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David A.

Rosenberg July 6, 2009


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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave


DUE TO BUSINESS TRAVEL, BREAKFAST WITH DAVE WILL RETURN ON
THURSDAY, JULY 9.

WHILE YOU WERE SLEEPING


IN THIS ISSUE
Equity markets globally are in the red column today as investors reassess
economic recovery prospects, in fact, the MSCI world index has fallen now for • Equity markets overseas
three days in a row. Europe is off nearly 2% thus far, the Nikkei down 1.4% to reassess economic
9,680 and the Hang Seng slipped 1.2% to 17,979. While practically every recovery prospects
market was off, it was notable to see the Korean Kospi index advance 0.6% and • U.S. stock markets may
the bubble in China continues unabated — rising 1.2% and up 72% for the year. have run ahead of the
fundamentals
Bond markets are bid overseas but there is very little movement so far in the • The ‘green shoots’ get
U.S.A. outside of a moderate yield decline at the front end of the curve. The shot
more defensive investment posture is also being reflected in a better tone to the
• Some bad calls on the
U.S. dollar (as well as the yen versus the euro — another signpost of renewed
unemployment rate
investor caution). As bad as things are in America, they seem to be little better
across the pond (see Exporters Squeezed by Euro Strength on page 13 of the FT • U.S. bank credit continues
to shrink
and Brown Fears Economic Recovery Is In Peril on page 4).
• Commercial real estate a
On the data front, we saw European investor confidence decline in July for the big accident waiting to
first time in four months. Commodities and resource-based currencies are also happen
seeing a big round of selling in the wee hours of the morn: oil is off 4% to a five- • Consumers looked
week low of $64/bbl (AAA reported that U.S. gasoline demand was down 2.6% negative in 2Q and
YoY over the holiday weekend); copper fell 2.3% today and has declined now for entering 3Q on a soft note
three days running on Chinese stockpile concerns (nickel is down 3.3%). Even
the farming sector is deflating now with corn futures slumping 2.9% to their
lowest level in four months; soybeans are following suit (for the bulls, the
problem is when the weather is cooperative).

On the international front, all the press headlines are about Obama’s trip to
Russia and India’s budget, which is going to push the fiscal deficit to a 15-year
high of 6.8% relative to GDP (and pulled the Bombay stock index down 5.8% in
the aftermath of the news). The country is also doubling its import taxes on gold
and silver, which is very likely going to bite even further into bullion demand
(where imports are already down 55% YoY and the prime reason why gold has
been unable to make a new high).

Please see important disclosures at the end of this document.

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July 6, 2009 – BREAKFAST WITH DAVE

It’s fairly light on the U.S. data calendar until we get the PPI and retail sales
reports on July 14. One of the pieces of data that is coming out that could The entire rally in the
garner some attention, however, is today’s non-manufacturing ISM index for U.S. equity markets
June — consensus is hopeful that it will edge up to 46 from 44 in May. Usually, from March to May
this data point comes out in time to help out the predictions for nonfarm payrolls was driven by multiple
but this time, it is the jobs data that should help provide some clues over this expansions
diffusion index. All we know is that the 244k plunge in service-sector payrolls
was the eighth largest slide in the past 70 years, so it will be interesting to see
how this lines up with a consensus-style two point gain in the non-manufacturing
ISM index today. As an aside, we found a nearly 70% historical correlation
between service sector employment growth and the diffusion index.

EQUITY MARKET MAY HAVE RUN AHEAD OF THE FUNDAMENTALS


The entire 40%+ rally from March to May was driven by multiple expansions.
Any further gains are going to rest on how the profit picture unfolds and there is
quite a bit of good news being discounted. The bottom-up consensus estimate
for 2010 is $74.48, which would represent a 27% jump over 2009. Only once in
the past have we ever seen such an annual gain in operating EPS and it was in
1993 when the economy was nearly two years out of recession and nominal
GDP rose by more than 5%.

Even looking at reported earnings, which often tend to get a bigger bounce
coming off the trough as write-downs subside, the consensus is discounting an
earnings backdrop that occurs less than 10% of the time. Page 25 of Barron’s
runs with an article on the earnings backdrop and cites a separate survey from
Capital IQ that shows a lower forward consensus estimate than Thomson at
$68.45, which would represent a more traditional 17% recovery.

As for the data, the 467k slide in U.S. payrolls in June more or less kyboshed the
notion that the green shoots we saw in early spring were anything more than
noise on what is still a fundamental downtrend. The decline was so large that it
surpassed the worst months of the last four recessions, not to mention lining up
in the top ten largest slides going back to 1950.

A CHECK ON THE MARKETS


It looks like risk appetite is starting to fade after a brief six-week splurge in
March and May:

• Baa spreads have widened 15bps from their recent lows. Junk bond spreads
have continued to widen but probably not for much longer.
• The CRB has corrected 8% from the mid-June highs.
• Bond yields have rallied 50bps from their recent peaks.
• The S&P 500 is coming off three weeks of decline and has corrected more
than 5% from the June 12 peak and the index is actually lower now than it
was on May 4. Everyone seems to believe we are in some sort of new bull
market because of a 40% dead-cat bounce off the most oversold condition
since the 1930s.
• The U.S. dollar has stabilized and despite rumours of its demise, has not
made a low since June 2.

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July 6, 2009 – BREAKFAST WITH DAVE

• The Rasmussen investor confidence index, at 84.8, is at a four-week high so


the fact that the bear market rally is over has yet to resonate … but it will.
THE SHOOTS GET SHOT
To repeat, we had always been of the view that the green shoots were little more
than noise on what is still a fundamental downtrend in economic activity. We We had always been
have to acknowledge that nothing moves in a straight line and that after a
of the view that the
green shoots were
September-January period when pieces of data were collapsing at annual rates
little more than noise
of between 20% and 80% there was always the prospect of a bounce along the
way, but relative to an economic performance that we had not seen since the
1930s. These are not green shoots as much as blips on a screen, and history
teaches us that ISM’s and other diffusion indices and leading indicators (like the
ECRI) that may work well in a garden-variety recession do not work so well in the
aftermath of a credit collapse and deleveraging cycle, where the transition to the
next bull market and economic expansion is long and arduous and replete with
deflation and double-dip recession risks. We have to focus on the forest, not the
trees, to navigate the strategy in the coming quarters and years. To this end, we
are grateful to a faithful reader of our research who sent this our way today — it
is an excerpt from Milton Friedman’s “The Great Contraction: 1929-1933”.

“….after the turn of the year, there were signs of improvement in those
indicators of economic activity [ed note: (refers to personal income, industrial
production etc]. No doubt partly cause and partly effect of the
contemporaneous minor improvement in the monetary area. Industrial
production rose from January to April. Factory and employment, seasonally
adjusted, which had fallen uninterruptedly since August 1929, continued to fall
but at a much reduced rate … Other indicators of physical activity tell a similar
story. Personal income rose sharply, by 6 per cent from February to April 1931,
but this is a misleading index since the rise was produced largely by government
distributions to veterans. All in all, the figures for the first four or five months of
1931, if examined without reference to what actually followed, have many of the
earmarks of the bottom of a cycle and the beginning of revival.”

The similarities this time around are rather striking, especially the “rate of
change” in economic data that were influenced by government intervention,
which ultimately did not prove to be self-sustaining.

SOME BAD CALLS ON THE UNEMPLOYMENT RATE


The official U.S. unemployment rate is now at 9.5%, the highest since August
The current
1983. Only in 13 other months has the jobless rate been higher than this in the
unemployment rate
post-WWII era, and at the current pace, it will break above the late-1982 peak of
level (at 9.5%) makes
10.8% by October. This basically renders the Fed’s central tendency projection
the Fed’s 9.4%
of 9.4% by year-end as obsolete, which means there is no chance of a rate hike projection by year end
at any time on the horizon unless Mr. Bernanke wants to totally jeopardize his obsolete
chances of being reappointed as Chairman come February 2010.

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Then again, the White House forecast has been even worse than the Fed’s. Then again, the U.S.
Back in January, we were told by the Administration that with the passage of the Administration’s
fiscal stimulus bill, the unemployment rate would peak at 8% (a full percentage forecast is even worst
point lower than if the stimulus had not gone through). You have to go back to than the Fed’s
February to find the last time the jobless rate was anywhere near 8%.

As if a 13% fiscal deficit to GDP ratio isn’t big enough, the most interventionist
Administration on record — these deficits are twice as big as FDR’s — seems to
be planning more fiscal stimulus. See the front page of the WSJ — Calls for More
Stimulus Grows (though a strong argument against yet another fiscal
blockbuster can be found in the op-ed section (page 7) of today’s FT — We Do
Not Need a Second Stimulus Plan.

Meanwhile, the government is going ahead this week with a minimum wage hike
(to $7.25/hour from $6.55) that is going to force companies, especially in the
retail sector, to economize even more on their labour input at a time when the
unemployment rate is at a 25-year high of 9.5% (affecting nearly 3 million
workers who earn the minimum wage).

BANK CREDIT CONTINUES TO SHRINK


Well, if there is a lack of green shoots in any particular data series, it is in the
weekly bank lending data out of the Federal Reserve. For the third week in a row,
the supply of bank wide real estate loans declined in the June 24th week, this time
by $6.2 billion, bringing the cumulative contraction to over $50
billion. Outstanding consumer credit fell by $600,000,000 and has now shrunk
for four weeks in a row — a combined decline of nearly $13 billion. We also see
that business credit — commercial & industrial loans — dropped $2.5 billion during
the week and have also contracted for four weeks running ($37 billion in total).

In sum, bank wide credit extended to the private sector was down $9.4 billion in
the June 24th week and by over $90 billion during the last four weeks, which is
epic. How anyone can believe we are going to see any kind of recovery as the
commercial banks focus on reducing their non-liquid assets remains one of life’s
mysteries. In the meantime, what the banks did build up on their balance sheet
during the week was CASH, which rose $57.3 billion to $937 billion or about
four times what could be considered a normal amount.

At the same time, it looks as though the Fed is now in the process of snugging
monetary policy. We don’t hear from the inflation-ists that the central bank has
actually been allowing its bloated balance sheet to lose some weight in recent
weeks and that the growth rate in the once-red-hot monetary aggregates is
shrinking and the monetary base is also shrinking. Over the last 13-weeks, the
monetary base has contracted at a 23% annual rate (!), M2 growth has softened
to a 1.4% annual rate and MZM has slowed to a mere 4.6% annual rate.

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The charts below vividly illustrate the growing shift towards liquidity preference
at all levels of the economy. Banks, non-financial corporations and households,
in a complete show of caution, are building up cash and cash equivalents on
their balance sheet at a frenetic pace. The ultimate question is where all this
cash is going to be deployed, and we believe will ultimately be diverted towards
debt repayment.

CHART 1: BANKING SECTOR CASH-TO-ASSET RATIO


United States
Cash-to-Asset Ratio
(ratio)

0.10

0.08

0.06

0.04

0.02
90 95 00 05
Shaded area represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff

CHART 2: CORPORATE SECTOR CASH-TO-ASSET RATIO


United States
Nonfarm Nonfinancial Corporate Business Cash-to-Asset Ratio
(ratio)

0.050

0.045

0.040

0.035

0.030

0.025

0.020
80 85 90 95 00 05

Shaded area represent periods of U.S. recession


Source: Haver Analytics, Gluskin Sheff

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CHART 3: HOUSEHOLD SECTOR CASH-TO-ASSET RATIO


United States
Household Cash-to-Asset Ratio
(ratio)

0.18

0.16

0.14

0.12

0.10

0.08
75 80 85 90 95 00 05

Shaded area represent periods of U.S. recession


Source: Haver Analytics, Gluskin Sheff

Households are so strapped for cash that they are challenging their property tax
bills in droves — see the front page of the Sunday NYT (Tax Bill Appeals Take
Rising Toll on Governments). This, in turn, is wreaking further havoc on state
and local government finances because for the first time, on record property tax
revenues are declining due to the wave of reassessments. So how are the state
and municipal governments dealing with the situation? By taxing tourists —
hotel taxes, car rental fees and other such charges (great news for the
hospitality sector); see Tourists Pay Price as Taxes Climb on the front page of the
USA Today.

PUT SOME FOOD & INCOME IN YOUR BELLY


We’re not sure if you saw this but Janney Montgomery Scott just upped Kellogg’s
EPS views due to lower input costs and solid pricing. At the same time, General
Mills raised its quarterly dividend by four cents to 47 cents a share, providing a
very decent yield of 3.2% (40bps premium to the overall equity market and that
high a yield in bond-land does not exist out to the 10-year of the Treasury curve).

AIR TRAFFIC ON THE TARMAC


Continental (the 4th largest U.S. carrier) reported that passenger traffic was off
6.5% in June even as capacity dropped 7.8%.

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CANADIAN BANKS IN THE GLOBAL NEWS AGAIN


Last week we cited a USA Today article listing the reasons why the Canadian Canadian banks are
financial institutions managed to emerge from the credit crunch in far better ranked first globally;
shape than their U.S. counterparts — never mind not needing any government U.S. banks ranked 40th
bailout, not a single dividend was cut. In fact, in a recent World Economic Forum
survey, Canadian banks ranked first globally; U.S. banks ranked 40th. And as for
today’s newsflow, have a look at hiring trends — MBAs Bank on Canadian Jobs
on page 8 of the FT.

COMMERCIAL REAL ESTATE A BIG ACCIDENT WAITING TO HAPPEN


There is a total of $1.7 trillion commercial real estate credit sitting on U.S. bank
balance sheets that are about to become a big problem from a write-down
standpoint. The Investors Business Daily cites research indicating that a peak-
to-trough 50% slide in property values coupled with tougher underwriting
guidelines will prevent a “wide swath” of borrowers from refinancing in the
coming rollover wave in the next four years. The proportion of bank-held
commercial real estate mortgages that are 90 more days past due rose to
2.23% in 1Q, up 48bps from the fourth quarter. The deterioration in loan quality
is already wreaking havoc with the regional lenders in particular — 45 banks
have already failed so far this year compared with 25 in all of last year.

New York City is now being particularly hard hit — the vacancy rate in Manhattan
just hit a 15-year high of 15.0%, versus 13.5% in 1Q and 7.2% a year ago (for
class A space). Asking rents plunged 11% QoQ and for those clinging to the
inflation view, many sectors are actually deflating; median apartment prices in
the city dropped between 13% and 19% as well last quarter. See the details on
page A6 of the IBD.

U.K. AND U.S. ECONOMIES JOINED AT THE HIP


U.K. homeowners, like their American counterparts, paid down mortgage debt in
1Q at the fastest rate in a year — draining funds that would otherwise be used
for retail spending. The £8.1 billion in net mortgage paydown brings the
cumulative redemption to £22 billion over the last three quarters.

THE DEFLATIONARY IMPLICATIONS FROM THE NEW ERA OF CONSUMER


FRUGALITY
It’s all there for all to see on page 62 of the Economist — Help
Yourself: Customers Are Working For Companies Free of Charge, And They Like
It. Definitely worth a read. Oh yes, and as for income generation emerging as a
key investment strategy and how the demographic trends will reinforce that
theme, see the current BusinessWeek (front cover says it all — Rethinking
Retirement).

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CONSUMER LOOKED NEGATIVE IN 2Q AND ENTERING 3Q ON A SOFT NOTE


Chain store sales in July looked to have come in below plan and auto sales were
off 2.0% MoM to 9.69 million units at an annual rate. The growth bulls claim
that vehicle sales are going to zoom ahead in coming months as the Obama
‘Cash for Clunkers’ gimmick kicks in. Well, there’s a nifty article in this topic on
page 26 of BusinessWeek, citing analysis by Standard & Poor’s that the
maximum impact on unit sales will be 3.0%, which is rounding error. The
reasons:

• The Federal government has approved just $1 billion for the program. That is
equivalent to 250,000 autos or basically a week’s worth of current sales
levels.
• The program will run from August to November, so it is very short-term in
nature.
• The government will cut cheques of between $3,500 and $4,000 to dealers
so they can buy old cars that get 18 miles per gallon or less and then sell the
owner a more fuel-efficient replacement. But the problem is that most cars
on the road already get more than 18 mpg, so they won’t qualify. In addition,
while there are a lot of old cars that will qualify, the question is whether, even
with a $4,500 discount, the owners will want to take new car payments at a
time of rising unemployment rates and declining wage rates.

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