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

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March 2, 2011 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave
WHILE YOU WERE SLEEPING Equity markets overseas are down considerably as the realization of what $100 oil is likely to do to purchasing power at the consumer level and profit margins at the producer level. The U.S. dollar is still soft and gold is consolidating after yesterday’s surge to new record highs. Treasuries are surprisingly not benefiting from the slide in equities though there is a modestly positive tone in European debt markets and a nice 5bps rally in Japanese government bonds back down to 1.25% (didn’t Japan just get downgraded recently … twice??). It is still testament to the greed factor that according to the just-released Investors Intelligence survey, we still have over 50% bulls and less than 20% bears populating the poll universe. Yikes! On the data front we had decent construction data out of the U.K. supporting the pound and aggressive producer price numbers out of the eurozone underpinning the euro. In the U.S.A. we just got the ADP private employment figures and they were strong, up 217k, better than the 180k penciled in by economists. Keep in mind that this indicator has a shoddy track record of helping predict nonfarm payrolls (NFP) recently. In January for example, it was pointing to a near-190k increase and private nonfarm payrolls came in at just 50k. Over the past two months, we have seen ADP overestimate NFP by over 100k and we doubt that many economists will be making materials changes to NFP estimates (consensus estimates are sitting around 200k for private payrolls and 190k for total). We also received the Challenger job figures for February. While hiring rose nicely to a four-month high — though 85% of the tally was in one sector (retail) — job cut announcements jumped 20% YoY to the highest level in 11 months. FIFTEEN REASONS TO LOVE THE LOONIE (WE COULDN’T STOP AT TEN!) 1. Better growth than in the U.S.A. and without need for stimulus 2. Responsible central bank, limiting growth in its balance sheet 3. Better fiscal backdrop 4. More conservative political environment 5. Triple the exposure to raw material than the U.S.A. 6. Investors get 115 basis points premium over Treasuries at the front end of the government yield curve 7. Canada in the top 15 net oil exporters globally … U.S.A. top importer 8. TSX dividend yield at 2.36%; S&P 500 dividend yield at 1.82% 9. Housing market in balance in most of the metro areas; no foreclosure supply coming IN THIS ISSUE
• While you were sleeping:

equity markets overseas are down; U.S. dollar is still soft and gold is consolidating

• Fifteen reasons to love the

loonie (we couldn’t stop at ten!)

• Bank of Canada

statement rather benign ... fails to ratify hawkish view on rate sluggish

• Chain store sales look • Construction still in the

doldrums

• Optim-ISM: ISM

manufacturing index came in better than expected in February

• Random market thoughts

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

March 2, 2011 – BREAKFAST WITH DAVE

10. Inflation is low and stable with minimal risk of deflation 11. Economic recovery being fuelled principally by business spending 12. Corporate tax rates on a sliding scale down 13. Immigration and capital flows running at record levels 14. Vancouver rated top city in the world to live 15. Stable banking system with consistent dividend growth BANK OF CANADA STATEMENT RATHER BENIGN ... FAILS TO RATIFY HAWKISH VIEW ON RATE The Bank of Canada basically said economic activity here and in the U.S.A. is improving in line with expectations; however, caveats in these statements matter and the addition of “although risks remain elevated” suggests that there is a wide error term around its macro projections. Acknowledging that the recovery here is “proceeding slightly faster” than the Bank had been projecting was simply a mark-to-market exercise and the word “slightly” tells me they are not convinced over the veracity or longevity considering that GDP growth in Q4 did come in a full percentage point above expected. Household spending is seen rising in line with “household incomes” (i.e. not expecting any further decline in the savings rate), exports are seen as being “challenged” and while bullish on Canadian capex based on the press statement’s wording, “expand rapidly”, underlying inflation is still seen as “subdued”. The “persistent” strength in the Canadian dollar is cited — the Bank ostensibly feels there is enough restraint being exerted by the loonie. The bottom line is that not until the Bank gets rid of the statement “considerable slack in the economy” will it be appropriate to start factoring in Bank of Canada rate hikes (and if you look at the statement it was there). In my view, the consensus and market views that the Bank would start to tinker with rates sometime in the second quarter are still off base. Despite the recent GDP pickup, the Bank does not expect the output gap to close until the end of 2012 based on this statement and that is key. The 2-year Government of Canada yield is trading 84 basis points north of the policy rate and the 5-year is trading at a +164bps spread. Historically, the average spread is about 60bps (over 20 years of data) and 120bps respectively, so there would seem to be a bullish rates opportunity at the front-to-mid part of the Canada curve if the Bank opts to stay on the sidelines for longer. CHAIN STORE SALES LOOK SLUGGISH The weekly data came out for the end of February from the International Council of Shopping Centers (ICSC) and YoY sales growth slowed to 2.2% for the month from the 4.7% pace posted in January. Of course we now know that in real terms total consumer spending actually contracted fractionally in January and while this metric feeds into GDP, it receives scant attention next to the same-store chain store sales data, especially on a YoY basis. But what we do know is that the retailers were planning for a 2.5-3.0% range for February, so 2.2% was a tad below. No doubt that the U.S. economy is performing better than last summer

The Bank of Canada basically said economic activity here and in the U.S.A. is improving in line with expectations; however, caveats in these statements matter

Of course we now know that in real terms total consumer spending actually contracted fractionally in January and while this metric feeds into GDP, it receives scant attention next to the samestore chain store sales data

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March 2, 2011 – BREAKFAST WITH DAVE

when double-dip fears reached their apex, but is it really outperforming expectations currently? CONSTRUCTION STILL IN THE DOLDRUMS Even with a (spurious) rebound in residential outlays that was largely skewed by a surge in multi-family housing starts, total U.S. construction spending sagged 0.7% MoM in January on top of a 1.6% slide the month before. Non-residential expenditures tumbled 3.3% sequentially and are down now in each of the past four months. Between that, real consumer spending and capex shipments, we may well begin to see all those 4% GDP growth forecasts for Q1 end up being cut in half! OPTIM-ISM Too bad the ISM index doesn’t feed right into GDP. The economy would be booming. The ISM manufacturing index did come in better than expected in February but rarely has such a strong number in the past been so well advertised. The diffusion index ticked up to 61.4, which is the highest print since May 2004 (the peak for the cycle, but …. the bulls would tell you that still meant another 3-plus years of economic growth and a bull market mania), not to mention up seven months in a row. That is a streak and nothing in the components suggested any near-term giveback. New orders edged up to 68.0 from 67.8 while inventories were run down to 48.8 from 52.4 in January. So what this in turn did was kick the orders-to-inventories ratio higher for the third month in a row, to 1.39x from 1.29x — the best print since January 2010, and if you recall, that led the headline index to a new interim high three months hence. Most components posted gains, including the jobs sub-index, which was in contrast to most of the regional manufacturing indicators. It jumped to 64.5 from 61.7 in what was the fastest advance since January 1973— when factory payrolls rose a hefty 0.65% (which would translate into +75,000 today!). The other 10 times that the employment index was this strong or stronger was in the 1950s, and factory payroll rose an average of 1.2% (which would equate to +130,000!). RANDOM MARKET THOUGHTS Only time will tell if yesterday’s market action was a true watershed. It was the first time since last July that the stock market was down on the first day of the month. Till yesterday, the opening days in January and February had already accounted for over half the year-to-date gains in the S&P 500 (over 90% last year).

Too bad the ISM index doesn’t feed right into GDP. The economy would be booming

It was the first time since the last leg of the bear market rally began six months ago that “good” news failed to ignite equity prices

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March 2, 2011 – BREAKFAST WITH DAVE

It was also the first time since the last leg of the bear market rally began six months ago that “good” news failed to ignite equity prices. Yesterday we saw auto sales shoot up 6.7% to 13.4 million units (at an annual rate) which was the best level since August 2009, and we also saw the ISM inch higher to 61.4 from 60.8 with the “internals” of the report just as solid as the headline. This is likely a sign that Mr. Market had already paid up for these nice tidings. Recall that last September the data were still looking iffy, and it was not clear that double-dip risks had totally faded, but the stock market ripped in any event. That was a mirror image sign that at the time, all the “bad” news was priced in. We also have a situation where economists are now taking down their GDP numbers after four months of raising them. Analysts have stopped raising their EPS forecasts. Corporate guidance has been spotty at best, and we have corporate insiders selling their stock at 10x the rate they are buying it. Not an encouraging signpost at all. The short interest is flirting with three-year lows so the absence of any short-covering as the market retreats could end up making price declines more intense than normal. So far, a big market decline has been averted because the “buy the dip” mentality is so well ingrained, but dangerous at the same time. The widespread view that $100 oil will only cause a ripple in the global economic outlook is equally dangerous. The complexion of the FX market has also changed materially. The U.S. dollar, always a safe-haven in troubling times as it was in the aftermath of the global credit collapse and periodically last year amid the European debt fiasco, is no longer playing that traditional role during this latest round of turmoil overseas. Gold, silver, the yen and the Swiss franc have emerged as the safe-havens this time around. Could be a sign of the U.S. dollar losing its allure as the place to go when the going gets tough and no doubt spur talk as to whether the reserve currency status will ultimately be relinquished. The weak performance of the U.S. dollar would certainly seem to reflect, at a certain level, a lack of confidence over U.S. policy making. Nothing in Ben Bernanke’s sermon yesterday should alter that view, especially his dismissive response to the Fed’s role in fuelling the surge in the commodity complex since last summer. He claims that since commodity prices have risen in all currency terms, hence this is not a weak-dollar story. To us, this misses the point. The Fed’s stated intent was to encourage risk-taking behaviour with QE2. He even mentioned the Russell 2000 on CNBC recently. Well, emerging equities have a tight correlation with small cap stocks, and by igniting a huge rally in those markets, their economies boomed from the hot money investment flows. And since it is this part of the world that is the marginal buyer of raw material, it is little wonder why the supply-demand balance for commodities was thrown further off kilter by the Fed’s quantitative easing. Ben Bernanke said his concern was that inflation had fallen last summer to uncomfortable levels. So the main aim was to reflate and the stated goal was a wealth effect on spending. But only 20% of Americans own equities directly. And the inflation that the Fed has helped generate are in necessities, which is why in
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A big market decline has been averted because the “buy the dip” mentality is so well ingrained, but dangerous at the same time

Emerging equities have a tight correlation with small cap stocks, and by igniting a huge rally in those markets, their economies boomed from the hot money investment flows

March 2, 2011 – BREAKFAST WITH DAVE

real terms, wages are either stagnating or contracting outright. If we hadn’t had a strong price deflator in January, consumer spending would have also been up in real terms, not down. No doubt we will get a nice cushion for February spending out of auto sales — an antidote to what seems to be a lacklustre chain store sales. But even with incentives running wild, auto sales are still nowhere near the 16-18 million unit pre-credit-bubble norm. This is about as good as it will get, even with the subprime market for auto loans staging a revival. Two more items from Ben Bernanke’s testimony that investors may want to pay attention to: “... downside risks to the recovery have receded, and the risk of deflation has become negligible.” These are not the words of someone about to embark on QE3. This could be important for a market that has had an 86% correlation with movements in the Fed’s balance sheet over the past two years. “Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.” Something else for investors to consider. How sustainable is a two-year 100% rally in equity prices if the economic recovery itself isn’t sustainable? This is what we have said all along — the U.S. economy is much more fragile than is commonly believed, and liquidity-induced rallies are never sustained if the macro fundamentals don’t follow suit.

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March 2, 2011 – BREAKFAST WITH DAVE

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As of December 31, 2010, the Firm managed assets of $6.0 billion.

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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 49% owned by its senior levels. Our performance results are those management and employees. We have of the team in place. public company accountability and governance with a private company We have a strong history of insightful commitment to innovation and service. bottom-up security selection based on 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. We assemble concentrated portfolios 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 which we have the highest conviction. Equity Portfolio in 1991 (its inception date) would have grown to $10.2 million on December 31, 2010 versus $6.5 million for the S&P/TSX Total Return Index over the same period.
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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 Equity Portfolio in 1991 (its inception date) would have grown to $10.2 million2 on December 31, 2010 versus $6.5 million for the S&P/TSX Total Return Index over the same period.

$1 million usd invested in our U.S. Equity Portfolio in 1986 (its inception date) would have grown to $12.9 million 2 usd on December 31, 2010 versus $10.6 million usd for the S&P 500 Total Return Index over the same period.
Notes:

Our success has often been linked to our long history of investing in underfollowed and under-appreciated small and mid cap companies both in Canada and the U.S.

PORTFOLIO CONSTRUCTION
In terms of asset mix and portfolio construction, we offer a unique marriage between our bottom-up security-specific fundamental analysis and our top-down macroeconomic view.
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March 2, 2011 – BREAKFAST WITH DAVE

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