Written by Michael Waring

We have to begin by expressing our pleasant surprise at the on-going strength of global equity markets (See Chart One). In our last letter, we suggested the market was due for a pause after the run-up of the first quarter. Fortunately, we remained fully invested and our portfolios out-performed again in the second quarter.

Chart One - Global Equity Market Index

We believe the strength in equities reflect a generally buoyant global economy, somewhat better corporate earnings than analysts' expectations in the second quarter and abundant global liquidity. Although the U.S. housing sector remains in the headlines, a sub-prime fall-out appears to be contained. However, some slowdown is noted in the retail sector evidenced by Sears and Home Depot results that were below expectations. Both China and India continue to power ahead with GDP growth of 10.6% and 9.4% respectively. The growth in the Indian economy is the quickest in 20 years.

To be sure, growth in both countries is above target and government authorities have taken some measures to slow their economies. Yet, to date, the measures appear to have had little impact. As anecdotal evidence of the strength in the global economy, the Wall Street Journal reported on June 18, 2007, of a crane shortage that is hindering construction projects around the world. Crane manufacturers are running flat-out with up to a two-year delivery time.

For equity markets going forward, the next 1-2 quarters corporate earnings are critical. Our sense is that corporate management is generally providing conservative guidance and that analysts' estimates will be met or slightly exceeded.

U.S. core inflation numbers (ex food and fuel) remain under control (See Chart Two) but to borrow a page from Don Coxe of BMO Harris Trust, "there has been an alarming rise in food prices".

Chart Two: U.S. Inflation: Shelter Inflation Cooling, But Food Costs Rising

According to Peter Brabeck, Chairman of Nestle, the world's largest food company, food prices are set for a period of "significant and long-lasting" inflation because of demand from China and India and the use of crops for biofuels (Financial Times, July 6, 2007). This bears close monitoring as it has the potential to raise consumers' perception of overall inflation and possibly result in social unrest in developing economies.

In China the GDP growth rate remains stubbornly above target and the corporate profits boom continues unabated (See Chart Three).

Chart Three: China, The Profit Boom

This strong growth in earnings underpins the move in Chinese equities. However, the performance of A-shares on the Shanghai exchange has all the earmarks of a bubble in the making. In our view, the bubble is the result of excess liquidity and ultra low interest rates that encourage households to speculate in equity investments. Because mainland Chinese citizens are not permitted to invest outside of mainland China, they turn to the Shanghai exchange as their only option. The positive news is that the government has taken steps to significantly increase the volume of new share and bond issues over the next few months. In May, 300,000 new share-trading accounts were being opened each day. That figure has now dropped to 100,000 accounts according to the Financial Times (July 6, 2007). The intent of authorities is to take the massive momentum out of the market without causing a dramatic correction. The Chinese holdings in our portfolios trade on the more tightly regulated Hong Kong Exchange and have much more reasonable valuations than those listed in Shanghai. (See Chart Four)

Chart Four: Historical Trailing PE

One of our favourite China investment themes remains pollution abatement. Until recently, pollution concerns have taken a back-seat to industrial growth. However, our view is that much has changed in the past several months. On July 5, 2007, Zhou Shengxian, director of the State Environmental Protection Administration (SEPA), said in an interview that the central government would give water pollution top priority later this year and polluters would face "iron-fist" measures. The 11 th 5-year plan released late 2006 outlined plans for improved efficiency across the energy sector and set down stringent plans for environmental clean-up. We hold significant weightings in both water and air pollution companies with exposure to the Chinese economy. For example, Chinese officials have advised visitors to the 2008 Olympics in Beijing to not drink tap water. It is contaminated during its transport through the underground pipes.

We believe that pollution control and abatement is an investment theme that will play out for many years in China. Pollution levels have reached a crisis point and government officials have to act now.

Just a brief word on Chinese food inflation. Like elsewhere around the globe, China is experiencing significant food price inflation, especially in pork prices. The situation is serious enough that the government has established a central task force to tackle the rising price of pork and other foods. Pork prices have risen to record levels recently according to a report in the South China Morning Post (July 5, 2007). The concern is simply that food inflation may lead to social unrest in the countryside where peasants can ill-afford the higher costs.

Much has been written recently on the subject of wage inflation in China and what this may imply for economies dependent on Chinese imports. We believe that the reported labour shortages are localized and are mainly concentrated in skilled workers and experienced management staff. Also, overall nominal wage increases are being offset through significant productivity gains by industry. This implies that inflationary pressures from seemingly rapid wage growth remain low. Although China has probably passed the 'peak' in terms of lower costs, we do not expect China to begin exporting inflation to the west any time soon.

In terms of buying power, China is all about the future. McKinsey and Associates expects China's lower middle class to swell to 290 million people by 2011 and the upper middle class (defined by those earning an annual income of $4,000-12,000) to rise to 520 million by 2025. While the income levels are still a fraction of the U.S. economy, this suggests enormous pent-up demand in China for the foreseeable future.

A final note on China relates to the current trade tensions with the United States. We are concerned that the current tension could lead to an outright trade war between the two countries. No doubt there is a strong sense of frustration on Capital Hill regarding trade and currency exchange rates. However, in our view, a full-blown trade war is not likely. We believe that U.S. politicians will press China into removing unfair trade practices and opening its markets, rather than taking blunt steps that would hurt both nations. In addition, China is actively pursuing a response to U.S. pressure which is also reducing protectionist risks.

On a contrarian note, we would point out that, according to Investors Intelligence, more financial advisors are predicting a correction in the U.S. stock market than at any other time in almost a decade. The bearish view has jumped to 32.6% last week, up from 25.8% a week earlier and the highest level since August 1997. We see this as a bullish sign and we believe that retail investors have largely missed this bull market move. Based on anecdotal evidence, many investors have remained on the sidelines. This is the proverbial "wall of worry".

The situation in Iran bears watching as the government is in the throes of it most ferocious crackdown on dissent in many years, with the authorities focusing on labour leaders, universities, the press, women's rights advocates and Iranian-American citizens. This oil-rich country is now instituting gasoline rationing. We expect to see more social unrest in the weeks and months to come. In our view, the situation in Iran will only get worse and should be monitored closely by investors.

Our final topic is climate change. The debate over climate change appears to have ended. Voters and consumers are demanding that action be taken to address their concerns. Numerous multinational corporations from GE to Wal-Mart and from Unilever to Toyota have recognized this seismic shift as an opportunity and they are going green. Governments, too, have recognized this public groundswell as a means to secure votes. The bandwagon appears to be picking up speed.

On this particular issue private enterprise is ahead of government (particularly in the U.S.). General Electric has sold its petro-chemicals-based plastics division to the Saudis. At the same time, GE has announced that it is going to double its renewable energy investments by 2010. The company's new stated mission is to help customers overcome environmental challenges. Wal-Mart management has initiated a complete review of its business practices from energy consumption to merchandise packaging in an effort to minimize the impact on the environment. British Petroleum (BP) has morphed itself to 'Beyond Petroleum'. The company is currently constructing a wind farm in up-state New York. They even went so far as to buy an equity interest in Clipper Windpower, a U.K. based wind turbine manufacturer after they reviewed their coming requirements. Toyota has invested heavily in the development of hybrid vehicles recognizing the direction of automotive buyers' intentions and it is gaining market share as a result.

In the corporate world, perception is everything. In the case of BP, a wind farm is insignificant relative to the sheer scale of their hydrocarbon production. Yet they can point to that wind farm as an example of their efforts to address climate change. Investments and projects that did not make economic sense 3-5 years ago will now proceed partly on the basis of perception.

Political parties also have recognized the vote-getting opportunities. From turning food into fuel (corn to ethanol) to banning conventional light bulbs, politicians understand the need to be perceived as doing something about climate change. In our view, this will lead to numerous distortions in the global economy providing investment opportunities for investors who are forward thinking.

We have significant exposure in our portfolios to many climate change opportunities that we have identified.

In terms of investment themes, we continue to favour the following:

Platinum - higher automotive emission standards

Renewable Energy - prefer wind and water over solar

Agriculture - especially China

Pollution Abatement - water pollution in China

Infrastructure Plays

Oil - specialized stories in developing economies

Wood Fibre - beetle kill in Western Canada, reduced exports from Siberia and growing

bio-fuel demand

LED Lighting

Molybdenum - growing shortage and expanding uses

Uranium - we have sold

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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