David A.

Rosenberg November 8, 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
We start off the week with the equity markets around the globe mixed to lower. • While you were sleeping:
European bourses and the euro are succumbing to heightened fiscal and we start off the week with
sovereign debt concerns in Greece, Portugal and Ireland. In the past three the equity markets around
months, to little fanfare as investor attention turned exclusively to Ben the globe mixed to lower;
now that the midterm
Bernanke, the 10-year Irish-German yield spread have ballooned to 525bps elections and Fed meeting
from 240 bps. Today’s news that German industrial production sagged 0.8% in are behind us, the next key
September — compared with consensus views of a 0.4% gain — has provided an issue for the markets is
added drag on the euro. The U.S. dollar is receiving an added boost from going to be how effective a
rumblings out of South Korea that it will soon take action to reverse the runup lame-duck Congress is
going to be
on the won. And, the growth bulls should note that the OECD leading indicator,
which came out for September, stagnated for the third month in a row. • What has the Fed really
done? The Fed’s action
If you want to know why Ben Bernanke believes he is the only pro-growth sheriff seems to have unleashed
in town, just have a look at Now in Power, G.O.P. Vows Cuts in State Budgets in a wave of speculative
trading activity in risk
today’s NYT. That said, the WSJ op-ed column today by Fed Governor Warsh
assets, but it is still early
provides a sobering assessment of the Fed’s limited ability to deal with the days
structural headwinds confronting the economy (The New Malaise and How to
End it). Also have a look at Battles Loom Over Tax Breaks, Spending Cuts in the • Lies, damned lies,
statistics: It is astounding
WSJ — and here everyone thought that the election brought an end to the how market commentators
political uncertainty. leap on every piece of
economic data, for
As for the inflationist among us, have a read of Wal-Mart Fires Shot in Toy War in example the U.S.
today’s NYT. Just because commodity prices and air fares are on the rise does employment report and
not mean everything is too, although admittedly the oil bulls will love the article consumer credit. But one
has to look at the entire
in today’s WSJ titled, China's Oil Demand is Poised to Push Up Prices.
release to see what is
really happening
Now that the midterm elections and Fed meeting are behind us, the next key issue
for the markets is going to be how effective a lame-duck Congress is going to be. • U.S. pending home sales
lose traction: pending
There is a lot of work to be done between now and year-end, from the extension of
home sales, which tend to
the Bush tax cuts, to the changed treatment of estate taxes, to the Alternative lead existing home sales,
Minimum Tax. Not to mention the five million Americans about to roll off their 99 unexpectedly fell 1.8% in
week jobless benefit programs in coming months. September

The markets are a bit hyped about the Bush tax extension and it is not 100% clear
that a compromise will be reached — see Democrats Divided on Tax Cut Strategy
on page 30 of the Sunday NYT front section. Even if there is a deal sealed to
temporarily extend the relief to high-income earners, the reality is that there is
never going to be a good time to do this because today’s fragile economy is highly
likely to be equally fragile a year from now, and how can the United States possibly
afford to blow another $4 trillion hole in the public purse over the next decade by
extending the tax cuts that nobody ever really needed anyway (nice way to fund a
couple of wars — cut taxes).

Please see important disclosures at the end of this document.

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
November 8, 2010 – BREAKFAST WITH DAVE

The markets seem to think that gridlock is going to be good, but that is hardly
always the case just because it happened under the Reagan and Clinton eras, We can understand how the
which encompassed the most pronounced secular bull market of all time. We market thrives on liquidity,
are still in a cyclical bull run in the context of a secular bear phase that has a but the market was hardly
good six years to fully run its course. The U.S. economy is still in horrible shape liquidity constrained even
and while some of the recent economic data releases have been decent, this is before the Fed began its
still an economy that is operating on government life support. verbal campaign to brace
the market for added
Let’s not forget that an economy that requires a zero policy rate, a 0.3% two-year
infusions of bank reserves
note yield and a 1% five-year note yield, is hardly what I would refer to as robust.
In fact, go back to how the Fed described most of the incoming economic
information that the markets seem to be fawning over in the first paragraph of
the FOMC press statement — three words: “slow”, “weak” and “depressed” — to
think that Howard Green would call me a “perm bear” on BNN (a Canadian news
station) last Friday. What does that make Bernanke, other than a monetary
helicopter pilot?

WHAT HAS THE FED REALLY DONE?

In the Fed’s latest QE quest, by targeting the front- and mid-part of the U.S.
Treasury curve, it is only really influencing yields that were already at microscopic
levels before anything was even announced. It is hard to figure out what a 0.3%
yield on the 2-year T-note or a sub 1 % yield on the 5-year T-note is really going to
accomplish as far a spending stimulus is concerned.

The equity market has surged since the Fed first started hinting at QE2 on August
27th at Jackson Hole, and it indeed is strange to see the major averages break out
even to new recovery highs after the fact. We can understand how the market
thrives on liquidity, but the market was hardly liquidity constrained even before the
Fed began its verbal campaign to brace the market for added infusions of bank
reserves. Households, businesses and banks were already sitting on a record
stash of cash so what the extra money does remains to be seen.

The 10-year Treasury note has remained range-bound and the yield on the long
bond has backed up since last week’s FOMC press release. Considering that
the equity market is a long-duration asset, one would have thought that the
greater response would have been to the back end of the curve as opposed to
the short end.

There is this belief that the steepening of the Treasury yield curve is good for the
banks; however, the question is, which part of the curve is relevant for financials?
It is likely more the overnight to 2-year notes or 5-year notes than the 10-year
notes or bonds. As a result, it can be argued that the curve has actually flattened
in the past week, not steepened.

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November 8, 2010 – BREAKFAST WITH DAVE

All a $600 billion QE package does is make the difference between the
unemployment rate being at 9.4% as opposed to the current posted 9.6% rate. The Fed’s action seems to
It barely adds much more than a quarter-point to GDP growth. And, for the have unleashed a wave of
output gap to close and the deflation case to be closed entirely, the Fed would speculative trading activity
need a package closer to $5 trillion or equivalent to half the size of the entire in risk assets — from stocks,
bond market. to commodities, to emerging
markets
The Fed’s action seems to have unleashed a wave of speculative trading activity in
risk assets — from stocks, to commodities, to emerging markets. Perhaps the
hope is that asset inflation, as long as it lasts, produces a wealth effect on
consumer spending and unleashes the “animal spirits” in businesses to an extent
that the recovery regains its legs and the economy begins to expand above
potential and on a sustained basis. If the key to success in QE1 was credit and
mortgage spreads, the success of QE2 will hinge on what happens to the
unemployment rate.

So far, the evidence is mixed, though it is early days. The unemployment rate
didn’t budge last month. And while U.S. auto sales were solid in October, chain
store sales turned in their poorest results in six months.

While the Fed has so far managed to reflate equity valuation, it has been less
successful in bolstering the housing market, which is even more important from a
consumer wealth effect standpoint. Beazer Home’s results last week showed
order books compressed 20% from a year ago, revenues plunged 25%, closings
sagged 30% and backlogs were down nearly 35%.

The Fed’s QE hints and then announcement have also been successful in
sanctioning a further depreciation of the U.S. dollar — a de facto beggar-thy- The Fed’s QE hints and then
neighbour policy of gaining share of the global market by cheapening your prices. announcement have also
The greenback has slipped 7.5% since late August and is on a slippery slope, and been successful in
this is indeed part of the Fed’s strategy of boosting growth even at the expense of
sanctioning a further
depreciation of the U.S.
its trading partners, and so far it seems to be working because we already saw ISM
dollar
export orders soar to a five-month high in October, from 54.5 in September to 60.5
in October.

The equity market has decided to shoot first and ask questions later — just as it
did after the first set of discount rate cuts in the fall of 2007 and the opening
weeks of the QE program in Japan in the spring of 2001. What you see is not
always what you get. I’m sure that this will fall on deaf ears today, but what we
have on our hands right now could be a huge sucker’s rally.

The law of unintentional consequences has to be heeded. What can go wrong in

this whole situation? What do we know with certainty? Well, we know that other
countries are not happy with Ben Bernanke’s surreptitious strategy of weakening
the U.S. dollar, and this in turn may lead to a global currency war and perhaps
trade wars.

Page 3 of 10
November 8, 2010 – BREAKFAST WITH DAVE

Remember that the unexpected turn of events in the equity market in October
1987 began with a war of words and policy discord between the U.S., Germany Countries, like China,
and Japan, which first manifested itself in intensifying currency instability and U.S. Germany and Korea, are not
dollar weakness. happy with Ben Bernanke’s
surreptitious strategy of
Look and see what foreign officials had to say about Ben Bernanke’s QE strategy weakening the U.S. dollar…
over the weekend:

“The problem is not a shortage of liquidity. It’s not that the Americans
haven’t pumped enough liquidity into the market, and now to say let’s
pump more into the market is not going to solve their problems ... what
the U.S. accuses China of doing, the U.S.A. is doing by different
means.” (German Finance Minister Wolfgang Schaeuble).

“Many countries are worried about the impact of the policy on their
economies. It would be appropriate for someone to step forward and
give us an explanation, otherwise international confidence in the
recovery and growth of the global economy might be hurt.” (China's
Vice-Foreign Minister Cui Tiankai). … And this in turn may lead
to a global currency war and
“There is a common understanding that if we do not work among perhaps trade wars
ourselves, we fear we will return to protectionist measures.” (South
Korea’s President Lee Myung-bak).

As for interesting news reports on Bernanke’s QE, take a read of the following:

• China Tees Up G20 Showdown With Snub For U.S. Plan to Limit Surpluses on
page A1 of the weekend FT;
• Fed Chief Defends Action in Face of Foreign Criticism on page B1 of the
Saturday NYT,
• G-20 Nations Aim to Grill Fed on Purchases on page A2 of the weekend WSJ;
• Critics Line Up to Attack Fed's Latest Stimulus Plan on B1 of the Globe & Mail;
• Peer Pressure Seen as Currency War Fix, and;
• The real doozy was the Fed's Desperate Measure is a Watershed Moment on
page 16 of the weekend FT. The last paragraph in the FT summed it up well
— “This is an extremely dangerous way to try to make money. But then the
Fed's way of stimulating the economy, while possibly necessary, is also
extremely dangerous”).
Next week’s G20 meeting in
Next week’s G20 meeting in Seoul should be a thriller! Seoul, South Korea, should
be a thriller
When we say that the Fed has managed to unleash a new round of speculative
fervour, what are we talking about, exactly?

• Cyclical stocks now command higher P/E multiples than growth companies.
• There are twice as many bulls as there are bears in the sentiment surveys.
• The share of bond issuance this year that has been placed by CCC-rated
companies has risen to 16% from 11% in 2009.
• Emerging markets have broken out in a material way.

Page 4 of 10
November 8, 2010 – BREAKFAST WITH DAVE

Moreover, look at the latest Commitment of Traders report at what has It is astounding how market
happened to the commodity complex. commentators leap on every
piece of economic data; they
• The speculative long interest in gold has risen since late August to a near-
record 253,638 contracts; merely look at the headline
figure and pronounce
• The speculative longs in oil have doubled to 208,726 contracts; whether it is weak or strong;
• For copper, the net non-commercial longs has tripled to 25,139 contracts; this may be enough for the
• Meanwhile, there is a huge net short position in Treasury bonds on the bond or stock trader …
Chicago Board of Trade of 25,240 contracts, and;
• The net longs on the euro has swelled on the Mercantile Exchange, to
35,879 contracts.

Lord help us if the U.S. dollar ever embarks on a countertrend rally — everything
from credit, to stocks, to volatility, to commodities have become abnormally
correlated to the greenback.

LIES, DAMNED LIES, STATISTICS

It is astounding how market commentators leap on every piece of economic data;
they merely look at the headline, and then make a judgment on whether it is weak
or strong. The U.S. payroll report that came out last Friday was spurious, at best.
Yes, yes, the +151,000 headline was nice and well above expectations, but it was
also highly concentrated in just a few service sector industries, led by waste
management. For an economy gone to waste, maybe that’s totally apropos.

But let’s get real here. The raw data showed that 919,000 payrolls were
somehow created in October, which therefore would have made this the second … However, for a labour
strongest October in the last 11 years — in October 2009, the tally in the raw market analyst, what is
nonfarm payroll data was 646,000 even though the economy then was important is the information
accelerating at a 5% annual rate. That 919,000 not seasonally adjusted surge that comes from many parts
in October far surpassed what we saw at the peak of the cycle in 2007 of the Household survey
(740,000 jobs) as well as the boom periods of 2006 (698,000) and 2005
(727,000). The data bear no resemblance to the reality of an economy barely
growing at all in real per capita terms.

For a bond or a stock trader, it all comes down to the headline nonfarm payroll
number. For a labour market analyst, what is important is the information that
comes from many parts of the Household survey. Who in their right mind could
ever refer to the jobs report — it is an entire report, by the way — being strong when
the employment-to-population ratio (the “employment rate”) dipped two-tenths of
a percentage point to 58.3% in October. The labour force plunged 254k and the
participation rate fell from 64.7% in September to 64.5% — the lowest level since
November 1984! How is that bullish? If not for the slide in the labour force last
month, the unemployment rate would have gone back up to 10%!

Page 5 of 10
November 8, 2010 – BREAKFAST WITH DAVE

CHART 1: NOT EXACTLY A PICTURE OF LABOUR MARKET STRENGTH

United States: Civilian Employment-to-Population Ratio
(percent)
66

64

62

60

58
90 95 00 05 10
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff

The level of unemployment rose 76k in October and is up now in two of the past
three months. They may take issue with Mr. Market’s and Mr. Media’s response
to the headline payroll figure. The Household survey, when put on the
comparable footing to the payroll report (the “population and payroll concept
adjusted” series), showed a 505k slide in employment last month, the steepest
decline of the year. That was certainly no +151k. Not only that, but the
Household survey found that 124,000 full-time jobs were lost in October,
making it a five-month streak during which 1.1 million of these positions
vanished, only replaced in part by 690k part-time workers.

CHART 2: FULL-TIME JOBS CONTRACTING AGAIN

United States: Civilians Employed Full-Time
(millions)
122.5

120.0

117.5

115.0

112.5

110.0

107.5
99 00 01 02 03 04 05 06 07 08 09 10

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Page 6 of 10
November 8, 2010 – BREAKFAST WITH DAVE

To be sure, the payroll survey flagged upward revisions, an uptick in the

workweek and a rebound in work-based pay. But the Household survey is The statistical mirage was
consistent with an economy still mired in deep malaise if not contraction. So not confined to the
which survey is correct? Hard to say. Historically, only 5% of the time do the employment data. On Friday
Household survey and Payroll survey diverge in any given month to this extent, afternoon, we also received
and usually it is the former that has the story right. Time will tell. the September release of
consumer credit from the
Now the statistical mirage was not confined to the employment data. On Friday Fed — headline rose $2.1bln
afternoon, we also received the September release of consumer credit from the
in September
Fed. The headlines read how consumer credit rose $2.1 billion in September and
pundits were questioning how there could be a credit crunch with net borrowings
rising for the first time in seven months. But take a look at the credit data and
here is what you see happened in September:
• Bank credit contracted by $14.9 billion.
• Financial companies contracted $3.1 billion.
• Credit unions contracted $1.6 billion.
• Securitization pools contracted $1.0 billion.

But ... federal government supported consumer credit surged $27 billion, on top
of the $26 billion runup in August — completely unprecedented and very likely
hooked to public sector financing for student loans (ie, nothing to do with the
economy).

In other words, consumer credit outside of government loans is collapsing at an

alarming rate — for eight months running and more than $20 billion alone in
September.

CHART 3: CONSUMER CREDIT EXCLUDING GOVERNMENT LOANS —

CONTRACTING FROM THE BUBBLE PEAK
United States
(billions)
2500

2000

1500

1000

500

0
60 65 70 75 80 85 90 95 00 05 10
Shaded region represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff

Page 7 of 10
November 8, 2010 – BREAKFAST WITH DAVE

CHART 4: CONSUMER CREDIT EXCLUDING GOVERNMENT LOANS

United States
(year-over-year percent change)
20

15

10

-5

-10
60 65 70 75 80 85 90 95 00 05 10

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Let’s also keep in mind that despite all the brouhaha over the Fed’s QE2, the
creation of bank reserves will not necessarily translate into monetary reflation or
credit creation any more than QE1 managed to accomplish. For the week
ending October 17, bank credit contracted $13.5 billion and this followed a
$31.8 billion decline the week before.

And oh yes, how can we forget? The FDIC ate four more U.S. banks over the
weekend, bringing the year-to-date tally of failed financial institutions to 143.
What a great economy!

PENDING HOME SALES LOSE TRACTION

After the blowout U.S. nonfarm payroll report last Friday, the pending home sales
data slipped mostly under the radar. Pending sales fell unexpectedly by 1.8%
MoM in September (analysts had expected a gain), which was slightly offset by a
modest upward revision to the August print (now 4.4%). The decline was broad-
based with three of the four regions registering declines. The Midwest saw a
particularly steep drop of 5.7%, after a few strong readings. The West was the
only region to see a gain.

Pending home sales tend to be a forward indicator so we could see a decline in

existing home sales. The National Association of Realtors, who puts out this
report, noted that the foreclosure moratorium had stalled sales so it’s difficult to
tell from one months’ worth of data if this is another leg down. But it’s not
smooth sailing from here — even with Friday’s strong payroll number the outlook
for housing and consumer spending remained clouded, especially with two
million people set to lose extended unemployment benefits in December alone.

Page 8 of 10
November 8, 2010 – BREAKFAST WITH DAVE

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