David A.

Rosenberg January 7, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
For the first time this year, we see red on our Bloomberg equity market screens:
Europe down 0.7% and practically every region of Asia (Kospi -1.3%, China • While you were sleeping —
-1.9%, Hang Seng -0.7%, Nikkei -0.5%) and U.S. futures down a tad. Bonds are overseas equity markets
are down today; bonds are
ever so slightly bid. The S&P 500 is at a critical technical juncture, sitting at the ever so slightly bid; global
50% retracement line and a whole lot of positive news already priced in. economic data
languishing
The commodity complex is also off today with copper coming down from its 16-
• Policy paralysis — the
month highs on Chinese moves to curb lending growth; crude oil so far snapping transition mechanism
a 10-day winning streak that was underpinned by the cold snap; gold is down from monetary policy to
around 4% today on the back of a firmer tone to the U.S. dollar, which has the financial system and
occurred on the back of the first comments from the new Japanese Finance the broad economy
Minister Naotio Kan to the effect that he welcomes a weaker yen; and he is remains broken
getting it. Note that this verbal intervention is a big shift from the strong Yen • Income theme still intact
policy that was being advocated by his predecessor, Hirohisa Fujii. Nifty article — retail investors in the
on page 22 of the FT is worth a read – Japan and U.S. in Libor See-Saw. U.S. continue to pour
Japanese 3-month Libor has recently moved down into line with the U.S. level of money into bond funds
just over 25bps, which may have taken away from the “dollar carry trade” that • Pithy thoughts — despite
depressed the greenback through much of 2009. the bearish sentiment
towards U.S. Treasuries,
It could also very much be the case that the departures of several senior attempts at the 4% mark
has been futile
Democrats this week (including Messrs Dodd and Dorgan) is adding some
positive sentiment to the greenback as well, insofar as this reflects some • What to look for in the
discontent with the current policy backdrop. U.S. payroll data
• Minutes from the
Again, the data from abroad were less than stellar, and that is actually a polite December FOMC meeting
way to put it — German real manufacturing orders came in well below expected is a really big deal
at +0.2% for November (consensus was +1.2%) and retail sales plunged 1.1% • The non-manufacturing
(and down 1.2% for the entire Eurozone). ISM index fails to revive
all that much
This is what we were talking about the other day. Everyone thinks that U.S. earnings • More on the secular
derived from the global economy are going to skate consensus forecasts of a 36% frugality theme
profits boom onside this year. But the only “boomers” are the BRIC countries and
• Another roadblock for the
they represent the grand total impact of 1% on the broad U.S. economy. housing industry

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Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms. Founded in 1984 and focused primarily on high net
worth private clients, we are dedicated to meeting the needs of our clients by delivering strong, risk-adjusted returns together with the highest
level of personalized client service. For more information or to subscribe to Gluskin Sheff economic reports, visit www.gluskinsheff.com
January 7, 2010 – BREAKFAST WITH DAVE

Meanwhile, all of Europe is still struggling and that is a region as large as the
U.S., in terms of economic impact, and Japan is clearly still very much stuck in Information going into
the mud as far as domestic demand and the impact on U.S. exports is tomorrow’s nonfarm payroll
concerned. The reality is that the rest of the G7, perhaps as un-dynamic as it is report is mixed at best
relative to the likes of China and Brazil, are still four times more important for
the U.S. economy than the BRIC economies. So this notion of a global boom
when we get spending data out of Germany this weak and Japan in dire need of
a weak currency policy to put a floor under its ongoing deflation in nominal GDP
is a bit ridiculous.

We were never very big on the Monster employment index (after all, it isn’t even
seasonally adjusted) but it did show a rare four point decline to 115 in
December. The information going into tomorrow’s nonfarm payroll report is
mixed at best:

• We had a weaker than expected ADP figure yesterday but all the pundits are
talking about is how an 84,000 decline is good news because when you factor
in the extent of the “miss” in this index versus payrolls in recent months, this
actually would point to a positive print.
• The jobs components in the Conference Board survey improved a tad but
remained at deep recession levels.
• The ISM index pointed to improved factory payrolls but that certainly did not
get picked up in the ADP data (-43k compared with -42k in November). While
the non-manufacturing ISM suggested contraction in service-sector jobs, this
was actually the one pleasant surprise in the ADP with growth in this area for
the first time in 21 months.
• The jobless claims data have improved of late but then again, they never
suggested we would see nonfarm payrolls come in at only -11k in November,
either.

So who knows? But if you ask us, the one economist in the Bloomberg survey
calling for down-100k may be the guy you want to latch on to; or we will see a
revision to the downside in that surprising number that came out a month ago.
POLICY PARALYSIS
We were asked the question yesterday as to why the equity market doesn’t see
what we see. Look, we have a market here that is at least 25% overvalued and
it can stay overvalued for extended periods of time but what makes overvalued
markets unique is that they become very susceptible to any adverse news. If the
stock market was not so overvalued in October 1987, for example, the crash
would not have been so intense. If the U.S. housing bubble had not been so
profound back in 2006, then the plunge would have been far less severe.

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January 7, 2010 – BREAKFAST WITH DAVE

Go back to 2007 and you will see the stock market peaked in October 9 of that
year. It kept going up to new highs long after New Century Financial closed its Back in 2007, the S&P 500
doors, long after the deflation in residential real estate began, long after the kept on going up despite all
financial stocks rolled over, months after the two Bear Stearns hedge funds the obstacles
went bust, and indeed, a full three months after the credit collapse really got
going with the blowup in the money market forcing the Fed to cut the discount
rate in August. So the stock market, in some sense, has swung from being a
classic leading indicator to something quite a bit different.

The financial situation in what is the world’s largest economy — the BRIC
countries haven’t changed that fact quite yet — remains extremely tenuous. We
have rates at zero, a $2.2 trillion Fed balance sheet and a Fed Chairman who
has taken out a tool kit that has never been used before, not to mention a 10%
budget deficit-to-GDP ratio.

We only got a 2.2% rebound in GDP out of all this in Q3, so it’s good news that it
is not negative but this goes down as the weakest response to such an overt
monetary/fiscal policy thrust ever recorded. The economy actually responded
much more forcefully to the dramatic incursion of the central bank and Treasury
back in the mid-1930s; though it pays to note that the Depression really didn’t
end until the 1940s.

Look at the charts below and you will see how little effect the policy stimulus is
exerting leaving the government continuing with demand-growth policies, such The financial situation in the
as extended and expanded housing tax credits, and the Fed, Treasury and the world’s largest single economy
FHA doing all it can to keep the credit taps open … and for marginal borrowers at remains extremely tenuous
that. So the charts below show what, exactly? That the transmission
mechanism from monetary policy to the financial system and the broad
economy is still broken fully 2½ years after the first Fed rate cut. Cash on bank
balance sheets as a share of total assets is at a three-decade high.

CHART 1: BANKS SITTING ON A LOT OF CASH

United States: Commercial Banks: Cash Assets as a share of Total Assets
(percent)

12

10

2
85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

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January 7, 2010 – BREAKFAST WITH DAVE

Bank lending to households and businesses has contracted more than 7% from
a year ago, an unheard-of rate of decline unless you want to go back to Japan in
the 90s or the U.S.A. in the 30s.

CHART 2: BANK LENDING CONTINUES TO CONTRACT

United States: Commercial Banks: Loans & Leases in Bank Credit
(year-over-year percent change)

20

15

10

-5

-10
75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

The money multiplier is breaking down and the velocity or turnover of money is still
showing no signs of turning around; perhaps some stabilization at best, but at a
very depressed level. This is why deflation, not inflation, is the principal risk in
2010, and why it is that utilities, the most out of favour equity group, may be the
surprise for the year — that 4.1% dividend yield looks very juicy next to the sub-2%
yield for the overall market.

CHART 3: MONEY MULTIPLIER HAD BROKEN DOWN

United States: M1 Money Multiplier
(ratio of M1 money supply to the adjusted monetary base)

3.2

2.8

2.4

2.0

1.6

1.2

0.8
85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

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January 7, 2010 – BREAKFAST WITH DAVE

CHART 4: TURNOVER OF MONEY IS STILL

NOT SHOWING SIGNS OF A TURNAROUND
United States: Nominal GDP relative to M1 Money Supply
(ratio)

10.50

9.75

9.00

8.25

7.50

6.75

6.00
95 00 05

Source: Haver Analytics, Gluskin Sheff

INCOME THEME STILL INTACT

We said a few days back that one of the key hurdles for the equity market this
year will be whether the retail investor will capitulate and pick up the baton
In the final week of 2009,
American investors redeemed
since the primary sources of buying power from short covering (the shorts are
a net $1.2 billion and
out), PMs putting cash to work (liquidity ratios are back to where they were at
reallocated the proceeds to
the market peak in October 2007) and hedge funds (now that the high-water
bond funds
marks have been re-attained in many cases) are very likely to subside.

Well, for the week ending December 29th, the little guy was still following a
strategy of selling into the bear market rally rather than chase performance —
and this increasingly looks like a secular behavioural change. (By the way, the
retail investors shed his/her image as being a lagging indicator back in the fall
of 2007 when the credit collapse began because there was actually net selling
of equity funds during that time frame even as institutional investors were
lowering their cash ratios). In the final week of 2009, American investors
redeemed a net $1.2 billion and reallocated the proceeds to bond funds, which
took in a net $4.2 billion to close out the year.

PITHY THOUGHTS
Three attempts at 4.0% on the U.S. 10-year Treasury note and all three attempts
failed despite widespread bearish sentiment towards bonds. Makes you wonder
if Treasuries are a buy or at least an opportunity if we get another spasm.

Everyone believes we are in a recovery but could it be aggressive seasonal

adjustment factors at play? After all, what sort of recovery is it when state/local
tax revenues are down 10.7% YoY as of the third quarter?

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January 7, 2010 – BREAKFAST WITH DAVE

Auto sales looked better in December but 20% of the pickup was in fleet sales, All the economic growth in the
which do not show up in the retail sales data. Consumer spending intentions on U.S. in Q3 was due to
autos and homes are at multi-decade lows. government stimulus, and just
about all the growth in the
The unsold housing inventory is higher than you think — we have two million current quarter is a declining
vacant units for sale in the U.S.A. and on top of that we have one million units rate of inventory destocking
being held off the market for unmentioned reasons and on top of that, 3.5
million folks with a home for sale that haven’t sold. That brings us to 6.5 million
houses and condos that are overhanging the market and another 15 million
foreclosures that could well be in the pipeline.

The consensus of economists see 4% nominal GDP growth in the coming year;
strategists see 36% profit growth. Both can’t be right.

According to the latest Investors Intelligence Poll, the share of PMs who are bulls
now stands at 48.3% versus 16.9% for the bears. In other words, there are
three times as many bulls out there as there are bears. The industry is
populated with rose-coloured glasses.

All the economic growth in the U.S. in Q3 was due to government stimulus. And
just about all the growth in the current quarter is a declining rate of inventory
destocking. We reiterate that what is normal after a recession ends is that the
first quarter of growth sees real GDP expand at a 7% annual rate, not 2.2%.
Indeed, 2.2% was the weakest quarter to follow a recession — assuming we are
out of recession — in recorded history.

One has to wonder what sort of recovery we have in the housing market when a
5% mortgage rate can’t lift mortgage applications — the purchase index is down
28% from what were ultra-depressed levels of a year ago.

WHAT TO LOOK FOR IN THE PAYROLL DATA?

To reiterate, a glaring gap has developed between the ADP private payroll results
and what we see out of the nonfarm payroll (“Establishment”) survey. Part of
the reason is that the nonfarm payroll report is not fully reflecting what is
happening at the small business level, and this is the key part of the economy
that is lagging the trends in output, orders and sales evident among large
corporations at this time.

The Household survey has its own flaws; it is just a poll of individuals and has
sampling errors of its own. But there is a metric that puts the Household survey
on a comparable basis to the payroll survey (called the ‘payroll and population
concept adjusted’ employment — now doesn’t that just roll off the tongue?) and
it fell 109,000 in November and is off 1.2 million over the past three months.
Some recovery. This measure, by the way, was early in picking up what was
happening with the economy as it started to peel off in April 2007 or about nine
months before the recession officially began, and it began to pick up in August
2002, at least six months before the recovery really took hold.

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January 7, 2010 – BREAKFAST WITH DAVE

This measure is useful because it better captures what is happening at the small
business level — the nonfarm payroll survey covers 160,000 businesses and
government agencies while the ADP covers 400,000. So you can see which one
of the two may be a better representation of the small business sector.

CHART 5: TODAY’S RELEVANT EMPLOYMENT

MEASURE IS STILL IN FREEFALL
United States: Household Employment: Population and Payroll Concept Adjusted
(millions)
140

135

130

125

120

115

110
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Haver Analytics, Gluskin Sheff

FOMC MINUTES A REALLY BIG DEAL

Anyone who thought we were going to see the Fed raise rates any time on the
forecasting horizon are probably going to have to switch their view. So long as
the Fed is out of the picture there is precious little chance of any sustained
increase in bond yields, large-scale fiscal deficits notwithstanding. The yield
curve is already at its steepest level in three decades, so the trend will likely
be towards bull flattening, which must be the most contrary trade out there
today (besides being overweight the utilities or health care sectors).

It is amazing that after 2½ years of rate cuts and over a year of quantitative
easing, coupled with the most dramatic fiscal stimulus of all time, that there
would be so much concern — and debate — over the economic outlook. Go
back to 1960 and isolate the nine Fed easing cycles. What you will see is that
what is “normal” is that 10 quarters after the first rate cut the magic is
working and on average GDP growth is rocking and rolling at a 5% annual rate.
Sort of puts a fiscally-induced 2.2% rebound in Q3 and a near 4% inventory-led
pace in Q4 into a certain perspective. So maybe it is not a surprise as the
stock market hyperventilates that policymakers, for the most part, are
extremely nervous over the economic outlook.

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January 7, 2010 – BREAKFAST WITH DAVE

All the kings horses and men have yet to put Humpty together again and this is
at a time when the easing began 2½ years ago and has hit a level that would
leave you wondering what can be done next if the economy were to fall short
of growing at trend rate of growth, let alone relapse which is a distinct
possibility in a post bubble credit collapse that is being cushioned by dramatic
government stimulus.

Here are some of the key quotes from the December 15-16 FOMC minutes,
which were released yesterday:

“Participants agreed that underlying inflation currently was subdued

and was likely to remain so for some time. Some noted the risk that,
over the next couple of years, inflation could edge further below the
rates they judged most consistent with the Federal Reserve's dual
mandate for maximum employment and price stability; others saw
inflation risks as tilted toward the upside in the medium term.”

“While these developments were positive, participants noted several

factors that likely would continue to restrain the expansion in
economic activity. Business contacts again emphasized they would
be cautious in adding to payrolls and capital spending, even as
demand for their products increases. Conditions in the commercial
real estate (CRE) sector were still deteriorating. Bank credit had
contracted further, and with many banks facing continuing loan
losses, tight bank credit could continue to weigh on the spending of
some households and businesses. Some participants remained
concerned about the economy's ability to generate a self-sustaining
recovery without government support.”

“With rising levels of nonperforming loans expected to be a

continuing source of stress, and with many regional and small banks
vulnerable to the deteriorating performance of CRE loans, bank
lending terms and standards were seen as likely to remain tight.”

“While survey evidence suggested that small businesses considered

weak demand to be a larger problem than access to credit,
participants saw limited credit availability as a potential constraint
on future investment and hiring by small businesses, which normally
are a significant source of employment growth in recoveries.”

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January 7, 2010 – BREAKFAST WITH DAVE

“The weakness in labor markets continued to be an important

concern to meeting participants, who generally expected
unemployment to remain elevated for quite some time. The
unemployment rate was not the only indicator pointing to substantial
slack in labor markets: The employment-to-population ratio had
fallen to a 25-year low, and aggregate hours of production workers
had dropped more than during the 1981-82 recession. Although the
November employment report was considerably better than
anticipated, several participants observed that more than one good
report would be needed to provide convincing evidence of recovery
in the labor market. Participants also noted that the slowing pace of
employment declines mainly reflected a diminished pace of layoffs;
few firms were hiring. Moreover, the unusually large fraction of those
individuals with jobs who were working part time for economic
reasons, as well as the uncommonly low level of the average
workweek, pointed to only a gradual decline in unemployment as the
economic recovery proceeded. Indeed, many business contacts
again reported that they would be cautious in their hiring, saying
they expected to meet any near-term increase in demand by raising
their existing employees' hours and boosting productivity, thus
delaying the need to add employees.”

“The decelerations in wages and unit labor costs this year, and the
accompanying deceleration in marginal costs, were cited as factors
putting downward pressure on inflation. Moreover, anecdotal
evidence suggested that most firms had little ability to raise their
prices in the current economic environment.”

“A few members noted that resource slack was expected to diminish

only slowly and observed that it might become desirable at some
point in the future to provide more policy stimulus by expanding the
planned scale of the Committee's large-scale asset purchases and
continuing them beyond the first quarter, especially if the outlook for
economic growth were to weaken or if mortgage market functioning
were to deteriorate.”

THIS ISM INDEX FAILS TO REVIVE ALL THAT MUCH

While the ISM manufacturing index managed to blow through expectations, the
non-manufacturing index came up a tad short in December even if it did nudge up
to 50.1 from 48.7 in November. Orders and backlogs fell; employment and
inventories rose but the former was still at 44.0; therefore, signaling contraction in
the service sector, which was missing in the last nonfarm payroll report.

Amazingly, only 39% of the industries that are included in this survey recorded any
positive growth in December. Only 33% saw their order books expand and 22%
said employment rose last month. Hardly inspiring results.

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January 7, 2010 – BREAKFAST WITH DAVE

Unlike the manufacturing ISM, this report showed that only 5% of respondents
believe customer inventories are “too low” (44% said “too high”). The In the fourth quarter, U.S.
comparables in the manufacturing ISM report were 37% and 7%, respectively. apartment vacancy rates hit a
new all-time high
MORE ON THE SECULAR FRUGALITY THEME
A valued friend sent along to us a consumer report that cited a Fidelity survey on
New Year’s resolutions, and it dovetailed very nicely with our ongoing Ozzy and
Harriet theme. In essence, the survey found that 60% of those who made
resolutions related to improving their financial position stuck with them in 2009
— the average for all resolutions is just a snick above 50% so this is a
meaningful result.

For the year ahead, 70% said that improving their financial position was going to
be their resolution. A similar Putnam survey showed that this is topped the share
of responses who pledged to “lose weight”. This is a different way to tighten the
belt — pay down debt, boost savings, radically re-prioritize the family budget, invest
in prudent financial products.

ANOTHER ROADBLOCK FOR THE HOUSING INDUSTRY

Ries just published their Q4 numbers and showed that U.S. apartment vacancy
rates hit a new all-time high of 8.0%, forcing landlords to cut asking rents by 2.3%
from a year ago. This is the most pronounced rate of deflation since records
began in 1980, and that understates the situation because “net effective” rents
are down more like 3%. And here we have bond bears talking about inflation.
Well, maybe in raw materials but certainly not in rents, wages, the broad retail
sector and finished goods manufacturing. This is why home prices have the
potential to decline another 10% to 15% this year — the process of mean reverting
relative to rents or incomes has not yet been completed. In our view, this next leg
down in home prices will pose the greatest challenge of the year to the outlook for
confidence and spending; not to mention foreclosures, debt forgiveness and
banking sector writedowns.

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January 7, 2010 – BREAKFAST WITH DAVE

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