July/August 2010

¾ At this point in the economic cycle we see no double dip on the horizon, in North America or globally. Those who
attach a high probability to a double-dip scenario have generally been arguing consumer deleveraging, credit market
weakness and lack of employment growth. We challenge this view.
¾ One of the most important factors in the sustainability of this recovery is the strength of corporate earnings. U.S.
national-accounts profits are within striking distance of the pre-recession peak. At the profits bottom of Q4 2008, they
were down 47.4%.
¾ Until now, producers may have been reluctant to rebuild inventories given the risks posed by U.S. consumer
deleveraging. This concern is now abating. The share of U.S. disposable income required to meet household financial
obligations, including the energy bill, has declined notably in recent quarters and is now down to the long-term
average.
¾ Given our view that GDP growth will continue to exceed its long-term potential over the rest of 2010, we continue to
favour above-average exposure to most cyclicals.
¾ Information Technology should continue to outperform, particularly in a U.S. portfolio. Canadian Industrials have
entered a phase that we consider ideal for increased exposure.
¾ An environment of rising short-term interest rates coupled with unwinding of fiscal stimulus measures earmarked for
consumers will crimp some interest-sensitive sectors, especially Consumer Discretionary stocks in a Canadian
portfolio.
¾ In light of increased geopolitical risk, we are also restructuring our positioning in Materials. With the European
sovereign debt crisis at the fore of market risk, we think it prudent to hedge our portfolio toward safe-haven exposure.
We suggest raising gold mining one notch to market weight. Base metals are reduced to market weight.
¾ With geopolitical risks having increased in importance over the last couple months, we recommend increasing cash to
the benchmark 5% from zero and easing equities to 60% from 65% (benchmark 55%). Our year-end index targets are
unchanged at 1280 for the S&P 500 and 12,700 for the S&P/TSX.
Stéfane Marion
stefane.marion@nbf.ca
Marco Lettieri
marco.lettieri@nbf.ca

ECONOMIC AND STRATEGY GROUP – 514.879.2529

Stéfane Marion, Chief Economist and Strategist
General: National Bank Financial (NBF) is an indirect wholly owned subsidiary of National Bank of Canada. National Bank of Canada is a public company listed on Canadian stock exchanges. ♦ The particulars contained herein were obtained
from sources which we believe to be reliable but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer
to buy or sell the securities mentioned herein. ♦Canadian Residents: In respect of the distribution of this report in Canada, NBF accepts responsibility for its contents. To make further inquiry related to this report or effect any transaction,
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without in each case the prior express written consent of National Bank Financial.

A double dip? Not in our view
At midyear, the questions we asked six months ago
remain pertinent. Probably one of the most important
on many investors’ minds is whether the economy will
double-dip. The answer is heavy with implications for
asset mix. The right call could make the difference
between healthy and anemic portfolio return over the
year ahead.
History suggests that a long position in equities brings
generous rewards in the first two years after a
recession bottom – in the absence of a second dip.
Table: S&P 500 index performance after U.S. recession
Recession end 1st year 2nd year
Monthly EQUITY Monitor
We challenge this view. First, consumer deleveraging
does not necessarily mean that consumer spending
will contract. If the wage bill is growing, consumption
can grow despite deleveraging. This is exactly what is
happening in the U.S. at this point. Second, consumer
credit growth is not a reliable predictor, because it lags
consumption and the wage bill. This is most obvious in
an economic recovery (chart).
An increasing wage bill is driving consumption growth
Consumer credit vs. consumption and the economy-wide wage bill*
20 % y/y
18
The key driver of consumption during the early
phase of a recovery is not credit but the wage bill
16
14
12

Pre-WW2 10
8
Nov-27 38.7 -8.5 Consumption
6
Mar-33 75.8 -19.2
4
Jun-38 -7.0 -10.3
2
Oct-45 -12.1 2.0 0
Average(1927-1945) 23.9 -9.0 -2 Wage Bill
Credit
Post-WW2 -4

Oct-49 21.9 15.0 -6

84 86 88 90 92 94 96 98 00 02 04 06 08
May-54 31.9 12.7 *Defined as total payroll employment times hourly earnings times weekly hours worked
Apr-58 32.0 -4.5 Shaded for U.S. recession
NBF Economy & Strategy (Federal Reserve and BLS data via Global Insight)
Feb-61 9.7 -7.2
Nov-70 9.2 22.9
Mar-75 23.7 -3.0 On the employment front we expect continued progress.
Jul-80 8.0 -18.2 The U.S. labour market is improving. The household
Oct-82 20.8 2.4 survey shows a gain of 1.6 million jobs since December
Mar-91 8.9 11.4
2009. The payroll survey shows a gain of 982,000,
Nov-01 -17.8 14.3
including 495,000 in the private sector (chart). We
Jun-09 16.0 N.A.
Average (1949-2009) 14.9 4.6
expect a pickup of momentum in the second half of the
Avg. ex. 1958 & 80 13.8 8.6 year, given the quickening pulse of U.S. business at
Average (1958 & 1980) 20.0 -11.4 this early stage of the cycle.
*Shaded area represents a double dip, a period in which the economy falls
back in recession within 2-years after exiting a recession
U.S. jobs market will continue to improve in second half of
year
As the table above shows, equity returns in the second Private payroll employment (1-month change)
year after recessions since World War II have generally 500 (000)
400
been positive, averaging 8.6% when the economy kept 300
expanding. In the two cases when it did not, equities 200
100
took a hit in the second year. 0
-100

No contraction on the horizon -200

-300
-400
At this point in the economic cycle we see no second -500 Shaded for U.S. Recessions
dip on the horizon, in North America or globally. Those -600
-700
who attach a high probability to a double-dip scenario -800

have generally been arguing consumer deleveraging, -900

84 86 88 90 92 94 96 98 00 02 04 06 08 10
credit market weakness and lack of employment NBF Economy & Strategy (data via Global Insight)
growth.

July-August 2010 2
 Monthly EQUITY Monitor
Profits still growing U.S.: Strong economic momentum points to robust
revenue growth in Q2
In addition to the compatibility of consumer spending Top-line growth proxy for the factory sector* vs. sales of S&P 500 companies
Actual sales
growth with household deleveraging, one of the most 16 % (y/y)

12
important factors in the sustainability of this recovery is
8
the strength of corporate earnings. U.S. national-
4
accounts profits are now down only 6.9% from the pre-
0
recession peak. At the profits bottom of Q4 2008, they Revenue
-4 proxy
were down 47.4%. -8

-12
U.S.: National-accounts profits back to pre-recession levels
-16
Pretax profits after adjustments for inventory valuation and capital consumption
-20
1,700 $ billion
-24
1,600 1985 1990 1995 2000 2005 2010
1,500 * Product of factory production volumes and the PPI for manufacturing sector
NBF Economy & Strategy (data via Global Insight and Datastream)
1,400
1,300
1,200
1,100
Shaded for U.S. Recessions
Inventories still rebuilding
1,000
The other contribution to growth that has some way to
900
800
go before winding down is inventory rebuilding. As the
700 chart below shows, manufacturing sales growth is
600 usually followed by inventory growth, especially after a
500
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 recession.
NBF Economy & Strategy (data via Global Insight)

Rising sales suggest an inventory rebuilding cycle underway

Manufacturing: Inventories and sales growth
If earnings for Q2 2010 are as good as they promise,
% y/y
they will go far to calm investor fears about the 16
Sales
economy, especially if earnings growth is accompanied 12

by sales growth. Indicators from U.S. manufacturing 8

suggest that it will be. Factory output was up a robust 4

0.9% in May. After a soft patch early in the year, it has 0

expanded at 12% annually in the last three months. -4

Also encouraging is a 12-month rise of 6% in the -8

producer price index for manufacturing. Our proxy for -12

the aggregate top line of U.S. manufacturing, -16

Inventories

combining PPI with volume sales, has been expanding -20

-24
at 15.6% annually in Q2. Its 12-month rise is the 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

steepest in 24 years. These indicators suggest that the Shaded for U.S. recession
NBF Economy & Strategy (data via Global Insight)
S&P 500 companies could beat the current consensus
expectation of 10% revenue growth in Q2. This is true as long as the inventory-to-sales ratio is not
high, and today’s ratio is approaching the lower bound
of the comfortable range for retailers, wholesalers and
manufacturers (chart). GDP and sales growth will
mean inventory growth.

July-August 2010 3
 Monthly EQUITY Monitor
Inventory ratios are falling and approaching historical lows Cyclicals should still do well
Inventory/sales ratio for retailers, wholesalers, and manufacturers

Ratio
Given our view that GDP growth will continue to exceed
1.75
1.70
its long-term potential of around 2½% over the rest of
Retailer
1.65 2010, we continue to favour above-average exposure
1.60
1.55
to cyclicals.
1.50
1.45
Information Technology remains a sector that is likely
1.40 Manufacturing to do well, particularly in a U.S. portfolio. This sector
1.35
has been strong since the recovery began and in our
1.30
1.25 view will continue to surprise on the upside.
1.20
1.15 Wholesale The inventory-to-sales ratio of IT manufacturers has
1.10
1992 1994 1996 1998 2000 2002 2004 2006 2008 fallen abruptly since peaking at the end of the U.S.
recession. It is now at the lower bound of its historical
NBF Economy & Strategy (data via Global Insight)
range (chart). The drop suggests that demand has been
Until now, producers may have been reluctant to much stronger than was anticipated by manufacturers.
rebuild inventories given the risks posed by consumer
Sales in IT sector stronger than expected
deleveraging. This concern is now abating. The share U.S. manufacturing of information technology: Inventory to sales ratio
of U.S. disposable income required to meet household
Ratio
financial obligations, including the energy bill, has 1.85
Significant drop in
declined notably in recent quarters and is now down to 1.80 inventory to sales ratio
suggests stronger than
1.75
the long-term average. From now on consumption can expected demand
1.70
be expected to grow apace with the aggregate wage
1.65
bill.
1.60

1.55
U.S.: Deleveraging process well under way
Disposable income devoted to financial obligations* and energy spending 1.50

25.2 1.45
% of disposable income
24.8 1.40
24.4
1.35
24.0 98 99 00 01 02 03 04 05 06 07 08 09

23.6 Shaded for U.S. recession

23.2 NBF Economy & Strategy (data via Global Insight)
22.8 Historical average
22.4
U.S. semiconductor output shows a solid rebound and
22.0
21.6
is now only 4.4% off the 2008 peak (chart). Worldwide,
21.2 semiconductor sales set a new record in Q2.
20.8
20.4
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Strong rebound in semi-conductor industry
U.S. semi-conductors production (volume)
*Financial obligations is an estimate of debt payments to disposable income that
also includes automobile lease payments, rental payments on tenant-occupied
property, home insurance, and property tax payments. 320 Index
NBF Economy & Strategy (Federal Reserve and BLS data via Global Insight) 300

280

260
In sum, the features of the current economic landscape 240
– unusually high profitability, increased investment, a 220

need to rebuild inventories, an improving labour market 200

Only 4.4% from peak levels
180
– are inconsistent with a double-dip. Failing a major 160

shock, pro-cyclical forces will dominate. 140

120

100
2003 2004 2005 2006 2007 2008 2009

NBF Economy & Strategy (data via Global Insight)

July-August 2010 4
 Monthly EQUITY Monitor
Finally, corporations have established the highest level Growth in U.S. manufacturing is positive for Canadian Rail
of liquidity as a percentage of total assets since the traffic
Canadian average weekly railway carloads and US ISM purchasing mangers index
early sixties. This suggests that the investment
decision will not be hampered by a lack of disposable Units Index 64
60
funds, a plus for the return of business investment.
56
52
U.S.: Lots of cash available for investment spending 48
Nonfarm nonfinancial corporate business: Total liquid assets % of total assets 84,000
80,000 PMI 44
76,000 40
7.6 %
72,000 36
7.2
68,000 32
6.8 Carloads
64,000
6.4 60,000 Expansion of U.S.
6.0 56,000 manufacturing industry is
5.6 52,000 positive for transportation
Shaded for U.S. Recessions 48,000
5.2
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
4.8
Shaded for U.S. recession
4.4 NBF Economy & Strategy (data via Bloomberg)
4.0
3.6
3.2
Transporters are also gaining pricing power. The PPI
2.8 of the U.S. rail industry rose 1.6% in May, the strongest
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
monthly increase since the summer of 2008. The PPI
NBF Economy & Strategy (data via Global Insight)
of the trucking industry was up 0.8%, after a 1% rise in
However, our sentiment for the Canadian IT sector is April. The 12-month rise in the PPI of U.S. transporters
less optimistic. In light of the lacklustre results reported is the best since 2008.
by Research in Motion (which accounts for over 70% of
U.S.: Improved pricing power for transportation industry
the IT sector in Canada), we have decided to reduce U.S. producer prices: Rail & trucking (annual % change)
our weighting for the IT sector to market weight.
16 % y/y

Revisiting Industrials 14
12
10
Canadian Industrials have entered a phase that we 8
Rail
consider ideal for overweighting the sector. Industrials 6
4
tend to do well after the first phase of an economic 2
recovery, as the lead of early cyclicals begins to wane. 0 Trucking
-2
As corporate capital spending gains momentum and
-4
trade increases, the capital goods and transportation -6 Shaded for U.S. Recessions
industries both benefit. -8
-10
06M01 06M07 07M01 07M07 08M01 08M07 09M01 09M07 10M01
Since the Canadian Industrial sector is heavy in railway
NBF Economy & Strategy (data via Global Insight)
stocks, their performance tends to dominate that of the
sector as a whole. Canadian railways are exposed to
both domestic and U.S. demand. The former is now Also, earning revisions for the transportation industry
riding high, with real GDP up 6.1% annualized in Q1. have outpaced those for the S&P/TSX as a whole in
As for the latter, Canadian railway traffic tends to rise the last two months (chart). Given our outlook for the
when the ISM manufacturing index is in expansion economy, we expect further upward revisions for the
territory (above 50). This index is currently well up transportation industry and Industrials generally in the
there, pointing to strong growth in railway carloads near term. These earnings upgrades will help Industrials
(chart). outperform the index.

July-August 2010 5
 Monthly EQUITY Monitor
Strong earnings revisions in the transport sector
Canada: S&P/TSX and Transport index 3-month earnings revisions
Bullion feeds on geopolitical risk
12
%
Strong revisions in
We are also restructuring our positioning in Materials
transport EPS relative
8
to the composite for increased geopolitical risk. Until now we have been
4
underweight gold mining stocks, a strategy that was
0

-4
based on an appreciating U.S. dollar vs. the euro. But
-8 with the European sovereign debt crisis at the fore of
-12 market risk since April, we think it prudent to increase
-16
our exposure in the safe-haven industry. We suggest
-20

-24
raising gold mining one notch to market weight and
-28 reducing metals and mining to market weight. Overall
2006 2007 2008 2009 2010

NBF Economy & Strategy (data via Datastream)
BoC rate hikes and sector rotation
In early June the Bank of Canada began normalizing
its target overnight rate. Its quarter-point hike to 0.50%
is likely to be the first of a string of increases on
consecutive rate-setting dates. Given the robust state
of the Canadian economy and the resilience of inflation,
we currently expect a policy rate of 1.50% by year end.
An environment of rising rates will crimp some interest-
sensitive sectors, especially Consumer Discretionary
stocks. This sector tends to perform best in the
recovery phase of the cycle, before rates start rising.
Once they do, revenue growth tends to soften. Despite
the fact that we expect labour market conditions to
continue improving, the introduction of the harmonized
sales tax in B.C. and Ontario in July and the one
percentage point increase in the PST in Quebec in
January 2011 lead us to reduce our exposure to this
sector to market weight.
Among its constituent industries, we are reducing
media and autos & parts to market weight and
consumer services to underweight.
NBF Market Forecast
Canada
Actual
Index Level juin-22-10
the Materials sector remains at market weight. The
recent announcement by China to strengthen its
currency should be viewed as supportive for
commodity prices, thus limiting the relative downside
risk to the Materials sector.
Asset mix and targets
This month we make the first significant change to our
asset mix recommendations since we initiated strong
overweighting of equities in June 2009. The scenario we
put forward at that time has been borne out: equities
have strongly outpaced fixed income issues over the
last year. In the second half of 2010, when geopolitics
will most likely loom large among investor concerns, we
think a slightly more prudent strategy is in order. We
recommend increasing cash to the benchmark 5% from
zero and easing equities to 60% from 65% (benchmark
55%). However, we continue to see strong earnings
growth over the rest of the year, supported by a robust
global economy. Our year-end index targets are
unchanged at 1280 for the S&P 500 and 12,700 for the
S&P/TSX.
NBF Market Forecast
United States
déc-10 Actual déc-10
Target Index Level juin-22-10 Target

S&P/TSX 11 798 12 700 S&P 500 1 095 1 280

Assumptions Q4-10 (Est.) Assumptions Q4-10 (Est.)

Level: Earnings * 684 800 Level: Earnings * 71 85
Dividend 324 360 Dividend 22 24
PE Trailing (implied) 17,2 15,9 PE Trailing (implied) 15,4 15,1
PE Forward 14,7 PE Forward 12,9
Q4-10 (Est.) Q4-10 (Est.)
Treasury Bills (91 days) 0,53 1,75 Treasury Bills (91 days) 0,13 0,49
10-year Bond Yield 3,26 3,85 10-year Bond Yield 3,16 3,86
* Before extraordinary items, source Thomson * S&P operating earnings, bottom up.

July-August 2010 6
 Monthly EQUITY Monitor

NBF Fundamental Sector Rotation - July/August 2010

Name (Sector/Industry) Recommendation Weight

NBF S&P/TSX

Energy Overweight 29.0% 26.8%

Energy Equipment & Services Overweight 0.8%
Oil, Gas & Consumable Fuels Overweight 26.0%
Materials Market Weight 20.0% 20.2%
Chemicals Market Weight 3.0%
Containers & Packaging Overweight 0.1%
Metals & Mining * Market Weight È 4.6%
Gold Market Weight Ï 12.1%
Paper & Forest Products Market Weight 0.4%
Industrials Overweight Ï 7.5% 5.6%
Capital Goods Overweight 1.9%
Commercial & Professional Services Market Weight 0.5%
Transportation Overweight Ï 3.3%
Consumer Discretionary Market Weight È 4.5% 4.7%
Automobiles & Components Underweight È 0.7%
Consumer Durables & Apparel Market Weight 0.3%
Consumer Services Underweight È 0.5%
Media Market Weight È 2.5%
Retailing Overweight 0.7%
Consumer Staples Underweight 1.0% 2.5%
Food & Staples Retailing Underweight 1.9%
Food, Beverage & Tobacco Underweight 0.6%
Health Care Market Weight 0.5% 0.5%
Health Care Equipment & Services Market Weight 0.2%
Pharmaceuticals, Biotechnology & Life Sciences Overweight 0.3%
Financials Market Weight 30.5% 30.6%
Banks Market Weight 20.4%
Diversified Financials Market Weight 1.2%
Insurance Overweight 6.3%
Real Estate Market Weight 2.6%
Information Technology Market Weight È 3.5% 3.0%
Software & Services Overweight 0.6%
Technology Hardware & Equipment Market Weight È 2.4%
Telecommunication Services Underweight 3.0% 4.5%
Utilities Underweight 0.5% 1.7%

* Metals & Mining excluding the Gold Sub-Industry.

July-August 2010 7
 Monthly EQUITY Monitor

May 2010 8