JP Conklin 704-887-9880 office jp.conklin@pensfordfinancial.com www.pensfordfinancial.

com Leveling the Playing Field January 9, 2012 _______________________________________________________________________ Happy New Year to everyone, we hope you managed to find yourself safely on this side of the new year. Theres a lot to cover after a two week layoff, so lets jump right in and overlook the fact that PSU got housed by Houston, the Heels got rocked by Mizzou, and the Eagles missed the playoffs because Mark Sanchez is the most overrated QB in the NFL. Fridays labor data was stronger than expected and yet market reaction was mixed. The unemployment rate dropped to 8.5%, the lowest reading in 3 years. Non-farm payrolls added 200k jobs last month. State College showed a net gain of one job. So what gives? Why didnt equities take off and rates jump? It could be that last months data was revised weaker, somewhat offsetting these gains (and calling into question the governments desire to manipulate the headline numbers and make corrections a month later when no one is looking). Also, 42k of the gains came from Christmas courier/messenger hires a nearly identical repeat of last Decembers seasonal hiring which was then reversed in January when NFP went from 152k to 68k. The labor force also shrank by 50k, which contributed to the decline in the unemployment rate. Bigger picture, weve only regained about 1/3rd of the jobs lost during the recession. Public sector positions continue to experience contraction. And perhaps most telling, if the labor force participation rate was at pre-recession levels, the unemployment rate would be 11.4%. A point that Obama will be sure to overlook in his speeches. Really, the data feels modestly positive. Its been a long time since I felt optimistic, but the US economy is showing resiliency. We can nitpick a 200k job gain all we want, but its still not a negative number. Manufacturing added 23k vs 3 month average of 3k jobs created. Healthcare added 26k jobs, restaurants added 24k jobs, and professional and technical positions added 10k. Even construction, which has showed contraction the last two months, gained 17k jobs. Things appear to be improving, but very slowly. And in this day of instant gratification, that is a tough pill to swallow.

Consumer confidence is steadily marching higher since it bottomed out in August and last weeks headline employment numbers will likely help push this higher in the coming months.

The bigger reason for the muted reaction from markets is probably that the economy still seems susceptible to potential shocks. Shock #1 Europe The euro is trading below 1.27 and at an 11 year low against the yen. We could see eur/$ push to 1.20 in the near term. Check out the CDS of several key Eurozone nations below. After the temporary decline in December, sovereign CDS levels are back up about 15%. During the 2008 financial crisis, Greek CDS peaked at 294bps. Today, AAA-rated France is trading just slightly below that level. Spains deficit was revised wider (theres those sneaky revisions again) and Spanish 10yr bond yields rose to 17 year highs. Remember when we said haircuts on Greek bonds could be as high as 90% even though the initial announcement was 50%? Guess what Greece asked for last week? 90% haircuts. And Belgium is about to be told to make deeper budget cuts or risk economic sanctions.

Shock # 2 - Oil Oil prices continue to rise as tension in the Middle East builds. On Thursday, oil peaked at $102.80 and appears headed for $110/barrel in the near term. Iran is moving towards nuclear armament and Israel is rattling its sabers. Nigeria, the 5th largest provider of oil to the US, just called for a national strike by its oil workers. Shock # 3 Interest Rates Operation Twist is working as planned, with the yield curve flattening another 20bps in December. The issues in Europe have clearly helped the cause. Twelve months ago, the 10 yr Treasury was at 3.50% (see graph below). On a 10 year home mortgage for $250k, thats $35k in additional interest. On a 10 year commercial real estate loan for $25mm, thats an additional $3.5mm of additional interest. On $15T of US Treasurys, thats an additional $2.25T in additional interest expense. S&P downgraded the US over the summer while Fitch and Moodys have the US on negative watch. I wonder if this sort of thing keeps Tim Geithner up at night?

Other noteworthy shocks certainly include the upcoming elections, a Tim Tebow injury, or Ben Williams being appointed to any position within the Treasury department.

LIBOR Outlook The FOMC announced it will begin adding their projections of the target Fed Funds rate to the economic projections already provided in the Summary of Economic projections published quarterly. The first disclosure will occur at the January 24-25 meeting and will incorporate projections for the next several years. This is intended to provide increased transparency and mimic the impact of additional rate cuts. These are projections made by each FOMC member independently, which means they could be all over the map. And some members will be making projections well beyond the term of their voting rights. This feels dangerous and we wonder about unintended consequences. I suspect the short term reason is the Fed has no intention of hiking rates in 2013 and wants to really hammer that fact home. But what happens when

circumstances change? This strategy works well in a neutral rate environment, but whenever a hike is on the horizon markets may swing violently based on these projections. Imagine what the 10 year Treasury will do the first time these projections suggest a hike on the horizon?

Fixed Rate Outlook Operation Twist and Eurozone concerns are keeping a lid on long term fixed rates for the time being. Our suspicion is that if the Eurozone resolves its issues, long term yields could move sharply higher in short order. But that doesnt feel like a near-term possibility right now. Dont forget the political benefit from keeping rates low.

This Week On Monday, Merkel and Sarkozy will meet in Berlin to discuss fiscal discipline and Germanys opposition to any increase of the $636B Economic Stability Mechanism. Germany, Spain, and Italy all have bond auctions scheduled, which should help gauge overall interest in those markets. Domestically, a slew of Fed speeches as well as our own Treasury auctions.

I forgot to tell a story from my mid-December vacation. I was at one of those resorts that has 3 different restaurants on-site to choose from and one night the main restaurant had an amazing stir-fry table where they cooked the plate in front of you. The downside was you had to wait in line and I would say the wait was about 10 minutes. Normally you spend that time sitting at your table, so it did feel longer. But on one trip to the fry table, I almost got steamrolled by an unusually large and irate woman who was screaming at the chef about how long it was taking. She was being nasty! Then she stomped over to the manager and screamed at him, too. Here we were in a very relaxed setting at the beach with perfect weather and not a care in the world and this woman is yelling McDonalds doesnt take this long! (I may have made the last part up)

ECONOMIC CALENDAR
Economic Data Day Monday Tuesday Time 3:00PM 7:30AM 10:00AM Wednesday 7:00AM 2:00PM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 10:00AM 2:00PM Friday 8:30AM 8:30AM 8:30AM 9:55AM Consumer Credit NFIB Small Business Optimism Wholesale Inventories MBA Mortgage Applications Fed's Beige Book Initial Jobless Claims Continuing Claims Advance Retail Sales Retail Sales less Autos Business Inventories Monthly Budget Statement Import Price Index (MoM) Import Price Index (YoY) Trade Balance U. of Michigan Confidence -$45.0B 70.4 0.2% 0.3% 0.4% -$79.0B -0.1% 0.7% 9.9% -$43.5B 69.9 0.2% 0.2% 0.8% 0.4% 1.6% Report Forecast $7.000B Previous $7.645B

Speeches and Events Day Monday Tuesday Time 12:40PM 10:30AM 1:00PM Wednesday 8:40AM 9:00AM 12:30PM Friday 12:45PM 1:00PM Report Fed's Lockhart speaks on Economy Fed's Williams speaks on Economy Fed's George speaks on Economic Outlook Fed's Evans speaks Fed's Lockhart speaks on Economy Fed's Plosser speaks on Economy Fed's Lacker speaks on Economy Chicago Fed President Charles Evans speaks Place Atlanta, GA Vancouver, WA Kansas City, MO Lake Forest, IL Atlanta, GA Rochester, NY Richmond, VA Indianapolis, IN

Day Tuesday Wednesday Thursday

Closing 1:00PM 1:00PM 1:00PM 3 year Treasury 10 year Treasury 30 year Treasury

Issues

Size $32B $21B $13B

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