Situation Analysis

The European Crisis And What May Lie Ahead
Prepared: December 27, 2011 Executive Summary
The financial crisis enveloping Europe, in our view, is the most significant issue facing world capital markets today. In a survey recently conducted by U.S. Bank Wealth Management of high net worth investors, concern and uncertainty about how and when the crisis in Europe may be resolved was rated the largest risk investors currently face. While the European financial crisis impacts all 27 countries in the European Union, it is most acutely felt within the 17 countries that have accepted the euro as their currency, which is known as the European Monetary Union. Similar to the financial crisis centered in the U.S. three years ago, the crisis in Europe is being felt worldwide. In fact, given that the combined economies of Europe are comparable to that of the U.S., we think it is fair to expect a similar global impact from the larger European crisis. While it is impossible to predict the final outcome and ultimate impact of the European crisis, this paper will address key questions by providing our expectations of what could occur in the coming months. We also provide guidance for investors attempting to effectively position their assets in light of the crisis.

What are the core issues of the European crisis?

Monetary union without fiscal union At a fundamental level, the EMU is an economic and monetary union with a common currency shared across The concept of Europe forming an economic union has its 17 member countries. However, the EMU has not been evolving since the end of World War II. In 1957, the proven to be effective at integrating fiscal (budgetary) European Economic Community (EEC) was created to policies among its members. allow for some economic integration between countries. Subsequently, the European Union (EU) was formed, When the EMU was formed, member nations were and finally, the European Monetary Union (EMU) was expected to abide by specific fiscal or budgetary established around a common currency — the euro. guidelines. For example, annual budget deficits were not In our opinion, three core issues, some institutional and some driven by policy decisions, appear to be the major contributors to the challenges facing Europe today. These include: • The EMU represents a monetary union, but not a fiscal union. to exceed 3% of an individual member nation’s Gross Domestic Product (GDP), with national debt not to exceed 60% of GDP. However, what was lacking was a mechanism to enforce these agreements.

Out of control governmental spending Since the launch of the euro in 1999, several EMU • Governmental spending by some countries within the member countries began to allow budgetary imbalances to form, with spending outpacing economic capacity. EMU has spiraled out of control. Excess spending, of course, needed to be funded by • Efforts to bring EMU member countries in line have met resistance, both from cultural differences, as well as issues of national pride and sovereignty.

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borrowing. This lack of discipline was exacerbated by the fact that, as a part of the EMU, member countries were able to borrow at interest rates that were often lower than those the market would otherwise have dictated if each member countries were to borrow on a stand alone basis. For example, until just recently, smaller, poorer countries (like Greece) have borrowed at interest rates normally associated with richer, more financially-stable countries (like Germany). Now, however, investors fear that the European Central Bank (ECB), the International Monetary Fund (IMF), or a strong member country like Germany will not come to the rescue, and the bond market is pricing bonds (the yield required to entice investors) based on the actual underlying ability of individual member nations to repay their debt. Recently, interest rates on bonds issued by several of the weakest EMU members have experienced an alarming increase. For example, as events unfolded during the fall of 2011, investors seemed to become increasingly concerned about the possibility of weaker EMU countries defaulting on their sovereign debt. This resulted in demands for higher interest rates in order to compensate for the potential risk that bond repayments would not be made as they should. Most dramatic has been the rise in yields on ten-year bonds issued by Greece, lingering above 25% over the last few months. The market appears to essentially be passing judgment that the Greek government is at great risk of going bankrupt. Larger and more important economies, like Spain and Italy, have also experienced interest rate pressure as they cope with their own budget challenges. Since November 2011, the yields on ten-year bonds issued by the governments of Spain and Italy have hovered in the 6% to 7% range. While high in comparison to the broad market for government bonds issued during the same time period, it is a signal that Spain and Italy may face significant risk, but are not yet beyond hope. The risk for Italy is that it may be unable to afford its debt service costs if the bond market demands that interest rates remain near or above 7%. Italy is dealing with a current debt-to-GDP ratio of 120. If interest rates remain high, the result could be a downward spiral for its financial situation.

One major concern about the problems facing nations like Greece, Spain and Italy is the fear that a “contagion” may occur — spreading through the rest of Europe like a virus. Even some of the strongest economies in Europe have felt the effects. France, like Germany, currently carries a AAA rating on its debt, although yields on French bonds are generally higher than on German bonds. This suggests that investors may perceive a somewhat higher degree of risk with French debt even though both countries carry the same credit rating. As the crisis deepened, the yield spread between French and German bonds widened, yet even Germany, considered to be the financial foundation of the EU, has seen weak demand for its bonds in recent offerings, driving its yields higher. Compounding the problem, and a major difference between the financial crisis in Europe compared to the mortgage debt problems that led to the U.S. financial crisis in 2008, is that European banks play a much larger role in the economy than banks do in the U.S. economy. In Europe, banks hold substantial amounts of bonds issued by EU member countries. As the European financial crisis builds, member countries may default, potentially putting the European banking system at risk. This is one reason why so much concern has been raised about the financial stability of major European banks. National sovereignty and cultural differences In our view, the most troubling design flaw of the EMU structure (that it is a monetary union without a being true fiscal union), to some extent, reflects the relationships and long histories that exist between the EU countries. The European Economic Community was a way for the countries recovering from World War II to help each other grow and gain economic power on the global economic stage, which at the time was dominated by the U.S. The U.S. in fact, encouraged this development in the wake of its significant Marshall Plan investment in the belief that strong trading partners would be less likely to become military adversaries. Nevertheless, these countries retained meaningful cultural differences and a strong sense of national sovereignty. These factors have no doubt contributed to the limitations that exist in the current EU monetary

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union and may represent the largest obstacles to overcome if a long-term resolution of the European financial crisis is to be achieved.

We regularly hear of measures being implemented in an effort to avert the European debt crisis. Why do these steps seem to be so ineffective?
The bond market appears to want structural issues in the EMU to be addressed. This means significant and potentially painful cuts in spending. So far, in our opinion, Europe’s leaders have only taken steps to address some of the symptoms of the larger problem, not the cause. For example, the European Financial Stability Facility (or EFSF) has been created to provide emergency funds to countries at risk of default. In exchange for emergency funding, the EU required recipient countries to cut spending in an effort to reduce their budget deficits. The spending cut requirements vary by country, but are meaningful. In Greece, required cuts amount to approximately 14% of family disposable income, on average. Cuts in Portugal amount to 7% of family disposable income. In Spain, the impact is a 5% cut to family disposable income. However, as presently funded, the EFSF would not have the capacity to come to the rescue of a large economy, such as in Italy. It should be noted that total government debt of Europe combined is no greater than that of the U.S. The primary concern is that individual member countries carry far more debt than they can afford in terms of interest payment obligations on this debt. In short, individual nations need to aggressively reduce spending in many areas, including pensions and social support programs. On another front, the ECB has also provided liquidity to European banks to keep them solvent and has made sizable purchases of bonds issued by member countries to help keep interest rates down and relieve budgetary pressures. The bonds issued by several EMU member nations have been severely discounted in the bond market. Even incremental bond purchases by the ECB have not reversed the trend of declining asset values. European

banks, and the entire European banking system, are at risk. European banks appeared to face a critical liquidity crisis at the end of November 2011, similar in some ways to the liquidity crisis that resulted in the abrupt collapse of Lehman Brothers in 2008. To avert the potential crisis, global central banks provided discounted dollar-based financing to the EU banks. While this may have solved a short-term liquidity problem, it is not a long-term solution to the growing crisis. What do we think the investment markets would like to see out of the EU? Some possibilities include: • Assurance that the largest and most important economies facing budgetary struggles — Italy and Spain for example — will not default on their debts. • A firm commitment to defend key economies. Smaller countries, like Greece, may be beyond saving, but bankruptcies at that level may be less threatening to the entire EU than similar problems in one of Europe’s major economies. • A clear policy that protects the European banks from insolvency. Any policies that merely convey an intention to protect banks, but come up short of a firm commitment, may be seen by capital markets as window dressing.

What prevents EU leadership from acting decisively to address structural issues?
Europe’s leaders appear unwilling to provide full support to member countries and European banks without an assurance that nations facing the biggest problems will undertake significant structural reforms. Political leaders in countries such as Germany also must contend with a potential backlash from their own citizens if they are perceived as going too far with a rescue package. These leaders will want some control in the development of specific structural reforms before committing substantial financial support required to bridge through the crisis period. Yet the challenge of the EU not being a fiscal union comes into play here. Control of individual national budgets still remains with each respective country. This limits the ability of the EU to dictate the terms of any solution to be implemented in any member nation.

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Some members of the EMU appear reluctant to give any control over their finances to a central European authority and will likely try to maintain their independence as long as possible. America faced similar challenges when the original 13 colonies had to forge a true union of states, but that occurred when these were new entities and therefore, may have been more flexible. EMU member countries may be challenged by centuries of history, both good and bad.

failure of Bear Stearns and the firm was forced into an emergency sale to JP Morgan. This also occurred in September of 2008 with the collapse of Lehman Brothers, a key event that deepened the global financial crisis. As financial conditions rapidly declined in Europe in November 2011, global central banks acted in a coordinated fashion to avert another Lehmantype liquidity crisis from occurring. In our opinion, more needs to be done, but it will take time. A major structural reform of the EU will probably require a referendum vote in each member nation. The immediate crisis is progressing too rapidly to accommodate the likely time frame required for deeper structural reforms. Still, meaningful crisis response strategies can be implemented in the short term. These include securing the European banking system and reinforcing the financial stability of larger economies in crisis such as Italy and Spain. However, we think the EU is likely to continue to struggle with the challenges ahead. This means that markets are likely to continue to experience high, periodic volatility in the near term as events unfold and as investors react.

What do we expect to occur in the months ahead?
Pressure appears to be building within Europe to address the crisis in a more substantive way. In our opinion, failure by Europe’s leaders to take decisive action is likely to be so damaging that there will be no choice but to compromise and make the culturally difficult decisions required to stabilize the EMU. However, given the high level of apparent political resistance to creating strong fiscal bridges across the EU, our sense is that real compromise may not occur until the crisis becomes more severe and a clear sense develops that few options exist. This may indicate that opposing sides within the EU are not yet ready to compromise in meaningful ways. Until structural reform decisions are made, we believe financial conditions within the EU will worsen. There is concern by some that delaying substantive action for too long could lead to an irreversible crisis and possibly the collapse of the euro and all or part of the economic union. While EU leadership debates various solutions and financial pressures mount, investors may not be willing to wait for political compromise to be achieved. In these conditions, investors may tend to be skeptical that politicians will act appropriately and may react, for example, by selling European bonds now and holding cash until EU leadership identifies a workable solution. Our concern is that excess selling by investors could create a short-term liquidity crisis and a breakdown in normal market trading. This occurred in early 2008 related to

What impact may there be on the capital markets?
During the final months of 2011, capital markets diverged regarding the European crisis and situation. Global stock markets have reacted favorably to the announcement from EMU leadership, primarily Germany and France, of plans to build a stronger fiscal arrangement and supervision capability within the EMU. In addition, Italy is proposing a spending cut of approximately $40 billion over three years to try to address its budget imbalances. Global stock markets also cheered the concerted central bank action in late November 2011 to provide inexpensive liquidity to European banks.

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The bond market has been much more reserved in its reaction. Bond investors appear skeptical of EU action until more concrete plans are defined. Interest rates have moved only modestly lower as a result. What should investors make of these different market reactions? The bond market appears to be acting as expected. Bond investors tend to be more cautious and risk-averse than stock investors. For most in the fixed income market, the first priority is the ability of the debt issuer to repay the investor. It is no surprise that the bond market historically exhibits much less volatility than the stock market. In the short term, the bond market is likely to continue to maintain a “show me” stance and demonstrate little change. Stock investors may try to anticipate the upside impact of current and foreseeable events. Relatively small developments in the near term can have a lasting effect over the long run. The result is that fluctuations in the stock market can be of greater magnitude and occur more rapidly than in the bond market. In our opinion, without further good news about progress in the EMU, stock markets are likely to drift lower. The positive news of the central bank action may gradually recede in investors’ minds without evidence that additional progress is being made. Conversely, U.S. and emerging market stocks may be poised for better performance in the foreseeable months, supported by decent and slowly improving economic fundamentals in the U.S. and stimulative policies in emerging countries. Again, we believe markets will remain volatile for the foreseeable future. The path to a resolution to the EU crisis is likely to be far from perfect. Ultimately, we expect the EU crisis to abate and as it does, global capital markets will likely respond favorably.

What should investors do?
In light of the crisis in Europe and our assessment of the potential short- and long-term outcomes, investors should pay close attention to their goals across various time horizons. In our opinion, assets required to achieve more immediate goals (in the next one to three years) should be managed conservatively given our outlook that markets will remain volatile over any given short-term time period. Conversely, long-term investors may be better served by maintaining or re-building prudent growth-oriented positions within their portfolios, consistent with their investment objectives. We believe the events in Europe in recent months have resulted in more attractive values in equity markets that may reward investors over time. If EU leadership is successful in navigating through the crisis, building positions in stocks at today’s value may reward investors. Bonds may be in a more vulnerable position if the crisis wanes and because U.S. interest rates are likely to move higher with corresponding value declines in bonds owned. Cash investments in instruments like money market funds offer little reward potential in the long term because yields are far below inflation, which is likely to remain stubbornly high during the foreseeable future. Because we believe that volatility is likely in the shorter term, investors may want to consider hedged styles of investment management when appropriate. These have historically performed better than traditional long only styles in such an environment.

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This information was developed on December 27, 2011 and represents the opinion of U.S. Bank. It does not constitute investment advice and is issued without regard to specific investment objectives or the financial situation of any particular individual. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts will come to pass. The information presented is for discussion purposes only and is not intended to serve as a recommendation or solicitation for the purchase or sale of any type of security. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not responsible for and does guarantee the products, services or performance of its affiliates or third-party providers. Past performance is no guarantee of future results. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Hedged equity and hedged fixed income investment strategies are typically available via hedge funds which may not be appropriate for all clients due to the speculative nature and high degree of risk involved in these investments. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Alternative investments very often use speculative investment and trading strategies. There is no guarantee the investment program will be successful. Alternative investments may not be suitable for every investor, even if the investor does meet the financial requirements. It is important for investors to consult with their investment professional prior to investment in these investments. Hedge funds are speculative and involve a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem units in a hedge fund. ©2011 U.S. Bancorp (12/11)

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