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David A.

Rosenberg June 1, 2009

Chief Economist & Strategist Economics Commentary
+ 1 416 681 8919


Breakfast with Dave

It really is a whole new investing world when a Chinese manufacturing diffusion IN THIS ISSUE
index can generate a gigantic melt-up in equity prices across the globe. But that • Inflation fears overrated,
is indeed what is happening. Even in the face of GM’s imminent bankruptcy in our view
filing, the news that China’s purchasing managers’ index came in at 53.1 in May
• Foreclosure crisis
from 53.5 in April (the CLSA comparable was 51.2 from 50.1) was enough to
continues unabated …
kick the MSCI Global index up 1.4% to its highest level since last November
(markets had been led to believe for the past few weeks that a sub-50 reading • … And troubled loans in
general are still mounting
was quite possible).
• Signs of credit market
Emerging markets advanced 2.6% and now up 55% from the lows. Russian improvement are still
equities soared 5.8%, helped out by the rising oil price (page A2 of today’s WSJ mixed
contains a healthy dose of scepticism over the longevity of the oil price rally • Retail investors caught
given lingering weakness in global crude demand). Asian equities climbed 2.9%, the bounce — equity
led by a 4.0% surge in the Hang Seng index to 18,888 (now how lucky is that?). mutual funds posted a
But gains were broad based right across the continent, with Japan up 1.6%, the $12.3bln net inflow in
Kospi rising 1.4% and the Shanghai index rallying 3.4%. European marts are up
2.7% (up now in five of the last six sessions) and again, practically every country • Asia revival may be for
is flashing green. real

Bonds are selling off, as one would expect, with the yield on the 10-year note up
6bps this morning to 3.53% as risk appetite gets whetted even further. This is
further ratified in the commodity complex where oil has firmed $2.00/bbl to
$68.29/bbl, copper has soared 3.5% and gold has risen nearly 1.0% to around
$988/bbl as it closes in on the cycle highs.

The dollar continues to lose ground, hitting its low-water mark for the year, and
the flip side is big rallies in Asian FX (led by the Korean won and Taiwan dollar),
the Euro (five-month high), Sterling (eight-month high), the Russian Ruble (six-
month high) and the commodity currencies (notably the Aussie and Kiwi). CDS
spreads, which gauge corporate bond risk in Europe also have come in 14bps to

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Elsewhere on the data front, it was all good. The European PMI came in
better than advertised, at 40.7 in May from 36.8 in April (consensus was 40.5).
The U.K. comparable improved to 45.4 from 43.1 in April too – best result in a
year. And not only that, but UK home prices as measured by the Hometrack
survey were flat in May – first time in 20 months that it did not show a decline.

It also looks as though Treasury Secretary Geithner managed to soothe Chinese

concerns over the U.S. fiscal situation — by most accounts we have seen
regarding his trip to Beijing. And the data show that foreign central bank
support for the Treasury market remains intact — custodial bond holdings at the
Fed rose 3.3% in May to $69 billion, the third most on record. This has helped
ease fears that the U.S.A. would be facing a credit outlook downgrade in the
near future (as the U.K. experienced last week).

Equity market still ripping: The late-day surge in the Dow pushed it up 1.1%
for the session and 4.1% for the month. Over the last three months, it is up
20.4%, which is the best performance in such a short span since November
1998. For the S&P 500, it advanced 5.3% in May and 25% in the last three
months, which is a feat last achieved in August 1938.

Oh Canada! For the week, the TSX rose 3.8% and for the month the index was
up 11.2% — the best performance since June 2000 and the fifth highest monthly
gain in recent history (data back to 1984). The TSX has now risen three-months
in a row, a feat last accomplished back in the spring of 2007. The monthly
pattern is +7.4% in March, +7.0% in April and 11.2% in May and that is the best
three-month performance ever. But note that in the past, when the TSX is up
10% or more, which only happened 5 times going back to 1984, the index
usually takes a breather and is flat as a beaver-tail three months later.

Global institutional investors still lagging behind this rally: See page 13 of
today’s Financial Times – it cites a Barclay’s survey that shows:

• Only 17.5% believe “risky assets” have more room to rally

• 4.5% are believers in the V-shaped recovery
• 69% see a U-shaped or W-shaped recovery
• 60% see what we have experienced in equities as a “bear market rally”
• 91% are running positions that are “average” or “light” in terms of equity
exposure (there is cash on the sidelines, but no conviction)
• Just 9% are at limit or capacity in their equity investments

Critical test ahead for the Treasury market: not only is this a heavy data-week
(see below), but on Thursday the Treasury is expected to announce the size of
the 3, 10 and 30-year auctions for the following week (likely to be a $65 billion

Awaiting the testing phase; the equity market has been moving in a saw-
tooth pattern since hitting its interim high back on May 8. We have said for

Page 2 of 15

some time that for there to be proof that the March lows were the lows, the
market would have to successfully retest those lows as it did in March 2003
(though the July 2002 test did fail). With this in mind, it is encouraging to see
that the folks at S&P are in general agreement with this premise, and Sam
Stovall, who is the Chief Investment Strategist for the agency, found that typical
retests usually see the stock market correct 7.0% from the interim post-trough
highs; but the decline is closer to 14% on average after a “mega downturn” of
the likes we saw from October 2007-March 2009. That would put 800 on the
S&P 500 as the proverbial line in the sand. See What About the Valley After the
Rally on page 4 of the Sunday New York Times business section.

Big fiscal squeeze coming in the world’s 8th largest economy --

California: It’s interesting that so many pundits dismiss the notion that we
are in some form of economic depression because the policy response is so
far more pronounced than it was in the 1930s. While there is an element of
truth to that from a Fed policy standpoint, fiscal policy has so far been wholly
ineffective and in fact, as California now takes a sharp knife to its social
programs, historians may well look back at this as a classic policy error. Then
again, the laws are such that state governments are not allowed to run
operating deficits. See Deep Cuts Threaten to Reshape California on page 15
of the Sunday New York Times (front section).

Gasoline prices are soaring and this may be one reason why the tax
stimulus is not working — the savings are being siphoned into the gas tank:
Indeed, U.S. retail gasoline prices have spiked 45 cents in the last month to
$2.50/gallon — the equivalent of a $60 billion annualized pay cut (which
basically offsets the reduction low-and middle-income workers are seeing
come off their paychecks in terms of reduced withholding taxes).

Best read of the weekend: For a truly wonderful indictment of the pro-labour
and anti-market initiatives the White House is pursuing, have a look at Driving
the Bond Markets to Ruin by James Glassman on page A17 of the Saturday New
York Times.

Keys for the week: It’s jam packed – Canadian real GDP today for Q1, the Bank
of Canada policy statement on Thursday and May employment on Friday. We
would advise against being long the Canadian dollar ahead of the BoC
statement because there is little chance that it won’t be addressed. The loonie
has rallied 15% in less than three months, double the increase in the commodity
price index that matters most for the central bank (while oil, gold and copper
have soared, wood products and natural gas – which represent 10% of
Canada’s export base – have actually fallen). In other words, half of the
Canadian dollar’s rally has been de facto monetary restraint on the overall
(fragile) economy and as such is unwelcome and troublesome. In the U.S.A.,
there is a ton of data, from ISM today to nonfarm payrolls on Friday, and we will
hear twice from Fed Chairman Bernanke too, with his Wednesday 10 a.m.
testimony to the House Budget Committee likely to be a key event. The BoE and
ECB also meet on Thursday.

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There is no sustainable inflation without the labour market coming along for the
ride because wages/salaries are the most important variable in the corporate
cost structure; and what we see, for the first time in recorded history, is wage
deflation. Ask the auto workers, financial sector employees or those 200,000
public servants in California who are being asked to accept a 5% pay cut if there
is inflation in their sectors.

A just-released Hewitt survey also showed that 16% of U.S. companies have
made base salary reductions so far in this recession, and a further 21%
intend to follow suit. In the 2000-01 downturn that had the Fed consumed
with deflation fear, the share of companies cutting base salaries was so
negligible that Hewitt didn’t even publish the results (see page 47 of
BusinessWeek – Cutting Salaries Instead of Jobs).

How is the working class responding? By being thankful that they have a job
(this is not the 1970s at all for those believing we are heading for some
stagflation era – this is still about deflation, pure and simple). All anyone needs
to know is that union bargaining power is now so weak that the number of
Americans who were on strike in May totalled zero, nada, zippo; and that has
been the case all year long. When we start seeing workers form a picket line
and garnering concessions instead of giving them, we’ll start to reassess the
inflation landscape.
More homeowners than ever are falling behind on their mortgage payments,
despite the most intense government efforts ever to stem the tide: We now
have a situation where 5.4 million of the 45 million home loans in the United
States are in some stage of the foreclosure process. The first-quarter Mortgage
Bankers Association data show that 12.07% of all mortgages are in foreclosure
or delinquent — up from 11.93% at the end of 2008. While the problem remains
centered in California, Florida, Arizona and Nevada (a 46% share of new
foreclosure activity), the problem is spreading geographically.
While the banking sector income statement is gaining relief from the super-
steep yield curve, the balance sheet is still being undercut by a rising and
record level of bad loans: According to just-released FDIC data, the share of
the entire volume of loans and leases outstanding as of March, 7.75% were
showing some signs of distress. That compares to a 6.9% share at the end of
last year and 4.1% a year ago. If you’re definition of ‘green shoots’ is that the
increase is slowing down, well then, go with that story. From our lens, the bigger
story is that we are not even past the bottom of the business cycle and the loan
quality in the banking system has already deteriorated to levels that far surpass
the worst points of the 1990-91 recession (when delinquency rates hit a peak of

Page 4 of 15

In terms of sectors, the major culprit remains real estate – with an 8.77% late-
payment rate. Construction and development loans are clearly in the worst
shape with 17.68% of credit here going bad. The one area now with the greatest
risk of playing catch-up is commercial real estate (including stores and offices),
which, at 4.01%, is less than half the peak of the last negative real estate cycle
in the early 1900s.

The stress is evident in the fact that the charge-off rate for bad debts in the
banking system just hit 7.79%, and to cover this, the FDIC reported that two-
thirds of the banks either cut or eliminated their dividends in the first quarter of
the year.
Yes, corporate spreads, the TED spread, Libor-OIS spreads have all come in rather MARKET IMPLODES
dramatically from their peaks, which is a good sign that liquidity in secondary United States
markets is ample. The problem, of course, is that we have over $1 trillion of Commercial Paper Outstanding: Nonfinancial Issuers
($ billion, seasonally adjusted)
excess cash the Fed has created sitting on bank balance sheets instead of being
re-circulated through the real economy. In the meantime, Fannie and Freddie 225

mortgage bond yields are now soaring, and credit spreads are hardly tightening —
widening more like it — in the commercial mortgage-backed securities 200

market. And, while interest rate spreads have tightened in the secondary market,
the reality is that nearly one million small-business owners, according to the USA 175

Today, have been forced to find a new line of credit (credit card issuer Advanta
stopped accepting new charges on Saturday). 150

Bank-wide commercial & industrial loans contracted $8 billion in the May 20th 125

week – and down $22 billion so far for the month. The outstanding level is now 06 07 08

below $1.5 trillion for the first time since June 4, 2008, and the nonfinancial Source: Haver Analytics, Gluskin Sheff

commercial paper market shrank $10 billion last week to $148 billion – the
smallest it has been in three years (and $75 billion smaller than its prior peak).
The banks continue to build up huge cash reserves (see below) – up another
$35 billion last week to stand at a record high $1.13 trillion (almost 30% more
than outstanding consumer loans).

As a sign of how ineffective Fed policy has become, a study by JPM Chase
shows that the central bank is “under water” to the tune of around 10% on its
fixed-income portfolio — it would have to take a $5bln hit if it were forced to
mark-to-market its book. The Fed has already purchased $480bln of MBS and
another $130bln of Treasuries to help keep market rates low, and in recent
weeks, the trend has moved in the other direction. See Fed Mortgage Efforts
Prove Costly on page C3 of today’s WSJ.

Page 5 of 15

United States

Cash Assets: All Commercial Banks

($ billion, seasonally adjusted)






05 06 07 08

Source: Haver Analytics, Gluskin Sheff


Private investors saw the potential for a market rebound very quickly after the
lows were turned in — equity mutual funds posted a $12.3 billion net inflow in
April — only the second positive inflow over the last year (this contrasts with a
$27.2 billion net outflow in March). There is always potential for more money to
be put to work, we would have to admit, because the year-to-date tally still
represents a net outflow of $30 billion (almost the same amount as the $33
billion that was pulled out this time last year). So far in May, the weekly data
point to less robust but still positive inflows into equity funds totalling just under
$10 billion.

Our “income-theme” seems to be catching on too because bond funds attracted

a whopping $28.8 billion of net new inflows in April and that was on top of $19.9
billion in March. The last time we saw retail investors put this much money into
the fixed-income market was back in July 2002, and far from being a “contrary
negative” indicator for bonds, longer-dated yields did not hit bottom for almost
another year.

Remember – 25% of the household balance sheet is in equities; 30% in real

estate; over 6% in consumer durable goods; 12% in cash and only 6% is in the
fixed-income market. There are 78 million boomers, whose median age is 52
and will very likely be seeking cash flow as opposed to the pervasive focus on
capital gains (which has lost them money in the past decade) as they focus on
their savings strategy in the immediate leadup to their retirement years.

Page 6 of 15


United States: Share of household assets (percent, 2008 Q4)

Treasuries Real Estate
0.4% 31.2%

Non-government bonds

Consumer Durables

Cash Equities
11.7% 24.7%

*Life insurance and pension reserves

Source: Federal Reserve Board, Gluskin Sheff


Unless the data are lying, we are seeing spreading strength across the
continent, even Japan where industrial production rose a record 5.2% MoM in
April; and there is a good chance that this solid performance will be followed Unless the data are
by an 8.8% surge in May (though admittedly, the most recent figures on lying, the Asia
employment, prices and household spending were all quite soft). The revival may be for
Japanese government is also set to unveil its fourth fiscal stimulus package real
since last August — a $144 billion plan that includes tax cuts. India also
posted a stronger-than-expected 5.8% YoY print in its real GDP for the first
quarter. Korean production has jumped at a 15% annual rate over the past
three month. The current BusinessWeek runs with an article titled The
Surprising Strength of Southeast Asia — well worth a look.

This is all quite bullish for the commodity complex, which is now breaking out
according to the charts. Gold, copper and oil have all broken above their 200-
day moving averages just as the U.S. dollar has broken below its trendline. The
U.S.A. is still the largest economy in the world by far, but it is losing its
dominance each year and the fact of the matter is that it is a mature service-
driven economy — health services, education services, recreation services and
of course, financial services. Emerging Asia in general, and China in particular,
are still the marginal buyer of basic materials, and their economic success is
more critical to the outlook or commodities. The data speak for themselves –
even with the number of miles travelled by motor vehicles in the U.S.A. down
1.2% YoY and declining now for 16 consecutive months, oil prices are fast
approaching $70/bbl. Why? Because Chinese crude oil imports in April
surged 2.3% sequentially and 13.6% on a YoY basis.

Page 7 of 15

Last December, I saw several reasons why the commodity complex looked
attractive. The prospect of recurring bouts of currency devaluations is bullish
for hard assets. Trade protectionism provides governments with the incentive From a cyclical
to stockpile material. From a commodity perspective, fiscal policies involving
standpoint, what I
didn’t count on was
infrastructure spending more than compensate for the hit to demand
an early turnaround
associated with declining U.S. consumer spending. China’s imports of refined
in Asian economic
copper rose nearly 150% YoY in April, as an added example, and soybeans by
55%. In the aggregate, imports of red meat and poultry in the developing
world are expected to total 21 million tons this year (DoA estimates), creating
a boom for the grains used as feedstock.

From a cyclical standpoint, what I didn’t count on, but may be the most bullish
reason of all for the commodity sector, was an early turnaround in Asian
economic growth. While there is always room for healthy scepticism, no
country has moved to stimulate its economy as much as China has, and it has
the means (unlike the U.S.A.). The economic and credit data indeed suggest
that China has turned the corner in its mini-recession, and if this is indeed the
case, then the outlook for commodities is quite constructive even if we should
expect some sort of profit-taking to occur near-term after the breathtaking
rally of the last few months, which has seen the likes of copper, oil, gold and
the CRB all test or pierce their 200-day moving averages. And the commodity
currencies, like the Canadian and Australian dollars, have been taken along
for the ride. Again, some giveback may be in order, but the fundamental trend
is up in the resource sector.


Real GDP (annual % change)


-2 -1.3 -1.4
-2.5 -2.8 -3.0
-3.5 -3.7
-4.0 -4.1
-5.6 -6.0

United Kingdom






United States

*IMF forecast
Source: IMF, Gluskin Sheff

Page 8 of 15


Real GDP (annual % change)

8 7.5

3 2.2
2 1.5 1.3 1.2 1.0
0.6 0.5 0.5 0.4
-1 -0.4

United Kingdom





United States

*IMF forecast
Source: IMF, Gluskin Sheff
There are three observations worth making:
First, emerging Asia already went through its restructuring and depression
over a decade ago. They made the painful economic adjustments and political
changes necessary to embark on a sustainable economic path. We doubt the Emerging Asia
U.S.A. will ever experience the true pain of such a restructuring as countries already went
like South Korea, Indonesia and Thailand endured in the late 1990s. They through its
have been on secular growth paths the past several years, and cyclical restructuring and
setbacks should be viewed in that context. depression over a
decade ago
Second, for all the talk about how “decoupling” ended up being a hoax –
maybe, just maybe, it wasn’t. To be sure, after the Lehman collapse in
September, the entire global economy imploded. Trade finance dried up
completely, which wreaked extra havoc on the Asian economies. But we do
know that the U.S. was technically in recession starting in December 2007
and so there was a nine-month period of time up until September 2008 that
we can use as a microcosm — and during that stretch, we have news for you:
China’s real GDP expanded at an 8.9% annual rate; India by 6.1%; Indonesia
by 5.2%; the Philippines by 4.7% (and Russia by 3.5%; Brazil by 2.4%). So yes,
growth slowed but was still intact and that is the major point. Now that we are
past the worst point of the credit cycle and seeing as how the Asian economy
has been the first region to show something more than faint pulse, the
backdrop for the resource market has certainly improved and will continue on
that path so long as the Asian economic pickup is not a ‘head fake’ (as an
aside, the IMF expects China and India, followed by Brazil, to top the global
GDP growth charts both this year and next).


Page 9 of 15

Real GDP (Q3 2008 / Q4 2007; annual % change)

China 8.9

India 6.1

Indonesia 5.2

Argentina 5.0

Philippines 4.7

Russia 3.5

Brazil 2.4

Chile 1.7

Malaysia 1.6

0 2 4 6 8 10

Source: Haver Analytics, Gluskin Sheff


Real GDP (Q1 2009 / Q3 2008, unless otherwise noted; annual % change)

Philippines* 3.5

China 2.7

Indonesia 2.0

India* 0.6

Argentina* -1.2

Chile -6.6

Malaysia* -10.0

Brazil* -13.6

Russia -20.2

-24 -20 -16 -12 -8 -4 0 4 8 12 16

*Using Q4/Q3 2008 figures

Source: Haver Analytics, Gluskin Sheff

Page 10 of 15

Third, we just endured the steepest world economic setback in 70 years and
yet commodity prices across a broad front — gold, oil, copper, soybeans —
managed to bottom at their highest “recession levels” of all time. Look at oil We just endured the
— it bottomed just above the $30/bbl mark, which in most other cycles in the
steepest world
economic setback
past represented the peak, not the trough. This attests to the supply
in 70 years and yet
discipline by today’s resource companies compared to their predecessors, and
commodity prices
affirms our belief that what we experienced last year was a severe cyclical
managed to bottom
correction in what is still a secular bull market — you can connect the dots on at their highest
the chart and see that the CRB looks a lot like what the S&P 500 looked like in “recession levels” of
the months following the sharp 1987 collapse. It seemed like the end of the all time
world in October of that year, and yet in retrospect it was just the 5th year in
what proved to be an 18-year secular bull phase. Commodities seem to be in
one of those long secular up-waves right now.


Where Commodities Where Commodities Bottomed

Bottomed This Cycle During Recessions
(average of five recessions, except where noted)
Wheat $4.86/bushel Wheat $3.08/bushel
Soybean $7.59/bushel Soybean $5.05/bushel
Corn $2.72/bushel Corn $2.08/bushel
WTI $30.81/bbl WTI $20.00/bbl
Gold $712.50/oz Gold $307.30/oz
Copper $1.25/Lb Copper* 0.70¢/Lb
Silver $8.81/troy oz Silver $5.76/troy oz
Lead 61.72¢/Lb Lead* 38.27¢/Lb
Zinc 57.42¢/Lb Zinc* 51.17¢/Lb
CRB Spot (1967 = 100) 302.34 CRB Spot (1967 = 100) 229.11
*Average of the last two recessions

Source: Haver Analytics, Gluskin Sheff

This is ultimately very constructive for the Canadian equity market, where
47% of the TSX market cap is in resources, compared to just a 16% share in
the S&P 500. It is also a bullish underpinning for the Canadian dollar, even if
a pullback is likely over the near-term.

Page 11 of 15


T S X C om pos i t e In dex

Financials 29.2%

Energy 28.5%

Materials 18.6%

Industrials 5.3%

Telecom 4.8%

Info Tech 4.6%

Cons. Discret 4.0%

Cons. Staples 3.0%

Utilities 1.6%

Health Care 0.4%

Source: Haver Analytics, Gluskin Sheff

Chart 9: … THAN THE S&P 500

United States
S & P 500 C om pos i t e I n dex

Info Tech 17.4%

Health Care 14.2%

Financials 13.2%

Energy 13.0%

Cons. Staples 12.1%

Industrials 10.2%

Cons. Discret 8.9%

Utilities 4.0%

Telecom 3.6%

Materials 3.3%

Source: Bloomberg, Gluskin Sheff

Page 12 of 15


Great article in the Economist on the secular post-bubble shift from frivolity to
frugality — Trading Down – From Decadence to Discounts. Very deflationary It wasn’t just a
stuff. Between 2000 and 2007, the average American raised his/her housing bubble; it
consumption by 44% and this accounted for 77% of the overall growth in was also a
GDP. It wasn’t just a housing bubble; it was also a leveraged consumption leveraged
bubble (this did not happen in Japan, by the way, which is why the situation consumption
now is even more troubling). Fully $500 billion of consumption was funded by bubble
taking cash out of the home during the bubble, and about $1 trillion of the
windfall was used to purchase even more real estate and equity assets — it
was all totally illusory but now we are paying the piper as spending patterns
reverts to the mean. Real-life examples are Tiffany’s 62% plunge in its Q1
earnings at a time when ‘value’ recession-hedge retailers like McDonalds’s
continued to ramp up earnings growth as it has done each year since 2003.

I have been of the view for about a year now that the post-bubble world was
going to involve a significant shift in consumer attitudes towards credit,
homeownership and discretionary spending. This is clearly occurring in the
automotive sector, where the 20% of three-car families are becoming two-car
families, and the vast majority of two-car families are either downsizing to one
vehicle or are doing everything they can to extend the life of their current
car/truck/SUV. See Nation’s Love For New Cars On the Wane: Signs that
Slump May Become New Normal on the front page of the Sunday New York
Times. This secular decline in the automotive sector may be something the
American taxpayer might want to be aware of as it is forced into the position of
being a 70% equity stakeholder in GM.

Page 13 of 15


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