Breakfast With Dave_060509

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

June 5, 2009 Economics Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave WHILE YOU WERE SLEEPING You don’t even have to go to the equity market page on Bloomberg to know what sort of day it’s going to be — just check out the Yen-Euro cross rate, another barometer of investor risk appetite. We see that it is on the decline, which is a thumbs-up for everything that is not a safe-haven. The Aussie dollar is up 0.5% as neither the Reserve Bank of Australia (or the Bank of Canada for that matter) can keep these beta-currencies down (Sterling, as an aside, is being hit by intensifying concerns over the longevity of Gordon Brown’s government). Emerging market equities rallied 0.9% today and are up 2.0% for the week; Asia finished today’s session with a healthy 0.6% advance. We see that the FT-SE is up more than 1.0% (politics ostensibly only matter for currencies and bonds, not for equities) and the rest of the continent has gained 0.7%. U.S. futures are in the green and Treasuries are selling off once again, apparently caught in a no-win situation; if the Fed doesn’t step in and buy more government bonds, investors are going to conclude that there is not enough demand to absorb all of the new supply coming on stream. Yet, if the Fed were indeed open to the idea of expanding its bloated balance sheet further, then the ‘monetization of debt’ would cause the inflation-phobes to panic and sell their long-duration paper. As we said, a no-win situation.

IN THIS ISSUE • Canadian employment — a big decline in May • The Investor Intelligence survey shows that 42.5% of PMs are now bullish on the equity market; 25.3% are now bearish • It’s employment day in North America; we already got the Canadian number, it was B-A-D • Consumer spending and housing still in the doldrums • Bank of Canada talks down the loonie (without much success) • Deleveraging cycle in the U.S. is far from over

With the economy still in recession, little hope of a vigorous recovery when it does come around, and widening excess capacity (not to mention a hugely positive ‘carry’) one would have expected the yield on the 10-year T-note to be in a 2.0-3.0% range as opposed to the near 3¾% yield we have today. The 10-year note is on a knife’s edge having given up most of its recent rally. We are still constructive on the bond market, but let’s just say that at this point we are nervous bulls. No sense being dogmatic. But fixed income is not limited to govies. We have for some time, and still do, favour high-grade corporates regardless of what Treasuries do — at least this is a market where, in classic ‘Fisherian’ fashion, supply is creating its own demand — the amount of global issuance in the last year has tripled and spreads have continued on a narrowing path. Look for that to continue.

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June 5, 2009 – BREAKFAST WITH DAVE

As for commodities, oil is bid around $69/bbl — up 5.0% for the week — as is copper (also up around 5.0% for the week). Gold is consolidating. The U.S. dollar is stable today but with the 50-day crossing below the 200-day moving average the bear market is entrenched, which is a net positive for the commodity complex. (Though why the Euro should strengthen on an ongoing basis given the region’s deep problems is a bit of a mystery — for one example, turn to Baltic Storm Threatens Euro Banks on page C12 of the WSJ). On the data front, all we saw were some benign inflation data across the pond — UK input prices +0.4% MoM in April and -9.4% on a YoY basis (steepest deflation rate in seven years) while core output prices edged up 0.2%; and the ECRI leading inflation index for the EMU hit a historic low in April — down to 82.4 from 84.1. WE CAN UNDERSTAND ALL THE ANGST SURROUNDING INFLATION We just don’t agree with it. Inflation is about a sustained uptrend in the absolute price level; commodities going up only really tell us about what is happening to relative prices, that’s all. Because precious few final-state manufacturers or domestic retailers have any pricing power at all, the run-up in basic material costs either comes at the expense of profit margins or, as we just saw in the Canadian employment data, the labour market. For a taste of what we are talking about, go to Discounting by Pricier Chains Fails to Give Retail Sales a Lift on page B3 of the WSJ. When we read about price cuts failing to lift sales volumes, we start to contemplate the prospect that this cycle is turning more Japanese with every single data point. (Japan also enjoyed sporadic ‘green shoots’ too — they are called cherry blossoms over there — and intermittent stock market rallies and bond market selloffs, but the fundamental trend was really in one direction for the last 10-15 years for the economy and the asset classes.)

When we read about price cuts failing to lift sales volumes, we start to contemplate the prospect that this cycle is turning more Japanese

IT’S NONFARM PAYROLL SURVEY DAY The consensus is looking for a 520,000 decline — the optimists would inevitably treat this as a ‘green shoot’ since it is a second-derivative improvement relative to the 539,000 falloff in April, not to mention the -741,000 print posted in January. But do they realize that the worst number we ever saw in the 2001 recession was -325,000? Just to put a 500,000+ decline into perspective. ADP recorded a 532,000 decline; the Monster employment index also dipped two points last month; non-manufacturing ISM employment is a lowly 39; and jobless claims have remained above 600,000 now for 18 straight weeks — the longest stretch ever. Not until they fall below 500,000 will it be safe to call the recession as being over.

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WE ALREADY GOT THE CANADIAN NUMBER! B-A-D •

Canadian employment -41,800 in May, double the decline expected by the market

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All the drop was in full-time too — down 58,700 — which more than wipes out the 39,400 gain in April (Canada has lost 224,000 full-time jobs this year — some ‘green shoot’)

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The unemployment rate surged to an 11-year high of 8.4% from 8% (was 6.6% at the start of the year)

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Manufacturing employment plunged 58,400 — brings YTD carnage to 162,100

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Ontario employment slid 60,000 — the unemployment rate in the province is now 9.4% — the highest since June 1994!

Canadian jobless rate surged to an 11-year high; Ontario’s unemployment rate hits a 15-year high

Bottom Line: This is bullish for GoC bonds and rather bearish for the Canadian dollar; the slide in manufacturing jobs attests to the high degree of CAD overvaluation even with the commodity price backdrop. I still maintain it should be closer to 83 cents right now and I am pretty sure the BoC would agree. TOO MUCH BULL? The Investor Intelligence survey shows that 42.5% of portfolio managers are now bullish on the equity market; 25.3% are now bearish. This looks to be an overbought market, from our vantage point. As a sign of how selective the market is right now regarding the data, the ISM orders number that came out on Monday — highest since November 2007 — was the toast of the town. But the fact that non-manufacturing ISM orders FELL 2.6 points to 44.4 (and this covers 90% of the economy) has been hardly mentioned in the media or research commentaries. CONSUMER SPENDING IN THE DOLDRUMS The chain store sales that came out for May in the U.S.A. were very soft — samestore receipts down 4.6% YoY in May. The consensus was looking for a 3.6% gain so this also lacked ‘green shoot’ veracity — not only that but fully 66% of retailers fell short of their revenue targets! Apparel sales slipped 5% YoY, department store sales fell 9.4% and luxury retailers posted a whopping 18.1% falloff. We must still be in recession because the only positive performer was the drug stores — a 0.9% gain. Discounts stores are down but outperforming — off 3.5% on a YoY basis.

May U.S. chain store sales lacked ‘green shoot’ veracity

BANK OF CANADA TALKS DOWN THE LOONIE (WITHOUT MUCH SUCCESS) “In recent weeks, financial conditions and commodity prices have improved significantly, and consumer and business confidence have recovered modestly. If the unprecedentedly rapid rise in the Canadian dollar (which reflects a combination of higher commodity prices and generalized weakness in the U.S. currency) proves persistent, it could fully offset these positive factors. “

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June 5, 2009 – BREAKFAST WITH DAVE

The Bank of Canada indeed referenced the surge in the Canadian dollar in yesterday’s press statement; it did not mention the loonie at all in the April statement. The bottom line is that the loonie is on the BoC’s radar screen and as such I think the currency has put in a near-term top, notwithstanding my secular bullish stance. With policy rates where they are — the Bank’s options are limited insofar as it could intervene in the FX market or embark on more forceful quantitative easing — the June statement is either bearish for the CAD, bullish for bonds, or both. In a nutshell, the BoC recognized that the loonie has overshot the recent upturn in commodity prices. That it verbalized its concern in the press statement is significant insofar as the Bank does not generally make it a habit to openly discuss the currency market.

The BoC talks down the loonie … without much success

The Bank also had this to say over the outlook — how one can make a bearish call for the fixed-income market based on these comments, not to mention the continued pledge to provide investors with a huge positive carry trade well into next year: “The already significant output gap will continue to widen through the third quarter, putting downward pressure on inflation. The Bank continues to expect that the global and Canadian recoveries will be more muted than usual … the overall risks to its inflation projection remain tilted slightly to the downside. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target.” MORE EVIDENCE OF THE SECULAR SHIFT TOWARDS FRUGALITY All one has to do is look at and admire the 13.0% increase in same store sales at Dollar General in Q1 as one example — in stark contrast to the negative results at most other retailers, not to mention the 9.2% in comparable sales at Dollar Tree. HOUSING STILL IN THE DOLDRUMS First, we saw from Toll Brothers and Hovnanian that revenues and orders are still in freefall (the entire group is up 5.0% year-to-date, believe it or not). Revenues at both companies are down around 50.0% YoY; deliveries at Hovnanian down 44.0% and signed contracts still down 29.0% from a year ago.

Revenues from the major homebuilders still in freefall

Second, MBA mortgage applications index fell 16.2% during the week ending May 29 — the level is at its lowest in 13 weeks. This was on top of the 14.2% decline seen last week. Since its recent peak, which was back just eight weeks ago, mortgage applications have plunged nearly 50.0%. The refinancing index (refi) is down 24.1% for the latest week, on top of the 19% fall seen last week. The level on the refi index is at its lowest in 16 weeks and from its recent peak, which also happened eight weeks ago, the index has shed nearly 60.0% (-57.0% to be exact).

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This halt in activity was due to the massive rise in mortgage rates. The 30-year mortgage rate zoomed 44bps to 5.25%, the highest level since the end of January, and in the last two weeks mortgage rates have risen by 56bps. The 1-year ARM rate has also been gradually rising – up in five of out of the last six weeks — and is currently at 6.61% — highest since the week of December 5. DELEVERAGING CYCLE FAR FROM OVER The chart below is the ratio of household debt to total net worth — it has exploded to an all-time high of over 26.0%. Depending on where it normalizes — either to the pre-bubble level of 20.0% or the long-run norm of 16% — we are talking about between $3.0 and $5.0 trillion of debt elimination in coming years. The household debt to asset ratio (see Chart 2), now at 21.0% versus prior cycle lows of around 13.0%, would also be consistent with over $5.0 trillion of debt elimination. While there will undoubtedly be help from Uncle Sam and the lenders in the form of loan modifications and forgiveness, this overhang is still too big for the taxpayer to absorb. A goodly chunk of this excess debt — bringing credit into realignment with the permanently new and lower level of household net worth — is going to have to be paid down (or defaulted on). This is the lingering deflation risk that the bond bears have yet to factor in. Chart 1: HOUSEHOLD DEBT-TO-NET WORTH AT AN ALL TIME HIGH United States Household Credit Market Debt as a share of Net Worth (percent) 28 24

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Source: Haver Analytics, Gluskin Sheff

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Chart 2: HOUSEHOLD DEBT-TO-ASSETS RATIO United States Household Credit Market Debt as a share of Assets (percent) 24

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Source: Haver Analytics, Gluskin Sheff

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