Current edition contains:

A COUPLE OF NOTES ON EUROPE

1
The house of cards is slowly falling down.
AUSTERITY IN US NEEDED AS WELL
2
Public finances in US do not look much better than in Europe.
IS IT TIME TO START BUYING CHINESE SHARES?
3
Chinese shares are back to very appealing valuations.
MEXICAN PESO IS OFFERING SOME VALUE
4
Improving non-oil trade balance of Mexico gives hopes for appreciation.
BRUTAL CORRECTION OR BACK TO BEAR MARKET?
5
Volatility is at extremes again and memories of 2008 are returning.

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1) A COUPLE OF NOTES ON EUROPE

Like every single month, it is hard not to mention the tragic and pathetic situation in Europe. Shorting Spanish banks,
the strategy we recommended last month, turned out to be quite profitable. And surprisingly, the banks in Spain
managed to hit new lows even after the EUR 750bn rescue package was announced. As far as recent data are
concerned, core inflation in Spain turned negative for the very first time in many years, public wages, pension hikes
and baby bonuses were scrapped. Savings banks get nationalized. It is austerity time. Portugal started to tax banks’
profits. France, a country that ran budget deficits for 39 years, finally woke up and looks for cuts as well. With
governments trying to improve their budgetary image, we look at numerous aspects that may shape investors’
decisions. Let us mention some of them:

a) Will banks in strong parts of Eurozone turn into goldmines?

Given the steepness of yield curve across European nations, the effective guarantee from ECB and bailout packages,
the banks in stronger nations could play a carry game for some time. Let us be more specific. ECB decided that it will
keep accepting Greek debt as collateral for liquidity operations despite its junk status. So the European banks holding
Greek debt can cash in high interest from these bonds without any serious impact on their balance sheet. Secondly,
the EU rescue package should keep funding Greek debt for at least next few years. What a paradox. Did the same
bankers who piled up their balance sheets with subprime mortgages stuff their books with Greek debt again? Will
those who did not do their homework and bought junk Greek government debt be saved once again? We can be
pretty sure that in coming quarters, banks will post “unexpected” trading gains (well, we should say carry gains).
Now, the question is whether governments will secretly let banks recapitalize or will they tax the carry profits as
Portugal or Britain did? Will shareholders see any benefits from these carry gains or will capital adequacy ratios be
raised so that the capital stays in banks and gets not distributed to shareholders through dividends?

b) Will we experience the European paradox of thrift?

We already know that consumers across Europe are either in a deleveraging mode or do not want to add any
additional debt in today’s turbulent times. So the government is the debtor of last instance. Wait, but are not the
public budgets currently under an epic pressure and scrutiny from the bond vigilantes? If all sectors of the economy
deleverage at once, we are effectively decreasing the amount of money in the economy, which is profoundly
deflationary. We just want to suggest that ECB should finally stop hiding behind cheap talks and start its printing
presses in earnest. As a matter of fact, it may be already doing so secretly. Despite the fact it went on with the
sterilization of government purchases, its other channels of pumping liquidity into market through medium-term and
long-term refinancing operations are running at full speed. In reality, it does not really matter whether ECB buys
government bonds outright in the market or commercial banks do so and immediately turn to ECB for super-cheap
funding. ECB should be creating new money and ECB should print. If it does not do so, Europe will sink into
deflationary spiral. Just watch the core CPI trend dangerously below 1% in Europe. With each year of government
austerity, ECB should stay very accommodative. Thus it may not be completely dumb idea to buy EURIBOR futures
with maturity as long as December 2012. At least if you believe Europe is set to fall into second recession and 3
month interbank lending will remain lower than 2%.

© ATWEL International, s.r.o. www.atwel.com Page 2

 c) It matters how you balance the budget

The public sphere is rotten to the bone. Wherever you look, you see wasteful spending on infrastructure that will
hardly ever repay itself. You see a lot of services provided by government that could be taken over by private sector
and done in a more cost-efficient way. Efficiency of governments is simply very mediocre. Then does not it make
sense for government to give up on providing certain services and reduce its deficit by cutting costs, rather than start
increasing taxes? We believe so. One should carefully watch for states that decide solving its problems by taxing and
redistributing more as these states will most probably suppress its long-term potential growth. On the other hand, if
countries succeed getting rid of the embedded socialist welfare state, then Europe could truly go through its cultural
revolution and rejuvenate itself.

d) What about Greece?

Greece is clearly the weakest party in the game. According to IMF predictions, the general government debt should
reach as much as 150% by 2013, when the government is supposed to be running primary balance surpluses and
annual interest payments will constitute 8% of GDP. From this point on, Greek should be already paying down the
debt. Does IMF really believe that? Well, we do not and even the CEO of Deutsche Bank has serious doubts that
Greek debt will be repaid. We were recently told that the word “default” is not in the vocabulary of European
officials. Do not let get yourself fooled. Four months ago, we were told Greek debt would not be allowed as collateral
at ECB. Talk is cheap.

Now the question is how do you take patient off the drugs? Private capital in Europe has been partying on the back
of public expenditures. And with fiscal austerity, prospects for economic growth in Europe are diminishing.
Unfortunately, in Europe we are trying to save everyone – savers, investors, government, it is not possible to save
everyone. At some time, somebody has got to take the pain. And Europe can’t solve the problem of too much debt
by adding yet more debt. Greece is insolvent, and some of its peers aren’t in much better shape. That’s a far bigger
worry for bondholders than any short-term cash-flow issues. How about Germany? Will it retain its AAA status when
it is guaranteeing debt for everyone? It remains to be seen whether the rating companies, which are under almost
daily regulatory threat from European governments for finally doing their job and downgrading weak borrowers,
have the backbone to follow through on this logic. Or will these agencies be replaced by a European rating agency
that gives an AAA sticker to everyone? Risks are running high. At the beginning of the year, we wanted to be net
buyers at market corrections, but the speed of structural deterioration in Europe is scaring us. Fortunately in the
investment industry, you get rewarded for worrying.

© ATWEL International, s.r.o. www.atwel.com Page 3

2) AUSTERITY IN UNITED STATES NEEDED AS WELL

The fiscal situation in Europe is refueling questions on sustainability of US public deficits, especially in the light that
Europeans started acting vigorously and US has not. Is US on the path to European destiny? We do not believe so,
but also want to stress out that fiscal reform is necessary and it will be painful. US has been running overall public
debt (Federal + State + Local authorities) of around 70% of GDP by the end of 2009. That stands in comparison with
80% that is calculated for EU-16.

Fortunately, the US is not in a position where it has to start immediately decreasing its deficits rapidly as some
European countries do. First, the US Treasuries are still considered safe heaven, with yields hitting 3.17% and
allowing for cheap debt refinancing. Secondly, any swift adjustment in the spending cuts would undermine the
ongoing recovery.

We believe the adjustment of federal budget in US will take many years and will be only gradual. In the near term,
the forces that will help the adjustment are as follows: a) Fiscal stimulus will be gradually drawn down, some
programs like unemployment benefits will have to be, however, extended; b) Financial sector does not need similar
support as in 2009 when it constituted 17% of budget deficit. GSEs will however need to be supported well beyond
2011; c) Tax cuts on capital gains and some dividends are likely to be let expire; d) Voices to freeze certain
discretionary spending are becoming more vocal in Washington and we can expect certain small programs to be cut
down on.

These policies alone, however, can get the US budget only so far. Estimates suggest the deficits may drop by 4-5
percentage points within three years, still leaving budget deficits of 4%. That is still too bad, debt needs to start being
repaid, not accumulated. This structural budget deficit is a pure reflection of unsustainable Medicare and Medicaid
programmes. As a matter of fact, without any significant changes to Medicare or Medicaid, Congressional Budget
Office estimates that federal budget would start deteriorating again around 2018.

US, Budget Deficit as % of GDP

percentage points
4

-2

-4

-6

-8

-10

-12
68 72 76 80 84 88 92 96 00 04 08 12 16

US, Budget Deficit as % of GDP

© ATWEL International, s.r.o. www.atwel.com Page 4

As problems need to be solved at its core, the health care sector remains the most vulnerable one. It is responsible
for most of the deficits and needs to be tackled soon. Public opinion unfortunately suggest only tiny percentage of
population gives any support to cuts in the field of Medicare. Health care companies in US remain trading at
significant discount at estimated FY10 P/E ratios of 10, compared to overall market estimated FY10 P/E ratios of 13.
Companies, that are, however, capable of delivering new products at lower costs or specialize at streamlining
healthcare services, could do exceptionally well.

© ATWEL International, s.r.o. www.atwel.com Page 5

3) IS IT TIME TO START BUYING CHINESE SHARES?

Despite China remains one of the fastest growing economies out there, the Shanghai A-Shares Index has entered
into a bear market. A-Shares Index has already lost 23% from its local peak of 3650 points that was hit in August 09.
Such a move is a pure reflection of several forces: a) worries about the property market as the government tries to
cool off speculative buying; b) continuous monetary tightening from the central bank in terms of rising reserve
requirements; c) raising capital by major banks to the extent of RMB300bn sponging up any excess capital; and d)
USD is on the rise which has been historically bad for emerging Asia.

Contrary to these negative forces, current valuation of Chinese shares is becoming ever more appealing. Earnings for
2009 have already exceeded the earnings peak of 2007 which means a contraction in the PE multiple is occurring.
Price to earnings ratio dropped to multiple of 20 and for the full year of 2010 is expected to be down to 15. That is a
multiple we have not seen in China for quite some time and that is quite cheap for a country with a structural growth
of 8%. These are certainly very good news for any value investor. But for now, the strong corporate earnings clearly
do not have any power to move the stocks upwards.

Actually we worry, that value investors may stay locked in the value trap for some more time. Historically, equity
market speculation has been driven by cash savings deployment. As we know, property market is now ever more
financed by debt, thus there is a diminishing pool of money that can be piled into the equity market. With the risks
of inflation, the central bank is not likely to get seriously accommodative anytime soon, so we will probably have to
wait for P/E ratios to drop even further before value gets so enticing that more people jump into the markets.

Unlike us, who are in the patient mode before deploying funds into Chinese shares, there are people like Jim Chanos,
who are outright short China. Well, to be correct, shorting the property sector. On the back of this theme and
especially given the weak present fundamentals of commodities, we were able to make a profitable trade shorting
copper and nickel, exploiting the 20% fall (see our last edition from last month). But apart from that we are not China
bears and we think consumption in China will easily keep growing throughout next few years, if not decade. Property
and consumption in China is simply not deeply interlinked as in US because the financial system in China is still in its
infancy and mortgage equity withdrawals are very rare. Rising property prices only create a wealth effect that pushes
consumption forward, but we believe this is more than offset by rising wages both in urban and rural areas.

The fact that new marginal houses in China are financed increasingly by debt (at double rate compared to 2003-2009
average) increases the inherent risk in the system. Property developers in China have been doing extremely poorly in
past few months. After measures were taken to crack down speculation, sales in large cities reportedly fell by as
much as 30%. We certainly will, and also suggest it to other investors, follow various indicators on the health of
Chinese property market, i.e. pricing, construction, and sales volume.

© ATWEL International, s.r.o. www.atwel.com Page 6

© ATWEL International, s.r.o. www.atwel.com Page 7
4) MEXICAN PESO IS OFFERING SOME VALUE
Mexican Peso underwent a sharp correction, together with most other emerging market currencies and risky assets.
But for those who are willing to add some risk to their portfolio and take some carry, we do like Mexican Peso as it is
a good play on US economy and growth in Latin America and believe it’s fair value stands close to 12 rather than
current 13 USD/MXN.

USD/MXN
exchange rate
16

15

14

13

12

11

10

8
02 03 04 05 06 07 08 09 10

Mexico’s proximity to the US is a key competitive advantage due to low cost of transport and short supply time
spans. As the employment in US slowly recovers and personal income rises, Mexico should do well in terms of its
exports. United States are virtually Mexico’s sole trading partner, absorbing 80% of Mexican total exports and 90% of
its manufacturing exports. In the last quarter, Mexican economy took off echoing rebound in manufacturing and
consumption north of the border. Mexican GDP grew by 4.3% y/y, about 0.3% above expectations. Potential growth
in Mexico could be as high as 5% but without addressing structural weakness, it will most probably remain at around
3.5%. The investment rate is relatively low (20.6% of real GDP in 2000-09 on average) by emerging markets
standards, notably compared with Emerging Asia.

Mexico enjoys relatively solid political institutions and solid protection of intellectual property, thus we wonder why
imports of capital goods have slowed down recently. Mexico needs higher investments and scale up transfers of
higher value-added capital goods that will help it compete with Asian trade rivals. Mexico’s long term growth
potential is also strained by the still mediocre quality of its human capital and infrastructure, rigid job market, and
domination of public and private monopolies undermining competition.

© ATWEL International, s.r.o. www.atwel.com Page 8

 Mexico, Capital Goods Imports
million USD
4 000

3 500

3 000

2 500

2 000

1 500

1 000

500

Mexico, Capital Goods Imports

Public sector budget is more or less in balance and boasts relatively low indebtedness. Public external debt
accounted for just 7% of GDP at the end of 2008. The government has however failed to address the crucial issues of
budgetary dependence on oil revenues (35% of total revenue comes from oil). The government is trying to increase
its tax base standing just at about 10% GDP, but we believe it would be more then welcomed if it opened up its oil
industry to foreign competition. The fiscal deficit is expected at MXN 96bn or 0.75% of GDP next year, which is quite
comforting compared to woes of European budgets.

In terms of the external position, we believe Mexico is on a sustainable path. The current account deficit stands at
around 1% of GDP and can be easily financed by portfolio inflows and external loans. What we especially like is the
non-oil trade balance being on the mend since mid 2008, which is very supportive for the Peso.

Mexico, Non-Oil Trade Balance

million USD
0
-1 000
-2 000
-3 000
-4 000
-5 000
-6 000
-7 000
-8 000
-9 000

Mexico, Non-Petroleum Trade Balance

Going forward, unless the situation in risky assets escalates, we foresee a move in the exchange rate towards 12
USD/MXN level. Any further appreciation would require structural reforms from the Mexican government. Waiting
for our target, we will get paid about 5% p.a. carry.

© ATWEL International, s.r.o. www.atwel.com Page 9

5) BRUTAL CORRECTION OR BACK TO BEAR MARKET?

Whether markets are just going through a brutal correction or whether bear market is striking back, we will
unfortunately know only in the hindsight. Over the summer months, we will revise our semi-annual outlook, but
going through the data each day, we seem to be running out of positive catalysts. Governments in Europe are forced
by markets to close their funding gaps, which brings down aggregate demand. American data are still strong, yet the
stimulus in housing is over and pace of growth is slowing down. Chinese are afraid of over stimulating so we cannot
count on any additional measures from their side. And recent fears from North Korea completely killed most of risk
appetite.

Current equity valuation points out to an earnings yield of 8% (inverse P/E); while 30Y BAA corporate bonds yield
around 6%. With cash yielding next to nothing, it would seem reasonable to be overweight equities. Unfortunately,
the risk indicators advise us to be a little bit more patient.

a) Implied volatility at extreme highs

VIX, the measure of implied volatility in the markets, reached as high as 50 last week and now settled back to about
38. Such spike may seem as interesting buying opportunity, but short-term funding markets show more warnings
signs.

© ATWEL International, s.r.o. www.atwel.com Page 10

b) 3M USD Libor still climbing up

The difference between 3M Libor (how much banks charge for lending each other money for three months) and
overnight lending, is creeping higher. That shows low confidence among banks, especially so in Europe, where banks
are holding a lot of junk Greek government bonds and nobody knows what will the rules look like tomorrow.
Before VIX and Libor-OIS spread start reversing down, we will not be inclined to meaningfully add to our long
position. On the other hand, unlike in 2008, real corporate bond yields are still drifting downwards which means
companies with access to capital markets can fund themselves still very cheaply. Copper has also stabilized and did
not participate in last weeks of carnage.

Disclaimer

This document is being issued by ATWEL International s.r.o. (Company), which is a financial intermediary registered with Czech National Bank.
Company provides this document for educational purposes only and does not advise or suggest to its clients or other subjects to buy or sell any
security traded at financial markets, despite the fact such security may be mentioned in this material. Company is not liable for any actions of a
client or other party that are based on the opinions of the Company mentioned in this material.

Trading and investing into financial instruments bears a high degree of risk and any decision to invest or to trade is a personal responsibility of
each individual. Client or a reader understands that any investment or trading decisions that he or she makes is a decision based on his or her will
and he or she bears responsibility for such action.

Educational methods of the Company do not take into consideration financial situation, investment intentions or needs of other persons and
therefore do not guarantee specific results. Company and its employees may purchase, sell or keep positions in shares or other financial
instruments mentioned in this material and use strategies that may not correspond to strategies mentioned in this material.

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