The Final Chapter of the Old Story

Strategic Research February 11, 2011 MARK O. LAPOLLA, CFA WWW.KNIGHT.COM 404.736.2431 | [email protected] The Final Chapter of The Old Story

Nevertheless, like me in 1958, investors refused to see the ground shifting beneath them, even though the environment was no longer what they knew and thought they understood. Like me, they were walking into a trap where the responses were not what they had anticipated. Like me, they were headed toward big surprises for which they had no preparation. It has been said that good forecasters have a good sense of history. I suppose that is true. But the best lesson from the past is to forget it before it shoves you into trouble — and remember that surprises and ruptures surely lurk ahead. Peter L. Bernstein, (1919-2009) on the Financial Crisis “To Botch A Forecast, Rely on Past Experience” The New York Times; December 30, 2007

Refer to important disclosures at the end of this document. Knight Capital Americas, L.P. Strategic Research

We believe that the credit crash of 2007—2008 ended a 75-year Consumer Credit Super Cycle in the developed world, and that government policy actions— particularly in China and the United States—and the market responses to them, have pushed the cyclical and structural terms of global trade past their tipping points.

Thus, we believe that the consensus global growth story is ending, and so too, the gilded age of the Emerging Markets.

The global economy will fully enter into a generational transformation requiring the painful maturation of the developing world, the end of entitlements based democracy in the developed world, and the hopeful renaissance of U.S. economic and geopolitical leadership.

Knight Capital Americas, L.P. 2 Strategic Research Say It Ain’t So

Surely the endgame is upon us. Higher commodity prices will fuel inflation and materially higher interest rates. And necessarily, this will precipitate a collapse in the dollar and threaten the fiscal sustainability of the United States. Moreover, if prevailing economic and financial theory are to be believed, then all these statements are true and the implications quite troubling. But, the prevailing orthodoxy is NOT to be believed, nor the de facto conclusions which they imply.

With the presumption of a broadening economic rates; but in a startling divergence from economic in the dollar and threaten the fiscal sustainability of recovery around the world, the global financial theory, it did not. the United States? And if so, wasn’t the leader of markets are once again focused on rising In his now famous speech given in April 2005, Ben the Communist Party of China, Hu Jintao, correct commodity prices, the global growth story and the Bernanke offered an explanation for why long-term when he declared at the G20 summit this past present risk that economic and foreign exchange interest rates stayed low. It wasn’t excess consumption November, “We are the masters now.”? imbalances will trigger the end game of the that fueled the current account imbalance; rather, If prevailing economic and financial theory are to “Sovereign Debt Crisis” leading to higher interest it was a “global savings glut”—primarily in Asia— be believed, the resounding answer to all these rates, currency debasement, and the possibility of which by extension (we are being facetious here) questions is, “yes.” But the prevailing orthodoxy is hyper-inflation. forced the United States to consume more in order NOT to be believed, nor the de facto conclusions And such is the nearly uniform consensus around the to absorb the excess savings of our trading partners. which they imply. world. The storyline goes something like this: But causal clarity is not important to the story line. And this is the rub—and the ambitious Profligate developed world nations—most What is, however, is the entrenched belief that “we” (foolhardy?) challenge of this publication: to particularly the United States—have recklessly and are dependent upon “them” for economic balance present our views in a simple and approachable irresponsibly adhered to expansive monetary policies and survival. form that efficiently challenges the orthodox and regulatory regimes to support undisciplined And nothing has changed. Today, the Federal Reserve consensus, and at a minimum, will serve as fiscal spending and gross “excess consumption” by is proceeding apace with QE2, U.S. budget deficits the foundation for spirited dialogue going the household sector. ensure an ongoing ramp-up of accumulated debt, forward. In turn, as a matter of accounting identity, domestic and stock and commodity prices have skyrocketed. To accomplish this, we have chosen to minimize dis-savings had to be balanced by foreign savings; Inflation is breaking out across the emerging world, verbiage and maximize illustrations; and on namely, the purchases of Government debt the December UK Retail Price Index of inflation (4.8%) balance, to keep the logical flow going without obligations by “rich nations” flush with trade doubled wage growth, and German unions—citing succumbing to tedious—and in all likelihood— surpluses and excess foreign exchange reserves. rising inflation—are pushed for higher wages at the unconvincing detail. Ultimately, our objective European Union Summit. This dynamic led to an ever-widening current account with this publication—as with all our work—is to deficit which drove the exchange rate of the dollar Surely the endgame is upon us. Higher commodity apply experience, common sense, and intuition to down and should have resulted in higher interest prices will fuel inflation and materially higher interest uncover powerful investment themes obscured by rates. And necessarily, won’t this precipitate a collapse the fallacies of conventional thinking.

Knight Capital Americas, L.P. 3 Strategic Research

The Gist

“To understand reality is not the same as to know about outward events. It is to perceive the essential nature of things. The best-informed man is not necessarily the wisest. Indeed there is a danger that precisely in the multiplicity of his knowledge he will lose sight of what is essential. But on the other hand, knowledge of an apparently trivial detail quite often makes it possible to see into the depth of things. And so the wise man will seek to acquire the best possible knowledge about events, but always without becoming dependent upon this knowledge.” Dietrich Bonhoeffer, Lutheran Minister

Knight Capital Americas, L.P. Strategic Research Executive Summary

It is our contention that the current levels of supported and cheered by the political establishment to its cyclical end. Moreover, we believe that the unemployment are structural, and likely understate (who have historically retained power through the consensus view on U.S. monetary policy and the the magnitude of dislocation across the workforce. extension of benefit,) as well as the financial sector impact that accumulated debt, persistent budget It was Keynes who first wrote of “technological whose power and sway upon the affairs of the world and trade deficits will have on interest rates, unemployment” back in the days when machine was crested at unimaginable heights. inflation, and the dollar, is wrong. replacing man at a furious rate. At the same time, the world was growing fond Our view remains that stable/growing cash flow Today, we believe the U.S. economy is suffering of the rising emerging markets; in some cases streams denominated in U.S. dollars are the most from the cumulative effect of a different type of laden with resources, in most cases laden with attractive assets in the world. We believe that technological unemployment; in this case, the rapidly inexpensive labor, and in all cases, laden with unlevered cash on cash returns will once again diminishing value of “average” human capital within large populations hungry for higher standards become the measure of “value.” a society where IP (intellectual property) is the driver of living. This of course implied an insatiable By design, this publication does not delve into of marginal productivity and profit. demand for commodities and all the elements tactical concerns, sector weights, or security As a result, labor has been steadily losing its power, necessary for massive infrastructure development; selection. It is our hope that by providing clarity on and with it, wage growth. Thus, we view the housing and ultimately, of course, explosive demand for pivotal macro issues, this work will be applicable boom and bust in the context of a society desperately branded goods from the developed world. to all investors and those concerned with the trying to extend lifestyle gains to a workforce desiring It is our contention that the emerging market allocation of assets over the coming decade. to live far above what their economic value justifies. story—which has now blossomed into the Listed below are some key takeaways from our Needless to say, this was an outcome broadly “global growth thesis”—has matured and come work.

BBThe U.S. Labor Market Is Structurally Broken BBMonetary Policy Cannot Create Inflation BBConsumer Credit Is Dead BBThe U.S. Current Account Deficit Is a Non-Issue BBThe “Recovery” Is Just a Stabilization BBThe Fed Anchors and “Controls” Rates BBNominal GDP Will Remain Anemic for Years BBThe U.S. Is Fiscally Sustainable BBCorporate Profitability and Main Street Economics Are Uncoupled BBInterest Rates Will Remain Low BB Corporate Margins Will Not Revert Back to Their Long-Term Mean BBThe Euro Will Survive, but the Dollar Standard Will Grow Stronger BBRising Commodity Prices Are Deflationary in the Developed World BBNominal Is All That Really Matters BBSustaining Inflation in the U.S. Will Not Be Possible for Years BBThe Global Growth Story Is Over: and China Is the Linchpin BBThe Global Terms of Trade Are Past Their Tipping Point BBFood Is More Important than Oil

Knight Capital Americas, L.P. 5 Strategic Research

The Fall of Labor

“For the moment the very rapidity of these changes is hurting us and bringing difficult problems to solve. Those countries are suffering relatively which are not in the vanguard of progress. We are being afflicted with a new disease of which some readers may not yet have heard the name, but of which they will hear a great deal in the years to come--namely, technological unemployment. This means unemployment due to our discovery of means of economising the use of labour outrunning the pace at which we can find new uses for labour.” John Maynard Keynes “Economic Possibilities for our Grandchildren” (1930)

Knight Capital Americas, L.P. Strategic Research Prosperity Cannot Be Guaranteed

And it is our contention, that from this base of expectation—reinforced time and again by those governing the land—many workers in America allowed their economic value to grow stale; even as the world was changing and their indebtedness grew. So today, without the benefit of massive credit subsidies and the elixir of rising home prices, both the economy and far too many of its workers are struggling.

The transformation of labor—and the steadily was the period of Upton Sinclair’s The Jungle; the Moreover, Hoover’s belief that Federal support declining EVA (economic value added) of its core— nation was sympathetic, and the politicians were would undermine the character of the American lies at the root of today’s economic crises and is falling in line. Times were good. worker, was all labor needed to galvanize its the singular challenge of this generation. But unfortunately for labor—thanks to the Roaring support around FDR. Two hundred years ago, some 92 percent of Twenties and the attendant explosion in stock And with these words, spoken in April of 1938, Americans worked in agriculture, 5 percent in prices and debt—times got too good; and labor FDR firmly established Government’s heavy manufacturing, and 3 percent in the service sector lost its power. Until, that is, The Great Depression. hand in the free markets: “Not only our future (i.e.“household servants.”) Immediately following the Crash, President Hoover economic soundness but the very soundness By 1890 less than 100 years later—machines had adopted a tough love policy based upon his belief of our democratic institutions depends on already grown to dominate the economic landscape. that a strong, dependable wage for those employed the determination of our government to give But rapid industrialization into the new century would carry the nation through the storm. And employment to idle men.” brought with it serious abuses and unacceptable although less than ten percent of big corporations And with that proclamation, and as furthered business practices which needed major reform. actually cut wages in 1930, collapsing demand and by Lyndon Johnson’s Great Society pledge, the And through this period, the American Federation the crush of debt service forced smaller and weaker United States plunged forward with a growing of Labor (A.F.L.) was the dominant organization companies to slash both wages and jobs; and so belief that it was government’s role to guarantee representing unionized labor. the cycle of deflation accelerated. By November of prosperity. Founded in 1886 by Samuel Gompers, the A.F.L. 1932, it is estimated that some 33 percent of all And it is our contention, that from this base of was the culmination of labor’s long struggle to wage earners were unemployed. Between 1929 expectation—reinforced time and again by those create a “super” union of all crafts. From its launch and 1933, labor income had declined a staggering governing the land—many workers in America until the early ‘20s, the A.F.L. had great success. 48 percent. allowed their economic value to grow stale; even As membership grew (peaking at 5.1 million in But then, Franklin D. Roosevelt emerged as the as the world was changing and their indebtedness 1920), their powerful political influence resulted in Democratic candidate for the Presidency and grew. reducing the work week, dramatically increasing immediately won labor’s strong support. Rightfully So today, without the benefit of massive credit real wages, improving working rights for women so, the nation was tired of Hoover’s mantra of subsidies and the elixir of rising home prices, and children, and restrictive immigration policy. rugged individualism, and devastated by his refusal much of the economy and far too many of its On a relative basis, this was labor’s best time. It to use Federal money to relieve unemployment. workers are struggling.

Knight Capital Americas, L.P. 7 Strategic Research Productivity Explosion: Exponential Output Growth and Steady Labor Decline

US Manufacturing Output Growth vs. Manufacturing Labor Decline 1950-2010

900

800 y = 50e0.6931x R² = 1 700

600

500

400

300

200 y = -33x + 133 R² = 1 100

0 1950 1980 2010

"US Manufacturing Output (1950=100) "US Manufacturing Workers (1950=100) Expon. ("US Manufacturing Output (1950=100)) Linear ("US Manufacturing Workers (1950=100))

Source: Federal Reserve, Bureau of Labor Statistics, KSR

Knight Capital Americas, L.P. 8 Strategic Research “X” Marks the Spot

Despite perceptions to the contrary, by output, the United States is still the leading manufacturer in the world. By “value-added”, the gap is 3X China. Yet, as shown below, the government employs twice as many people as manufacturers.

Non-Farm Payroll Components as Percent of Total Non-Farm Payroll

70% 40%

35% 65%

30% 60%

25%

55%

20%

50% 15%

45% 10%

40% 5% 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Private Service as Percent of Total (LS) Govt as Percent of Total (RS) Manufacturing as Percent of Total (RS) Source: Bureau of Labor Statistics, KSR

Knight Capital Americas, L.P. 9 Strategic Research As Manufacturing Intensity Declined, So Did Wage and Output Growth

US Nominal GDP Per Capita YoY % Change US Personal Income versus Transfer Payments SAAR (Indexed 100=1-31-1999) +4 Stdev 240

16.00% +3 Stdev 220

+2 Stdev 200 11.00%

+1 Stdev 180

6.00% Median 160

-1 Stdev 1.00% 140

-2 Stdev 120 -4.00% -3 Stdev 100 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 -4 Stdev -9.00% US Personal Income SAAR Indexed 100=1-31-1999 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 Personal Income Transfer Payments to Persons SA Indexed 100=1-31-1999 Source: Bloomberg, KSR Source: Bureau of Economic Analysis, KSR Reflects services growing to 70% of the employed Despite the housing boom—or perhaps because of labor base. it, transfer payments grew twice as fast as personal income.

Acceleration (second derivative) in Household Debt 10-Year Payroll Growth 100%

60% 50%

50% 0% -6.37%

-50% 40%

-100% 30%

-150% 20% -200% 10% -250% 0% -300%

-10% -350% 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 US Employees on Nonfarm Payrolls Total SA 120-Month % Change US Recession Household Debt YoY % Change US Employees On Nonfarm Payrolls Total Government SA 120-Month % Change Source: Federal Reserve, KSR US Employees on Nonfarm Payrolls Total Private SA 120-Month % Change Source: Bureau of Labor Statistics, KSR This divergence between government and private In times of heavy leverage and deflationary pressure; sector payroll growth is a VERY big deal. NOMINAL dollars are everything.

Knight Capital Americas, L.P. 10 Strategic Research The Global Economy Has Rapidly Bifurcated Between IP and Scale

WEALTH ACCELERATING ECONOMIC WEALTH WEALTH ACCELERATING ECONOMIC WEALTH BIFURCATION BIFURCATION

LABOR DENSITY COMPETITION ECONOMIC VALUE ADD

LIFESTYLE /CREDIT SQUEEZE

INNOVATION POLITICAL PRESSURE IP RICARDIAN ADVANTAGE SCALE

LABOR DENSITY IP RICARDIAN ADVANTAGE SCALE Source: Knight Strategic Research ECONOMIC VALUE ADD COMPENSATION Source: Knight Strategic Research

For the past twenty years, the global economy As IP has followed Moore’s law, innovative has been rapidly bifurcating between Intellectual competition has pushed most workers EVA below Property (IP) and Scale. their compensation costs. Commonly known as the global labor arbitrage, This, in conjunction with rising benefit and regulatory Ricardo’s theory of comparative advantage has been expense, has kept wage growth anemic and job playing out in dramatic fashion. insecurity high. Thus, credit has been the necessary lifeblood to keep most workers lifestyles moving higher.

Knight Capital Americas, L.P. 11 Strategic Research IP Versus Scale

IP & MATURE CREDIT = DEFLATION RISK IP & MATURE CREDIT = DEFLATION RISK SCALE & ACCELERATING. CREDIT = INFLATION SCALE & ACCELERATING. CREDIT = INFLATION

WEALTH LABOR DENSITY WEALTH WEALTH LABOR DENSITY WEALTH

ECONOMIC VALUE ADD ECONOMIC VALUE ADD

COMPENSATION DISINFLATION COMPENSATION

WAGE PRESSURE DEFLATION RISING DEMAND INFLATION

FALLING DEMAND WAGE PRESSURE TECHNOLOGY COMMODITIES

IP RICARDIAN ADVANTAGE SCALE IP RICARDIAN ADVANTAGE SCALE Source: Knight Strategic Research Source: Knight Strategic Research

So as wage pressures and the modern form of Keynes The disparity of wealth and income is easily “technological” unemployment have accelerated, understood from this chart. IP is accelerating at the aggregate nominal earnings and demand have been highest levels, while debt deflation is crushing the falling in the IP world. vast majority of workers down the chain. Conversely, demand for low-cost manufacturing So too, those who own Scale production are the and assembly to feed this disinflationary trend robber barons of this day, but rising input costs have has accelerated. This has markedly increased wage triggered a wage-price spiral that will likely end their pressures in the Scale world. era of exponential growth.

Knight Capital Americas, L.P. 12 Strategic Research

The Necessary Rise of Credit

“Keeping up with the Joneses”. The phrase was popularized when a comic strip of the same name was created by cartoonist Arthur R. "Pop" Momand which first appeared in The New York World in 1916. It offered a sad parody of abject consumerism; the title of which, is still a widely used colloquial expression for needless consumption.

Knight Capital Americas, L.P. Strategic Research A Home for Every Household

And as financial innovation and capital formation accelerated, the competitive dynamics and speed of commerce intensified. Moreover, the development of technology and transportation systems unleashed an enormous productivity wave and the now fabled Ricardo global labor arbitrage. But no matter. The aggressive subsidization of mortgage credit and home ownership, and all forms of seductive consumer lending, bridged the gap between labor’s falling economic value add and its desire for an ever increasing standard of living.

Since our founding, the United States has been Although our financial markets were always to credit dependency; and from saving to consumption. generally committed to the pursuit of two seemingly forward leaning, it wasn’t until the end of The From a societal perspective, we progressed from “Hey opposite agendas: free-market capitalism and social Great Inflation and the Volker era that the Buddy, can you spare a dime?” to “Hey Buddy, do you welfare. Without the benefit of experience, planning, democratization of capital exploded full force. The want to borrow a dime?” from “A chicken in every pot” or continuity, the course of economic development stage was set with the signing of the Employment to “A home for every household.” was charted by politicians, bureaucrats, and the Retirement Income Security Act of 1974 (ERISA) This virtuous cycle of rising asset values and expanding rising influence of “special interests.” Money was and the subsequent control of pension portfolios leverage fostered an unprecedented period of capital the lubricant for the inherently sordid affair; as power by consultants; the explosion of mutual funds and gains and economic expansion. desired wealth, and wealth desired power. defined contribution retirement plans; the Interstate And as financial innovation and capital formation Banking and Branch Efficiency Act of 1994, and Naturally, avaricious political promises often collided accelerated, the competitive dynamics and speed of the 1999 repeal of the Glass-Steagall Act of 1934; with prudence and reality; thus, forward “progress” commerce intensified. Moreover, the development and of course, the nearly 20-year reign of laissez- required ever-increasing indebtedness. Our nation of technology and transportation systems unleashed faire capitalism under Ayn Rand devotee, Federal moved forward—even through the Great Depres- an enormous productivity wave and the now fabled Reserve Chairman Alan Greenspan. sion—but with each economic cycle, government Ricardo global labor arbitrage. intervention and social assistance grew more impor- It was these factors that fueled an unprecedented As a result, labor lost its power rather quickly, and tant, and so did our dependence upon debt. explosion in financial innovation, but it was the the earnings gap between those who “produced” politically-mandated expansion of home ownership So, after the devastating inflation of the 1970s, the and those who “supported” began to widen which laid the foundation and drove the trend. US Government and all its monetary and regulatory dramatically; and metaphorically, having previously Under the auspices of the US Department of Housing authorities, committed to leveraging the American sold their inheritance for “free” health care coverage, & Urban Development (HUD) and as executed by the dream of homeownership to launch the greatest rising benefits costs soon eclipsed wage gains. consumer credit boom in history. “quasi-governmental” Fannie Mae and Freddie Mac, politicians transferred wealth to the private sector, But, no matter. The aggressive subsidization of With an economy duly tied to credit growth and while—as we now know—irresponsibly allowing the mortgage credit and home ownership, and all forms politicians duly tied to the extension of social benefit, socialization of risk. of seductive consumer lending, bridged the gap it shouldn’t be surprising that housing became the between labor’s falling economic value add and its Culturally, we made a wholesale shift from debt aversion Universal Good. desire for an ever increasing standard of living.

Knight Capital Americas, L.P. 14 Strategic Research Debt Growth Plateaued After the Baby Boom

US Consumer Credit Outstanding as a % of Nominal GDP (1946-1980)

13%

11%

3% 1946 1951 1956 1961 1966 1971 1976 Source: Federal Reserve, Bureau of Economic Analysis, KSR

Knight Capital Americas, L.P. 15 Strategic Research Productivity Growth and Declining EVA Caught Up With Labor

Nominal Wage & Salary and Corporate Profits as a % of Congressional Budget Potential Nominal GDP

56% 16%

54% 14%

52% 12%

50% 10%

48% 8%

46% 6%

44% 4%

42% 2%

40% 0% 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 Wage & Salary From The GDP Report US Nominal Dollars SAAR / Congressional Budget Office Potential Nominal GDP US Corp Profits With IVA Total SA / Congressional Budget Office Potential Nominal GDP (RS)

Source: Bureau of Economic Analysis, KSR#N/A N/A, KSR

Knight Capital Americas, L.P. 16 Strategic Research Massive Amounts of Credit Was Needed to Facilitate Lifestyle Growth

THE CONSUMPTION BUBBLE LIFESTYLE

CONSUMER CREDIT / LEVERAGE

WAGES

EVA

Source: Knight Strategic Research DECLINING MANUFACTURING →→→ RISING IP

Knight Capital Americas, L.P. 17 Strategic Research The Housing Bubble Marked the End of a 75-year Credit Super Cycle

Target leverage

Stronger Balance sheets

Increase B/S size

When mega cycles end, they are usually the Asset price boom completion of many convergent trends. In the case of the housing boom, it capped the transition from Source: Federal Reserve Bank of New York the totally debt averse post-Depression culture The pro-cyclicality of the credit cycle was immensely to the credit dependent sense of entitlement so powerful. As leverage increased and balance visible at the peak. sheets grew larger, direct flows into assets drove prices higher. This in turn, strengthened creditors and induced more lending.

Knight Capital Americas, L.P. 18 Strategic Research Hall of Fame Metrics

Total Consumer Debt Including Debt Intensity of US Economy Mortgages Relative to Personal Income (Annual Debt Growth / GDP Growth)

4,500 65%

60% Billions $ 3,500

55%

2,500 50%

45% 1,500

40% 500 35%

30% -500

25% -1,500 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 20% 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 US Total Domestic Debt YoY Change GDP US Nominal Dollars SAAR YoY Change Source: Bloomberg, KSR Source: Federal Reserve, Bureau of Economic Analysis, KSR The prevailing belief was that home prices couldn’t And no one cared until they had to. fall.

Commercial Banks versus Shadow Banking The Most Pronounced Debt Cycle Ever Credit Creation (Billion $ SAAR) YoY % Change in Household Credit Growth

3,000,000 6 5.5 2,500,000 5 2,000,000

1,500,000 4

1,000,000 3 2.6 500,000 2.24

2 1.7 1.75 0 Annual Percentage Change Annual

-500,000 1 0.8 0.45 -1,000,000 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 0 Shadow Banking Credit Creation Commercial Bank Credit Creation 2Q58 - 1Q60 1Q61 - 3Q69 4Q70 - 3Q73 1Q75 - 4Q79 4Q82 - 2Q90 1Q91 - 4Q00 4Q01 - 2007Current Source: Federal Reserve, KSR Source: Federal Reserve, Bloomberg, KSR Deregulation and gross regulatory failure facilitated And what’s worse, job creation during the “boom” the disintermediation of the banking system. was the weakest of any modern expansion.

Knight Capital Americas, L.P. 19 Strategic Research Both House Prices and the Allocation of Credit Were Unhinged from Reality

PEAK HOME VALUE CALCULUS PERVERSE SELECTION

EQUIVALENT RENT 6% + TAX BENEFITS 5% - 4% PROPERTY TAXES + 3% PROXIMITY PREMIUM (Jobs, Schools, Community, Climate) MORTGAGE RATES - COST OF CAPITAL (Required Equity + API) + 5% 10% 15% 20% 25% 30% SPECULATIVE PREMIUM HOUSE PRICE APPRECIATION Source: Knight Strategic Research Source: Knight Strategic Research

So let’s be honest: who really thought about Certainly the origination machine believed in the anything other than how much house they could speculative value of residential real estate. buy? As shown here, the cost of capital actually fell—materially—in relation to the rate of price acceleration in local markets. Wow.

Knight Capital Americas, L.P. 20 Strategic Research How Can There Be Any Risk When Prices Never Fall?

We calculated this ratio by applying the average amount of leverage in the housing market (Fed data, adjusted for the multi-decade 30% of homeowners with no mortgage), the Case-Shiller 20-market index, and the 5-yr treasury bond yield as the risk-free rate. Sharpe Ratio for Residential Real Estate

-2

-4 Dec-94 Apr-96 Aug-97 Dec-98 Apr-00 Aug-01 Dec-02 Apr-04 Aug-05 Dec-06 Apr-08 Aug-09 Source:Source: Blooomberg; Bloomberg, Case Case-Shiller,-Shiller; Federal Federal Reserve, Reserve, KSR KSR

Knight Capital Americas, L.P. 21 Strategic Research Asset Rich and Cash Poor

Net financial investment / PCE Quarterly Change vs. Quarterly MEW and Personal Income vs. Personal Savings Rate MEW as a Percent of Nominal GDP 20% 15 600 6%

15% 500 10

400 4% 10% 5 300

5% 200 2% 0 100 0% 0 0% -5 -5% -100

-200 -2% -10 -10% -300

-15% -15 -400 -4% 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 1995-Q2 1996-Q4 1998-Q2 1999-Q4 2001-Q2 2002-Q4 2004-Q2 2005-Q4 2007-Q2 2008-Q4 Net financial investment / Disposable Personal Income Quarterly Change PCE $ Billions SAAR MEW Annualized $ Billioins US Personal Saving as a % of Disposable Income (RS) MEW as Percentage of Nominal GDP (RS) Source: Federal Reserve, KSR Source: Bureau of Economic Analysis, Federal Reserve, Bloomberg, KSR

By 1998, households were liquidating financial Mortgage equity withdrawals (MEW) played assets in earnest—even as their savings rate an enormous role in fueling consumption from diminished. 2003—2007. Remember the Bank of America ads? “I bet you didn’t know your home was your own personal ATM!” Incredible.

Knight Capital Americas, L.P. 22 Strategic Research And the Party Was Without End

Growth in Real PCE as Pct of Growth in Real GDP Contribution to Real GDP Growth (7-Year Rolling Period) 100% (Volatility by Component) 8.0 95% 7.0 Gross domestic product 90% Personal consumption expenditures 6.0 Gross private domestic investment 85% Net exports of goods and services

80% 5.0 Government consumption expenditures and gross investment State and local 75% 4.0

70% 3.0 Percent Volatility

65% 2.0 60% 1.0 55%

0.0 50% Post-War Boom High Inflation Stability Post CRA/GS 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 1946-1968 1969-1984 1985-1995 1996-2007 US Recession Growth in Real PCE as Pct of Growth in Real GDP (7-Year Rolling Period) Source: Bureau of Economic Analysis, KSR Source: NBER, Bloomberg, KSR

The incremental GDP growth coming from This chart depicts the “Great Moderation;” the personal consumption was not unprecedented; low volatility economic environment (aka the although it was clearly unsustainable. Minsky “equilibrium”) which fostered the gross But the question remains: What will take its place? misallocation of capital and the collapse of risk premiums around the world.

Knight Capital Americas, L.P. 23 Strategic Research

The Crash

“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” John Maynard Keynes “The Consequences to the Banks of the Collapse of Money Values” (1931)

Knight Capital Americas, L.P. Strategic Research Price Momentum Does Not Justify Capital Commitment

The highly reflexive and procyclial expansion of leverage ran amuck; and contrary to popular and politically correct opinion, it was ultimately made possible by the gross misallocation of capital by the globe’s largest institutional investors who allowed relative performance and momentum to substitute for the prudent allocation of credit.

Like all nations throughout recorded history, which can give rise to initially self-reinforcing or unsustainable the relationship—is at the the extension of credit has been central to but eventually self-defeating boom-bust heart of reckless momentum. And through the economic affairs of America; and so too, processes, or bubbles.” He continued, “I transference, it is the very momentum of belief the dangers of over-indebtedness have been came to realize that market participants which clouds judgment, suspends common central to our culture’s shared wisdom. cannot base their decisions on knowledge sense, and alters the perspective of current Unfortunately, the fact remains that the history alone, and their biased perceptions circumstance to sustain and reinforce itself. of financial crises in the United States is all too [incentive driven] (our comment)] have Precisely in this way, the highly reflexive and robust for a supposedly “enlightened” country ways of influencing not only market prices procyclial expansion of leverage ran amuck; of such short life; notably, the Panics of 1837, but also the fundamentals those prices are and contrary to popular and politically correct 1857, 1873, and 1907; the Great Depression supposed to reflect.” opinion, it was ultimately made possible by the of 1929-1933, and the Credit Crash of 2007— We agree with Mr. Soros on virtually all gross misallocation of capital by the globe’s 2008. Surprising? Hardly. counts. There is a great conundrum that largest institutional investors who allowed In his book, “The New Paradigm For arises—most particularly as a result of relative performance and momentum to Financial Markets”, George Soros makes suboptimal incentive structures—between substitute for the prudent allocation of credit. the case that the global financial order has truth and price; wisdom and value. “Post hoc, been developed on the basis of a flawed ergo proctor hoc,” as translated: “after it, paradigm. Central to his argument is the therefore because of it,” is undoubtedly the notion that market prices do not randomly most common and destructive fallacy present deviate from a theoretical equilibrium; but in the financial markets. If P=>Q; Q=>P; pure rather, that “there is a two-way reflexive circularity. The insatiable desire to ascribe and connection between perception and reality act on causality—no matter how specious

Knight Capital Americas, L.P. 25 Strategic Research The Failure to Incorporate Stress Tests for HPA in Risk Models Set Up the Crash

Over Valued Homes Home Sales vs. Transaction Dollar Volume

$300,000 7.5 1,700 Q2 2006

7.0 $250,000 1,500 Q2 2010 Q3 2010 6.5 Q4 2010 Q4 2008 Q4 2009 $200,000 1,300 6.0

$150,000 5.5 1,100 $ Billions SAAR Billions$ 5.0 $100,000 900

4.5

$50,000 Existing One Family Home Sales Average Price Average SalesFamilyHome One Existing 700 4.0

$0 3.5 500 0 50 100 150 200 250 300 350 400 450 500 Jan-00 Nov-00 Sep-01 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Diaposable Income / 10-Treasury US Existing Homes Sales Millions SAAR Existing Home Sales Transaction Value (Sales * Median Price) (RS) Source: National Assoc. of Realtors, Federal Reserve, Bureau of Economic Analysis, Bloomberg, KSR Source: National Assoc. of Realtors, KSR

What we find most amazing, is how the most As with most every asset market; volume follows sophisticated financial analysts around the world price. However, as seen in 2010, price did not failed to account for the inevitable reversion follow spiking volumes. And why would it? A very of HPA (house price appreciation) in their risk large part of the transactions were foreclosure models. liquidations. But then again, the OFHEO told us in 2002 that HPA was not part of their risk models because “the price series isn’t volatile enough and never goes negative.” Really?

Knight Capital Americas, L.P. 26 Strategic Research The Magnitude of this Shock Has Definitely Increased the Propensity to Save

Delinquencies As % Of Total Loans Acceleration (second derivative) in Household Debt 100%

10.0 50% 9.5 0% 9.0 -6.37%

8.5 -50% 8.0 -100% 7.5

7.0 -150% 6.5 -200% 6.0

5.5 -250% 5.0 -300% 4.5

4.0 -350% 3.5 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 Mar-79 Mar-83 Mar-87 Mar-91 Mar-95 Mar-99 Mar-03 Mar-07 US Recession Household Debt YoY % Change Source: Mortgage Bankers Association Source: Federal Reserve, KSR

The rise in delinquencies across the consumer Now that’s deceleration; kind of like a test car credit markets has been unprecedented. But such hitting a wall. are the conditions when 75% of the debt is tied to deflating collateral. Moreover, with the now ingrained sense of what we will call “debt entitlement,” as well as the credit market’s eagerness to bring bankrupt households back into the fold, delinquency, default, and foreclosure, don’t carry the same penalty or societal stigma as they used to.

Knight Capital Americas, L.P. 27 Strategic Research Reflexivity Works Both Ways; Aggressive Policy Action Prevented a Depression

Target leverage Federal Reserve Disintermediation Credit Created By Shadow Banking System (Trillions $ SAAR)

3.0

2.5

Weaker 2.0

Balance sheets 1.5

1.0 Reduce B/S size 0.5

0.0

-0.5 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 Source: Federal Reserve, KSR Asset price decline Source: Federal Reserve Bank of New York Were it not for massive government intervention and regulatory forbearance, there is no question The ugly unwind works the same way as the in our minds that the credit crash would have expansion did; only in reverse. Weaker balance resulted in a global depression. sheets force deleveraging which cuts off the flow of capital supporting asset values. In turn, this As shown, the deleveraging cycle is as reflexive makes smaller, more conservative balance sheets and procyclical as its twin. weaker still, which drives further deleveraging.

Knight Capital Americas, L.P. 28 Strategic Research The Crash Exposed a Labor Market That Was Already Broken

Permanent Job Loss as Pct of Total Unemployment US Unemployment Duration Average Num Weeks SA

56% 41

51% 36

46% 31

41% 26

21 36%

16 31%

11 26%

6 21% 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 US Recession US Unemployment Duration Average Number of Weeks SA Source: Bureau of Labor Statistics, KSR Source: NBER, Bureau of Labor Statistics, KSR

The collapse of the credit market slammed Similarly, the duration of unemployment has been nominal economic activity. And nominal is what on the rise for the past several decades. matters in a deflating economy. The crash in nominal GDP accelerated the Thus, even as the IP vs. Scale dynamic was elimination of excess capacity and the maturation permanently eliminating a rising percentage of web-based IP services, systems, and processes of jobs, the blow to marginal consumption and has massively increased business productivity. intensifying competition has accelerated what is commonly called “creative destruction.”

Knight Capital Americas, L.P. 29 Strategic Research But Amidst the Crash, Wall Street Invented De-Coupling

Markets are amazing. They will just move from one game to the next regardless of the underlying thesis. But then again, the incentive structures around the world guarantee it.

MSCI BRIC, GSCI Commodity TR, SPX, FTSE 100 Indexed 100=7-2-2007 150

140

130

120

110

100

80 2-Jul 24-Jul 15-Aug 6-Sep 28-Sep 20-Oct 11-Nov 3-Dec 25-Dec 16-Jan 7-Feb 29-Feb 22-Mar

MSCI BRIC Indexed 100=7-2-2007 S&P GSCI Enhanced Commodity (Total Return) Indexed 100=7-2-2007 S&P 500 INDEX Indexed 100=7-2-2007 FTSE EUROTOP 100 INDEX Indexed 100=7-2-2007 Source: Bloomberg, Goldman Sachs Commodity Index, KSR

Knight Capital Americas, L.P. 30 Strategic Research The De-coupling Fueled a Commodity Boom... and Deflation

Impact of Gas Price Change on Consumer Spending US GDP Nominal Dollars YoY % (Billions $ Annualized) $4.25 250 versus Crude Oil (Inverted) 10 $4.00 200 7.0

$3.75 150 30 $3.50 100 5.0 $3.25 50 50 $3.00 0 3.0 70 $2.75 -50

Gas Price Per Gallon Per Price Gas $2.50 1.0 90 -100 $2.25

-150 SpendingConsumerof$ Billions Annualized $2.00 110 -1.0 $1.75 -200

$1.50 -250 130 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 -3.0 Consumer Spending Hit when above $2.75 (RS) Daily National Avg $/ Gal Unleaded Mar-91 Nov-92 Jul-94 Mar-96 Nov-97 Jul-99 Mar-01 Nov-02 Jul-04 Mar-06 Nov-07 Jul-09 Cumulative Consumer Spending Hit (RS) US GDP Nominal Dollars YoY SA WTI CRUDE FUTURE (RS Inverted $/bbl) Source: American Automobile Associatio, Federal Highway Administration, KSR Source: Bureau of Economic Analysis, New York Mercantile Exchange, KSR

In 2008, we were among the few who warned And although some seemed to understand that that: 1. The commodity markets were being within a deflating economy, increases in money overrun by speculators, and 2. That rising spent on non-discretionary items directly reduced commodity prices were not inflationary—but the funds available for discretionary use; the would actually accelerate deflation in the cash- world was focused on the inflationary impacts of strapped developed world. $100/bbl oil. Amazing. Thus, we warned that every .01/gal increase in Rule of Thumb: ∆↑ 10% $/bbl oil  ∆↓ 2.5% GDP gasoline was the equivalent of a $1.5b (annualized) tax to consumption.

Knight Capital Americas, L.P. 31 Strategic Research And the Fear Was Inflation

Global Aggregates Core Inflation YoY % Change 5.0%

4.5%

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0% Jan-02 Aug-02 Mar-03 Oct-03 May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09 Aug-09 Core Inflation World Core Inflation Industrial Economies Core Inflation Emerging Economies Source: IMF Publications, KSR

Knight Capital Americas, L.P. 32 Strategic Research

All the King’s Horses and All the King’s Men

“The more I see, the more I find reason for those who love this country to weep over its blindness. The inquiry constantly is what will please, not what will benefit the people. In such a government there can be nothing but temporary expedient, fickleness, and folly.” Alexander Hamilton

Knight Capital Americas, L.P. Strategic Research The Government Faced an Unprecedented Post-War Collapse in Nominal GDP

We will keep making the point. NOMINAL is what matters in a deflating/deleveraging economy. Debt is a cruel taskmaster; it requires what it requires—regardless of asset price and monetary velocity deltas.

YoY Chg Consumer Credit vs. YoY Chg Nominal GDP

900 250

200 700

150 500

100 300

100 0

-100 -50

-300 -100

-500 -150 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 YoY Chg Nominal GDP ($ Billion) YoY Nominal Chg Consumer Credit (RS $ Billions) Source: Bureau of Economic Analysis, Federal Reserve, KSR

Knight Capital Americas, L.P. 34 Strategic Research So the Legislative Branch Blew Out the Budget and Spent

Although most agree with our position—namely that the “multiplier” of fiscal spending is at best 1X; in our minds the spending was absolutely necessary to help forestall a complete collapse in confidence. The debate on how it was spent is another matter entirely.

Borrowing by Sector (Billions SAAR)

6,000 6,000

5,000 5,000

4,000 4,000

3,000 3,000

2,000 2,000

1,000 1,000

0 0

-1,000 -1,000

-2,000 -2,000

-3,000 -3,000 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10

Non-Financial Domestic Private Sector Financial Sector

Total Federal & Local Govt Total Domestic + Financial Sector (RS) Source: Federal Reserve, KSR

Knight Capital Americas, L.P. 35 Strategic Research The Collapse in Both Stocks and Home Prices Crushed Household Net Worth

Nominal US Household Net Worth 12-Quarter % Change 60%

50%

40%

30%

20%

10%

-10%

-20%

-30% 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 Source: Federal Reserve, KSR

Knight Capital Americas, L.P. 36 Strategic Research The Fed Became the Lymph Node of the Credit System; Then It Was Mortgage Time

The simple story is that the Fed stood underneath the collapsing shadow banking system and caught the junk so the banks could recapitalize by milking the steep yield curve. Then, the Fed bought up the mortgage market to accelerate deleveraging and to lower rates to stimulate refis and encourage origination.

Fed Balance Sheet 2,500

2,000 $ Billions $ Extraordinary Balance Sheet Growth 1,500

1,000

Treasury Holdings 500 Now Just Above Normal 0

-500

-1,000 Extraordinary Reserve Growth -1,500

-2,000

-2,500 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Treasury Securities Held Fed Agency Securities Held MBS Held Emergency Facilities & Other Assets Currency in Circulation Balances with Reserve Banks All Other Liabilities Source: Federal Reserve, , KSR

Knight Capital Americas, L.P. 37 Strategic Research The Housing Market Is Structurally Broken; and Therefore, So Is Credit Creation

SUSTAINABLE HOME PRICE MODEL

EQUIV. SHOW ME THE COLLATERAL! RENT

COST OF EQUITY CAPITAL TAX INCENTIVES LENDER COLLATERAL BORROWER

LOCATION PREMIUM - DEBT SERVICE (PROPERTY TAXES) COMMUNITY LEVEL SUSTAINABLE CASH FLOWS Source: Knight Strategic Research Source: Knight Strategic Research

The game is over. The speculative premium is Credit creation requires collateral; it cannot be gone, and now the market is returning to a extended substantively without it. And since sustainable model for home prices. 75+% of consumer credit balances are residential And the foundation, community level cash flows, mortgages, we see reignition of the credit is nothing more or less than the proximity to machine as impossible. income. It’s all about the prospect of jobs and economic vitality .

Knight Capital Americas, L.P. 38 Strategic Research Financial System Stability but No Improvements In Employment

Unemployment Rate (%) vs Duration of Unemployment Number of Weeks SA

1/31/2011 35

10 Avg Duration of Uneployment Number of of WeeksNumberUneployment of Duration Avg 5

0 0 1 2 3 4 5 6 7 8 9 10 11 12 Unemployment Rate (%)

1948 to Nov 2007 Dec 2007 - Present Linear (1948 to Nov 2007) Source: Bureau of Labor Statistics, KSR

Knight Capital Americas, L.P. 39 Strategic Research So the Fed Reinforced Its Politically Inspired “Dual-Mandate”

Full Employment Gap

150 Millions

145

140

11,000,000 JOBS SHORT OF MATCHING POPULATION GROWTH 135

130

125 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11 Jul-12 May-13 US Nonfarm Payrolls Total SA Source: Bureau of Labor Statistics, KSR Source: Knight Strategic Research

The concept of NAIRU (the rate of unemployment Now this chart is REAL. It doesn’t depict a theory. below which inflation would accelerate) is really There is a certain rate of job creation—currently http://upload.wikimedia.org/wikipedia/commons/thumb/e/e3/NAIRU-a theoretical compromiseSR-and-LR.svg/2000px-NAIRU-SR-and-LR.svg.png since[2/3/2011 4:15:58 the AM] data never somewhere around 140,000/month—that is supported the “natural rate of full employment” needed to satisfy population growth. concept. Let’s just say, we don’t buy ANY of it. But as most are aware, shockingly weak job Economists regress past data with the assumption growth isn’t new. The last recession was also the that all environments trend toward some weakest in history. amorphous state of equilibrium, and then they call it a theory. Unfortunately, their theories don’t account for changes in the underlying structural conditions.

Knight Capital Americas, L.P. 40 Strategic Research So Without Credit Growth and No Job Creation, What Lever Could the Fed Pull?

Note to Self: No collateral, no cash And the winner is? Inflation? Really??? flow, no credit. The stock market.

IP needs “smart” IP vs. Scale and NOT numbers. massive slack

Source: Ahead of the Curve by Joseph H. Ellis, KSR

Knight Capital Americas, L.P. 41 Strategic Research Rising Stock Prices Haven’t Inspired Small Business and It Creates the Jobs

NFIB Optimism Index vs. US Jobs Lost and Months to Recover Peak Average Duration of Unemployment Aligned at Maximum Loss 1% 110 (Inverted Lagged 16-Months RS) 5 0%

10 105 -1%

15 -2% 100

20 -3% 95 -4% 25 Farm Payroll as a Percent of Peak NFP Peak of Percent as a Payroll Farm 90 - -5% 01/31/2011 30 Non

-6% 85 35 -7% (28) (26) (24) (22) (20) (18) (16) (14) (12) (10) (8) (6) (4) (2) 0 2 4 6 8 10 12 14 16 18 20 22 80 40 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Number of Months Before to After Maximum Job Loss 1948 1953 1957 1960 1970 1974 1980 1981 1990 2001 2007 NFIB Small Business Optimism Index Unemployment Duration Avg Weeks Lagged 16-Months Inverted (RS) 23 24 25 21 19 20 11 29 33 49 31 Source: Nat'l Fed. of Ind. Business, Bureau of Labor Statistics, KSR Source: Bureau of Labor Statistics, KSR

Small business operators are facing the most No matter how often we look at this chart, we are challenging—and potentially rewarding—time in stunned—but not surprised—at the condition of modern history. With the nominal demand and the job market. credit likely to remain weak, and with technology And some would like to argue that high continuing to accelerate, this is the time to take unemployment rates and duration aren’t share or die. structural?

Knight Capital Americas, L.P. 42 Strategic Research Income Expectations Are Shockingly Weak So Deleveraging Continues

6 Month Forward Consumer Expectations: Revolving Consumer Credit YoY % Change Spread between Higher Income - Lower Income 24% 28 20% 23

16% 18

12% 13

8% 8

4% 3 MarchMarch 12-18, 12-18, 2007 2007 Fusion 0% -2

-7 Goldman, Lehman & Bear Stearns,-4% Oh My!

-12 -8% As covered in our Mosaic’s this week, the awe of these firm’s transcendent powers. Of par- -17 -12% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Love does make the Jan-90 Sep-91 May-93 Jan-95 Sep-96 May-98 Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 Source: Conference Board, KSR broker reports and subsequent earnings calls world go round.... ticularSource: Federal humor Reserve, KSR (quote published in Mosaic) was were.....well, a joke. No, I don’t have access to but VAR and FICO hold GS CFO’s answer to the performance of their it together Son the data nor the forensic accounting skills “models”. This chart truly reflects deep seated One thing IS certain; ongoing deleveraging pessimismto uncover because the dirty mathematically, secrets that weren’t thedis- isAs consistent the cartoon (my with new income hobbie) to expectations the left sug- and consumer cussed,income but expectations I will say, as is in shown keeping here with unemploymentgests, there is whole trends. lot riding on VAR models cannot bethe true literary given quality recent of mydata work, releases. there is and the calculation and application of consumer Some suggest“something the recent rotten upturnin Denmark”. in spending, credit scores.--not to mention the third leg of the which is unconfirmedFrom Goldman’s by implied employment characterization and stool; the rating agencies. What I am setting up wage growth,of the overall implies environment the data as “status is wrong quo” or here, is future discourse on what I believe will be because tax receipts are strong. We would in english “great”; to Lehman’s projection the key players in the next and deeper saga of this emphasize this series more heavily than that nuancedof this approach. year’s stock market returns, I am in unwinding credit cycle.

Knight Capital Americas, L.P. Asset Correlation is A Major Issue 43

These charts show that the high- yield debt and credit default swap markets trade with a ≈95% correlation to the S&P 500--this relationship has tightened from 50% over the past two years. That’s why credit markets have started to drive equity indexes--bond traders are using SPYs to hedge. Similarly, as more leverage has been applied to the positioning of “uncore- lated” commodities, directional, risk-based linkages are unmistak- able. This is why the reliability of portfolio risk tools and hedging strategies should be considered suspect as volatility increases--not to mention the structure of many institutional portfolios.

Sixth Man 2 Research Sixth Man Research 2 Strategic Research And This Is All We Get With All That Stimulus?

The economic “recovery” has really just been a stabilization. Inappropriately in our view, the market continues to focus on “real” growth, when in fact, “nominal” is what matters. And from that perspective, nominal GDP growth under 5% should be considered recessionary. Composition of US Nominal GDP Growth 100% 5%

80% 4%

60% 3%

40% 2%

20% 1%

0% 0%

-20% -1%

-40% -2%

-60% -3%

-80% -4% Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 PCE Inventories Government Res Invest Non-Res Invest Net Exports Nominal GDP YoY % (RS)

Source: Bureau of Economic Analysis, Bloomberg, KSR

Knight Capital Americas, L.P. 44 Strategic Research It Ain’t Mew, but Look What the Cat Dragged In

We haven’t heard anyone else talking about this. So, we got to wondering: How much money was being “saved”/spent by squatters? The chart below is self-explanatory. We don’t have anyway of knowing how/if these funds are accounted for in the national accounts data, but we would guess they aren’t. Windfall? Monthly Change in Nominal PCE (SAAR) vs. Annualized Monthly "Savings" of Non-Performing Mortgages* (Assumes $1250/mo as imputed "Squatters" benefit) 300

200

100

0 $ Billions

-100

-200

-300

-400 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Annualized Non-Performing Mortgages @$1250 Monthly Change in Nominal PCE (SAAR) Source: Bloomberg; BEA; * Lender Processing Services (2007 montly data imputed from industry trend), KSR

Knight Capital Americas, L.P. 45 Strategic Research The Recent Spending Rise Doesn’t Jive

US Food Stamp Participants US Nominal PCE YoY % Change SA 45 % 16

Millions +3 Stdev 40

35 +2 Stdev 12

30 +1 Stdev

25 8 Median

-1 Stdev 4 15

-2 Stdev 10 0 5 -3 Stdev

0 -4 -4 Stdev 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 1961 1964 1966 1969 1972 1975 1978 1981 1983 1986 1989 1992 1995 1998 2000 2003 2006 2009 Source: Bureau of Economic Analysis, KSR Source: USDA, Food and Nutrition Service, KSR

This data is shocking. Biblical wisdom says “The Again, “real” doesn’t tell the story. When poor will always be with you,” but almost 15% of reported inflation is collapsing, aggregate data the population of the most powerful nation on paints a flawed picture—particularly when earth??? disinflation turns into deflation. (No, the economy is not IN deflation, but the primary collateral stock (real estate) is. Inflation? Really?

Knight Capital Americas, L.P. 46 Strategic Research But What About the Stock Market? Doesn’t THAT Indicate Recovery? The amazing run in stocks from the July lows has actually seen the S&P 500’s P/E Ratio fall. This is consistent with a move considered cyclical rather than secular, and we are fast approaching an inflection where valuations will need to expand or stocks will fail.

S&P 500 Index vs S&P 500 P/E Ratio

1,400 25

23 1,300

21 1,200 19

1,100 17

1,000 15

13 900

11 800 9

700 7

600 5 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 S&P 500 Price Index S&P 500 P/E Ratio (RS) Source: Bloomberg, KSR

Knight Capital Americas, L.P. 47 Strategic Research Productivity and Scale

Standard & Poor's 500 Index Positive Surprises Relative Strength of US Corporate Net Cash Flow Indexed 100=1-31-2007 SA versus US Nominal GDP (SAAR)

140 12%

135 11% 130

125 10%

120

9% 115

110 8%

105

7% 100

95 6% 90 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 US Corporate Profits With IVA and CCA Net Cash Flow SA / Gdp Us Nominal Dollars Saar Source: Bloomberg Indices, KSR Source: Bureau of Economic Analysis, KSR

The collapse in nominal economic activity around The expectation that margin expansion was the world in Q4 2008, established a base of primarily being fueled by payroll cuts and working pessimistic expectation for operating companies capital reductions, was misguided. that was discontinuous from their ability to We believed then (March ‘09) what we believe manage fixed and variable cost. now; namely that the IP deployments made So, once demand recovered, incremental margins over the past decade got the full attention of exploded, and so did cash flow. management teams trying to drive profitability given weak demand prospects.

Knight Capital Americas, L.P. 48 Strategic Research Incremental Corporate Profitability Is Growing Exponentially

Growth of NIPA US Non-Financial Profits NIPA Profits (billions) vs. per Employed Person Number Employed (thousands) 900 $1,200

800

$1,000 700

600 $800

500

$600 400

300 $400

200 $200 100

0 $0 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 50,000 60,000 70,000 80,000 90,000 100,000 110,000 120,000 130,000 140,000 150,000 Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR

The acceleration of profitability per employee has Another way of looking at the same productivity gone exponential. data; this chart shows that the last $400MM of This supports our IP-Scale construct, and certainly corporate profit was made with only 5 million explains the intensifying weakness of labor. incremental jobs. That’s an incremental profit per employee of $80,000 versus average profitability $14,000. Stunning.

Knight Capital Americas, L.P. 49 Strategic Research And Bigger Is Better

We believe that scale has been an enormous benefit in this recession. As weaker/ poorly capitalized operations have suffered or closed; stronger competition has been able to take market share and utilize its flexibility to shift capacity based upon market conditions.

MAIN STREET LOSSES ARE PUBLIC CO. GAINS

CAPACITY SHRINK

WEAKWEAK COMPETITION;COMPETITION; POORLYPOORLY FINANCED;FINANCED; OVER-LEVERAGED;OVER-LEVERAGED; NON-COMPETITIVE NON- COMPETITIVE

SHARE GAINS FLAT REVENUE

WELL FINANCED; STABLE/GROWING MARKET SHARE; COMPETITIVE ADVANTAGE ANEMIC NOMINAL GDP CREDIT CONTRACTION

Source: Knight Strategic Research

Knight Capital Americas, L.P. 50 Strategic Research Unquestionably, Corporate America Is Thriving Relative to Main Street

Corporate Cash Flow vs. Household Net Worth The Growing Chasm $1,800 $70,000 Billions Billions $1,600 $60,000

$1,400 $50,000 $1,200

$1,000 $40,000

$800 $30,000

$600 $20,000 $400

$10,000 $200

$0 $0 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 US Corporate Profits With IVA and CCA Net Cash Flow SA Household Net worth (RS) Source: Bureau of Economic Analysis, Federal Reserve, KSR

Knight Capital Americas, L.P. 51 Strategic Research

The Game Is Over

“If investors all get caught in a 1914-style crisis, they will all go down together and nobody will underperform the benchmark,” he says.“But if they become pessimistic too early and are wrong, they will underperform. Therefore it’s better to consign a major geopolitical crisis to the realm of uncertainty, and treat it like the risk of an asteroid hitting the earth. Common sense tells us that a major war is much more likely than an asteroid, or indeed the melting of the polar ice caps. But there are incentives for investors and financial professionals to ignore the risk of crises. Niall Ferguson Barron’s: March 12, 2007

Knight Capital Americas, L.P. Strategic Research The Commodity Markets Are Overrun and Present a Major Risk to Global Stability

UN Food and Agriculture World Food Price Index Crude vs Copper vs CRB Raw Industrials 220 Indexed to 100 1/2/09 340

200 300

260 180

220 160

180

140 140

120 100

100 60 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 WTI CRUDE FUTURE Indexed 100=1-2-2009 80 COPPER FUTURE Indexed 100=1-2-2009 Jan-91 Sep-92 May-94 Jan-96 Sep-97 May-99 Jan-01 Sep-02 May-04 Jan-06 Sep-07 May-09 Commodity Research Bureau/Reuters US Spot Raw Industrials Indexed 100=1-2-2009 Source: Food and Agriculture Organizat, KSR Source: Bloomberg, Commodity Research Bureau, KSR

Quite obviously, controlling food price inflation is It is incredible to us that the debate regarding the critical to the well-being of the world. We cannot deleterious and destabilizing impact that speculators understand why the United States agricultural belt is have on the commodity markets still rages on. We fully still being used to produce corn for ethanol rather than appreciate the necessary role that true speculators bring being markedly expanded to increase production for to the markets, but we are aghast that more isn’t done trade around the world. Perhaps an enlightened client to rationalize access. How can it possibly not distort will inform us? price and, therefore, the operations of real businesses and the functioning of the global economy, when investment banks are caught stockpiling? And how can the profusion of ETFs which are heavily marketed to individuals not be a negative?

Knight Capital Americas, L.P. 53 Strategic Research Manufacturing Labor Has a Call on Finished Goods Pricing

The economic value of manufacturing labor is inextricably linked to finished goods pricing. If for example, you worked the factory floor making lawn mowers and your gross annual wage could buy 100 machines, if input prices rose 20% and finished goods prices rose 10%, your “value” in the chain declined by 9%; because now you could only buy 91 machines. Moreover, if we assume that your productivity increases by 10%/year, your compensated value would decline even further. COMMODITY PRICES FORCE WAGE INFLATION

RGIN OFLABOR VALUE DECLINING MA

INPUT COSTS

LABOR

Source: Knight Strategic Research

Knight Capital Americas, L.P. 54 Strategic Research Thus Commodities Can Drive Wage/Price Spirals When Manufacturing Density Is High

But that is NOT the case for IP-centric economies like the United States. Because wages are NOT tied to commodity prices, rising finished goods prices will face stiff elasticities of demand—or outright substitution. So if commodity price increases persist, the manufacturing intensive emerging world will either: 1. Have to hold margins and sell less 2. Hold prices and earn less, or 3. Hold wages flat.

The latter promises revolt, and either of the first two risk the deflationary collapse of marginal capacity.

WEAK DEMAND FLAT PRICES CFLO CREDIT PROBLEMS

CHINA DEVELOPED WORLD RISING INFLATIONARY/ FOREIGN EXCHANGE DEFLATIONARY COMMODITY PRICES STAGFLATIONARY RESERVES FALL PRESSURE PRESSURE

WEAKER DEMAND INCREASED PRICES WAGES INFLATION Source: Knight Strategic Research

Knight Capital Americas, L.P. 55 Strategic Research So Really, Commodity Price Increases Will NOT Lead to Inflation Here

This schematic (borrowed from the government of New Zealand!) shows the flow of prices across a balanced economy. As you will note, rising commodity producer price inputs MUST be passed along to export markets, or domestically, through imports or direct to consumer price increases.

Inflation Flows in the Economy Export Price Index

Producers Price Index Import Price Index (outputs)

Production Sector Expenditure by production/government sector Expenditure by household Sector outputs

Labor Current Capital costs costs costs

Producers Price Capital Goods Consumers Labor Cost Index Index (inputs) Price Index Price Index

Source: Government of New Zealand, KSR

Knight Capital Americas, L.P. 56 Strategic Research Because in the Aggregate, Nominal Consumer Demand Is Structurally Impaired

COLLATERAL?

EQUITY? NO CREDIT/DELEVERAGING EXCESS CASH FLOW?

RISING ASSET VALUES?

Inflation Flows in the Economy Export Price Index

Producers ANEMIC WAGES Price Index Import Price Index (outputs) JOB SECURITY?

Production Sector Expenditure by production/government sector Expenditure by household Sector outputs RISING PROPENSITY TO SAVE CUSHION?  Labor Current Capital NEW RETIREMENT CALCULUS costs costs costs DEMOGRAPHICS Producers Price Capital Goods Consumers Labor Cost Index Index (inputs) Price Index Price Index

Source: Government of New Zealand, KSR COMPETITIVE IN IP MODEL?

BLEAK WAGE & ROI EXPECTATIONS DRIVE VALUE IN IP CHAIN?

INVESTMENT/EQUITY RETURNS?

Knight Capital Americas, L.P. 57 Strategic Research We Therefore Believe “The Game Is Over”

We first made our “Game Over “ call back in November; and (particularly China) are in the process of pushing the markets since then, our conviction level has increased. What we are towards a significant dislocation. saying is that structurally, per this chart, the global terms of Specifically, as we will cover later in this report, China is trade have been pushed past their tipping point. And it is our caught in a double-bind of its own making. We believe hope that the elements of this publication will all come together that the price/wage spiral that has commenced will not be in support of our position. contained by policy initiatives. Attempts to do so, will only In essence, we believe the disparity between the prevailing keep the upward pressure on commodities and input prices economic and financial structures around the world, in firm, making the inevitable breakdown of past trend that conjunction with the policies being effected by governments much worse.

GOVERNMENT POLICY

TERMS OF TRADE

ECONOMIC SECURITY RESOURCE & INDUSTRY

Source: Knight Strategic Research

Knight Capital Americas, L.P. 58 Strategic Research We Believe the BRIC and Commodity Rally Is An Echo Bubble

MSCI BRIC (12/10) vs DOW 1929 vs NDX 2000

5,000 500

4,500 450

400 4,000

350 3,500

300 3,000 250 2,500 200

2,000 150

1,500 100

1,000 50

500 5 YEARS 0 NDX Index 2000 Peak MSCI BRIC 2007 Peak DOW Index 1929 Peak (RS) Source: Bloomberg, KSR

Knight Capital Americas, L.P. 59 Strategic Research Which Is More Plausible Looking At This Chart

With all the hoopla about an extended cycle for commodities; is it possible that ALL related things are coming to an end? This chart depicts the 10-year average growth rate of commodities since 1800; the importance is that it has reached a well defined trend line.

CommodityCommodity PricesPrices inin thethe USUS 10-Year10-Year AverageAverage GrowthGrowth RateRate 12% 12%

10% 10%

8%8%

6%6%

4%4%

2%2%

0%0%

-2%-2%

-4%-4%

-6%-6%

-8%-8% 18051805 1835 1835 1865 1865 1895 1895 1925 1925 1955 1955 1985 1985 2015 2015 Source:Source: U.S.U.S. CensusCensus Bureau,Bureau, BLS,BLS, KSRKSR

Knight Capital Americas, L.P. 60 Strategic Research And As Confirmed By These

US Stock Prices Relative to Commodity Prices S&P 500 INDEX / ThomReuters/JefferiesCRB

102.4 Four Periods of Commodity Outperformance 1100%

1000% 51.2

900% 25.6

800% 12.8

700% 6.4 600%

Logarithmic Scale Logarithmic 3.2 500%

1.6 400%

0.8 300%

0.4 200% 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 Jan-95 May-96 Sep-97 Jan-99 May-00 Sep-01 Jan-03 May-04 Sep-05 Jan-07 May-08 Sep-09 Jan-11 Source: Shiller, US Census Bureau, Bloomberg, KSR Source: Bloomberg, KSR

Stocks have underperformed commodities in Calling long-term cycles on the basis of charts four distinct periods since 1900. The difference alone is foolhardy, but the evidence is starting to now, and the argument against the prior 10-year build. average growth chart? This cycle has only lasted about two-thirds as long. So are the bulls right and the trend lines wrong? We don’t think so, because the structural conditions in the developed world can’t tolerate a different outcome.

Knight Capital Americas, L.P. 61 Strategic Research

“We Are the Masters Now”

“It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain...[since] investment based on genuine long-term expectation is...scarcely practicable [because] capital investment [is controlled] by persons [without special knowledge or perspective] seeking to outwit the crowd, and pass the bad, or depreciating, half-crown to the other fellow.” John Maynard Keynes, The General Theory of Employment, Interest and Money (1935)

Knight Capital Americas, L.P. Strategic Research China Is Caught in Its Own Trap

China circa 2011 shares many similarities with the United States in both 1929 and 2007, as well as Japan in the 1980s: 1. Massive disparity of wealth, income, and education. 2. Rapid industrialization and displacement of labor. 3. Opaque and misleading economic and financial data. 4. Massive build-up of leverage across the “rising” class. 5. Bubbles in both residential real estate and fixed asset/infrastructure development. 6. Accelerating and uncontrolled growth in disintermediated credit. 7. Expected transference of economic growth to domestic demand. 8. Accelerating price/wage spiral.

Source: IMF The clearest investment case against China is also the China has created a tide of inflation that threatens most fundamental. It is trapped in a double bind of its widespread social unrest. And what is its option? To own making. For despite the CPC’s own hubris—and crush speculation and the extension of credit and risk a the ubiquity of the world’s confidence in it—China deflationary collapse? appears to have lost control. And in an ironic twist, it China no longer controls its own destiny; the free has done so by doing everything it can not to. For in its markets do. own zeal to placate the masses through rapid growth,

Knight Capital Americas, L.P. 63 Strategic Research Fixed Asset Investment Is Now 70% of GDP

China GDP; Composition of Growth China Fixed Assets Investment versus Net Exports, Capital Formation, Final Consumption China Export Trade (Projected 6 Months) 100% 14,000 160

R² = 0.9988 R² = 0.9506 140 12,000 80%

120 10,000 60% 100 8,000 40% 80

6,000 Billions $ CNY Billions CNY 20% 60

4,000 40 0% 2,000 20

-20% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0 0 China Yearly GDP by Expenditure - Net Exports of Goods & Serv May-99 Apr-00 Mar-01 Feb-02 Jan-03 Dec-03 Nov-04 Oct-05 Sep-06 Aug-07 Jul-08 Jun-09 May-10 China Yearly GDP by Expenditure - Gross Capital Formation 12M Avg. China Fixed Assets Investment China Export Trade (RS) $ Billions China Yearly GDP by Expenditure - Final Consumption Poly. (12M Avg. China Fixed Assets Investment) Poly. (China Export Trade (RS) $ Billions) Source: CEIC Data, KSR Source: China Economic Information Net, KSR

Much like Japan in the 1980s, China’s culture of thrift has prevented the hand-off of economic Plain and simple, the physics of finance and growth to domestic consumption. The bull case economics—and all that makes for good common is that this impediment (household savings rate sense and practical experience—says that the runs between 30% - 50%) will vanish when the exponential expansion of fixed assets supported CPC establishes a social security system. We don’t by a pyramid of debt always ends in tears. agree. If the U.S. populace does not trust our government’s management of a similar system, will the trust of the Chinese populace be so strong as to transform its own culture?

Knight Capital Americas, L.P. 64 Strategic Research Does It Have to End? This Chart Speaks Volumes

This IMF chart has been widely published by analysts struggling to put China’s capex boom into context. But now that we have 2010 data we have updated the illustration. Hmmm.

Intensity and Duration of Capex Booms (Fixed Asset Investment/GDP and Years)

70% CHINA (2010)

65%

60%

55%

China ('96-2009) 50%

Maylaysia (90-97) 45% Thailand (89-97)

Korea (90-97)Singapore (91-99) 40% Japan (68-74)

35% 5 6 7 8 9 10 11 12 13 14 Source: IMF, KSR Number of Sequential years of Capex Boom

Knight Capital Americas, L.P. 65 Strategic Research Banking System Leverage and Government Debt Are Grossly Understated

China's Debt to GDP Is At Least 70% Net New Credit Flows (CNY Billions) versus the "Official" 17.5% 12,000

70% 10,000

60% 8,000

50%

6,000 40%

4,000 30%

20% 2,000

10% 0 2007 2008 2009 H109 H110 9M09 9M10 0% CNY and FX Loans Undiscounted Acceptances "Official" Policy Bank Bonds NPLs on state- LGFV Bonds LGFV Infrastructure LGFV "Other" CWMPs and CTPs (Credit-Related Wealth Management/Trust products) Claims of Hong Kong Banks on China Government Bonds owned AMC Loans Loans Source: Wind, Fitch, KSR Source: Merrill Lynch

China’s arcane system of laws and the Fitch Ratings has done groundbreaking work on requirement that local governments fund the uncovering the disintermediation of domestic credit bulk of infrastructure development, has given in China. According to its research, some 3 trillion rise to an opaque network of over 8,000 LGFVs yuan of credit has been created within China’s trust (local government funding vehicles). Essentially banking system, in 2010. This is a 40% increase over the these are China’s form of public sector SIVs, and government’s stated numbers. The primary purpose its massive build-up of debt isn’t included in is to create yield-enhanced, short-term instruments. “official” estimates of national debt, as we see it. Moreover, Fitch recently reported that Chinese banks are broadly utilizing undiscounted acceptances to understate leverage to regulators.

Knight Capital Americas, L.P. 66 Strategic Research The Incremental Productivity of China’s Runaway Credit Growth Is Collapsing

China’s economic growth appears increasingly dependent upon a system of Ponzi finance. And given the price/wage spiral that its own zeal for growth has unleashed, it is most certainly caught in a double bind.

China Total Loans YoY Change vs. GDP YoY Change (CNY)

12,000 As Adjusted Per Fitch Findings

10,000

8,000

6,000

4,000

2,000

0 Mar-00 Feb-01 Jan-02 Dec-02 Nov-03 Oct-04 Sep-05 Aug-06 Jul-07 Jun-08 May-09 Apr-10 China Total Loans of Financial Institutions YoY Change (CNY Billions) China GDP 4Q Sum YoY Change (CNY Billions) Source: China Economic Information Net, Bloomberg, KSR

Knight Capital Americas, L.P. 67 Strategic Research And This Is a Great Risk for Asia

Citigroup Economic Asia Pacific Surprise

-40

-90

-140 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-1 Citigroup Economic Surprise Index - Asia Pacific Source: Hong Kong Monetary Authority Source: Citigroup, KSR

The Hong Kong Monetary Authority published The trend of economic surprise in Asia is already this data. It shows the CoVAR between Asian perilous. nations as measured by CDS volatility. If China catches a cold....

Knight Capital Americas, L.P. 68 Strategic Research And for the Developed World

G7 Composite Leading Index YOY % Number of US Cos Issuing Financial Outlooks Up / vs. MSCI World Index YoY % Number of US Cos Issuing Financial Outlooks Down 14 75% 1.6 +4 Stdev

1.4 10 50% +3 Stdev 1.2

6 +2 Stdev 25% 1.0

2 0.8 +1 Stdev 0% 0.6 Median -2

0.4 -25% -1 Stdev -6 0.2 -2 Stdev -50% -10 0.0 -3 Stdev -0.2 -14 -75% -4 Stdev 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 -0.4 OECD G7 Composite Leading Ind. Total Trend Restored YOY % MSCI WORLD YoY % Change Jan-00 Dec-00 Nov-01 Oct-02 Sep-03 Aug-04 Jul-05 Jun-06 May-07 Apr-08 Mar-09 Feb-10 Jan-11 Source: Organization for Economic Coop, KSR Source: Bloomberg Indices, Bloomberg, KSR

It looks to us like the global equity markets This chart is striking. As we entered 2011, the have done a very thorough job of pricing in the imbalance between US companies raising and recovery of G7 leading indicators. lowering guidance was almost 4 standard deviations above normal. And although we cannot gauge just how much guidance would soften in the event of a China breakdown, given such acute sentiment, a major disruption seems reasonable.

Knight Capital Americas, L.P. 69 Strategic Research

Don’t Trust the Orthodoxy

“Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.” John Maynard Keynes, The General Theory of Employment, Interest and Money (1935)

Knight Capital Americas, L.P. Strategic Research We Heartily Disagree with the Consensus View and Orthodox Theory

We believe that consensus opinion and the orthodox theoretical views of how government indebtedness and the actions of the U.S. Treasury and the Federal Reserve impact interest rates, inflation, and ultimately, fiscal sustainability, are wrong. The prevalent view is very powerful because it is quite intuitive. It is based upon two central beliefs: 1) that the monetary policies of the Federal Reserve can create inflation; and 2) that the deteriorating fiscal position of the United States—fueled by persistent budget deficits, and guaranteed by the growing unfunded liabilities of Social Security and Medicare—will cause Treasury bond holders to demand higher rates of return on their loans. The natural extension of this reasoning, therefore, is that interest rates will go up; and when they do, the interest expense on accumulating government debt will spiral without bound, and with it, the purchasing power of the dollar will collapse. We heartily disagree, and fully appreciate that of all our dissenting opinions, none is more controversial than this one. This is a very complex issue, and recognizing that our position is far afield from what is commonly understood, we expect—and hope—that many of you will desire a more detailed presentation than the high-level introduction that follows.

(We would like to acknowledge our deep gratitude and indebtedness to Scott T. Fullwiler, Associate Professor of Economics and James A. Leach, Chair in Banking and Monetary Economics at Warburg College, for their work and assistance in helping us understand the view to which we now subscribe.)

Knight Capital Americas, L.P. 71 Strategic Research Monetary System Basics Within A Free-floating Currency Regime

1. Central bank’s operating target is necessarily an interest 5. Interest rates are Monetary, Not Real Phenomena rate target. a. Central bank targeted rate anchors other rates. 2. Modern, currency issuing sovereigns with free-floating FX b. With interest payment on reserves and no bond sales, spend via the crediting of reserves. rate on national debt is rate paid on reserves. a. “Printing money” vs. “financing” spending is a false c. If short-term bonds are issued, these rates are set via dichotomy. arbitrage with Fed’s target. b. Present value of liabilities or “pre-funding” makes no d. If long-term bonds are issued, these rates are set via sense since “user” and “issuer” of the currency are arbitrage with current and expected Fed target AND one and the same. premium attached to debt of increasing maturity. 3. Bond sales and tax collections are interest rate mainte- e. Long end of term structure is set mostly by expecta- nance operations, NOT financing operations. tions of short-term rates. 4. Deficits with or without bond sales—whether to the Fed or to the private sector—has no affect other than on the overnight rate. a. It is the size of the deficits themselves, not whether bonds are sold, that matters for aggregate demand, as government deficits necessarily increase private savings. b. Whether deficits actually raise aggregate demand and potentially create inflation depends upon the private sector’s relative proclivity to save or spend. i. Note Japan’s deficits of >7% of GDP.

Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53

Knight Capital Americas, L.P. 72 Strategic Research Money Supply Growth Does Not Cause or Reflect Rising Inflation

Despite prevalent belief to the contrary, expanding monetary aggregates do not cause or reflect rising inflation. Inflation is a self-reinforcing systemic issue, not a simple matter of rising prices. For rising prices cannot be sustained if they are not supported by inelastic demand; and inelastic demand cannot exist unless supported by rising wages—or credit. Thus, in the current environment, when commodity prices rise the effect is deflationary, because discretionary spending is redirected to satisfy non-discretionary needs.

US Personal Consumption Expenditure Core Deflator Three Month Annualized % vs. M2 YoY% % 12 14%

12% 10

10% 8

8% 6 6%

4 4%

2 2%

0 0% 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 US Personal Consumption Expenditure Core Deflator Three Month Annualized % Federal Reserve Money Supply M2 SA YoY % Change (RS) Source: Bureau of Economic Analysis, Federal Reserve, KSR

Knight Capital Americas, L.P. 73 Strategic Research The Fed Cannot Create Credit Growth

The Federal Reserve targets interest rates by managing the mix of government liabilities held by the public. These are: currency in circulation, bank reserves, and Treasury debt. So, by dramatically increasing the asset side of its balance sheet, the Fed dramatically increases the government’s liabilities; in this case, mostly bank reserves. However, as is clear, huge reserve balances have no affect on credit growth when the system is already overleveraged.

Fed Balance Sheet 2,500

2,000 $ Billions $ Extraordinary Balance Sheet Growth 1,500

1,000

Treasury Holdings 500 Now Just Above Normal 0

-500

-1,000 Extraordinary Reserve Growth -1,500

-2,000

Knight Capital Americas, L.P. 74 Strategic Research Thus as Experienced in Japan, QE2 Cannot Force Credit Growth Either

Since its founding in 1913, the Federal Reserve has held an amount of Treasury bonds about equal to currency in circulation; that is, until it liquidated a huge portion of its holdings to shore up emergency funding activity in 2008. Thus, until just the past sixty days, the Fed was simply reconstituting its “normal” position. But now, as the Fed’s purchases continue, its “excess” holdings are further inflating the asset side of its balance sheet and putting more reserves into the system. And to what effect? Interest rates are rising, and so too are concerns about the fiscal position of the United States.

Federal Debt Held by Federal Reserve Banks vs Currency in Circulation 1,200

$ Billions $ 1,000

800

600

400

200

0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Currency In Circulation Federal Debt Held by Federal Reserve Banks Source: Federal Reserve, KSR

Knight Capital Americas, L.P. 75 Strategic Research So the Justifiable Concern Is Sustainability

The Orthodox View of Fiscal Sustainability “The government’s total fiscal policy may be considered balanced if today’s publicly held debt plus the present value of projected non-interest spending is equal to the present value of projected government receipts. For the entire federal government’s policy to be sustainable, its fiscal imbalance must be zero.” The government cannot spend and owe more than it will receive as revenue in present value.”

Fiscal Present Value Present Value Net National Imbalance Expenditures Revenues Debt

Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53

Knight Capital Americas, L.P. 76 Strategic Research The Orthodox View Is Quite Easy to Understand

The Government’s Budget Constraint G + iB = T + ΔB + ΔM Where: G = Government Spending B = Accumulated Deficit T = Taxes ΔB = Budget Deficit ΔM = Change in Money Supply iB = Interest on Debt

Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53

Knight Capital Americas, L.P. 77 Strategic Research Because It Requires a Balanced Budget, Which Makes Sense

Fiscal Imbalance and Sustainability

For Fiscal Imbalance = 0, projected Σ(G-T) = -B

If Fiscal Imbalance=0, then B/GDP does not grow Does not require B →0 DOES require Σ(G-T) <0 if currently B>0

If Fiscal Imbalance>0, B/GDP grows without bound (i.e., is UNSUSTAINABLE) due to iB and ΔB (pace depends on G-T and r-Ө) Where: r = Real Interest Rates Ө = Real GDP Growth

Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53

Knight Capital Americas, L.P. 78 Strategic Research But the Government Can Print Money to Pay Interest; So It All Hinges on Rates

The top table illustrates the orthodox view. Rates are assumed to be higher than GDP growth, since it is intuitive that the markets would demand higher compensation for funding a deteriorating fiscal position. This data was intended to show that the only way “out” was through a budget surplus varying inversely with GDP growth.

Infinite Horizon In 30 Years In 75 Years Real Fiscal Primary PV of future GDP Imbalance Deficit Primary

Θ Eq. (12) g-t Deficits int/GDP ∆b 30 b 30 int/GDP ∆b 75 b 75

3% 0 -0.28% -5,137 1.68% 1.4% 48.0% 1.68% 1.4% 48.0%

3% 44,214 2.13% 39,077 4.33% 6.45% 126.7% 9.43% 11.56% 273.6%

2% 0 -0.75% -5,137 1.69% 0.94% 48.0% 1.69% 0.94% 48.0%

2% 44,214 5.73% 39,077 10.01% 15.74% 293.9% 33.25% 38.98% 962.6%

This table shows another way “out;” interest rates must remain below GDP growth. And note, under this condition, both debt/GDP and interest expense/GDP are a decreasing burden in a slower growth environment. Sustainable Fiscal Policy with Θ - r = 1%

Infinite Horizon In 30 Years In 75 Years Real Fiscal Primary PV of future GDP Imbalance Deficit Primary

Θ Eq. (12) g-t Deficits int/GDP ∆b 30 b 30 int/GDP ∆b 75 b 75

3% 0 0.47% -5,137 0.93% 1.4% 48.0% 0.93% 1.4% 48.0%

2% 0 0.47% -5,137 0.47% 0.94% 48.0% 0.47% 0.94% 48.0%

Source: Interest Rates and Fiscal Sustainability, Scott T. Fullwiler Working Paper No. 53

Knight Capital Americas, L.P. 79 Strategic Research And THIS IS THE KEY: The Fed Anchors Rates and Arbitrage Limits the Spread

US Generic Govt 10 Year Yield Less Federal Funds Effective Rate US

+4 Stdev

5.7 +3 Stdev

+2 Stdev 3.7

+1 Stdev

1.7 Median

-1 Stdev -0.3

-2 Stdev

-2.3 -3 Stdev

-4.3 -4 Stdev Feb-89 Dec-90 Oct-92 Aug-94 Jun-96 Apr-98 Feb-00 Dec-01 Oct-03 Aug-05 Jun-07 Apr-09 Feb-11 Source: Bloomberg, KSR Ping all they want, but the “bond market vigilantes” and the market do NOT set rates. Banks need reserve balances to settle +/- $2 trillion of transactions per day. As a result, through its target rate, the Fed influences all other short-term rates through arbitrage. And this affect holds true at longer maturities as the coupons flow down the term structure of the yield curve. Thus, “Any market induced—foreign or domestic–driven—upward pressure on U.S. intermediate or long-term rates would/will be limited by the leash of the Fed’s...anchoring of the Fed funds rate...[functionally] there is a limit to how steep the yield curve can get if the Fed just says no—again and again.” (Paul McCulley, “Fed Focus”, October 2003, PIMCO)

Knight Capital Americas, L.P. 80 Strategic Research Also, Note That Budget Austerity Crushes the Impact of Fiscal Stimulus

Deflationary Impact of Fiscal Spending Given Trend Toward Austerity

Fiscal stimulus through deficit spending anchors forward expectations of expense cuts and/or tax increases.

Past patterns of Government behavior strongly favor tax increases.

 1%  Taxes  3%  GDP

Economic Benefit Net Present Liability of from Expected Future Tax  Fiscal Spending  Increases

Source: Knight Strategic Research

Knight Capital Americas, L.P. 81 Strategic Research But What About Persistent Balance of Payments (BOP) Deficits? A Different Perspective on the U.S. Balance of Payments

Balance of Payments (BOP) = Current Account + Capital Account

Current Account = Trade Balance + Net Return on Capital Account

Capital Account = Net Investment Position

IP (Intellectual Property) Capital Markets Central Banking U.S. ROW Labor Oil Trade Surplus

Source: Knight Strategic Research

It is common wisdom that global “imbalances” are a negative for growth and necessitate major currency adjustments. We don’t agree, however. Cost differentials between countries—such as wage rates in the U.S. and China—cannot be “balanced” through currency changes. And since said “imbalances” have been persistent for decades, we think it more likely that a different balance is being struck. As shown in this graphic, we think that the United States has effectively exported: IP, global central banking, and the deepest and most secure financial markets in the world; in exchange for: cheap labor, oil, and capital investment.

Knight Capital Americas, L.P. 82 Strategic Research Trade Is the Largest Component of the BOP; and It’s Not So Bad

Net US Trade Deficit & Net Trade Balance & Positive Services Offset Balance Net of Petroleum Imports $10 $10

$0 $0

-$10 -$10

-$20 -$20

-$30 -$30

-$40 -$40

-$50 -$50

-$60 -$60

-$70 -$70

-$80 -$80 Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08 Apr-09 Nov-09 Jun-10 Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08 Apr-09 Nov-09 Jun-10 Positive Services Balance (Billions) Net US Trade Balance (Billions) Net Trade Balance (Billions) Trade Balance Less Crude Imports (Billions) Source: U.S. Census Bureau, KSR Source: U.S. Census Bureau, , KSR

The U.S. trade deficit—one of the hottest political So the product account is decidedly negative, but footballs of recent times—really has three guess what? Petroleum has been averaging 50% component parts. The first is the services balance, of the deficit since mid-2007. which has always been—and remains—positive. By the looks of the orange line—which represents The other component, which gets all the attention, the U.S. trade deficit net or petroleum imports— is the US negative product account. (We don’t it appears that our non-oil negative balance has believe this accurately reflects a thing given the been cut by 50% since 2005. vagaries of accounting for technology—not to mention the vast amounts of IP that are pirated.)

Knight Capital Americas, L.P. 83 Strategic Research And Then the Capital Account; Though “They” Own More, “We” Earn More

Foreign-owned assets in the United States vs U.S. Return on Foreign Owned Assets vs. U.S.-owned assets abroad Foreign Return on U.S. Owned Assets 10.0% $25

9.0% $ Billions$

$20 8.0%

7.0%

$15 6.0%

5.0%

$10 4.0%

3.0%

$5 2.0%

1.0% 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 $0 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Payments on Foreign-Owned Assets in the U.S. / Foreign-Owned Assets in the U.S. Foreign-owned assets in the United States U.S.-owned assets abroad Income on U.S.-Owned Assets Abroad / U.S.-Owned Assets Abroad Source: Bloomberg, KSR Source: BEA, KSR

Yes, the U.S. capital account is negative, and But despite our negative capital account, the consistently so since 1990; i.e. “they” own more spread between our returns on “their” assets, of us than we own of “them.” and “their” returns on our assets has always been But, so what? Can you blame “them?” The United positive. So much so, that in the aggregate, the States has long had the most attractive asset pool U.S. investment account is also positive. in the world; particularly when coupled with the This is easy to understand if we consider the U.S. strength of our property laws and the depth of to be the “world’s banker.” our capital markets.

Knight Capital Americas, L.P. 84 Strategic Research The U.S. Chooses to Sell Bonds; and We Don’t Need China to Buy Them

China Holdings of US Treasuries vs. US Household Treasury Holdings (ex-Savings Bonds) and Household Holdings as % of Net-Worth 1,000 2.5%

900

800 2.0%

700

600 1.5%

500

400 1.0%

300

200 0.5%

100

0 0.0% Mar-00 Feb-01 Jan-02 Dec-02 Nov-03 Oct-04 Sep-05 Aug-06 Jul-07 Jun-08 May-09 Apr-10 US Treasury Foreign Holders China $ Billions FOF Households and NPO Total Treasury Securities Ex-Savings Bond Assets $ Billions Treasuries as % of Household Net Worth (RS) Source: US Treasury, Federal Reserve, Bloomberg, KSR As a sovereign issuer of fiat currency within a free-floating foreign exchange regime, the U.S. government in not financially constrained. As we view it, the Treasury sells bonds at their own discretion. That said, however, the consensus seems to believe that the United States needs China to buy its bonds. Not true. As shown in the chart above, U.S. households now own more Treasury bonds than China, a position acquired in just 18 months and one that only represents about 2% of their net-worth.

Knight Capital Americas, L.P. 85 Strategic Research But If All That Is True, What About the “Value” of the Dollar?

The Shocking Truth About Money

• Money is the most basic form of credit; it has “no value” in and of itself. • Thus, “fiat”—derived from the Latin origin “let it be done”—is not “backed” by the tangible wealth of the issuing Sovereign; but rather, by the “full faith” of the issuing government to uphold the laws and regulations which support its value as a transaction medium. • Moreover, it is the Sovereign itself—through the collection of taxes, which must be paid with fiat, and through payment of its own obligations with the same fiat—that ensures private sector acceptance of the currency; and therefore, ensures its foundation of credit “worthiness.” • And as a “reserve” credit (i.e. a reserve currency) the utility of any fiat is directly related to the breadth of its use and the scope of its acceptance around the world. • In this sense, gold is not money; nor is any other store of value. That does not mean that barter systems could not—and do not—use such things as “money”, but ultimately, as history is our guide, those systems have always failed.

Knight Capital Americas, L.P. 86 Strategic Research The Rising Use and Acceptance of the Euro Helps Explains the Trend of the EUR/USD

Foreign Exchange Holdings % of Foreign Exchange Holdings In US Dollars % % vs. Euro/USD Exchange Rate (inverted) 74 30 % 80 0.8

72 28 78 0.9

76 70 26 1.0 74

68 24 1.1 72

70 1.2 66 22

68 1.3 64 20 66 1.4 62 18 64

1.5 62 60 16 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 60 1.6 Total Foreign Exchange Holdings In US Dollars As A Percentage Of Total Allocated Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Total Foreign Exchange Holdings In Euros As A Percentage Of Total Allocated (RS) Total Foreign Exchange Holdings In US Dollars As A Percentage Of Total Allocated EURO SPOT (RS) Source: International Monetary Fund, KSR Source: International Monetary Fund, Bloomberg BGN, KSR

Accordingly, we believe the secular increase in demand for the Euro versus the static demand for The ECB did an outstanding job of increasing dollars (by definition given its dominant reserve the structural demand for the euro once Trichet position) was a driving factor in determining the took over. By inserting the euro and the ECB into cross-rate. various types of international transactions (some rather esoteric like the old Brady bonds), the Moreover, and certainly more conjecturally, we amount of global reserves held in Euros rose from believe that the invasion of Iraq by the United 18% to 27% in a decade. States, ignited a fire storm of anti-imperialist sentiment which directly translated into the accelerating use and preference of the euro.

Knight Capital Americas, L.P. 87 Strategic Research In the Short-Term, Sentiment and Momentum Drive FX Currency Market Price Signals Are Often Untrustworthy

BBThe Foreign Exchange Market (FX) is the world’s largest and most liquid financial bazaar with close to $4 Trillion being traded each and every day. BBImportantly, the market itself has an expected return of zero. In other words, individual traders may be able to derive repeatable positive returns, but in the aggregate, profit and loss will always equal zero. BBAnd yet, despite this starkly “non-investable” quality; academics, consultants, and institutional investors alike are coming to believe that FX trading is an “asset class.” BBWhy? For precisely the same reasons many believe commodities are an asset class; because the returns generated from various active and passive strategies are both: 1) Uncorrelated to the performance of their core portfolio holdings, and 2) Because the hope of return enhancement justifies the means.

Knight Capital Americas, L.P. 88 Strategic Research But the Exchange Value of Reserve Currencies Are Self-Correcting The Dollar Cannot “Collapse” Without Causing a Global Depression

BBHighly regarded orthodox economists correctly predicted a financial crisis for the United States, but their expectation was that foreign savings would abandon the dollar and drive down real rates abroad, and drive up real rates in the U.S. BBIn addition, reflecting the change in rates, asset prices abroad should have risen while all U.S. asset prices fell. Moreover, this would spike savings in the U.S. relative to other countries, which would not only “correct” the U.S. account deficit, but the real value of the dollar was to fall by 40% to reflect the adjustment to more production and less consumption. So much for theory. BBAs we see it (and as briefly covered earlier) the United States will remain the global “safe haven;” and therefore, the “world’s banker.” But more than that, because some 85% of the world’s financial transactions occur in dollars, and because of the now obvious structural factors which preclude the euro from ever becoming a primary reserve vehicle, we consider abandonment of the dollar standard to be literally impossible. BBTherefore, as THE reserve currency for the foreseeable (and most likely distant future), the exchange value of the dollar versus every other fiat currency is of significant and material importance to every open economy in the world. BBMoreover, the exchange value of the dollar cannot change by itself. Again, as a unit of credit—not a store of value—shifting exchange rates directly impact the relative price and competitive position of goods and services from different countries. BBThus, as was experienced when the EUR/USD traded near 1.60, the economic pressure on EU nations was severe. BBWe will not make our case here—namely, that we see the EUR/USD trading towards parity over time— but simply reinforce a very fundamental idea: FX cross-rates cannot materially change without forcing— or reflecting—material changes in economic position and structure.

Knight Capital Americas, L.P. 89 Strategic Research So Here’s the Good News

BBLong-term fiscal sustainability results when nominal interest rates are kept below nominal GDP growth; as we see it, it is a mathematical reality. BBThe Federal Reserve anchors the yield curve by maintaining a targeted rate and paying reserves on unused balances. And if the Fed’s policy stays firm, arbitrage will reverse any attempt by speculators to drive yields past what is defined by the coupon roll down the term structure. BBThe degree to which future deficits might cause inflation is a function of their size and the private sector’s proclivity to save or spend. BBThe dollar has no “value” other than its use a vehicle for exchanging credits. On this basis, the dollar standard’s security is a function of its use; and currently, some 85% of all the world’s financial transactions are in dollars. BBThe exchange value of the dollar—as the established reserve currency—is gated by its relative impact on other economies; and therefore, it cannot decline significantly and precipitously without having materially negative consequences for the global economy. BBThe U.S. account deficit, as it is today, does not need to be “balanced” in a conventionally theoretical way; and does not present a material risk to the U.S. economy or global trade.

Knight Capital Americas, L.P. 90 Strategic Research

The Long Road Ahead

“The ideals which have lighted me on my way and time after time given me new courage to face life cheerfully, have been Truth, Goodness, and Beauty. . . . The ordinary objects of human endeavour -- property, outward success, luxury -- have always seemed to me contemptible.” Albert Einstein; The World As I See It (1934)

Knight Capital Americas, L.P. Strategic Research

It is our great hope that the credit crash of 2007—2008 has ended the era of governance based upon the extension of social entitlements without sacrifice, and the guarantee of prosperity without vision. We contend that the death of the 75-year Consumer Credit Super Cycle has rent the fabric of power in Washington; and whether the political establishment knows it or not, America is just fine, but the old ways of government are on the way out.

Knight Capital Americas, L.P. 92 Strategic Research The Water Line Has Receded and the Truth Is Exposed

Steadily increasing transfer payments have obscured the weakening condition of household income growth. If we could chart standard of living growth relative to income, we are quite sure the line would have been steeper than at any other time in modern history and warned of great danger ahead. YoY% Change US Disposable Personal Income Less Transfer Payments (w/ Recession Bars)

19.00% +4 Stdev

+3 Stdev

14.00% +2 Stdev

+1 Stdev 9.00%

Median

4.00% -1 Stdev

-2 Stdev -1.00%

-3 Stdev

-6.00% -4 Stdev 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 Source: NBER, Bloomberg, KSR

Knight Capital Americas, L.P. 93 Strategic Research The Disparity in Income and the Public Sector’s Self-Enrichment Are Shocking

US Share of Income for Top 1% Population Average Compensation: June 2010 23% $ per hour worked

21% Public Private Public/Private 19% Sector Sector Ratio

17% Total compensation $39.74 $27.64 1.44 Wages and salaries 26.13 19.53 1.34 15% Benefits 13.62 8.11 1.68

13% Paid leave 3.01 1.86 1.62 Supplemental pay 0.34 0.78 0.44 11% Health insurance 4.55 2.08 2.19 9% Defined-benefit pension 2.86 0.42 6.81 Defined contribution pension 0.31 0.54 0.57 7% Other benefits 2.55 2.43 1.05 5% 1913 1918 1923 1928 1933 1938 1943 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 Source: Emmanuel Saez, Income and Wealth Inequality, KSR Source: Bureau of Labor Statistics

The disparity of wealth and income is accelerating And the income disparity is not just between around the world. In the United States, we surmise the rich and the poor; but between the public (this data series stops in 2008) that it is now equal to and the private sectors. Even though this issue the top set before the Great Depression. has received a growing amount of attention, we Moreover, not only will this factor greatly intensify don’t believe that the U.S. body politic is fully political pressure in the tough times ahead, but from an aware of just how outrageous the differential is. analytical perspective, we are convinced that it distorts But of course, there is more... aggregate measurements of consumer behavior.

Knight Capital Americas, L.P. 94 Strategic Research Public Labor Unions Are in the Cross-Hairs; and They Will Lose

California % Unemployment vs YoY % Chg Private and Public Union Membership Total Non-Farm US Payroll 14 -6% and Density, 1977-2006

16 45% 12 -4%

14 40%

35% 10 -2% 12 30% 10 8 0% 25% 8 20% %Union ` 6 2% 6 15% Members (millions) ` 4 10% 4 4% 2 5%

0 0% 2 6% 1977 1980 1983 1986 1989 1991 1994 1997 2000 2003 2006 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Source: Barry Hirsch, Georgia Tech University: W.J. Usery Chair of the American Workplace

Unemployment Rates by State California US Non-Farm Payroll YoY % Chg Inverted (RS) Pub_Mem Priv_Mem %U_Private %U_Public Source: Bureau of Labor Statistics, KSR

Although California’s real estate market has rationalized itself much faster than other We first heard about the push to enable state’s distressed markets (due to a more effective legal to declare bankruptcy back in the September. It structure), employment as not improved. made great sense then, and still does, as it appears We believe this reflects both the large impact to be the only real way to bust public union stran- of its fiscal crisis, as well as the broadly disparate gleholds. wealth and income profile across the state. Moreover, we surmise that high unemployment will improve the fight to change the state’s charter and attack its public unions.

Knight Capital Americas, L.P. 95 Strategic Research The Excesses of the Past Decade Are Extraordinary

Square Feet of Housing Built Per Occupant Per Capita (Working Population) Cost of Transfer Payments 1,000 $19,000

950 $17,000 900

850 $15,000

800 $13,000 750

$11,000 700

650 $9,000

600 $7,000 550

500 $5,000 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Jan-90 Oct-91 Jul-93 Apr-95 Jan-97 Oct-98 Jul-00 Apr-02 Jan-04 Oct-05 Jul-07 Apr-09 Source: U.S. Census Bureau, Current Population Survey, KSR Source: Bureau of Economic Analysis, Bureau of Labor Statistics, KSR

The gluttony of square footage built during the That’s right: $17,000 per capita is the annual cost housing boom has left an overhang that will of transfer payments. never effectively “clear.” Essentially, with the speculative premium now gone, value will be driven by proximity to work. Therefore, “excess” square footage becomes a liability; particularly given the likely pressure from property taxes and rising utility bills.

Knight Capital Americas, L.P. 96 Strategic Research And the Population Is Growing Older Quite Quickly

The Accelerating Explosion of the AGED RETIREMENT CALCULUS US Census Projection of Population Change by Age

14000 LIFE EXPECTANCY YOU ARE HERE 12000

Thousands 10000 BASE EQUITY SAVINGS

8000 INVESTMENT EXPECTED RETURNS

6000 WAGE 4000 EXPECTATIONS CONSUMPTION 2000 SAFETY NET

0 2000-2010 2010-2020 2020-2030 2030-2040 2040-2050 LIKELY 20-64 65-85+ DEPENDENTS Source: Census.gov Source: Knight Strategic Research

Demographic shifts are immutable; and ours is The credit crash has ushered in a new retirement favorable. Less workers coming on-line will be calculus. People are living longer, accumulated fortuitous given ongoing productivity increases wealth is lower, expected returns from both and the preexisting challenges facing the current wages and investments are lower, confidence labor pool. in pension and social entitlements is lower, and the most fortunate will most likely need to help support family.

Knight Capital Americas, L.P. 97 Strategic Research And Older Populations Mean More Pressure on Retirement Funding

Public Pension Plans Median Annualized Returns Demographic Inflation Forecast by Time Span 3,000,000 18% 20%

14% 2,500,000 15% 10%

2,000,000 6% 10%

1,500,000 2%

5% -2% 1,000,000

-6% 0% 500,000 -10%

0 -14% -5% 1914 1921 1928 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998 2005 2012 2019 2026 2033 2040 1 Year 3 Year 5 Year 10 Year 25 Year Annual Labor Force Growth (20yr olds - 63 yr olds) Annual Inflation CPI YoY (RS) Median Annualised Returns for Public Pension Plans by Time Span Expected Return of 8% Source: Census.gov Projected Population, Bureau of Labor Statistics Source: Callan Associates, NASRA, KSR

The most significant thing about the management This long-term inflation model is a trend indicator, of pension funds is the discount rate they (on not a forecasting tool. But that said, as illustrated average) use to calculate their benefit obligations. in our “retirement calculus” slide, the impact of 8% is NOT feasible given their heavy allocations to demographic shifts on inflation are positive from bonds; and a stretch even if equities were 100% an overall perspective, but decidedly not for those of their holdings. counting on cost-of-living adjustments through The world is awash with current assets looking retirement. for long duration return; something that is very, very scarce.

Knight Capital Americas, L.P. 98 Strategic Research And Pension Assets Are Enormously Important to American Households Household balance sheets have been whipped around by shifting exposures to stocks and housing. Clearly, the aggregate numbers here are misleading, as the population as a whole was far more affected negatively by declining home prices than they are currently being helped by rising stock prices. That said, there is one constant shift: the move away from privately-held businesses to pension reserves. This will be an enormous issue going forward; particularly for the public sector, as the analyses we have reviewed suggest a $3 trillion to $4 trillion under-funding.

Composition of Household Net-Worth; 1945-2010Q3 100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0% 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Deposits Life Insurance Reserves Municipal Securities Treasury & Agency Securities Corporate Bonds & Mortgages Pension Fund Reserves Privately Held Businesses Stock Investments Residential Home Equity Source: Federal Reserve Z.1, KSR

Knight Capital Americas, L.P. 99 Strategic Research Confidence in the Economy and Political Leadership Go Together

Conference Board Consumer Confidence SA 1985=100 Members111th of 111Congressth US Congress’ Previous Previous Work Experience Work Experience

350 140

300 120

250

100 200

80 150

60 100

50 40

0 20 Career Blue Healthcase Professionals Law Entertainment Judges Military Ministry 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Politicians Collar Professionals Enforcement Lawyers Source: NBER, Conference Board, KSR Source: Congress Demographic

The 111th US Congress recorded the lowest It is truly startling to see just how pessimistic the approval ratings in history; and for good consumer has been, and still is. It is not without reason. Casting all partisanship aside, not only good reason and cause however; and clearly was the entrenched approach to governance Congress has not helped. and leadership diametrically opposed to what the country needed through this crisis, but a review of the personal histories of the legislators confirmed one of our greatest fears; hardly any had the experience and facility to deal with the complexity of the financial issues at hand.

Knight Capital Americas, L.P. 100 Strategic Research When Wants Are Supplanted by Needs; Ideology Gives Way to Pragmatism

Political ideology often carries a very high price. So the propensity for ideological support is not a function of personal conviction—but at the margin—offset by relative economic cost. So, as societal wealth/prosperity falls (represented by the arrows pushing down on the curve), there is a non-linear acceleration of those who “can no longer afford” the principled beliefs they held during more prosperous times.

UNAFFORDABLE IDEOLOGY WEALTH WEALTH

FINANCIAL PRESSURE

IDEOLOGY IDEOLOGY Self Preservation JOBS

TRANSFER LIBERTARIAN PAYMENTS Source: Knight Strategic Research

Knight Capital Americas, L.P. 101 Strategic Research We Don’t Subscribe to the Widely Touted “New Normal”

“New Normal” proponents suggest that the future will hold more extreme “surprises.”

In simple non-statistical terms, that means less happens around the median and more

happens towards the edges of good and bad. FAT ) FAT TAIL ) TAIL Source: Knight Strategic Research

Knight Capital Americas, L.P. 102 Strategic Research We Are Thinking That Normal Has Become an “Abnormal” Skew The chart below, and as would be intuitively obvious, the distribution of tax returns by frequency and income level is negatively skewed. That simply means that a lot more returns are filed below the median than above. And given the structural economic and financial backdrop described in this report, we think this curve is a better descriptor of future surprises.

Distribution of 2006 Tax Returns by Frequency of Gross Income Bracket & Percentage of National Gross Income

30% Income Disparity accelerates dramatically above 25% $200K, and from $1.5MM and above, less than half of one percent earn over 17% of the nation's Gross Income. 20%

15%

10%

Percentage of Filed Returns Percentage of National Gross Income Source: IRS Tax Stats, KSR

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Knight Capital Americas, L.P. Strategic Research Bibliography (cont’d) 16, 2010 2006 36. Date, Raj, “The Giants Fall” Eliminating Fannie 22. Carr, Roman, Graham Seckar and Matthew 30. Croke, Hilary, Steven B. Kamin, Sylvain Leduc, Mae and Freddie Mac, Chairman and Executive Garman, “European Equity Strategy: Strategy “Financial Market Developments and Economic Director, Cambridge Winter Center, Research Data Gallery”, Morgan Stanley, Equity, European Activity during Current Account Adjustments in Note, March 3, 2010 Equity Strategy, December 7, 2009 Industrial Economies”, Board of Governors of the 37. Date, Raj, “Through the Looking Glass (Steagall): 23. Chancellor, Edward, “China’s Red Flags”, GMO Federal Reserve System, International Financial Banks, Broker Dealers, and the Volcker Rule, White Paper, March 2010 Discussion Papers, Number 827, February 2005 Executive Director, Cambridge Winter Center, January 27, 2010 24. Chen, Yu-chin, Kenneth Rogoff and Barbara 31. Currie, Jeffrey, Allison Nathan, David Greely, Sa- Rossi, “Can Exchange Rates Forecast Commodity mantha Dart, Damien Courvalin, Stefan Wieler, 38. Davidson, Paul Ph.D., “Reforming the World’s Prices”, Abstract, June 20, 2008 “The commodity risk premium rises as policy International Money”, Editor, Journal of Post concerns multiply”, Commodity Watch, Goldman Keynesian Economics, Visiting Scholar, Schwartz 25. Chu, Charlene, Wen Chunling and Hiddy He, Sachs, February 5, 2010 Center for Economic Policy Analysis, The New “Chinese Banks No Pause in Credit Growth, Still 32. Currie, Jeffrey, Allison Nathan, David Greely, School Paper for conference “Financial Crisis the on Pace with 2009”, Fitch Ratings, 2 December U.S. Economy and International Security in The 2010 Samantha Dart, Janet Kong, Damien Courvalin, Stefan Wieler, “2010 Outlook: Resource Realign- New Administration, November 14, 2008, The 26. Cohen, Randolph B., Christopher Polk and ment”, Goldman Sachs, Commodities, December New School, New York, NY Tuomo Vuolteenaho, “Money Illusion in the 3, 2009 39. Davidson, Paul, Ph.D., “Alternative Explana- Stock Market: The Modigliani-Cohn Hypothesis”, 33. Currie, Jeffrey, David Greely, Allison Nathan, tions of the Operation of a Capitalist Economy: First draft: April 14, 2004, This draft: December Efficient Market Theory vs. Keynes’s Liquidity 9, 2004 Giovanni Serio, Samantha Dart, Ruifang Zhang, and Abish Khan, “The Revenge of the Old ‘Po- Theory”, Editor, Journal of Post Keynesian Eco- 27. Congressional Budget Office, “Estimated Impact litical’ Economy”, Goldman Sachs, Commodities, nomics, May 2009 of the American Recovery and Reinvestment Act March 14, 2008 40. Davidson, Paul, Ph.D., “Securitization, Liquidity on Employment and Economic Output as of Sep- and Market Failure”, Visiting Scholar, Schwartz tember 2009”, CBO, Report, November 2009 34. Dadayan, Lucy and Donald J. Boyd, “Recession or No Recession, State Tax Revenues Remain Center for Public Economic Policy and Editor for 28. Corrado, Carol, Charles Hulten and Daniel Sichel, Negative”, Another Double-Digit Decline in Third the Journal of Post Keynesian Economics, Chal- “Measuring Capital and Technology: An Expand- Quarter 2009; Weakness Extends to End of Year, lenge Magazine, vol. 51, No. 3, May/June 2008 ed Framework”, Staff Working Papers 2004- The Nelson A. Rockefeller Institute of Govern- 41. Davidson, Paul, Ph.D., ”Crude Oil Prices: “Market 65, Finance and Economics Discussion Series, ment, State Revenue Report, January 2010, No. Fundamentals” or Speculation?”, Visiting Scholar, Divisions of Research & Statistics and Monetary 78 Schwartz Center for Economic Policy Analysis, Affairs, Federal Reserve Board, Washington, DC, Editor, Journal of Post Keynesian Economics, April 2002, Revised August 2004 35. Date, Raj, “Through the Looking Glass (Steagall): Banks, Broker Dealers, and the Volcker Rule”, Ex- Challenge Magazine, vol. 51 No. 4, July/August 29. Coughlin, Cletus C., Michael R. Pakko and William ecutive Director, for Financial Institutions Policy, 2008 Poole, “How Dangerous Is the U.S. Current Cambridge Winter Center for Financial Institu- 42. Dooley, Michael P., David Folkerts-Landau and Account Deficit?” The Regional Economist, April tions Policy, January 27, 2010 Peter M. Garber, “Bretton Woods II Still Defines

Knight Capital Americas, L.P. Strategic Research Bibliography (cont’d) the International Monetary System”, National Toward a Logic of Historical Thought”, Harper 61. Grantham, Jeremy, “Stop the Presses! The Good Bureau of Economic Research, Working Paper Perennial, 1970 News Volckerization”, GMO Quarterly Letter, 14731, February 2009 52. Frenk D., M.W. Masters, “Anthropic Finance and January 21, 2010 43. Dudley, William C., “More Lessons from the Optimal Markets”, Toward a new understanding 62. Gross, Bill, “Let’s Get Fiiscal”, Investment Outlook, Crisis”, Remarks at the Center for Economic of how markets function and the role they serve PIMCO, January 2010 Policy Studies (CEPS) Symposium, Princeton, New in society, 2010 63. Hameed, Allaudeen, Wenjin Kang and S. Viswa- Jersey, President and CEO, Federal Reserve Bank 53. Friedman, Milton and Anna Jacobson Schwartz, nathan, “Stock Market Declines and Liquidity”, of New York, November 13, 2009 “A Monetary History of the United States, 1867- This Version: May 27, 2006 44. Duke, Elizabeth A., “The Economic Outlook”, 1960, Princeton University Press, Copyright 1963, 64. Harris, Ethan S., Michael Hartnett, Bin Gao, remarks at The Maryland Bankers Association by National Bureau of Economic Research Jeffrey A. Rosenberg, Steven Pearson, Daniel Te- First Friday Economic Outlook Forum, January 7, 54. Fullwiler, Scott T., Ph.D., “Interest Rates and Fiscal nengauzer, Francisco Blanch, “2010 – The Year 2011 Sustainability”, prepared for the annual meetings Ahead: new normal opportunities”, Bank of 45. Dunkelberg William C., and Holly Wade, “NFIB of Eastern Economics Association, Manhattan, America Merrill Lynch, Global Macro Research, Small Business Economic Trends”, January 2010 New York, March 5, 2005 December 6, 2009 46. Eggertsson, Gauti B. (NY Fed), Paul Krugman 55. Fullwiler, Scott T., Ph.D., “Interest Rates and Fiscal 65. Hendry, Hugh, “China: Hugh Hendry Warns in- (Princeton), “Debt, Deleveraging and Liquid- Sustainability”, working paper No. 53, July 2006 vestors’ infatuation is misguided”, Telegraph. ity Trap: A Fisher-Minsky-Koo approach, paper, 56. Garrett, Thomas A., and Howard J. Wall, “Passive co.uk, February 12, 2010 11/16/2010 Policies for Entrepreneurs”, Federal Reserve Bank 66. Hirsch, Barry T., “Sluggish Institutions in a 47. Engel, Charles, Nelson C. Mark and Kenneth D. of St. Louis, October 2005 Dynamic World: Can Unions and Industrial Com- West, “Exchange Rate Models Are Not as Bad 57. Gensler, Gary, The Regulation of Over-The-Coun- petition Coexist?” Discussion Paper Series, No. as You Think”, comments by Kenneth Rogoff for ter (OTC) Derivatives, Particularly with Respect 2930, July 2007 NBER Microeconomics Annual 2007 to Energy Markets, testimony Before the House 67. Historical Statistics of the United States 1789- 48. Ferguson, Nial, “A Greek crisis is coming to Amer- Committee of Energy and Commerce, Subcom- 1945, “A Supplement of the Statistical Abstracts ican”, FT.com, Financial Times, February 10, 2010 mittee on Energy and the Environment, Decem- of the United States 49. Ferguson, Nial and Moritz Schularick, “The End ber 2, 2009 68. Hong, Harrison and Motohiro Yogo, “Digging of Chimerica”, working paper 10-037, Harvard 58. Gilonna, Jonathan, Miguel Crivelli, “Focus on into Commodities”, Abstract, First Version: Sep- Business School Government Risk”, Credit Research, Bank and tember 18, 2008, This Version: June 16, 2009 50. Fermon, Daniel, “Worst case debt scenario, Pro- Finance, Barclays Capital, January 26, 2010 69. Honk Kong Monetary Authority “Half-Yearly tecting yourself against economic collapse, Hope 59. Gladwell, Malcolm, “Outlines The Story of Monetary and Financial Stability Report”, Sep- for the best, be prepared for the worst”, Societe Success”, Little, Brown and Company, November tember 2010 Generale Cross Asset Research, A Global View 2008 70. Horowitz, Keith, Craig Singer, Steve Foundos, From Europe, October 13, 2009 60. Gomez, Michael, “Emerging Markets Watch”, Kinner Lakhani, Sentoor Kanagasabapathy, 51. Fischer Hackett, David, “Historians’ Fallacies PIMCO, December 2009 Andrew Coombs, Kimon Kalanboussis, “Global

Knight Capital Americas, L.P. Strategic Research Bibliography (cont’d) Banks: Breaking Down the Fixed Income Trading 80. Kiesel, Mark, “Picking the Winners”, U.S. Credit Journal, 2009 Black Box”, Citigroup Global Markets, January 7, Perspectives, PIMCO, January 2010 90. Masters, Mike, “How Wall Street Financialized 2010 81. Kliesen, Kevin L., “Inflation May Be the Next The Commodities Markets”, presentation to RBC 71. Hussman, John P., Ph.D., “Credit Crisis Generally Dragon to Slay”, Economist, Federal Reserve Capital Markets, December 8, 2009 Require Multi-Year Adjustments”, Weekly Market Board, St. Louis, The Regional Economist, January 91. McCulley, Paul and Tomoya Mosanao, “Where Comment, Hussman Funds, December 7, 2009 2010 Exit Should be an Oxymornon: The Bank of 72. Independent Strategy Limited, “Emerging Market 82. Kolesnikova, Natalia, “Community Colleges A Japan”, Global Central Bank Focus, PIMCO, credit crisis: a New Monetarism framework”, Route of Upward Economic Mobility”, Federal January 2010 Regulated by the Financial Services Authority in Reserve Bank of St. Louis, March 2009 92. McCulley, Paul, “The Shadow Banking System the United Kingdom, November 4, 2008 83. Lansing, Kenneth J., “Inflation-induced valuation and Hyman Minsky’s Economic Journey”, Global 73. Independent Strategy, Global Markets, “Dooms- errors in the stock market”, Senior Economist, Central Bank Focus, PIMCO, May 2009 day for the US Dollar”, May 27, 2009 Federal Reserve Bank of San Francisco, April 13, 93. McKinsey & Company, Global Institute, “Debt 74. International Financial Services Research, “Hedge 1985 and deleveraging: The global credit bubble and Funds 2009”, In partnership with: City of London, 84. Levitt, Steven D. and Stephen J. Dubner, “Freako- its economic consequences”, January 2010 UK Trade and Investment, April 2009 nomics A Rogue Economist Explores the Hidden 94. McTague, Jim, “Taking the Pinch off Pensions”, 75. International Monetary Fund, “A Policy-Driven, Side of Everything”, Harper Collins Publishers D.C. Current, February 15, 2010 2005 Multispeed Recovery”, World Economic Outlook 95. Mendell, Emily and Channa Brooks, “House of Update, January 26, 2010 85. Lindh, Thomas, “Medium-Term Forecasts of Po- Representatives Penalizes Job Creators to Pay 76. International Monetary Fund, “Navigating the Fi- tential GDP and Inflation Using Age Structure In- for Year End Tax Extensions”, National Venture nancial Challenges Ahead”, Global Financial Sta- formation”, Department of Economics, Uppsala Capital Association, December 9, 2009 bility Report, October 2009 University Institute of Future Studies, Stockholm, Submitted as a working paper at Sveriges Riks- 96. Minack, Gerard and Jason Todd, “EM Vs DM”, 77. International Monetary Fund, “Sustaining the bank, November 28, 1999 Downunder Daily, Morgan Stanley Research, Recover”, World Economic Outlook October Asia/Pacific, January 30, 2010 2009 86. Lowenstein, Roger, “When Genius Failed”, Random House Trade Paperback Edition, 2001 97. Minack, Gerard and Jason Todd, “Good Report, 78. Investment Strategy Group, “Commodities: A So- as Expected”, Downunder Daily, Morgan Stanley lution in Search of a Strategy”, Investment Strat- 87. Lucas, MacKenzie and Maurissa Kanter, “Pay Research Asia/Pacific, February 3, 2010 egy Group, Goldman Sachs, January 2010 Awards Reached an All Time in 2009”, Hewitt Associates, August 12, 2009 98. Minack, Gerard and Jason Todd, “Last Drinks”, 79. Johnson, Robert and Erica Payne, “Make Markets Downunder Daily, Morgan Stanley Research Be Markets”, Project on Global Finance, Step 88. Mankiw, Gregory N., “What’s Sustainable About Asia/Pacific, January 29, 2010 1: Restoring the Integrity of the U.S. Financial This Budget?” New York Times, February 13, 2010 99. Minack, Gerard and Jason Todd, “Pedal to the System, Volume Editors, Roosevelt Institute, Metal”, Downunder Daily, Morgan Stanley Re- March 3, 2010 89. Markowitz, Harry M., “Proposals Concerning the search Asia/Pacific, February 5, 2010 Current Financial Crisis, article Financial Analysts

Knight Capital Americas, L.P. Strategic Research Bibliography (cont’d) 100. Minack, Gerard and Jason Todd, “Reconsid- Qureshi, Dennis B.S. Reinhardt, “Capital Inflows: 116. Reinhart, Carmen M., and Kenneth S. Rogoff, ering the Set-back”, Downunder Daily, Morgan The Role of Controls”, International Monetary “This Time is Different: A Panoramic View of Stanely Research Asia/Pacific, February 14, 2010 Fund, IMF Staff Position Note, February 19, 2010, Eight Centuries of Financial Crises”, Abstract, 101. Nash, John Forbes, “Non-Cooperative SPN/10/04 April 16, 2008 Games,” A Dissertation, Presented to the Facil- 108. Pakko, Michael R., “Considering the Capital 117. Roche, David and Bob McKee, “New Mon- ity of Princeton University in Candidacy for the Account”, Economic Synopses, Federal Reserve etarism”, An Independent Strategy Publication, Degree of Doctor of Philosophy, May 1950 Bank of St. Louis, 2004, Number 26 2008 102. Obstfeld, Maurice and Kenneth Rogoff, 109. Pension Benefit Guaranty Corporation, 118. Roosevelt, Franklin D., First Inaugural speech “Global Imbalances and the Financial Crisis: Prod- “Pension Insurance Data Book 2008”, by the 1932 by the President of the United States ucts of Common Causes”, paper prepared for the Policy, Research and Analysis Department, pro- 119. Rotenberg, Jason and Amit Srivastava, “Cor- Federal Reserve Bank of San Francisco Asia Eco- duced by the Communications and Public Affairs porate Profits”, Bridgewater Daily Observations, nomic Policy Conference, October 18-19, 2009 Department, Pension Benefit Guaranty Corpora- November 25, 2009 tion, Number 13, Summer 2009 103. Obstfeld, Maurice and Kenneth Rogoff, “Per- 120. Roosevelt Institution, “Make Markets Be spectives on OECD Economic Integration: Impli- 110. Pettis, Michael, “China’s Loan Growth Isn’t Markets”, Project on Global Finance, Step 1, Re- cations for U.S. Current Account Adjustment”, Boosting My Confidence in China’s Green Shots”, storing the Integrity of the U.S. Financial System University of California, Berkeley, Recent Papers ChinaStakes.com, July 29, 2009 2000 121. Sack, Brian P., “The Fed’s Expanded Balance 111. Plender, John, “Decline but no fall”, FT.com, Sheet”, Remarks at the Money Marketeers of 104. Obstfeld, Maurice and Kenneth Rogoff, “The Financial Times, November 12, 2009 New York University, New York City, Executive Unsustainable US Current Account Position Re- 112. Poulson, Barry W. Ph.D., Arthur P. Hall, Ph.D., Vice President, Federal Reserve Bank of New visited”, abstract, First draft: October 14, 2004, “State Pension Funds Fall Off a Cliff”, American York, December 2, 2009 Second draft: November 30, 2005 Legislative Exchange Counsel, 2010 122. Sowell, Thomas, “Economic Facts and Falla- 105. Obstfeld, Maurice, “Lenders of Last Report 113. Public Pension Systems, “Statements of cies, Published by Basic Books, A Member of the and Global Liquidity Rethinking the system”, Key Investment Risks and Common Practices to Perseus Books Group, 2008 World Bank Institute, Development Outreach, Address Those Risks”, Endorsed by: Association December 2009 123. Stiglitz, Joseph E., “The Challenge of Creat- of Public Pension Fund Advisors, July 2000 ing Jobs in the Aftermath of the Great Reces- 106. Ostry, Jonathan D., Atish R. Ghosh, Karl 114. Reinhart, Carmen M. and Kenneth s. Rogoff, sion”, testimony before the Joint Economic Com- Habermeier, Marcos Chamon, Madvash S. “The Forgotten History of Domestic Debt”, Ab- mittee, December 10, 2009 Qureshi, Dennis B.S. Reinhardt, “Capital Inflows: stract, April 17, 2008 The Role of Controls”, International Monetary 124. Stroebel, Johannes and John Taylor, “Analys- Fund, Research Department, JEL Classification 115. Reinhart, Carmen M., and Kenneth S. Rogoff, ing the impact of the Fed’s mortgage-backed se- Numbers: F21, F32, February 21, 2010 “This Time is Different: A Panoramic View of curities purchase”, VOX, January 27, 2010 Eight Centuries of Financial Crises”, National 125. Surowiecki, James, “The Wisdom of Crowds”, 107. Ostry, Jonathan D., Atish R. Ghosh, Karl Bureau of Economic Research, Working Paper Habermeier, Marcos Chamon, Madvash S. Anchor books, A Division of Random House, Inc., 13882, March 2008 2004, 2005

Knight Capital Americas, L.P. Strategic Research Bibliography (cont’d) 126. U.S. Bureau of Labor Statistics, “Consumer Growth in American Exploring Where Good Jobs committee on Commercial and Administrative Price Indexes for Rent and Rental Equivalence”, Grow”, Research Officer, Federal Reserve Bank of Law, Moody’s Economy.com, January 29, 2008 Consumer Price Index, February 9, 2010 St. Louis, July 2005 144. Zhang, Wenlang and Daniel Law, “Analys- 127. U.S. Department of the Treasury, Presenta- 134. Whyte, Jamie, “Crimes Against Logic”, ing Interconnectivity Among Economies” Hong tion to the Treasury Borrowing Advisory Commit- McGraw Hill, 2004Wikipedia, the free encyclo- Kong Monetary Authority abstract, Working tee, U.S. Department of the Treasury Office of pedia, 2008-2009 Keynesian resurgence Paper 06/2010, 10 May 2010 Debt Management, November 3, 2009 135. Wikipedia, the free encyclopedia, Balance of 145. Zhang, Wenlang and Daniel Law, “What Drives 128. U.S. Department of the Treasury, Office of payments China’s Food-Price Inflation and How Does It Affect Debt Management, November 3, 2009, Presen- 136. Wikipedia, the free encyclopedia, Inter- the Aggregate Inflation?” Hong Kong Monetary tation to the Treasury Borrowing Advisory Com- national monetary systems, (Redirected from Authority abstract, Working Paper 06/2010, 29 July mittee Bretton Woods, II) 2010 129. United States Government Accountability 137. Wikipedia, the free encyclopedia, Nash equi- 146. Xiaochman, Zhou, “Reform the International Office, “Defined Benefit Pension Plans”, Guid- librium Monetary System” March 23, 2009 ance Needed to Better Inform Plans of the Chal- lenges and Risks of Investing in Hedge Funds and 138. Wong, Alfred and Tom Fong, “Analysing In- Private Equity, Report to Congressional Request- terconnectivity Among Economies”, Research ers, GAO-08-692, August 2008 Department, Hong Kong Monetary Authority, Working Paper 03/2010, 10 May 2010 130. United States Government Accountability Office, “Loan Performance and Negative Home 139. Xiaochuan, Zhou, Ph.D., “Reform the Inter- Equity in the Nonprime Mortgage Market”, mem- national Monetary System”, Governor of the orandum to The Honorable Carolyn B. Maloney, People’s Bank of China, Essay, March 23, 2009 Chair Joint Economic Committee House of Rep- 140. Yang, Du, Gao Wenshu, Wang Meiyan, “The resentatives, The Honorable Charles E. Schumer, Lewisian Turning Point and Its Implications to Vice Chairman Joint Economic Committee United Labor Protection” States Senate, December 16, 2009 141. Zakaria, Fareed, “The Post-American World”, 131. Warsh, David, “Why The Rich Stay Rich, The W.W. Norton & Company, 2008 Poor Stay Poor”, The Boston Globe, December 142. Zandi, Mark, “The Causes and Current state 8, 1985 of the Financial Crisis”, written testimony before 132. Wheeler, Christopher H., “Earnings Inequali- the Financial Crisis Inquiry Commission, Chief ty within the Urban United States 2000 to 2006”, Economist and Cofounder, Moody’s Economy. Research Officer, Federal Reserve Bank of St. com, January 13, 2010 Louis, July 2008 143. Zandi, Mark, “The Growing Mortgage Fore- 133. Wheeler, Christopher H., “Employment closure Crisis: Identifying Solutions and Dispelling Myths”, written testimony before the House Sub-

Knight Capital Americas, L.P. Strategic Research February 11, 2011 MARK O. LAPOLLA, CFA WWW.KNIGHT.COM 404.736.2431 | [email protected] Important Disclosures This communication has been prepared by Knight Strategic Research personnel (“Analyst”) of Knight Capital Americas, L.P. (“KCA”), a subsidiary of Knight Capital Group, Inc. (“Knight”). The information contained herein may be the personal perspective of the KCA Analyst and/or commentary com- piled from public sources. The information from public sources is believed to be reliable but Knight does not guarantee or represent its accuracy or com- pleteness. The opinions and views expressed by the individual Analyst do not represent the opinions and views of Knight, its affiliates, officers or other personnel. No responsibility and no express or limited liability is assumed jointly or individually for any losses or damages arising out of errors, omissions, delays in the receipt of this information, or any actions taken in reliance upon the information. Past performance is not a guarantee of future results, and no representation or warranty, express or implied, is made regarding future performance of any security mentioned in this report. Data presented in this communication is current as of the most recent date available. Certain charts may include data as of the previous trading day and are marked as such. This Market Letter was prepared for the institutional and broker-dealer clients of Knight Capital Americas L.P. and its affiliated companies. This presentation was not prepared for any individual client or prospective client of KCA or any of its affiliated companies. The information contained herein does not provide investment advice and is not a sufficient basis for an investment decision. No information contained herein should be construed as a solicitation or an offer to buy or sell any security or product. No responsibility is assumed to maintain and/ or update the information. KCA or its affiliates may take a position or an action which may be inconsistent with the opinions and views expressed therein. Questions regarding the information presented herein should be referred to your Knight Representative. KCA’s parent company, Knight Capital Group, Inc (“Knight”) is comprised of trading and related entities under common control such as, Knight Capital Americas, L.P., Knight Execution & Clearing Services, LLC, Knight Capital Europe Limited (a U.K. registered broker-dealer), Knight Capital Asia Limited (a Hong Kong registered broker-dealer) and HotSpot FXi. Disclosure for United Kingdom and European Union: This report is approved for distribution in any European Union jurisdiction by Knight Capital Europe Limited (KCEL) and is intended exclusively for persons who qualify as a Professional client or Eligible Counterparty under the Markets in Financial Instru- ments Directive. Research analysts employed by Knight Capital Americas, L.P. who wrote or who were involved in writing this report are not compensated by KCEL. Knight Capital Europe Limited is Authorized and Regulated by the Financial Services Authority. Distributed by Knight Capital Asia Limited (License Number: ADX009, regulated by Hong Kong Securities and Futures Commission in Type 1 and Type 4 activity, which accepts responsibility for its contents). © 2011 Knight Capital Group, Inc. All rights reserved. No part of this document may be reproduced, distributed, transmitted, displayed, or re-published without the prior written permission of Knight Capital Group.

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