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ol
tf Argonaut Macro Partnership, LP
Global Macro Fund, LTD
May 2010 Investor Letter
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The fund finished the month down 3.0% net, and suffered setbacks across asset
classes. In the weeks leading up to May’s climactic events in the Eurozone, we
observed that economic activity in most major economies (including key
Eurozone economies such as Germany) had actually accelerated since the end
of the winter. The combination of solid growth around the world combined with
what appeared to us to be fairly limited transmission channels of financial stress
from the Eurozone to the rest of the world led us to take a handful pro-risk
ar

positions in the portfolio. Consequently, these positions set back as a result of

market skepticism over the Eurozone rescue package, combined with growing
fears over policy-induced economic slowdown in China. These losses were
nonetheless smaller than the 8.2% decline in the S&P 500 during the month and
even larger declines in most emerging market indices. Furthermore, the fund
remains up slightly year-to-date.
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Our biggest winner in the month was our position in the euro and related
European distress trades. Unfortunately these gains were offset by losses in
other currency positions, predominantly our long in Asian currencies that we
expected to appreciate alongside what we believed would be imminent
appreciation of the renminbi. We likewise suffered a setback in our short yen
position. The flight to quality, particularly out of the Eurozone, also caused a
powerful rally in the long end of the U.S. yield curve that set back our steepener.
In equity indices and related products, we lost smaller amounts of money in both
U.S. index futures and sector ETFs.

1
 An Assessment: What Went Wrong in the Markets in May

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Although the month of May began with markets fixated on the fiscal problems in
southern Europe and the possibility of sovereign default, the volatility in the
second half of the month was due to a confluence of events around the world
that caused market confidence in the global economic outlook to evaporate
rapidly. Indeed, what began with concerns over the integrity of the European
monetary union had by the end of the month become a full-blown panic over

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global conditions. In our opinion, this was caused by a combination of three
factors.

1. Evidence of the peak in economic growth. First, evidence is accumulating

that the global growth cycle is currently at its apex and set to fall in the
months ahead. While we have long held the thesis that the peak in global

tf
economic growth would coincide with the period of the maximum stimulus
from both fiscal and monetary policy (in the first half of 2010), the market’s
generic expectation has been that growth would remain at trend levels over
the balance of the year and into 2011.

GDP Growth With Contribution from Fiscal Stimulus

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quarter-on-quarter seasonally adjusted annualized rate
8
6
4
2
0
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-2
-4 GDP Grow th Not Attributable to Fiscal Stimulus
Fiscal Impulse
-6 GDP Grow th

-8
1Q 2009 2Q 2009 3Q 2009 4Q 2009 1Q 2010 2Q 2010 3Q 2010 4Q 2010
Source: Argonaut Capital, Goldman Sachs, and Congressional Budget Office
2Q 2010 - 4Q 2010 data are estimates
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It is interesting that U.S. and European economic data released over the
course of May by and large exceeded market expectations, consistent with
the cyclical acceleration that we described in last month’s investor letter. Yet
this positive news was shrugged off in the throes of the market sell-off in the
middle of the month. One of the reasons for this, we believe, was the
deceleration in economic data released out of the major emerging markets
over that same period. As our data surprise index for the emerging markets
illustrates (on the next page), the growth deceleration over the past several
months has shaken complacency regarding ever-higher growth rates in the
emerging world.

2
 Argonaut Growth Diffusion Indices
2-Month Change in Index Level

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changes in index level co rrespo nd to strength o f eco no mic data relative to expectatio ns
8
6
4
2
0

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-2
-4
US Grow th Surprise DI
-6
EM Grow th Surprise DI
-8
-10
J-08 A-08 O-08 D-08 F-09 A-09 J-09 A-09 O-09 D-09 F-10 A-10

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2. The impact of Europe’s debt crisis. The second major factor behind the sell-
off, particularly in the second half of the month, was the dawning implication
of fiscal austerity on the growth outlook in Europe. The need to redress
unsustainable fiscal deficits is clearly an urgent one not just in the troubled
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economies on the European periphery, but also in core Eurozone economies
such as France and Belgium as well. At the same time rapid fiscal
retrenchment is highly problematic for the growth outlook. The multiplier on
fiscal spending is sufficiently high such that GDP growth going forward is
likely to undershoot current projections. This also means that debt/GDP ratios
are likely to remain more elevated than currently envisaged in the various
Eurozone countries’ austerity plans.
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Separately, the significant fiscal tightening planned by the German

government further clouds the European growth outlook beyond 2010. As we
discussed in last month’s letter, the big risk going forward is that slower
growth in Europe causes problems to emerge in over-levered private sector
entities within the Eurozone. Continued pressure on markets such as Spain
(where the problem of the cajas, the debt-laden state-sponsored banks,
remains at the forefront of market concerns) suggests that the risk of overly
m

aggressive fiscal tightening continues to trouble the market.

3
 Cumulative Change in Spanish Sovereign CDS
120

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100 5/9/10:
80 Announcement
of EFSF
60
40
20

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-
(20)
(40)
4/30 5/5 5/10 5/15 5/20 5/25 5/30 6/4 6/9 6/14
Source: Bloomberg

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With so many serious questions hinging on political and economic outcomes
in Europe, senior Argonaut researchers spent a portion of May in Berlin and
Frankfurt discussing the Eurozone crisis with policy analysts and local market
participants. A couple of clear takeaways emerged:
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x First, and foremost, there remains no wavering in the political commitment
to the monetary union in Germany, which spans the political spectrum.
This is an important anchor to the euro that is often under-appreciated in
North America.

x That said, there is a huge divide between the policy community and
market participants (generically speaking, Berlin and Frankfurt,
ar

respectively) over the appropriate course of ECB action going forward.

Those with closer links to policymakers in general were extremely
uncomfortable with how the ECB had strayed from its statutory mandate of
price stability, and expected vociferous action by the ECB to re-assert its
independence and inflation-fighting credibility as soon as markets calm
down sufficiently. Those in Frankfurt, by contrast, anticipate that the ECB
would continue to be pragmatic and would not seek to tighten conditions
m

pre-emptively or shade market expectations through hawkish rhetoric.

While there can be no certainty about which side in this debate will prevail,
we found the discourse to be quite revealing about the schisms within the
ECB. What this suggests to us is that the coherence of monetary
policymaking in the Eurozone is less than optimal, and that headline risk
will remain substantial.

In our view, one of the key mistakes made by the Fed in the early stages
of the financial crisis was an attempt to guide inflation expectations lower
by increasing the hawkish rhetoric in their communications (in the fourth
quarter of 2007). This certainly was not helpful at the time, and may in

4
 fact have exacerbated the crisis at a time when the markets required
reassurance on the provision of liquidity by the central bank. The odds

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that the ECB repeats this sort of mistake appear high to us, as the current
situation in Europe has many commonalities with the United States in late
2007 and early 2008. Perversely, those voices within the ECB that would
seek to “talk up” the euro may in fact ultimately undermine market
confidence in the stability of the monetary union.

ol
S&P 500 Reaction to the Fed's Waffling in 2007
1600 8/7/07: 10/31/07:
Fed keeps Fed cuts rates 25 bp;
statement is hawkish 12/11/07:
1550 rates on hold Fed cuts rates 25
bp; statement is
1500 hawkish

tf
9/18/07:
1450 Fed cuts rates
50 bp

1400 8/17/07: 1/22/08:

Fed holds extraordinary meeting;
Fed capitulates, cuts
statement is dovish
1350 rates by 75 bp;
statements is dovish
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1300
Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08
Source: Bloomberg, Federal Reserve, and Argonaut Capital

x One area in which European governments are clearly moving faster than
the United States is in their recognition of the problems associated with
large long-term structural deficits. The German government’s plan to
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bring its fiscal deficit back into line with a constitutionally-mandated 0.35%
limit of GDP should be interpreted in this light. While we applaud the
resolve of policymakers to bring longer-term deficits back down to
sustainable levels, we remain highly concerned about the way in which
they are going about it.

We have long described the current economic environment as a

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“contained depression,” by which we mean that the global economy was

headed for a second Great Depression before the combined impact of
fiscal and monetary policy easing in 2007 and 2008 pulled the global
economy back from the brink. While one can debate the efficacy of the
specific fiscal programs enacted, and the optimal distribution of fiscal
expansion between expenditures and tax cuts, we believe that a large
share of the recovery in GDP growth since early 2009 is due both directly
and indirectly to fiscal policy.

As such, plans for aggressive fiscal retrenchment threaten to undermine

the recovery, just as the momentum behind the global recovery appears to
be waning. Clearly unsustainable fiscal policies indeed need to be

5
 altered, but we would argue that the danger to long-term economic
stability comes from ballooning liabilities associated with entitlements,

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which the current fiscal plans around the world attempt to redress only
minimally if at all. Thus we are concerned that governments around the
world may inadvertently engineer the next economic slowdown, which, if it
occurred, would perversely cause debt to GDP ratios to rise (in the face of
persistent deficits but flat to lower GDP).

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The combined impression from these observations is that the risks to
Europe still lie firmly to the downside. Though cyclical performance in the
less-impacted members of the Eurozone has actually been fairly strong,
and the impact of a weaker euro should have a salutary effect on their
economic outlook, the risk of major policy error looms over the entire
economic bloc. Incoherent and possibly pre-emptively hawkish monetary

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policy combined with premature fiscal tightening will not solve Europe’s
problems, nor will it foster a rapid improvement in Europe’s debt/GDP
ratio. Our trend view on the euro remains a bearish one.

3. A policy-engineered slowdown in China. The final factor in May’s global

market sell-off was rising apprehension about growth conditions in China.
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First, fears that the policy-engineered slowdown in the property sector were
spreading rapidly to other areas of the economy led to somewhat hysterical
fears that the major engine of global recovery was slowing sharply. On top of
this, semi-official pronouncements that renminbi appreciation against the
dollar was off the table for the time being as a result of the rapid rise in the
value of the renminbi against the euro hit numerous currency markets in Asia
that had priced in imminent appreciation by China.
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Argonaut has long been involved in the renminbi trade, and our currency book
suffered in May as a result. Clearly the events of May and China’s reaction to
them has led us to re-evaluate our thesis. At this juncture, while we do not
think China will maintain its dollar peg indefinitely, the time-table for such a
move has probably been pushed off to the later months of the year at the
earliest. We still believe it to be in China’s overwhelming interest to allow for
renminbi appreciation in order to spur domestic demand growth in its own
m

economy, particularly in light of slowing economic growth in its major export

markets. As such we believe the question of renminbi appreciation remains
one of “when” and not “if”.

We also visited China during the month of May, and though the snapshot one
sees from visiting only a few places does not necessarily translate into an
accurate view of conditions in the country as a whole, it would appear to us
that economic conditions in China remain solid to robust. Consumption
growth still appears strong, and there is little tangible sign that the property
slowdown has caused a dramatic downshift in activity outside of the
residential real estate sector. Economic data—both the widely analyzed

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 This letter brought to you by MarketFolly.com

official data as well as more high frequency survey and proprietary data we
follow—would appear to confirm this impression as well. The slowdown in

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construction, the main driver of Chinese economic activity since the economic
conditions bottomed in 1Q 2009, means that aggregate demand growth in
China has also peaked like that of most other countries around the world.

Strong but slowing:

Chinese Automobile Output YoY%

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150
125
100
75
50
25
-

tf
(25)
(50)
J- A- O- D- F- A- J- A- O- D- F- A-
08 08 08 08 09 09 09 09 09 09 10 10
Source: National Bureau of Statistics
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Chinese Steel Output YoY%
60
50 Rolled Steel Crude Steel
40
30
20
10
-
(10)
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(20)
J- A- O- D- F- A- J- A- O- D- F- A-
08 08 08 08 09 09 09 09 09 09 10 10
Source: National Bureau of Statistics

At this juncture it appears likely that the process of policy tightening in China
is nearing its end. Clearly the authorities wanted to drive housing prices
m

down in the frothiest eastern seaboard markets, and have succeeded in doing
so. It is equally clear to us, however, that there remains a huge amount of
pent-up demand for housing as the rural-to-urban migration process
continues, particularly in the second- and third-tier cities in China’s vast
interior. Thus a full-blown housing recession would not appear to advance
the leadership’s goals of social stability. As such, we believe that apart from
a few further token measures (an official interest rate hike or two, for
example) that Chinese policymakers are likely to err on the side of caution in
the face of global uncertainty and hold off on further policy firming.

7
 Transitioning Our Portfolio

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In light of both our mark-to-market losses and developments that caused material
changes to the outlook we have adjusted the themes in our portfolio. The most
obvious change was the reduction in the renminbi appreciation theme that we
discussed above. Specifically, we cut out all the Asian currency exposure that
we believed would benefit if and when China allowed the resumption of the
renminbi crawl. We retain a small risk position in outright renminbi forwards,

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which now price in just over 1% appreciation per annum out over the next five
years.

CNY Annualized % Pace of Appreciation Implied by Forwards

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8.0 6/16/10
7.0
4/29/10
6.0
5.0
3.2
4.0
3.0
2.0 1.2
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1.0
0.0
1-Month 2-Month 3-Month 6-Month 9-Month 1-Year 2-Year 3-Year 4-Year 5-Year
Source: Bloomberg

Second, we have reduced our long-standing U.S. yield curve steepener. We

believe that while the potential supply/demand imbalance at the long end of the
curve remains daunting, the crisis in Europe has improved the demand outlook
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for longer-dated U.S. Treasuries. Simply put, the euro has been the big
beneficiary of attempts by big institutional investors (such as central bank reserve
managers) to diversify their holdings away from dollars over the past decade.
Only a small portion of reserves are held in outright currency, however, but rather
in fixed income instruments denominated in specific currencies. With questions
over the long-term viability of the euro unresolved, we expect to see these
diversification flows reverse, which is not only bearish for the euro, but should
m

also be positive for Treasuries.

Additionally, evidence continues to accumulate that the risk of deflation remains

high in the United States. Anyone familiar with our views going back to the
period when quantitative easing began in the United States in early 2009 will
recall that we have long been of the view that deflation, not inflation posed the
bigger threat. Our analysis of dozens of pricing series has strengthened our
conviction on this point in recent months, and we fear that core inflation readings
in the United States could dip into outright deflationary territory in coming
months. This should be positive for longer-dated fixed income.

8
 On the Road to Deflation?

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CPI YoY % Change
3.0

Core
2.5 Core Ex-Tobacco and Vehicles
Cleveland Fed Median CPI
2.0

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1.5

1.0

0.5

tf
-
M-09 J-09 J-09 A-09 S-09 O-09 N-09 D-09 J-10 F-10 M-10 A-10
Source: Bureau of Labor Statistics, Cleveland Fed, and Argonaut Capital

We have retained a residual position in the yield curve, albeit in much reduced
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size. Our particular expression of this view in the forward interest rate swap
market, while highly profitable over time, unduly suffered as a result of credit
market issues in May. In particular, the swap market underperformed cash
Treasuries as counterparty credit concerns permeated all areas of the capital
markets. Approximately half of the flattening in our position during the month of
May was due to the spike in short-dated swap spreads. As such, at a minimum
we should gain back this portion of the flattening as counterpart credit concerns
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slowly fade.

May Losses in Argonaut's Forward-Starting U.S. Swap Curve Steepener

10

-
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(10)

(20)

(30) Flattening Due to Rally in 10-Year Treasuries

Flattening Due to Wider Swap Spreads

(40)

(50)

(60)
30-Apr 7-May 14-May 21-May 28-May
Source: Bloomberg and Argonaut Capital

9
 The two themes in which our conviction was strengthened as a result of the

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events of May remain, as we discussed last month, our short in the euro and our
long in gold. The euro position has been reduced from its peak earlier in the
spring as a result of both the speed of its decline combined with sentiment that is
heavily biased toward the bearish view. As always, in these circumstances we
consider our use of options to be a competitive advantage, as we are able to
maintain exposure while limiting our downside risk simply to the premium

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invested.

Peak Growth and Market Expectations

One area of intensive research for us over the past several months has been an
effort to identify areas in which embedded growth expectations appear

tf
unrealistically high given our expectation of lackluster growth in the developed
economies. At first glance, it would appear that the data is not on our side on
this issue, as corporate profits have bounced strongly since the end of the
recession last summer.

Scratching beneath the surface, however, reveals a different story. The bulk of
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the growth in profits since mid-2008 has in fact come from the financial sector,
which has been heavily subsidized both directly and indirectly (via easy monetary
policy) by the federal government. By contrast, non-financial corporate earnings
appear to be trailing the post-recession pace of recovery in every instance dating
back to the 1950s. Note that this is inconsistent with the purported strength in
profits being described by the popular financial media.
Nonfinancial Corporate Profits in Recessions and Recoveries
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Indexed so that last quarter of recession=100

190

170 1957-58
m

1960-61
150 1969-70
1981-82
130 2001
2007-2009
110

90
-24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24

Source: Bureau of Economic Analysis

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 MarketFolly.com is your source for hedge fund letters

Largely because the fall in earnings in 2008 was so acute, analyst earnings

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growth estimates for 2010 and 2011 would be among the fastest on record if
realized. Here is where we believe the disappointment is likely to lie. Indeed,
our bottom-up works suggests that earnings are likely to end 2010 towards the
bottom end of the range of major analyst’s estimates.

Growth in S&P 500 Earnings in First Year Following Recessions

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90%

80%

70%

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60% Argonaut
Consensus
50%
Range of
40% Wall Street
Estimates
30%

20%
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10%

0%
1950 1956 1966 1975 1980 1982 1989 2001 2007

Source: CapitalIQ and Argonaut Capital

On a sectoral basis, there are several standouts that we think have an outsized
probability of disappointing analyst estimates. While strong earnings growth
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expectations for the materials and energy industries are driven by the anticipation
of continued high commodity prices, we believe that it is more difficult to justify
the expectations for strong growth in the consumer discretionary sector. As
recent disappointments in consumer sector results illustrate, we still believe an
over-levered and under-employed consumer sector will be a significant drag on
the economy over the balance of the year. Likewise, we believe that
m

expectations for strong growth in technology sector earnings may be overly

aggressive, although the international exposure of the sector may help it meet
expectations. We certainly do not expect the strength of domestic corporate
capital expenditure and consumer spending on technology to be sufficient to
meet consensus estimates, however.

11
 ly
ol
tf Source: CapitalIQ and Argonaut Capital
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There are two further reasons why we believe that earnings will be unable to
meet lofty expectations. The first is that top-line revenue estimates are going to
be difficult to meet. The combination of little to no price inflation and relatively
restrained GDP growth will continue to make it difficult for the nonfinancial
corporate sector to meet these expectations. In fact, the big growth in S&P 500
net earnings in 2009 was not a product of top-line expansion, but rather a result
of squeezing costs out of the system. While it might be possible for the corporate
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sector to eke out further profitability through additional cost cuts, we believe that
it is already operating about as leanly as it can (the record decline in inventories
in 2009 combined with a nearly ten percentage point increase in the broad
unemployment rate would certainly attest to this). Thus we believe that the S&P
500 index members will need to generate very strong revenue growth in 2010 to
meet consensus profit expectations, and we see this as a very difficult challenge.
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12
 ly
ol
tfSource: CapitalIQ and Argonaut Capital

The second reason we think that aggressive profit expectations for 2010 are
likely to be disappointed comes from the very cost-cutting dynamic we discussed
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above. Gross private investment as a percentage of GDP has averaged
approximately 15% going back to the end of World War II. The 2007-2009
recession saw investment fall sharply, approaching the rate of depreciation. Put
differently, the rate of net private investment basically fell to 0%. In the initial
stage of the recession it was easy enough to bring capacity back on line without
bearing significant expenses. Going forward, however, corporations are likely to
need to boost capex substantially to raise output, which would eat into bottom
line growth.
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m

13
 Gross and Net Private Investment
% of GDP

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Private Gross Investment Depreciation Net Private Investment
20%

15%

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10%

5%

0%

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1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010
Source: Bureau of Economic Analysis

Conclusion

The first several months of 2010 have highlighted an inherent tension in the
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global capital markets, between a skittish market awash in liquidity and a fragile
recovery largely driven by expansionary economic policy. One overwhelming
conclusion from our read of the economic data is that the “take-off” phase of the
global recovery is now behind us, with economic growth at best leveling out, but
more likely decelerating going forward. Whether one completely agrees with our
analysis on the volatility of May or not, the examination of the root causes of the
month’s market action overwhelmingly point to policy action and the potential for
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policy mistake as a main driver of market volatility. With the greatest growth
impulse from policy easing now in the past, there is no reason to expect volatility
and the potential for sudden reversals in markets to fade in the months ahead.

Though months such as May are unpleasant experiences, our risk management
as always was disciplined and unwavering. As we commit to our investors, we
cut risk once our monthly losses exceeded 2.5%, and took risk down
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aggressively as losses continued. Though the events of May have caused us to

re-evaluate some of our long-held economic views, we believe that the
indiscriminate selling of risk assets and the likelihood of a continued rise in the
volatility of both markets and economic activity will offer an incredibly fruitful
environment for macro investing in the months ahead.

June 17, 2010

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