David A.

Rosenberg June 17, 2009

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

GREEN SHOOTS TURNING BROWNISH
IN THIS ISSUE
Well, we can forget about calling for an end to the recession. Three of the
ingredients are still contracting: • With industrial production
still contracting,
1. Industrial production is still contracting — down 1.1% in May and this employment falling and
came on top of a downwardly revised -0.7% print in April (was -0.5%). nominal wages
This was the SEVENTH decline in a row and left the level of production at contracting, we can forget
an 11-year low (July 1998, believe it or not). Even outside of the auto about calling an end to
industry (-7.9%), output was still down 0.7% last month and it is now very the recession
difficult to discern any improvement at all since the credit collapse
started to subside in March. Every major industry posted a decline in May • Demand for newly-issued
— so much for the ISM (then again, it is only a diffusion index). Oh yes, it corporate paper has been
is early days yet but we do have the NY Empire index and it fell back to extremely strong; make
-9.41 in June from -4.55 in May — and this is a proxy for tech spending. hay while the sun shines
It’s a sign that we could see a setback for ISM this time around — though • Could the Dow Transports
we will await the Philly Fed survey before making any definitive statement. be signaling a sell signal?
2. Employment fell in May — indeed, the 345k slide in May was worse than • Consumer spending on
the depths posted in each of the last two recessions. Strange way for a basic TV services
recession to end. As for jobless claims, it is not enough that they have expected to rise; all part
fallen from their near-depression highs — they have to break well below of the cocooning wave
500k before payrolls stop declining, and only then will it be safe to call for coming our way in the
the end of the recession. frugal future
3. Real organic personal income — one of the key ingredients (sorry, but the
• But for overall spending,
ECRI, which was predicting an ongoing boom in July 2007, doesn’t go into
frugality is a killer — just
the NBER definition). Never mind ‘real’, in nominal terms, average weekly
ask Best Buy
earnings fell 0.2% in May for the second time in the last three months.
• Is booming money supply
Yes, yes, the housing start number was a good number, especially the single- really inflationary? Not
family result (+7.5% to 401k units at an annual rate — the third increase in a when we are in a liquidity
row); as well as the 7.9% MoM bounce in single-family permits. Still, it is difficult trap
to really say anything except that perhaps the single-family sector has found
bottom — after all, natural demographic demand for single-family homes is
closer to 500k than 400k, the level at which starts are still hovering around.
The report also lost part of its luster from the previously released NAHB index,
which slipped back to 15 in June after two months of gains.

When multi-unit construction is added in, what we see is that total housing
starts came in at 532k at an annual rate, which by today’s standards may
qualify for a ‘green shoot’, but in reality was the third worst rally ever in the 50-
year history of the data series. Still, lumber futures managed to buck the overall
down trend in commodity prices and closed at a nine-month high, and the
homebuilding stocks outperformed.

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June 17, 2009 – BREAKFAST WITH DAVE

But the market for residential real estate, where the unsold inventory is close to
12 months’ supply when properly measured, remains in a very deep deflationary For all the talk
funk, with specific reference to the high-end where there will be multiple sellers about reflation or
by boomers seeking to downsize and fewer trade-up buyers since their inflation, someone
demographic is much smaller and not to mention the fact that the new secular forgot to tell the PPI
theme is ‘getting small’ and living below our means. — the YoY rate is
falling 5.0%
Finally, for all the talk about reflation or inflation, somebody forgot to tell the PPI,
which rose just 0.2% MoM in May (consensus was around +0.6%) and this
dragged the YoY down to a 50-year deflation low of -5.0%. The core was off
0.1% MoM too. Even better, the core intermediate PPI deflated 0.2% and has
declined now for eight months in a row, which is epic — this metric leads core
CPI inflation so this was quite bond bullish. While the core crude PPI did bounce
back 6.7% MoM on the back of the commodity rebound, it is still down 37% on a
YoY basis and the fundamental trend is still … down. As the Feds’ Beige Book
notified us last week, both WAGES and PRICES are either flat or falling in most
areas of the United States. In other words, deflation, fully two years into the
Fed’s great easing experiment, remains the predominant macro risk. Policy-
induced reflation remains at best a consensus forecast; at worst, a false hope.

As an aside, Martin Wolf writes a brilliant exposé today on how this current
economic downturn is tracking the 1930s — and it is not that far off despite all
the gobs of policy stimulus and booming money supply. See page 9 — the title
says it all: How Today’s Global Recession Tracks the Great Depression. This is
why it is so irresponsible to be drawing inferences (the fabled ECRI comes to
mind) from relationships that held in the post-WWII manufacturing inventory
downturns because what we have on our hands is a deleveraging cycle and they
take years, not months, to play out, and metrics such as unsold home
inventories, the savings rate, cash/asset ratios on commercial bank balance
sheets, labour turnover, debt/assets and debt/net worth in the household
sector matter far more than the ISM or other little ‘rules of thumb’ that so many
pundits rely on instead of recognizing that this is a different animal altogether.
At least we have a template from Rogoff and Reinhart (quoted in the article) that
shows that these types of balance sheet recessions lasts two years, the bear
market lasts three years, unemployment rises for four years and home prices do
not bottom for six years.

So even if we manage to post a fractionally positive GDP number in 3Q it will

very likely mean as much as the one we managed to experience — and was not
sustainable which is the key — in last year’s second quarter. That too was
initially met with a certain degree of euphoria, pundit calls that the lows (March
at that time) were turned in, and a brief but ill-fated rally in the so-called ‘early
cyclicals’. The only difference between now and then is that the stock market
bounced off a deeper oversold low.

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June 17, 2009 – BREAKFAST WITH DAVE

There seems to be this universal belief that policymakers “get it” and that the
countercyclical policies that extended the economic malaise will simply not be
repeated this time around. As for the folks that lay claim to this — while they
focus on the Fed’s efforts to save the RV industry with its balance sheet — are
they also watching the belt-tightening moves by the fiscally-challenged state
governments who are now raising taxes at the worst possible time in the
business cycle. For the latest, see Plan to Raise Income Tax in Pennsylvania on
page A14 of the New York Times (the state intends to boost its income tax rate
by 16% in the next three years).

MAKE HAY WHILE THE SUN SHINES

There is no doubt that in contrast to the Treasury auctions, the demand for
newly-issued paper in the corporate market for debt and equity has been
extremely strong. Issuers are well advised to tap the sentiment now because
there is no guarantee in an extended sub-par economic cycle that the window is
going to remain open. Moody’s sure seems skeptical — see Moody’s Warns on
Funding Problems on page 21 of the FT. The rating agency found that $615
billion of corporate paper globally is set to mature in the coming 12 months.
Also, as many as 46% of speculative-grade companies are less than 20% below
their debt covenants (up from 20% a year ago); the comparable figure for
investment-grade is 17% (triple the 6% share a year ago).

DOW TRANSPORTS — SELL SIGNAL?

It’s the irony of ironies that when so much was made of the fact that the S&P
500 kissed its 200-day moving average a short two-weeks ago that the event The Dow Transports
would mark the end of the bear market rally. Then again, Mr. Market is a
never did confirm
this wonderful
malevolent beast and full of surprises in both directions.
40%+ rally from the
lows
Guess what? The Dow Transports never did confirm this wonderful 40%+ rally
from the lows, which just ended. As Chart 1 shows, the rally in this critical
economic-sensitive barometer posted a most unimpressive rally from its
oversold March lows, and put in a classic double top. The peak was turned in
back on May 6 when nobody was looking, and after yesterday’s 1.0% drubbing,
the Transports are now down 6.5% from the nearby high (and down 10.0% for
the year). The Dow Utilities index, by way of comparison, is holding in
comparatively well and the ratio to the Dow Transports looks consistent with a
further down-move in 10-year Treasury note yields, to a 3.00 - 3.25% zone —
adding some much-needed confirmation to this positive reversal we are seeing
in the bond market.

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June 17, 2009 – BREAKFAST WITH DAVE

Chart 1: DOW TRANSPORTS — SELL SIGNAL?

Dow Transportation Index

5,500

5,000

4,500

4,000

3,500

3,000

2,500

2,000
Jun 2008 Aug 2008 Oct 2008 Dec 2008 Feb 2009 Apr 2009 Jun 2009

Source: Haver Analytics, Gluskin Sheff

THE CONSUMER FRUGALITY IS GOOD FOR THIS

It's called the TV set — sales volumes are up more than 10.0% year-on-year.

A new forecast published by the Global Entertainment and Media Outlook found
that by 2013 U.S. consumer spending on basic TV services will have risen 33%
from 2009 levels to $68.3 billion. Video-on-demand movies and shows are seen
almost doubling from $2.7 billion to $4.5 billion. This is all part of the cocooning
wave coming our way in the frugal future.

BUT FOR OVERALL SPENDING, FRUGALITY IS A KILLER

Just ask Best Buy, who woefully missed its fiscal 1Q estimates (not to mention
The 78 million
its cautious guidance, which definitely did not fit in well with the ‘green shoot’
boomer population
mood the economists and strategists are still in) and saw its stock crater 7.0%
is clearly in hunker-
yesterday. Also, as we have said in the past, the 78 million boomer population
down mode
is clearly in hunker-down mode after seeing their retirement assets take a giant
hit from the bursting of two bubbles less than seven years apart. They are not
going to line up at the trough a third time as the median age of this critical
demographic group moves through his/her mid-50s. It’s all about savings. See
For Boomers, Recession is Redefining Retirement on the front page of the USA
Today. A survey by the AARP (American Association of Retirement Professionals)
found that 56% of the boomer population is now putting off a major purchase;
24% have postponed retirement (supporting our ‘income’ theme).

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June 17, 2009 – BREAKFAST WITH DAVE

IS BOOMING MONEY SUPPLY REALLY INFLATIONARY?

Not when you are in a liquidity trap, which is where we are. The problem with
the Fed's monetary experiment is that the money supply boost is still not
circulating through the economy but rather sitting on bank balance sheets. At
least there's no delinquency risk with net free reserves.

Paul Krugman uses some great historical examples in his Monday column in the
NYT (Stay the Course). Between 1929 and 1939, the monetary base doubled
(and the dollar devalued) and yet prices deflated 19%. In fact, despite seven
years of New Deal stimulus and rampant FDR incursion into the economy, the
1930s ended with the unemployment rate at 15%, the CPI declining at a 2%
annual rate and the level of GDP still below its 1929 peak. Between 1997 and
2003, Japan's monetary base surged 85% — deflation pressures remained
intact. We just do not believe it is still appreciated that when the economy slips
into a deleveraging phase, which by its nature involves asset liquidation, debt
repayment and rising private sector savings rates, it takes years before the
economy makes the transition to the next up-cycle and only then with massive
amounts of fiscal and monetary stimulus.

HOW PRO-GROWTH IS FISCAL POLICY?

Let's not forget that fiscal policy is still not nearly as stimulative as it could be.
How can we possibly say that with a U.S. fiscal deficit/GDP ratio at a record
13%? Because part of the federal pump-priming is only serving as an antidote
to the restraint at the state and local government level — an estimated $230
billion gap has to close between now and 2011. For a look at how the severe
the fiscal restraint actually is at the lower levels of government, have a read of
Children Suffer As States Cut Health Budgets on page D1 of the WSJ and
California Schools’ Tough Choices on page A3.

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June 17, 2009 – BREAKFAST WITH DAVE
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June 17, 2009 – BREAKFAST WITH DAVE
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