Written by Michael Waring

The debacle in financial stocks is not yet over. We suspect that Asset Backed Commercial Paper (ABCP) and U.S. real estate have further to fall from current levels. And the odds of the U.S. economy falling into recession have definitely increased (50% +?) since our last letter. Whether a U.S. recession is imminent is anyone’s guess at this point. Yet, determining whether the U.S. economy is actually in recession is somewhat akin to looking in a rear view mirror. By the time we know it, it will be largely discounted by the market.

We believe that the U.S. Federal Reserve Bank has been ‘behind the curve’ in terms of its response to the weakening U.S. economy. Further significant reductions in U.S. interest rates now seem inevitable, perhaps all the way down to 3% by late-2008. Whether rate cuts will be effective at this point to prop the economy up is open to debate.

As always, the issue for equity investors is to what extent have markets already discounted a recession scenario? With so many pundits predicting that the U.S. economy is now in recession, the contarian in us has to think that much of the bad news has been priced in. Yet we believe that analysts earnings expectations for U.S. companies in 2008 remain too high and are subject to downward revision. In our view, we will likely see further weakness in equity markets during the first quarter as a result of a lowering in earnings forecasts for U.S. corporations.

However, we also believe that the global economic bull market is far from over as there is simply too much momentum in emerging economies. Massive investment in infrastructure as well as rising domestic demand are two key drivers behind this momentum. As well, trade patterns are evolving with less dependency on the U.S. economy as evidenced by China’s changing trade relationships (See Chart One).

Chart One: China’s Changing Trade Pattern

While the debate goes back and forth whether emerging markets can actually de-couple from the U.S. economy, we would argue that the odds are the highest they have ever been that growth will continue in emerging markets despite the U.S. slowdown.

Living next door to the largest economy in the world as Canadian investors do, we tend to obsess over the state of the U.S. economy. Yet the reality is that global trade patterns and global wealth is changing. At Galileo, we believe a more global view is warranted with the myriad of changes we now see taking place around the world. 2008 will likely not be an easy year for equity investors, or at least not in the next six months. But we believe that we have identified numerous investment opportunities abroad that will grow regardless of the vagaries of the U.S. economy.

Oil

New oil supplies will be restrained due to geological challenges, higher exploration and development costs and rising political risks. Even with these constraints, demand will remain robust due to continued import pressure from emerging economies notably China and India. The price will exhibit continued volatility, but we believe prices will remain closer to $100 per barrel than $50 per barrel with $75 as the settling price. There will be further industry consolidation in 2008 as oil-producing companies are facing continued difficulty in replacing reserves. In the December 24, 2007 Fortune Magazine, Investor’s Guide 2008, Jim Rogers, a former investment partner of George Soros and author of many investment books including his new book “A Bull in China: Investing Profitably in the World’s Greatest Market”, stated, “I have never sold a drop of oil. And I don’t intend to until 2020 or something.”

Natural Gas

Natural gas has become a true contrarian’s investment. Due to the low commodity price, exploration in Western Canada has significantly declined this year vs. the level recorded one year ago. The threat of Liquified Natural Gas (LNG) imports has subsided as industry cost factors are rising dramatically thereby pricing LNG imports out of the North American market at current natural gas price levels. In our view, it is only a matter of time before the lack of new supply meets up with demand. With a 1-2 year view, natural gas is a solid contrarian’s investment from current levels.

Metals and Materials

We recognize that commodity prices are volatile and subject to sharp changes. In the short term, a large correction in the price of copper or nickel for example could scare investors out of their investment positions. And in near term, metal prices will correct with the slowing U.S. economy. However, we believe that commodity prices will remain higher for longer than in past cycles. We base our view on trends that we see taking place in the build-out of the global infrastructure.

There has been a significant lack of infrastructure reinvestment over the past 25 years in developed economies. The OECD estimates that its member countries will need to spend $US 27 trillion on infrastructure by 2030.

At the same time, explosive GDP growth in emerging economies is straining existing infrastructure. China, Vietnam, India and other ASEAN countries all have very aggressive spending plans for infrastructure in order to facilitate continued growth.

Recognizing the scale of investment required, many of these countries have opened up infrastructure development to the private sector, most notably communist Vietnam. There were 46 private infrastructure investment funds in 2006 and more are on the way. The next 20 years will witness global infrastructure investment at levels never before seen in history.

This build-out has enormous ramifications for natural resources, experienced professionals and transportation. Byron Wien, for many years the sage strategist at Morgan Stanley and now a partner at Pequot Capital Management, stated in December, “The most dramatic contrast I have observed is that the infrastructure in many parts of the developing world, particularly China, is improving very rapidly in comparison with the United States.” A prime example of this is a thematic map of China showing the size of the country in 1996 vs. 2007 based on the time required to travel between select city pairs. China is shrinking, which only opens up greater investment opportunities. (See Chart Two)

Chart Two: Shrinking China

Going forward, this investment represents an enormous competitive advantage for emerging economies and will place continued pressure to spend on infrastructure rehabilitation in the so-called developed world.

As Jim Rogers recently stated in December 2007, “There will be corrections, of course. Nickel is correcting right now. But the commodities bull market still has years to go. I just don’t see anything on the horizon that can stop it.”

Notwithstanding the short term challenges posed by a slowing U.S. economy, we remain bullish on the longer-term prospects of the basic materials sector. In our view, any significant sell-off in these stocks is a buying opportunity.

As always, we believe that the long-term view will prevail.

China

With China’s robust economic growth and its continued rural to urban migration (15-30 million people per year), it is no surprise that municipal waste has become a major problem (or opportunity). Inadequacies in existing waste treatment facilities and landfill areas have led to rampant open dumping in city outskirts. (See Chart Three) This improper dumping of municipal waste is leading to a whole host of problems, notably ground water pollution. The current waste incineration market share of 5% in 2005 is targeted to reach 30% in 2030 which should drive the market for incinerated waste at a 15% CAGR over the period.

Chart Three: Disposal Methods of Collected Waste in China

According to the 11th Five Year Plan, China intends to invest RMB 51.6bln. ($US 7.4bln) in this sector, more than five times the amount invested under the previous plan. In our view, China will follow European and U.S. trends and begin charging for dumping garbage in landfills. This will only likely accelerate the drive towards waste incineration to energy. Municipal waste can be incinerated to reduce waste volume and produce steam or electricity. And it should be noted that incineration actually produces less greenhouse gas emissions than landfills (See Chart Four)

Chart Four: Emissions

Non-Methane Organic Compound                              CO2

Galileo Global Equity Advisors have identified several of companies that are poised to benefit from this long-term growth trend and needless to say, we are very excited about the investment potential.

Outlook

We continue to favour investments that are not directly correlated to quarterly swings in U.S. GDP growth. While a weaker U.S. economy may lead to lower global earnings multiples in the near term, we believe that our holdings’ underlying businesses are set to grow regardless. We have oriented our portfolios to holding companies where investment is very long-term in nature.

As investment themes, we continue to be excited by the following ideas:

            Platinum – supply challenges and growing auto catalyst demand

            Gold – safe haven from inflation risks and lack of new supply

            Oil & Gas – select global companies with attractive risk /reward opportunities

            Coal – both thermal and metalurgical based on strong demand from India and China

            Alternative Energy – driven by concerns regarding climate change

China – select China exposure notably agriculture; renewable energy, pollution control and infrastructure

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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