David A.

Rosenberg May 19, 2010

Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Potluck with Dave

DO YOU LONG (OR SHORT?) YESTERDAY?
IN THIS ISSUE
“Yesterday, all my troubles seemed so far away
Now it looks as though they’re here to stay • Do you long (or short?)
yesterday? Yesterday’s
Oh, I believe in yesterday.”
market action was a real
exclamation mark, in
Yesterday was a real exclamation mark in terms of representing the end of the terms of representing the
bear market rally: end of the bear market
rally
• Dow down 115 points to 10,510.95
• The U.S. is inching closer
• S&P 500 down 1.4% to 1,120.8 to deflation: CPI down
0.1% on the month and
• TSX off 48.5 points (-0.4%) to 11,764.51 the year-over-year pace
slowed to 2.2%
• U.S. 10 year Treasury note yield rallied 9bps to 3.36%
• Where is the housing
• U.S. 2-year note yield rallied 5bps to 0.76%
rebound in the U.S.?
• Canadian 10-year note yield rallied 10bps to 3.40%
• Train wreck coming in the
• Canadian dollar sold off a bit yesterday, to 1.035 versus the U.S. dollar (from U.S. housing market
1.0325). In U.S. cents, the loonie went from 96.85 to 96.39 cents. And so far • Good as gold
today, the CAD is down further, to 1.05 (or 95 U.S. cents) — now below its
200-day moving average. • And you thought we were
bearish!
• Euro hit a four-year low of 1.2211 from 1.2395 yesterday and the Euro/Yen
cross is near eight-year lows; 50% of Fibonacci retracement on the Euro is at
1.2134 (from the October 2000 level of 0.8230 to the July 2008 level of
1.6038)
• Crude oil price down 42 cents to $69.66/bbl, to October 2009 levels.

Indeed, the S&P 500 has now sliced below the 50-day moving average and is
within 15 points of doing so with respect to the 200-day m.a., which would mean
a real rupture. The yield on the 10-year T-note has already dropped below
moving averages, and ditto for the oil price. There is a rally all right — in risk
aversion trades.

Oh yes — how can we forget? If you don’t see deflation then you are obviously
not looking at lumber futures — it seems that the market responded more to the
U.S. building permits data than the headline housing start number yesterday
because lumber prices were cut down a further 8.6% and have now plunged for
four straight sessions and is down 26% from the nearby April 21 high.

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
May 19, 2010 – POTLUCK WITH DAVE

The pressures are continuing to build into the wee hours of today and it seems
as though Angela Merkel’s move to ban naked short selling on equities, According to Ken Rogoff, the
government bonds and CDS have done little more than cause investors to $1 trillion financial rescue
become that much more panicky. A Bloomberg interview with Ken Rogoff who plan will do little to prevent
said that the ballyhooed $1 trillion financial rescue plan will do little to prevent an ultimate debt
an ultimate debt restructuring among Club Med sovereigns has not helped restructuring among Club
matters at all — at least for the bulls. As a result, government bond markets Med sovereigns has not
retain a bid for the most part: Greece is up 8bps today across the yield
helped matters at all
curve. Libor-OIS spreads widened a basis point to 25bps and CDS spreads for
Asian investment grade corporate bonds moved out 10bps to 132bps.

We also have global equities down 1.3% today (emerging markets lost 2.5% and
we have Asian markets down to three-month lows) and commodities sinking
across the board (copper -2.9%, nickel -5.5%, zinc -5.1% and platinum and
palladium down to seven week lows). Gold is off 0.7% but the overall long-run
picture for bullion is bright even if overbought technically right now.

Commodities and equities are now riding a five-day losing streak, which is not
something the green-shooty, rose-coloured glasses crowd were accustomed to
seeing for most of the past 14 months. For a sign of how quickly the global
investor base is shedding cyclical exposure, the Aussie dollar has dropped to
eight-month lows; and the kiwi down to three-month lows (aided and abetted by
dovish comments out of the Reserve Bank of New Zealand).

There was no data to speak of except for the news out of China that new home
sales in Shanghai have declined to a five-year low. It looks like some helium is
coming out of the balloon.

INCHING CLOSER TO DEFLATION

No sooner did we print a negative U.S. PPI for April then we get a minus sign in
front of the CPI figure — down 0.1% sequentially, pulling the year-over-year trend No sooner did we print a
down to 2.2% from 2.3% in March and the base effects from a year ago are so
negative U.S. PPI for April
then we get a minus sign in
high from June to November that we are going to see the YoY pace melt away
front of the CPI figure —
before the year is out. As an aside, seeing both the CPI and PPI decline in the
down 0.1% sequentially …
same month is literally more than a 1-in-10 event. Remember, we have not
come close to seeing the effects of the commodity price falloff and U.S. dollar
strength hit the data yet.

Looking at the components of the CPI report, the deceleration in pricing in the
retail sector was fairly broad based. Rents were flat so this was only part of the
story. Auto prices fell 0.2% MoM, prices for personal care products deflated
0.5% and communications and restaurants were basically unchanged. If there
was a big story, and this also showed through in the retail sales number, it was
in apparel where pricing slumped 0.7% MoM (the steepest decline since the
onset of recession back in February 2008) and the fourth decline in a row (on a
seasonally adjusted basis).

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May 19, 2010 – POTLUCK WITH DAVE

What investors should focus on for “cyclical” pressures is the core consumer
goods CPI component, which fell 0.3% MoM in April and is now down three … And, core CPI came in flat
months in a row. That has not happened since the depths of despair as 2008 and the YoY rate has slowed
drew to a close. The critical difference is that back then, the core services CPI to 0.9% from 1.1% in March
index was running close to a 3% annual rate and today the trend is sub-1%. This and 1.9% from a year ago
is why deflation risks are so high — we are on the precipice.

The core CPI (which excludes food and energy) came in flat and the YoY rate is
now down to 0.9% from 1.1% in March and 1.9% a year ago — the last time
when the core inflation rate was this low was back in March 1961 when, like
today, the yield on the 10-year Treasury note was locked below the 4% threshold
(the six-month core CPI trend is all the way down to a 0.28% annual rate — last
there in December 1960). As for the equity market and the view that low
inflation rates deserve higher-than-normal multiples, we’ll just point out that the
P/E ratio on the S&P 500 is at least three points higher today than it was the
last time core rates of inflation were where they are today.

CHART 1: CORE INFLATION INCHING CLOSER TO DEFLATION TERRITORY

United States: CPI less Food and Energy
(six-month percent change at an annual rate)

16

12

0
65 70 75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession.

Source: Haver Analytics, Gluskin Sheff

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May 19, 2010 – POTLUCK WITH DAVE

CHART 2: CORE INFLATION NOW RUNNING AT 0.9% YOY —

SLOWEST PACE SINCE MARCH 1961
United States: CPI less Food and Energy
(year-over-year percent change)

15.0

12.5

10.0

7.5

5.0

2.5

0.0
65 70 75 80 85 90 95 00 05

Shaded region represent periods of U.S. recession.

Source: Haver Analytics, Gluskin Sheff

As an aside, this relentless deceleration in the price data is not a statistical

illusion nor a government concoction just related to rents (CPI excluding rent
also fell 0.1% last month). The downdraft is far too widespread to pin it solely on The relentless deceleration
the treatment of housing costs. This is the by-product of what we left the in the U.S. price data is not a
recession with: near-record excess capacity in real estate, labour and
statistical illusion nor a
government concoction just
manufacturing in conjunction with an ongoing debt deleveraging cycle. That is a
related to rents
deflationary brew, especially since the peak of the inventory cycle and
government stimulus is now behind us.

As for the direction of bond yields in the U.S., remember this: the trend in core
inflation is statistically more than twice as important as fiscal deficits (or
surpluses for that matter) in determining the trend in market interest rates.

WHERE IS THE HOUSING REBOUND?

Not only was the NAHB index completely at odds with the UofM homebuying
intentions index and the sharp falloff in building permits, but look at what the
mortgage application data showed us this morning for the week of May 14: a
27% plunge in the new purchase index to the lowest level since May 1997. (At
that time we were worrying about Thailand, not Greece, which still had its own
currency!) This slide in the purchase index followed on the heels of the 9.5%
slide the week before.

All the homebuyer tax credit did (like cash for clunkers before it) was to distort
spending patterns and bring forward demand. Mortgage purchase applications
surged 13% in the final week of April — but that’s history. The U.S. homebuilders
are vulnerable as are the housing-sensitive retailers.

Page 4 of 9
May 19, 2010 – POTLUCK WITH DAVE

MORE DEFLATIONARY ANECDOTES

This one is a response from one of our faithful subscribers (priceless in
We often receive comments
Seattle?):
from our readers about the
current economic landscape
This is a great story on signs of global deflation. These informal anecdotes are
and sometimes these
often more revealing than official releases.
informal anecdotes are more
revealing than the official
“In Seattle, we have two tales. The cruise ships to Alaska ports from
press releases
here (after the mandatory Jones Act stop in Vancouver, Canada.). We
handle reservations for the ships at the piers (port of Seattle). The
most recent report is that cruise sales are lagging last year (which
was down 20-30% from prior years) and the number of ships this
year will be about 70% of last year. This in spite of significant
discounts for the 7 day trips on some of the newer, most elegant
ships in the cruise fleet. Bigger discounts could be on the way for last
minute sales.

Then, Boeing says landing the new DOD tanker contract is

“important”, then we learn its 737-800 (bread and butter ship) is
being back ordered by airlines in China and Europe. This is a tale on
the overseas markets and U.S. exports. Either caution or real slack,
no one seems to want to say what is happening, and Boeing lets the
airlines slide orders for a fee. But the bottom line is clear,
aircraft deliveries will be down this year, 2010, and maybe 2011.”

TRAIN WRECK COMING?

Sometimes one email correspondence with one reader goes a long way. This
contact of ours has a slightly less ebullient view of the housing market than
Messrs Paulsen and Paulson.

His firm had a meeting with the entire management team of a leading mortgage
REIT. Apparently, a very impressive presentation — the one thing that caught my
friend’s attention was that a “second shoe” was seen as likely dropping in the
housing market starting in September/October. The reason apparently is resets
for option ARMS created in large numbers by the likes of Golden West
Financial/Wachovia. The senior managers of this REIT indicated that they spend
a great deal of time with the folks at Fannie and Freddie, as well as the
Congressional oversight people. As our contact poignantly said, “open ended
disaster with no end in sight!”

GOOD AS GOLD
Yet another letter in a day of anecdotes — this one from a long-term friend. I’m
not in the inflation camp but if he’s right, just another reason to ensure that
precious metals comprise a core part of anyone’s portfolio. To wit:

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May 19, 2010 – POTLUCK WITH DAVE

“… You might be interested in this. A client points out that over a 5-

year period ALL currencies are down by about the same amount
(165-190%) versus gold. It’s not like one is underperforming
another. Did you read Cochrane’s op-ed? While we face a
deflationary near-term future, the temptation will be to go through a
door which, somewhat inevitably, will lead to inflation. While it was
hard for me to imagine how developments in the housing market in
2007 would not be ruinous to the brokers (with MER trading at $78)
it is equally hard to see how the western hemisphere can withstand
the temptation to inflate their way out of this mess.”

AND YOU THOUGHT WE WERE BEARISH!

Here is one of the most insightful — if frightening — emails we have received in
some time. We still maintain that portfolios should have a concentration in
securities that spin off an income stream. But again, a “barbell” approach with
hard assets such as commodities will act as an effective hedge if government
policies produce inflation. Have a read of this zinger below:

“I don’t know if you remember but we worked together at Merrill. I

ran emerging markets from 1985 to 1996. I’ve always been a loyal
fan and kept up with your writings.

As you know, I used to specialize in what we called then toxic waste

countries. Reality has obviously taken a turn and what was toxic now
is golden and the prime is now toxic. Our best countries are being
run like banana republics and the famed moral hazard issues are
now at the individual level with the strategic mortgage defaults. Keep
in mind that in Mexico, it moved to wholesale credit card defaults at
the last stage of the correction.

It is interesting to note that back then (the 80s) without currency

zones but a fixed dollar, the order was devaluation, default,
restructuring and budget balance with exports beginning the process
of recovery. It was not until Summers’ bailout of Mexico that we
entered this ridiculous world of constant bailouts, raising the size of
them at every turn and lowering the bar to what constitutes risk.

Now, it’s worst than ever. The developed economies have huge fiscal
deficits with no state assets to sell. The balance sheets of the
developed nations are over leveraged. The deficits have taken a
permanence to them. In the case of Europe with no individual
devaluation alternative and their new massive debt load, the EU must
now make huge fiscal cuts to get credibility. This is very reminiscent
of the pre-depression year. If the EU follows through it will push a
weak world into a severe double dip and bring the question of
capacity to repay to the forefront anyways.

Page 6 of 9
May 19, 2010 – POTLUCK WITH DAVE

Monetization or printing may end up being the only end alternative. I

know, and agree with you, that to have inflation you need demand.
Where I disagree is that you can’t have inflation with such a
significant slack in the economy. For those of us that lived or worked
in the hyperinflationary South American zone of the seventies and
eighties, inflation comes when people lose faith in the currency and
see material goods as a store of value. Because commodities rise
and the goods can no longer be expected to be made at the same
cost structure, people assume that they will be worth more in the
future creating a self fulfilling upward spiraling effect. You can
anticipate that these state governments will introduce price controls
as well as potentially fixing exchange rates worsening the situation.

My biggest fear is that these politicians and advisors have little

experience in this area and are more concerned about controlling the
political short term without regard to the longer term implications. I
see this like an attempt at covering holes in a cracking dam with your
fingers while the cracks are spreading. Bonds in the thirties were not
a safe haven because they were restructured into 30 to 40 year
bonds at 1.0-2.0% interest. Ultimately spending habits must decline,
debt must be restructured, and growth must be promoted through
the private sector.

Political interests must be aligned with long term economic objectives

and I don’t see that any time soon. Obviously, I’m very negative right
now. What am I missing?”

ON A LIGHTER NOTE...
Or should I say heavier note? The only putting on weight is ... me. This is from
another reader.

“Blintzes!

I love these titles.‬

You’ve still got babkas, hamentashen, knishes, latkas, matzah balls,

bagels, mandelbread, komish bread, (my family had a Jewish bakery
in Philadelphia).”

Page 7 of 9
May 19, 2010 – POTLUCK WITH DAVE

Gluskin Sheff at a Glance

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Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to the
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May 19, 2010 – POTLUCK WITH DAVE
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