Breakfast With Dave_052709

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

May 27, 2009 Economics Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave WHILE YOU WERE SLEEPING There is significant spill over from yesterday’s super-positive U.S. action to the Asian equity markets, which hit their highest level in eight months today – up 1.6% on the session. The Hang Seng index soared 5.4%, Taiwan by 3.1% and Japan by 1.4%. All the risk-preference trades are in vogue – Sterling hit the 1.60 mark for the first time in six months, copper just reached a three-week high, oil has broken above $63/bbl (up 1% so far today), and gold is off. The crude oil price received a nice lift in particular from comments out of the Saudi oil minister (Ali Naimi) who said that the world could live with $75-80 oil. Treasuries are tremendously oversold but as we saw in the summer of 2007 when they broke to 5.3%, there is always a risk of an overshoot. They are ever so slightly bid this morning as the Fed is going to come in today and purchase T-notes that mature between May 2012 and August 2013 and this is helping provide a bit of a better tone right now (though there is $35 billion of new 5-year supply hitting the market today).

IN THIS ISSUE • Why the U.S. will not get downgraded, in our view • Home prices continue to deflate, down 2.2% MoM in March and -18.9% YoY • The equity markets surged on the back of the Conference Board consumer confidence report • The Chicago Fed’s national activity index entrenched in recession terrain

All eyes on U.S. existing home sales for April this morning as the ‘green shoot’ advocates are back on the front burner. According to Bloomberg News, the latest NABE (National Association of Business Economists) survey shows that the consensus believes the recession will end next quarter. If the consensus is right – as it is generally less than 20% of the time – then the lows of March 9 should indeed hold based on the typical lags between bear market and business cycle troughs. On the data front, pretty light today -- the closely-watched Belgian business sentiment index came out earlier and was below expected in May, at -27.6 (consensus was -27). German state inflation data so far in May are coming in negative for the month, which is below expected. Exports in Asia are starting to revive – Japan saw its YoY trend in April at a still negative 39% but this was better than the -42% that was widely expected, and on a MoM (seasonally adjusted) basis, outbound shipments rose 1.9%. What’s the next shoe to drop? Commercial mortgages, no doubt. According to Bloomberg, S&P is on the precipice of cutting a significant tranche of high-grade loans that were issued during the debt binge from 2005 to 2007 – which of course could then affect the debt that is eligible for the TALF program.

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May 27, 2009 – BREAKFAST WITH DAVE

YESTERDAY’S ACTION The bond market got beaten up again – the confidence index seemed to win out over the home price data. The bond market sold off sharply even though the 2year note auction went rather well (2.94x bid-to-cover ratio versus a 2.43x average over the last ten auctions). We hear that technically the 3.56% is a critical level of support, and as we said late last week, the worst-case scenario is a move to 4.1% on the 10-year T-note. This is all very reminiscent of that sharp spasm we saw back in the summer of 2007. The only difference is that the ‘inflation-adjusted’ real yield back then was 3% and today it is a juicy 4 ¼%. The equity market rallied sizably and responded largely to the booming consumer confidence number, which we would classify as a third tier economic indicator (the Russell 2000 soared 4.8%, snapping a four-day losing streak, but the gain was led by the homebuilders even though house-buying intentions were the weakest link in the consumer confidence report!). It may tell us something about hope, but it doesn’t feed into GDP or corporate earnings. The S&P 500, at 910, is still below the 928 nearby peak on May 8 and the 937 peak for the year posted back on January 6, which begs the question, did we just see a double peak? Since that interim May 8 high, we have endured three triple-digit down days and three triple-digit up days. So, all Mr. Market is really telling us is that he is currently in a very volatile mood. We had a reader email us yesterday who stated “I am finding it harder and harder to reconcile reality with your analysis.” Well, as I have said in the past, this is still a bear market rally until we see the improvements in the second derivative begin to morph into first derivative improvements. The risk, as I see it, is much the same as in late 2001 and early 2002 when the recession ended but the recovery was aborted until we were into the second half of 2003. Asset deflation and credit contraction cycles never play out according to the historical script, which is one reason why we remain cautious and not at all trusting over the durability of this market bounce of the last two months. In other words, this should be treated as a bear market rally. The only meaningful change in my view is that I am no longer as sure as I was before that we will go back to the old lows of March, but I still think a testing phase will be in order. As for “reality” – well, tell me, what is the reality? What was the “reality” when the market was up 2% for the month, 15% over the prior year and the Dow up a resounding 120 points on the very day of the peak back on October 9, 2007. I’m sure the reality at the surface was that we had a Goldilocks economy. The reality a few months later was quite different with the onset of recession, and this was before Bear Stearns and Lehman collapsed. So, the market will do what the market will do, which is to overshoot and undershoot in both directions. As I see it, what the market has done is price out the recession, but please , at 900+ on the S&P 500 (where it was when Warren Buffet told you to buy the market last October), I’m not sure it’s telling you much about the shape of any recovery. Plus, as we show below, bullish sentiment has recently risen to near-extreme levels, which is bearish from a contrary perspective.

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Be that as it may, the big risk now for the cautious (our) view of the market is less the fundamentals and more the fund flows; we are aware that portfolio managers are sitting with $3.5 trillion of cash, and the major upside risk is that they start to chase performance. At the least, the temptation to now “buy the dips” could well ensure that the lows have been put in and that it would take a 2002-style relapse in the economy and adverse corporate news (ie, Enron, Worldcom back then) to trigger a setback to fresh cycle lows. We have not changed our views on the macro outlook, but the markets have a tendency historically to overshoot in both directions. We have to be mindful of that. But for the time being, it does look as though all we are seeing is backing and filling and a consolidation with the early May interim highs. WHY THE U.S.A. WILL NOT GET DOWNGRADED I realize this it is borderline heresy to say anything positive about the U.S. economy so I will just say something that is less positive. It is highly unlikely that the U.S. government will ever default. Why? Well, it can always print dollars – and all its liabilities are in dollars. Not only that, but it was comical to see the markets focus on the U.S. dollar and the Treasury market following the downgrade to the U.K.’s credit outlook. There is no use comparing the diversified economic base between the two countries. Not only that, but the taxing capacity in the United States is much larger – government revenues absorb 42% of national income in the U.K. versus 33% in the U.S.A. Those comparable figures are 43% in Germany, 46% in Italy, and 49% in France. In Canada, it is 40%. But here is the grim reality for American workers, especially those in the upper income echelons. The President ran on a campaign to redistribute income, and at the same time he has beefed up what was already a near-intolerable deficit, and as we saw in the 1930s as the top marginal tax rate climbed to nearly 80%, Uncle Sam is going to be increasing its revenue take for a long, long time. The era of the word ‘tax’ being a dirty three-letter words in the United States is about to come to a close, if it hasn’t already in areas like New York, where the top rate has already risen to 46%. Shades of Ontario during the Rae years of the early 1990s. HOME PRICES STILL DEFLATING U.S. home prices (according to the Case-Shiller home price index) continue their descent – down 2.2% in March and -18.7% on a year-over-year basis. Prices are now down 32% from their 2006 highs and there is still no sign of relief. Just wait until the post-foreclosure-moratorium inventory surge hits the market in coming months – prices will adjust even lower. (Note that RealtyTrac just released its April data and found that a record 340,000 default notices were handed out during the month.) All 20 metropolitan areas are deflating year-onyear, with Phoenix, Las Vegas and San Francisco still the major culprits in this never-ending story. Overshooting to the downside as much as they overshot the upside would mean the prospect of another 20-30% decline from here. Meanwhile, plain-vanilla mortgage rates have stopped falling and jumbos are on the rise; not only that, but keep in mind that the rental vacancy rate nationwide is now over 10%.

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Chart 1: HOME PRICES — STILL DEFLATING AFTER ALL THESE YEARS United States S&P/Case-Shiller Home Price Index: Composite 20 (Jan 2000 = 100, seasonally adjusted) 220 200

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Source: Haver Analytics, Gluskin Sheff

THE MARKET SURGED ON THE BACK OF THE CONFERENCE BOARD CONSUMER CONFIDENCE REPORT FOR MAY •

The headline index surged to 54.9 from 40.8 in April and the 25.3 low in February. The 29.6 point jump over the last three months is a record. This will revive the ‘green shoot’ advocates.

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The confidence index is back to where it was in September when the economy was nine months into recession. In the last two recessions, as an example, the end of the recession coincided with this index north of 80. So it is telling us what so many other indicators are signaling which is it that things are “less bad” than they were; but this is not enough to terminate the recession call.

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The bulk of the increase in the index was in “expectations”, which surged to 72.3 from 54.0 in April – to stand at its best level since December 2007! This index is influenced largely by the rally in the equity market, which becomes circuitous since the market then rallies off a number like this.

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The ‘facts on the ground’ present situation component came in at 28.9, which was marginally better than the 25.5 print in April – but less than half where it was last September (61.1). This is key because it tells us that the delta in this report from consensus all came in the form of hope, not necessarily reality.

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Interestingly, the homebuying intentions component fell to a three-month low (but plans to buy a major appliance rose to its highest level in eight months). Auto buying plans rose to its best level since April 2008 so the incentives may be working for the time being. Consumer intentions to take a vacation fell to its lowest level in 41 years!

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May 27, 2009 – BREAKFAST WITH DAVE

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Finally, the share of households who are bullish on equities rose to 35.8% from 31.7% in April and the March low of 19.6% (this is the highest since July 2001). The ‘bear share’ fell to 30.8% from 35.7% (was 52.8% at the March market lows) — the lowest the bear share has been since October 2007. Could be the hidden ‘contrary’ negative data-point in a report that is being viewed as widespread bullish for equities.

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THE LAST TIME THAT THERE WERE MORE EQUITY MARKET BULLS (35.8%) THAN BEARS (30.8%) WAS BACK IN OCTOBER OF 2007 WHEN THE MARKET WAS HITTING ITS PEAK. THIS METRIC WORKS LIKE A CHARM BECAUSE LAST MARCH, AT THE MARKET LOWS, THE GAP BETWEEN THE BEARS (52.8%) AND THE BULLS (19.6%) IN THE OTHER DIRECTION WAS THE LARGEST SPREAD SINCE JULY 2008 (AND THE SECOND LARGEST GAP ON RECORD).

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As for bonds, as a sign of how negative the sentiment is, the share who see yields backing up rose to a six-month high of 47% from 39% in April. The share believing that interest rates will head lower slid to 18.1% from 23.4%. The last time there was such a huge differential between the bond bulls and bond bears (in favour of the bears) — by 29 percentage points — was back in September 2007 when the bull market in Treasury was just getting going. Just to show how great a contrarian this indicator is, at the December lows in bond yields (when the 10-year note touched 2.0%), 39.4% of the public were bond bullish (an eight-year high) and only 30.9% were bearish (the lowest in over seven years!).

We can understand that any piece of good news is going to be pounced on as a sign that the recession is over or about to be over. We noticed a lot of economists pointing to the fact that the “expectations” index is some critical barometer of the future. All we can say for investors is that the reliability of these confidence surveys in predicting anything of importance is highly questionable. Just as an example, the “expectations” component of the survey peaked in May 2000. The recession didn’t begin for another 10 months. Then it bottomed in March 2003, a year-and-a-half after the recession ended. And when did it peak? Try December 2003 — and the bull market and the economic expansion had another four years to run. Interpret surveys like these very carefully — the fabled “expectations” index has the grand total of a 33% historical correlation with consumer spending growth. Feeling better doesn’t always necessarily translate into opening up the wallet. Interesting that so much attention was paid to that ripping Conference Board survey for May, when there was a lack of validation from the ABC News consumer comfort index, which slid to -47 in the May 24th week from -45 the week before and -42 the week before that. It was also fascinating to see that the “personal finances” segment has eroded the most over this time period (to -8 from -4 and +4 — a 12 point swing in two weeks) since it was the equity market bounce that supposedly gave that nice “expectations” induced lift to the Conference Board survey.

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Perhaps the Conference Board survey Chief Lynn Franco put it best when she said that “less pessimistic is the best way to describe consumer attitudes” and noted that even with the stock market’s exuberant response, May was “still a weak reading” and “not a very optimistic number”. In any event, there is still plenty of evidence that the American consumer is undergoing a secular change in behavior, and as vacation plans are cut back, what is replacing the plane trip to the theme park are camping trips – welcome to the frugal future. Good article on this in the USA Today (Go Camping to Cut Vacation Costs). For investors, this may mean running “company screens” on sales exposure to tents, flashlights and sleeping bags! CHICAGO! One of the best barometers of the economy is the Chicago Fed’s national activity index, which blends together 85 different variables — a number below zero highlight an economy operating below its potential, but data below -0.70 represents an economy in contraction phase. In April, the index (the 3-month smoothed, which the Chicago Fed says is the key metric to monitor), the index was -2.65, which indeed was “better” than the -3.29 print in March and the terrible -3.68 low for the cycle posted in January. What this index is saying is that the recession is intact, with very little light at the end of the tunnel, with the only reasonably positive highlight being that it is off its worst levels when pundits were talking about “depression” and “widespread nationalization” at the turn of the year. At -2.65, the Chicago index is basically back to where it was in November, and even slightly worse than it was in September when LEH collapsed (-2.23). At the current pace of improvement, this metric does not hit the zero mark until the end of this year. Chart 2: CHICAGO FED’S NATIONAL ACTIVITY INDEX ENTRENCHED IN RECESSION TERRAIN United States FRB Chicago National Activity Index: 3 Mo. Moving Average (+ = growth above trend) 2 1

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

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