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

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August 24, 2010 Economic Commentary


Breakfast with Dave
WHILE YOU WERE SLEEPING It’s a tad brutal overnight, with most Asian markets in a sea of red, and Europe seemingly following suit. The Asia-Pacific index sagged 0.8% today with the Nikkei off 1.3%, to 8,995, which is the lowest close since May 1, 2009 and now officially in bear market terrain with a 21% slide from the April peak. Watch the U.S. indices play catch-up. Bonds are also rallying hard despite all the bubble talk — 10-year German bunds are a snick above 2¼%, a new record low, and 30-year bunds have rallied to 2.83% (long Treasuries in the U.S. need to rally nearly 80bps to catch up). As we have said time and again, in a deflationary backdrop, safe income is king (long governments are carrying extremely well and not only that, long-dated investmentgrade corporates still command a nice 200bp premium over Treasuries). Caution is also evident in the FX market as the yen has strengthened to an eightyear high against the euro and to a 15-year high against the U.S. dollar. At the same time, the cyclically-sensitive commodity currencies are taking it on the chin this morning, so even with the slide against the ultra-defensive yen, the DXY has rallied this morning and broken back above its 50-day moving average (of 83.3)! In the commodity complex, look no further than the oil prices, which are slipping for the fifth day in a row; ditto for industrial metals (nickel is off 2% today; copper by nearly 1%). Nobel laureate Joseph Stiglitz is on the tapes saying that with all deference to the blowout Q2 German GDP data, the continent is facing growing recession risks amid the radical cutbacks in government spending. Bank of England official Martin Weale pretty well told the London-based Times the same thing about the U.K. economic outlook. Have a look at Eurozone Growth Loses Impetus and Doubts Over Paris Outlook for Economy on page 2 of the FT. And don’t look now but credit default swaps in poor Ireland, which has tried to do everything right to turn its fiscal ship around, have widened 100bps in March to nearly 300bps, which implies a 22% chance of default within five years. Hey, where is its bailout? Meanwhile, long-time bull, David Wyss, who is Chief Economist at S&P, said at a Tokyo speech (how a propos) that “I think there is still a realistic possibility in the U.S. that it’s slipping into this pattern like Japan has – 10, 20 years of stagnation.” Sacrilege! How can he get away with saying such a thing? And, if you want to know what Japan looks like — a decade after rates went to zero and with a 200% government debt-to-GDP ratio — have a read of the tear-jerker on page B3 of the NYT (Japan Finds It Has Few Options in War Against Falling Prices). IN THIS ISSUE • While you were sleeping: global equity markets sold off overnight; global bond markets rallying hard despite all the bubble talk; commodity-based currencies taking it on the chin; commodity prices slipping • Chicago! The Chicago Fed National Activity Index not out of the woods; the consumer/housing component still shows that the U.S. economy might not be out of the recession yet • If Bank of Canada Governor Carney is not done … well he should be. The BoC is an inflation driven bank and there is no more smoking gun • Even more job loss ahead? We could see a situation where another 4-5 million jobs could be shed in the U.S. • Getting small — sushi style: there was a really terrific editorial piece in the Sunday NYT that is worth a read (Japan and the Ancient Art of Shrugging) • Is Ed Leamer, head of the forecasting center at L.A.’s Anderson School of Management, a dreamer?

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

August 24, 2010 – BREAKFAST WITH DAVE

But look at the bright spot, we are finally exiting the denial stage and heading towards acceptance. That, my friends, is progress in its own right. When Washington realizes that the solutions lie in supply-side policies that will promote growth in the capital stock and hiring/work incentives — education, infrastructure, payroll taxes, a coherent energy strategy (nuclear!) — and begin to abandon failed policies such as this ongoing emphasis on Keynesian short-term spending quick fixes, the adoption of “too big to fail” strategies, initiatives aimed at bailing out delinquent homeowners, measures that actually try to prevent market forces from working, initiatives that pay people to stay off work for 99 weeks with no thought behind skills improvement and training in return, and attempts at influencing the equilibrium level of asset prices, such as real estate, then indeed, when we have finally broken free from these failed interventionist and distorting manoeuvres, then we will likely have much more reason to turn optimistic. CHICAGO! The Chicago Fed National Activity index came out for July and rang in at a stagnant 0.0 after hitting a recession-like -0.70 print the month before. The chart below just about says it all ... the consumer/housing segment has been below zero now for each of the past 43 months, which is unprecedented. CHART 1: THIS IS ONLY 75% OF THE ECONOMY — DID IT EVER GET OUT OF RECESSION?
United States: Federal Reserve Bank of Chicago National Activity Index: Personal Consumption and Housing (positive = growth above trend)

The Chicago Fed National Activity index came out for July and rang in at a stagnant 0.0 after hitting a recession-like -0.70 print the month before





-0.6 70 75 80 85 90 95 00 05 10
Shaded region represent periods of U.S. recession Source: Haver Analytics, Gluskin Sheff

Now we’ll tell you why this is a depression, and not just some garden-variety recession. For all the chatter about whether the recession that started in December 2007 ended sometime last year, here is what you should know about the historical record. The 1930s depression was not marked by declining quarterly GDP data every single quarter. In fact, the technical recessionary aspect to the initial period following the asset and credit shock goes from the third quarter of 1929 to the third quarter of 1933.

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August 24, 2010 – BREAKFAST WITH DAVE

There was another deep downturn in 1937-38, but the initial recession lasted four years and if you read the Benjamin Roth diary, you will see the euphoric response to any piece of good news — as brief as they may have been. Such is human nature and nobody can be blamed for trying to be optimistic; however, in the money management business, we have a fiduciary responsibility to be as realistic as possible about the outlook for the economy and the markets at all times. What is important to know is this. In that initial four-year economic downturn, from 1929 to 1933, there were no fewer than six — six! — quarterly bounces in the GDP data. The average gain in these up-quarters was 8% at an annual rate! But because they proved not to be sustainable, the National Bureau of Economic Research (NBER) refused to declare that the recession officially ended, even though the stock market rallied 50% in the opening months of 1930 on the belief that the downturn was about to end. False premise. And guess what? We may well be reliving history here. If you’re keeping score, we have recorded four quarterly advances in real GDP, and the average is only 3%. It wasn’t really until we could put together a string of very solid GDP data in 1934, 1935, and well into 1936 that the recession definitely had come to a close and at least an intermitted period of solid growth took hold. That is, until the policy mis-steps of 1937. All that second recession of the decade proved was just how fragile the post-bubble recovery really was. The 80% rally of 2009 that whipped up so much excitement at the time and reignited all the criticism over the “bears” and how they didn’t understand the power of stimulus and how their call over the 2007-08 meltdown was just dumb luck, will be remembered in the future about as much as the 50% rally of the 1930. It’s funny how nobody seems to recall that massive dead-cat bounce off the lows; people just remember 1930 was a period of soup lines, bread lines, and unemployment lines. Maybe it’s because we ended up with a classic Bob Farrelllike third wave — the fundamental downtrend to a new low over the next two years, and the overall economic malaise with double-digit unemployment rate lasted for another decade even with massive doses of government intervention. We can understand how emotional the debate can get over whether or not we have actually just stumbled along some post-recession recovery path or whether or not this is actually a depression in the sense of a downward trend in economic activity merely punctuated with noise that is influenced by recurring rounds of government intervention. The reality is that the Fed cut the funds rate to zero, as was the case in Japan, to little avail (perhaps only making a bad situation less bad). Then the Fed tripled the size of its balance sheet — again with little sustained impetus to a broken financial system (see the op-ed on page A15 of the WSJ by George Melloan — The Fed Can Create Money, Not Confidence).

For all the chatter about whether the recession that started in December 2007 ended sometime last year, keep in mind that the depression in the 1930s was not marked by declining quarterly GDP every single year

What is important to know is this. In that initial four-year economic downturn, from 1929 to 1933, there were no fewer than six — six! — quarterly bounces in GDP

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August 24, 2010 – BREAKFAST WITH DAVE

Keep in mind that by now the Fed was suppose to be shrinking its pregnant balance sheet but has refrained from doing so, though the Bernanke-led move to sustain its incursion in the capital markets is not being universally supported (have a look at the front page of the WSJ — Fed Split on Move to Bolster Sluggish Economy). Also keep in mind that the Fed sliced its economic forecast twice in the past two months and we are coming off a Q2 GDP growth pace that was likely little better than a 1% annual rate (as we will see post-revision this Friday). When you cut your forecast and the economy is barely growing faster than 1%, a renewed contraction cannot be ruled out (in fact, the monthly data showed this erosion to be taking place as we type). How’s that for a reality check. It’s not too late, by the way, to shift course if you have stayed long this market. IF CARNEY IS NOT DONE … …then he should be. This is an inflation-driven Bank of Canada and as such, there is no more smoking gun. We could care less about somebody’s definition of what “emergency” interest rates are. The critical issue for the Bank is whether their policy setting is consistent with a stable price environment. The proof in the pudding is always in the eating – but the reality is that the current interest rate structure is proving to be totally consistent with a disinflation backdrop at a time when measured inflation rates are microscopic. Look at the latest CPI data. Strip out the effects of the HST, and consumer prices fell 0.1% in July. Not only that, but the CPI excluding indirect taxes has been flat or down now for six months in a row, during which it has deflated at a 1.2% annual rate. You read this right — deflation, and with a much lower unemployment rate than is the case south of the border to boot (7.3% on a comparable U.S. basis versus the actual 9.5% in the United States). What if we looked at “core” excluding indirect taxes? This price metric dropped 0.2% in July and over the past six months is running at the grand total of a 0.0% annual rate. Only one other time in recorded history was the rate this low over a six-month span — at the troughs of the last two economic downturns (2008 and 2001) the trend was 0.7% at an annual rate and 0.8% respectively, and here we are into some sort of economic recovery and it is running at zero. Imagine where this trend goes if the economy continues to slow down or even catches some of the U.S. double-dip fever — well, this is a prospect that we are sure a pragmatist like Mark Carney is imagining in his mind’s eye. The Bank should be done hiking for now. EVEN MORE JOB LOSS AHEAD? The article in yesterday’s WSJ titled Specter of Layoffs Stalks Wall Street really resonated with us. As we said in yesterday’s note, the size of the securitized loan market has shrunk 60% in the past two years. Balance sheets, production, order books and staffing requirements are all rightsizing to this new semipermanent landscape of reduced credit availability.

The critical issue for the Bank of Canada is whether their policy setting is consistent with a stable price environment

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August 24, 2010 – BREAKFAST WITH DAVE

In fact, we could see a situation where another 4 to 5 million jobs could be shed in the United States — and in the three sectors that were, and remain, the most affected by the housing crisis and financial collapse. For example, historically, the construction industry employed three workers for every housing start. Today, that ratio is closer to 10. This could easily mean that we see 3 to 4 million construction jobs being lost going forward, barring a major revival in the housing market, which isn’t happening. The ratio of employees in the financial sector to outstanding private sector credit is at a new and lower level that would warrant around a workforce 500,000 lower than is the case today — just to get to productivity ratios that prevailed in the pre-bubble era. And the third sector, which is the fiscally-challenged state and local government segment, for payrolls there to mean revert to the level commensurate with the ever-declining level of public spending would also mean roughly 500,000 employment cutbacks. No doubt there are other sectors that will provide some offset in health and education and even manufacturing, but it took 25 years for these areas combined to rise five million and something tells us that the downsizing that is left in the housing, financial and state/local government sectors will occur in a much shorter period (and the latter too, if what happened recently in New Jersey is any indication, the social contract with public sector unions will soon go the way of the dodo bird). Note that the year-on-year trend in layoff announcements, after a brief period of declines, is now re-accelerating in the three above-mentioned affected sectors. For the first time since late 2007, the financial sector posted no hiring announcements in each of the last two months and this has also been the case in three of the past four months in the real estate sector. Government sector hiring announcements, as an aside, have plunged 75% from year-ago levels. The signs are already there — get ready for another downleg in employment as the jobless claims are now suggesting — especially as it pertains to this 33 million or 25% chunk of the total workforce. CHART 2: RATIO OF CONSTRUCTION EMPLOYMENT TO HOUSING STARTS
United States (ratio)
15.0 12.5

We could see a situation where another 4 to 5 million jobs could be shed in the United States — especially in the three sectors (construction, finance and state/local government) that were, and remain, the most affected by the housing crisis and financial collapse


7.5 5.0


0.0 60 65 70 75 80 85 90 95 00 05 10

Shaded region represent periods of U.S. recession Source: Haver Analytics, Gluskin Sheff

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August 24, 2010 – BREAKFAST WITH DAVE

GETTING SMALL — SUSHI STYLE There was really a terrific op-ed piece in the Sunday NYT by Norihiro Kato, a professor of Japanese literature at Waseda University, titled Japan and the Ancient Art of Shrugging. He explains to us how the next generation in Japan was affected by the fallout of the credit collapse and real estate deflation. It’s all about ‘getting small’ — one of our long-lasting post-bubble themes. Deflation at its penultimate. The article was all about how attitudes are changing among young people in Japan, and there may well be some takeaways from this for the rest of us: “Three years ago, I saw a television program about a new breed of youngster: the nonconsumer. Japanese in their late teens and early 20s, it said, did not have cars. They didn’t drink alcohol. They didn’t spend Christmas Eve with their boyfriends or girlfriends at fancy hotels downtown the way earlier generations did. I have taught many students who fit this mold. They work hard at part-time jobs, spend hours at McDonald’s sipping cheap coffee, eat fast food lunches at Yoshinoya. They save their money for the future. These are the Japanese who came of age after the bubble, never having known Japan as a flourishing economy. They are accustomed to being frugal. Today’s youths, living in a society older than any in the world, are the first since the late 19th century to feel so uneasy about the future. I saw young Japanese in Paris, of course, vacationing or studying, but statistics show that they don’t travel the way we used to. Perhaps it’s a reaction against their globalizing elders who are still zealously pushing English-language education and overseas employment. Young people have grown less interested in studying foreign languages. They seem not to feel the urge to grow outward. Look, they say, Japan is a small country. And we’re O.K. with small. It is, perhaps, a sort of maturity.” Getting small, how novel. Make sure your portfolio dovetails with this theme. IS LEAMER A DREAMER? We mentioned yesterday that the Ceridian-UCLA Pulse of Commerce Index ticked up in July, prompting its architect, Ed Leamer, to tell that Globe and Mail that “I don’t think that a double-dip is in the cards.” Never mind that this index appears to have peaked in early 2008, after the recession actually began. But no sooner did the ink dry on our report that we received this from a faithful reader, regarding Mr. Leamer: “My favorite WSJ quote (12/14/2006) to this day is: “This time will be different,” Ed Leamer, who heads the forecasting center at the University of California at Los Angeles’ Anderson School of Management, predicts in a report: “This time the problems in housing will stay in housing.” Come to think it, this sounds like something Bernanke would have said.

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As of June 30, 2010, the Firm managed 1 assets of $5.5 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 2 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 under-followed March 31, 2010 versus $5.7 million for the and under-appreciated small and mid cap S&P/TSX Total Return Index over the companies both in Canada and the U.S. same period. $1 million usd invested in our U.S. Equity Portfolio in 1986 (its inception date) would have grown to $8.7 million 3 usd on March 31, 2010 versus $6.9 million usd for the S&P 500 Total Return Index over the same period.

Our investment interests are directly aligned with those of our clients, as Gluskin Sheff’s management and employees are collectively the largest client of the Firm’s investment portfolios.

$1 million invested in our Canadian Value Portfolio in 1991 (its inception date) would have grown to $11.7 million2 on March 31, 2010 versus $5.7 million for the S&P/TSX Total Return Index over the same period.

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August 24, 2010 – BREAKFAST WITH DAVE

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