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Breakfast With Dave 051110

Breakfast With Dave 051110

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Published by Tikhon Bernstam

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Published by: Tikhon Bernstam on May 11, 2010
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David A. RosenbergMay 11, 2010
 Chief Economist & Strategist Economic Commentarydrosenberg@gluskinsheff.com+ 1 416 681 8919
Breakfast with Dave
Across the pond — still asea of red
Making PIIGS squeal: wedid some indepth analysison how the economies of  the PIIGS would fare if thedeficit-to-GDP ratios were to revert back to thecriteria of 3.0%
Redefining a treaty: theEMU political elite and theECB bypassed theircharters in order to take the easy road and ensure that bad credits getrewarded
Canadian housing: arehomebuilders building inventory?Well, I think the turbulent global events of the past few weeks underscore thereason why I have maintained a cautious investment approach for the past year,notwithstanding the massive recovery in risk assets we saw from the March2009 lows, which from my lens bore a huge resemblance to the bungee jump in the market back in 1930. In fact, at one point two weeks ago, at the highs, thestock market had already achieved, in barely more than a year, what took fiveyears to accomplish in the 2002 to 2007 bull market, and at least that marketwasn’t being fuelled by unprecedented government intervention in the economyand incursion into the capital markets.The dramatic government stimulus was global in nature, and this was theprimary prop behind the rally in equities over the past year and change, and themessage coming out of Greece, and not just Greece but many othergovernments in the European Union and across the globe, is that governmentsare probing the outer limits of their deficit finance capacities. History doesindeed show that it is quite common to see sovereign default risks follow on theheels of a global banking crisis, which was the story for 2007 and 2008; it tooka respite in 2009 and we are now in a new chapter of this prolonged debtdeleveraging story. These cycles of balance sheet repair, alternating between the private and public sector, typically lasts 6 to 7 years. We are barely into year three, and what is extremely important in this roller coaster ride is to focus oncapital preservation strategies that minimize the volatility in the portfolio, whichis one reason why I have favoured long-short income and equity strategies.In my opinion, Greece is the same canary in the coal mine that Thailand was foremerging Asia in 1997, which ultimately led to the Russian debt default anddemise of LTCM; the same canary in the coal mine that New Century Financial inearly 2007 proved to be in terms of being a leading indicator for the likes of Bear Stearns and Lehman. So, the most dangerous thing to do now is to viewGreece as a one-off crisis that will be contained. Even with this new andaggressive EU-IMF financing arrangement that has managed to trigger a wildshort covering rally yesterday, the risks are still high that the contagion spreads to countries like Portugal, Spain, Italy and even the U.K., which has alreadyreceived some warnings from the major rating agencies and is gripped withpolitical gridlock in the aftermath of last week’s uncertain election results.
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 highestlevel of personalized client service. For more information or to subscribe to Gluskin Sheff economic reports
visit www.gluskinsheff.com
May 11, 2010
In my opinion, Greece isthe same canary in thecoal mine that Thailandwas for emerging Asia in1997, and New CenturyFinancial in the U.S. inearly 2007Even before this latest legin the European financialcrisis, China was alreadytightening monetary policyaggressively to leanagainst what appears tobe a property bubble in various urban centers
The problem of there being far too much debt on balance sheets globally has notgone away and in many cases has become worse, and the ability to service these debts especially in countries that have weak economic structures likeGreece, Portugal and Spain has become seriously impaired. It remains to beseen how Greece and the other problem countries in the euro area will manage to cut their deficits without, at the same time, controlling their monetary policyand their currency, which of course we were able to do here in Canada during  the 1990s but with the help of a 30% currency devaluation.Speaking of Canada, the downdraft in our market and our dollar shows onceagain that we can be doing everything right, and in terms of fiscal policy we stilllook good on a relative basis. However, being a small open economy sensitive to commodity prices, this is one of those times where sudden shifts in globaleconomic sentiment can hit us disproportionately.Even before this latest leg in the European financial crisis, China was already tightening monetary policy aggressively to lean against what appears to be aproperty bubble in various urban centers. One has to consider what the outlookis for the global economy in general, and near-term prospects for the resourcesector in particular, when the Shanghai equity index is down more than 20%from the nearby highs; yet something else to add to the concern list.Recall that we headed into this latest round of turmoil with the equity marketspriced for a return to peak earnings as early as next year, bullish sentiment on the stock market and institutional investor cash ratios at levels we last saw inlate 2007 when the market was just rolling off its highs, and measures of volatility at extremely low levels, the VIX index was a mere 15 as an example, asign of widespread complacency. It is at times like that, when all the good newsis priced in and then some, and the exact opposite of what was happening at thelows just over a year ago, that the markets are most susceptible to a pullback.With the benefit of hindsight, it is clear that the time to start to wade into the riskasset pool was a year ago after a 60% plunge in equities. However, 80% lateron the upside, it’s time to get more defensive and less cyclical with a keen eye towards taking advantage of this crisis if it presents opportunities in the equitymarket as the panic in the corporate bond market presented to us back in early2009. I, for one, am looking forward to having my temptation level tested if thismarket heads back into undervalued or even fair-value terrain, which it onlymanaged to achieve for a few months early last year.While the coincident economic indicators, such as employment, have improvedin recent months, many of the leading indicators have begun to roll over. In fact, these indicators are pointing towards a discernible slowing in economic andearnings growth in the second half of the year and into 2011 when we will see the stimulus shift to significant fiscal restraint in both Canada and the U.S., and the lagged impact of the Chinese policy tightening.
Page 2 of 8
May 11, 2010
In addition, while the periphery of Europe received a financial lifeline package, the conditions for accessing the funds will require massive fiscal tightening andit will be interesting to see how countries like Spain, let alone Greece, can cutspending and raise taxes at a time when the unemployment rate is at a sky-high20%. Remember, 20% of the global economy is going to be slowing down going forward, the question is by how much and this in turn will impact North Americanexports. On top of that, the equity and debt cost of capital, which had been on adeclining path for much of the past year and has very supportive of risk appetite,is now going on the opposite path. This is not necessarily a double-dip recessionscenario, but I would not rule it out.
What’s important from aninvestor standpoint is thatthe uncertaintysurrounding the macrooutlook is much wider nowthan it was before
What’s important from an investor standpoint is that the uncertainty surrounding  the macro outlook is much wider now than it was before. Over the near term, there is still more downside but the main message is that one should beprepared to take advantage of the springtime selling by using cash and near-cash as part of a tactical asset allocation strategy because one of the best way to make money in this tumultuous environment is not to lose it, but to have itready to put to use once things get really cheap.At the same time, we are confronting a deflationary shock at a time when mostmeasured rates of underlying inflation in most parts of the world, especially theU.S. are already extremely low, barely 1%, and in such an environment, having anincome theme as a core component of the portfolio makes a whole lot of sense.
We did some in-depth analysis on how the economies of the “PIIGS” (Portugal,Italy, Ireland, Greece and Spain) countries (and the rest of Europe) would fare if deficit-to-GDP ratios were to revert back to the Maastricht criteria of 3%. Theadjustment will be painful for Europe in general, slicing off about 1% GDP growthannually over the next three years, and very painful for the PIIGS specifically. If  these countries’ fiscal ratios were return to 3%, Ireland would see fourpercentage points (ppts) shaved off nominal GDP annually over the next threeyears, Greece 3.5ppts, Spain 2.8ppts, Portugal 2.2ppts and 0.8ppt for Italy.It would not be a picnic for the rest of Europe, where many countries were running deficits greater than 3% of GDP in 2009. We estimate that fiscal cuts will shaveabout 1.5ppts off France’s nominal growth, 1.0ppt for Belgium, and 0.8ppt for theNetherlands. Austria and Germany would only have to endure 0.2ppt and 0.1pptlower GDP growth, respectively, to bring their ratios back in line with targets.Finland is the only country with a GDP deficit under 3% (using 2009 data). Note that the starting point for our analysis was 2009 — the adjustment could be morepainful as deficit-to-GDP ratios look to have deteriorated further in 2010.
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