Breakfast With Dave June 2

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

June 2, 2009 Economics Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave DUE TO TRAVEL REQUIREMENTS, BREAKFAST WITH DAVE WILL RETURN ON FRIDAY. WHILE YOU WERE SLEEPING A slightly different tone to start the day: Europe is off 0.6% and most of Asia is down as well (the Hang Seng index slipped 499 points or 2.2%; the Kospi dipped 0.2%, Singapore Straits and the Sensex closed 0.7% lower; though the Shanghai and the Nikkei eked out fractional gains). All in, emerging markets declined 1.1% (reports that North Korea is getting set to test launch more missiles didn’t help much). Emerging markets in general can hardly be described as cheap as they trade at 43x earnings, but nothing really stands out as being undervalued right now. The S&P 500 has gone ahead, in our view, and priced in an earnings profile we don’t see occurring for another three years — at the earliest. As everyone gazes at the 200-day moving average being taken out for the first time in 18 months, we are still wondering (see below) what the omen was yesterday from the fact that the VIX index, for the first time in at least seven years, rose alongside a 2%+ performance in the S&P 500 (normally, the VIX index declines between 10% and 20% on such a rally).

IN THIS ISSUE • The Dow trades in two legends — will shift tech and financial weightings • There are four factors driving the equity markets: technicals, fund flows, valuation and fundamentals • The folks at the ISM claimed that the recession has come to an end … wishful thinking • Caution on the Canadian dollar as we head into the BoC meeting

Bonds are still trading quite defensively, and the yield on the 10-year T-note has managed to do in less than six months, which is to soar 170 basis points, what it took 48 months to do in the last bear market in bonds (June/03 to June/07). Inflation expectations are getting way ahead of themselves — the 5-year/5-year breakeven levels in the TIPS market are now at 2.4% (above the average of the past five years — you would think we’d be staring at a fully employed economy right in the face). This is at a time when both the YoY trends in the CPI and PPI are negative to boot, not to mention the highest underlying jobless rate and lowest industry CAPU rates in modern history! Talk about a new paradigm. The U.K. gets its credit outlook downgraded, and its currency soars and its bond market vastly outperforms Treasuries. Welcome to silly season. The 2s-10s curve is back at 275bps, a record steepness, and never before has a curve this steep been sustainable — it will flatten, the question is how.

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

June 2, 2009 – BREAKFAST WITH DAVE

The futures market, without perhaps understanding what history teaches us about the stance of monetary policy following a credit collapse, which is to keep rates to the floor for, oh, about a decade, has gone ahead and priced in no fewer than three Fed rate hikes over the next 12 months. Then again, it’s the same futures strip that started to price out the easing cycle in late 2007 and price in Fed tightening this time last year. This is what opportunities are made of. We still expect to see long-dated yields enjoy a significant second-half recovery once it becomes evident — likely later this summer — that there is no durable recovery starting in the third quarter.

We still expect to see long dated yields enjoy a significant 2H recovery once it becomes clear that there is no durable recovery starting in Q3

As an aside, from our lens, part of the run-up in Treasury yields may be related to the shift to risky assets, perhaps related as well to exuberance over some of the economic data and hopes the recession will end. Though we did see yields bottom in 1993 and again in 2003, long after recessions ended, so the contours of the recovery are also very important in the interest rate outlook — bond yields never hit their bottom until after the unemployment rate peaks, and that is likely at least a year away, in our view. But there are technical factors at play too, which is mortgage-related selling (mortgage investors move to offset their duration exposure when rates back up by selling Treasuries — this last happened in a situation like this in the summer of 2007 and it ushered in one of the most fantastic buying opportunities in years at the long end of the curve). Those pundits calling for higher yield activity seem more bent on following the market than calling it. In any event, overnight, we did see along with the profit-taking in equities (and we shall soon see if yesterday’s move was a classic ‘double top’ with the January 6th intra-day high or if the break of the 200-day m.a. was the onset of a whole fresh set of legs for this cyclical up-move), the yen and dollar recover and oil and copper retreat a tad. The commodity-based currencies are also off a bit, in part because the Reserve Bank of Australia said that there is “scope for some further easing” in policy. That trimmed about 0.5% from the Aussie — will the BoC also find a way to curb the over-enthusiasm over the loonie when it releases its press statement on Thursday? (We think so.) On the data front, a mixed bag overall: While the U.K. printed a ‘green shoot’ data-point in the form of home loan approvals (43,201 in April from 40,038 in March — best in a year), the CIPS construction index dropped to its lowest level in at last three years (45.9). France’s PPI deflated 0.9% MoM in April and -6.4% on a YoY basis versus -4.7% in March (consensus was for a -5.5% reading on a YoY basis). And, the Eurozone unemployment rate jumped to a 10-year high of 9.2% in April from 8.9% in March (coming in above the 9.1% consensus estimate). Inflation rates through most of Asia have just plunged to their lowest level in two years.

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BOND SELLOFF BELIES DEFLATION REALITIES Nothing is as important to the inflation backdrop as the labor market — wages/salaries/benefits are seven times more powerful in determining the corporate pricing structure. With this in mind, we see today a reference to a Challenger, Gray and Christmas survey conducted in May showing that 52.4% of companies have instituted salary cuts and/or other cost-cutting initiatives. DOW TRADES IN TWO LEGENDS — WILL LIFT TECH & FINANCIAL WEIGHTINGS The Dow 30 is dropping not just GM (for the first time since 1925 — only G.E. has been in the index longer) in favor of Cisco (bringing the tech weighting to 17% and likely to usher in more volatility as a result), but Citi is also going to be replaced by Travelers, which in turn raises the financials share to 10% from 7%. THERE ARE FOUR DIFFERENT FACTORS THAT DRIVE THE EQUITY MARKET They are: 1.

Technicals

2.

Fund flows/Market positioning

3.

Valuation

4.

Fundamentals

Let’s examine each one at the current time. 1. With regard to the technicals, they are uber-bullish. Not only has the A-D line broken out to the high side, but the S&P 500 yesterday broke above the intra-day high of 943 set back on January 6, not to mention taking out the 200-day moving average. The ultimate retest will have to wait another day. This market is at risk now of melting up; and, as I said before when I was keeping an open mind regarding the longevity of this rally, notwithstanding my skepticism, if credit spreads, Libor, the Ted spread and commodity prices could all go back to pre-Lehman levels, why couldn’t the S&P 500 too? That would mean a possible test to the high side of 1,200, believe it or not. That is an observation, not a forecast, by the way. Back when we hit that level last fall, it was a glass-half-empty feeling of being down 20% from the highs; this time around it is a cause for celebrating an 80% move off the lows! The S&P 500 is now up more than 4.0% for the year; the Nasdaq, which was the first of the major averages to break above the 200-day m.a., is up 16.0% year-to-date. The Dow is roughly flat. 2.

The rally seemed to have stalled out on May 8 and for the next three weeks, all the market seemed to do was range-trade between 880 and 920 on the S&P 500 … until yesterday. The initial source of buying power in March was the dramatic short-covering and pension fund rebalancing. Then in April the retail investor became enamoured of the ‘green shoots’ and found $12 billion of money to put into equity mutual funds (only the second net inflow in the last year, by the way). And, as May morphed into June we likely have started to see the capitulation among institutional portfolio managers, who collectively shard by cautious view.

Technicals for the equity market are uber-bullish

In the last three weeks, it seems that the market was going nowhere … until yesterday

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As the just-released Barclays survey of some 600 fund managers revealed, fully 60% had been viewing the move off the March lows as a bear market rally, less than 5% bought into the V-shaped recovery forecast; and only 9% were fully invested. The risk of being pressured to chase performance is high, and along with that, the odds of a further melt-up, all the more so with the technicals being pierced in resounding fashion. 3.

The global trailing P/E multiple has surged five points during this rally to 15x. So this market is far from cheap. Let’s look at the S&P 500. A classic mid-cycle multiple is 15x, so basically the market is pricing in $63 of operating earnings. That is being generous because based on where the corporate bond market is trading, the fair-value multiple is around 12.5x, which then means that equities are discounting $75 of earnings, which we would not expect to see until 2013 at the earliest. (A 15x multiple is also rather generous when one considers that we now have an economy where large chunks — autos, insurance, mortgages, banks — are at least partially owned by the government.) Look at this way — we are going to be hard-pressed to see operating EPS much better than $43 this year. A ‘normal’ first-year earnings bounce is 20%, and again this is being generous, but that would leave us with $52 EPS for 2010.

From a valuation standpoint, this market is far from cheap

We give that prospect very little chance of occurring, and we have some difficulty with the stock market going ahead and pricing in an earnings profile that is likely four or more years away from occurring. Are we going to be back pricing in end-of-cycle or recession earnings this time next year at the rate at which investors are discounting the future. There may be upside to this market based on factors (i) and (ii) but we remain concerned about its longevity because at some point, post-bubble earnings realities in a deflationary top-line environment (nearly two-thirds of S&P 500 companies missed their revenue targets in Q1) will re-emerge on the front burner. 4.

The economic fundamentals are open for debate, to be sure. The same consensus and equity market that couldn’t see the recession coming two months before it did surface back in 2007 are now supremely convinced that the recession is over and that economic renewal has begun. This has gone even further than ‘green shoots’. But what provided the real spark yesterday was the ISM index coming in at 42.8, up from 40.1 in April; as with the consumer confidence surveys, this was the best result since last September when Lehman collapsed. What caused the excitement was that the folks at the ISM claimed that at 41.2 on the business diffusion index, the recession comes to an end.

WISHFUL THINKING Maybe that is true in a classic manufacturing inventory recession, but this was a downturn led by asset deflation and a credit collapse. Let’s go back to when the recession began in December 2007 and you may be interested to know that the ISM was 49.1. The month before LEH collapsed, oh, only eight months into the recession, the ISM was sitting at 49.3. So somehow, we are to believe that the recession has ended because the ISM broke fractionally above 41.2. Mercy. This was not a manufacturing-led recession — the factory sector was an innocent bystander in this de-leveraging cycle.

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Moreover, within the ISM survey details, what we see is that 28% of businesses reported any growth at all last month, compared with 39% in May 2008 — again, when the recession was into its fourth month. Somehow, with fewer industries expanding now compared to then, the recession, we are told, is done. If only it were true. No doubt there was good news in the ISM orders component (it rose to 51.1 from 47.2 — best level since December/07) and the customer inventory segment was at its tightest level since April/08. But it is hard to believe that orders will continue to expand in the absence of a recovery in consumer sales; and that is going to require an end to the multi-month wave of job losses. What was dismissed, for some reason, from the ISM report was that the employment component dipped to 34.3 from 34.4 — when the recession began, it was sitting at 48.7. Fascinating way to the end the recession — ISM employment 14 points lower than when the downturn officially began.

The folks at the ISM claimed that the recession has come to an end … if only it were true

Not only must employment bottom before the recession ends, but so must consumer spending. So what we saw yesterday morning that was interesting was that the combination of the tax relief and benefit increases gave personal income an artificial $110 billion boost (at an annual rate) in April, and even with that stimulus, consumer spending still contracted $5½ billion or 0.1% on top of a 0.3% decline in March. Wages and salaries in the private sector contracted $1.3 billion, the eighth decline in a row totalling a cumulative $160 billion loss. As with so many other parts of the economy (mortgages, autos), the only factor holding up household incomes is the government. The really big story is that the fiscal stimulus is assisting in the household balance sheet repair process, but is not really doing much to spur consumer spending — highlighted by the rise in the personal savings rate to a 15-year high of 5.7% from 4.5% in March and zero a year ago — never before has the savings rate risen so far over a 12-month span. Note that the post-WWII high in the savings rate is 14.6% and that is where I believe we are heading. Despite the conventional wisdom, this is highly deflationary. For a very good ‘take’ on how spending behaviour is changing on a secular basis, see Americans Get Even Thriftier as Fears Persist on page A2 of the WSJ. While street economists are consumed with ‘green shoots’, which is just noise in a downward spending trajectory, I found what the economist from John Hopkins University (Christopher Carroll who specializes in consumer behaviour) had to say in the article very interesting. In real terms, consumer spending was down 0.1% after a 0.3% drop in March and points to a moderate contraction for the current quarter. Remember that consumer spending was also marked down in the revised Q1 report to 1.5% at an annual rate from 2.2%. Still no evidence of much in the way of ‘green shoots’ here outside of improvement in the second derivative.

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We are not as bearish on the stock market, at least over the short-term, with the S&P 500 breaking its 200-day moving average. As we said, there is the risk of a melt-up as portfolio managers play catch-up. After seeing housing starts collapse 13%, core capex orders slide 1.5% for two months in a row, jobless claims pierce the 600k mark for an unprecedented 17 weeks in a row, organic personal income drop for eight months running and back-to-back declines in retail sales with little sign of a turnaround in the weekly May data-flow, it stands to reason that this is an equity market that is extremely forgiving and resolute in its belief that the recession will give way towards sustainable positive growth starting next quarter. We say this with the utmost of humility, but the onus, indeed the pressure, is now squarely on the bears.

Q3 will be key and the debate whether or not we are seeing a recovery will not be settled until we have a good two months of data to digest

The first quarter was a write-off for GDP and the second quarter is going to show a contraction of between 2.0% and 4.0% at an annual rate — practically every economist has this in their forecast. The key is the third quarter and the reality is that the debate will not be settled until we have a good two months worth of data to glean at, which means that this rally could well be extended through the summer; after a 40% rally from the lows, that is certainly a possibility. As for bonds, well, as with equities the technicals have been pierced and the next level of support on the 10-year T-note yield is 4.11%. However, long-term, we believe that the U.S. economy is in a gigantic mess and that risk-taking in the stock market is not going to be rewarded on a sustained basis. We continue to hold the view that the stock market, which peaked in 2007 just two months shy of the most intense recession in 70 years, is vastly overrated as a forecasting device and we strongly believe that portfolios will need to be cash-generating machines. If the portfolio isn't providing steady income, the return for investors is going to be extremely minimal or even negative. So obviously bonds will be playing a huge role — Treasuries and Canadas at current levels offer a significant inflationadjusted yields and high-grade corporates still look attractive despite the ongoing compression in spreads. Within equities, we hold to the view that investors should focus on strong dividend-payers and stable cash flows. One final item to note on Mr. Market; it is not a shoe-in that the stock market is about to stay on this one-way ticket north. Two things happened yesterday that is worth noting. First, the late-day round of profit-taking left the S&P 500 at 942.87, which was below the intra-day high of 946.0 reached back on January 6. And something very strange happened in yesterday’s session, which is that the VIX index rose 3.8% even as the S&P 500 rallied 2.6%. Not only has the VIX index, in the past, fallen over 95% of the time that the stock market advances, at no time in the last seven years did a 2%-plus surge in the S&P 500 coincide with an increase in vol … until yesterday.

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CAUTION ON CANADIAN DOLLAR: Crude oil and the metals have broken out but natural gas and forest products (together 10% of the export base) have actually fallen during this CAD run. The CRB index has gone nuts but the rally in the loonie has more than doubled the increase in the BoC’s commodity index so this has actually been a significant net tightening of monetary conditions. I don’t think the BoC necessarily changes its outlook but if it doesn’t at least pay any lip service to what the currency has done since the last meeting I think it is going to look out of touch. All that has to happen in the statement is an acknowledgment that the appreciation, while deserved based on the favorable terms of trade shock, has overshot the commodity fundamentals nonetheless.

We wouldn’t be long the CAD heading into the BoC meeting this coming Thursday

Just a hint that the BoC isn’t happy with the pace of the CAD’s runup, which is destabilizing for the economy, let alone unwarranted (also unprecedented) — could well see a few pennies lopped off the loonie if investors decide to take same profits. As an aside, the CAD has the identical correlation with natural gas as it has with the oil price (70%). I would say that the loonie “should” be trading closer to 83 cents as opposed to 93 cents based on what the overall terms of trade effect has been from the commodity price pickup. So brother, can you spare a dime? But make no mistake, the commodity sector is on a serious run here, and looks like the flip-side of the breakdown in the U.S. dollar, which has declined to its low water mark of the year and could easily slip another 5-10% from here. Oil prices have surged to their highest levels since last November (like so many other things) and seemingly poised to move into that OPEC range of $70-75/bbl. Copper has broken out in a meaningful way too — now at a fresh seven-month high. The CRB index is firming too and just came off its best month — a 14% run-up in May — since July 1974. The much-maligned Baltic Dry Index surged 5.4% yesterday and has now doubled in just the last month, and this has proven in the past to be a fairly decent leading indicator of the broad resource complex. Unlike the USA, which has not enjoyed a three-month string of 50+ ISM prints since SeptemberNovember of 2007, China just managed to achieve that feat — hence the rally in the commodity market. As we said yesterday, this bodes well for the Canadian stock market, which has an 86% positive correlation with the CRB index versus 28% for the S&P 500. Moreover, while the Canadian economy is clearly hitched to the United States, the TSX enjoys a 60% correlation to the Shanghai index — whereas the more insular U.S. market is only 40% correlated.

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