David A.

Rosenberg January 8, 2018

Chief Economist & Strategist Economic Commentary
research@gluskinsheff.com
Twitter: @GluskinSheffInc

MARKET MUSINGS & DATA DECIPHERING

Dear Readers,

I published this report for our paying subscribers two weeks ago, but I
wanted all of you to read it. So I’m pleased to now publish it as a free
edition. Feel free to share it with your friends and colleagues
FREE TWO-WEEK TRIAL
As we take out the crystal ball once again to provide our forecasts for
the year ahead, it pays to drum up the old adage that to know where you Promo Code: 2018
are going you have to know where you have been.
Redeem from:
With that in mind, I have to wonder what it means to be heading into a http://research.gluskinsheff.com
new year with the global economy in sync, the Fed tightening policy, the
U.S. Treasury curve flattening, the equity markets hitting new highs, the
credit cycle peaking out, extremely low volatility and investor
complacency equally high, excessive valuations across most asset
classes, and a U.S. labour market that is drum tight. As I dig into my
memory bank, this backdrop is eerily similar to 1988, 1999, and 2006.
And what we know about each of those years is that the one that
followed was the last of the cycle.

So if the past is a precedent, we had better enjoy the next twelve If the past is a precedent,
months. The economic expansion and bull market won’t necessarily end we had better enjoy the
in 2018, but they will be on their last legs, nonetheless. Expect strains to next twelve months
emerge as the lags from the tightening in Fed policy expose the
excesses in various corners of the financial markets. Constantly thinking
of how to invest late in the cycle is the most prudent advice we can give,
and how we are positioning our asset mix and portfolios.

Ten Late-Cycle Signposts

 Expansion turning nine in June  Flattening yield curve

 Full employment  Excessive P/E multiples
 Decade-low savings rate  Very tight credit spreads
 Cycle-high consumer confidence  M&A boom
 Fed tightening  Peak autos/housing

Read on…
January 8, 2018 — BREAKFAST WITH DAVE – FREE EDITION

We also have a new and untested Federal Reserve (with a virtually

unprecedented four of seven Governor seats on the Federal Open
Market Committee (FOMC) vacant at the moment), midterm elections
looming in the United States (where the Democrats stand a reasonably
good chance of retaking the House), ongoing investigations into the
Trump team, and questions over how tax reform will play out as well as
the central bank’s reaction to the stimulus. Not only do we have a
relatively inexperienced Fed given that it just lost a combined 35 years
of monetary policymaking with the departures of Yellen, Fischer and
Dudley, but only three FOMC members are still around from the group
that built up the now bloated balance sheet nine years ago. So we have
a crew dismantling the balance sheet who simply lack the knowledge
and gravitas of Ben and Janet, it will be interesting to see if a policy
It will be interesting to see
misstep awaits us in 2018. The history of new Fed chairs is that they if a policy misstep awaits us
overtighten — Volcker (1979), Greenspan (1987) and Bernanke (2006) in 2018
— and we know what history says about the consequences, whether they
are economic, financial, or both.

The Bank of Canada (BoC) and the Bank of England (BoE) have already
joined the Fed on the path towards higher interest rates, though it
remains unclear how much more these monetary authorities will follow
suit. It looks like U.S. monetary policy is on autopilot, even though we
are just two rate hikes away from an inverted yield curve. At the same
time, while the reduction in the size of the balance sheet is gradual for
now, by the end of 2018 enough will have been done to be equivalent to
taking out two-thirds of the first round of quantitative easing. If you
recall, this had a major impact in reviving the economy and stimulating
investor risk appetite. So it would stand to reason that we will see the
movie run in reverse this coming year. And fiscal stimulus will only
compound the negative implications for Fed liquidity if it causes any
further tightening in a labour market that has already hit the proverbial
wall.

The European Central Bank (ECB) will be set to announce a new

president, and it looks as though the job will go to a German this time,
not an Italian, so the contours of global monetary policy are set to shift
and with important implications for market liquidity. As things stand, the
central bank is looking to gradually remove stimulus, but a new more
hawkish ECB President could well accelerate this process. Perhaps one Perhaps one of the greatest
of the greatest risks for 2018 will be a global melt-up in German bund risks for 2018 will be a
yields. We saw a small template of what this looks like, and the spillover global melt-up in German
globally, when the 10-year bund yield surged from 0.15% to 0.60% in bund yields
the first half of 2017.

While Emmanuel Macron remains on course with his impressive

economic reforms in France, the otherwise constructive developments
on this front have been blunted somewhat by the political uncertainty in

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January 8, 2018 — BREAKFAST WITH DAVE – FREE EDITION

Germany, and the ongoing clouds over the Brexit negotiations. The
prospect of an abrogation of NAFTA is another source of uncertainty,
especially with respect to supply chains in North America, with negative
implications for the auto sector, consumer staples and agriculture.

Last but not least, we have China, whose economy has recently begun to
display some slowing signposts and whose government officials are
beginning to become less accommodative towards the highly indebted
state-owned government sector. That said, we are encouraged about the
continued shift to consumption from fixed asset investment,
underscored by the success of Alibaba and other e-commerce
companies in China. These are helping in the previously stated goal of
rebalancing the economy. In the coming year, we will be watching the
supply side in China very carefully to see if the Xi government will
promote the reduction in outdated capacity.

In other words, expect a year where volatility re-emerges as an Expect a year where
investable theme, after spending much of 2017 so dormant that you volatility re-emerges as an
have to go back to the mid-1960s to find the last annual period of such investable theme
an eerie calm — look for some mean reversion on this file in the coming
year. This actually would be a good thing in terms of opening up some
buying opportunities, but taking advantage of these opportunities will
require having some dry powder on hand.

In terms of our highest conviction calls, given that we are coming off the
101 month anniversary of this economic cycle, the third longest ever
and almost double what is normal, it is safe to say that we are pretty late
in the game. The question is just how late. We did some research
looking at an array of market and macro variables and concluded that
we are about 90% through, which means we are somewhere past the 7 th
inning stretch in baseball parlance but not yet at the bottom of the 9 th.
The high-conviction message here is that we have entered a phase of
the cycle in which one should be very mindful of risk, bolstering the
quality of the portfolio, and focusing on strong balance sheets, minimal
refinancing risk and companies with high earnings visibility and
predictability, and low correlations to U.S. GDP. In other words, the exact
opposite of how to be positioned in the early innings of the cycle where it
is perfectly appropriate to be extremely pro-cyclical.

So it’s either about investing around late-cycle thematics in North

America or it is about heading to other geographies that are closer to
mid-cycle — and that would include Europe, segments of the Emerging
Market space where the fundamentals have really improved, and also
Japan. These markets are not only mid-cycle, and as such have a longer
runway for growth, but also trade relatively inexpensively in a world
where value is scarce.

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January 8, 2018 — BREAKFAST WITH DAVE – FREE EDITION

I would have to say that if there is a market that has broken out of a 25-
year secular downtrend and where the economic and political tailwinds
are significant, it is Japan. I get told all the time that Japan’s population
is declining, but we are buying companies, not bodies, and the bottom
line is that even with this declining population, earnings momentum is
on the rise and profit margins are on an impressive expansion phase,
and not nearly priced in. In fact, Japan is one of the few markets globally
that is not trading at premium multiples relative to its history and is an
under-owned market both globally and locally. Moreover, an important
part of Prime Minister Abe’s strategy is to improve corporate governance
in Japan, and there are signs of early success as cash comes off
corporate balance sheets and a rising number of companies are putting
non-Japanese executives on their boards. This is one of the catalysts
that has driven margins to multi-decade highs. We are searching for
companies that have the balance sheet and cash flow yield that would
prompt management to increase payouts through rising dividends and,
more importantly, share buybacks.

Turning to Canada, there is some visibility here in the oil price given the
following developments: the high degree of OPEC compliance; the
drawdown in U.S. inventories; declines in global storage; solid world
demand, especially from oil-hungry emerging markets; and a geopolitical
risk premium coming back into the market. The shape of the oil curve
doesn’t lie and the recent move from contango to backwardation is an The recent move from
added sign of how tight the crude market has become. The beauty here contango to backwardation
is that the Canadian E&P stocks are not priced for where oil is today, is an added sign of how
testing $60 per barrel for WTI, and over the near term there is more tight the crude market has
upside potential than downside risk. So they look attractively priced become
here, once again in a world where inexpensive assets are in short
supply. And given the correlations between energy and the Canadian
banks, this is good news for this sector as well.

It also seems to me that with the Bank of Canada remaining

accommodative and with the Fed likely to raise rates, there are
increased odds of the Canadian dollar faltering. And let’s face it, the
economy here is going to need another dose of some currency-related
stimulus because of the combination of NAFTA uncertainty, the
tightened B20 mortgage regulations (which is sure to bite into the
housing market next year), and a clouded fiscal picture in terms of the
outlook for taxation (I have no clue as to why the federal government is
adding more complexity to this situation, but it is just another reason for
the Bank of Canada to stay on the sidelines).

In any event, the resultant weakening in the loonie is a positive

underpinning for many of our sectors, and again, that includes energy.
There are a host of other Canadian companies in our portfolio that have
U.S. dollar revenue streams in areas like real estate, banks, insurers

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January 8, 2018 — BREAKFAST WITH DAVE – FREE EDITION

and forest products, that are going to benefit from this renewed period
of Canadian dollar weakness.

I can’t help but be as concerned as ever, in today’s ultra-low volatility

and high complacency investment world, that there is very little in the
way of anything possibly going wrong being priced into the riskiest and
most cyclical asset markets. Now, I am far from advocating that anyone
heads for the hills or move totally into cash just yet — there is always the
danger of being way too early. But it is more a message to mold the
portfolio into something that works more often than not late in the cycle,
which is the opposite of how you would treat it in the early innings. The
level of risk is just completely different and has to be priced as such.

While there may be more questions than answers, there are areas of
conviction around which we can invest. No matter how good the news is, No matter how good the
no matter how synchronized global growth may be, valuations in most news is, no matter how
risk assets already have this ebullience priced in. Central banks are synchronized global growth
changing direction and this augurs for less, not more, risk-taking, as may be, valuations in most
liquidity growth slows and yield curves flatten or invert. Bank lending risk assets already have
already is decelerating in North America, and regulatory shifts in Canada this ebullience priced in
will reinforce this trend, keeping the BoC accommodative and the
Canadian dollar vulnerable to recurring bouts of downward pressure
(with or without the end of NAFTA). Financial conditions are very easy at
the moment but, as history has taught us, these can shift very quickly.
And it is the biggest bubbles — passive investing, leveraged ETFs, and
the cryptocurrency mania — that will pay the biggest price. It would also
seem probable that once the lags of higher interest rates begin to make
their way through the system, the peak in global growth will be at hand,
and that means that industrial commodity prices will either be contained
or edge lower.

Although the vast majority of pundits and seers are very bullish on 2018
because of U.S. tax cuts, much of this is already discounted at an 18x
forward P/E multiple for the S&P 500. And history tells us that there is History tells us that there is
an 80% chance that the House turns Democrat next November, and this an 80% chance that the
will undoubtedly cast a cloud over the policy outlook during the second House turns Democrat next
half of the year. While there is likely to be an initial boost to economic November
activity from the tax relief package, over time, the cumulative impact will
be negligible after taking all the effects into account (as in the reaction
from the Federal Reserve and simple fact that the tax cuts on the
personal side are so regressive). In fact, the Penn Wharton Budget
Model estimates that the lift to annual growth rates resulting from this
legislation over the course of 10 years will be, at most, 0.1 percentage
point. Finally, it will be no match for the overriding theme for the year of
increasingly less-friendly central bank-induced liquidity.

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January 8, 2018 — BREAKFAST WITH DAVE – FREE EDITION

No doubt the debate over inflation will be center stage, but with the Fed
raising interest rates and shrinking its balance sheet alongside the
already-evident decelerating trend in the monetary and credit
aggregates, it is very difficult to see what the factors are that will
generate any sustainable inflation pressure that would not have already
occurred this cycle. Yes, tight labour markets may yet ignite a wage
uptrend, but given the intense competitive environment, especially in
the broad retail sector, any acceleration in labour costs will likely
impinge more on lofty profit margins than on the pricing outlook. Not
only that, but the productivity gains that are now showing through in the
midst of this technological revolution — automation, AI, robotics and the
shared economy — will likely keep unit labour costs, the root cause of
inflation, flat or negative. So the risk is not really about inflation any
more than it was in the late 1980s, the late 1990s or the mid-to-late
2000s, for that matter — the risk is the Fed’s perception of inflation and
its willingness to be pre-emptive in a classically late-cycle setting.

To reiterate, while the bull market in equities isn’t over yet, we are in the While the bull market in
very late stages and that means it is time to become a little more equities isn’t over yet, we
cautious. This is also true as far as the market for corporate bonds is are in the very late stages
concerned, and we expect a more challenging asset class performance
in 2018 to create more periods of spread widening and price dislocation
as liquidity becomes less abundant, which in turn will create more
investment opportunities during the year. We fully expect leadership
within the nonfinancial corporate space to be rather narrow, with
challenges evident in retail, healthcare, telecom, and media. While
North American credit markets are expensive, they do offer better value
than their European counterparts. Both within the investment grade and
high yield arena it will be very important to maintain minimal exposure to
low coupon/long duration paper that is interest rate sensitive as the Fed
continues to hike (homebuilders and rental companies come to mind
and also are very expensive). As with the equity market, energy is one
sector that we favour within the credit markets, though again, liquidity
will be a very high priority as the cycle continues to mature.

In sum, we intend to remain defensive in 2018, fully expecting

heightened volatility, and will seek out corrections in valuation to add
exposure when yields move in favour of lenders instead of borrowers.
This is one switch we expect will occur in classic late-cycle fashion in the
coming year. This environment will be underscored by less generous This environment will be
liquidity provisioning by the major central banks with the Fed continuing underscored by less
to raise rates while shrinking its balance sheet, a new ECB leadership generous liquidity
provisioning by the major
more prone to tapering, at least another hike out of the BoE and the
central banks
People’s Bank of China’s efforts to deleverage the extremely debt-heavy
Chinese financial system.

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January 8, 2018 — BREAKFAST WITH DAVE – FREE EDITION

SO HOW TO INVEST IN 2018?

Answer: be aware of where we are in the cycle and construct your
portfolio appropriately:

1. Reduce domestic cyclical exposure; focus more on global

equities even as the trade gets more crowded — Japan is still
underowned both globally and locally.
2. Focus on companies with strong balance sheets; low
refinancing risks.
3. Screen more heavily on earnings quality and predictability; cut
the overall beta of the equity portfolio.
4. Protect the equity portfolio by writing call options or buying puts.
5. Diversify geographically into markets that are in an earlier part
of the cycle (many parts of Europe, Asia).
6. Step up exposure to dividend growth areas and to less
economically sensitive parts of the market.
7. Credit hedge funds with attention paid to better quality should
help preserve capital and provide a recurring cash flow.
8. Long-term bond yields never rise during a recession — so no
matter how low they are, they can indeed go even lower unless
this cycle goes to extra innings; if the Fed fully inverts or
flattens the yield curve and growth slows sharply, high-quality
long-duration bonds will be a nice escape valve.

HOW ARE WE POSITIONED IN CANADA?

Overweight Underweight

 USD revenue streams  Canadian housing

 Industrials (weak CAD play)  Canadian consumer
 Energy producers
 Financials (Lifecos over Banks)
 Apartment REITs

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January 8, 2018 — BREAKFAST WITH DAVE – FREE EDITION

OVERVIEW
PERSONAL Our investment
interests are directly
aligned with those of
our clients, as
Gluskin Sheff’s
management and
employees are
collectively among
the largest clients of
the Firm.
LEADING

$1 million invested in our

ALIGNED flagship GS+A Premium
Income Portfolio in 2001
(its inception date) would
have grown to
approximately $6.4
INNOVATIVE million2 on November 30,
2017 versus $3.2 million
for the S&P/TSX Total
Return Index3 over the
same period.

Notes:
1. Past returns are not necessarily indicative of future performance. Rates of return are those of the composite of segregated Premium Income portfolios and are presented net of
fees and expenses and assume reinvestment of all income. Portfolios with significant client restrictions which would potentially achieve returns that are not reflective of the
manager’s portfolio returns are excluded from the composite. Returns of the pooled fund versions of the GS+A Premium Income portfoli are not included in the composite.
2. Investment amounts are presented to reflect the actual return of the composite of segregated Premium Income portfolios and are presented net of fees and expenses.
3. The S&P/TSX Total Return Index calculation is based on the securities included in the S&P/TSX Composite and includes dividends and rights distributions. This index includes
only Canadian securities.

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January 8, 2018 — BREAKFAST WITH DAVE
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