socgen - from muni crisis to us sovereign debt crisis?

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Please see important disclaimer and disclosures at the end of the document

19 July 2010

EconomicsBeyond the Cycle

www.sgresearch.com

American ThemesFrom muni crisis to US sovereign debt crisis?Stephen GallagherChief Americas Economist

(1) 212 278 [email protected]

Aneta MarkowskaUS Senior Economist

(1) 212 278 [email protected]

Martin RoseResearch Associate(1) 212 278 [email protected]

The 2008-2009 recession has produced a significant crunch in state finances. Last year, budgetgaps were plugged with federal stimulus money, but now that the funds are running out, statesface renewed pressures. Here, we evaluate the risks for the US economy and financial markets.Q Municipal defaults likely to rise We anticipate a rise in municipal defaults in the comingquarters, which is normal following deep recessions. A state default would be far more

serious, but remains unlikely in our view. There has only been one state default in the past 110years. Arkansas defaulted in 1933 and functioned on federal money for two years.

Q EMU members vs. US statesThe key similarity is the need for austerity, which is the onlysustainable solution to the current budget woes. The main difference is the financial linkages,

which are much weaker in the case of municipal debt. Only 10% of the $2.8 trillion municipal

debt market is held by banking institutions, with the vast majority owned by wealthy

households. This suggests much smaller risks of financial contagion.

Q What could go wrong risk scenarios A rise in municipal defaults could spook investorsand trigger a funding crisis for state and local governments. While the Fed can purchase

short-term municipal paper as part of open market operations, we believe that the first round

of help would come from the federal government. How much help might be needed? We

estimate the projected budget gaps plus refinancing needs add up to about $300-$350 bn, or

about 2% of GDP. In the event of a federal bailout, we must also consider the risk of second-

round contagion effects into the Treasury market. If this risk were to materialize, we believe

that the Fed would likely restart quantitative easing. Fed purchases would cap Treasury yields,

but the dollar would suffer in this monetization end-game.

How are states closing their budget gaps? FY2010 cuts by program:

-

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

K-12 Education Higher Education Public

Assistance

Medicaid Corrections Transporation Other

USD bln

FY'2010 spending cuts by program

Source: National Governors Association

This document is being provided for the exclusive use of MARTIN ROSE (SGCIB)


2/22

American Themes

19 July 2010

Recent tremors in the municipal debt marketThe 2008-2009 recession has produced a significant crunch in state finances. Last year,

budget gaps were plugged with federal stimulus money, but now that the funds are running

out, states face renewed pressures. In recent months, several small municipalities have

warned against potential default.

A rise in municipal defaults is not unusual following recessions, and particularly following the

last recession which was very severe both in its depth and its duration. However, these

warnings have spooked municipal bond investors. The average municipal CDS spread as

measured by the MCDX index have widened out from 120 bps in late April to 250 bps in late

June (although spreads are still below the peak levels of 2008 when the auction rate market

shut down, triggering funding problems for many issuers). Spread movement in the cash

market has been less pronounced. In price terms, most securities have not moved much and

state and local governments have not seen much change in their borrowing costs, albeit

municipal yields failed to follow Treasury yields down over the past month.

The sharp widening in the CDS market has triggered a lot of concern among investors. In

particular, there have been a lot of questions about potential contagion to the broader

financial markets, similar to the way the seemingly small Greek problems spilt over to other

peripheral sovereigns and ultimately to the banking sector.

Municipal spreads show some pressures though yields have remained stable

-100

-50

0

50

100

150

200

250

300

350

400

02 03 04 05 06 07 08 09 10

bps

-200

-150

-100

-50

0

50

100

150

200

250

300

Markit CDS Index 5Y (LHS)

Muni AAA/A- vs. Treasury (RHS)

2.0

3.0

4.0

5.0

6.0

7.0

8.0

00 01 02 03 04 05 06 07 08 09 10

bpsMuni AAA/A-

Muni Insured

Muni BBB+/BBB-

Source: Bloomberg, SG Cross Asset Research

Whats in the $2.8 trillion municipal debt market?The municipal debt market is very fragmented and represents many different types of issuers

including, states, counties, cities, towns, school districts, special districts, utilities,

transportation systems, universities and hospitals, often with multiple securities. The bonds

can be backed by revenue streams tied to specific projects (65% of the market), or, in the

case of general obligation bonds, by the full faith and credit of the issuing governmental body

(35% of the market).

The average size of a municipal issue is much smaller than in the corporate markets. While the

overall size of the corporate market is much larger, at $11 trillion in total vs. $2.8 trillion in

Troubled States5Y CDS S&P

Rating

Illinois 315.0 A+

California 281.9 A-

New York 248.6 AA

Michigan 245.8 AA-

New J ersey 240.0 AA

Nevada 210.0 AA+

Florida 153.8 AAA

Troubled EMU Members5Y CDS

S&P

Rating

Greece 802.2 BB+

Portugal 289.3 A-

Ireland 250.9 AA

Spain 220.5 AA

Italy 176.2 A+ Source: Bloomberg; data as of Friday July 16



3/22

American Themes

19 July 2010 3

outstanding municipal securities, the municipal market has about 50,000 issuers vs. 3,000

corporate issuers.

Defaults tend to be much lower in the municipal market, for the simple reason that the issuers

operate as monopolies in their respective markets and have greater flexibility raising revenue

than corporations, either by raising taxes, increasing fees or implementing new user charges.

However, municipalities are much more constrained in managing their expenses as they are

often burdened by unfunded mandates passed down from the federal and state governments

(healthcare, social services).

Why are states in trouble?States in fiscal perilMany comparisons have been made between US states and the weaker EMU members with

unsustainable debt dynamics. From the debt load perspective, the states are in much better

shape. Overall state and local government debt is at just 20% of GDP. Adding it to the federal

debt pushes the overall general government debt to roughly 75% of GDP, which is more

problematic. However, the bigger of the two problems is federal government which is in much

worse shape than the states given its large debt loads and an unsustainable fiscal outlook.

Standalone state debt In the context of federal debt

0

5

10

15

20

25

30

35

40

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

% of GDP State & Local Gov't Debt

0

10

20

30

40

50

60

70

80

90

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

% of GDP Treasury Debt

State & Local Gov't Debt

Source: Global Insight, SG Cross Asset Research

For the states, the key problem is not debt levels, but the recent budget gaps. The lastrecession was the costliest post-war downturn for the states, both because of its severity and

its duration. In the previous recessions, states fiscal problems lasted for several years after the

economic trough; this time, problems could persist even longer, for several reasons. First,

consumption is likely to remain below pre-recession levels for some time, implying a lasting

drag on sales tax revenues. Persistently high unemployment also means that income tax

receipts are unlikely to return to pre-recession levels for several years. At the same time, the

persistently high levels of unemployment are also putting upward pressure on social benefit

spending, particularly unemployment insurance, Medicaid (health insurance for the poor) and

welfare.



4/22

American Themes

19 July 2010

Debt-to-GDP ratios by state

0

20

40

60

80

100

120

Delaware

Mon

tana

Oregon

Rho

de

Islan

d

Ca

liforn

ia

New

York

Missouri

M

assachuse

tts

New

Jersey

Neva

da

Pennsy

lvan

ia

Alaska

Illino

is

Sou

thCaro

lina

Texas

Co

lora

do

Flori

da

Wash

ing

ton

Hawa

ii

Ken

tucky

Indiana

Vermon

t

Arizona

Ida

ho

Michigan

Sou

thDa

kota

Ohio

New

Mexico

Connect

icu

t

Mississ

ipp

i

Ne

braska

Ma

ine

Utah

Ne

wHampsh

ire

Alabama

Minneso

ta

Georg

ia

Wisconsin

West

Virg

inia

Kansas

Tennessee

Mary

lan

d

Virg

inia

Iowa

Lou

isiana

N

ort

hCaro

lina

Arkansas

Okla

homa

Nort

hDa

kota

Wyom

ing

Districto

fCo

lum

bia

%o

fsta

teGDP

State and Loc al Government Debt

Federal debt portion

Total debt-to-GDP ratios shown above include both municipal and federal debt. We pro-rated Federal debt according to the states GDP. Total debtexpressed as % of states GDP.

Source: Global Insight, SIFMA, SG Cross Asset Research

Though revenues have begun to rise, helping to narrow overall budget shortfalls relative to last

year, this may not be enough to offset the coming declines in fiscal stimulus money. The

Center on Budget and Policy Priorities estimates that state budget gaps before the use of

federal stimulus funds amounted to $200 bn in FY 2010 and will be followed by $180 bn in

FY2011 and $120 bn in FY2012. However, after the use of stimulus funds, the projected

shortfall peaks in FY2011 (which for most states began on July 1, 2010). As such, the worst

may not be over yet for state and local governments.

Projected state budget gaps with and without fiscal stimulus funds

-$71

-$137 -$144-$119

-$39

-$63

-$36

-$1-$110

-$200

-$180

-$120

-220

-170

-120

-70

-20

FY 2009 FY 2010 FY 2011 FY 2012

USD bln -220

-170

-120

-70

-20

Budget gaps offs et by Recovery Act

Remaining bu dget g aps after Recovery Act

$260 bn over

the next two

years

The projected total budget shortfalls reflect state fiscal conditions at the start of the fiscal period, i.e. before deficit-closing actions are taken (i.e. before fiscal stimulus funds, budget cuts, tax increases and reserves).

FY2010 was the worst year in terms of overall budget gaps. However, after adjusting for fiscal stimulus funds, FY2011shortfalls are projected to be slightly larger.

Source: Center on Budget and Policy Priorities



5/22

American Themes

19 July 2010 5

FY2010 budget shortfalls, % of state GDP

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Ca

liforn

ia

Alaska

Orego

n

New

Jersey

Illinois

Connecticu

t

Rho

de

Islan

d

Arizona

Was

hington

Hawa

ii

New

York

Main

e

Massac

huset

ts

Kansas

Wiscons

in

Minneso

ta

Nort

hCarolin

a

New

Mexico

Vermon

t

Nevad

a

Georg

ia

Oklahom

a

Pennsy

lvan

ia

Idah

o

Mary

lan

d

Miss

issipp

i

Iowa

Alabama

Uta

h

Virginia

De

laware

Lou

isiana

Districto

fCo

lumb

ia

Florid

a

Sou

thCarolin

a

Ken

tuck

y

Ohio

Michiga

n

New

Hampshir

e

Missou

ri

Co

lorad

o

Indian

a

Wes

tVirginia

Tennesse

e

Arkansas

Ne

brask

a

Texa

s

Sou

thDako

ta

Wyomin

g

Montan

a

Nort

hDako

ta

FY'2010 Budget Shortfalls, % of state GDP

FY'2010 total shor tfall = $200.1 bn

Source: Center on Budget and Policy Priorities, SG Cross Asset Research

Box 1: Balanced budget amendment what does it mean for the states?

In principle, a balance budget amendment which has been adopted in some form by 49 US states

(except Vermont) means that the state cannot spend more than its income. In practice, the implications

are not as straightforward. Thats because the balanced budget amendment applies to the state

governments general fund which receive all tax and fee collections and are subject to legislative

appropriations. The general fund excludes several important items:

Q Federal grants, which are typically committed for specific purposes

Q Transportation funds raised from gasoline taxes, which are earmarked for highways and other

transportation purposes

Q Tax collections apportioned to local governments

Q Capital expenditures, which are part of the states capital budget (separate from the operating

budget)

State general funds receive about 50%-60% of all revenue sources and only those funds are subject to

the balanced budget amendment. The balance budget amendment means that states generally cannot

finance operating shortages with long-term debt.

Unlike the US federal government or governments of troubled European countries which are

issuing large amounts of debt to finance current budget gaps, state and local governments

have less flexibility to do so. Most states have adopted balanced budget amendments which

prevent them from accumulating deficits over time. Some states have taken unconventional

measures to get around the requirement, such as delaying vendor payments, issuing IOUs or

delaying tax refunds; however this simply pushes the budget gap into the next fiscal period.

Given the size of projected budget gaps for the next few years, it is clear that states will have

to address them via tax increases and/or spending cuts.



6/22

American Themes

19 July 2010

What are the problems in problem states?As mentioned earlier, the problem currently facing states and local government is not the

accumulation of earlier deficits, but rather the current and projected deficits that are a product

of an unusually severe recession. The states facing largest budget gaps tend to have theworst-performing economies with high unemployment rates and foreclosure rates above

national averages. As a result, these problem states have experienced the largest revenue

drops while their costs have ballooned.

What do problem states have in common?Budget gap - %

of General Fund

Budget

Budget gap

$ bln

Budget gap

% of state GDP

Debt / state

GDP

Change in

revenue

Unemployment

Rate

Prime

foreclosure

rate

Sub-prime

foreclosure

rate

Needs

supermajority?

2010 estimate 2010 estimate 2010 estimate 2010 estimateQ1'2008 -

Q1'2009May-10 Apr-10 Apr-10

California 64.5% 54.6 3.0% 29.5% -16.2% 12.4% 2.6% 13.2% Yes

Arizona 57.9% 5.1 2.0% 22.8% -16.5% 9.6% 3.1% 11.9% Yes

Nevada 47.6% 1.5 1.1% 25.1% 1.5% 14.0% 6.3% 19.0% Yes

Illinois 40.9% 14.3 2.3% 24.5% -10.9% 10.8% 3.7% 16.8% No

New Jersey 38.4% 11.0 2.3% 26.0% -15.8% 9.7% 4.0% 24.8% No

New York 38.0% 21.0 1.8% 29.4% -17.0% 8.3% 2.6% 19.8% No

Rhode Island 33.0% 1.0 2.1% 30.2% -12.5% 12.3% 1.9% 10.7% Yes

Kansas 32.9% 1.8 1.5% 18.3% -11.1% 6.5% 1.3% 7.9% No

Alaska 30.7% 1.3 2.7% 25.0% -72.0% 8.3% 0.7% 7.3% No

Oregon 29.0% 4.2 2.6% 33.4% -19.0% 10.6% 1.8% 12.7% Yes

Florida 28.5% 6.0 0.8% 23.4% -11.5% 11.7% 9.8% 30.6% Yes

Vermont 28.1% 0.3 1.2% 22.8% -7.2% 6.2% 1.8% 15.9% No

Oklahoma 28.0% 1.6 1.1% 13.3% -12.6% 6.7% 1.8% 10.2% Yes

Washington 27.8% 6.2 1.9% 23.2% -9.0% 9.1% 1.3% 10.1% Yes

Maine 27.6% 0.8 1.7% 19.9% -11.0% 8.0% 2.6% 16.4% No

New Hampshire 27.5% 0.4 0.7% 19.3% -2.5% 6.4% 1.2% 8.8% No

Connecticut 27.0% 4.7 2.2% 20.8% -11.4% 8.9% 2.3% 15.6% No

Hawaii 26.4% 1.2 1.9% 23.2% -10.2% 6.6% 3.3% 15.8% No

North Carolina 26.2% 5.0 1.2% 14.5% -7.6% 10.3% 1.4% 6.6% No

Georgia 26.1% 4.5 1.1% 19.0% -19.1% 10.2% 2.1% 8.3% No

Wisconsin 23.8% 3.2 1.3% 18.8% -11.2% 8.2% 2.4% 15.8% No

Colorado 23.3% 1.6 0.6% 23.7% -10.1% 8.0% 1.4% 9.5% Yes

Pennsylvania 23.3% 5.9 1.1% 25.0% -5.5% 9.1% 1.6% 10.3% NoIowa 22.7% 1.3 1.0% 15.3% 3.6% 6.8% 2.0% 12.0% No

Alabama 22.5% 1.6 0.9% 19.2% 3.0% 10.8% 1.0% 5.4% No

Virginia 22.5% 3.6 0.9% 15.7% -19.9% 7.1% 1.1% 7.0% No

Idaho 22.4% 0.6 1.1% 22.2% -14.2% 9.0% 2.1% 11.2% No

Minnesota 22.3% 3.4 1.3% 19.2% -9.7% 7.0% 1.5% 10.8% No

Utah 22.2% 1.0 0.9% 19.9% -3.4% 7.3% 1.8% 12.4% No

Missouri 21.8% 1.7 0.7% 28.8% -1.3% 9.3% 1.1% 5.8% Yes

Louisiana 21.6% 1.9 0.9% 15.0% -8.8% 6.9% 1.9% 10.7% Yes

Maryland 21.1% 2.8 1.0% 17.1% -1.2% 7.2% 2.0% 11.5% No

South Carolina 20.0% 1.2 0.8% 24.2% -11.0% 11.0% 2.0% 10.9% No

Mississippi 18.7% 0.9 1.0% 20.6% -7.6% 11.4% 1.7% 6.5% Yes

New Mexico 18.0% 1.0 1.2% 21.2% -12.8% 8.4% 2.0% 10.3% No

Massachusetts 17.7% 5.6 1.5% 26.2% -16.8% 9.2% 1.7% 13.6% No

Delaware 17.2% 0.6 0.9% 45.6% -3.0% 8.8% 2.3% 16.2% Yes

Kentucky 14.5% 1.2 0.8% 23.0% -3.8% 10.4% 2.0% 11.6% Yes

Ohio 14.0% 3.6 0.8% 21.3% -9.0% 10.7% 3.1% 12.5% No

Michigan 12.4% 2.8 0.7% 22.1% -16.5% 13.6% 2.1% 7.8% Yes

Tennessee 11.1% 1.1 0.4% 18.2% -10.2% 10.4% 1.2% 5.5% NoIndiana 10.6% 1.4 0.5% 22.8% -3.5% 10.0% 2.9% 11.1% No

Texas 9.8% 3.5 0.3% 23.8% -8.8% 8.3% 0.9% 5.7% No

Nebraska 9.0% 0.3 0.4% 20.5% -5.5% 4.9% 0.9% 7.0% No

Arkansas 8.7% 0.4 0.4% 13.5% -4.2% 7.7% 1.1% 5.5% Yes

West Virginia 8.0% 0.3 0.5% 18.5% -9.4% 8.9% 1.3% 6.9% No

South Dakota 4.3% 0.0 0.1% 21.4% -6.2% 4.6% 0.8% 10.9% Yes

Wyoming 1.7% 0.0 0.1% 11.3% 19.7% 7.0% 0.8% 6.6% No

Montana 0.0% 0.0 0.0% 41.2% 3.2% 7.2% 1.2% 11.3% No

North Dakota 0.0% 0.0 0.0% 13.1% -12.1% 3.6% 0.5% 8.2% No

National Avg 15.2% 200.1 1.1% 22.2% -11.7% 9.7% 2.7% 13.6%

Source: Center on Budget and Policy Priorities, Global Insight, SG Cross Asset Research



7/22

American Themes

19 July 2010 7

Based on 2010 budget gaps projected before any deficit-closing actions were taken, the

states facing the strongest budget pressures include some of the usual suspects, in the

following order: California, Arizona, Nevada, Illinois, New Jersey and New York.

Unemployment in these states averaged at 11.3% in May vs. the national average of 9.7%. As

of April, the problem states recorded a prime foreclosure rate of 3.9% vs. 2.7% nationally and

a sub-prime foreclosure rate of 17.1% vs. 13.6% nationally.

Another problem facing some states is the requirement for a supermajority vote (2/3 or in

some cases or 3/5) for the approval of budgets and tax increases, which can make it very

difficult to make the necessary cuts. This has been a chronic problem in California which is

currently functioning without a budget.

Whats the damage?States in austerityDuring fiscal year 2010, state government resorted to a variety of methods to close their

budget gaps. Significant cuts were made in education, transportation, Medicaid and in the

corrections department. States instituted layoffs and furloughs, reduced salaries, cut

employee benefits, raised tuition, boosted transportation fees and reorganized agencies.

States also enacted over $20 bn in tax and fee increases which included sales tax hikes,

higher gasoline and tobacco prices and in some cases higher personal income taxes. These

austerity measures have been a drag on growth, both directly via lower government spending,

and indirectly via higher taxes.

State austerity already hurting growth more to come

-6

-4

-2

0

2

4

6

8

10

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

3m ann %

-40

-20

0

20

40

60

80

monthly change

State and Local Government Spendin g (LHS)

State Employment (RHS)

2 qtr moving averages


If no more federal stimulus funds are made available which is most likely going to be the

case states will need to take further steps to close the projected $144 bn FY2011 shortfall.

In direct terms, this translates to roughly 1% of GDP; however the impact on the economy will

depend on the types of measures taken. Spending cuts would likely translate to a more direct

hit to demand. Tax increases, particularly those on the wealthy, are likely to have lower

multiplier effects, producing a more modest hit to growth.



8/22

American Themes

19 July 2010

How states solved their 2010 budget gaps

0

5

10

15

20

25

30

35

40

User

fees

Higher

educationfees

Courtrela

tedfees

Transpo

rationrelat

edfees

Busine

ssrelat

edfees

Layoffs

Furloughs

Early

retirem

ent

Salar

yreductions

Cutstoe

mplo

yeebe

nefits

Across

-the-bo

ard%

cuts

Targeted

cuts

Reduce

aid

tolocalg

ovt's

Reo

rganize

agencies

Priva

tization

Rainy

day

fund

Lottery

expansio

n

Gaming

/gambli

ngexpansio

nOthe

r

# of states taking action

Source: National Governors Association

Financial contagion risks lower than sub-prime or GreeceWhile the economy can probably survive state austerity, its chances for sustaining the

recovery would become much slimmer in the event of financial contagion. The sharp widening

in CDS spreads certainly raises concern, particularly in light of recent European experience.

However, the key to the contagion issue lies in who owns the debt.

Ownership of municipal debt limited exposure of the banking sector

Households

Funds (mmkt,

mutual, closed

end)

Banks

Brokers and

dealers

Insurance

Companies

Rest of the

world

Other

$2.8 trln outstanding


The European sovereign crisis became contagious because banks were significantly exposed

to the troubled governments. In the case of state and municipal debt, the situation is very

different. The ownership of municipal debt is dominated by US households which own about

70% of the $2.8 trillion outstanding, either via direct holdings or via money market and mutual

funds. Banking institutions hold just 10%, or $270 bn. For US commercial banks, municipal

holdings make up just 1.5% of their assets (vs. 1.7% of assets in Treasury debt).



9/22

American Themes

19 July 2010 9

US states vs. EMU membersWe can draw many parallels between US state governments and those of individual EMU

members. In both cases, the governments in question have no independent monetary policy

that can be tailored to the specific regional economy and its problems. They also have noindependent currency that can be used as a macroeconomic tool.

EMU states vs. US statesEMU Countries 50 States

Independent currency/monetary policy No NoMacroeconomic policy function (fiscal) Yes No

Budget rules Imposed from above, thoughdiscipline has been uneven

Most states have adopted balancedbudget amendments; room formaneuver varies across states

Parental support? Recently made explicit with EFSF(though with strings attached andcapped).

No expectation of direct bailout, butfiscal support common (e.g. stimulusfunds, Buy America Bonds)

Central bank intervention? Ongoing Possible within normal open marketoperations (but limited to 6m

maturities)

Default mechanism? No Yes for municipal debt, no for state

Financial contagion risks? Higher large debt ownership bybanking institutions

Lower bulk of municipal debt ownedby households

Source: SG Cross Asset Research

However, we see several important differences that suggest lower risk of contagion frompotential defaults in the municipal debt market. In addition to the weaker financial linkages

discussed earlier, there are also important institutional differences. When the European debt

crisis first broke out, there was no institutional framework in place to support states facing

funding problems. Some of those shortcomings have been addressed, but only after the initial

damage to the financial markets. In the US, the institutional framework is not perfect, but it is

much better defined than it was in Europe six months ago. First, the Fed has the ability to

purchase municipal debt under normal open market operations (albeit limited to 6m

maturities). Another big shortcoming for Europe has been the lack of shared fiscal

responsibility. In the US, fiscal help for states is subject to political winds, but the risk is

nonetheless much smaller when only one fiscal authority is involved. There is a strong

precedent for fiscal support of the states. Lastly, the US also has institutional support for

banks in the form of FDIC insurance. The absence of deposit insurance in the Europeanbanking system contributed to financial contagion risks during the recent sovereign crisis

Another difference between US states and EMU members is that state governments share

responsibility for many services with the federal government. In the unlikely event of a state

default, the federal government would continue to pay social security, Medicare and other

programs funded at the federal level.



10/22

American Themes

19 July 20100

Box 2: Federal vs. state government - who pays for what?

Services paid for by the federal government:

Q Social Security

Q Defense

Q Welfare (including food stamp programs)

Q Medicare (healthcare for the elderly)

Q Medicaid (healthcare for the poor shared with states)

Q Education (basic costs covered by the states, but the federal government funds various specializedprograms)

Q Employment/job training (incl. long-term unemployment benefits)

Q Public housing assistance

Q Transportation

Q Postal service

Q Hospitals

Services provided by state and local governments:

Q Education (elementary, secondary and higher)

Q Medicaid (healthcare for the poor shared with the federal government)

Q Unemployment benefits (extended benefits shared with federal government)

Q Transportation

Q State police, fire protection

Q Hospitals

Q Parks and recreation

Defaults in the municipal debt marketState defaults are extremely rare. There has only been one state default in the past 110 years.

Arkansas defaulted during the Great Depression and functioned on federal money for two

years. Prior to that, several states also defaulted in the 1840s following a banking panic and a

five-year recession.

Chapter 9 bankruptcy filings by municipalities

0

2

4

6

8

10

12

14

16

18

20

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

# of filings per year

Source: United States Courts



11/22

American Themes

19 July 2010 11

Municipal defaults are more common although less frequent than corporate defaults. Most

municipalities that miss a payment generally make up for it within a few months. For those

defaults that do end up restructuring their debt, this is done via Chapter 9 proceedings. Since

1937, there were only 616 Chapter 9 filings. Since 1980, 245 cases were filed, and about 1/3

of those were dismissed by court without any debt adjustment.

Box 3: Debt restructuring mechanism for state and local governments

A state is a sovereign and as a sovereign it cannot file for bankruptcy. There is no legal process for

restructuring state debt.

Municipalities file for bankruptcy protection under Chapter 9 proceedings. This is different than

businesses which file under Chapter 7 (liquidation) or Chapter 11 (reorganization). Key features of Chapter

9 protection include:

Q Only the debtor can initiate Chapter 9 proceedings involuntary bankruptcies are not permitted in

the municipal world

Q Chapter 9 allows for adjustment of debts, not for liquidation

Q Bottom line: municipality continues its existence in bankruptcy, and often continues to pay its debt.

The court cannot decide what services will be provided by the governmental body.

Some states have statutory provisions to authorize (or block) municipal bankruptcy filings. The

state can:

Q Offer bridge financing or refinancing of the trouble debt

Q Offer grants to the municipality to bridge financing crisis

Q Transfer services to other governmental agencies to reduce expenditures

Q Use intercept of state tax payable to the municipality to ensure essential services

Default statsMunicipal defaults are not uncommon. However, municipal bonds have historically exhibited

much lower default rates and higher recovery rates than corporate bonds. In a recent study

based on the 1990-2007 period, Fitch found that the cumulative five-year default rate on

investment-grade municipal debt averaged at 0.1% compared with 1.2% for corporates.

These results are broadly in line with a recent Moodys study, the results of which are shown

in the table below. Average recovery rates are also significantly higher on municipal debt. The

ultimate recovery rate has averaged at 67% on municipal issues vs. 38% on senior unsecured

corporate bonds.

Municipal default rates typically lag the economic cycle, given the delayed impact of

recessions on state budgets. Most municipal defaults are concentrated among weaker creditsand weaker purposes, such as hospitals and housing bonds. Stronger purposes, such as

utilities, universities, or even general obligation bonds tend to default less frequently given a

greater ability to collect on their receivables.



12/22

American Themes

19 July 20102

Default Rates: municipal vs. corporate debt Recovery Rates: municipal vs. corporate debtMunicipal Bonds

Senior Unsecured

Corporate Bonds

30-day post-default price 59.9% 37.5%

Ultimate recovery rate (avg) 67.0% 38%*

Ultimate recovery rate (median) 85.0% 30%*

* based on data from 1987 to 2007

The data above covers the period from 1970-2009. Based on a study that

covers only Moodys rated bonds. There were 18,400 bonds in the sample asof 2009.

Source: Moodys

It is important to keep in mind that in the case of general obligation bonds which are backed

by the full faith and credit of the local governments, a decision to default is largely political.

While it is politically difficult to raise taxes of lay off public sector workers, the implications of

defaulting and being shut out of the debt markets are far more severe. This is why local

governments generally tend to side with bondholders rather than the constituents.

Bailout optionsOur central scenario is that states will close their projected gaps by spending cuts and/or tax

increases. Municipal default rates will likely rise, but that is normal following recessions and is

expected by the market. Bailouts for states and/or municipalities are not very likely at this

stage. Indeed, the heads of President Obamas debt commission recently told governors not

to count on the federal government for more budget bailouts. The only scenario in which we

envision more aid for state and local governments is one in which a rise in defaults spooks

investors and triggers widespread funding problems in the municipal market.

Central bank able, but not willingThe Feds ability to purchase state and local government debt is clearly spelled out in section

14 of the Federal Reserve Act. This ability is part of normal market operations, not emergency

powers.

The Fed can buy securities issued in anticipation of the collection of taxes or in anticipation of

the receipt of assured revenues by any State, county, district, political subdivision, ormunicipality in the continental United States, including irrigation, drainage and reclamation

districts. However, there is an important restriction built into the stature which limits the Feds

buying to municipal securities maturing within six months of the purchase. Since municipal

debt tends to be long-dated, we estimate that this limits the Feds buying ability to only about

$100 bln.

Despite its ability to purchase municipal debt, historically, the Fed has been reluctant to do so.

Municipal debt purchases were considered in the late 1990s when the Treasury was running

fiscal surpluses and reducing the amount of debt outstanding. The Fed needed alternative

10-year cumulative

Default Rates

Municipal

Bonds

Corporate

Bonds

Aaa 0.00% 0.50%Aa 0.03% 0.54%

A 0.03% 2.05%

Baa 0.16% 4.85%

Ba 2.80% 19.96%

B 12.40% 44.38%

Caa to C 11.60% 71.38%

Investment Grade 0.06% 2.50%

Speculative Grade 4.55% 34.01%

All Rated 0.09% 11.06%10-year cumulative default rate is the percentage of bonds that ended up in default 10

years after issuance



13/22

American Themes

19 July 2010 13

asset classes to conduct open market operations. After considering municipal debt, the Fed

decided against it. The Fed also did not intervene in the municipal market in late 2008 and

2009 despite significant dislocations and some political pressure.

We conclude that the Fed intervention in the market is unlikely and, in the event of disruptions

in the municipal debt market, the first round of aid would come from the federal government.

Federal government strong precedent of bailoutsThere is no explicit mechanism for Federal bailouts of failing states or municipalities. However,

there is a strong precedent. Following the default of Arkansas in 1933, the state functioned on

federal money for two years (until it passed a sales tax). There are also more recent examples

of federal aid for cash-strapped state and local governments.

Q Last years stimulus funds. As part of the American Recovery and Reinvestment Act

(ARRA) of 2009, the federal government earmarked about $140 bn (1% of GDP) in direct relief

to state and local governments to be distributed over a roughly 2 year period. The funds,which cover about 30% of projected state shortfalls, largely took the form of increased

Medicaid funding and a State Fiscal Stabilization Fund. Stimulus money has reduced the

extent of state spending cuts and state tax increases.

Q The Build America Bonds program. The program was introduced on February 17, 2009,

as part of the ARRA. These are taxable municipal bonds that carry special tax credits or direct

federal subsidies. All issuance to date has been in the direct-pay BABs, where the Treasury

Department provides borrowers with cash subsidy payments equal to 35% of their interest

costs. With tax-credit BABs, investors receive the right to a federal income tax credit equal to

35% of their BAB interest income. The tax credit can be carried forward to future years if the

bondholders tax liability is insufficient in a given year. The net effect in either case is

substantially reduced interest expense to state and local governments. Unlike tax-exemptdebt, normally issued by state and local government, BAB bonds are attractive to taxpayers in

lower tax brackets or to those that do not pay income taxes (e.g. pension funds, endowments

or foreign investors). Since the launch of the program, $180 bln in Buy America Bonds have

been issued, or about 20% of total municipal issuance. Under current law, the program is

open to bonds used to finance capital expenditure projects and issued before January 1,

2011.

How much aid may be needed?The total projected budget shortfall for FY2011 is about $145 bn. While this gap will be closed

at least partially via austerity measures, in the worst case scenario we can assume that the

burden will fall back on the federal government. This amount is roughly equal to the relief fund

for states included in the 2009 fiscal stimulus package.

Refinancing needs for states are relatively low given the long-term nature of most municipal

debt. We estimate that about $200 bn in municipal debt is maturing over the next 12 months,

or 7% of all issues outstanding.

In the worst case scenario, whereby the municipal debt market shuts down completely, the

federal government may have to provide $350 bn in aid. This is equivalent to 2.4% of US

GDP. This would roughly offset the expected improvement in the federal deficit over the next

year.



14/22

American Themes

19 July 20104

How vulnerable is the Treasury market?Unlike Japan, which is facing a chronic savings surplus, the US is facing a chronic savings

deficit. Market mechanisms to resolve this problem are higher bond yields and/or weak

currency. For now, massive portfolio flows into the US are delaying these adjustments andkeeping Treasury yields artificially low. However, the heavy reliance on ongoing purchases is

precisely the reason for our upside bias on Treasury yields.

In our baseline scenario we assume a gradual adjustment toward higher yields and higher

savings rates, offset by a shrinking trade deficit. However, the 2007 episode taught us an

important lesson that we should not become too complacent on the ability of the US economy

to finance its external deficit. In 2007, the main source of financing was the sale of structured

credit assets which came to an abrupt stop. The savings deficit is now being financed via

sales of US Treasury debt which has its own fundamental issues. Indeed, federal government

is facing greater fundamental challenges than state and local governments.

Foreign Private Purchases of US Assets Foreign Official Purchases of US Assets

-20

-10

0

10

20

30

40

50

60

70

95 97 99 01 03 05 07 09

Treasury

Agency

Corp Bonds

Equity

-15

-10

-5

0

5

10

15

20

25

95 97 99 01 03 05 07 09

Treasury

Agency

Corp Bond


Given the ongoing reliance on external financing, we cannot ignore the possibility that foreign

investors might lose confidence in the US government and significantly reduce their

purchases of Treasury debt. It is not clear what might cause such a scenario, but another

bailout for state and local governments could be a potential trigger.

In the event of a municipal debt problem and contagion to the Treasury market, we believe

that the Fed would step in and become a buyer of government paper. To the extent that the

Feds purchases are successful in capping bond yields, the dollar would become the main

adjustment variable.



15/22

American Themes

19 July 2010 15

ConclusionsState austerity is the only sustainable solution to the current budget woes. In this regard, state

and local governments are similar to the troubled EMU members. We see the risk of financial

contagion as less pronounced than in the case of sub-prime mortgages or Greece.

We see a state default as highly unlikely. A rise in municipal defaults is likely and normal

following a deep recession. Higher municipal defaults are expected by the market.

The main risk would be above-normal defaults rates, or defaults occurring in unusual

segments of the municipal market such as general obligation bonds and/or revenue bonds

backed by stronger purposes (utilities, education). This could spook investors and trigger

funding problems for state and local governments. If this occurs, we see the following as the

most likely sequence of responses:

Q The first round of help would likely come from the Federal government rather than theFed.

Another stimulus package with relief funds for local governments.

More direct intervention is less likely, but could occur in the event of a state funding

crisis.

Market impact: There is some risk that Federal support for states might spook foreign

buyers of Treasury debt. This would also weigh on the dollar.

Q In the event of contagion, the Fed would likely step in to support the Treasury market.

Monetization is the end game in this scenario.

Market impact: Fed purchases could cap bond yields, but the dollar would suffer.



16/22

American Themes

19 July 20106

SG Forecasts

Economic forecastsQuar ter ly Annual ized Growth Rates Annual year /year

2008 2009 2010 2011

Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 A A E E

Real GDP 2.2 5.6 2.7 3.2 3.1 2.9 2.6 2.3 0.4 -2.4 3.1 2.7

Real Final Sales 1.5 1.7 0.8 3.0 2.9 2.8 2.6 2.5 0.8 -1.7 1.9 2.6

Consumption 2.8 1.6 3.0 3.3 3.3 3.0 2.6 2.7 -0.2 -0.6 2.6 2.9

Non-Resid Fixed Investment -5.9 5.3 2.2 8.5 8.1 7.6 7.6 5.3 1.6 -17.8 3.2 7.0

Business Structures -18.4 -18.1 -15.5 -10.0 -10.0 -5.0 0.0 0.0 10.3 -19.8 -14.3 -2.3

Equipment and Software 1.5 19.0 11.4 16.0 15.0 12.0 10.0 7.0 -2.6 -16.6 11.8 10.1

Residential 18.9 3.7 -10.3 3.0 5.0 10.0 10.0 10.0 -22.9 -20.5 0.2 8.0

Inventories Chg, % contibut to GDP 0.7 3.7 1.9 0.2 0.2 0.1 0.0 - 0.1 -0.3 -0.6 1.2 0.0

Net Trade, % contri but to GDP -0.8 0.3 -0.8 -0.3 -0.4 -0.5 -0.5 -0.5 0.7 0.9 -0.5 -0.5

Exports 17.8 22.8 11.3 10.0 8.0 6.0 5.5 5.5 5.4 -9.6 12.1 6.2Imports 21.3 15.8 14.8 10.0 9.0 8.0 8.0 8.0 -3.2 -13.9 11.6 8.2

Government Spending 2.7 -1.3 -1.9 0.1 0.1 0.3 1.7 1.6 3.1 1.8 0.1 1.1

Federal Govt 8.0 0.0 1.2 3.3 2.5 2.2 2.0 1.7 7.7 5.2 3.0 2.0

State & Local -0.6 -2.2 -3.8 -2.0 -1.5 -1.0 1.5 1.5 0.5 -0.2 -1.8 0.4

PCE Deflato r 2.6 2.5 1.5 -0.4 1.4 2.0 1.5 1.6 3.3 0.2 1.5 1.6

PCE Core 1.2 1.8 0.6 0.9 1.1 1.2 1.3 1.5 2.4 1.5 1.1 1.3

CPI 3.7 2.6 1.5 -0.8 1.6 2.2 1.7 1.8 3.8 -0.3 1.6 1.7

CPI Core 1.5 1.5 0.0 0.8 1.0 1.2 1.3 1.6 2.3 1.7 1.0 1.3

Unemployment Rate 9.6 10.0 9.7 9.7 9.6 9.5 9.4 9.2 5.2 9.3 9.6 9.1

Personal Income -1.4 2.2 3.9 5.0 4.3 4.4 4.7 4.7 2.9 -1.8 3.2 4.6

Disposable Personal Income -1.2 2.5 3.7 5.5 4.0 3.8 4.1 4.2 3.9 1.0 3.5 4.2

Real Disposable Pers. Income -3.6 0.0 2.1 5.9 2.6 1.8 2.6 2.6 0.5 0.8 2.0 2.6

Savings Rate 3.9 3.7 3.5 3.9 6.8 3.6 3.5 3.5 2.7 4.2 4.5 3.4

Corp Profits 50.7 36.0 35.9 8.6 12.4 15.0 10.8 8.1 -11.8 -3.8 25.9 10.9

2010 E 2011 E2009 A

Source: BEA, SG Cross Asset Research

Rates and FX forecastsCentral Bank Rate Forecasts current 3 mths 6 mths 9 mths 1 yr

US 0.25 0.25 0.25 0.25 0.50

Canada 0.50 0.50 0.75 1.25 1.75

10 year bond yields current 3 mths 6 mths 9 mths 1 yr

US 2.95 3.00 3.25 3.50 4.00

Canada 3.17 3.25 3.50 4.00 4.50

FX rates current 3 mths 6 mths 9 mths 1 yr

USD per EUR 1.30 1.20 1.20 1.15 1.10

USD per GBP 1.53 1.50 1.52 1.50 1.50

CAD per USD 1.05 1.00 0.98 0.96 0.95

J PY per USD 87.0 90.0 92.0 94.0 96.0 Source: SG Cross Asset Research

The US economy lost some

momentum since late springand we have recently

downgraded our 2010

forecast form 3.8% to 3.1%.

The reasons for the

slowdown are totally clear,

but may reflect a combination

of expiring stimulus programs

and some spillover effects

from the European debt

crisis. We still see the odds

tiled towards sustaining the

recovery, albeit at a slowerpace than previously thought.

The consumer is still

supported by decent income

gains and the capex cycle

remains underpinned by

strong profit growth.

However, confidence remains

shaky. The inventory cycle is

coming to an end and adds

to the overall economic

slowdown. Lastly, fiscal

stimulus is peaking andthough the fiscal drag should

be gradual, it is nonetheless

no longer adding to growth.

The upcoming tax increases

at the local and federal level

are the key reason for our

below-consensus 2011

forecast.

The downside risks on

growth and inflation suggest

that the Fed should remainon hold through mid-2011. In

the context of steady Fed

policy, we see limited upward

pressure on bond yields over

the next 6 months. Longer,

term, a sustained recovery

should start to push bond

yields higher, particularly as

the Fed signals tightening.



17/22

American Themes

19 July 2010 17

SG Proprietary IndicatorsSG Business Cycle Index

-15

-10

-5

0

5

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

-6

-4

-2

0

2

4

6

SG US B usiness Cycle Index (LHS)

GDP , 2 qtr moving average (RHS)

SG Real-Time Recession Probabil ity Model

Real-time recession pro babilities are derived from a regime switching model using the same fo ur coincident indicators used by NBER cycle

dating co mmittee. These include: employment, real income, real sales (retail + business) and industrial productio n

-

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

NBER recessions

Modeled Rec. Prob

Probability derived from a probit model based on employment, core inflation, ISM index and a liquidity index

Historical Perspective - 6 month ahead probability

SG Fed Mod el

Rate Cut Probability Rate Hike ProbabilityLatest Probabilities

15%

40%

63%72%

0%

20%

40%

60%

80%

100%

3M 6M 9M 12M

probability of at least one rate cut w ithin the next 3,6, 9 and 12 months

0% 0% 1%5%

0%

20%

40%

60%

80%

100%

3M 6M 9M 12M

Probability of at least one rate hike

within the next 3, 6, 9 and 12 months

0%

20%

40%

60%

80%

100%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

rate cuts

Probability of at least one rate cut within next 6 months

0%

20%

40%

60%

80%

100%

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

rate hikes

Probability of at least one rate hike within next 6 months

Source: SG Economic Research

Our Business Cycle index

suggests that the economy

is slowing from 4% pace in

Q4-Q1 towards 2% pace.

This is above our current

GDP forecasts and

suggests further downside

risks. However, some of

the recent weakness

reflects movements in

financial variables which

could bounce back. High-frequency economic

indicators have stalled, but

are not showing renewed

deterioration. Overall, the

BCI is consistent with a

loss of momentum, but

argues against a double-

dip scenario.

Our real-time recession

tracking model now

updated through May

shows very slim chances

that the economy is

entering recession.

Our fundamentally-derived

Fed probability models

show slim chances that the

Fed will be hiking rates in

the next 12 months,

although the chances of

additional rate cuts (read:

additional easing) have

been fading. the Fed has

opened the door for a

possible resumption of

quantitative easing, but the

economy would have to

deteriorate much further

before the Fed takes such

a step.



18/22

American Themes

19 July 20108

Rates and Short-term FundingFed Funds Expectations

Real Treasury Yields

A1/P1 Nonfin CP vs. OIS (3m)

Inflation Expectations

Treasury Yiel d Curve (10y - 2y)

Short Term Funding

ABCP vs. OIS (3m)

Rates

Libor vs. OIS (3m) - Historical and Impl ied

0.00

0.25

0.50

0.75

1.00

7/10 9/10 11/10 1/11 3/11

%

Latest

Week ago

Month ago

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1/09 4/09 7/09 10/09 1/10 4/10 7/10

-0.2

-0.1

0.0

0.10.2

0.3

0.4

0.5

1/09 4/09 7/09 10/09 1/10 4/10 7/10

0.0

0.5

1.0

1.5

2.0

2.5

1/09 4/09 7/09 10/09 1/10 4/10 7/10

5yr real

10yr real

1.0

1.5

2.0

2.5

3.0

3.5

1/09 4/09 7/09 10/09 1/10 4/10 7/10

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1/09 4/09 7/09 10/09 1/10 4/10 7/10

10yr breakeven

5yr 5yrs forward

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

J an-

07

Apr-

07

J ul-

07

Oct-

07

J an-

08

Apr-

08

J ul-

08

Oct-

08

J an-

09

Apr-

09

J ul-

09

Oct-

09

J an-

10

Apr-

10

J ul-

10

Oct-

10

%

Source: Bloomberg, SG Economic Research

Market expectations for

rate hikes have been

pushed back notably over

the past two months.

Double-dip concerns and

renewed deflation fears

have triggered bullish

flattening of the Treasury

yield curve. Inflationbreakevens have declined

to lowest levels since

October 2009.

Funding pressures tied to

the European sovereign

crisis have eased

somewhat, but funding

spreads remain

significantly above April

levels.



19/22

American Themes

19 July 2010 19

Credit AvailabilityMortgages & Consumer CreditConformi ng Mortgage Rate

ABX AAA Tranches

Corporate Credit

Swap Spread (10yr)

HY Spreads(Lehman HY - 10yr Swap)

Inv Grade Corp SpreadDJ Inv Grade CDX Index

Sector CDS Spreads

Fannie/Freddie MBS Spreads

Consumer ABS Spreads

0.40

0.80

1.20

1.60

1/09 4/09 7/09 10/09 1/10 4/10 7/10

Fannie/Freddie M BS vs. swap

20

30

40

50

60

70

80

90

100

1/08 7/08 1/09 7/09 1/10 7/10

index 2006-12006-2

2007-1

2007-2

3.0

3.5

4.0

4.5

5.0

5.5

6.0

1/09 4/09 7/09 10/09 1/10 4/10 7/10

30yr Fannie MB S

30yr Conforming Mortgage Rate

0

200

400

600

800

1000

1200

1/09 4/09 7/09 10/09 1/10 4/10 7/10

bpcredit cards

autos

0

50

100

150

200

250

300

1/09 4/09 7/09 10/09 1/10 4/10 7/10

-20

-10

0

10

20

30

40

50

1/09 4/09 7/09 10/09 1/10 4/10 7/10

600

800

1000

1200

1400

1600

18002000

2200

1/09 4/09 7/09 10/09 1/10 4/10 7/10

0

50

100

150

200

250

300

350

400

450

1/09 4/09 7/09 10/09 1/10 4/10 7/10

Financials

Industrials


The European sovereign

crisis and US double-dip

concerns have triggered a

rotation to safe haven

assets and away from risk.

Among risky assets,

equities have been hurt the

most. Corporate credit has

been a bit more resilient, in

part helped by declines ingovernment bond yields.

Mortgages have benefited

the most. The 30yr fixed

conforming rate has

dropped to around 4.9%,

matching the lows

registered in 2003. This is a

silver lining that offers

some offset to the adverse

impact of tighter financial

conditions.



20/22

American Themes

19 July 20100

FX MonitorDollar Major Dollar Inde x

USD/EUR

Carry Trade Index

FX Volatili ty (G10 avg)

JPY/USD

Carry-to-Risk Ratio

Yield Differential

Implied Vol

5

10

15

20

25

30

1/09 4/09 7/09 10/09 1/10 4/10 7/10

70

72

74

76

78

80

82

84

86

88

1/09 4/09 7/09 10/09 1/10 4/10 7/10

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

99 00 01 02 03 04 05 06 07 08 09 10

%

+/- 1St Dev range

More

attractive

Less

attractive

1.0

2.0

3.0

4.0

5.0

6.0

00 01 02 03 04 05 06 07 08 09 10

5

15

25

35

00 01 0 2 03 04 05 0 6 07 0 8 0 9 10

100

110

120

130

140

150

160

170

1/00 7/00 1/01 7/01 1/02 7/02 1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10 7/10

80

85

90

95

100

105

1/09 4/09 7/09 10/09 1/10 4/10 7/10

1.1

1.2

1.2

1.3

1.3

1.4

1.4

1.5

1.51.6

1/09 4/09 7/09 10/09 1/10 4/10 7/10


The dollar has benefited

from the European

sovereign crisis, but

recently gave back some

of those gains. The

reversal reflects a rotation

of economic fears from

Europe to the US. The data

has been weak in the US

while large European

economies are benefiting

from the weak currency.

Additionally, there is a

sense that European

policymakers are finally

addressing some of the

institutional weaknesses

that have led to the crisis

(EFSF, ECB purchases of

sovereign debt, bank

stress tests).

Over the next 12 months,

we see the dollar gaining

further as the US avoids a

double-dip recession while

the European periphery

continues its struggle with

austerity.



21/22

American Themes

19 July 2010 21

Commodities and EquitiesCrude Oil (Nymex WTI)

Copper

Consumer Staples -0 .2%

Utilities -0 .7%

Telecom -2 .7%Health Care -3 .7%

IT -4 .3%

Materials -4 .6%

Financials -4 .9%

Industrials -6 .4%

Energy -6 .9%

Consumer Discretionary -8 .7%

VIX

GoldCommodities

Volatility Skew(25 delta put - 25 delta call, SPX Index)

Sector Performance - 4 wk chg

Equities

Baltic Dry Index

20

40

60

80

100

1/09 4/09 7/09 10/09 1/10 4/10 7/10

500

600

700

800

900

1000

1100

1200

1300

1/09 4/09 7/09 10/09 1/10 4/10 7/10

0

10

20

30

40

50

60

1/09 4/09 7/09 10/09 1/10 4/10 7/10

0

2

4

6

8

10

12

14

16

18

1/09 4/09 7/09 10/09 1/10 4/10 7/10

0

50

100

150

200

250

300

350

400

1/09 4/09 7/09 10/09 1/10 4/10 7/10

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1/09 4/09 7/09 10/09 1/10 4/10 7/10


European austerity,

double-dip fears in the US

and growing concerns on

China have created a

difficult backdrop for

commodities. Aside from

double-dip fears, the

global inventory cycle is

coming to an end now that

production has converged

to demand. This by itself

has reduced demand for

commodities.

While we may not see a

resolution to the above

concerns in the near-term,

we believe that the global

economy will ultimately

overcome the headwinds

and avoid a double-dip.

Sustaining the globalrecovery should underpin

commodity demand and

be supportive for risk

appetite.



22/22

American Themes

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