David A.

Rosenberg May 10, 2010

Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

EURO-SCLOROSIS NO LONGER
IN THIS ISSUE
In what can only be described as a spectacular showing of solidarity, the EU
finance ministers managed to cobble together a €750bln stabilization program • Euro-sclorosis no longer:
the EU finance ministers
(that is nearly $1.0 trillion!) that includes €440bln of government-backed loan
managed to cobble
guarantees ($570bln) and bilateral loans provided by Eurozone members; €60bln together a €750bln
($75bln) provided by all EU members through expansion of an existing balance of stabilization program …
payments facility; and up to €250bln provided by the IMF. This is over and above
• … So what now? A relief
the €110bln Greek bailout package announced last week and is widely seen as a rally in risk assets —
very powerful countermove against the “wolf pack” that had been attacking the equities, commodities,
peripheral Eurozone financial markets over the past few weeks. credit and lower-tiered
sovereign bonds should all
The size of the rescue plan is so large that the loans are equivalent to 24% of improve markedly
GDP for the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) and basically • Market comment on last
covers the funding needs for Portugal and Spain for the next three years (as last week: the Dow is now
week’s package did for Greece). If credible, this package is big enough to quash down for the year; the
contagion sovereign default risks that had been overhanging the markets for the Nasdaq sliding 8% last
past few weeks, but there are caveats (more below). week; VIX index is up
139% from its low
The ECB also made some comment about “conducting interventions” in the debt • Canada, the beacon of
market, which could signal a willingness to embark on a soft form of QE (Greek light in this unpredictable
bonds would rally huge on this). Although these interventions will be sterilized, it global financial market
does show that the ECB stands prepared to buy bonds of all credit quality. • Sober second thoughts on
U.S. April retail sales
Funding pressures in the Euro area should also subside with emergency dollar
• More on the U.S.
liquidity swap lines with the Fed being reactivated. The ECB has also reactivated employment backdrop
unlimited offerings of three-month loans — unlimited liquidity for the regional
banks. These measures should go a very long way towards avoiding a credit • What to buy? The clear
winner in this latest bout
crunch if Eurozone money markets seize up.
of financial turbulence has
been gold
So what can we expect going forward?
A relief rally in risk assets — and at the lightning speed that markets operate in • Deflationary pressures
intact: wages, real estate,
today’s world this short squeeze could be over today. Equities, commodities
credit and now
(and commodity currencies), credit and lower-tiered sovereign bonds should all commodities
improve markedly. CDS should come in from their lofty levels and Libor
pressures will ease. • The U.K. political
background — another
cloud: for the first time
The U.S. dollar, Yen, gold and high-quality bonds will give up a good part of their since 1974, Britain has a
flight-to-safety gains at the expense of the likes of oil and copper and spread minority government
product. Bank paper will undoubtedly soar over the very near-term.
• Big problems linger at the
U.S. state government
level
• U.S. home prices still
overvalued

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
May 10, 2010 – BREAKFAST WITH DAVE

Whether this is all sustained will depend on the details of how these facilities will In the final analysis, if the
be operational and who makes the allocations and how they are made. Recall EU lends money to Greece
the initial reaction to the TARP program — shoot first, ask questions later, buy or to any other problem
some time. As the TARP initiation showed, it is one thing to announce a big and country in the zone, debt
bold rescue package, but it is quite another task to have its credibility built and ratios (including
actually initiate the plan with no wrinkles. Good luck. Back then, a huge contingent liabilities) in
immediate relief rally of 11% gave way to a 30% slide to the lows — the bottom the region will only rise
was only turned more than four months later once the kinks were worked out further
and the specifics of the stress tests were announced. Keep this in mind if
anyone decides to extrapolate today’s short-covering rally into the future.

In a sign of how euphoric this manic market has suddenly become today, as it
digests the bailout news, Greek 10-year bonds enjoyed their strongest session
on record, with yields falling 569 basis points, to 6.73%, and with spreads over
German bunds tightening around 350 basis points. Greek 2-year note yields
plunged 1,327bps (you read that correctly) to 4.9%.

Among other Eurozone periphery nations, yields on Spanish 10-year debt fell
48bps, to 3.96%, and Portuguese 10-year government bond yields slid 61bps, to
5.64%. Spreads on Greek CDS plummeted 444bps, to 561bps (CDS spreads on
all periphery sovereign debt receded sharply too).

While global equities are in the green, the Greece ASI 20 stock market index
climbed 11% — stock markets in Spain are up 12% (led by an 18.5% bounce in
financials). And look Ma, no fat fingers (that only happens on down days).

Beyond today’s knee-jerk reaction, there are issues left on the table. The
emergency measures just announced buys some time but should help take
some of the fear and illiquidity out of the market over the near-term. However,
what were not addressed are the intense structural fiscal problems plaguing
much of the Eurozone.

In the final analysis, if the EU lends money to Greece or to any other problem
country in the zone, debt ratios (including contingent liabilities) in the region will
only rise further. It will be interesting to see how the rating agencies end up
handling this. It cannot be lost on them, or the global investment community,
that while loans, guarantees and central bank provisioning can deal effectively
with liquidity issues, they are ineffective in addressing what’s really at stake
here, which are structural fiscal issues. So the deal over the weekend is only
going to be successful insofar as they are backed up by meaningful reforms (it
must be emphasized that the rescue package critically hinges on the Club Med
countries accepting deep budgetary retrenchment notwithstanding their weak
economic structures. Indeed, it will be interesting to see how Spain can manage
to meet EMU deficit requirements at a time when the unemployment rate is
currently at 20%, just as one example.)

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May 10, 2010 – BREAKFAST WITH DAVE

Since the ECB has come out and said that it will buy both government and The threat of default and
corporate bonds, then what is clear is that any rally in the Euro should be faded concerns over the future of
because the lines between fiscal and monetary policy has just become the Euro will not dissipate
blurred. The cost of the ECB helping drive long-term yields in the periphery lower entirely. The region,
is jeopardizing the sanctity of the central bank balance sheet. And, just as the especially the Club Med
Fed has ceased in expanding its balance sheet, the ECB is set to expand its partners, will be in for a
balance sheet, and this is a Euro-negative. Of all the knee-jerk bounces today, long period of extremely
the Euro is the one most vulnerable to reversal. weak economic growth

Although the measures will help mitigate the growing dangers of contagion in
the Euro area, the IMF/EU loans come with a “strong conditionality” with respect
to intense budgetary restraint and structural fiscal reforms. The massive
package of loans and guarantees buys time, but the issue of whether the
austerity package for Greece will be accepted by the public (almost half do not
approve) is still up in the air. Portugal and Spain are in need of credible
packages to cut their deficits. This will exert an enormous fiscal squeeze across
wide swaths of the Eurozone and require a weaker Euro as an antidote.

Against this backdrop, the threat of default and concerns over the future of the
Euro will not dissipate entirely. The region, especially the Club Med partners, will
be in for a long period of extremely weak economic growth. In fact, even with
the weaker currency and the underpinning this should give the Eurozone export
sector — at the expense of the U.S. — we are seeing EU real GDP estimates for
2010 come down right across the board today.

MARKET COMMENT ON LAST WEEK

Well, well — no sooner were the major averages hitting new 18-month highs
when another chapter of the global deleveraging story gets in the way. The Dow
is now down for the year and off 7.4% from the April 26 high — not to mention off
to its worst ‘sell in May’ episode on record. The Nasdaq has already moved into
corrective terrain — off 10.3%, the first time this happened since the market
trough of March 2009. The 8% slide in the tech-heavy index represented the
worst weekly performance since the dark days of November 2008. In a sign of
heightened investor defensiveness, small caps are now woefully
underperforming as the Russell 2000 ended the week down 8.9% (250 basis
points worse than the S&P 500).

While the U.S. market has been hit by the heightened risk aversion, it has been
far worse overseas — Europe is now down 6.3% for the year. Japan is off 1.7%
for the year too as the Nikkei came off its sharpest weekly side since January
2009 (-6.3%). Asian stocks hit a 10-week low as the Greek problem went global
in terms of declining risk appetite. Canadian equities are highly correlated given
the commodity exposure and have fallen now for five days in a row. But no
market is down as much as Greece — plunging 12.8% last week and down
25.5% for the year.

Page 3 of 10
May 10, 2010 – BREAKFAST WITH DAVE

The VIX index is up 139% from its low (now at 37.16 versus the low of 15.58 Volatility has come back to
back on April 12, 2010). And on a 20-day percent basis, the VIX index is up the market place — the VIX
130%, not quite a high. The last time we saw such an increase, on a 20-day index is now up 139% from
basis, was back in early October 2008. Actually, in the entire history of the VIX its recent low
index, there were only 16 instances when the VIX surged 100% or more on a 20-
day basis. And, 12 happened after 2008 and prior to 2008, it only happened 4
times. In 2008, there were 10 times when the VIX index rose more than 100%
or more on a 20-day basis and it all happened in October. Now, we have seen
the VIX index surge 100% or more in two days (Thursday and Friday).

All the uncertainty has also cut into capital markets activity — four IPOs were
pulled last week due to the spreading impact of the Greek debt crisis, and only
$2.5 billion of investment-grade corporate bond paper made its way to the
market globally, which was the slowest week since May 1990. We should
probably add that U.S. regulators closed four more banks on Friday, bringing the
tally for the year to 68. A normal recovery indeed.

TOUGH TO KEEP IT TO 10?

I received this email from a loyal reader on Friday, and it goes to show that I am
not exaggerating when it comes to assessing the macro and market challenges
the world confronts.

“Dave — as always, great to read your Breakfast/Lunch/Dinner/Snack/(Whiskey

next? If things keep going as is…) w/ Dave notes. I used to work with Guy
Moszkowski back when you were at ML, I left recently. I read your worry list
today and thought, wow I could add a number of things to that, among them the
German NRW elections on Sunday, Congress catching onto U.S. Taxpayer
participation in EU bailouts, liquidity crisis in Japan, funding issues for Aussie
banks, housing in China, etc, etc. Must have been a challenge to keep it to 10.”

CANADA, THE BEACON OF LIGHT IN THIS UNPREDICTABLE GLOBAL MARKET

While the Canadian dollar
While the Canadian dollar has taken it on the chin of late, it has really only has taken it on the chin of
corrected towards levels more consistent with the fair-value line. There has late, it has really only
been no shift in the fundamentals. In fact, Canada is increasingly being viewed corrected towards levels
as an oasis of stability in an increasingly unpredictable global financial market. more consistent with the
In fact, there was no shortage of kudos in the weekend press — like The Least fair-value line
Band Rich-World Country: The Charms of Canada on page 14 of BusinessWeek.

SOBER SECOND THOUGHTS ON APRIL RETAIL SALES

Upon closer examination, U.S. same-store retail sales came in at +0.5% YoY
versus the target pace of +1.7%; and that tepid gain was on top of a -2.7% trend
a year ago. Every retail sector fell short of expectations — a hefty 78% of the
universe missed their expected results last month (though the upper end
retailers still posted impressive results; we shall see how long this lasts).

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May 10, 2010 – BREAKFAST WITH DAVE

MORE ON THE U.S. EMPLOYMENT BACKDROP

One other item to discuss is how inflated that 290k nonfarm payroll headline
Upon closer inspection,
was — 66k came from the Census hirings and another 62k came from the
the 290k U.S. nonfarm
Bureau of Labor Statistic’s birth-death model. Revoming these, the underlying
payroll headline was
figure was closer to 162k.
inflated — 66k came from
the Census hirings and
A new IBD/TIPP poll found that 28% of Americans say at least one family another 62k came from
member is looking for work and 34% say they are worried a family member the birth-death model
could be laid off. Maybe this is why despite all the joy over the April payroll data,
we have seen wages stagnate since the turn of the year.

Meanwhile, the Chief Economist, William Dunkelberg, of the National Federation

of Independent Business had this to say last Friday:

“The steep recession will unlikely be followed by a steep recovery,

the numbers just aren’t moving in that direction. Average
employment per firm first turned negative in April of 2007. It has
been negative for 10 of the last 12 quarterly readings ending with
a negative 0.18 in April 2010 (seasonally adjusted). Since July
2008, employment per firm fell steadily each quarter, logging the
largest reductions in the survey’s 35-year history.

Eleven percent (seasonally adjusted) of small business owners

reported unfilled job openings in April, up two points but
historically very weak. Over the next three months, 7 percent plan
to reduce employment (unchanged), and 14 percent plan to
create new jobs (down one point), yielding a seasonally adjusted
net negative 1 percent of owners planning to create new jobs.
The net percent of owners increasing employment in the last
three months fell one point to a net negative 12 percent. April
marks the 27th consecutive ‘no new jobs’ monthly reading.

There is little enthusiasm among owners to hire more workers,

primarily due to continued weak sales trends.”

Yikes! And we thought we were cautious on the macro outlook.

WHAT TO BUY?
Thus far, the clear winner in this latest bout of financial turbulence has been
gold, which tacked on a further 1.1% on Friday, to close at $1,210/oz and is
now up over 9% for the year. And, the yellow metal has continued to hit new all-
time highs in Sterling and Euro terms.

Page 5 of 10
May 10, 2010 – BREAKFAST WITH DAVE

DEFLATIONARY PRESSURES INTACT

Wages, real estate, credit … and now commodities. Amidst one of the worst
financial crises in Europe,
• Crude oil closed the week at $75/bbl, down 13% and at the lowest level since Britain chose now to opt
mid-February. for the first minority
• There is a big shake-out going on in the copper market where the red metal is government since 1974
back down to where it was in January — dropping 6% last week.
• Aluminum prices sank more than 7%.
• All in, the GSCI commodity index slid 8.5% last week in its worst showing since
July 2009.

THE U.K. POLITICAL BACKGROUND — ANOTHER CLOUD

Well, the timing could not be worse. Amidst one of the worst financial crises in
Europe, Britain chose now to opt for the first minority government since 1974 —
and two years after that, as a reminder, the country went to the IMF (one reason
why Sterling sagged to its lowest level of the year on Friday; not to mention
slumping 2.4% against the beleaguered Euro). In fact, it looks like the country is
heading down the path of a coalition government including the Liberal
Democrats (which received 57 seats of 650 seats with something like 23% of
the vote — do the math and tell me if that makes any sense) which is something
Britain has not seen since Churchill’s wartime alliance in the 1940s.

This is not a political backdrop that promises to be very effective at tackling the
U.K.’s deep fiscal challenges ahead — a balance sheet that does not look
altogether that much different than Greece. Remember, the credit rating agencies
made it very clear that for the U.K. to hang on to its AAA rating, any new
government would have to unveil a credible plan to improve its fiscal situation.

The bond market is starting to sniff out some problems here as Gilt-bund yield
spreads have widened out to 112 basis points — the highest since August 1998
when the LTCM fiasco froze up global credit markets. We see on page B6 of the
Saturday NYT that once the myriad of off-balance sheet debts are added to the
U.K. government balance sheet, debt is 150% of GDP (as opposed to the reported
53% figure) and the deficit is 18% (not 12%) — both much higher than Greece, by
the way. Then again, the U.K. has a currency it can devalue — and it too is a short.

BIG PROBLEMS LINGER AT THE STATE GOVERNMENT LEVEL

The article on Illinois that made its way to page A3 of the Friday WSJ was quite
disturbing and a reminder that at some point, the problems are going to come
back this side of the Atlantic. Illinois, the U.S. state, whose credit rating is the
worst of all states, outside of California, is finding it exceedingly difficult to
eliminate its huge $13 billion deficit. It looks as though the legislature is going
to grant the governor ‘emergency budgetary powers’ in order to get through
income tax hikes as well as draconian spending cuts. Many U.S. states are in a
similar predicament.

Page 6 of 10
May 10, 2010 – BREAKFAST WITH DAVE

THESE ARE THE PEOPLE THE OBAMA TEAM IS BAILING OUT

According to the Treasury Department, the median ratio of total debt to income
It is amazing what the U.S.
for households receiving a modified mortgage under the HAMP program is 61%.
government has money for
Perhaps that is why the program has seen such limited success (228,000
— cash for clunkers, cash
modifications thus far) — it’s not only mortgage debt that has these people in
for appliances and now
trouble. Maybe the best form of stimulus would be a government-assisted cash for caulkers
program to defray the costs of a credit counsellor. See Mortgage Paid. A Dozen
Debts to Go on page A3 of the weekend WSJ.

It’s amazing what the government has money for. First it was cash for clunkers.
Then the State governments, who are in fiscal disarray, offer up cash for
appliances, which helped underpin retail sales for the last couple of months.
And, now we see that Washington is set for a new method to spur spending —
cash for caulkers. We should just call it Rebate Nation.

U.S. HOME PRICES — STILL OVERVALUED

If you haven’t already done so, you should check out Robert Shiller’s website
where he provides the underlying data for the charts in his book “Irrational
Exuberance” (for free!). We often quote the Shiller P/E (which goes back to the
1880s). In addition to long-term stock prices, Professor Shiller also provides data
on long-term home prices going back to 1890 (which he painstakingly cobbled
together from various data series and real estate listings from newspapers).

The chart below shows this index of home prices, adjusted for inflation. Relative
to long-term trends, it shows just how overvalued the U.S. housing market was at
its peak in 2006 — prices were 3.5 standard deviations above the long-term
average. Currently, prices are nearly one standard deviation above historical
norms, which suggests in ordet to mean-revert to the long-term average, home
prices need to fall by another 20%.

CHART 1: U.S. HOME PRICES – THE LONG, LONG TERM VIEW

United States: Real Home Prices* (index, 1890=100)
220

2006: 3.5 standard

200 deviations

180

160

140 1 standard deviation

120

100

80
-1 standard deviation

60

40
1890 1902 1914 1926 1938 1950 1962 1974 1986 1998 2008

Note: For details of series construction, see” Irrational Exuberance” by Robert Shiller (Page 13, note 3). Q1 2010
estimate by Gluskin Sheff, using latest Case-Shiller home prices index. Source: Robert Shiller, Gluskin Sheff

Page 7 of 10
May 10, 2010 – BREAKFAST WITH DAVE

U.S. CONSUMER CREDIT EDGES UP

Consumer credit rose $2 billion in March, although this increase did not offset the
(upwardly) revised $6.2 decline in February. The increase was driven by a jump in
non-revolving credit (for example auto loans and lines of credit), which has been
up for three out of four months. This is not that surprising given that auto sales
jumped over 14% in March. Revolving credit (ie, credit cards) slipped by $3.2
billion, extending a long string of declines, which started in October 2008.

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

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