Written by Michael Waring
Friday, 31 March 2006

Q1 - 2006 - Market Communtary : The S&P/TSX 60 registered a solid 8% gain in the first quarter. Gains were especially evident in mines, metals and gold driven by sharp upward moves in the underlying commodities. Even oil prices remained firm despite abundant stocks in storage. Only natural gas fell due to the mildest January on record.

While we believe that these commodity price moves have been amplified by hedge fund activity, we think the strength in the sector reflects a global economy that is in synchronous growth. China, India, U.S., Japan (finally), and to a lesser degree, Europe, all appear to be sporting healthy growth rates. Global leading indicators are strong and appear to be heading up. (See Chart One)

Chart One: Industrial Commodity Prices: A Warning Sign or Not?

Both the U.S. and Japanese non-financial corporate sectors are experiencing a significant recovery. (See Chart Two)

Chart Two: Japanese and U.S. Corporate Performances Are Converging

China?s economy is on track to deliver 8% - 9% growth GDP this year with projected softening next year to a still strong 7.5%. (See Chart Three)

Chart Three: China?s GDP growth

And in Europe, cyclical growth appears to be accelerating. (See Chart Four)

Chart Four: Euro Area Economy: Cyclical Growth Accelerating

So with this as the background in the first quarter, we have to ask the question, what could go wrong? We have four negative scenarios:

1. The direction of the U.S. housing market
2. Rising protectionism
3. Recycling Petro-dollars
4. Skilled Personal Shortage

Much has been said and written regarding the U.S. housing market with concern that it may represent a bubble. We have never bought into the bubble theory but we do admit that the real estate market, in general, has come a long way and that selected markets have become overheated. Although core inflation appears well contained (See Chart Five), the risk as we pointed out in our last few letters is that the U.S. Federal Reserve over tightens with respect to interest rates and monetary policy. The Fed seems intent to remain on an inflation hunt and our fears now appear to be justified.

Chart Five: U.S. Core Producer Prices - Inflation Scare Fading

Despite the current strength of the U.S. corporate sector, the U.S. housing market now appears to be headed for a decisive slowdown. (See Chart Six) The decline is being driven by a significant reduction in affordability in large part due to higher interest rates. (See Chart Seven) And with this slowdown in the housing market comes a decline in real consumption.

Chart Six: U.S. Housing Watch - Slowdown Underway

Chart Seven: U.S. Spending Growth to Follow the Housing Market

This set of events could be the cause of a mid-cycle slowdown in the growth of the U.S. economy. Let us be clear, we are not suggesting that a new bear market is about to emerge from hibernation but a slowing in U.S. GDP growth is potentially brewing.

Our second concern involves rising trade protectionism. With the U.S. trade deficit spiralling out of control, we are worried that U.S. politicians may embark on a misguided quest to protect jobs and the economy. It seems too tempting to blame other nations (e.g. China) for their own internal issues. Reflecting back on economic history, protectionism is perhaps the most insidious disease that affects global trade. It comes about for all the wrong reasons and typically has perverse effects. Rising protectionism is something to watch for.

With the significant rise in oil prices, there has been a quantum shift of wealth to oil producing nations, especially Middle Eastern countries. What they do with their new found wealth and how they invest it is a critical question. For instance, if Saudi Arabia decides that future monetary reserves should be invested in Euro backed investments vs. U.S. dollar investments to diversify their exposure, it would have a major impact on the strength of the U.S. currency and ultimately U.S. interest rates. The Dubai Ports episode may be a harbinger of things to come. Any significant shift away from U.S. Dollar investments could have profound effects that are negative for the U.S. dollar, which will further stir trade protection issues.

Our final concern relates to the growing shortage of skilled trade and craftsmen worldwide. As an example, Chart Eight shows the projected labour requirements in the province of Alberta over the next several years based on the oil sands and pipeline projects announced to date.

Chart Eight:Labour Requirements

Alberta may represent an extreme, but skilled labour shortages are affecting extractive industries on a global basis. We do not know where the skilled people will come from to meet demand. Project slippage and cost overruns are likely to be rampant. (As an aside, we expect that the BC Winter Olympics will experience serious cost overruns.)

These are the issues that keep us awake at night. None of these four scenarios have to necessarily play out. But they do cause us sleepless nights.

We would be remiss if we didn?t discuss our favourite subject, China. In our view, China?s economy is simply catching up to the rest of the Western world after a series of setbacks due to misguided leadership. (See Chart Nine)

Chart Nine: The History of the World

China clearly has a long way to go to catch up to the rest of the world. China?s economic boom has continued unabated since 2000 with relatively benign inflation. (See Chart Ten)

Chart Ten: Low-Inflation Boom Continues

This low inflation rate is significant given the high rate of growth that has occurred over the past few years. The central government in Beijing is planning to construct 1.2 million kilometres of new public roads over the next five years. (See Chart Eleven)

Chart Eleven: China - The Farm Factor

This on-going build-out of the China?s road and highway infrastructure will have enormous ramifications. The ease of trade to the interior provinces will improve and the growth in truck traffic will undoubtedly surge. And as we have written before, the Chinese ?miracle? thus far has only really involved the 300 million people that live in coastal areas. We believe that this is set to change as a result of a set of rural development initiatives announced recently by the government in Beijing. Taxes are to be eliminated; price subsidies will rise and numerous infrastructure improvement (such as roads) are to be implemented.

These developments are a significant positive force for consumer confidence and retail sales in rural areas. This should help shift China?s economy from an external, export driven model to a domestic led economy.

In our opinion, China will continue to have a voracious appetite for raw materials over the next several years.

China?s geopolitical power is set to rise exponentially as its economic power increases. China will likely surpass Japan in Asia as the dominant economy within 10 years. We have a singe word of advice. Make sure your children are fluent in Mandarin.

In sum, we are bullish on the longer-term outlook for the global economy. However, we do have some short-term concerns that equity and commodity markets have moved ahead of themselves in terms of valuation. A pause may be required. With five-year U.S. bond yields approaching five percent, equity markets are facing competition. Finally, the month of May is only two weeks away and market seasonability is something to keep in mind.

Higher than normal cash holdings may be appropriate over the next quarter.

P.S. Thanks to Bank Credit Analysts for all their great charts!

And now for some investments:

HIGHPINE OIL & GAS LTD. (Listed HPX ? TSX, $23.65)

Highpine is a high growth oil and gas exploration company whose asset base, particularly it?s Pembina and Windfall assets, should provide significant additions of prolific, high netback reserves. Exploration results in the Pembina/Nisku light oil play will be a key driver in Highpine?s growth over the next several years. The company?s well-seasoned management team has the necessary technical skills to develop its high-impact plays and the high level of ownership by management and directors aligns their interests with those of shareholders. Highpine?s strong balance sheet should allow the company to fund its exploration program with cash flow and incremental debt. We expect Highpine to be a consolidator in the Pembina area as there are several smaller companies in the play.

CREW ENERGY INC. (Listed CR ? TSX, $16.37)

Natural gas-focused Crew Energy has an experienced management team, a very strong balance sheet and one of the lowest cost structures in the sector. The company plans a significant drilling program in 2006 as it continues to take advantage of its large inventory of low- to medium-risk prospects, while maintaining its low cost position and producing top decile netback results. Crew will direct 20% of its capital expenditure program to high impact exploration targets that will provide further upside potential beyond current forecasts. Realistically, natural gas prices are not expected to lift until the third quarter. We expect that Crew will have several attractive entry points as a result.

AETERNA ZENTARIS INC. (Listed AEX ? TSX, $8.11)

Aeterna possesses an impressive pipeline of over 20 products focusing on the large endocrine disorder and oncology markets. The company generates cash from two marketed therapies and over 200 laboratory reagents and has signed over 16 partnerships.

The company?s lead anti-cancer therapy, Perifosine, is in a newer class of drugs that have had blockbuster success such as Herceptin, Gleevec and Erbitux.

Aeterna also has several endocrine modulators in late stage trials for BPH, endometriosis, uterine myoma and hormone-dependent prostate cancer ? all large markets.

The company owns 48.5% of publicly traded Atrium, a profitable firm that is focused on the sale of active pharmaceutical ingredients, specialty chemicals, health and nutrition products. Atrium is expected to have sales of over $330 million in 2006.

With over $40 million in cash, Aeterna has over two years of cash to achieve its business plan.

YAMANA GOLD CORP. (Listed: YRI ? TSX, $12.68)

Yamana is one of the better emerging gold producers with operations in Brazil and Central America. The company recently acquired RNC Gold and Desert Sun Mining placing Yamana in a strong intermediate position among global gold producing companies. With the integration of these acquisitions, Yamana?s 2006 annualized gold production will be in excess of 450,000 oz., more than 700,000 oz. in 2007 and more than 800,000 oz. in 2008. Total cash costs of $270/oz. in 2006 will decrease to $125/oz. in 2007 and to $115/oz. in 2008.

With this kind of production and cost profile, Yamana should easily make the transition to the higher multiple intermediate producer category and could become an acquisition target by a major gold producer.

AURORA ENERGY RESOURCES INC. (Listed: AXU ? TSX, $4.49)

Aurora controls a uranium district in Labrador with the largest undeveloped uranium deposit in Canada. With a platform of 36 million pounds of uranium, the company has multiple new discoveries and untested targets and plans an aggressive exploration program in 2006 that should deliver significant discovery upside.

The outlook for the uranium market remains very attractive as increasing nuclear capacity and decreasing uranium supply is translating into a 70 million pound uranium production deficit per year.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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