the U.S., essentially have a two-tiered labor market – i.e., a labor market in which there are blue-collar manufacturing workers on the one hand and high-end financial services and tech workers on the other. The supply of people in the second group is very tight relative to the supply of people in the first group, and changes in their compensation levels reflect this. For example, one of the big reasons for the differences in the ECI and the compensation per hour inflation rates is due to stock options that affect the second group and not the first group. We expect the compensation levels in the second group to increase at an increasing rate, while the compensation levels of the first group to rise at a much slower rate, and the gap in earnings between the two groups to continue to widen. This will have political and tax 13 Bridgewater ® Daily Observations 2/7/2007
  • 14. implications, particularly over the next four years, particularly if there is an economic crisis going into the next presidential election. These political and tax changes can also be bearish for bonds as they will be designed to shift wealth and income toward labor at the expense of capital. Regardless of political and tax changes, over the next six months or so we expect that the headline CPI will at first decline to reflect the commodity price and import price declines that we saw already but haven’t yet fully passed through the numbers and that it will then flatten out. At the same time, we expect to see the core CPI rise due to rising rents and rising core inflation rates of domestically produced items. As the bond market is more sensitive to the core rate, we believe that changes in these inflation numbers will be modestly bearish for bonds during this period. For the inflation outlook in the second half of next year, we expect both the headline CPI and the core CPI to rise together. That is because we don’t think that growth is slowing adequately worldwide to alleviate the commodity pressures, so we expect commodity prices to turn up again driving the headline number up, and we expect to see the core rates to continue to rise due to the inflation pass through to both labor and rents. Further, since we expect the dollar to decline, we expect that to contribute to higher imported goods prices during the second half of next year. So we think that the Fed and the markets are a) paying too much attention to growth, b) over-exaggerating the importance of U.S. housing in forming their outlooks and c) underestimating the effects of inflation and the impact of the U.S. external imbalance. Having said that, we don’t believe that inflation will be a major problem, even in the second half of next year. Rather, I believe that it will be an emerging problem that will affect both the bond markets and central bank policies. The chart below shows the average world CPI and developed countries’ CPI numbers, just to give you two global perspectives. As shown, they are low and they are trending higher. For a previously explained reason, we expect them to continue to slowly trend higher until, or unless, U.S bond holders choose sell their bonds, get cash and do something else with it. World CPI * Developed World Core CPI 0% 5% 10% 15% 20% * 56 countries 70 73 76 79 82 85 88 91 94 97 00 03 06 As shown in the next chart, U.S. bond yields are still low in relation to U.S. nominal growth, which is basically conveying that money is cheap relative to the various things to do with it. That is a positive force for credit expansion and the associated activity, hence relatively strong growth and higher inflation. This relationship between interest rates and nominal growth is far truer globally, especially in emerging countries (like China). 14 Bridgewater ® Daily Observations 2/7/2007
  • 15. USA Nom GDP Y/Y (Right Axis) USA Nom Bond Yld (Left Axis) 18% 16% 14% 12% 10% v 8% 6% 4% 2% 70 73 76 79 82 85 88 91 94 97 00 03 06 Below we show U.S. real yields in relationship to U.S. real growth rates. You can see how low real yields are. You can see that at their low point, they were the lowest ever. So, while they’ve come up some, the gap is still very large between the level of real yields and the level of real GDP growth. We don’t expect the real GDP growth level to change much, but we do expect real yields to rise. USA Real Bond Yld (Left Axis) USA Real GDP Y/Y (Right Axis) 5.0% 10% 4.5% 8% 4.0% 6% 3.5% 4% 3.0% 2% 2.5% 0% 2.0% -2% 1.5% -4% 70 73 76 79 82 85 88 91 94 97 00 03 06 The table below shows past bond yields in a cyclical context going back to 1954. It shows what the cyclical lows in yields were, when they occurred, how much they rose, to what levels and when. For example, if you look at the table that shows nominal interest rate changes, and you go down to February ‘83, you’ll see that there was a 3.79% increase in bond yields to the cyclical peak from the cyclical low. In the next cycle starting in August ’86, there was a 2.79% increase; in the next cycle there was a 2.5% increase and in the next cycle there was a 2.3% increase. Note that each cyclical increase was less than the one before it, because the amount of indebtedness was greater, meaning that it took smaller interest rate increases to raise debt service burdens enough to stop the economy. We think that this time it will take about a 2 to 2¼% increase causing U.S. bond yields to peak at around 5½%. 15 Bridgewater ® Daily Observations 2/7/2007
  • 16. Low 2.52% 3.12% 3.79% 4.59% 5.70% 6.87% 10.34% 10.53% 7.07% 5.50% 4.46% 3.38% Date Sep-54 Apr-58 Aug-60 Apr-67 Mar-71 Dec-76 Jun-80 Feb-83 Aug-86 Oct-93 Sep-98 May-03 Nominal Change Move % Change 1.21% 37 48% -0.61% 6 -16% 1.25% 21 40% -0.58% 7 -13% 1.39% 73 37% -0.59% 7 -11% 3.32% 37 72% -2.21% 10 -28% 2.73% 54 48% -1.56% 15 -19% 6.25% 38 91% -2.78% 4 -21% 6.13% 15 59% -5.94% 17 -36% 3.79% 16 36% -7.25% 26 -51% 2.79% 13 39% -4.36% 73 -44% 2.57% 13 47% -3.61% 46 -45% 2.32% 16 52% -3.40% 40 -50% 10-Year Treasury Note High 3.73% 4.37% 5.18% 7.91% 8.43% 13.12% 16.47% 14.32% 9.86% 8.07% 6.78% Date Oct-57 Jan-60 Sep-66 May-70 Sep-75 Feb-80 Sep-81 Jun-84 Sep-87 Nov-94 Jan-00 Average Increases Range of Increases 3.07% 30 1.2% to 6.3% 13 to 87 Average Decreases Range of Decreases -2.99% 23 -7.3% to -0.6% 4 to 73 2) Debt The charts below show total debt as a percentage of GDP and the bond yield going back to 1960. As shown, since 1981 when interest rates started falling, debts accelerated relative to GDP. Americans were essentially given a whole lot more buying power because of the decline in interest rates. Also, these declining interest rates caused most asset values to rise as lower interest rates increased the present values of most assets such as stocks and real estate That increase in debt still is essentially pulling purchasing power from the future into the present. 16 Bridgewater ® Daily Observations 2/7/2007
  • 17. Total Debt % GDP 320% 300% 280% 260% 240% 220% 200% 180% 160% 140% 120% 60 65 70 75 80 85 90 95 00 05 US 10yr Interest Rate 60 65 70 75 80 85 90 95 00 05 2% 4% 6% 8% 10% 12% 14% 16% 18% The acceleration in debt over the last five years has been dominated by mortgage and financial sector debt. The first chart below shows mortgage debt relative to household income levels. In addition to financing housing purchases, mortgage debt has been used to finance consumer activity in other forms. The second chart shows debt/GDP levels by sector. So, as you can see, the household sector’s debt has accelerated (particularly related to mortgage debt), and the financial sector’s debt has accelerated, partially related to agency debt and partially because of a leveraging up of financial institutions. Because swaps and other derivative positions of these financial institutions are not considered debt, but they can have many of the same sort of risks as debt, in our opinion, while these debt numbers are large, they understate the amount of financial risk in the system. 17 Bridgewater ® Daily Observations 2/7/2007
  • 18. Mortgage Debt/ Income 90% 80% 70% 60% 50% 40% 30% 60 65 70 75 80 85 90 95 00 05 US Debt Breakdown (%of GDP) 120% Households 100% Non-Fin Corp Govt 80% Financial+Agency 60% 40% 20% 0% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 The next page shows what we call excess mortgages as a percentage of GDP. By excess mortgages we mean the amount of mortgage borrowing that was used for purchases that were not homes. Excess mortgage borrowing has been primarily used to boost consumer purchases. As you can see, it accelerated over the last few years and it’s beginning to come down. 5% US Excess Mortgage % GDP 12MMA 4% 3% 2% 1% 0% -1% -2% -3% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 18 Bridgewater ® Daily Observations 2/7/2007
  • 19. While the savings rate has declined in a manner that is shown in the next chart, housing purchases are considered savings, making the savings numbers much larger than they would be if one looked at just financial savings. Because houses are less liquid than financial savings, we plotted the savings rate ex-housing in the second of the two charts. Whether one looks at the first or the second of these charts, in relation to the previously shown debt charts, it is clear that it is unlikely that these trends can be extrapolated far into the future and that the boost that we have experienced in our living standards due to increased borrowing and reduced savings was an aberration. $1,600 Savings Per Head (in $) 12mma $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 -$200 -$400 60 65 70 75 80 85 90 95 00 05 -$3,000 -$2,000 -$1,000 $0 $1,000 $2,000 Net Financial Investment Per Head (in $) 12mma 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 As mentioned earlier, this excess debt growth has been heavily financed by foreign lenders. In the next chart, we show the U.S. current account balance as a percent of GDP (the red line) and the U.S. real exchange rate measured in two ways. The blue line shows the real exchange rate as it is traditionally calculated, which assumes that the mix of companies that we import from and export to is essentially fixed. The green line shows the real exchange rate adjusted for the changing mix of countries that we trade with, which we consider to be more relevant. In either case, our real exchange rate has not declined much, certainly not in relation to our deteriorated current account balance. Barring a significant decline in the U.S. real exchange rate and rise in U.S. real yields, we expect the U.S. current account balance to go from 6 to 7 to 8 to 9% of GDP over the next five years. So the amount of money that we’re going to need to borrow from the rest of the world, particularly from those who are hell bent on holding their currencies down, will increase continually. 19 Bridgewater ® Daily Observations 2/7/2007
  • 20. -10% -5% 0% 5% 10% -50% -35% -20% -5% 10% 25% Financing Hurdle US Current Account Balance % GDP Real Trade Weighted US$ Substitute Adjusted 80 82 84 86 88 90 92 94 96 98 00 02 04 06 As shown in the next chart, virtually 100% of our current account balance is financed via debt. One of the problems of borrowing is that we have to pay it back, or at least service our debts. When we finance our current account deficit with sales of equities and FDI, it doesn’t create a fixed obligation. Share of US Current Acct Deficit Financed by Foreign Lending 0% 25% 50% 75% 100% 125% 1998 1999 2000 2001 2002 2003 2004 2005 The next chart shows the United States net asset balance. Something like 20% of our GDP is owed in one form or another to foreigners. 20 Bridgewater ® Daily Observations 2/7/2007
  • 21. 15% 10% 5% 0% US Net Asset Balance as % of GDP -5% -10% -15% -20% -25% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 The next few charts show the percentage of our debt holdings held by foreign investors. As shown, about 55% of our treasury’s debt, about 40% of our corporate bond market, and about 40% of the agency market is owned by foreigners, which has risen and will need to continue to rise at a fast pace to maintain the status quo. Foreign Holdings of Treasuries as % of Marketable Securities 0% 10% 20% 30% 40% 50% 60% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Foreign Ownership of Corporate Bond Market 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 21 Bridgewater ® Daily Observations 2/7/2007
  • 22. 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Foreign Ownership of US Agency Bonds % Total Agency Bond Market 3) “The China” and “Productivity” Factors Regarding China (and emerging countries like China), their picture is essentially a mirror image of the United States. With an average income about 3% that of the United States and other mature industrialized countries, a population that’s intelligent, industrious and motivated by material gain and a business friendly environment, China is a good place to produce stuff, so it is attracting capital and running large trade surpluses. With labor costs so low in relation to going sales prices and revenues, companies in China can afford to manufacture more at cheaper prices and make good profits. So, they can afford to pay more for, and they demand larger quantities of, raw materials and they produce more manufactured goods at cheaper prices. I underlined raw, because this is not a commodity phenomenon – it is a raw commodity phenomenon. China is wildly building refining capacity, demanding and putting upward pressure on raw commodity prices while producing and putting downward pressure on refined commodities. So, nearly everything raw is tight and nearly everything manufactured is in surplus. This of course is deflationary for manufactured goods, so good for consumers, while it is inflationary for raw materials and makes the demand for, and the real price of, labor in developed countries decline. This also causes the rewards to capitalists to rise relative to the rewards to workers, widening the income and wealth gaps in developed countries. This dynamic is also causing a very rapid shift in wealth from developed countries to China (and other similar emerging countries). Were it not for government interventions, income and consumption levels in developed countries would fall and incomes and consumption levels in China (etc.) would rise faster than we are seeing with government interventions. The most important government intervention is coming in the form of 1) China, 2) other similar low labor cost countries (like India) and 3) countries that export raw materials lending to the United States (and, to a lesser extent, other developed countries). So, consumption levels in the U.S. have not fallen in line with the relative declines in income and wealth levels – hence, the balance of payments is being balanced with the production of the enormous amount of dollar denominated debt. This is the most important force behind the liquidity boom and a boom in the financial services industry. The following charts help to paint the picture. The first chart shown below is our index of competitiveness, measured in terms of the market shares of each country’s exports. As conveyed, China’s competitiveness is increasing at a very fast pace, those of other emerging countries is increasing at a much slower pace, and those of developed countries is declining. 22 Bridgewater ® Daily Observations 2/7/2007
  • 23. Competitiveness Gauges -0.8% -0.6% -0.4% -0.2% 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% Developed Countries Emerging Countries ex-China 100% China 80% 60% 40% 20% 0% -20% -40% 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 The next chart shows annual growth rates of China’s export shares. As you can see, it’s accelerating rather than tapering off. In other words, China is becoming more competitive at an increasing rate. This is as much because China is becoming highly competitive in advanced, high value-added industries such as information technology as it is because of China’s increasing market share in basic, low value-added industries such as textiles and toys. China is becoming extremely competitive in virtually everything. China is essentially the Wal-Mart of countries. China's Annual Rate of Export Share Gains 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 As previously mentioned, Chinese exports of manufactured goods is leading to increased imports of commodities. This is shown in the next chart. Since we expect export growth to continue to accelerate, we expect China’s imports of raw commodities to continue to accelerate. 23 Bridgewater ® Daily Observations 2/7/2007
  • 24. Chinese Trade Balance by Type of Good (%GDP) Commodities Manufactured -6% -1% 4% 9% 95 96 97 98 99 00 01 02 03 04 05 06 07 As you know, as a reflection of these developments, China’s savings in the form of its foreign exchange reserves is enormous and accelerating (see below). China Reserves (US$ Blns) 0 100 200 300 400 500 600 700 800 900 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Not only does China have a great, cheap labor force, but it has some of the newest and best equipment in the world because China’s investments in plant, equipment and technologies are large and growing at a fast pace. As shown in the next chart, the amount of money going into investment in China is now about the same as that which is going into investment in the United States, even though China is a much smaller economy. In fact, as costs are cheaper in China, the actual amount of investment in China is larger. Large investment will lead to increased competitiveness. 24 Bridgewater ® Daily Observations 2/7/2007
  • 25. Fixed Investment (%of US NGDP) United States China 0% 2% 4% 6% 8% 10% 12% 14% 16% 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 The affects of these trends on U.S. employment has been obvious and direct. These are most obvious in the sharp decline in U.S. employment in those industries in which Chinese production growth has been strongest (see the blue line in the chart below) and in terms of Chinese exports as a percent of U.S. imports. US Employment in Strong China Industries (000's) Chinese Exports as % of US Imports (12mma) 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Below we then show the total world foreign exchange reserves held in US dollar denominated debt, with a three year moving average to eliminate the wiggles. That giant spike up was largely to offset the external imbalances and not because of an increase in the perceived attractiveness of U.S. bonds. World Foreign Exchange Reserves Held in USD ($Bln) 3yr Chg 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 6,000 6,500 7,000 7,500 8,000 8,500 9,000 9,500 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% -500 0 500 1,000 1,500 2,000 2,500 25 Bridgewater ® Daily Observations 2/7/2007
  • 26. Interest rates in China are ridiculously low in relation to these growth pressures. This is reflected in the following charts. In the first chart, the blue line shows the nominal three month interest rate in relationship to the red line that shows nominal GDP growth. In the middle chart the real 3­ month interest rate is shown in relation to real GDP growth. In the last chart, the 3-month interest rate is shown in relation to the inflation rate. These charts convey the attractiveness of borrowing money to invest in growth. The Chinese government has tried to control credit and economic growth through non-monetary controls that are reminiscent in their lack of effectiveness of credit and price controls that previously occurred in numerous other countries. As with all other countries, we believe that China will want to have an independent monetary policy more than it will want to have a fixed exchange rate, though we can’t say exactly when and to what extent that will occur. 0% 5% 10% 15% 20% 25% 30% Chinese NGDP Growth 3mo Nominal Rate 96 97 98 99 00 01 02 03 04 05 06 -5% 0% 5% 10% 15% Chinese RGDP Growth 3mo Real Rate 96 97 98 99 00 01 02 03 04 05 06 26 Bridgewater ® Daily Observations 2/7/2007
  • 27. 96 97 98 99 00 01 02 03 04 05 06 -5% 0% 5% 10% 15% Chinese Nominal 3mo Rate Chinese Inflation Rate Clearly a monetary tightening is occurring, albeit in a limited way, as any tightening must be given that it’s tied to the USD. In the chart below, you can see the 1-year Treasury bill rate. Chinese 1yr T-bill 1.2% 1.4% 1.6% 1.8% 2.0% 2.2% 2.4% 2.6% 2.8% 3.0% Sep-06 Aug-06 Jul-06 Jun-06 May-06 Apr-06 Mar-06 Feb-06 Jan-06 Dec-05 Nov-05 Oct-05 Sep-05 Aug-05 Jul-05 When interest rates are raised, that exerts upward pressure on the exchange rate. It’s just a mechanical thing. That’s because tightenings are bullish for currencies (because they lead to improvements in the balance of payments via both an improved trade balance and capital inflows, which should strengthen the real exchange rate, plus tighter money tends to lower inflation, which is also bullish. Yet, since the spot-forward relationship reflects the interest rate difference, when China tightens, it is suppose to drive the forward RMB down in relation to the spot. For example, suppose China’s interest rates rose to 10 pct, and the U.S. interest rate was still 5%, that would mean that, if the spot rate held steady (because of interventions), the one year forward RMB rate would be priced to depreciate by 5% over the next year. That would be crazy – i.e., a license to steal. If people were happy to buy one-year forward RMB at a 3% premium when money was easy, imagine what kind of demand you’d have for one-year forward RMB at a 5% discount when Chinese money was much tighter. Forwards would not decline; we think that they’d rise because everyone who could would buy forward RMB -- not just “speculators”, but businesses, banks and individuals. That would exert a lot of upward pressure on the spot exchange rate. So China right 27 Bridgewater ® Daily Observations 2/7/2007
  • 28. 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 now is increasingly in a dilemma. It’s certainly a manageable dilemma, but it’s an increasing dilemma – i.e., the desire to tighten monetary policy and raise rates is inconsistent with the desire to maintain a fixed exchange rate. The chart below shows both the spot and forward RMB/USD exchange rates and shows how the tightening has affected these exchange rates. RMB/USD Spot Rate 1yr Forw ard 7.50 7.60 7.70 7.80 7.90 8.00 8.10 8.20 8.30 1/3/05 2/3/05 3/3/05 4/3/05 5/3/05 6/3/05 7/3/05 8/3/05 9/3/05 10/3/05 11/3/05 12/3/05 1/3/06 2/3/06 3/3/06 4/3/06 5/3/06 6/3/06 7/3/06 8/3/06 9/3/06 10/3/06 11/3/06 So, over the near term, we don’t expect China to make any dramatic moves. More likely, they will let their problem grow from being tolerable (as it is now) until it is intolerable. Until China tightens materially, which means until it revalues its currency materially, we do not expect its upward influence on world growth and on world commodity prices to materially subside. The next chart shows productivity growth in the U.S. and in the developed world. Note the exceptionally high levels from 2003 to 2005, and how this is now tapering off. Productivity 10% US 8% Developed World 6% 4% 2% 0% -2% -4% -6% 28 Bridgewater ® Daily Observations 2/7/2007
  • 29. The next two charts show U.S. and world productivity growth rates in their cyclical contexts with the 0 point (designated as the vertical line) designating the transition month from contraction to expansion. Though higher than normal (for previously explained reasons), they are following their normal cyclical paths, which we expect to continue. So, going forward, we expect productivity growth rates to decline slowly at the same time as labor costs rise, exerting upward pressure on inflation. US Productivity Growth 6% 4% 2% 0% -2% -4% -36 -32 -28 -24 -20 -16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 Typical Cycle 1 StDev This Cycle (Sep-01) World Productivity Growth -36 -32 -28 -24 -20 -16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 -4% -2% 0% 2% 4% 6% 8% Typical Cycle 1 StDev This Cycle (Mar-02) Summary So, in a nutshell, I believe that we’re in a US debt bubble that’s very similar to that which occurred in 1967-70. However, I don’t believe that there is any reason for it to pop now because I don’t see what will prick it. I think that its more likely that after a bit slower growth in the U.S, (and no notable slowdown elsewhere), growth and inflation will pickup in the U.S. and globally again and interest rates and commodity prices will rise again and I believe that’s likely to be the last upward leg of this cycle and when the bubble will pop. I suspect the politics during this time (i.e., going into the U.S. presidential elections) will add to the risk, because Democrats are less friendly to the Chinese and capitalists and because who knows what the Bush administration, or Israel as a proxy, might do before there’s a changeover. As mentioned, I also don’t think this is a bad time to own gold. 29 Bridgewater ® Daily Observations 2/7/2007
  • 30. Other Industrialized Countries Canada’s New Oil Wealth For a long time, people have been aware of the vast resource within the oil sands of Canada. Suncor, the first producer in the area, has extracted oil from the heavy oil laden sands since 1967, but because of the difficulty and expense in extracting the oil, the profitability of the oil sands was low and little expansion occurred. Even though the oil resource was substantial in theory (the proven reserves are only second to Saudi Arabia in volume), it didn’t play a big role within Canadian markets because it wasn’t worth it to extract the oil given market prices. In recent years the profitability of the oil sands has changed substantially. With improving confidence in extraction techniques and higher oil prices, there has been an increased interest. Below we examine the impact of oil sands on the Canadian markets to date and on a going forward basis. The increased interest in the oil sands has occurred at all levels of development. Hectares leased (the first step in the development process) has increased from just 68,000 in 2003 to 680,000 this year through September 2006, with the average price paid to lease the property rising from C$280/ha to C$1,700/ha. While lagged because of development time, CAPEX has still increased from US$3.1 billion in 2003 to nearly US$5.8 billion in 2005. The reason for this activity is that the economics of investment have also improved substantially. What was once an expected return below 10% has expanded to rates of return above 30%, based on our estimates. Year Expected Return on Investment 1991 8.7% 1992 8.0% 1993 5.3% 1994 4.9% 1995 6.1% 1996 8.9% 1997 6.9% 1998 -0.1% 1999 8.4% 2000 15.3% 2001 12.1% 2002 14.4% 2003 17.0% 2004 27.9% 2005 34.3% Companies have also realized significant appreciation in value given the increased profitability, with Canadian Oil Sands Trust gaining in market cap from just C$3 billion in 2003 to nearly C$13bln most recently. Even an ETF has been announced (TSX:CLO) that will track equities in the oil sands sector specifically. All of this increased activity and investment will impact the future oil production from the oil sands as well as the future oil export volumes from Canada. As the chart below shows, the current estimated future production from the oil sands will substantially increase Canadian overall oil production even though conventional production is expected to fall by half over the next 10 years. 30 Bridgewater ® Daily Observations 2/7/2007
  • 31. Historical Total Production (Bln bbl) Future Production Historical Conventional Production (Bln bbl) Future Conventional Production 2.0 Historical Oil Sands Production (Bln bbl) Future Oil Sands Production 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 1990 1995 2000 2005 2010 2015 2020 2025 To put this in perspective, this additional oil production would take Canada from the world’s 8th largest oil producer to the world’s 4th largest by 2015, given current projections of investment. Given the estimated future production of oil from the oil sands, along with little expansion in domestic consumption, Canada will become a larger exporter of petroleum. Increased production from the oil sands will impact other commodity markets within Canada. The extraction process used for the oil sands demands a large quantity of natural gas. This increased demand, combined with the future increased domestic demand in other industries and falling production, combine to create a worsening trade balance in natural gas. Historical Natural Gas Production (Quad Btus) Future Production Historical Natural Gas Consumption (Quad Btus) Future Consumption Historical Natural Gas Exports (Quad Btus) Future Exports 1990 1995 2000 2005 2010 2015 2020 2025 As oil sands shift from being an unprofitable source of oil to one that is profitable at today’s market prices, wealth has been created. The chart below shows the estimated net worth of the entire oil sands (estimated using the market cap of oil sands companies). It has increased by about 25% of GDP since 2003. This level of wealth creation is equivalent to an additional 10% annualized equity market return over the last 3 years. -1 0 1 2 3 4 5 6 7 8 31 Bridgewater ® Daily Observations 2/7/2007
  • 32. Implied Oil Sands Mkt Cap - as % of GDP 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 93 94 95 96 97 98 99 00 01 02 03 04 05 06 The wealth creation from the oil sands has impacted both the currency and the equity markets over the last three years. Almost all of the difference between the performance of the US and Canadian stock markets can be attributed to the change in the market value of the oil sands, as shown below. CANMarket Cap - Actual 3 Year Change (C$ Bln) Estimated CANMkt Cap 3 Year Change fromUS % Change + Oil Sands Mkt Cap 3 Year Change 96 97 98 99 00 01 02 03 04 05 06 -600 -400 -200 0 200 400 600 800 1000 The three-year rise of the Canadian dollar is coincident to the rise in oil sands value. The period also represents a time when other commodities produced by Canada saw similar price appreciations. The balance of payments surpluses in Canada are generally more directly attributable to non-oil sands forces, such as investment in other minerals and mining industries. 32 Bridgewater ® Daily Observations 2/7/2007
  • 33. Implied Oil Sands Mkt Cap - as % of GDP YoY Level Change 20% Canada Spot FXvs USD 0.95 15% 0.90 0.85 10% 0.80 5% 0.75 0.70 0% 0.65 -5% 0.60 94 95 96 97 98 99 00 01 02 03 04 05 06 The rise in oil prices and subsequent creation of commodity wealth within Canada was clearly realized within the equity markets and probably has had some impact on the currency market (it is one of many important drivers). The future longer-term impact of oil sands production on the currency, debt and equity markets within Canada will likely be dependant on the future path of oil prices and profitability of production from the oil sands. Conclusions Credit Markets N. America US Canadian US Bonds Bonds Euro$ Moderately Moderately Bearish Bullish Neutral Europe UK Euroland UK Euroland Gilts Bonds Euro£ Short rates Moderately Moderately Bearish Bearish Neutral Neutral Asia Japanese Bonds Australian Bonds Japanese Euro¥ Australian Bank Bills Neutral Moderately Bearish Neutral Neutral Currency Markets CAD v USD EUR v USD JPY v USD AUD v USD Moderately Bullish Moderately Bullish Moderately Bullish Moderately Bullish Equity Markets US Equities Japanese Equities German Equities UK Equities French Equities Canadian Equities Australian Equities Neutral Neutral Neutral Neutral Neutral Moderately Bearish Neutral Note: Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the 33 Bridgewater ® Daily Observations 2/7/2007
  • 34. recipients. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it does not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues. 34 Bridgewater ® Daily Observations 2/7/2007