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Citadel Us Outlook

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CITADEL CONFIDENTIAL INFORMATION SUMMARY The macro outlook has improved. We expect approximately 3.5% real GDP growth in the U.S. next year. The combination of strengthening labor market conditions, improved household balance sheets and greater clarity on the tax policy should trigger an improvement in consumer spending. Business spending should be robust as well. Profits continue to grow at a healthy pace and the capital stock has not grown in over two years. The not-so-good news is that there are still several structural headwinds weighing on the economy. Home prices are still deflating, households are still deleveraging and state and local governments are set to implement austere measures next year. For now, these headwinds are slowing the pace of the recovery rather than reversing the trend. Downside risks include a policy mistake (e.g. higher taxes at the state level without entitlement reform), a financial shock (e.g. sovereign defaults in peripheral Europe) or a supply shock (e.g. spike in oil). Upside opportunities include a material improvement in business confidence triggering more hiring than expected and a turn around in housing activity which remains extremely depressed. CONTACT Ron Wexler Citadel Asset Management 131 South Dearborn Street Chicago, Illinois 60603 312-395-3948 ron.wexler@citadelgroup.com 2011 U.S. Outlook: A Return to Trend Growth Ron Wexler, Macro Analyst Last year, our 2010 year-ahead outlook piece was entitled, “A Glimmer of Sunshine With a Chance of Rain”. This year, the outlook is more optimistic. As we head into the New Year, we expect stronger growth and less uncertainty as the year progresses. Although there is no shortage of things to worry about, in comparison to last year, there appears to be less downside risk. That is the good news. The not-so-good news is that even if this view of the world comes to fruition, it will do little to meaningfully lower the unemployment rate or dramatically increase capacity utilization rates. Chart 1: We expect stronger growth in 2011 0% 10% 20% 30% 40% 50% 60% 70% Less than 2.5% 3.5% +/-.5% >3.5% Probability Growth Scenarios 2011 U.S. Real GDP Outlook Chart 2: With less downside risk than in 2010 0% 10% 20% 30% 40% 50% 60% 70% Less than 2% 2.5% +/-.5% >3% Probability Growth Scenarios 2010 U.S. Real GDP Outlook
Transcript
Page 1: Citadel Us Outlook

CITADEL CONFIDENTIAL INFORMATION

SUMMARY

The macro outlook has improved. We expect approximately 3.5% real GDP growth in the U.S. next year.

The combination of strengthening labor market conditions, improved household balance sheets and greater clarity on the tax policy should trigger an improvement in consumer spending.

Business spending should be robust as well. Profits continue to grow at a healthy pace and the capital stock has not grown in over two years.

The not-so-good news is that there are still several structural headwinds weighing on the economy. Home prices are still deflating, households are still deleveraging and state and local governments are set to implement austere measures next year.

For now, these headwinds are slowing the pace of the recovery rather than reversing the trend.

Downside risks include a policy mistake (e.g. higher taxes at the state level without entitlement reform), a financial shock (e.g. sovereign defaults in peripheral Europe) or a supply shock (e.g. spike in oil).

Upside opportunities include a material improvement in business confidence triggering more hiring than expected and a turn around in housing activity which remains extremely depressed.

CONTACT

Ron Wexler Citadel Asset Management 131 South Dearborn Street Chicago, Illinois 60603 312-395-3948 [email protected]

2011 U.S. Outlook: A Return to Trend Growth Ron Wexler, Macro Analyst

Last year, our 2010 year-ahead outlook piece was entitled, “A Glimmer of Sunshine With a Chance of Rain”. This year, the outlook is more optimistic. As we head into the New Year, we expect stronger growth and less uncertainty as the year progresses. Although there is no shortage of things to worry about, in comparison to last year, there appears to be less downside risk. That is the good news. The not-so-good news is that even if this view of the world comes to fruition, it will do little to meaningfully lower the unemployment rate or dramatically increase capacity utilization rates.

Chart 1: We expect stronger growth in 2011

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Chart 2: With less downside risk than in 2010

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 2

So What Has Changed?

1. Household balance sheets have improved. Earlier this year, the Bureau of Economic Analysis conducted their annual benchmark revisions and revealed that the household savings rate was indeed much higher than initially reported (charts 3 & 4). In fact, it appears that households were de-leveraging more quickly than originally believed and were able to reduce their debt service ratios to more manageable levels (chart 5). As a result, the risk of a material up-tick in the savings rate (which hurts consumer spending) has diminished (chart 6). With the labor market gradually improving, assets reflating, consumer confidence on the mend, labor income rising and greater clarity on the tax policy front, the outlook for consumer spending (70% of the economy) has materially improved.

Chart 3: The savings rate was higher than originally thought

Chart 4: After revisions, savings were ~$200B higher per year

Personal Saving Rate (After the Revision)SAAR, %

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1009080706Sources: Bureau of Economic Analysis /Haver Analytics 12/19/10

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Chart 5: Households spent 2010 paying down debt

Chart 6: Higher asset values = less need to increase the savings rate

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10050095Source: Federal Reserve Board /Haver Analytics 12/19/10

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CITADEL CONFIDENTIAL INFORMATION 3

2. Personal income growth has accelerated. The most important driver of consumer spending is labor income. Labor income can increase because individuals receive pay raises, work longer hours or because more people are employed. In 2010, we actually observed an improvement on all three fronts (chart 7). Through November, 1.2 million private sector jobs were created in 2010, the work week lengthened from 33.8 hours to 34.3 hours and average hourly earnings increased by $0.37 / hour. Private sector labor income (number of bodies, multiplied by hours worked, multiplied by wages) is currently growing at a respectable 4% annualized pace and should continue to improve as we head into next year. Additionally, with announced layoffs at lower levels, jobless claims should decline in 2011 (chart 8). The combination of better labor income and fewer layoffs should trigger both improved confidence and an improvement in spending patterns.

Chart 7: Labor Income is improving Chart 8: Announced layoffs are down. Jobless claims to follow.

Income Proxy = Total Private Payrolls * Avg Weekly Earnings

(Billions)

1110090807Source: Haver Analytics 12/19/10

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Challenger, Gray & Christmas: Announced Job Cuts, Total

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Unemployment Insurance: Initial Claims, State ProgramsSA, Thous [RHS]

10050095Sources: CGCI, DOL /Haver 12/19/10

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3. Corporations had a great year and are on pace to make $1.6 trillion in 2010 (chart 9 & 10 on the next page). Although capex improved this year, the increase was modest relative to profits (chart 11 on the next page). As a result, we saw a material build up in cash balances, now totaling $1.9 trillion1. From a corporate finance perspective, one would expect resources to be more efficiently deployed (cash balances are earning close to 0% while return on equity is close to 8%). With uncertainty slowly subsiding, CEO sentiment picking up again, bank credit standards easing and profits continuing to grow at a healthy pace, corporations are likely to start deploying their excess cash balances more efficiently next year. Historically, this combination of constructive corporate fundamentals has been associated with strong capex recoveries and solid hiring growth (chart 14 on the next page).

1 Through Q3:2010 corporate cash balances were approximately 7% of assets. The historical norm, according to our calculations, is in the 4-5% range.

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CITADEL CONFIDENTIAL INFORMATION 4

Chart 9: Strong net cash flow + tentative spending = …

Chart 10: … very high cash balances

Corporate Net Cash Flow with IVA

SAAR, Bil.$

10050095Source: Bureau of Economic Analysis /Haver Analytics 12/19/10

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100500959085807570Source: Federal Reserve Board/Haver Analytics 12/19/10

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Chart 11: Profits have grown a lot faster than capex Chart 12: ROE now north of 8%

Before Tax Profits / Fixed Investment

100500959085807570Source: Haver Analytics 12/19/10

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100500959085807570Source: Haver Analytics 12/19/10

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Chart 13: The capital stock has not grown in 2 years Chart 14: Capex has picked up, will payrolls follow?

Nonfarm Nonfinancial Corporate Assets: Equip & Software [Hist Cost]NSA, Bil $

Industrial CapacitySA, Percent of 2007 Output

100500959085807570Sources: Federal Reserve Board /Haver Analytics 12/19/10

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100500959085807570Sources: BEA, BLS /Haver 12/19/10

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CITADEL CONFIDENTIAL INFORMATION 5

4. Credit conditions have eased. 2010 was a very solid year for the financial sector. Profits roared back and returned to 2004 levels. Moreover, both delinquencies and charge-off rates started to decline (charts 15 & 16). By year-end, banks were actually easing lending standards for the first time in three years, and in the past, more lenient credit standards have preceded a pick-up in economic activity by approximately one year (charts 17-19). The implied magnitude of the improvement (in economic activity) should not be taken too literally, but it is worth noting that credit conditions should change from a headwind to a tailwind next year. While the demand for credit is currently anemic, when the labor market has recovered following a recession, the demand for credit typically follows suit (chart 20 on the next page). After two years of de-leveraging, if there is a gradual increase in credit demand, final demand could end up surprising to the upside in 2011.

Chart 15: Profits in the financial sector surged this year

Chart 16: Charge-offs and delinquencies declined

Corporate Profits with IVA & CCAdj: Financial

SAAR, Bil.$

151005009590858075Source: Bureau of Economic Analysis /Haver Analytics 12/19/10

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Chart 17: Lending standards eased pointing to more inventory investment…

Chart 18: … more commercial real estate investment

Banks Tightening C&I Loans to Large Firms [1 Year Lead - LHS]Scale Inverted

Manufacturers' Inventories: Durable Goods (RHS)% Change - Year to Year EOP, SA, Mil.$

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 6

Chart 19: … more consumer spending Chart 20: If job growth improves so will the demand for credit

Banks Willingness to Lend to Consumers [2 Qtr Lead -LHS]%

Real Personal Consumption Expenditures [RHS]% Change - Year to Year

100500959085Sources: FRB, BEA /Haver 12/19/10

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5. Less uncertainty. At the beginning of 2010, many investors were concerned that the economy would roll over due to a litany of structural headwinds. Household balance sheets were damaged and the expectation was that the savings rate (then at 3.7%) would increase to 8-10%. The banking system was impaired and not lending, the housing market was still deflating, there were concerns that overly burdensome regulations were looming, and no one had any visibility on whether the Bush tax cuts would be allowed to expire. Fast forward 12 months and the list of concerns have decreased. A tax deal has been reached and was more stimulative than anyone initially expected. The savings rate is no longer rising, the financial sector continues to grow at a robust pace, credit standards are in the process of being relaxed, and although there is still some uncertainty about the contents of the health care and financial bills, both could have been more punitive. At the margin, there is greater visibility than last year, and this should lead to higher confidence and faster growth. 6. President Obama appears to be moving to the middle. Since the mid-term elections, President Obama has proposed a two-year Federal worker pay freeze and organized a summit with CEO’s to see how government and the private sector can better work together. The President also met with Wal-Mart’s CEO to discuss the economy, signed a free trade agreement with Korea (similar trade deals with Panama and Columbia are pending) and recently agreed to allow the extension of the Bush tax cuts for all levels of income along with a cut in the payroll tax (an idea espoused by many supply-siders). President Obama also enlisted former President Bill Clinton to offer advice and counsel. A move to the middle should lead to higher confidence and more risk taking by the business community. 7. Fiscal policy will be less of a headwind than originally feared. In our 2010 piece, we argued that fiscal stimulus would actually become a drag on the economy in 2H:2010 and detract more than 1% from growth in 2011. However, Congress recently passed a bipartisan agreement which not only extends the expiring tax cuts and unemployment benefits, but is also more stimulative than originally anticipated. The combination of the payroll tax holiday and extended unemployment benefits will boost household income by roughly $175 billion per year ($120 billion from the tax holiday and $55 billion from the unemployment benefits). The fiscal deficit could end up being $150-$200 billion wider per year than was expected just a few weeks ago.

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 7

8. Quantitative Easing (“QE2”) seems to be working better than expected. Although bond yields have risen faster than expected, equities are up over 20% since Chairman Bernanke’s Jackson Hole speech on August 27, 2010 (chart 21). Both business and consumer confidence have improved (chart 22), triggering an uptick in economic activity. A slightly weaker U.S. Dollar (“USD”) has also contributed to the improved trend in exports (chart 23 & 24). Most economists and strategists did not expect this outcome a mere three months ago. Today, many sell-side economists are now actually upgrading their GDP forecasts to reflect the improvement in economic activity2.

Chart 21: Since August 27, stocks are up…

Chart 22: … CEO sentiment is up

Standard & Poor's 500 Stock Price Index

1941-43=10

10Source: New York Times /Haver Analytics 12/19/10

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Chart 23: … the USD is down Chart 24: … and exports are improving

Nominal Broad Trade-Weighted Exchange Value of the US$

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DECNOVOCTSEPAUGJULJUN10MAYAPRMARFEBJANSource: Federal Reserve Board /Haver Analytics 12/19/10

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Port of Long Beach: Outbound Loaded Containers

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2 According to Bloomberg, over the last two months the consensus 2011 real GDP growth forecast has climbed to 2.6% from 2.4%. Similarly, the consensus 2012 real GDP growth forecast has climbed to 3.2% from 3%

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CITADEL CONFIDENTIAL INFORMATION 8

2011 U.S. Economic Forecast

~3.5% real GDP growth in 2011.

As uncertainty subsides, we expect hiring to pick up (about 150,000 jobs created per month, with 125,000-150,000 created in the first half and 150,000-175,000 created in the second half), triggering an improvement in confidence and spending. The unemployment rate finishes the year at approximately 9%.

The demand for autos and homes begins to show meaningful signs of improvement by year-end (driven by an improvement in the labor market and less uncertainty).

The “use-it-or-lose-it” accelerated depreciated tax credit incentivizes corporations to pull forward capex spending that might have otherwise taken place in 2012.

On the supply side, we expect a deceleration in productivity (which is par for the course mid-cycle). At the margin, we expect companies to step up hiring and lengthen the work week to meet end demand rather than continuing to sell out of inventories and/or making existing staff work harder. This should translate into higher unit labor costs and should dampen corporate profit margins.

Corporate profits should rise about 5%, which is a material deceleration from the ~50% increase in 2010. Although sales continue to grow 7%-10%, margins contract due to higher input costs. Note that aggregate sales for the S&P 500 tends to grow faster than U.S. GDP because of its sizable exposure to emerging markets and its relatively small exposure to the U.S. consumer.

Core inflation stops falling and inflation expectations inch higher.

Manufacturing capacity utilization rate climbs to approximately 75% (from 73%).

The household savings rate inches lower to 5% (from 5.7%).

Long-term interest rates rise ~50 basis points on the back of better macro data and rising inflation expectations.

Stocks rise ~10%, driven largely by multiple expansion (tail risks fade as year progresses, binary views on inflation subside). The bulk of the gains occur early in the first half of the year. In the second half of the year, as the recovery begins to look sustainable, we suspect investors will start to contemplate how much longer the Fed’s policies will remain extremely stimulative. Financial stress in Europe and fears of contagion also remain a key risk.

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CITADEL CONFIDENTIAL INFORMATION 9

Components / Parts / Drivers % GDP Historical Growth Rate +/- 1 SD 2011 Growth Forecast

Real GDP 3.3% +/- 2% ~3.5% growth +/- 0.5%

1. Consumption 71% 3.5% +/- 2% ~3.5% growth

Key DriversWages Slowly improving; Should be up 4-5% next yearEmployment Slowly improving. Expect ~150k jobs created per monthWealth Housing wealth down, but positive savings rate + rising stocks will more than offset that Private interest rates FavorableAccess to credit Slowly improvingConsumer Expectations Slowly improvingPrices FavorableHH Leverage Still high. Deleveraging continuing. But Smaller Headwind than in 2010

2. Business Investment 9% 4.3% +/- 7% Fixed Investment to grow ~10%Capex 6% Up ~15%Inventories mean = 0% slight dragCommercial Real Estate 3% Up 0-5%

Key Drivers Strong fundamentals for business spendingCorp Profits StrongBorrowing Rates Cost of capital quite low Business Sentiment Rising after the electionsAccess to credit Decent for large firms; tough for small; at the margin, conditions improvingCash on balance sheet Sizable, and growingCapacity Utilization Very low, but off the bottom

3. Residential Investment 2% 2.6% +/- 14%p g p p

~5%. Key Drivers Affordability quite high, but ltd reason to build more supply

Housing Starts very weakHome Sales Declining after the expiration of the housing tax creditHome prices Incihing lower; risks to the downsideAccess to financing Mortgage aps are plummeting post-tax credit expiration; lending standards remain tightInventory very high

4. Net Exports -3% Higher oil prices + weak Europe/Japan + US consumer recovery

= modest negative contribution from tradeKey Drivers Becoming less supportive

Global growth US growth is accelerating while Japan and Europe to remain quite weakUSD Declining again Oil prices Up sharply since 2008

5. Government Spending 21% 2% +/- 3% Should add about 0-0.5% to GDP GrowthState and Local 13% New tax bill suggests Federal spending could grow in excess of 3% in 2011Federal 8% Running sizable deficits. We could see higher taxes and less spending in 2011.

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CITADEL CONFIDENTIAL INFORMATION 10

Downside Risks to the Base Case

Although cyclically the economy is in an upswing, there are still a number of significant structural headwinds hindering the U.S. economy. These headwinds should slow growth, rather than reverse the trend. However, should the economy face a policy mistake (e.g. Fed hikes rates too soon, state and local governments raise taxes too aggressively), a financial shock (e.g. an unraveling in peripheral Europe), or a supply shock (e.g. an oil spike in the absence of an improvement in economic fundamentals), we would likely alter our view to the downside.

1. European sovereign debt concerns are mounting. Yield spreads over German Bunds for Greece, Ireland, Portugal and Spain have blown out to significant levels, and ultimately, these financing costs are unsustainable. To make matters worse, peripheral Europe will face a surge in issuance next year (chart 25). Given that German, French and British banks have sizable exposure to peripheral Europe, investors are starting to worry that contagion could spread (chart 26).

Chart 25: Government debt due (Principal + Interest)/GDP

Chart 26: German, French and U.K. banks are highly exposed to peripheral Europe (billions $)

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The good news is that unlike April of this year, the EU is more capable of dealing with sovereign stress. The European Financial Stability Facility (EFSF) is now operational, the European Central Bank is purchasing distressed sovereign debt through the Securities Market Program (~€70bn since May 2010), and there appears to be the political will to fix the problem. The critical question that remains is whether policy makers can insulate Spain from the crisis. The Euro zone's emergency bailout program, in our opinion, is large enough to cope with Greece, Ireland and Portugal’s needs, but might not be substantial enough to also bail out Spain. Ultimately the key call is not the macro impact (Ireland, Portugal and Greece are not a large share of the Euro zone’s GDP), but whether financial contagion spreads into the interbank funding markets. For now, there is limited evidence of spillover, but to the extent that contagion spreads and financial conditions tighten (higher rates, tighter credit standards, lower equity prices), a loss in confidence could trigger slower consumer and business spending. Given that balance sheets have improved over the last two years (leverage has been decreased, inventories have been depleted, unproductive assets have been written down and cash balances have been built up), we believe that it would take a sizable shock (e.g. Spain defaults) to trigger a material tightening in financial conditions.

Source: HedgeEye. Source: Bank for International Settlements.

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CITADEL CONFIDENTIAL INFORMATION 11

2. The long-term U.S. fiscal outlook remains worrying. About one month ago, President Obama’s Fiscal Commission published a sobering report detailing the country’s longer-term finances. On the first page of the report, Alan Simpson and Erskine Bowles said:

Together, we have reached these unavoidable conclusions: The problem is real. The solution will be painful. There is no easy way out. Everything must be on the table. And Washington must lead… After all the talk about debt and deficits, it is long past time for America’s leaders to put up or shut up. The era of debt denial is over, and there can be no turning back.3

The Commission’s proposal was to broaden the tax base, slow the growth rate of discretionary spending, cap tax revenues at 21% of GDP and put Social Security on a more sustainable path by reducing benefits to higher income earners and increasing their payroll taxes, and have middle-income earners work longer. Not surprisingly, the Commissioners were unable to amass the necessary 14 votes needed to debate the proposal in the Senate. What was surprising though, was several weeks later, President Obama struck a deal with Congressional Republicans to extend the Bush tax cuts and provide additional stimulus which exacerbates fiscal deficits by $150-200 billion per year. Rather than following a path of long-term fiscal sustainability, the U.S. appears to be headed in the opposite direction.

As we are quickly discovering from watching developments in peripheral Europe, there are limits to how high government deficits (and debt ratios) can rise before investors begin to worry about the sustainability of fiscal policy. Rates have risen sharply across peripheral Europe, funding markets have dried up and the affected countries have been forced to implement painful austerity measures. While the likelihood of a comparable spike in U.S. Treasury yields is low, it would not be completely unexpected for borrowing rates to trend higher next year. Higher real yields have historically been a headwind for both economic prospects and financial assets. A slow and steady rise in yields accompanied by improving fundamentals is part of our base case. However, a sharp increase in interest rates would likely dampen both economic activity and financial conditions. Charts 27 and 28 demonstrate how fragile the fiscal situation is. A material backup in rates would have a profound effect on the budget deficit.

The uncertain fiscal outlook also creates economic uncertainty for business executives. The worse the fiscal situation gets, the greater the risk that CEOs remain risk averse for a prolonged period of time. Not only would heightened risk aversion translate into a weaker jobs outlook, but it would also have knock-on effects on consumer confidence and subsequently consumer spending as well.

Chart 27: Government borrowing rates have been very low by historical standards

Chart 28: One reason for that is because a lot of debt issuance has been short term and the fed funds rate is ~0%

Public Debt Average Interest Rate: Interest-Bearing Debt

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3 The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform.

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 12

3. Home prices are likely to decline another 5-10% next year. When coupled with healthy job growth, the decline in home prices should only be a modest headwind. However, if home prices decline by more than 10% and the impact spills over into the financial system, a negative feedback loop could ensue. Moreover, if job growth is modest (less than 50,000 jobs created per month), a 5-10% decline in home prices could lead to a renewed loss of confidence and a higher savings rate. In both cases, consumer spending would be much weaker than expected, and the effects would ripple through to business spending and inventory accumulation decisions.

4. Quantitative easing (QE) negatively impacts a sizable portion of the population whose wages are fixed and who cannot afford a material increase in commodity prices. Determining exactly how high food and energy prices need to rise before demand destruction kicks in is difficult. In 2008, for example, consumer spending did not start to contract until oil prices exceeded $100 / barrel. Should food and energy prices collectively climb 20% or more in 2011, consumer spending would likely grow at a slower-than-expected pace next year (especially if prices sharply in a short period of time).

Chart 29: Higher food and energy prices tax the poor

Chart 30: Fast increases in oil have historically triggered recessions

Spot Oil Price: West Texas Intermediate [Prior'82=Posted Price]

$/Barrel

10050095908580757065Source: Wall Street Journal /Haver Analytics 12/19/10

150125100

75

50

25

13

6

2

15012510075

50

25

13

6

2

5. QE2 should also lift inflation expectations. As inflation expectations rise, bond yields tend to follow suit. While the pass through to private market interest rates is not one-for-one, there has also been a meaningful uptick in private sector borrowing rates over the last couple of months (chart 32 on the next page). For now, rates remain exceptionally low, and the run-up has not been a major issue. After all, the rise has been accompanied by a commensurate improvement in macro fundamentals. However, if long-term inflation expectations were to rise above 4% and do so in an abrupt manner, this could become problematic and put the Fed in a very difficult situation. While the FOMC’s goal is to stimulate the economy and lower the unemployment rate, the Fed also wants to ensure that inflation expectations remain contained. If inflation expectations become unhinged, this could trigger concerns that the Fed might not want to complete QE2. Given how well financial assets have reacted to QE2, there is a reasonable chance that equities and commodities could come under pressure in such a scenario. Second, if rates rise, the USD would likely appreciate relative to the Euro and Yen, which would dampen the competitiveness of U.S. exporters and would make imported goods more attractive (which would have a negative impact on the trade balance). Third, although higher interest rates would initially induce “fence-sitters” to buy a home (for fear that rates will continue to rise) or car, ultimately higher rates would have a negative long-term effect on consumer spending. Simply put, materially higher inflation expectations would be problematic. A disruptive surge in interest rates is a low probability event, in our opinion, but should it materialize, it could become a sizable headwind.

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CITADEL CONFIDENTIAL INFORMATION 13

Chart 31: As inflation expectations rise, bond yields tend to follow suit

Chart 32: Private market interest rates are also climbing

10-Year Treasury Note Yield at Constant Maturity (LHS)Avg, % p.a.

10-Year Inflation Expectations (RHS)10-Year Nominal minus 10-Year TIP Rate

1009Sources: FRB /Haver 12/19/10

4.4

4.0

3.6

3.2

2.8

2.4

2.50

2.25

2.00

1.75

1.50

1.25

1.00

Moody's Seasoned Baa Corporate Bond Yield (LHS)

% p.a.

30-Year Fixed Mortgage Rate (RHS)%

1009Sources: FRB, WSJ /Haver 12/19/10

9.00

8.25

7.50

6.75

6.00

5.25

6.0

5.6

5.2

4.8

4.4

4.0

6. Meaningful fiscal retrenchment at the state and local government level. The 2009 stimulus legislation provided $144 billion of federal funding over two years. Federal support for states is set to decline next year. In general, the fiscal conditions for many states remain extremely weak. According to the Center on Budget and Priorities, “48 states have started to address shortfalls in their budgets this year (some have cut services and some have raised taxes), but given the size of the deficit ($191 billion, 29% of state budgets, the largest gap on record), more cuts are likely.4” By law, almost all states are required to balance their budgets. This could be achieved with either sizable spending cuts or large tax increases. An improvement in labor market conditions will partially mitigate this headwind, but risks are clearly to the downside. As charts 33 & 34 demonstrate, the imbalances are sizable. Any decision to quickly close these gaps would trim an additional 1% from real GDP relative to the baseline forecast.

Chart 33: There are sizable deficits at the state level

Chart 34: The deficits would be higher without Federal aid

State Shortfalls After Use of Recovery Act Funds

Budget shortfalls in billions

-$79

-$123-$101

-$134

-$31

-$68

-$59

-$6

-$250

-$200

-$150

-$100

-$50

$0FY 2009 FY 2010 FY 2011 FY 2012

Remaining budget gaps after Recovery Act and extension

Budget gaps offset by Recovery Act and Extension

Source: Center on Budget and Policy Priorities

Largest State Budget Shortfalls on Record

Total state budget shortfall in each fiscal year, in billions

-$40

-$75 -$80

-$45

-$110

-$191

-$125 -$112

-$250

-$200

-$150

-$100

-$50

$02002 2003 2004 2005 2009 2010 2011 2012

-$160

-$140

Last Recession

**

*Reported to date Estimate

Source: Center on Budget and Policy Priorities

4 For more please see States Continue to Feel Recession’s Impact at http://www.cbpp.org/cms/?fa=view&id=711

Bernanke Speech Bernanke Speech

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CITADEL CONFIDENTIAL INFORMATION 14

Upside Risks to the Base Case

There are a number of positive forces that could have a “tailwind” effect, propelling the economy to grow in excess of 3.5%.

1. Housing activity and the demand for durable goods could surprise to the upside. Early in a recovery, housing activity and the demand for durable goods tend to recover quickly. This time, however, spending in many cases has remained below replacement (charts 35 & 36). Any material increase in confidence could trigger a sizable improvement in the cyclical parts of the economy. Although the deleveraging process probably limits the upside in the coming year, to the extent that hiring takes off and asset prices continue to rise quickly, these two segments of the economy could surprise to the upside and easily contribute a couple of percentage points to real GDP.

Chart 35: The U.S. auto scrappage rate is between 12-14M units. For a second straight year, auto sales have been less than 12 million

Chart 36: About 1 million new households were formed in 2010 and we estimate ~350k homes were torn down. Only 500k homes were built

Auto Scrappage Rate

(millions)

0500959085Source: Haver Analytics 12/19/10

18

16

14

12

10

8

18

16

14

12

10

8

Housing Starts

SAAR, Thous.Units

1005009590858075706560Source: Census Bureau /Haver Analytics 12/19/10

2800

2400

2000

1600

1200

800

400

2800

2400

2000

1600

1200

800

400

Chart 37: Very weak recovery in auto sales Chart 38: Very weak recovery in residential investment

Auto Sales After a Recession

90

95

100

105

110

115

120

125

130

1 2 3 4 5 6 7 8 9

Qtrs After Recession Ends

Inde

x =

100

End

of R

eces

sion

Average

Current

Source: Haver, Citadel

Residential Investment After a Recession

90

95

100

105

110

115

120

125

130

1 2 3 4 5 6 7 8 9

Qtrs After Recession Ends

Ind

ex =

100

En

d o

f R

eces

sion

Average

Current

Source: Haver, Citadel

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CITADEL CONFIDENTIAL INFORMATION 15

2. A meaningful increase in business spending. Business spending has been weak over the last two years. The capital stock has shrunk and the average age of the capital stock is now above average. With profits as a percent of GDP approaching all-time highs and CEO sentiment beginning to rise again, it is entirely possible that capex could grow in excess of 20% next year.

Chart 39: Capex makes up a below average share of GDP

Chart 40: The capital stock is now older than average

Nonresidential Investment

% GDP

1005009590858075Source: Haver Analytics 12/19/10

15

14

13

12

11

10

9

15

14

13

12

11

10

9

Average Age: Private Equipment & Software

Years

100500959085807570Source: Bureau of Economic Analysis /Haver Analytics 12/19/10

7.4

7.2

7.0

6.8

6.6

6.4

6.2

7.4

7.2

7.0

6.8

6.6

6.4

6.2

Chart 41: However profits as % GDP near all-time highs

Before Tax Profits

% GDP

1005009590858075Source: Haver Analytics 12/19/10

14

12

10

8

6

14

12

10

8

6

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CITADEL CONFIDENTIAL INFORMATION 16

3. Small business conditions stage a turn-around in 2011. Small businesses account for about half of the economic activity in the U.S. Performance in this sector has dramatically lagged conditions at larger corporations since the recovery began. This can be seen by comparing S&P profits to proprietor’s income or comparing the ISM index to the NFIB report. Both tell the same story. The new tax legislation should help turn this trend around. It provides clarity in terms of the tax structure for the next two years, creates a financial incentive to invest in the business (100% depreciation allowance in 2011), and adds a significant injection to disposable income (which should help underpin final demand). With credit conditions loosening and final demand set to accelerate, this could provide the financial incentive for small businesses to accelerate expansion plans. Bottom line - a material improvement in small business conditions could provide meaningful upside.

Chart 42: Large companies with international exposure have bounced back faster than small companies that only have domestic exposure

Chart 43: If final demand continues to pick up, small businesses should start to see an improvement in conditions

ISM Mfg: PMI Composite IndexSA, 50+ = Econ Expand

NFIB: Small Business Optimism IndexSA, 1986=100

10050095Sources: ISM, NFIB /Haver 12/19/10

67.5

60.0

52.5

45.0

37.5

30.0

110

105

100

95

90

85

80

Final Sales to Private Domestic Purchases

% Change - Year to Year SAAR, Bil.Chn.2005$

NFIB: Small Business Optimism IndexSA, 1986=100

1005009590Sources: BEA/H, NFIB /Haver 12/19/10

7.5

5.0

2.5

0.0

-2.5

-5.0

-7.5

110

105

100

95

90

85

80

4. Increased inventory investment. From 2007 to mid-2009, we saw the sharpest inventory draw-down on record. In 2010, we started to see a bounce-back. A look at the historical trajectory of inventory investment suggests that the pace of inventory investment will slow next year, modestly detracting from growth. However, if job growth is stronger than expected in 2011, there is a possibility that inventory investment could also be stronger than expected. Inventory to sales ratios are still quite low across most sectors, and there is anecdotal evidence of stockpiling in anticipation of higher input costs.

Chart 44: Rare for inventories to meaningfully add to GDP in back-to-back years

Chart 45: However, the inventory to sales ratio is very low

Real Change in Private Inventories:Contrib to Real GDP Change

%

100500959085807570656055504540Source: Bureau of Economic Analysis /Haver Analytics 12/19/10

3

2

1

0

-1

-2

-3

3

2

1

0

-1

-2

-3

Mfrs' Inventory/Sales Ratio: All Manufacturing Industries

SA

10050095908580757065Source: Census Bureau/Haver Analytics 12/19/10

2.2

2.0

1.8

1.6

1.4

1.2

1.0

2.2

2.0

1.8

1.6

1.4

1.2

1.0

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 17

5. Improvement in job growth. Over eight million jobs were lost in the last recession. Since then, over one million private sector jobs have been recouped. To meet end-demand, companies have benefited from strong productivity and sizable inventory stockpiles. In a nutshell, companies have not had to meaningfully add to their payrolls. How much longer will this persist? The answer is a function of final demand and CEO confidence, but our sense is that before there is a material increase in the pace of job growth, companies will opt to convert part-time employees to full-time and/or lengthen the work week. To the extent that corporations decide to hire in excess of 200,000 workers per month next year, this would create upside risks to our consumer spending forecast.

How will we know if our macro views are incorrect? As a general matter, we do not rely on any one particular data release. Rather, we consider a mosaic of information. To determine whether growth is coming in stronger or weaker than expected, we will pay close attention to the data releases in the table below. This is by no means an exhaustive list, but it is broad and timely enough to provide an early warning system should economic prospects materially deviate substantially from base case.

Table 1: A Check List of Macro Data to Help Gauge the Vigor of the Recovery

Double Dip V-Shaped Recovery

High Frequency Indicators

Initial jobless claims >500K <350k

Bloomberg Financial Conditions Index less than -3 greater than 1

ISI weekly company surveys <45 >55

Corporate spreads (Moody’s Baa Yield – 10 year yield) >400bps <200bps

Velocity of money (Monetary base/ bank lending) Declines Rises sharply

Consumer Staples/Consumer Discretionary Outperforms by > 10% Underperforms by > 10%

Baltic Freight Index <1000 >6000

Monthly Data Points

ISM <45 >60

Leading Indicators (LEI) 3+ sequential declines Yr/Yr > 10%

Retail sales 3+ sequential declines Yr/Yr > 7%

Home prices Another 10% decline Rising 5%+

Employment 3+ sequential declines 200k+ per month

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CITADEL CONFIDENTIAL INFORMATION 18

Interesting story lines to watch in 2011 1. Macro policy – Who is right, the Keynesians or the Austrians? Since the Great Depression, economists have debated how policy makers should respond to severe recessions emanating from stretched balance sheets. At one extreme is the Austrian school of thought, whose core tenet is that recessions are necessary and healthy reactions to distortions created in the previous boom. To deal with recessions, the Austrian school of thought suggests:

The proper reaction is to curtail consumption, save more, replenish balance sheets and ultimately re-deploy capital to more profitable ventures. Policies that encourage consumption or prop-up wages only delay and obstruct the adjustment process. The less the government interferes, the faster the economy can recover.

The government should avoid propping up unsound business situations - doing so simply prolongs the malaise. Although the near-term cost of retrenchment is a painful recession, as consumers save more, banks can replenish

their balance sheets (funds are deposited into banks and re-invested in higher yielding instruments) and before long are in a better position to extend credit to worthy business ventures.

Because businesses make long-term investment decisions, short-term fiscal stimulus clouds the longer-term outlook. Ultimately the bill has to get paid - Governments should look for ways to reduce, not increase, uncertainty.

At the other end of the spectrum is the Keynesian school of thought, which argues that not only is “doing nothing” politically infeasible, it is not economically efficient either. According to the Keynesian school of thought, following a balance sheet recession, government spending is justified on the grounds that confidence is artificially low. In the lead-up to the bursting of the bubble, spending tends to be above “trend”. The bursting of the bubble awakens the private sector to the reality that they have over-spent, triggering a material curtailment in spending. It is argued that if the government does not step-in, the economy is at risk of heading into a debt-deflation spiral, deteriorating faster and more severely than would have otherwise been the case. Keynesians believe that government spending can offset the decline in private sector spending. The hope is that if fiscal expansion leads to an improvement in confidence, a self-reinforcing expansion could ensue, and in the long-run, raise more revenues than a scenario where the government does nothing or tries to raise taxes to balance the budget.

Who is right? Given that the U.S. and Europe have instituted very different macro policies following the Great Recession, we may soon find out5. Europe is set to undergo meaningful fiscal austerity in the coming years, while the U.S. appears to be moving in the opposite direction.

Ironically, the Sovereigns undergoing the most severe fiscal retrenchment have experienced the largest increases in borrowing costs and have received rating warnings and/or downgrades. The U.S., on the other hand, has seen the USD appreciate and rates rise by much less than peripheral Europe. As we head into 2011, we wonder how much longer peripheral Europe will continue with austerity measures if rates continue to stay elevated and there is continued financial stress. We also wonder whether the latest round of fiscal stimulus in the U.S. will trigger a meaningful improvement in business confidence. After all, the most recent tax compromise was temporary, not permanent6. If not, will the U.S. government try to implement more stimulus, or will they try to get their fiscal house in order? And if they do implement more stimulus, will the U.S. bond market continue to give Washington a pass without a long-term fiscal plan? How much longer can the U.S. run $1.5 trillion deficits before foreigners balk or rating agencies take notice? These open-ended questions cloud the longer-term economic outlook and create a financial disincentive for CEO’s to expand in the U.S. With U.S. budget deficits near record-highs and interest rates near record-lows, there is a risk that policy uncertainty hinders risk-taking activity for a long while to come.

5 Admittedly, it is unlikely that the Europeans chose the Austrian school of thought. The Euro periphery did not have a choice in the matter. Peripheral Europe probably would have preferred the U.S. approach. 6 According to Bank of America, the word “temporary” was repeated 22 times in the table of contents of the latest tax compromise. A growing share of the tax code is becoming temporary in nature. Many of these tax credits are subject to annual renewals, which could exacerbate the uncertainty overhang. Moreover, based on the current tax code, the U.S. will face sizable fiscal tightening beginning in 2012. While the fiscal bargain has removed some near-term fiscal uncertainty it has increased medium and long-term uncertainty.

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 19

2. With the economy mending and inflation expectations rising, will money flow back into equities? Charts 48-49 are quite informative. Historically, as the labor market improves, investors tend to gain confidence and deploy their assets into the equity market. Conversely, when the economy weakens, money flows out of equities and into bonds. Given that our base case calls for continued improvement in payroll growth and a gradual increase in both inflation and inflation expectations, we expect to see a rotation out of bonds and into equities.

Chart 46: Massive bond inflows over the last 2 years

Chart 47: Flows out of U.S. equities and into EM equities

ICI: Equity Fund Net Inflows12-month MovingTotal Bil.$

ICI: All Bond Funds: Net Cash Inflow12-month MovingTotal Bil.$

111009080706050403020100Sources: ICI /Haver 12/19/10

600

400

200

0

-200

-400

600

400

200

0

-200

-400

ICI: World Equity Funds: Net Cash Inflow (LHS)

12-month MovingTotal Bil.$

ICI: US Equity Funds: Net Cash Inflow (RHS)12-month MovingTotal Bil.$

111009080706050403020100Source: Haver Analytics 12/19/10

225

150

75

0

-75

-150

300

200

100

0

-100

-200

Chart 48: Equity flows are positively correlated with payrolls

Chart 49: Payrolls are negatively correlated with bond flows

Change in Total Private Employment (LHS)SA, Thous

ICI: Equity Fund Net Inflows (RHS)12-month MovingTotal Bil.$

1005009590Sources: BLS, ICI /Haver 12/19/10

500

250

0

-250

-500

-750

-1000

400

200

0

-200

-400

ICI: Taxable Bond Funds: Net Cash Inflow (RHS - Scale Inverted)

12-month MovingTotal Bil.$

Change in Total Private Employment (15 month lead - LHS)SA, Thous

1005009590Sources: ICI, BLS /Haver 12/19/10

375

300

225

150

75

0

-75 500

250

0

-250

-500

-750

-1000

In mid 2003 recovery gains traction and money flows into equities and out of bonds

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CITADEL CONFIDENTIAL INFORMATION 20

3. While traditional stock picking strategies have not worked well over the last year, we believe that fundamental stock picking will make a strong comeback in 2011. Broadly speaking, dispersion between high quality and low quality companies has been quite low for the past two years, creating numerous valuation dislocations. To illustrate this point, consider charts 50-51. Although intra-sector correlations between stocks in the consumer discretionary sector remain elevated by historical standards, note that the dispersion in growth estimates for this sector is actually higher than average (we had similar findings for the other GICS sectors as well). One of the reasons for this phenomenon is the proliferation of futures and ETF trading relative to single stock flows. There are many theories as to why this has occurred, but we believe that it largely reflects heightened uncertainty, risk aversion and a desire to hedge against tail risk.

If our view of the economy proves to be correct, then fears of tail risk should gradually subside and money should start to flow into the equity markets. These trends mirror what occurred in 2002 and 2003. During that particular period, the recovery was off to a slow start, and investors feared that the economy would roll over after fiscal stimulus subsided. Once the recovery looked sustainable, money flowed back into equities and correlations declined (charts 46-47 on the prior page).

Stock pickers will also benefit from QE2. As a result of this policy, commodity prices have risen. Companies operating at the final stages of production often have far less “wiggle room” to pass on higher costs compared to those at the early stages of production. Some companies will end up with margin compression (e.g. retailers), while others will have a much easier time passing along higher costs (e.g. E&P companies). In addition, QE is also triggering a material boom in emerging markets, and companies with exposure to emerging markets have benefited. In effect, QE is creating winners and losers. The combination of rising flows into equities and an increase in dispersion of operational performance should be good news for stock pickers.

Chart 50: The correlation of returns in the consumer discretionary sector has been high …

Chart 51: … but there has been dispersion in operational performance and future earnings prospects

Consumer Discretionary Average Pairwise Correlation

0

10

20

30

40

50

60

70

80

10/18/2000 6/18/2002 2/18/2004 10/18/2005 6/18/2007 2/18/2009 10/18/2010

Source: FactSet, Citadel

Standard Deviation in Expected Growth Rates

Consumer Discretionary

0

20

40

60

80

100

120

1/04 11/04 9/05 7/06 5/07 3/08 1/09 11/09 9/10

Source: FactSet, Citadel

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 21

4. Finally, the one theme which is well worth watching is how emerging markets will perform in the face of rising inflation, increasing policy rates, appreciating currencies, capital controls and continued weakness in both Japan and Europe. While there is no doubt that growth differentials favor the emerging markets, the question is what happens if growth surprises to the downside in emerging markets (EM) and to the upside in the developed world? Flows into EM have been significant this year, sentiment is extremely optimistic7, and valuation is no longer as compelling as it was several years back. At the margin, the short-term risk-reward is not as compelling as it’s been in the past.

Chart 52: There is a large interest rate gap between developed markets and emerging markets…

Chart 53: … And there is also large growth rate differential as well.

Brazil Selic Rate - US Fed Funds Rate

11100908070605040302Source: Haver Analytics 12/19/10

28

24

20

16

12

8

4

28

24

20

16

12

8

4

Real GDP Growing Much Faster in EM

-6.0%

-3.0%

0.0%

3.0%

6.0%

9.0%

12.0%

Jun-05 Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09

DM

EM

Source: Morgan Stanley

Chart 54: This is triggering sizable inflows into emerging markets

Chart 55: The flows have gone hand in hand with relative performance

-200

-100

0

100

200

300

400

500

600

700

800

Jan-09 Apr-09 Aug-09 Nov-09 Mar-10 Jun-10 Sept-10

Cumulative Flows to DM Funds ($ Bil)

Cumulative Flows to EM Funds ($ Bil)

Total Bond Flows ($ Bil)

Source: EPFR Global

The outperformance of EM

is backed by long term investors

70

80

90

100

110

120

130

12/21/2007 5/21/2008 10/21/2008 3/21/2009 8/21/2009 1/21/2010 6/21/2010 11/21/2010

Index = 100, Dec 2007

85

90

95

100

105

110

115

MSCI EM relative to MSCI World, LHS

EM cumulative flows, RHS

Source: State Street

7 According to a recent MS survey, 86% of investors were bullish on EM equities, the highest reading ever for any asset class. The ML fund manager survey points to the same conclusion.

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CITADEL CONFIDENTIAL INFORMATION 22

Chart 56: Because of the sizable EM outperformance over the last couple of years, EM is no longer cheap…

Chart 57: … And implied vols are now on par with those in the developed markets

Price/Book By Region

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

1/29/1999 1/29/2001 1/29/2003 1/29/2005 1/29/2007 1/29/2009

Latin America Eurozone Asia Pacific x Japan United States

Source: FactSet

Comparison of 3 month ATM implied volatility

EM - DM

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

10/8/2007 5/8/2008 12/8/2008 7/8/2009 2/8/2010 9/8/2010Source: Morgan Stanley

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2011 U.S. Outlook: A Return to Trend Growth

CITADEL CONFIDENTIAL INFORMATION 23

Additional Information

This presentation reflects the analysis and views of certain employees of Citadel LLC. No recipient should interpret this presentation to represent the general views of Citadel LLC or its affiliates (together “Citadel”) or its personnel. Facts, analysis and views presented in this presentation have not been reviewed by, and may not reflect information known to, other Citadel professionals.

This presentation is based upon information that Citadel considers to be reliable, but Citadel does not warrant to its completeness, accuracy or adequacy and it should not be relied upon as such.

Assumptions, opinions, views and estimates constitute certain individuals judgment as of the date of this presentation and are subject to change without notice and without any duty to update. Citadel is not responsible for any errors or omissions contained in this presentation and accepts no liability whatsoever for any direct or consequential loss arising from your use of this presentation or its contents.

The analysis in this presentation was based on a number of quantitative and qualitative estimations and assumptions. These assumptions and estimations were subjectively determined and may not be accurate. Different estimations and assumptions would have produced materially different results. As a result, the analysis in this presentation has many inherent limitations and no representation is being made that the analysis will translate into actual outcomes.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument.

Nothing in this presentation constitutes investment, legal, accounting or tax advice or a representation that any investment or strategy is suitable or appropriate to your individual circumstances or otherwise constitutes a personal recommendation to you.

This presentation is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Citadel to any registration or licensing requirement within such jurisdiction.

None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of Citadel.

Citadel may issue other presentations or materials that are inconsistent with, or reach different conclusions from, the information presented in this presentation. Those presentations and materials may reflect the different assumptions, views and analytical methods of the individuals who prepared them and Citadel is under no obligation to ensure that such other presentations or materials are brought to the attention of any recipient of this presentation.

Citadel is involved in many strategies that relate to the asset classes mentioned in this presentation. Citadel’s businesses may make investment decisions that are inconsistent with the views, opinions or conclusions expressed in this presentation.

All trademarks, service marks and logos used in this presentation are trademarks or service marks or registered trademarks or service marks of Citadel.

Copyright 2010. All rights reserved.


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