Breakfast With Dave_052209

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

May 22, 2009 Economics Commentary

BREAKFAST WITH DAVE

Market Musings & Data Deciphering WHILE YOU WERE SLEEPING European stock markets have been able to shrug off yesterday’s negative U.S. action but Asia did close lower. The Shanghai index has turned into a leading indicator of sorts; it closed down 0.5% and down 1.8% on the week.

IN THIS ISSUE • Commodities staging a comeback, giving boost to resource based currencies

Treasuries have a tiny bid this morning but are on tenterhooks nonetheless; however, this could be an opportunity for income-seeking boomer investors to add some yield to their portfolio. Corporate bonds remain the place to be, in our view, and are still priced for so much bad news that Baa spreads, at 475basis points, are still 130bps above the levels that prevailed after 9/11, 250bps above the levels during the LTCM crisis, and 300bps above the levels posted during the depths of the Asian crisis over a decade ago (see Chart 1).

• We can make sense of the equity market undergoing a testing phase … but the massive selloff in Treasuries was a bit unnerving • The view out there that the U.S. is about to receive a credit downgrade could be a little premature

Commodities are staging a comeback today with copper and oil recovering after yesterday’s giveback — this is giving an added boost to the resourcebased currencies like the Canadian, Australian and New Zealand dollars. We still favour these units long-term but have moved too parabolically of late and so a near-term retracement could be expected. The flip side of the story really is the sudden weakness in the U.S. dollar, which has faltered to a four-month low against the Euro, and the negative sentiment against the greenback was reinforced this morning by comments out of Boston Fed President Rosengren who mowed over the green shoots and declared that the U.S. recovery would be “slow”. (Is that really new news?) On the data front, it was quiet — unrevised U.K. first quarter GDP (-1.9%, not annualized) and car production for April was reported to be down a shocking 55%. We are getting signs that the worst of the housing downturn is behind us, though that does not mean we have hit bottom just yet. Radarlogic, which specializes in housing data, reported that U.S. home prices in the 25 metro areas it monitors fell 0.3% sequentially in both February and March, which at least is ‘less negative’ than the average 2% monthly declines posted in 2008. Be that as it may, inventories are still far too high and the demographic backdrop far too challenging to warrant a fundamental bullish call on anything housing related in the United States. Rallies in homebuilders and stocks that cater to the real estate market will be shortlived affairs that should be rented, not owned.

• The bulls will claim that initial jobless claims have peaked for the cycle … • … but keep in mind that job losses and recessions do not typically end until claims are sliced below 500k

Chart 1: Corporate Spreads Still Very Wide United States Baa Corporate Bond minus 10-year Treasury Note Yield (percentage point) 7 6

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For anyone long the tech area of the market, the headline today that may cause some concern is the one on page 13 of the Financial Times – Citigroup Ramps Up Tech Cuts (planned savings of $1 billion for the bank, but at the expense of the top line in the IT sector).

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Source: Haver Analytics, Gluskin Sheff

Please see important disclosures at the end of this document.

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May 22, 2009 – BREAKFAST WITH DAVE

ONE STRANGE SESSION Let’s see. The S&P 500 decides to slide 1.7% (third decline in a row and nine of the 10 GIC sectors down) on the same day that the leading economic indicator jumps 1% in its best showing since June 2005. What happened to the “green shoot” effect? And even with the CRB index slipping 1.8%, with crude, corn and copper crimped, not to mention in the face of the Fed’s proclamation that inflation would stay subdued for years to come, the breakeven level on the 10-year TIPS widened to 173 basis points — the highest since last September. That inflation expectations would take off the same day that Amtrak would announce a 25% fare cut through to early September is rather remarkable. We can make sense of the equity market undergoing a testing phase, but the massive selloff in Treasuries — the 10-year Treasury note yield surging 18 basis points to 3.38% was a bit unnerving, and it deserves an explanation. In part, some concern following the downgrade to the U.K. credit rating outlook, and while the FOMC minutes hinted that the Fed could come in and buy more bonds, actions speak louder than words and the central bank bought roughly $7 billion of the $45 billion of notes in the 2013-16 that were offered. (Still, the Fed has purchased $123 billion of Treasuries — over 40% of its plan has already been used up — since late March and the 10-year T-note yield is still up 60 basis points.) The Fed’s patience with this bond selloff will extend only so far as mortgage rates do not follow suit — and despite the sharp rise in Treasury yields, the bellwether 30-year fixed-rate mortgage closed the week down 4bps to 4.82%. Add to that the onset of more supply as the Treasury announced that it is going to sell $40 billion in 2s, $435 billion in 5s and $26 billion in 7-year maturities next week (and you can understand why nobody wanted to be caught long ahead of the long weekend). That said, a 4% real inflationadjusted yield now looks pretty juicy; although we must acknowledge, not juicy enough for some large institutional investors — like the Canadian Pension Plan (see Canadian Pension Fund Wary of Bonds on page 16 of the Financial Times). Moreover, we saw three other bad sessions just like this for bonds — October 8th, September 30th, and September 19th (3.72%, 3.85%, and 3.78% respectively). Each time, the bull market in Treasuries was declared to be over, and by the second half of December, the 10-year T-note was sitting just above 2%. One thing looks certain and that is the U.S. dollar, which is breaking down — the key reason why gold rallied 1.5% to over $950/oz (gold is proving to be a hedge against both inflation and deflation this cycle). It seems as though the only development that can help backstop the greenback at this point would be signs of sputtering in Asia’s economy, specifically China, which makes the June 1st release of the China PMI a very important event (there is talk of a sub50 reading).

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May 22, 2009 – BREAKFAST WITH DAVE

The fact that Deere expects sales to drop 19% this year or that CAT’s global machinery sales weakened 39% YoY in the three months to the end of April is a pretty clear sign that the global economy isn’t quite out of the funk that the equity market has managed to totally price out. Moreover, in the last 24 hours, we have seen Mexico’s GDP contract at a 21.5% annualized pace in the first quarter, even worse than Japan’s 15.2% slide and Germany’s 14.4% plunge. These figures made Taiwan’s and Singapore’s 10%+ decline almost look palatable. Moreover, global electricity usage is declining for the first time since 1945 (interesting take on what this means on page 3 of the Financial Times). A LITTLE TOO MUCH HYSTERIA? Yes, the U.K. received a downgrade to its credit outlook yesterday. And irony of ironies, it was the U.S. dollar that softened against the pound and the 10year T-note yield surge (+18bps) doubled the backup in gilt yields. While the U.K. government debt-to-GDP ratio is around 40%, the rating agencies are looking at 100% in coming years. The U.S. government debt/GDP ratio right now is near 65%, but clearly heading higher. It seems as though 100%+ is the trigger points for downgrades: Canada’s gross debt/GDP ratio was 114% when it lost its AAA status back in the mid-1980s; the Japanese ratio was closer to 120%. So the view out there that the U.S. is about to receive a credit downgrade despite the dramatic expansion of the government balance sheet is a little premature (though it cannot be totally ruled out in coming years if the largesse is not reversed). For now, it makes for nice cocktail conversation but as super-sized as the deficit is (13% of GDP), there is enough room in the debt ratio that the U.S. would likely have to run three more years of this sort of fiscal policy to be seen as a candidate for a downgrade. WITH THE DXY BREAKING DOWN, WE THOUGHT IT WOULD BE WORTHWHILE TO RUN SOME SIMPLE HISTORICAL CORRELATIONS: • Basic materials 87% inverse correlation •

Consumer staples 79% inverse correlation

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Industrials 62% inverse correlation

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Consumer discretionary 34% inverse correlation

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Utilities 28% inverse correlation

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Financials 22% inverse correlation

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Health care 18% inverse correlation

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Tech 5% positive correlation

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Telecom 13% positive correlation

So, the best performers typically would be basic materials (the stuff is priced in dollars); staples (high foreign currency translation) and industrials (relative improvement in export competitiveness). Financials, health care, tech and telecom have more of a domestic content and as a result screen the worst in a declining dollar environment.

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May 22, 2009 – BREAKFAST WITH DAVE

For more on the greenback’s fate, go to the column on page 21 of the Financial Times — Dollar’s Fall Reflects Loss of Haven Appeal. FROM FRIVOLITY TO FRUGALITY Anyone who has read my thematic pieces over the past year knows that this is a major secular shift. Auto sales are still languishing at quarter-century lows and well below replacement demand levels for an unprecedented eight months in a row. J.D. Power is reporting that U.S. motor vehicle sales jumped 9% in May (their estimate) but down 36% YoY. I think they are using nonseasonally adjusted data — May is always a very strong month seasonally for auto sales, typically up 10% MoM from April. If my calculations are correct, then the tally for May on a SAAR basis would be 9.1 million units, down 2.2% sequentially from April, and that would probably mark the third decline in a row in total retail sales because the weekly surveys are showing no rebound this month in same-store chain sales despite the tax stimulus … savings rate must be climbing even further. We also see from the just released USA Today/Gallup poll that 50% of respondents are going to cut back on travel this summer — up from 40% who said so last year when gasoline prices were at record highs and twice today’s levels. This tells you that we are in a secular, not merely cyclical downtrend in U.S. discretionary consumer spending. Attitudes are changing towards how the family budget is being allocated — medical care, food, and education are not likely to be sacrificed, but expensive vacations are and will be for some time. See page 3A of the USA Today (Summer Vacations Put on Ice) and keep in mind that the hotel/leisure group is still up 30% from its nearby lows. So how are companies that cater to the U.S. consumer surviving? Or making money for that matter? By cutting costs (thought this strategy can’t last indefinitely). See Gap Inc. and Sears Post Profits Despite Sales Declines on page B3 of the New York Times; Hormel Reports Higher Profits Despite Flat Sales and Children’s Place Profit Rises With Cost Cuts, Tax Benefit on page B4 of the Wall Street Journal (some aren’t so lucky — see Barnes & Noble Posts Loss as Sales Drop on page B6 of the WSJ). LESS OOMPH THAN MEETS THE EYE Perhaps there was not much enthusiasm in the stock market for the 1% bounce in the leading economic indicator because the S&P 500 is actually one of the 10 components. (Is that called double counting?) In fact, almost half of the gain came from the equity market and the steep yield curve contributed one-third to the advance. We will pay homage, however, to the coincident-tolagging ratio, which tends to lead the leader, as it did edge up, to 89.9 from 89.6 in March — the first increase in six months and something worth looking at if it makes more advances in coming months. As for the Philly Fed manufacturing index, it improved a touch, but was still in deep negative terrain, at -22.6 in May from -24.4 in April and -35 in March; in other words, “green shoots” are data that are just less negative. But what we Page 4 of 8

May 22, 2009 – BREAKFAST WITH DAVE

found that was key was the “special question” in the survey: When asked how to characterize the underlying demand for their manufactured products over the last two months, 56.1% said “decreased modestly or significantly” while 24.4% reported “increased modestly or significantly”. Only 31.8% who are experiencing faltering demand said that the “declines have moderated”. Finally, and in more forward-looking fashion, 44.2% said they do NOT expect to see an increase in demand within the next six months — 67% said any increase is at least three months away. That is the principal risk for the equity market — the absence of a V-shaped economic recovery in the second half of the year. Companies are saying they are not going to be rebuilding inventories in advance of a discernible uptrend in consumer sales. Initial jobless claims came in a tad above expected at 631k for the May 16th week, though down from 643k the week before (consensus was at 643k). The four-week moving average remains very high at 629k, about in line with where they were a month ago, so no reason to believe that nonfarm payrolls are going to show much improvement when the May data roll out on May 5th (they declined 539k in April). The bulls will claim that initial jobless claims have peaked for the cycle. That may be true but job losses and recessions don’t typically end until initial jobless claims have sliced below the 500k threshold. We are still a long way from seeing that unfold. From my lens, the big story is that claims have been north of 600k now for seventeen weeks in a row, which is … unprecedented. The unemployment rate correlates highly with consumer delinquency rates and wage growth. And, what in turn correlate with the unemployment rate is not so much the gross jobless claims but rather the backlog of continuing claims — those folks who were laid off and have yet to find a job. The level of claimants rose for the 18th week in a row to a new a record high of 6.662 million (up 75k from the week before; +524k over the past month). The “insured” unemployment rate edged up to 5.0% from 4.9% last week and 4.6% a month ago, which is consistent with a 10%+ official unemployment rate, by the way (and we found out in Wednesday’s Fed minutes that there was one FOMC member who sees that occurring this year). We also see that the Congressional Budget Office issued a forecast yesterday that it also expects to see a double-digit unemployment rate by 2010. Again, this is why we cannot turn outright bearish on Treasuries — history compels us to look through the intermittent spasms because not once in the last 60 years did the yield on the 10-year Treasury-note bottom before the unemployment rate hit its cyclical peak.

The sustained weakness in the labor market may be one reason why the U.S. consumer is slipping again this quarter. Retail sales fell in both March and April and I see no turnaround yet in the weekly data so far for May despite the onset of the tax stimulus (which began last month).

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May 22, 2009 – BREAKFAST WITH DAVE

The S&P 500 retailing index has a 92% historical correlation with employment and the group is still up more than 40% from the March lows (though it is off 6% from the nearby peak). Likely time to take some profits. We highly advise that readers have a look at today’s Lex Column in the Financial Times (U.S. Unemployment); you will see a familiar theme. For the first time since the 1930s, wages and prices are falling together. For those who like to use models to forecast the future based on post-WWII data, take note that wages and salaries have never before in the modern era deflated for six months in a row. While we like gold for different reasons, reflation trades based on a revival in consumer price inflation seem off-base to us. Chart 2: Continuing Claims Remain At A Record High United States Insured Unemployment, State Programs (thousands, seasonally adjusted) 7000 6000

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Source: Haver Analytics, Gluskin Sheff

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May 22, 2009 – BREAKFAST WITH DAVE

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