Breakfast With Dave 110509

David A. Rosenberg Chief Economist & Strategist [email protected] + 1 416 681 8919

November 5, 2009 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave GOLD-ILOCKS We are still contemplating the massive gold purchase by the Reserve Bank of India — the largest in at least 30 years that took up half of what the IMF intends to sell. Look for China to come in next. But here is the reality. All India did was bring gold to a 6% share of its total FX reserves from 4%. Fifteen years ago, that representation was closer to 20%. China has increased its gold holdings by 76% over the past six years but they are a mere 1.9% of the aggregate 2.2 trillion of reserves and Russia’s gold holdings is just under 5%. This is not the 1990s when Bob Rubin was running a hard U.S. dollar policy, U.S. fiscal deficits were vanishing and gold production was on the rise. Today’s world is exactly the opposite. Policymakers beginning in the 1990s wanted disinflation and got it. Now they want inflation — it will take years, maybe a decade, but it will come. For the near-term, we are still optimistic on Treasury securities but be forewarned that this view has an expiry date that is earlier than the peak we are likely to see in gold. It is very clear that central banks are behaving in a way that would suggest that gold is now again being considered a currency within the global monetary system. As we said before, it is all about relative scarcity and a well-defined supply curve — fiat currency at this juncture does not share that quality. As a good friend reminded me yesterday, when the Fed was created nearly a century ago, it was acceptable to have at least 40% of the money supply backed by gold reserves. The U.S. now has 8,133 tons of gold in reserve, which equates to $285 billion at this year’s pricing.

IN THIS ISSUE • Goldilocks — it’s clear that central banks are now behaving in a way suggesting that gold is again a currency • Our take on the Fed press statement — with the Fed inserting “inflation expectations” and “resource utilization” in the release suggests that rates will stay near zero for a long time • Some myths and realities • The new bubble in the U.S. is in stimulants • The ISM non-manufacturing index came in a tad below consensus; employment component still contracting • Retail rents drop in Manhattan

Meanwhile, the Fed has spiked the punchbowl to such an extent that the monetary base now stands at $1.7 trillion. Do the math — under the old regime (which indeed hamstrung the Fed), the U.S. alone would need to buy an incremental $400 billion of bullion or the equivalent of what would be nearly four times the typical level of annual demand. We could do the same calculation based on M2 but we don’t want anyone falling off their chairs. QUICK TAKE ON THE FED You read the various bank economic departments’ take on the Fed statement and it’s split evenly on whether it was “dovish” or “hawkish”. The fact that the Fed re-introduced “inflation expectations” and “resource utilization” into the communiqué was to explain why it expects to keep rates near zero for the rest of our lives (if not longer). What really caught my eye was that the press statement still characterized the economy as “weak”. Bernanke knows there’s rubble beneath the stimulus; and so does Carney.

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

November 5, 2009 – BREAKFAST WITH DAVE

MYTHS AND REALITIES Myth: Warren Buffett is making a big wager on the U.S. economy. Reality: The Oracle believes that with oil prices where they are and likely to go higher, rails will grab transport share from the truckers. This may also be a back-door bullish call on coal. Or maybe it’s a constructive sign on buying of U.S. made goods out of Canada where local domestic demand is hanging in just fine, thank you very much. Myth: There are signs of life in the retail sector. Reality: October auto sales in the U.S. did pick up from September’s abyss, but this was still the eighth worst month in the last 27 years. And yes, it does look like U.S. chain store sales are going to come in somewhere between +1.0-2.0% year-over-year. But beware. This actually says more about the detonation that took place a year ago — the “base” for the year-over-year calculations — than anything truly robust at the present time. Also, don’t forget that these are YoY same store sales from surviving retailers. Thousands have gone bankrupt in the last year, for example Circuit City, which for sure has helped BestBuy’s activity, and there are countless other examples. So the data, for lack of a better term, are distorted and tell you very little about what consumers are doing in the aggregate. Myth: The low end consumer is adjusting to the new frugality more than the high end. Reality: If only it were only so. Unfortunately, a gap has opened between employment-dependant spending and wealth-dependant spending. After all, the investor class is giddy after a 60% rally from the March lows in equities, a rally in which 2.7 million jobs in the U.S. have been lost. Epic. So in October, luxury goods sales came in at +6.5% YoY and jewellry at +7.2%! Meanwhile, department stores who cater to the guy (and gal) on the street posted a 1.5% sales decline (as per MasterCard’s SpendingPulse survey). Also keep an eye on where people are buying their food and what food they are buying (good article in yesterday's Wall Street Journal on this) — Cheesecake Factory is all of a sudden seeing a burst of sales activity (Starbucks too from what we are hearing and reading) that is eluding the fast-food chains at the moment. Myth: We have financial and tech leadership. Reality: We did. But not any longer. Not after UBS reported its larger-thanexpected Q4 loss, and not after Lloyds and RBS announced their need to raise capital (can they really be the only ones?). As for tech, well, Morgan Stanley researchers laid down the guantlet with its downgrade of semiconductor stocks to “cautious” from "attractive" (we love Wall Street lingo, having been there and done that. Why not shout “sell, Mortimer, sell!”?) And what about that downgrade to Intel?

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Myth: The boom in mergers and acquisitions (M&A) activity says that corporate America is feeling good about recovery prospects. Reality: While this is what we hear from many strategists, there may be other factors at play that are more strategic and micro in nature. Keep in mind that companies are sitting on a record cash hoard ($702 billion in the S&P 500 universe). If they were truly optimistic, they would be moving to expand their business organically. Instead, most of the M&A activity has been driven by companies buying out their competitors to grow a part of their operations that they were lagging in.

So the U.S. economy is growing again, but the real question should be “why only by 3.5%”?

As for the “boom” part — let's get a grip. So far this year, there have been 5,786 deals worth $620 billion (Dealogic data — for the U.S.). That is down 37% from a year ago (the level) and down 55% from where we were two-years ago. Matt Krantz at the USA Today could not have put it more succinctly — “despite the banner headlines, dealmaking is still stuck in the post-credit-bubble malaise.” THE NEW BUBBLE IS IN STIMULANTS So the U.S. economy is growing again. But how can it not be growing with all the dramatic stimulus? The question should be “why only 3.5%”? Now the U.S. government is going to not just extend but indeed expand the tax credits for homeownership. This is happening at a time when the fiscal deficit is 10% of GDP. Simply amazing. The sector already receives more in the way of government support than any other area, and it adds zero to the capital stock or productivity growth. Oh, but it makes us better citizens. Renting must be for losers. And then we see that the Fed’s TALF (Term Asset-Backed Securities Loan Facility) program that began in March just broke the $90 billion mark. This has basically supported 75% of the growth in the asset-backed market, almost evenly split between auto credit and credit cards because at over a 130% household liabilityto-disposable income ratio, the government seems to believe we don't have enough debt on our balance sheets. Honestly — you can't make this stuff up.

The U.S. housing market has managed to rise from the ashes because of the FHA program, which has filled the gap vacated by the private sector

But here is the real kicker. The Federal Housing Authority (FHA). If you’re wondering how it is that the U.S. housing market has managed to rise from the ashes, well, consider that the government-insured FHA program moved into high gear this year and has basically filled the gap vacated by the private sector. The efforts to allow practically anyone to secure a mortgage not just for a new purchase but for refinancing purposes (where default rates are really becoming a problem) should not go unnoticed (and they weren’t by the staff at the WSJ that uncovered the growing problems in yesterday's edition — FHA Digging Out After Loans Sour on page A2).

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November 5, 2009 – BREAKFAST WITH DAVE

The efforts to stimulate were so profound that the damn-the-torpedoes-fullsteam-ahead policy has resulted in an expected 24% default rate on loans originated in 2007, and 20% for 2008. So, what has happened is that the taxpayer has taken over the bad lending decisions that were Wall Street’s domain three, four and five years ago.

Indeed, the FHA began its aggressive moves to support the housing market in 2007 and has since spread its tentacles

According to the WSJ, the FHA is going to publish a report acknowledging that it may need to tap into general tax revenues for the first time in its 75 year history. Oh, but don’t worry, FHA officials say the agency has enough capital to withstand any expected losses. The FHA began its aggressive moves to support the housing market in 2007 and has since spread its tentacles. The FHA actions, foreclosure moratorium and tax credit have all given a false impression that we have seen a bottom in residential real estate. But all that’s happened here is the risks have been transferred to the public sector balance sheet. The share of FHA-insured borrowers with a sub-600 FICO score has rapidly approached the 40% mark. So, we have stimulated a recovery by inducing more bad debt accumulation, which got us into trouble to begin with. But it’s not Wall Street taking on the risks now, its Capitol Hill. This is an effective way to fight a credit collapse? No wonder global central banks are diversifying into gold. The U.S. is hardly going to pay for this by raising taxes (the newly emboldened GOP will see to that) nor by cutting spending (the union lobby groups won't stand for that). Moreover, we'll have to assume that global central banks are not stupid and can see the future supply of dollars that will be printed to fund all these initiatives. As for the unions, we highlighted in the past the link between reduced labour power in the Reagan years and the corresponding expansion in the P/E multiple in that last great secular bull market. We are not making a value judgment or a political statement, but for far too long whatever income was being generated by the economy was being devoted more to capital than labour. That much is true. Be that as it may, we are here to serve our clients. And once again, when we see headlines like this pop up in the WSJ (as our friend Don Coxe is fond of saying, “page 16 news”) — Philadelphia Transit Union Goes on a Surprise Strike and Supermarket Chains Brace for Possible Grocers’ Strike, we start to think that the time may not be that far off to think of strategies to defend against the possibility that we could be wrong and that cost-push inflation comes back sooner than we think.

Labour unions are once again on the move … costpush inflation may come back sooner that we think …

Please, this is not a change in view but an acknowledgment that we learn at least one thing new every day that either supports or refutes our opinions. To not accept the notion that facts on the ground can and do change is completely irresponsible and dogmatic, and while we have long-held strong views on how this cycle is playing out, there is no room for dogma in the wealth management business.

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For the first time in a long time, we are thinking about that prospect described above — not that inflation is an immeditate threat but, at the margin, it could surprise us earlier rather than later. So, it may not be a bad idea to look at hedges from all sources — expanding the exposure to gold and commodities, and even TIPS and real return bonds that offer what gold does not — an income stream. Just a thought.

… but we are not saying that inflation is an imminent threat …

ISM NON-MANUFACTURING INDEX A TAD BELOW CONSENSUS; EMPLOYMENT COMPONENT CONTINUE TO CONTRACT For October, the ISM non-manufacturing index fell three tenths of a point, to 50.6, which is a tad below market expectations of a rise to 51.5. This shows that growth within the non-manufacturing sector of the economy (which makes up 90% of the economy) is lagging behind the more export related manufacturing industries. Indeed, the responses from the respondents show an expansion that remains very fragile. • “General economic tone is still ‘wait and see.’ Capital outlays are postponed

for durable goods.” (Health Care & Social Assistance)

• “Cost-cutting efforts continue.” (Transportation & Warehousing) • “Overall business activity increasing — forecast even better market conditions

in the coming months.” (Construction)

• “Business climate remains encouraging, but recovery will remain slow in

rebounding.” (Professional, Scientific & Technical Services)

• “The weakening U.S. dollar contributing to upward pressure on commodity

prices.” (Wholesale Trade)

Although four out of the five components of the non-manufacturing ISM rose in October (albeit at a slower pace than the increases we saw in September and August), the most important component, the employment index, fell 3.2 points (largest monthly drop-off since March 2009) to 41.1 (a five month low). Nonetheless, we cannot deny the fact that the business activity index, at 55.2 in October, and the new orders index, at 55.6, both have now risen three months in a row and both metrics are now at their highest levels since October 2007.

… but it may be a good idea to look at hedges against inflation from all sources

As for prices, they are much more muted in the non-manufacturing survey compared to the manufacturing survey. For October, the non-manufacturing prices index rose 4.2 points, just partly reversing the 14.3-point plunge in September, to 53.0 – the prices index for the manufacturing sector is currently at 65.0. RETAIL RENTS DROP IN MANHATTAN — COULD BE SOME OPPORTUNITIES FOR THE LOW-TO-MID-RANGE RETAILERS TO OPEN SHOP According to CB Richard Ellis Group Inc., store rents on the island of Manhattan fell to its lowest since Q1 2007, falling in seven of the 10 districts. The largest decline in rent happened in the midtown area (Fifth Avenue from 42nd to 49th streets) where rents plunged 30% to $441/square foot. Even the highly coveted retail rentals on Fifth Avenue from 49th Street to Central Park saw rents drop 4.1% to $1,643 a square foot. Indeed, the drop in rent in these highly retail desirable areas of Manhattan could be a boom for low-to-mid-range retailers, like Target, Kohls, who have been pushed away from the retail mecca of the world due to high rent prices.

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Gluskin Sheff at a Glance 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 the prudent stewardship of our clients’ wealth through the delivery of strong, risk-adjusted investment returns together with the highest level of personalized client service. OVERVIEW

INVESTMENT STRATEGY & TEAM

As of June 30, 2009, the Firm managed assets of $4.5 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 65% 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. For long equities, we Our investment interests are directly look for companies with a history of longaligned with those of our clients, as term growth and stability, a proven track Gluskin Sheff’s management and record, shareholder-minded management employees are collectively the largest and a share price below our estimate of client of the Firm’s investment portfolios. intrinsic value. We look for the opposite in We offer a diverse platform of investment equities that we sell short. For corporate strategies (Canadian and U.S. equities, bonds, we look for issuers with a margin of Alternative and Fixed Income) and safety for the payment of interest and investment styles (Value, Growth and principal, and yields which are attractive 1 Income). relative to the assessed credit risks involved. The minimum investment required to establish a client relationship with the Firm is $3 million for Canadian investors and $5 million for U.S. & International investors.

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We assemble concentrated portfolios — our top ten holdings typically represent between 25% to 45% of a portfolio. In this way, clients benefit from the ideas in which we have the highest conviction.

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 $15.5 million2 on September 30, 2009 versus $9.7 million for the S&P/TSX Total Return Index over the same period.

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.

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