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Continental Capital Advisors, LLC

August 5, 2011

Rising Awareness Of The Global Debt Problem The sovereign debt crisis gained significant attention in July, yet while the equity market is overdue for a bounce, it remains significantly overvalued. The chart below, showing the highest debt/GDP ratios for developed nations as of 2010, demonstrates the severity of the sovereign debt crisis. Figure 1. 2010 Public Debt/GDP (Millions of Dollars)
Country Greece Italy United States Belgium Ireland Portugal Germany France Hungary Austria Malta Netherlands Cyprus Spain Debt/GDP 142.8% 119.0% 98.6% 96.6% 96.2% 92.9% 83.2% 82.3% 79.5% 72.2% 68.2% 62.7% 60.8% 60.1% GDP 322,242 2,168,343 14,660,000 494,117 215,514 241,779 3,498,320 2,705,922 137,824 398,174 8,727 828,068 24,451 1,487,627 Total Gov't Debt 460,023 2,580,221 14,460,000 477,427 207,304 224,658 2,911,480 2,227,637 109,549 287,296 5,948 519,439 14,866 894,274

Sources: Eurostat, Continental Capital Advisors

In the United States, government spending and fiscal responsibility have become the focus of politicians, citizens, central bakers and ratings agencies. The growing debate makes it clear that the days of an exponentially growing deficit are coming to an end. Government austerity will provide a headwind to an already weak economy, whereas reckless spending places the US credit rating at risk while not providing long lasting economic support. This is evidenced by the recently reported GDP data of below 2% for the first and second quarters despite QE2 lasting through the end of the second quarter. Given that both government austerity and reckless spending pose major threats to equity markets, the governments options are limited and therefore the economy is at significant risk. Meanwhile, the situation in Europe nearly spun out of control in July. Greece, Ireland and Portugal were again on the brink of default, and Italian and Spanish bond yields surged (see Figures 2 and 3). As a result, the European Commission announced a detail-lite plan whereby Greece, Ireland and Portgual will be able to borrow money from the European Financial Stability Facility (ESFS) at just 3.5% interest for 15-30 years. However, the plan is unlikely to work because of the moral hazard it creates, as countries such as Greece have no incentive to balance their budgets if they have access to nearly unlimited funding. The plan is also likely to fail because there are countries not receiving aid that are paying higher rates on their own debt than those countries receiving aid. As evidence that the ECBs plan will not work, Spanish and Italian bond yields rose to fresh highs just days after the new plan was announced (see Figures 2 and 3).

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Continental Capital Advisors, LLC

August 5, 2011

Figure 2. 2-Year Italian Bond Yields

Figure 2. 2-Year Spanish Bond Yields

Source: Bloomberg

Perhaps, if just Greece, Ireland, and Portugal were in distress, the announced plan could work because the three countries have small GDPs relative to Europe as a whole. However, Figure 4 shows that Italy and Spain are too large to bail out. Figure 4. 2010 GDP Rankings of European Countries (Millions of Euros)

Country GDP Germany 2,498,800 France 1,932,802 Italy 1,548,816 Spain 1,062,591 Netherlands 591,477 Poland 353,665 Belgium 352,941 Sweden 346,667 Austria 284,410 Denmark 234,005 Greece 230,173 Finland 180,295 Portugal 172,699 Ireland 153,939 Czech Republic 145,049 Romania 121,941 Hungary 98,446 Slovakia 65,906 Luxembourg 41,597 Bulgaria 36,034 35,974 Slovenia Sources: Eurostat, Continental Capital Advisors

Total Gov't Debt 2,079,629 1,591,169 1,843,015 638,767 371,028 195,777 341,019 146,406 205,212 102,065 328,588 87,216 160,470 148,074 56,404 37,073 78,249 26,998 7,661 5,843 13,704

Debt/GDP 83.2% 82.3% 119.0% 60.1% 62.7% 55.4% 96.6% 42.2% 72.2% 43.6% 142.8% 48.4% 92.9% 96.2% 38.9% 30.4% 79.5% 41.0% 18.4% 16.2% 38.1%

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Continental Capital Advisors, LLC

August 5, 2011

Figure 4 also dispels the myth of the German economic engine. Germanys debt/GDP is high and its annual budget deficit is greater than 3%, which is larger than the Maastricht Treaty allows. While Germany may be in better financial shape than other members of the EU, it is neither strong enough nor large enough to backstop the entire region. Therefore, the plan to offer low-interest-rate, longterm funds to Greece, Ireland and Portugal will not solve the European debt crisis. Thus, as the crisis in European sovereign debt continues, the Euro is likely to weaken dramatically against the dollar. While it is too soon to tell, July 2011 could have been the historical inflection point in the global debt crisis. Even though many countries have been running unsustainably high deficits for far too long, markets and citizens, until last month, had not paid much attention to the severity of the problem. Now that markets and governments are experiencing the consequences of too much debt, investors should expect lower GDP growth, higher interest rates, and lower asset prices.

Daniel Aaronson daaronson@continentalca.com Lee Markowitz, CFA lmarkowitz@continentalca.com http://www.continentalca.com


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