You are on page 1of 10

David A.

Rosenberg July 6, 2009

Chief Economist & Strategist Economics Commentary
+ 1 416 681 8919


Breakfast with Dave



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
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.

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

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.


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.


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.

Page 2 of 10

• 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.
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.


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.

Page 3 of 10

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).


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.

Page 4 of 10

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.


United States
Cash-to-Asset Ratio





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


United States
Nonfarm Nonfinancial Corporate Business Cash-to-Asset Ratio







80 85 90 95 00 05

Shaded area represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Page 5 of 10


United States
Household Cash-to-Asset Ratio






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.


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).


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

Page 6 of 10


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.


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. 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.


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

Page 7 of 10


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

• 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
• The program will run from August to November, so it is very short-term in
• 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.

Page 8 of 10


Gluskin Sheff at a Glance

Our mission is to be the pre-eminent wealth management firm in
Canada serving high net worth investors


Gluskin Sheff is an independent wealth Gluskin Sheff has a 24-year track record
management firm focused primarily on of solid investment performance. Clients
high net worth private clients, including investing in our GS+A Value Portfolio
entrepreneurs, professionals, family from inception (January 1, 1991) have
trusts, private charitable foundations and achieved a total net return of 773.8% to
estates. We also benefit from business May 31, 2009, outperforming the
relationships with a number of 379.1% return of the S&P/TSX Total
institutional investors. Return Index over the same period. Our
other longer-term investment models
OUR PEOPLE also have impressive performance
At Gluskin Sheff, having the best people records.
allows us to deliver strong investment
performance and the highest level of CLIENT SERVICE
client service. Our professionals possess At Gluskin Sheff, our clients are our most
the experience, dedication and talent to important asset. Serving them is a core
meet the individual needs of our clients. value maintained throughout the
Company. Clients receive individual
RISK MANAGEMENT attention and investment advice
Our unique dual risk management customized to their specific investment
approach focuses on meeting the needs objectives and risk profile.
of our clients by preserving their capital,
managing risk and delivering strong long- INVESTMENT PHILOSOPHY
term investment returns through various Our investment decisions are based on
economic and market cycles. “bottom-up” research that looks for
companies with a history of long-term
growth and stability, a proven track
record, shareholder-minded management
and a share price below our estimate of
intrinsic value.

Page 9 of 10

Copyright 2009 Gluskin Sheff + Associates Inc. (“Gluskin Sheff”). All rights and, in some cases, investors may lose their entire principal investment.
reserved. This report is prepared for the use of Gluskin Sheff clients and Past performance is not necessarily a guide to future performance. Levels
subscribers to this report and may not be redistributed, retransmitted or and basis for taxation may change.
disclosed, in whole or in part, or in any form or manner, without the express
written consent of Gluskin Sheff. Gluskin Sheff reports are distributed Foreign currency rates of exchange may adversely affect the value, price or
simultaneously to internal and client websites and other portals by Gluskin income of any security or financial instrument mentioned in this report.
Sheff and are not publicly available materials. Any unauthorized use or Investors in such securities and instruments effectively assume currency
disclosure is prohibited. risk.

Gluskin Sheff may own, buy, or sell, on behalf of its clients, securities of Materials prepared by Gluskin Sheff research personnel are based on public
issuers that may be discussed in or impacted by this report. As a result, information. Facts and views presented in this material have not been
readers should be aware that Gluskin Sheff may have a conflict of interest reviewed by, and may not reflect information known to, professionals in
that could affect the objectivity of this report. This report should not be other business areas of Gluskin Sheff. To the extent this report discusses
regarded by recipients as a substitute for the exercise of their own judgment any legal proceeding or issues, it has not been prepared as nor is it
and readers are encouraged to seek independent, third-party research on intended to express any legal conclusion, opinion or advice. Investors
any companies covered in or impacted by this report. should consult their own legal advisers as to issues of law relating to the
subject matter of this report. Gluskin Sheff research personnel’s knowledge
Individuals identified as economists do not function as research analysts of legal proceedings in which any Gluskin Sheff entity and/or its directors,
under U.S. law and reports prepared by them are not research reports under officers and employees may be plaintiffs, defendants, co-defendants or co-
applicable U.S. rules and regulations. Macroeconomic analysis is plaintiffs with or involving companies mentioned in this report is based on
considered investment research for purposes of distribution in the U.K. public information. Facts and views presented in this material that relate to
under the rules of the Financial Services Authority. any such proceedings have not been reviewed by, discussed with, and may
not reflect information known to, professionals in other business areas of
Neither the information nor any opinion expressed constitutes an offer or an Gluskin Sheff in connection with the legal proceedings or matters relevant
invitation to make an offer, to buy or sell any securities or other financial to such proceedings.
instrument or any derivative related to such securities or instruments (e.g.,
options, futures, warrants, and contracts for differences). This report is not Any information relating to the tax status of financial instruments discussed
intended to provide personal investment advice and it does not take into herein is not intended to provide tax advice or to be used by anyone to
account the specific investment objectives, financial situation and the provide tax advice. Investors are urged to seek tax advice based on their
particular needs of any specific person. Investors should seek financial particular circumstances from an independent tax professional.
advice regarding the appropriateness of investing in financial instruments
and implementing investment strategies discussed or recommended in this The information herein (other than disclosure information relating to Gluskin
report and should understand that statements regarding future prospects Sheff and its affiliates) was obtained from various sources and Gluskin
may not be realized. Any decision to purchase or subscribe for securities in Sheff does not guarantee its accuracy. This report may contain links to
any offering must be based solely on existing public information on such third-party websites. Gluskin Sheff is not responsible for the content of any
security or the information in the prospectus or other offering document third-party website or any linked content contained in a third-party website.
issued in connection with such offering, and not on this report. Content contained on such third-party websites is not part of this report and
is not incorporated by reference into this report. The inclusion of a link in
Securities and other financial instruments discussed in this report, or this report does not imply any endorsement by or any affiliation with Gluskin
recommended by Gluskin Sheff, are not insured by the Federal Deposit Sheff.
Insurance Corporation and are not deposits or other obligations of any
insured depository institution. Investments in general and, derivatives, in All opinions, projections and estimates constitute the judgment of the
particular, involve numerous risks, including, among others, market risk, author as of the date of the report and are subject to change without notice.
counterparty default risk and liquidity risk. No security, financial instrument Prices also are subject to change without notice. Gluskin Sheff is under no
or derivative is suitable for all investors. In some cases, securities and obligation to update this report and readers should therefore assume that
other financial instruments may be difficult to value or sell and reliable Gluskin Sheff will not update any fact, circumstance or opinion contained in
information about the value or risks related to the security or financial this report.
instrument may be difficult to obtain. Investors should note that income
Neither Gluskin Sheff nor any director, officer or employee of Gluskin Sheff
from such securities and other financial instruments, if any, may fluctuate
accepts any liability whatsoever for any direct, indirect or consequential
and that price or value of such securities and instruments may rise or fall
damages or losses arising from any use of this report or its contents.

Page 10 of 10