MONTHLY INVESTMENT NEWSLETTER

Global Macro Strategy: April 2011

Current edition contains:

INFLATION AND UNIT LABOR COSTS
1
Inflation in developed world driven by commodities, not wages.

HOW LONG WILL ECB KEEP HIKING AND WHEN DOES EURIBOR GET TOO EXPENSIVE?
2
Euribor above 3% in 2013 looks like a stretch to us.

WHEN TO GO SHORT VOLATILITY?

3
Buy puts on VXX when first futures contract on volatility reaches 25.

EXPENSIVE OIL AND LONG TERM IMPLICATIONS OF ELECTRIC CAR CONCEPT

4 Oil could correct down to 90 USD/b in next 12 months, electric car concept will not have
material impact before 2015.

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1) INFLATION AND UNIT LABOR COSTS

So far, inflation within the developed world has been mostly commodity driven. To be precise, it is the growing
demand from emerging world that has been pushing hard on prices of commodities, which feed into final prices of
products in developed world. Today, we are talking about supply side shock, not excessive domestic demand in
developed world. In order to start seeing inflation getting engrained in developed world, we would need to see labor
receive substantial wage hikes. If labor cannot get its hands on higher salaries, than with the same household
budget, bigger part will have to be spent on commodities and way less on discretionary goods. Diminished demand
for discretionary goods would feed into entire supply chain and hurt companies in emerging markets, cascading into
domino fall, slowdown in growth of world GDP and outflow of speculators from commodity sector. The very same
goes for VAT increases, when households pay more for goods, but if they receive no wage hikes, the only party
better off is the government, which is on the receiver side of VAT cash flows.

We have already seen some wage hikes in developed world, but as our analysis shows, these higher wages are
mostly offset by higher productivity. Productivity increases are deflationary by nature as companies can produce
more with same inputs and eventually have to lower prices due to competitive pressures. Higher wages should
therefore not necessarily impose threat of higher prices in future.

When analyzing unit labor costs, one should bear three things in mind. First, there are multiple versions of ULC,
depending on which sector of economy you are looking at (e.g. ULC in manufacturing, industry, or whole economy).
Second, comparing ULC across countries, one should not forget about moves in exchange rates. In case we are using
ULC as an inflation gauge, we do not need to convert into unified currency though. Third, unit labor costs are
published with significant lag (about 6M), which does not provide for a great forecasting tool.

Chart 1 depicts inflationary pressures within industry on a trend adjusted basis. Clearly, UK is doing poorly, Australia
is on the rise, and ULC in France are growing too, yet at a decelerating pace.

Chart 2 looks at the entire economy (incl. government) also on a trend adjusted basis. Here we see fastest growth in
labor costs in New Zealand and Australia. Both France and Germany are witnessing increases in ULC, but there is no
acceleration like in case of Australia. Italy in red is somewhat dubious (here we should mention that current account
of Italy and France has deteriorated lately). On the other hand, Spain and Sweden have decreased ULC in total
economy. Also, we see some first signals of ULC in US bottoming out.

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 Chart 1 Chart 2

140 125

135
120
130

125 115

120
110
115
105
110

105 100
100
95
95

90 90
1.3.2005
1.7.2005

1.3.2006
1.7.2006

1.3.2007
1.7.2007

1.3.2008
1.7.2008

1.3.2009
1.7.2009

1.3.2010
1.7.2010
1.11.2005

1.11.2006

1.11.2007

1.11.2008

1.11.2009

1.6.2005

1.2.2006
1.6.2006

1.2.2007
1.6.2007

1.2.2008
1.6.2008

1.2.2009
1.6.2009

1.2.2010
1.6.2010
1.10.2005

1.10.2006

1.10.2007

1.10.2008

1.10.2009
Spain Germany France Spain Germany France
UK Italy Australia
Greece UK Italy
Japan New Zealand Sweden
Australia Sweden US US

Chart 3 depicts wage growth across EU-15. By end of Q4 2010, growth in wages accelerated to 1.7%, which was
primarily driven by strong growth in Germany (as much as 4%). As you can see from the yellow line in the lower
pane, rate of change in wage growth is decelerating, not accelerating.

On Chart 4, we are trying to forecast actual development of ULC in Germany (the main contributor to wage growth
across Eurozone). We looked at ratio between wage growth and industrial production growth. The blue line shows
OECD’s official numbers on ULC and the green line is our wage/IP ratio. From the three month of additional data our
best guess is that wage inflation in Germany is not yet becoming a serious problem.

Chart 3 Chart 4

1,15 125

120
1,1
115
1,05
110
1 105

0,95 100

95
0,9
90
0,85
85

0,8 80
1.3.2001

1.7.2002
1.3.2003

1.7.2004
1.3.2005

1.7.2006
1.3.2007

1.7.2008
1.3.2009

1.7.2010
1.11.2001

1.11.2003

1.11.2005

1.11.2007

1.11.2009

There is of course more to the ULC than meets the eye. At VOX.eu (http://www.voxeu.org/index.php?q=node/6299)
you can read more detailed explanation of some ULC caveats. We are aware of them, yet we still use ULC as a decent
proxy for what is going on in the economy.

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In the next chapter, we will talk about the reason why ECB is hiking rates despite we see low probability of wage
inflation within Eurozone.

2) HOW LONG WILL ECB KEEP HIKING AND WHEN DOES EURIBOR GET TOO EXPENSIVE?

In order to understand why ECB started hiking rates way ahead of Fed, despite already having rates about 100bp
higher, we have to remind ourselves of the mandate that each central bank is entrusted with. Fed’s goal is to deliver
both price stability and full employment. On the other hand, ECB was established with the sole purpose of keeping
inflation stable.

In order to fulfill its mission to the nines, each central bank has to pay attention to different indicators. For instance,
ECB has to watch closely headline inflation as this headline enters into a lot wage indexation agreements. Labor
markets in Europe tend not to be as flexible as in US, therefore even high levels of unemployment do not necessarily
impose deflationary forces to such degree as in US. Headline inflation simply is a more serious problem for EU than
for US. In US, core inflation seems a better predictor of price changes to come.

Headline inflation in Europe is already 2.6%, while core has risen only slowly to 1.3% y/y (Chart 1). With headline
inflation well above inflation target of less than 2%, there is no surprise that ECB started its hiking cycle. But how
long will it last and how far will it go? The market is telling us that ECB will deliver a hike every third month until the
refinancing rate reaches 2.25% in March 2012 and 3.00% in March 2013 (Chart 2).

Chart 1 Chart 2
3M Euribor, term curve
%
3,50

3,00

2,50

2,00

1,50

1,00
04/11 07/11 10/11 01/12 04/12 07/12 10/12 01/13 04/13

If we look at the expected hikes in historical terms, the tempo of rising is pretty rapid (almost same as in 2005-2006),
yet we must acknowledge that the real rates are still in negative territory and nominal rates are at extremely low
base (Chart 3). If ECB were to set its monetary policy only for Germany, this pace of rate hikes would be perfectly
justified. As a matter of fact, if we look at real GDP growth + core CPI and claim this number to be a good proxy for
market neutral real rates, Eurozone would need on average about 3.27% rates (Chart 4, lower pane). The higher
pane however shows, that such rates would not only be too high for Ireland, Portugal, Greece which are already
paying more on debt anyways, but also for France, Spain, and Italy, where natural rate would stand at around 2.5%.,
1.7%, and 3.2% respectively.

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 Chart 3 Chart 4

3M Euribor, historical data + current term curve

%
5,50
5,00
4,50
4,00
3,50
3,00
2,50
2,00
1,50
1,00
0,50
01/99
10/99
07/00
04/01
01/02
10/02
07/03
04/04
01/05
10/05
07/06
04/07
01/08
10/08
07/09
04/10
01/11
10/11
07/12
04/13
01/14
10/14
Said in another way, whatever ECB does will be wrong. Either Germany will have boom or peripherals will not survive
(unless they get plenty of aid from the North). In order to demonstrate another conundrum for ECB, let us have a
look at following two charts. Chart 5 depicts output gap, which takes into account purely domestic environment and
takes into account difference of actual GDP from the trend. On this basis, a lot of spare capacity existing in Europe
should keep prices in check. The problematic part is that after crises, some part of potential GDP tends to be
destroyed and we cannot be exactly sure that our potential GDP measure is still valid.

Taylor rule on Chart 6 extends the simple measure of output gap for a difference between actual and target inflation.
As you can see, Taylor rule would historically justify a bit higher interest rates, and would imply rates today at 1.5%.
We think Taylor rule is slightly better measure than pure output gap as it takes into account ECB’s primary focus on
price level. In case we extended the Taylor rule (neutral rate + 0.5*inflation gap + 0.5* output gap) down to the end
of 2011, we would get interest rate estimate of: 3% + 0.5*(2.6% - 1.9%) + 0.5*(-2.4%) = 2.15%. Here, we are
assuming that CPI will stay elevated at 2.6% throughout the time. Such measure is roughly in line with Euribor
futures. If we looked at Sep-2013, we would be targeting model rate of roughly 2,4% compared to expected 2,7%.

Chart 5 – Output gap Chart 6 – Taylor rule

We agree with the market that ECB will hike three times more before year end, but the actual sequence will depend
on the data flow. We believe Euribor should definitely stay below 3% over next two years to help peripheries
deleverage and ensure reasonable growth. If rates moved above 3%, it would be quite punitive for a lot of countries.
In order to assess probability of future moves, we advise paying attention to following gauges:

a) Breakeven rates for Italy, Germany, and France; and

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 b) PMI New orders across Eurozone

With the raise of rates to 2% by year end, we see following implications:

a) EUR/USD will have tendency to remain strong;

b) EUR/CHF should correct to historical levels as interest differential will make holding of CHF more expensive;
c) Portugal, Greece, and Ireland are all paying much higher debt than Euribor (accepting or dismissing
necessary reforms will play much larger role in yields and risk premia than move in Euribor base), we can
have pockets of risk stemming from restructuring of debt and impact on banks, but we see little pressure
from rate hikes on these economies;
d) Consumption in Spain could be negatively hit as raising Euribor will make households pay more on their
floating mortgages;
e) We would buy puts on the March 2012 – March 2013 Euribor futures as we see little risk of more aggressive
ECB. We believe risks are more to the downside in economic activity due to higher price of oil and also a lot
of frontloaded government stimulus of US government into 2011, so 2012 could turn out to be bit weaker
than expected. Another reason why we see rates not going up strongly is the threat to profitability of
German banks. ECB has to make sure yield curve in Germany stays positive enough to allow German banks
recapitalize and build sufficient cushion for write-downs of Greek bonds.

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3) WHEN TO GO SHORT VOLATILITY

During the tsunami market shake-up, we have instinctively decided to short volatility, as the spike was couple of
sigmas event. We did so via puts so that our losses would be limited in case of this extraordinary and sad event
would grow into bigger scale.

Yet we did not feel about intuitivism later on and decided to work on some hard rule-based model that would help
us into future when to go long or short volatility.

The instrument of our choice is ETF:VXX, as you know, it rolls daily 1/30 of its position between first and second
future contract on VIX. Typically, there is a pretty strong contango of about 5-7% when UX1 (first futures contract of
VIX) goes to 20. Thus being short VXX brings some decent carry over long period of time, especially if we take into
account that UX1 generally oscillates around value of 14-15 and cumulative density of probability for UX1 being less
than 25 is about 78% (We have about 1.800 observations since 2004).

Chart 1 Chart 2
Contango between UX1 and UX2 Probability of UX1 value
x axis - UX1, y axis - contango in % x axis - UX1, y axis - probability
40% 12%

30%
10%
20%

10% 8%

0%
6%
-10%

-20% 4%

-30%
2%
-40%
10 20 30 40 50 60 70 80 0%

Contango Contango in last 30 days 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40

We know that VIX has the tendency to shoot up rapidly during these short periods of crises and then normalize over
time. We therefore decided to test at which point does it make most sense to go short VXX? We had to take into
account loss of value due to carry (the lower the UX1, the higher the gains via carry) and the underlying moves in
UX1 (the higher UX1 is then the higher a probability of normalization and gains via movements in the basis). These
two are opposite forces and the only way how to tell which force is stronger is through testing.

Therefore we made a test what would be the best geometric average of 14 day returns based on the initial value of
UX1. And we came to following conclusion. The best place to start shorting VXX is when UX1 reaches 26 area – that
roughly corresponds with VIX hitting 30. We believe it makes biggest sense to buy 2 month put option on VXX with
strike corresponding with UX1 equal to 16. This way, one can actually start initiating some very cheap bullish
positions with a high probability of positive payout.

We have done a slightly different exercise that involves bear call spread option strategy. If you sell one call option
with lower strike and buy another call option with slightly lower strike (both strikes higher than spot value of VXX)
with one month maturity, you will get some option premium that can be worth as much as 3% of underlying price
today. You will profit in case VXX will end up roughly no higher than the lower strike price. We have modeled
© ATWEL International, s.r.o. www.atwel.com Page 7
probability of outcomes based on historical data. With roughly 230 observations, the probability of positive outcome
is roughly 85%. If we assume that the bear call spread pays out 30% in case of positive outcome and loses 70% in
case of negative outcome, this strategy looks good on risk-weighted basis: 0,3*,85 + (-0,7)*,15 = 0,255-,105 = + 15%
on average per trade.

Chart 3 Chart 4
Geometric average on 14D return Bear call spread strategy, UX1 entry >25 & <30
x axis - UX1, y axis - geom. avg. in % x axis - cumulative number of observations, y axis - return over 30 days
60% 80%

60%
40%

40%
20%
20%

0% 7,1% 7,7% 0%
6,7% 4,9% 5,0% 6,1%
3,5% 6,3% 7,1% 7,9% 0,6%
3,6% 5,7% -5,0%
2,2% -20%
-20% -5,5% -4,7%
-40%
-40%
-60%

-60% -80%
0% 20% 40% 60% 80% 100%

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4) EXPENSIVE OIL AND IMPLICATIONS OF ELECTRIC CAR CONCEPT

In the following piece, we would like to touch couple of ideas that are related to oil. First and foremost, crude oil, has
reached levels where it acts as impediment for growth. We can either look at relationship between deviation of oil
price from a 4 year moving average in real terms and industrial production (Chart 1), or we can simply pay attention
to oil burden, which we measure as average of Brent and WTI compared to world GDP (Chart 2). Today, oil burden
has reached 4.5%, levels seen last during late 2007. If oil remains at 110-120 USD/b for the rest of the year, we
should start seeing some dire consequences by the beginning of next year, namely fall in industrial production (there
will be no credit bubble this time to shield the economy like in 2006-2007). The IEA has stated that an economic
slump often occurs when fuel expenditure worldwide reaches 5% of global GDP.

Chart 1 Chart 2
WTI Oil, impact on Industrial Production in US
%
-80 15%

-60
10%
-40
5%
-20

0 0%

20
-5%
40
-10%
60

80 -15%
1976 1981 1986 1991 1996 2001 2006 2011
Deviation of oil price from 4Y moving average in real USD
US, 9M rate of change in industrial production (12M lag)

The main reason behind the fast increase in oil from 90 to 120 USD per barrel was mainly a consequence of North
Africa turmoil. As of today, OPEC, delivering 40% of world’s oil output, is said to have effective spare capacity of 3.91
million barrels a day, which is a rather thin flexibility margin in 90 mb/d world. IEA also said that in case current
levels of demand were sustained and demand did not fall, oil stockpiles measured in days of consumption would
drop by December to near their lowest level in five years. This kind of uncertainty drives speculators to pile into
largest speculative positions in oil in history (Chart 3). But are speculators so active because of cheap money or
because of deteriorating balance between supply and demand, which price must eventually clear? In order to
answer this question, we need to look closely on supply – demand balance.

In terms of oil supply, we have plenty of reserves. According to annual BP Statistical Review, supply amounts to
around 50 years of production and has been fairly constant over time. The issue is that new reserves and production
fields that have to replace existing ones, by 2035 almost three quarters of currently producing fields will have to be
replaced and these tend to get more expensive over time as they are located in less accessible or happen to exist in
less refinery-friendly forms.

Also, price of materials has grown substantially and put pressure on marginal cost of rigs and oil production
platforms. We can see an example of that on Chart 4 which compares IEA forecasts of economic production price of
oil from 2004 and 2008. Note, that price of metals has risen steadily in line with price of oil, impacting price of
marginal barrel absent of any technological breakthrough. Over next five years, we absolutely cannot expect any big
changes in supply as it takes quite a while to discover and open new fields.

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 Chart 3 Chart 4

Source: Bloomberg Source: IEA, Cleu6

The common sense tells us, that if demand grows at higher rate than supply, price has to rise to kill demand and put
production and consumption back in line. From IEA, we know that demand for oil will be driven purely by emerging
markets in the transport sector, whereas in OECD, demand destruction will prevail. The most probable scenario,
where governments stick to their promises of clean energy promotion, oil demand should grow to 100 mb/d by
2035, according by IEA (Chart 6).

Chart 5 Chart 6

We have looked into the assumptions of IEA within the transportation sector and we think their predictions of 6% of
global electric vehicle sales in 2020 are quite low. McKinsey actually predicts more than 8% share of electric vehicles
in terms of global sales in 2020, closer to 10% predictions of Mr. Ghosn, who is CEO of Nissan. It may seem like quite
a stretch as today only about 2.5% of electric vehicles are sold in US (yet growing) and almost none in China (yet
targeted government subsidies should start to kick in this year). If we look at the total cost of ownership, electric cars
should start being quite competitive over next two years. Chart 8 shows a model study done by BCG that compares
total cost of ownership of traditional combustion engine car and electric car. If battery cost went down to 500
USD/kWh and oil breached 100 USD/b, electric cars would be more competitive than traditional vehicles. And that is
exactly the situation today, when adoption of electric vehicles starts accelerating and significantly improves fuel
efficiency.

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 Chart 7 Chart 8

Battery costs dropped from 1.000 USD/kWh two years ago to around 600 USD/kWh today and some industry rumors
say that several large volume deals were struck at 450 USD/kWh, however, these were probably done at the cost of
battery producer’s margin. The industry goal is 250, a magical number when the upfront cost would equalize with
the costs of internal combustion engine. Given the astonishing number of patent applications we are seeing across
the industry and level of government funding support, we would not be surprised to see a very steeply declining
learning curve with price reductions of at least 10% annually, allowing for viable mass production as soon as 2015
and commoditization by 2020.

Let us end up with several conclusions:

a) Marginal price of barrel will be driven by rising metal prices and necessity to open new fields in harder-to-
access environment. Supplies of oil are ample but it is more expensive to get them out of ground. Oil price
can easily grow by 4-5% p.a. without putting much strain on households (we assume 2-3% efficiency gains
p.a. and additional 2% annual wage growth going forward; add another 2-5% strengthening of EM
currencies and you are at 6-10% annual price increase in oil without too much impact). Even if Libya gets ok,
we should not expect bigger correction in oil than to 90 USD/b as speculators are aware of tight market
going forward.
b) If we see continuation in breakthroughs within the electric car concept, we should see demand dynamics
start decelerating. Demand destruction in OECD is a done deal. We need to start seeing some true
incentives in China and EM world and proliferation of fuel efficiency technologies into lower-cost segment
of cars.
c) It is premature to start betting on oil price decreases because of electric car concept. The visibility of
adoption rates is still extremely low. We believe we will have first clues about dynamics by mid-2012 or
rather early 2013 when most of new fuel-efficient products will be on the market and mass production will
kick in. It's for the 2013 model year that the plug-in electric car market is planned to take off dramatically.
Nissan is adding a 400,000-car capacity in Tennessee and the U.K., Chevrolet is looking at numbers well
above 100,000, and almost every other car maker is adding models -- Volkswagen, Volvo, Chrysler... well,
everyone. We could see model year 2013 plug-in electric car capacity for the U.S. market exceed 5% of the
entire car market if projections get fulfilled.
d) Going forward, we will devote more time to research of impacts on the entire supply chain as we see big
changes not only in the auto industry and oil, but also on commodities related to death of combustion
engine, particularly platinum and palladium used in auto catalysts and lead used in batteries. Although we
believe there will not be much of an impact for next three years at least, it is time to start building models
and get better understanding of when dynamics can be expected to change.
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