David A.

Rosenberg June 9, 2009

Chief Economist & Strategist Economics Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

MR. BOND IS SHAKEN AND STIRRED
The yield on the 10-year note has now risen 185 basis points from the lows and IN THIS ISSUE
up 135 basis points since the Fed announced in March that it was embarking on
a Treasury-buying program (clearly $300 billion is not enough). The question is • We ask the question, what
what is driving yields higher and what will cause the run-up to stop? Well, much is driving yields higher and
what will cause the run-up
is being made of supply and massive Treasury issuance, and to be sure, this has
to stop?
accounted for some of the yield backup but not nearly all of it — after all, Aussie
bond yields has soared more than 100bps despite the country’s fiscal prudence. • We believe that inflation
Clearly, the ‘green shoots’ from the data has been a factor forcing real rates expectation should
reverse course in the
higher. The doubling in oil prices and the rise in other commodity prices has coming months
generated some increase in inflation expectations, and the 40%+ move in equity
prices and sustained spread narrowing in the corporate bond market has • The latest surge in
gasoline prices offsets the
triggered a flight out of safe-havens (like Treasuries), and part of the move has
fiscal stimulus
been technical in nature owing to convexity-selling in the mortgage market with
refinancings plummeting since early April. • On a positive note, the
Conference Board’s
employment trend index
The fiscal largesse and new issuance are certainly not going to go away, but the
ticked up in May
other factors may well subside or reverse course in the second half of the year
leading to a possible significant rally in government bonds. We should add that • There is a lack of pass-
through from the
in real terms, the 10-year note yield is now 4.5% and the last five times it
commodity rush to final
approached this level in the past decade the nominal yield rallied each time and consumer prices
by an average of more than 50bps.
• The latest I/S ratio data
shows that defensive
Where we think the greatest potential will be is in inflation expectations — they
sectors are still better
should reverse course in coming months. Three different articles in today’s Wall positioned than cyclicals
Street Journal (WSJ) lead us to that conclusion:

• More Firms Cut Pay to Save Jobs (page A4)

• To Sustain iPhone, Apple Halves Prices (B1)
• In Recession Specials, Small Firms Revise Pricing (B5)

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June 9, 2009 – BREAKFAST WITH DAVE

GASOLINE PRICE SURGE OFFSETS THE FISCAL STIMULUS

U.S. retail gasoline prices are now up a full buck from the lows, to $2.62 a U.S. gasoline pump
gallon (up 41 days in a row) — the equivalent of a $130 billion drag on prices are now up $1
discretionary spending at an annual rate. Tack on the 60bps bounce in from the lows …
mortgage rates too, which has triggered a near-60% collapse in mortgage equivalent to a $130bln
refinancings. Then tack onto that the 0.2% decline in average weekly earnings
drag on discretionary
spending
in May — down now in two of the last three months — and a consumer relapse
could well be in the offing and end up snuffing out this ballyhooed inventory-
led recovery that has underpinned equities and undermined Treasuries over
the last 3-4 months. Have a look at the article Relentless Rise of Treasury
Yields Could Choke Nascent Recovery on page 23 of the FT. Also see On
Borrowed Time: Consumer-Led Recovery on page C1 of the WSJ.

NOT ALL THE NEWS IS GRIM, HOWEVER

The Conference Board’s employment trends index ticked up 0.2% in May — the
first increase in 16 months. Taiwan just posted a 9.0% jump in April exports,
adding to expectations that Asia is truly on the mend (the 0.5% increase in the
April OECD leading indicator has also been greeted receptively by the ‘green
shoot’ advocates). The once-bearish Paul Krugman stated yesterday in an
interview that the recession will very likely end in September. In the event, the
lows in the market posted in March were probably the lows for the cycle, even
if we believe equities are more than fully priced right now and offer limited
upside potential.

MORTGAGE DELINQUENCIES HIT PRIME LOANS

Everyone seems to believe that the foreclosure crisis has been confined to
subprime, but that is no longer the case at all. In the first quarter, fully half of
the foreclosures in the U.S.A. were concentrated in prime mortgages where the
default rate is now 2.40% — more than double the 1.10% rate a year ago. While
California, Nevada, Arizona and Florida are the main culprits, make no mistake,
half of the delinquencies are taking place in the rest of the country too.

Moreover, the problem has also spread more visibly to the commercial real
estate market, where the default rate is set to hit a seven-year high of 4.20% by
the end of the second quarter, from 2.25% at the end of March. Along with
credit cards — the delinquency rate at 1.32% in Q1, up from 1.19% a year ago —
this is not only the next shoe to drop but is a shoe that is already dropping (more
than $300 billion of commercial mortgages have to be refinanced this year).

LACK OF PASS-THROUGH FROM THE COMMODITY RUSH TO FINAL

CONSUMER PRICES
There seems to be quite a bit of concern that inflation is going to rear its ugly
head now that commodity prices have bounced back so sharply. Well, I went
back to the other five major commodity bull markets back to the early 1970s
and compared the run-up in the CRB index to the surge in the CPI to get a gauge
as to how much ‘pass-through’ there was into final-stage consumer pricing.

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June 9, 2009 – BREAKFAST WITH DAVE

Historically, there is a 37% pass-through, averaging out those cycles. In other

words, for every 10% increase in the CRB, 3.7% of that advance found its way to
the U.S. consumer. During the 2002-07
commodity run-up,
But in the 2002-2007 cycle, a 118% surge in commodity prices only managed to prices at the raw
translate into a 21% increase in the CPI — for an 18% pass-through. That was material stage surged
the smallest spill-over ever from the commodity sector to the consumer — half of 118% but only 21%
what we usually see (in the second half of the 1970s, by way of comparison, the translated to an
pass–through was 83%!). Also keep in mind that in the 2002-07 cycle we had a increase in CPI
booming leveraged U.S. economy, which took the unemployment rate down to
4.4% at the low (versus 9.4% now) and industry capacity utilization (CAPU) rates
up to 81% (versus 69% now). The story was that even with the drop in the
unemployment rate and rise in the CAPU rate, the output gap in the U.S.A. never
fully closed in the last expansion — the Fed never allowed the economy to
breach its full capacity limit (closer to 4.0% unemployment rate and 82% CAPU)
which made it very difficult for final stage manufacturers and retailers to pass on
much of the surge in raw material costs.

We now have a one-trick pony when it comes to the commodity story and it is
Chinese demand. While the U.S. economy did manage to expand on the back of
soaring housing wealth and surging credit growth from 2002-07, it played a
secondary role in the bull market in resource prices. So from my lens, if U.S.
retailers had difficulty passing along commodity costs in the last cycle when
credit was abundant, I fail to see how they are going to do so in the current and
prospective environment of declining household credit growth, rising savings
rates and near-record excess capacity in the product and labour market.

There is very little overall benefit to the U.S. economy from a China-led global
expansion outside of selected multi-national company sales impact. Insofar as
Chinese demand exerts strains on the global resource sector, what this means
for overall U.S. domestic profits is a giant margin squeeze (at least Canadian
profits gain some offset from higher resource-related revenues). This is why it is
so difficult to see S&P 500 operating EPS hitting $75 per share anytime soon
(before 2012, in fact) even with the clouds parting in the financial space.

CHARTS THAT SAY THE DEFENSIVE SECTORS STILL BETTER POSITIONED

THAN CYCLICALS
Last week we received the April factory orders/shipments/inventory data for the
U.S. manufacturing sector. I thought it would be useful to run a screen on
sectors whose inventory/shipment (I/S) ratios are below average and those who
are at or near peak levels. As the charts below illustrate, the two sectors that
really stand out positively in the sense of excellent inventory control are food
products and beverage/tobacco producers.

The durable goods sector I/S ratio is still flirting near cycle highs — the metals,
machinery and the transportation industries being the major culprits (tech and
electrical equipment have seen their I/S ratios roll off their recent peaks ... good
news for them).

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June 9, 2009 – BREAKFAST WITH DAVE

Chart 1: FOOD PRODUCTS SECTOR

SHOWING EXCELLENT INVENTORY CONTROL …
United States

Mfrs Inventory/Shipments Ratio: Food Products

(ratio, seasonally adjusted)

0.90

0.85

0.80

0.75

0.70
97 98 99 00 01 02 03 04 05 06 07 08

Source: Haver Analytics, Gluskin Sheff

Chart 2: … AND SO IS THE BEVERAGE/TABACCO SECTOR …

United States
Mfrs Inventory/Shipments Ratio: Beverage & Tobacco Products
(ratio, seasonally adjusted)

1.8

1.7

1.6

1.5

1.4

1.3

1.2
97 98 99 00 01 02 03 04 05 06 07 08

Source: Haver Analytics, Gluskin Sheff

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June 9, 2009 – BREAKFAST WITH DAVE

Chart 3: … HOWEVER, THE I/S RATIO FOR DURABLE GOODS

INDUSTRIES ARE STILL FLIRTING NEAR CYCLE HIGHS
United States

Mfrs' Inventory/Shipments Ratio: Durable Goods Industries

(ratio, seasonally adjusted)

1.9

1.8

1.7

1.6

1.5

1.4

1.3
97 98 99 00 01 02 03 04 05 06 07 08

Source: Haver Analytics, Gluskin Sheff

SOME NIFTY CONSUMER SPENDING PATTERNS

Although we are likely past the worst point of the recession, consumer spending
habits do not seem to be changing — the new frugality theme is very much
intact. There was a terrific article on this enduring theme on page 4 of the Week
in Review section of the Sunday New York Times — The Recession, Wal-Mart
Style. As the caption reads — “Pasta is Big. Prime Cuts Aren’t. Toilet training is
being fast-tracked.” The article quotes John E. Fleming, chief merchandising
officer for WMT, who says: “We’re seeing a movement away from protein into
carbohydrates. It stretches the dollar a lot further. This whole idea of staying
home and entertaining at home, we’re seeing that everywhere.”

The article mentioned some household goods that are benefiting from this
secular frugality theme:
• LCD televisions
• Popcorn/microwave poppers
• ‘Take and Bake’ pizzas
• Home repair products
• Car maintenance/motor oil/filters
• Pull-ups
• Vitamins/sleep aids/pain relievers
• Vegetable and herb seed

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June 9, 2009 – BREAKFAST WITH DAVE

I looked at the latest detailed U.S. consumer spending data for April and they
also showed a trend emerging towards ‘do it yourself’ and ‘cocooning’ goods
and services. (Remember, this was a month where despite more than $100
billion of federal government stimulus at an annual rate, consumer spending
dipped 0.1%):

• Garment/shoe repair +0.1%

• Watch/clock/jewellery repair +0.1%
• Tools +0.2%
• Telecom +0.2%
• Home improvement +0.5%
• Seeds, plants +0.5%
• Cable TV +0.5%
• Sewing kits +2.5%

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June 9, 2009 – BREAKFAST WITH DAVE
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June 9, 2009 – BREAKFAST WITH DAVE
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