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David A. Rosenberg Chief Economist & Strategist drosenberg@gluskinsheff.com + 1 416 681 8919

June 18, 2009 Economics Commentary

MARKET MUSINGS & DATA DECIPHERING

Economics Commentary MARKET MUSINGS & DATA DECIPHERING Breakfast with Dave WHILE YOU WERE SLEEPING Very quiet

Breakfast with Dave

WHILE YOU WERE SLEEPING

Very quiet overnight

European equities flat-ish and Asian markets down for the most part: Nikkei down 1.4%, Hang Seng off 1.7%, Kospi down 1.1%.

Commodities generally firm — outlook now wholly dependant on whether China’s fiscally-induced recovery is sustainable (the World Bank just raised its GDP growth forecast to 7.2%, — but is that enough?); also see the article on page 24 of the FT (China’s import demand has soared this year for steel, copper and a host of other raw material).

Little action in bond-land, but in the U.S.A., it is absolutely glaring how cheap bonds have become with the de facto real yield on the 30-year now a snick above 550 basis points. Real yields at these levels, notwithstanding the supply backdrop, are simply unsustainable — the last time we were anywhere close to a 5½% percentage point inflation-adjusted long bond yield (November 1994, July 1986, and January 1982) the nominal 30-year yield ended up rallying in the next six months each time and by an average of 75 basis points.

IN THIS ISSUE

• Screening for actual pricing power from the PPI the CPI and the capacity utilization (CapU) reports

• No credit, no inflation

• Era of the ‘green shoots’ is over

• Bonds still have potential, in our view

• Gas pains for the U.S. consumer

• Mortgage applications falling out of bed

While fiscal policy is a clear hurdle, the headwinds for bonds include a record output gap, which should help bring down inflation expectations; flat to low single digit nominal growth, which is the most important factor in interest rate determination; the lack of bullish sentiment, which is a contrary positive; the low ownership of Treasuries in domestic portfolios (less than 7% of the U.S. household balance sheet is comprised of fixed-income securities compared with 12% cash, 25% equities and 30% real estate); and the huge positive carry (aka steep yield curve) offered by the Fed and this is not likely to change until after the unemployment rate peaks and that could easily be 1 to 2 years away. Pundits who cling to the inflation view should have a read of Boston Paper Plans Talks (see page B4 of today’s Wall Street Journal) and tell the inflation story to the workers who are facing a 23% pay cut.

Note too that even as the fiscal shortfall hit new highs, the U.S. current account deficit is slip sliding away (to $101bln in 1Q or 2.9% relative to GDP, which is the lowest since 1999) which means that, at the margin, there is less need for foreign investors to fund the budget gap (we just need an awful lot of PIMCOs!).

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

June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE On the data front, it looks like the green

On the data front, it looks like the green shoots are turning yellow in the U.K. as well where we see that retail sales fell 0.6% MoM in May — first setback in three months (consensus was +0.3%, so wrong digit and wrong sign). On top of that, the U.K.’s CBI industrial survey came in weak with export orders down to their lowest level since October 1998! Needless to say, the British Pound took a pounding on the release of the data.

SOME IMPORTANT ITEMS TO NOTE REGARDING ENERGY SPACE/UTILITIES

1. Both the NYT and WSJ ran with articles today on the amount of natural gas that is going to be available for production in the next few years — up something like 58% over the past four years. A Senate panel just voted in favour of an energy bill that is going to also open up new areas for offshore drilling.

2. The House democrats are pushing for the Department of Energy to sell 70 million barrels of light sweet crude (and replace with cheaper heavier crude) out of the Strategic Petroleum Reserve (SPR) — a bill was just introduced to this effect.

3. The utilities sector is probably going to like the fact that a Senate panel just approved an energy bill that is going to impose less stringent mandates on utilities. The WSJ reports today that environmental groups are very upset over the less stringent renewable energy requirements — that’s always a good sign for the utilities space.

SCREENING FOR THE CPI

The consumer price index rose by a much lower than expected 0.1% in May and this, like the PPI, took the YoY trend to a five-decade low, of -1.0%. We are going to see some larger monthly prints due to higher gasoline prices but because of the huge base effects of a year ago, when oil hit $150/bbl, we could still very likely see the YoY headline inflation rate sink to as low as -2.0% by the end of the summer. It is very clear that we are either in an extremely benign inflation environment or on the precipice of a deflationary environment. Either way, pricing power is confined to relatively few sectors. These would include:

! Restaurants — up 0.2% MoM in May and 4.2% on a YoY basis.

! Alcoholic beverages — much like the PPI, up 0.3% MoM in May and +3.0% YoY.

! Sweets — as we said above in the PPI, chocoholics don’t mind paying higher prices, even in a borderline depression — pricing is up a solid 6.0% on a YoY basis.

! As the PPI also illustrated from the producer standpoint, at the retail level the CPI showed a 0.8% monthly rise and a 7.7% bubbly inflation rate for soft drinks.

! Prescription drugs — 0.6% MoM and 3.5% on a YoY basis.

! Pets/pet products — as with PPI, huge pricing power (+10.0% YoY).

! Telephone services — steady-as-she-goes with a 0.2% monthly increase in May and a decent YoY pricing trend of 2.4%.

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June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE Items that are in clear deflation mode are personal

Items that are in clear deflation mode are personal care products/services, toys, sporting goods, hotels, air fares, delivery services, apparel, jewelry, home improvement, appliances, recreation and grocery stores (across every category from bread, to meat, to poultry — restaurants are seeing much better pricing growth).

WHO HAS GOOD PRICING TRENDS AT A TIME OF -5.0% PPI?

We also ran sector screens on actual pricing power using the PPI and as the chart below illustrates, the YoY trend is running at -5.0%, the most pronounced deflation rate in 50 years. As is the case with capacity utilization (CAPU) rates, the key is to identify the sectors whose pricing is not deflating, let along making new 50-year lows.

CHART 1: PRODUCER PRICES ARE DEFLATING AT A 5% YOY RATE

United States

PPI: Finished Goods

(year-over-year percent change) 20 15 10 5 0 -5 -10 50 55 60 65 70
(year-over-year percent change)
20
15
10
5
0
-5
-10
50
55
60
65
70
75
80
85
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

S o what is hanging in well?

! How about soft drinks? Pricing grow th is slowing but still positive at 3.0% YoY. In relative terms, that is a 500bps premium to the rest of the market. The chart of Coca-Cola is looking just fine (and looking at the intermediate PPI, i t looks like a lot of the run-up in soft drink beverage base costs is behind us).

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June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE CHART 2: PRICING GROWTH FOR SOFT DRINKS REMAIN POSITIVE

CHART 2: PRICING GROWTH FOR SOFT DRINKS REMAIN POSITIVE

United States

PPI: Soft Drinks

(year-over-year percent change) 8 6 4 2 0 -2 90 95 00 05
(year-over-year percent change)
8
6
4
2
0
-2
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

! Beer/spirit prices are holding in great, at 3.8% YoY and the chart of the group also looks decent.

CHART 3: PRICING FOR BEER/SPIRITS ALSO HOLDING UP WELL

United States

PPI: Alcoholic Beverages

(year-over-year percent change) 8 6 4 2 0 -2 -4 90 95 00 05
(year-over-year percent change)
8
6
4
2
0
-2
-4
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

! Chicken producers are seeing 5.0% pricing growth (Tyson chart looks wonderful).

! Confectionary products is seeing solid 6.0% pricing (Hershey does not look inspiring on the charts, though) — again, looking at the intermediate PPI, sugar and confection costs seem to be peaking out; should provide some support here for margins because this group does indeed have pricing power (dairy products, on the other hand, are getting roughed up — PPI down 16.0% YoY).

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June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE ! Not sure who populates the pet food space

! Not sure who populates the pet food space but it is seeing ripping pricing power (11.0% YoY) and I have been reading in many reports that this is actually a staple in a recession — people will cut back on their own eating before they put their pets on a diet.

! Drug producers are seeing 6.0% pricing trends and producers of sanitary products/health products are also seeing 6.0% pricing trends, which is solid.

! The PPI for toys/games is running at 6.6% and deserve a look — not everything is looked at as a cyclical this cycle either. Anything related to capex — construction machinery, rail stock, computers, tools/dies, power transformers are losing pricing momentum.

CHART 4: AMPLE PRICING POWER IN TOYS, GAMES AND CHILDREN’S VEHICLES

United States

PPI: Toys, Games, and Children's Vehicles

(year-over-year percent change) 10.0 7.5 5.0 2.5 0.0 -2.5 90 95 00 05
(year-over-year percent change)
10.0
7.5
5.0
2.5
0.0
-2.5
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

NO CREDIT, NO INFLATION

As long as bank credit continues to contract and household balance sheets shrink, the Fed’s moves to boost the money supply will be little more than throwing spaghetti against the wall. Not much of it is going to stick — not with the Treasury telling us that in April, the 21 largest recipients of TARP funds actually saw their loan book slide 7%, with weakness across all lending categories.

ERA OF THE GREEN SHOOTS IS OVER

It was fun while it lasted but if the latest set of data couldn’t kybosh the ‘green shoot’ theory, then FedEx sure did when it posted earnings results that fell well short of target and the CEO announcing that the economic backdrop was “extremely difficult”. On top of that, UAL stated that its 2Q traffic is expected to drop as much as 10.5% YoY on a 9.0% decline in available seats.

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June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE Not only have the transports rolled over but so

Not only have the transports rolled over but so have the banks — the group that led the rally since early March — with a huge 3.3% loss yesterday (and now the group is down 20% for the year). Due to mounting concerns over commercial real estate exposure, S&P cut the ratings and/or outlooks on 22 banks yesterday (the regional banks of course — the ones that the Fed, Treasury and White House don’t believe are too big to fail. As an aside, to see how the U.S. government’s behaviour is dramatically altering private sector incentives, see Too Big to Fail, or Succeed in today’s op-ed section of the WSJ.) We also see in today’s FT (page 28) that Moody’s is considering a wave of bank downgrades of its own premised on its concerns surrounding the quality of subordinated debt on bank balance sheets.

BONDS MIXED BUT THERE IS STILL POTENTIAL

Treasuries had an up-and-down day but ended up selling off as the street prepares for another huge slate of supply next week with the 2-year, 5-year and 7-year auctions beginning June 23. But there is still quite a bit of residual Fed tightening priced in to the Treasury market that can still come out. The market is priced 40% of the way for a Fed rate hike by year-end, down from 65% a week ago but still some 40 basis points above what sanity would suggest those odds should be.

GAS PAINS FOR THE U.S. CONSUMER

Retail gasoline prices have now risen for 40 consecutive days, the longest streak since the records began in 1996. Over the past month alone, gasoline prices have jumped 50 cents a gallon to stand at $2.68 (national average — this is equivalent to a $65 billion annualized cash drain on the household sector — about a 1.0% pay cut equivalent). The fact that this is happening just as the incremental effects of the tax stimulus begins to wane tells us that this is going to be a long hot summer for retailing stocks.

One other factor that could end up suppressing the consumer is the escalating restraint at the lower levels of government — state income tax receipts plunged 26% YoY in the first four months of 2009, forcing state legislatures to dramatically revise their budget outlooks for the coming year. See State Income Tax Revenues Sink on page A4 of today’s WSJ.

MORTGAGE APPLICATIONS … FALLING OUT OF BED

Higher mortgage rates in the last few weeks are now affecting mortgage activity, which does not bode well for housing at all. The MBA’s applications, purchases and refinancing indices all fell during the week ending June 12. Mortgage applications tumbled for the fourth week in a row, down 15.8% to 514.4 — its lowest level since mid-November 2008. Applications for mortgages are now down 59% from their nearby peak, which we saw back during the week of April 3 rd . After rising three straight weeks, the purchase index sagged 3.5%, setting us up for a new home sales setback for this month. As for refinancing, the subindex lunged 23.3% for the week and is down 70% from the recent peak we saw back in mid April.

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June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE As for rates, the 30-year fixed mortgage rate did

As for rates, the 30-year fixed mortgage rate did fall 7bps last week to 5.50% but it is still 89bps higher than the rate posted back in late March. The one-year ARM rate did fall 21bps to 6.54%, but even with this decline the one-year rate is still 65bps higher than where it was in mid-January too.

CHART 5: REFINANCING BOOM IS LONG GONE

United States

MBA: Volume Index: Mortgage Loan Applications for Refinancing

(March 16, 1990 = 100) 8000 6000 4000 2000 0 07 08 09
(March 16, 1990 = 100)
8000
6000
4000
2000
0
07
08
09

Source: Haver Analytics, Gluskin Sheff

CHART 6: NO TRACTION ON NEW PURCHASES INDEX EITHER

United States

MBA: Volume Index: Mortgage Loan Applications for Purchase

(March 16, 1990 = 100) 600 500 400 300 200 00 01 02 03 04
(March 16, 1990 = 100)
600
500
400
300
200
00 01
02
03 04
05 06
07
08 0

Source: Haver Analytics, Gluskin Sheff

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June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE CAPU SECTOR SCREENS Aerospace/Defence; Telecom Equipment; Food/Beverage Producers;

CAPU SECTOR SCREENS Aerospace/Defence; Telecom Equipment; Food/Beverage Producers; Oil/Gas Extraction Screen Best

As Chart 7 shows, industry capacity utilization rates in the United States fell to a record low of 68.3% in May from 69% in April — the seventh decline in a row.

Chart 7: CAPU RATE AT A RECORD LOW — 68.3%

United States

Total Industry Capacity Utilization Rate

(percent) 92 88 84 80 76 72 68 70 75 80 85 90 95 00
(percent)
92
88
84
80
76
72
68
70
75
80
85
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

This is a key barometer of corporate pricing power and the key is isolating those sectors whose CAPU rates did NOT hit a new low this cycle. These are the ones to focus on in terms of the ability to pass on cost increases and protect margins. These sectors include food/beverage producers (who will need the ability to pass on higher feed costs), aerospace/defense, oil/gas extraction, and communications equipment (see charts below).

Except for energy, these sectors did not outperform during the whippy bear market rally even though they arguably possess the most solid demand-supply characteristics at this time (on a relative basis).

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June 18, 2009 – BREAKFAST WITH DAVE

June 18, 2009 – BREAKFAST WITH DAVE CHART 8: CAPU RATE FOR COMMUNICATIONS EQUIPMENT HOLDING UP

CHART 8: CAPU RATE FOR COMMUNICATIONS EQUIPMENT HOLDING UP

United States

Capacity Utilization: Communications Equipment

(percent) 100 90 80 70 60 50 40 75 80 85 90 95 00 05
(percent)
100
90
80
70
60
50
40
75
80
85
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

CHART 9: THE CAPU RATE FOR AEROSPACE REMAIN HIGH

United States

Capacity Utilization: Aerospace & Misc Transportation

(percent) 100 80 60 40 20 50 55 60 65 70 75 80 85 90
(percent)
100
80
60
40
20
50
55
60
65
70
75
80
85
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

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June 18, 2009 – BREAKFAST WITH DAVE

CHART 10: CAPU RATES FOR FOOD/BEVERAGE PRODUCERS NEED TO REMAIN HIGH

CAPU RATES FOR FOOD/BEVERAGE PRODUCERS NEED TO REMAIN HIGH United States Capacity Utilization: Food, Beverage, &
United States Capacity Utilization: Food, Beverage, & Tobacco Products (percent) 87.5 85.0 82.5 80.0 77.5
United States
Capacity Utilization: Food, Beverage, & Tobacco Products
(percent)
87.5
85.0
82.5
80.0
77.5
75.0
70
75
80
85
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

CHART 11: CAPU RATES FOR ENERGY PRODUCTS SOLID

United States

Capacity Utilization: Petroleum and Coal Products

(percent) 105.0 97.5 90.0 82.5 75.0 67.5 50 55 60 65 70 75 80 85
(percent)
105.0
97.5
90.0
82.5
75.0
67.5
50
55
60
65
70
75
80
85
90
95
00
05

Source: Haver Analytics, Gluskin Sheff

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June 18, 2009 – BREAKFAST WITH DAVE

ABOUT US

June 18, 2009 – BREAKFAST WITH DAVE ABOUT US Gluskin Sheff at a Glance Our mission

Gluskin Sheff at a Glance

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June 18, 2009 – BREAKFAST WITH DAVE

IMPORTANT DISCLOSURES

June 18, 2009 – BREAKFAST WITH DAVE IMPORTANT DISCLOSURES Copyright 2009 Gluskin Sheff + Associates Inc.

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