David A. Rosenberg Chief Economist & Strategist drosenberg@gluskinsheff.

com + 1 416 681 8919

May 19, 2010 Economic Commentary


Potluck with Dave
DO YOU LONG (OR SHORT?) YESTERDAY? “Yesterday, all my troubles seemed so far away Now it looks as though they’re here to stay Oh, I believe in yesterday.” Yesterday was a real exclamation mark in terms of representing the end of the bear market rally:
• Dow down 115 points to 10,510.95 • S&P 500 down 1.4% to 1,120.8 • TSX off 48.5 points (-0.4%) to 11,764.51 • U.S. 10 year Treasury note yield rallied 9bps to 3.36% • U.S. 2-year note yield rallied 5bps to 0.76% • Canadian 10-year note yield rallied 10bps to 3.40% • Canadian dollar sold off a bit yesterday, to 1.035 versus the U.S. dollar (from

IN THIS ISSUE • Do you long (or short?) yesterday? Yesterday’s market action was a real exclamation mark, in terms of representing the end of the bear market rally • The U.S. is inching closer to deflation: CPI down 0.1% on the month and the year-over-year pace slowed to 2.2% • Where is the housing rebound in the U.S.? • Train wreck coming in the U.S. housing market • Good as gold • And you thought we were bearish!

1.0325). In U.S. cents, the loonie went from 96.85 to 96.39 cents. And so far today, the CAD is down further, to 1.05 (or 95 U.S. cents) — now below its 200-day moving average.
• Euro hit a four-year low of 1.2211 from 1.2395 yesterday and the Euro/Yen

cross is near eight-year lows; 50% of Fibonacci retracement on the Euro is at 1.2134 (from the October 2000 level of 0.8230 to the July 2008 level of 1.6038)
• Crude oil price down 42 cents to $69.66/bbl, to October 2009 levels.

Indeed, the S&P 500 has now sliced below the 50-day moving average and is within 15 points of doing so with respect to the 200-day m.a., which would mean a real rupture. The yield on the 10-year T-note has already dropped below moving averages, and ditto for the oil price. There is a rally all right — in risk aversion trades. Oh yes — how can we forget? If you don’t see deflation then you are obviously not looking at lumber futures — it seems that the market responded more to the U.S. building permits data than the headline housing start number yesterday because lumber prices were cut down a further 8.6% and have now plunged for four straight sessions and is down 26% from the nearby April 21 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 www.gluskinsheff.com

May 19, 2010 – POTLUCK WITH DAVE

The pressures are continuing to build into the wee hours of today and it seems as though Angela Merkel’s move to ban naked short selling on equities, government bonds and CDS have done little more than cause investors to become that much more panicky. A Bloomberg interview with Ken Rogoff who said that the ballyhooed $1 trillion financial rescue plan will do little to prevent an ultimate debt restructuring among Club Med sovereigns has not helped matters at all — at least for the bulls. As a result, government bond markets retain a bid for the most part: Greece is up 8bps today across the yield curve. Libor-OIS spreads widened a basis point to 25bps and CDS spreads for Asian investment grade corporate bonds moved out 10bps to 132bps. We also have global equities down 1.3% today (emerging markets lost 2.5% and we have Asian markets down to three-month lows) and commodities sinking across the board (copper -2.9%, nickel -5.5%, zinc -5.1% and platinum and palladium down to seven week lows). Gold is off 0.7% but the overall long-run picture for bullion is bright even if overbought technically right now. Commodities and equities are now riding a five-day losing streak, which is not something the green-shooty, rose-coloured glasses crowd were accustomed to seeing for most of the past 14 months. For a sign of how quickly the global investor base is shedding cyclical exposure, the Aussie dollar has dropped to eight-month lows; and the kiwi down to three-month lows (aided and abetted by dovish comments out of the Reserve Bank of New Zealand). There was no data to speak of except for the news out of China that new home sales in Shanghai have declined to a five-year low. It looks like some helium is coming out of the balloon. INCHING CLOSER TO DEFLATION No sooner did we print a negative U.S. PPI for April then we get a minus sign in front of the CPI figure — down 0.1% sequentially, pulling the year-over-year trend down to 2.2% from 2.3% in March and the base effects from a year ago are so high from June to November that we are going to see the YoY pace melt away before the year is out. As an aside, seeing both the CPI and PPI decline in the same month is literally more than a 1-in-10 event. Remember, we have not come close to seeing the effects of the commodity price falloff and U.S. dollar strength hit the data yet. Looking at the components of the CPI report, the deceleration in pricing in the retail sector was fairly broad based. Rents were flat so this was only part of the story. Auto prices fell 0.2% MoM, prices for personal care products deflated 0.5% and communications and restaurants were basically unchanged. If there was a big story, and this also showed through in the retail sales number, it was in apparel where pricing slumped 0.7% MoM (the steepest decline since the onset of recession back in February 2008) and the fourth decline in a row (on a seasonally adjusted basis).

According to Ken Rogoff, the $1 trillion financial rescue plan will do little to prevent an ultimate debt restructuring among Club Med sovereigns has not helped matters at all

No sooner did we print a negative U.S. PPI for April then we get a minus sign in front of the CPI figure — down 0.1% sequentially …

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May 19, 2010 – POTLUCK WITH DAVE

What investors should focus on for “cyclical” pressures is the core consumer goods CPI component, which fell 0.3% MoM in April and is now down three months in a row. That has not happened since the depths of despair as 2008 drew to a close. The critical difference is that back then, the core services CPI index was running close to a 3% annual rate and today the trend is sub-1%. This is why deflation risks are so high — we are on the precipice. The core CPI (which excludes food and energy) came in flat and the YoY rate is now down to 0.9% from 1.1% in March and 1.9% a year ago — the last time when the core inflation rate was this low was back in March 1961 when, like today, the yield on the 10-year Treasury note was locked below the 4% threshold (the six-month core CPI trend is all the way down to a 0.28% annual rate — last there in December 1960). As for the equity market and the view that low inflation rates deserve higher-than-normal multiples, we’ll just point out that the P/E ratio on the S&P 500 is at least three points higher today than it was the last time core rates of inflation were where they are today. CHART 1: CORE INFLATION INCHING CLOSER TO DEFLATION TERRITORY
United States: CPI less Food and Energy (six-month percent change at an annual rate)

… And, core CPI came in flat and the YoY rate has slowed to 0.9% from 1.1% in March and 1.9% from a year ago




0 65 70 75 80 85 90 95 00 05
Shaded region represent periods of U.S. recession. Source: Haver Analytics, Gluskin Sheff

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May 19, 2010 – POTLUCK WITH DAVE

United States: CPI less Food and Energy (year-over-year percent change)
15.0 12.5


7.5 5.0


0.0 65 70 75 80 85 90 95 00 05
Shaded region represent periods of U.S. recession. Source: Haver Analytics, Gluskin Sheff

As an aside, this relentless deceleration in the price data is not a statistical illusion nor a government concoction just related to rents (CPI excluding rent also fell 0.1% last month). The downdraft is far too widespread to pin it solely on the treatment of housing costs. This is the by-product of what we left the recession with: near-record excess capacity in real estate, labour and manufacturing in conjunction with an ongoing debt deleveraging cycle. That is a deflationary brew, especially since the peak of the inventory cycle and government stimulus is now behind us. As for the direction of bond yields in the U.S., remember this: the trend in core inflation is statistically more than twice as important as fiscal deficits (or surpluses for that matter) in determining the trend in market interest rates. WHERE IS THE HOUSING REBOUND? Not only was the NAHB index completely at odds with the UofM homebuying intentions index and the sharp falloff in building permits, but look at what the mortgage application data showed us this morning for the week of May 14: a 27% plunge in the new purchase index to the lowest level since May 1997. (At that time we were worrying about Thailand, not Greece, which still had its own currency!) This slide in the purchase index followed on the heels of the 9.5% slide the week before. All the homebuyer tax credit did (like cash for clunkers before it) was to distort spending patterns and bring forward demand. Mortgage purchase applications surged 13% in the final week of April — but that’s history. The U.S. homebuilders are vulnerable as are the housing-sensitive retailers.

The relentless deceleration in the U.S. price data is not a statistical illusion nor a government concoction just related to rents

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May 19, 2010 – POTLUCK WITH DAVE

MORE DEFLATIONARY ANECDOTES This one is a response from one of our faithful subscribers (priceless in Seattle?): This is a great story on signs of global deflation. These informal anecdotes are often more revealing than official releases. “In Seattle, we have two tales. The cruise ships to Alaska ports from here (after the mandatory Jones Act stop in Vancouver, Canada.). We handle reservations for the ships at the piers (port of Seattle). The most recent report is that cruise sales are lagging last year (which was down 20-30% from prior years) and the number of ships this year will be about 70% of last year. This in spite of significant discounts for the 7 day trips on some of the newer, most elegant ships in the cruise fleet. Bigger discounts could be on the way for last minute sales. Then, Boeing says landing the new DOD tanker contract is “important”, then we learn its 737-800 (bread and butter ship) is being back ordered by airlines in China and Europe. This is a tale on the overseas markets and U.S. exports. Either caution or real slack, no one seems to want to say what is happening, and Boeing lets the airlines slide orders for a fee. But the bottom line is clear, aircraft deliveries will be down this year, 2010, and maybe 2011.” TRAIN WRECK COMING? Sometimes one email correspondence with one reader goes a long way. This contact of ours has a slightly less ebullient view of the housing market than Messrs Paulsen and Paulson. His firm had a meeting with the entire management team of a leading mortgage REIT. Apparently, a very impressive presentation — the one thing that caught my friend’s attention was that a “second shoe” was seen as likely dropping in the housing market starting in September/October. The reason apparently is resets for option ARMS created in large numbers by the likes of Golden West Financial/Wachovia. The senior managers of this REIT indicated that they spend a great deal of time with the folks at Fannie and Freddie, as well as the Congressional oversight people. As our contact poignantly said, “open ended disaster with no end in sight!” GOOD AS GOLD Yet another letter in a day of anecdotes — this one from a long-term friend. I’m not in the inflation camp but if he’s right, just another reason to ensure that precious metals comprise a core part of anyone’s portfolio. To wit:

We often receive comments from our readers about the current economic landscape and sometimes these informal anecdotes are more revealing than the official press releases

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May 19, 2010 – POTLUCK WITH DAVE

“… You might be interested in this. A client points out that over a 5year period ALL currencies are down by about the same amount (165-190%) versus gold. It’s not like one is underperforming another. Did you read Cochrane’s op-ed? While we face a deflationary near-term future, the temptation will be to go through a door which, somewhat inevitably, will lead to inflation. While it was hard for me to imagine how developments in the housing market in 2007 would not be ruinous to the brokers (with MER trading at $78) it is equally hard to see how the western hemisphere can withstand the temptation to inflate their way out of this mess.” AND YOU THOUGHT WE WERE BEARISH! Here is one of the most insightful — if frightening — emails we have received in some time. We still maintain that portfolios should have a concentration in securities that spin off an income stream. But again, a “barbell” approach with hard assets such as commodities will act as an effective hedge if government policies produce inflation. Have a read of this zinger below: “I don’t know if you remember but we worked together at Merrill. I ran emerging markets from 1985 to 1996. I’ve always been a loyal fan and kept up with your writings. As you know, I used to specialize in what we called then toxic waste countries. Reality has obviously taken a turn and what was toxic now is golden and the prime is now toxic. Our best countries are being run like banana republics and the famed moral hazard issues are now at the individual level with the strategic mortgage defaults. Keep in mind that in Mexico, it moved to wholesale credit card defaults at the last stage of the correction. It is interesting to note that back then (the 80s) without currency zones but a fixed dollar, the order was devaluation, default, restructuring and budget balance with exports beginning the process of recovery. It was not until Summers’ bailout of Mexico that we entered this ridiculous world of constant bailouts, raising the size of them at every turn and lowering the bar to what constitutes risk. Now, it’s worst than ever. The developed economies have huge fiscal deficits with no state assets to sell. The balance sheets of the developed nations are over leveraged. The deficits have taken a permanence to them. In the case of Europe with no individual devaluation alternative and their new massive debt load, the EU must now make huge fiscal cuts to get credibility. This is very reminiscent of the pre-depression year. If the EU follows through it will push a weak world into a severe double dip and bring the question of capacity to repay to the forefront anyways.

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May 19, 2010 – POTLUCK WITH DAVE

Monetization or printing may end up being the only end alternative. I know, and agree with you, that to have inflation you need demand. Where I disagree is that you can’t have inflation with such a significant slack in the economy. For those of us that lived or worked in the hyperinflationary South American zone of the seventies and eighties, inflation comes when people lose faith in the currency and see material goods as a store of value. Because commodities rise and the goods can no longer be expected to be made at the same cost structure, people assume that they will be worth more in the future creating a self fulfilling upward spiraling effect. You can anticipate that these state governments will introduce price controls as well as potentially fixing exchange rates worsening the situation. My biggest fear is that these politicians and advisors have little experience in this area and are more concerned about controlling the political short term without regard to the longer term implications. I see this like an attempt at covering holes in a cracking dam with your fingers while the cracks are spreading. Bonds in the thirties were not a safe haven because they were restructured into 30 to 40 year bonds at 1.0-2.0% interest. Ultimately spending habits must decline, debt must be restructured, and growth must be promoted through the private sector. Political interests must be aligned with long term economic objectives and I don’t see that any time soon. Obviously, I’m very negative right now. What am I missing?” ON A LIGHTER NOTE... Or should I say heavier note? The only putting on weight is ... me. This is from another reader. “Blintzes! I love these titles.‬ You’ve still got babkas, hamentashen, knishes, latkas, matzah balls, bagels, mandelbread, komish bread, (my family had a Jewish bakery in Philadelphia).”

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May 19, 2010 – POTLUCK WITH DAVE

Gluskin Sheff at a Glance
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As of March 31, 2010, the Firm managed assets of $5.6 billion.


We have strong and stable portfolio management, research and client service teams. Aside from recent additions, our Gluskin Sheff became a publicly traded Portfolio Managers have been with the corporation on the Toronto Stock Firm for a minimum of ten years and we Exchange (symbol: GS) in May 2006 and have attracted “best in class” talent at all remains 54% owned by its senior levels. Our performance results are those management and employees. We have of the team in place. public company accountability and We have a strong history of insightful governance with a private company bottom-up security selection based on commitment to innovation and service. fundamental analysis. Our investment interests are directly aligned with those of our clients, as For long equities, we look for companies Gluskin Sheff’s management and with a history of long-term growth and employees are collectively the largest stability, a proven track record, client of the Firm’s investment portfolios. shareholder-minded management and a share price below our estimate of intrinsic We offer a diverse platform of investment value. We look for the opposite in strategies (Canadian and U.S. equities, equities that we sell short. Alternative and Fixed Income) and investment styles (Value, Growth and For corporate bonds, we look for issuers 1 Income). with a margin of safety for the payment of interest and principal, and yields which The minimum investment required to are attractive relative to the assessed establish a client relationship with the credit risks involved. Firm is $3 million for Canadian investors and $5 million for U.S. & International We assemble concentrated portfolios — investors. our top ten holdings typically represent between 25% to 45% of a portfolio. In this PERFORMANCE way, clients benefit from the ideas in $1 million invested in our Canadian Value which we have the highest conviction. Portfolio in 1991 (its inception date) 2 Our success has often been linked to our would have grown to $11.7 million on long history of investing in underMarch 31, 2010 versus $5.7 million for the followed and under-appreciated small S&P/TSX Total Return Index over the and mid cap companies both in Canada same period. and the U.S. $1 million usd invested in our U.S. PORTFOLIO CONSTRUCTION Equity Portfolio in 1986 (its inception date) would have grown to $8.7 million In terms of asset mix and portfolio 2 usd on March 31, 2010 versus $6.9 construction, we offer a unique marriage million usd for the S&P 500 Total between our bottom-up security-specific Return Index over the same period. fundamental analysis and our top-down macroeconomic view.

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