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

com Leveling the Playing Field August 13, 2012 _______________________________________________________________________ A few months ago I wrote a newsletter during a flight from Charlotte to LA, while three kids kicked the back of my seat for the entire 5 hour flight. Im not sure if my frustration was evident in the newsletter, entitled I Hate The Fed and the Eurozone Crisis and S&P and USAir and $57 Choice Seats and Cookies and Dogs and Babies and Butterflies. But just to be safe, I decided to write this newsletter a day early so as not to be influenced by travel circumstances. A very light week of data last week ended up being one of the more volatile rate weeks of the summer. Last week we called for long term fixed rates to decline after the market had an opportunity to realize that Draghi hadnt actually said anything of significance. Of course, the 10 year Treasury yield promptly went up about 0.20% before retracing and finishing the week about 0.10% higher at 1.66%. The Fed is setting the table for additional QE just in time for the elections. The idea of an open-ended QE is gaining more and more traction, in part from strategic leaks to the WSJ by Fed officials. We still think the Fed will announce something at the September FOMC meeting and the increased chatter of Fed governors supports this. As always, the question remains how effective this will be. Global equities have been the clear benefactor from the $7 trillion in liquidity pumped into the markets by central banks over the last four years. Bridgewater released a report this week to investors outlining the diminishing returns of each subsequent QE over the years. The three contractions in global growth that have occurred since the financial crisis were offset by heavy blasts of fiscal and monetary stimulation by global governments and central banks. But each wave of support has also had less impact on global conditions than the previous wave. We remain concerned that the ability of those policy responses to stabilize the situation is diminishing. The third wave stabilized global growth after last summers dip and allowed for the bounce in global conditions and markets over the early part of this year but its impact on global conditions was more modest than that of earlier waves of stimulation. As the third wave has ended, global growth has again rolled over.

I wonder what state the economy would be in right now absent the additional QE over the last few years? The Fed is in a tough spot. No major developments in Europe last week, but it feels like the Troika is taking an approach of simply tackling the most pressing crisis at the time rather than sweeping change. Greece pops up, lets deal with it. Spain pops up, deal with it. Italy pops up, deal with itbut like Bridgewater notes above, this strategy also suffers from diminishing returns. Politically it makes sense to wait for a full blown crisis rather than to be forward looking its not MY fault! Were in a crisis and I HAVE to make these uncomfortable decisions. But it allows other problems to worsen (cough cough Italy) and so by the time the next crisis surfaces the order of magnitude has increased substantially. Right now, markets are satisfied that Greece hasnt imploded, so attention has slowly shifted to Spain and Italy. Weve written about this ad nauseum. Politicians will swoop in at the last second, backs to the walls, and unveil an incredibly expensive bailout package. But right now, we should really be looking even further down the road and asking what will happen to France. France is AAA, but for how long? We doubt Moodys downgrades France ahead of the September 12 German parliament vote, but a downgrade is imminent barring a dramatic shift in fiscal policy. Given the socialist government in place with taxes as high as 75% on millionaires, a retirement age of 60, and with government spending at 55% of GDP, dont hold your breath. But why make tough decisions about France right now when the public is largely unaware France has issues that can dwarf Greece? Just sit tight, deal with Spain and Italy, and deal with France when it rears its ugly head. If it costs 10x more at that time, so be it. Everyone will be

all-in at that point and be forced to push forward with an outrageously expensive bailout. Some interesting stats from a recent German survey done by ARD TV: 56% of Germans want their government to do everything to save the euro 76% say a euro break-up would be bad for Germany 64% of Germans believe the euro will survive 84% think the crisis will worsen 56% worry that the economy will deteriorate next year 70% believe Merkel is doing a good job

So if the Troika keeps plodding along from one crisis to the next, the next step is probably some type of ECB mechanism to buy peripheral bonds on a massive scale. And by massive I mean trillions. Because the law of diminishing returns requires ever higher spending to obtain less ideal outcomes. And once you start spending, you have to keep spending. Just ask the Fed. LIBOR Outlook
2012 2013 2014 Fed Funds Rate 3Q 2012 4Q 2012 1Q 2013 2Q 2013 3Q 2013 4Q 2013 1Q 2014 # of Replies 78 78 78 78 77 74 50 Median 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% Average 0.25% 0.25% 0.26% 0.26% 0.30% 0.34% 0.49% High Forecast 0.25% 0.25% 0.50% 1.00% 2.00% 2.00% 2.75% Low Forecast 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 3Q 2012 4Q 2012 1Q 2013 2Q 2013 3Q 2013 4Q 2013 1Q 2014
Median Average
High Forecast

Low Forecast

Fixed Rate Outlook We still believe the market is overly optimistic and reality will settle in shortly unless the Troika announces a definitive plan of action. Below is the most recent Bloomberg survey of approximately 60 economists on the 10 year Treasury forecast.
2012 2013 2014 3Q 2012 4Q 2012 1Q 2013 2Q 2013 3Q 2013 4Q 2013 1Q 2014 73 74 72 72 71 70 44 1.60% 1.65% 1.81% 2.00% 2.20% 2.38% 2.56% 1.63% 1.75% 1.93% 2.10% 2.29% 2.46% 2.75% 2.45% 3.25% 3.76% 4.03% 4.20% 4.80% 5.20% 1.25% 1.10% 1.30% 1.20% 1.25% 1.25% 1.30%

10 Year Note # of Replies Median Average High Forecast Low Forecast

6.00% 5.50% 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 3Q 2012 4Q 2012 1Q 2013 2Q 2013 3Q 2013 4Q 2013 1Q 2014

Median
Average

High Forecast Low Forecast

This Week Very full week of economic data. Tuesday brings July retail sales, which some economists think will be the first positive reading in over a quarter due to lower energy costs. But dont put too much stock into this release, Augusts release will be far more informative with back to school spending serving as a good barometer for consumer discretionary spending. And no matter what my daughter thinks, school clothing is, in fact, discretionary. Core inflation is expected to be stable at 2.2% y/y in July, giving the Fed all the wiggle room it needs to either take action or standby for more data.
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ECONOMIC CALENDAR
Economic Data Day Monday Tuesday 7:30AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 10:00AM 10:00AM Wednesday 7:00AM 8:30AM 8:30AM 8:30AM 8:30AM 8:30AM 9:15AM 9:15AM 10:00AM Thursday 8:30AM 8:30AM 8:30AM 8:30AM 10:00AM Friday 8:30AM 8:30AM NFIB Small Business Optimism Producer Price Index (MoM) Producer Price Index (YoY) PPI Core (MoM) PPI Core (YoY) Advance Retail Sales IBD/TIPP Economic Optimism Business Inventories MBA Mortgage Applications Consumer Price Index (MoM) Consumer Price Index (YoY) CPI Core (MoM) CPI Core (YoY) Empire Manufacturing Industrial Production Capacity Utilization NAHB Housing Market Index Initial Jobless Claims Continuing Claims Housing Starts (MoM) Building Permits (MoM) Philadelphia Fed University of Michigan Confidence Leading Indicators 0.2% 1.5% 0.2% 2.2% 7.00 0.5% 79.2% 35 364k 3300k -0.3% 0.7% -5.0 72.2 0.2% 92.0 0.2% 0.5% 0.2% 2.3% 0.3% 47.0 0.2% 91.4 0.1% 0.7% 0.2% 2.6% -0.5% 47.0 0.3% -1.8% 0.0% 1.7% 0.2% 2.2% 7.39 0.4% 78.9% 35 361k 3332k 6.9% -3.7% -12.9 72.3 -0.3% Time Report Forecast Previous

Speeches and Events Day Wednesday Thursday Time 8:00PM 8:00PM Report Fed's Kocherlakota speaks on the Fed Fed's Kocherlakota speaks on the Fed Place Minot, ND Williston, ND

Treasury Auctions Day Time Report Size