Breakfast With Dave 112210

8/8/2019 Breakfast With Dave 112210

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David A. Rosenberg November 22, 2010 Chief Economist & Strategist Economic [email protected]+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with DaveWHILE YOU WERE SLEEPING

Equity markets are currently selling off across Europe, but much, though not all,of Asia did rally in overnight trading (Hang Seng, Shanghai and the SingaporeStraits were notable decliners). The Nikkei advanced 0.9% and has emerged of late as a global outperformer, helped by the modest weakening of the yen. TheJGB market has sold off on the back of this move to Japanese equities — the 10-year yields spiked 7bps today to 1.125%, though they are flat to lower here andacross Europe so far this morning.

Risk aversion trades for the most part are unwinding now that Ireland hassuccumbed to EU and IMF pressure for a rescue package for i ts beleagueredbanks — details and conditions of which are still pending (market chatter isassistance totalling $130 billion). Wasn’t it just a week ago that Ireland said itdidn’t need any external help? And wasn’t it just eight months ago that theEuropeans said that the ESFS (European System of Financial Supervisors) was abazooka that was never going to have to be tapped (shades of Hank?).

Gold and silver continue to look good in this environment of an ever-declining level of faith in the integrity of the global financial system (gold is up 24% for theyear and silver has gained 65%). At the same time, some of the commoditycurrencies are taking it on the chin — New Zealand’s kiwi was just hit by adownward revision to its credit rating outlook by S&P 500 to “negative” from

“stable” and the Canadian loonie has been trading a tad more softly of late, too.Sterling and the euro are receiving a bid from the pending Irish bailout and therenewed risk-on trade to kick off the week is bolstering the emerging market FXmarket as well.

Now that an Irish rescue plan is priced in, the question is whether attention now turns to Portugal and Spain. There is also a lot of good news priced in to thecoming U.S. holiday shopping season and retailers have bulked up this year oninventories and staffing. One possible snag — see Holiday Drivers Face Higher Gas Prices in today’s WSJ. Equity market bulls are anticipating a pick-up in jobcreation even though it has been productivity gains and labour cost cutting thathave both underpinned the corporate profit revival. Sentiment is still verybullish, if not complacent. The investment community thinks the lame-duck

Congress will have no choice but to prevent the myriad of tax changes fromseeing the light of day come January 1 st — the Bush tax cuts, jobless benefits,payroll tax goodies, estate taxation and the AMT (Alternative Minimum Tax).

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

IN THIS ISSUE

• While you were sleeping:risk aversion trades for themost part are unwinding given that Ireland hassuccumbed to EU and IMFpressure for a rescuepackage; gold and silvercontinue to look good in

this environment of ever-declining level of faith in

the integrity of the globalfinancial system

• Reality check: with 20-20hindsight, it is now clear as

to what caused everyone to hyperventilate back inearly September regarding

the prospects of asustainable recovery

• Five risks to the outlook:China, European debtconcerns, massive

tightening in U.S. fiscalpolicy, gasoline prices in the U.S. and the expirationof many extended benefitsin the U.S.

• Deflation coming: the yearstarted out with the U.S.core consumer inflationrate at 1.8% YoY; now itsat a record low of 0.6%



November 22, 2010 – BREAKFAST WITH DAVE

Equities are at the high end of the 14-month range and only offer value if we domanage to see double-digit earnings growth in the coming year, which I findunlikely. Corporate bonds are fairly-valued but are no longer cheap. Long-datedU.S. Treasury bonds look very good north of 4% with core inflation heading

toward zero plus the fact that the security is universally detested, which is goodnews from a contrary standpoint. The yield on 2-year AAA-rated muni’s is 119%of comparable Treasuries, which has only happened two other times in its 20-year history, according to Bloomberg, and each time it presented a nice buying opportunity. Supply issues are real but default risks seem to be way overdone.

State and local government cutbacks are a higher prospect than haircuts forbondholders and as such those companies that have a relatively highconcentration of sales geared towards the lower levels of government may wellbe nice “shorting” candidates. So long as China does not overdo it on its

tightening moves — raising reserve requirements is indeed preferable to interestrate hikes — then commodity prices in general should remain on an uptrendeven if a corrective phase should be expected after the QE2-related surge of thepast few months. There is enough evidence supporting the notion that the Asianeconomy has decoupled from the U.S. consumer, and therefore, basic materialsshould still be a core holding in any given investment portfolio.

Once we get through this lame-duck session, we will then confront the real deal,which is an even more polarized legislature. If there is a potential crisis lurking,it would be in April when the United States hits its prescribed debt ceiling (havea glance at the article in today’s WSJ titled GOP Ranks Fray on Vote to RaiseDebt Limit ), and the GOP (Tea Party members, in any event) is looking for majorbudgetary concessions in return for an extension. Shades of 1995? Read Paul

Krugman’s article today for more ( There Will be Blood ). This prospect is bullishfor volatility and the VIX index right now is quite inexpensive.

REALITY CHECK

Well, with 20-20 hindsight, it is now crystal clear as to what caused everyone tohyperventilate back in early September regarding the prospects of a sustainablerecovery, just as it seemed as though the equity market was going to head into anew and lower range.

First, the Federal Reserve began advertising what became known as QE2 or thesecond stage of its quantitative easing program. Then, the mid-term elections in

the U.S. promised to replace uncertainty with gridlock, and the mantra in themarkets was that “gridlock is good”, though I don’t necessarily agree with that

assertion. Then practically everyone believed that the economy could find legsin the aftermath of the dramatic slowing we saw in the second and thirdquarters, especially with the further easing in Fed policy, and while the economicdata may look a little better, frankly, I doubt that we have anything close tosustainable economic growth on our hands. For those who think we do, I believe

they have to answer for why it is the U.S. economy needs another $600 billion of asset buying by the Fed or why it is that the extension of the Bush tax cuts issomehow so vital for the near-term macro backdrop.

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Equities are at the high endof the 14-month range andonly offer value if we domanage to see double-digitearnings growth in thecoming year, which I findunlikely

While the economic data inthe U.S. may look a littlebetter, frankly, I doubt thatwe have anything close tosustainable economicgrowth on our hands




It’s because the economic environment, and not just in the U.S. but in thedeveloped world as well, is extremely fragile. That is the point. There’s nodenying that the stock market rallied spectacularly from the August lows through

to early November, but it has been a rally based on a lot of speculation and a lotof hope, and I’ve never found hope to be a particularly useful investmentstrategy. All that said, since the exhaustive moves of November 4 th in virtuallyevery asset class, the markets have been pricing in the likelihood that the Fedand Congress actually have precious little to offer in terms of providing anystimulus in the near future. In fact, the political shift from left to right ischaracterized by a powerful move toward budget cutting both in Washington andat the State Houses. Apparently, the political will is being heard that the voterswant their government to practice a frugality similar to what they are attempting in their own households.

So what I think is being underestimated by the growth bulls is that the fiscaldisarray at the state and local government is a major headwind for the U.S.economy, at 13% of GDP it is the second largest contributor to spending outsideof the American consumer. We will all probably look back a year from now atwhat Cisco had to say last week about how its sales were pinched by the hugecuts from the state and local government sector and come to the conclusion

that this was an important inflection point. And, I want to remind everyone Ciscoproved to be a critical inflection point for the stock market in both 2000 and2007. History doesn’t rhyme, but...

In retrospect, we are coming off a period of extreme positive sentiment where itwas extraordinarily difficult and took tremendous courage to lean against theconsensus on both the direction of the markets and the economy. But, the

extremes now seem very clear, which I expect to be reversed in the intermediate term, and the divergences at the recent “failed high” in early November are veryreminiscent of what we saw in September 2000 and again in October 2007.Therefore, I think it would be a mistake to superimpose the rally since the end of August into the beginning of 2011. There are still plenty of risks, from thepolitical strife in the U.S., to the renewed fiscal concerns in Europe, to theintense volatility in the foreign exchange markets, to the rising municipal defaultrisks south of the border, that it would be totally appropriate, in my view, toexpect some sort of reversal in these risky pro-cyclical trades that worked so well

through most of September and October in advance of the Fed meeting and mid- term elections.

This begs the question, how well will the economy do without continued life-

support from the government? What if the actions of the government add to thecontraction that has been ongoing in the private sector? There is still scantevidence of a vibrant organic recovery 17 months into the statistical GDPbounce from the lows. At least initially, the reversal of all the risk-on trends in

the markets that dominated the landscape for the past two months suggests that the pullback that became apparent after the peak in April is likely to besustained over the intermediate term.

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The economic environment,and not just in the U.S. but inthe developed world as well,is extremely fragile

What I think is beingunderestimated by thegrowth bulls is that the fiscaldisarray at the state andlocal government is a majorheadwind for the U.S.economy

How well will the U.S.economy do withoutcontinued life-support fromthe government?




The U.S. economy is fragile, with real GDP growth likely to slow to a 1.5% annualrate this quarter, below the consensus view of 2.6%. The negative fiscal shockwe are likely to see early in 2011 could well trigger something closer to zerogrowth in the first quarter. In other words, we will very likely again be debating adouble-dip scenario in coming months.

In the meantime, core producer prices (which removes the effects of food andenergy) just came in at -0.6% in October, and core consumer prices wasnegative as well to the second decimal place, so evidence of any sustainedinflation at the final stage of production is hard to find. Odds makers shouldnote that seeing both of these metrics decline in the same month is precisely a1-in-441 event — we just witnessed history. The labour market picture remainsconfusing with a plethora of conflicting data points of late, but nothing on thisfile looks very promising. The housing market cannot get out of its own way.Gasoline prices are pennies away from hitting $3 a gallon. Heavy cutbacks arecoming from state and local governments in the U.S. (see State Tests Limits of Spending Cuts on the front page of today’s WSJ and States Weigh Ending Medicaid on page A6 of today’s WSJ). Extended/emergency jobless benefits areabout to lapse at a $70 billion cost to personal income over the next fivemonths.

Now to the market backdrop. Based on momentum and sentiment extremesachieved at the nearby highs, it seems likely that the stock market will be on adeclining path, at least through year-end. The number of new lows on the NYSErose dramatically last week and the share of stocks trading above their 50-daymoving averages has declined in the past three weeks from 90% to 70%. Inother words, there is less momentum supporting the market than meets the eye

and this same development occurred at the April highs as well.

More fundamentally, the S&P 500 has been locked in a rough 1,000-1,200range now for 14 months. Most pundits still believe we are in a cyclical bullmarket but that is not the case — it has been a sideways market now for over ayear. Moreover, after testing support in July, the market hit resistance levels inNovember, so it would seem logical to expect the index to make a run at the lowend of the range. The only question is whether support will hold up once again.

RISKS TO THE OUTLOOK

1. China is getting more active in its policy tightening moves as inflationpressures intensify. It’s not just food but wages too. Headline inflation, at4.4%, is at a 25-month high. The People’s Bank of China (PBOC) just hiked

banking sector reserve ratios by 50 basis points to 18.5% — the secondsuch increase in the past two weeks and the fifth for the year. This couldwell keep commodity prices under wraps over the near-term.

2. European debt concerns will not be fully alleviated just because a rescueplan has been cobbled together for Ireland as it deals with its banking crisis.The focus will now likely shift to other basket cases such as Portugal andSpain. Greece has a two-year lifeline before it defaults. This saga is going

to continue for some time yet.

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Based on momentum andsentiment extremesachieved at the nearbyhighs, it seems likely thatthe stock market will be on adeclining path, at leastthrough year-end

China is getting more activein its policy tighteningmoves as inflation pressuresintensify. It’s not just foodbut wages too




3. Massive tightening in U.S. fiscal policy coming via spending cuts and taxhikes. This is the part of the macro forecast that is not given enough

attention. See States Raise Payroll Taxes to Repay Loans on page A5 of theweekend WSJ.

Gasoline prices are about sixcents shy of re-testing the$3-a-gallon threshold for thefirst time since mid October2008

4. Gasoline prices are about six cents shy of re-testing the $3-a-gallon threshold for the first time since mid October 2008. On a national averagebasis, prices at the pump are up 26 cents from a year ago — effectivelydraining about $25 billion out of household cash flow. Tack on the coming extended and emergency jobless benefits that lapse at the end of the monthand you are talking about at least another $30 billion of lost income for thepersonal sector in the four quarters. These two effects come to a 1.5percentage point negative influence on fourth quarter GDP.

5. Many goodies will expire at the end of the year and question marks lingerover whether they will be extended. These range from the Build AmericaBond program that subsidized municipal issuance, the Bush-era tax cuts,

the extended/emergency jobless benefits, and the little-known Obama tax

benefit called the Making Work Pay Credit. The last initiative could beanother $61 billion hit to consumer spending; most individuals don’t evenrealize they are receiving this money as it is typically received by a reductionin federal withholding from each paycheck, typically $60 per month or so.

FRUGALITY R.I.P.?

Well, that appears to be the case according to the lead article in this week’sBarron’s ( Off to the Mall ). The thesis is that household balance sheets havemoved into much better shape and, as such, the consumer will “soon could be

spending freely.”

Then again, this may be a case of wishful thinking. Only in America is “saving” adirty six-letter word. The Barron’s article is worth reading but what is interesting

is that it comes on the heels of a nifty little report out of the New York Fed titledHave Consumers Become More Frugal?

The conclusion of the NY Fed paper?

“Yes. Holding aside defaults, they are indeed reducing their debts at a pace not seen over the last ten years” and added that “taken together, the mortgage andnon-mortgage series reported here indicate a change in consumer behaviour other than delinquency and default.”

Yes, indeed. The crushing blow to household sector balance sheets during theintense asset price declines of 2008-09 lingers on in terms of the effect it hasexerted on consumer attitudes towards discretionary spending, homeownership

and credit demands.

In the aggregate, household net worth is $12.2 trillion lower today than it was three years ago at the pre-recession peak — an unprecedented decline of 18.5%. That is about $100,000 per household of lost net worth. Not even aflashy bear market rally in equities has come close to making up for the wealthdestruction of the down-cycle. We must therefore invoke the Permanent IncomeHypothesis espoused by the legendary Milton Friedman.

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Only in America is “saving” adirty six-letter word




As the realization sets in to households that this loss of wealth is permanent,and that not even recurring quick fixes by the government and the FederalReserve can stop human nature in its tracks, then what happens is that thechanges in consumer behaviour become more entrenched.

CHART 1: NO IMPROVEMENT IN HOUSEHOLD NET WORTH

United States: Household Net Worth(12-quarter percent change)

1050505050505

60

40

20

0

-20

-40

Shaded region represent periods of U.S. recession

Source: Haver Analytics, Gluskin Sheff

Baby boomers are indeed shifting from denial to acceptance that theirretirement nest egg is going to be a whole lot smaller than they believed during

the period of linear extrapolation of double-digit growth in real estate valuation

during the peak of the bubble years. And, this in turn is exerting an ongoing impact on the household budget decision-making process. Pundits that do notsee the collapse of housing values and net worth as a critical inflection point, asit pertains to the discretionary segment of the consumer pie, are missing out onsomething extremely important and are highly likely to draw dangerouslymistaken conclusions.

The ratio of household net worth to disposable personal income has gone all the way from 639% at the bubble highs to 472% today. This is where the ratiowas in 1966, 1972, and 1986, when the savings rate was in an 8-10% bandwith near consistency. The savings rate is in a rising trend currently, thoughnot in a straight line up (what is?). At 5.5%, it still has a way to go before itreaches that level consistent with where the net worth/income ratio iscurrently. The savings rate may be a residual from the national accounts data,but it is still the most behavioural of all the pieces of economic data that comeour way every month or quarter.

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Baby boomers are indeedshifting from denial toacceptance that theirretirement nest egg is goingto be a whole lot smallerthan they believed




CHART 2: HOUSEHOLD NET WORTH TO DISPOSABLE INCOME NOW AT472% COMPARED TO 639% AT THE BUBBLE HIGHS

United States: Household Net Worth as a Percent of Disposable Personal Income(percent)

105050

640

600

560

520

480

440



Owners’ equity in the home has collapsed to below $7 trillion from the peak of $13.5 trillion. This is a key reason for the decline in net worth and a crucialfactor behind the still uncomfortably high level of mortgage delinquencies anddefaults.

I read a report from my friend and former colleague Richard Bernstein who,along with others like Brian Belski and Jim Paulsen, claim that this recovery is

turning out to be quite similar to what we saw coming out of the 1990 and 2001recessions. The difference, of course, is that those recessions barely registeredin terms of declining economic activity, so it would stand to reason that therecoveries would be tepid. Ordinarily, a decline of what we saw in 2008 and thefirst half of 2009 would have been met with a bungee-jump type of recovery soin fact, the renewal this time around has been extremely tepid anddisappointing.

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We see no reason why anyone should sugar coat a situation where employmentis down 7.5 million from where it was when the recession began (down 5.4%).That is completely abnormal. The number of full-time jobs is down by more than10 million and after five consecutive months of decline, the level is back towhere it was in December 1999.




CHART 3: THE CURRENT LEVEL OF FULL-TIME JOBS ISNOW BACK TO LEVELS SEEN BACK 1999

United States: Full-Time Employment(millions)

1098765432109

122.5

120.0

117.5

115.0

112.5

110.0

107.5



Full-time jobs are the source of sustained confidence and income, and it isagainst this backdrop that personal income excluding government handouts isstill $350 billion lower today than it was at the peak. Now how normal is that?

CHART 4: EXCLUDING GOVERNMENT TRANSFERS, PERSONAL INCOMEIS STILL $350BLN LOWER THAN IT WAS AT THE PEAK

United States: Personal Income Excluding Government Transfers(US$ trillion)

10987

1 0 . 6

1 0 . 4

1 0 . 2

1 0 . 0

9. 8

9. 6


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Only by the good graces of a declining labour force as discouraged job-seekersdrop out of the market like flies has the unemployment rate managed to avoidbeing above 12%. And, only by the long and generous arm of Uncle Sam, whonow contributes about 20% to the personal income pie, has the consumermanaged to buy much more than pasta, soap and toothpaste this cycle(strategic mortgage defaults have been an equally vital source of stimulus).




CHART 5: SHARE OF PERSONAL INCOME FROM UNCLE SAM’SGENEROSITY AT RECORD HIGHS

United States: Current Government Transfers as a Percent of Personal Income(percent)

1098765

19

18

17

16

15

14

13


One added response to my friends listed above. Keep in mind that heading into the second year of a post-recession recovery the pace of economic activity is typically running at a 5% annual rate and accelerating; not running in a 1-2%band and generating recurring talk of a double-dip. Sorry, there is nothing normal about a household balance sheet contractionary cycle.

With the growing support of the Tea Party, the days of fiscal stimulus seembehind us. This is why the Ben Bernanke is becoming much more aggressive —he feels he is the only sheriff in town to prevent the deflation. But all $600billion of bond buying at the short- and mid-part of the Treasury curve does isboost GDP growth by 0.25 percentage point and thereby puts a mere two-tenthsof a percentage point dent in the 9.6% unemployment rate. And, as we can see

in all the asset classes, QE2 was already priced in before the fact and since thelast FOMC meeting we have seen equities, bonds and the U.S. dollar all reversecourse to varying degrees.

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CHART 6: STATE AND LOCAL GOVERNMENT EMPLOYMENT CONTRACTS

United States(year-over-year percent change)

1098765432109

4

3

2

1

0

-1

-2






CHART 7: STATE AND LOCAL GOVERNMENT SPENDING AS WELL

United States: Real State & Local Government Consumption & Gross Investment(year-over-year percent change)

1098765432109

6

4

2

0

-2



DEFLATION COMING

The year started out with the U.S. core (excluding food and energy) consumerinflation rate at 1.8% YoY; now, it is at a record low 0.6%. This has occurred evenwith massive government stimulus, U.S. dollar weakness, a commodity boom andan ongoing inventory cycle. Imagine what would happen if these developmentsreversed course. But the reality is that if the deceleration of the past eight monthspersists, then the core inflation rate will become the core deflation rate by thesecond quarter of next year. Hence Bernanke’s quest for QE2.

This last down-leg in the core inflation rate has not been due to lower rentseither. We recall all too well when a litany of pundits were calling for higherinflation because the deceleration was all due to the rental component and thatonce this component stabilized or turned around we would see the core inflationrate reverse course. Bad call.

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Excluding shelter, core consumer prices actually deflated 0.05% (to the seconddecimal place) and this followed a 0.03% dip in September. The last time thismetric declined in successive months was back in November-December 2008when the financial system and the economy were imploding. Now, it is simply acase of a listless recovery failing to redress the vast amount of excess capacityoverhanging the macro scene. In the last three months, 70 basis points has

been shaved off the core excluding shelter inflation rate, which now sits just asnick south of 1.3% YoY. Back in March, the month the Fed was supposed to beshrinking its balance sheet if you believed what it had to say a year ago, this ratewas at 2.4% or 110 basis points higher than it is today. Good thing Bernanke etal did a re-think.




And, the deceleration has been very broadly based. Core goods prices havedeclined 0.24% for two months in a row, despite what commodities and thedollar have done. The YoY trend is now basically flat — it was 2% last March.Core services (which exclude energy) have been rising by only 0.1% or lower nowfor four months running and the YoY pace of 0.8% is a record low.

CHART 8: SERVICES EXCLUDING ENERGY SERVICES AT A RECORD LOW

United States: CPI Services Excluding Energy Services(year-over-year percent change)

105050505050

20

16

12

8

4

0


The intensity and broad-based nature of the disinflation momentum in the U.S.is quite striking and, I believe, will ultimately prove to be a vital source of supportfor the bond market. Just take a look at these sectors that are either deflating or disinflating:

• New car prices dipped 0.2% MoM last month, the first decline since April.

• Used car prices were down 0.9%, the second falloff in a row and the firstback-to-back decline since the depths of despair in March-April 2009.

• Despite the surge in food costs, grocery chains only managed to raise prices0.1% last month.

• Higher cotton prices have yet to filter through — apparel prices at the retaillevel fell 0.4% and are down in each of the past three months.

• Appliance prices deflated 1.2% in October, the second decline in as manymonths; furniture prices are down five months in a row. Clearly, the housing market has yet to stabilize or these items would still not be falling in price.

• Hotels saw a 1.3% price slide — negative now for three months in a row.

• Electronics prices dropped 0.1% in October and have deflated for fourmonths running.

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• Recreational services prices were off 0.3% and down for two months in a row.




CHART 9: RECREATION SERVICES ARE STILL DEFLATING

United States: Consumer Price Index: Recreation(year-over-year percent change)

10505

4

3

2

1

0

-1

-2


• After deflating for just the second time ever in September, education priceswere flat in October. The three-month trend, at -0.5% at an annual rate, is

the lowest this metric has ever been — for most of the past decade, the price trend here was locked in a 6-8% band, and now it is negative. Goes to showhow desperate the colleges are to draw in cash-strapped students.

CHART 10: PRICE OF EDUCATION IS FALLING

United States: Consumer Price Index: Education(year-over-year percent change)

10505

7.50

6.75

6.00

5.25

4.50

3.75

3.00


• Medical care goods, long a source of inflation, managed just a 0.1% priceincrease in October. Medical services were held to a 0.2% gain.

• Communication service prices fell 0.2% in October and are down threemonths in a row.

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• Tobacco prices dropped 0.3%, the first decline since February.




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• Toy prices slid 0.5% and have fallen now in seven of the past eight months.

• Personal care products slipped 0.3%, the second decline in a row.

• Despite higher fuel costs, airfares have been held to less than a 0.2%advance in each of the past two months.

• Jewellery prices fell 0.7% in October and are down in three of the past fivemonths.

• The price of sporting goods was flat after three months of decline. Ditto forreading materials.

This is getting pretty exhausting.




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