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Breakfast With Dave 081809 2

Breakfast With Dave 081809 2

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David A. RosenbergAugust 18, 2009
 Chief Economist & Strategist Economic Commentarydrosenberg@gluskinsheff.com+ 1 416 681 8919
 
MARKET MUSINGS & DATA DECIPHERING
Breakfast with Dave
WHILE YOU WERE SLEEPINGIN THIS ISSUE
While you were sleeping — tepid recovery in the Asianmarkets today; bonds are trading on the defensivesideAre the markets at a turning point?• What does an “L-shaped”recovery look like? Theeconomy not juststagnates but growth rateis choppy, sloppy and toppy• NY Empire StateManufacturing index — agood data point for techU.S. bank lending guidelines — still tight butless soHousing index edges upForeign investors load upon U.S. treasuries• Time for a new60%/30%/10%benchmarkVery tepid recovery in the equity market with the likes of Japan (+0.2% or 16points, to 10,284), Hong Kong (+0.8% or +168 points, to 20.306) and China(+1.4%) recouping but a fraction of yesterday’s steep losses. China hassuccumbed to signs of credit tightening after the lending boom of the lastseveral months — page 19 of the Financial Times reports that bank lending inJuly collapsed 77% MoM as stricter regulations were unveiled —the lowest sincelast October when the stock market was still searching for a bottom. Europeanbourses are bid on the back of a solid ZEW sentiment figure in Germany (it hit a three-year high in August). But this is a clear case of double-counting since theZEW is an investor confidence index and as such is a reflection of the equitymarket; so when it comes in higher it helps drive the equity market higher. Talkabout a self-perpetuating game. Sterling got a lift and U.K. gilts retreated onhigher-than-expected U.K. consumer price data (these days a “strong” CPInumber is one that merely doesn’t deflate — as was the case today).Commodities are trading more firmly than they were this time yesterday whilebonds are trading on the defensive side — but this is likely little more than profit- taking after yesterday’s monster rally in the U.S. Treasury market. With inflationrunning at -2.0% and deflating wages and rents likely to ensure that we see littledeviation from that trend with all deference to the oil price, we have a situationwhere the “real” yield on the U.S. 10-year T-note is a hefty 5.5%. That is, in aword, juicy and a nice compensation for a muddled fiscal outlook.In the meantime, all we see is more evidence of a revenue-less recovery. HomeDepot beat estimates but still posting a deflationary 9.1% sales plunge afterLowe’s announced a 9.5% slide in same-store receipts. And, don’t look now, but three-month dollar Libor rates are back on the rise in the aftermath of the seizureof Colonial BancGroup (bringing the number of failed banks this year to 77 ... hello, the credit crisis is not over just because the government bailed out the big boys).
ARE MARKETS AT A TURNING POINT?
 
Gold testing its 100-day moving average to the downside
 
Canadian dollar and the TSX are both seemingly on their way to test their 50-day moving average
 
The CRB index and the oil price broke below its 50-day m.a. yesterday
 
Another 35 points, or 3.5%, for the S&P 500 to do likewise
 
The 10-year Treasury note yield just smashed through its 50-day m.a. and has20bps to the downside left to test the 100 day m.a.
 
The VIX index jumped 15% to 27.89 — last time it was here (July 10), the S&P500 was sitting at 879 (100 points south of where it closed yesterday)
Please see important disclosures at the end of this document.
Gluskin Sheff + Associates Inc.is one of Canada’s pre-eminent wealth management firms. Foundedin 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 highestlevel of personalized client service. For more information or to subscribe to Gluskin Sheff economic reports
,
visit www.gluskinsheff.com
 
 
August 18, 2009
– BREAKFAST WITH DAVE
 
Also bear in mind that 28 of the 30 Dow Industrial stocks closed loweryesterday as did all 10 S&P GIC sectors. That this occurred even in the face of some good news — New York Empire Manufacturing Index, Japanese GDP(though strangely boosted by a 5.0% plunge in imports), NAHB housing marketindex — may be an early sign that the market is too way ahead of itself in thelast leg of the rally that carried the S&P 500 from the interim low of 879.13 onJuly 10 to the recent peak of 1,012.73 as of the August 13 close; a 15% rally that was built on a house of straw.
The decline inconsumer sentimentand the weakness inU.S. retail salescannot be readilydismissed
The selling was on higher volume to boot, making it the fifth straight‘distribution day’ in a row. Even non-technical analysts know that is not agood omen. But we should all keep an open mind because every time wehave seen even a minor pullback during this impressive bear market rally,somebody steps in to either do some buying or get out of their short positions.Be that as it may, the decline in consumer sentiment and the weakness seenin retail sales cannot be readily dismissed. Outside of the bounce in theotherwise moribund automotive area, those green shoots are hardly turning into redwoods.
L-SHAPED RECOVERY 
There seems to be quite a lot of confusion over what an “L-shaped” recovery isall about. It’s not that the economy just stagnates after the recession ends —it’s more like the growth rate is choppy, sloppy and toppy. It is below-trendand deflationary. We had this coming out of the last recession when realprivate sector spending came in at 0.5% (seasonally adjusted at an annualrate) in 2002Q1, 1.4% in 2Q, 2.1% in 3Q, and a mere +0.6% in 4Q. Call itwhat you will — but it’s more L-like than V.Even in the early 1990s, we had much the same: real private spending was a tepid2.5% annual rate in the first quarter of recovery in 1991, 1.5% in the second and0.0% in the third. So, most economists like to go back to the good old days of theearly 80s, mid 70s, early 70s, early 60s, late 50s and early 50s when we did haveV-shaped recoveries. But those cycles were completely irrelevant because thoserecoveries occurred in the context of an expanding secular credit cycle. That is tosay that when each of these recessions ended, the consumer came back evenstronger and was willing to take on ever-higher debt ratios.
“L-shaped” recoveriesare usually choppy,sloppy and toppy
During the last expansion, the housing bubble and the illusory wealthassociated with that mania, household credit ratios were allowed to riseparabolically to new record highs. We caught a whiff of this coming out of thecredit crunch of the early 1990s, but not nearly on the same scale as today. Itwas not until 1994 — nearly four years after the recession started — that theFed dared to let the foot off the accelerator. And, in the 2000-2002 cycle, itwas the need for corporate balance sheets to be cleansed and for theeconomy to emerge from the deflation gripping the technology capital stock.
Page 2 of 10
 
August 18, 2009
– BREAKFAST WITH DAVE
 
Again, it took the Fed three years to step on the brakes. We are now coming off a $14 trillion loss of household net worth, which represents a 20%implosion of the consumer balance sheet coupled with a post-bubble creditcollapse, which means that despite the government stimulus, the economy isgoing to be limping along for a prolonged period of time as savings rates riseand debt ratios decline.
In the next economicrecovery, whenever itcomes, we are most likelygoing to be dealing withthe idea that householdcredit ratios will undergo asecular, intentional andsteep downtrend
To repeat: In the next economic recovery, whenever it comes — and it will notbe determined by a one-quarter adjustment in auto assemblies, by the way —we are most likely going to be dealing with the idea that household creditratios will undergo a secular, intentional and steep downtrend and that iswhere conventional interpretation on the business cycle is most likely to goawry. Just because the conventional economists are drinking the Kool-Aiddoesn’t mean you have to.We can understand that “leading” financial indicators seem to be pointing  towards a recovery, but remember, they also priced in a “depression scenario”late last year and early in 2009 and that never came to fruition, so investorsshould be aware that we could be seeing a similar head-fake. Relying on theECRI index, for example, could be folly since the index has done little more than a bungee jump from levels we had never seen before. So keep in mind that even with the bounce, the equity market is still just back to levelsprevailing when the U.S. economy was “only” a year into recession. Corporatebonds spreads may have narrowed sharply, but are still at levels thatrepresented peaks during several prior economic downturns. The fact thatpractically everyone is declaring the recession to be over, from a purelycontrary standpoint, should be cause for pause as well because the herdmentality rarely proves to be the correct course.
If the economy were on asolid foundation towards asustainable recovery, thenwhy did the Fed move toextend the TALF program?
To be sure, if the economy were on a solid foundation towards a sustainablerecovery then we doubt that the Fed would have moved to extend the TALFprogram. The central bank sees what most economists do not — theimplications for the financial sector from the looming wave of commercial realestate defaults. The $83 billion in office, retail, industrial and apartmentproperties that have defaulted so far this year is the thin edge of the wedge — that represents a 2.25% default rate (up from 1.6% at the start of the year)and most credible estimates we have seen point to a doubling from here byyear-end and enough to drain GDP growth by at least a half a percentage point.Property values have gone down more in the commercial space than in residential— by around 40% from the 2007 peaks. The crisis has been prolonged by the fact that lenders have so far foreclosed on fewer than 10% of defaulted loans. In themeantime, what we have on our hands is a debt-rollover nightmare that comes tonearly $1 trillion in terms of the short-term commercial mortgages that are set tomature by the end of 2010. The odds that the Federal Reserve chooses to tightenmonetary policy in the midst of this epic rollover calendar is as close to zero as youcan ever possibly get, which means that the euro-dollar strips that relentlessly arepricing in rate hikes are currently low-hanging fruit.
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