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

com Leveling the Playing Field January 16, 2012 _______________________________________________________________________ In what is surely to be nominated for “Worst Kept Secret of the New Year”, S&P downgraded nine Eurozone countries, most notably France. France lost its AAA rating, Italy and Spain were downgraded two notches, while Portugal and Cyprus were downgraded to “junk” status. S&P: “Italy and Spain are particularly prone to the risk of a sudden deterioration in market conditions.” Italy is the third largest bond market in the world, so imagine what sort of impact an Italian default would have on credit markets. The remaining AAA’s in Europe are Germany, Finland, Netherlands, and Luxembourg. S&P: “Today's rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.” The ECB intervention may have prevented a more significant downgrade: “The ECB has in our view taken strong measures to avoid a significant downturn of the crisis, has greatly alleviated the funding crisis of the banks,” S&P said. “For the time being they have had a constructive role that they played.” This will have some near-term impact on the EFSF, but don’t forget that the ESM (European Stability Mechanism) is the permanent replacement of the EFSF (which was a temporary solution) and is supposed to be up and running by July of this year. This should mitigate the impact of the French downgrade. Let’s face it, if you’re reading about a looming French downgrade in the Pensford Letter in August 2011, then markets had already priced it in - we aren’t exactly on the cutting edge of financial data! That’s why when we include graphs like French CDS or 10yr government yields, the market is telling us a downgrade is coming. This wasn’t a shock to the market. In fact, this could be viewed as a slightly positive event since it eliminates uncertainty and was limited to a one notch downgrade. After coming out from under his desk and

putting away his white handkerchief, French PM Fillon said “This decision is a warning that should not be turned into a drama any more than it should be underestimated.” Perhaps more concerning is the fact that about half of Europe has been downgraded and 15 of 17 countries remain on negative watch. This is an incredibly pervasive issue across the entire continent with no short term solutions. S&P’s take on multi-national financial entities: “Following our placement of the ratings on the eurozone sovereigns on CreditWatch in December, we also placed a number of supranational entities on CreditWatch with negative implications. These included, among others, the European Financial Stability Fund (EFSF), the European Investment Bank (EIB), and the European Union's own funding program. We are currently assessing the credit implications of today's eurozone sovereign downgrades on those institutions and will publish our updated credit view in the coming days.” Translation: the EFSF is about to be downgraded, probably Monday or Tuesday. One very important yet unmentioned concern around the ESM is the fact that Eurozone policy makers could give it preferred creditor status in the event of Eurozone sovereign default. Would you buy sovereign bonds if you could become subordinated to the ESM at some point down the road? Or if you are forced to take the ESM’s terms for a restructuring? More bad news – this probably isn’t the last round of credit rating cuts. On France, S&P said “we believe that there is at least a one-in-three chance that we could lower the rating further in 2012 or 2013.” In Spain, unofficial unemployment numbers suggest their economy lost 400k jobs last month, the most since the Lehman collapse. Should the official release support this (due Jan 27), Spanish unemployment would rise from 21.5% to 23.3% in just one quarter. Finally, on the Eurozone as a whole, S&P said “we estimate a 40% probability that a deeper and more prolonged recession could hit the Eurozone, with a likely reduction of economic activity of 1.5% in 2012.” And the head of S&P’s sovereign ratings said he expects Greece to default shortly. The European crisis is three-pronged: 1. Banks are incredibly insolvent, with 30x their capital invested in European sovereign debt 2. This sovereign debt is not “risk-free” at all 3. The common currency (euro) prevents individual economies from printing their way out of their struggles.

The ECB et al have tried to replicate the Fed’s approach to the 2008 financial crisis, buying up sovereign bonds (namely Greece). This approach works for a liquidity crisis, creating a market where none exists. The Fed’s approach basically bought the banks some time and a few years later the banks have the most cash on hand ever. This approach does NOT work for a solvency problem. The countries are already insolvent, so buying them time doesn’t resolve anything (looking at you Greece). Austerity measures alone don’t work because it creates a vicious cycle where the economy shrinks and the pain worsens. The weak economies need to run a trade surplus and what’s the best way to do that in short order? Weaken your currency. But that’s not an option with a common currency like the euro. Germany rightfully doesn’t want to turn on the printing presses and back a bailout of the entire continent. Michael Fuchs (I can’t make that up), deputy leader of Merkel’s CDU party, said “I don’t think Greece, in its current condition, can be saved.” This is the way the euro ends This is the way the euro ends This is the way the euro ends Not with a bang, but a whimper

LIBOR Outlook Big FOMC meeting next week (not this week) that will reveal the new format of the Fed forecasts for interest rates. We have to believe the forecasts will show flat Fed Funds (and therefore LIBOR) for two years or more, intending to mimic the impact of an additional rate cut. Note: options (like caps) will get more expensive over the next week heading into the meeting. If you’re looking at buying a cap, we’d expect them to be less expensive after the meeting, rather than before it. Of course, a rapid deterioration in Europe will make options more expensive.

Fixed Rate Outlook European mess and Operation Twist suggest downward pressure on rates, particularly 5 years and less. But longer term Treasurys (mainly 30T, but 10T as well) are running even with headline inflation, so something has to give. With debt to GDP ratio at 100% and a flawed political/fiscal backdrop, can long-term US bonds be called the “risk-free” rate anymore?

This Week Yeah, Europe is the most significant situation on the horizon, but it’s also a very busy week for US data. The Fed speaking calendar is relatively quiet right ahead of next week’s FOMC meeting. Domestically, economists are scrambling to lower their forecasts for 2012 economic growth. JPM chief economist Michael Feroli released a report Friday, in part saying “we think growth will downshift from 3.0% in 4Q11 to 2.0% in 1Q12. Looking beyond the first quarter, we expect a growing private domestic sector will contend with a fading drag from the external sector and a persistent drag from the public sector.”

Generally, this material is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. Your receipt of this material does not create a client relationship with us and we are not acting as fiduciary or advisory capacity to you by providing the information herein. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. This material may contain information that is privileged, confidential, legally privileged, and/or exempt from disclosure under applicable law. Though the information herein may discuss certain legal and tax aspects of financial instruments, Pensford Financial Group, LLC does not provide legal or tax advice. The contents herein are the copyright material of Pensford Financial Group, LLC and shall not be copied, reproduced, or redistributed without the express written permission of Pensford Financial Group, LLC.

ECONOMIC CALENDAR
Economic Data Day Monday Tuesday Wednesday 8:30AM 7:00AM 8:30AM 8:30AM 8:30AM 8:30AM 9:15AM 9:15AM 10:00AM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 10:00AM Friday 10:00AM 10:00AM Time Report MARKETS CLOSED Empire Manufacturing MBA Mortgage Applications Producer Price Index (MoM) Producer Price Index (YoY) Core Producer Price Index (MoM) Core Producer Price Index (YoY) Industrial Production Capacity Utilization NAHB Housing Market Index Initial Jobless Claims Continuing Claims Consumer Price Index (MoM) Consumer Price Index (YoY) Core Consumer Price Index (MoM) Core Consumer Price Index (YoY) Housing Starts (MoM) Building Permits (MoM) Philadelphia Fed. Existing Home Sales (MoM) Existing Home Sales 0.1% 5.1% 0.1% 2.8% 0.5% 78.1% 22 385k 3595k 0.1% 3.0% 0.1% 2.2% -0.7% 0.0% 11.0 5.2% 4.65mm 11.00 9.53 4.5% 0.3% 5.7% 0.1% 2.9% -0.2% 77.8% 21 399k 3628k 0.0% 3.4% 0.2% 2.2% 9.3% 5.7% 10.3 4.0% 4.42mm Forecast Previous

Speeches and Events Day Monday Wednesday Time 6:00PM 9:30AM Fed's Duke speaks Fed's Tarullo to testify on Volcker Rule Report Place Richmond, VA

Treasury Auctions Day Closing Issues Size

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