David A.

Rosenberg August 17, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

NOT THE TIME FOR A JUBILEE
IN THIS ISSUE
My early Monday morning read yesterday almost served as an epiphany of sorts,
not because I have seen the light and about to change my views, but rather, that • Not the time for a jubilee:
in a nutshell, we are in the
they were solidified.
early stages of a secular
credit collapse following
The USA Today’s interview with Pimco’s Mohamed El-Erian who said: “Most the biggest credit bubble
people start off the day positioned for the Old Normal, not the New Normal … in in human history
the New Normal, you are more worried about the return of your capital, not the
• Canadian housing market:
return in your capital. Simply put, investors should own less equities and more A long, hard summer:
bonds. existing home sales in
Canada fell 6.8% MoM, the
Mortimer Zuckerman’s op-ed piece in the WSJ titled, The End of American 6th decline in seven
Optimism: “if there is one great policy failure of this recession, it’s that we have months
not used the crisis to introduce structural reforms.” • U.S. housing stuck in the
basement: the NAHB
And the WSJ article on page A2 titled Another Threat To Economy: Boomers housing market index
Cutting Back: “They have less money, they earn less on what they have, their sagged to 13 in August,
houses aren’t rising in value and the prospect of working longer to make up the the low-water mark for the
year and the lowest since
shortfall has dimmed significantly in a lousy job market.”
April 2009

In a nutshell, we are in the early stages of a secular credit collapse following the • Early glimpse of U.S.
biggest credit bubble in human history. manufacturing data
disappointing: the NY
Empire State
The credit expansion that began with the Diner’s Club card in the 1950s (one
Manufacturing survey for
card per family!) finally morphed into a full-fledged bubble post the 2001 August rose slightly but
“ownership society” craze when buy-now, pay-later mortgage loans populated misses market
and polluted the financial backdrop. The bubble was the result of a universal, expectations
irrational and linear belief in real estate asset appreciation that developed in the • The world, except for
1990s and reached its glorious peak in 2007. China, loves U.S.
treasuries: net long-term
But the problem of not having enough income nationally (globally, in fact) to flows into U.S. assets
support the record debt load, especially as asset prices succumbed to their own increased in June with
grotesque degree of overvalued excess, led to the credit collapse and financial foreigners picking up
$33.3bln in Treasuries
crisis. The credit collapse and financial crisis continued through 2008 despite
the cry and hue from the economic intelligentsia that all we were in for was a
soft-landing during this wonderful period labelled “The Great Moderation.” In
turn, what followed were that all the king’s horses and all the king’s men
brandishing marvellous new tools attempting, with futility, to put Humpty back
together again.

We then got a pause in the collapse and a spectacular bear market rally in the
final eight months of 2009 and into early 2010. But as Mick Jagger put it in an
oldie but goodie, “it’s all over now.”

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
August 17, 2010 – BREAKFAST WITH DAVE

Now we are rolling back into pronounced economic weakness, with contraction
in GDP likely to soon follow the stagnant economic conditions of the current We are rolling back into
quarter. The peaking-out and rolling-over in the equity market alongside the pronounced economic
virtual meltdown in government bond yields strongly suggest that, at the margin, weakness, with contraction in
investors are also belatedly and begrudgingly, coming around to this view. GDP likely to soon follow the
stagnant economic conditions
Our readers know that we often weave Bob Farrell into our work and we are of the current quarter
reminded of his sage advice in a report he wrote in the twilight of his storied
multi-decade tenure at Merrill Lynch back in 2001:

“Change of a long term or secular nature is usually gradual

enough that it is obscured by the noise caused by short-term
volatility. By the time secular trends are even acknowledged by
the majority they are generally obvious and mature. In the early
stages of a new secular paradigm, therefore, most are
conditioned to hear only the short-term noise they have been
conditioned to respond to by the prior existing secular condition.
Moreover, in a shift of secular or long term significance, the
markets will be adapting to a new set of rules while most market
participants will be still playing by the old rules.”

We are almost five months into this transition — past the interim peaks in the
stock market, bond yields and economic indicators such as the ISM index;
therefore, it seems to be an appropriate time to deliver a forecast for the next
stage in the new paradigm that began with the inflection of the secular credit
cycle. The first stage was the “Financial Crisis” with loan defaults and bank
failures. The second stage is the “Economic Crisis” with all its attendant
deflation and GDP contraction forces.

Since human psychology is slow to change, a broad economic move usually

occurs in three stages. The first stage begins when some unexpected event In the U.S., never before had
shatters an overdone psychological environment. However, while some people the home been used, and
respond immediately to this new lesson, most people, as they find it outside abused, as an ATM, as was the
their past experience, do not believe it. They need more evidence, and that is,
case during the 2001-07
mortgage cash-out cycle
the second stage. Typically, the majority become convinced during the second
stage and therefore the psychological background changes. People begin to act
differently, and their behaviour soon affects the performance of the economy.
Call it the classic Kubler-Ross five stages of grieving rolled into three.

Back to square one. The event that shattered the overdone psychological
environment this cycle was the abrupt reversal in the market for residential real
estate. Real estate had become the foundation for practically the entire
society’s financial plan, not to mention the primary source of discretionary
dollars for most households’ profligate consumption. Never before had the
home been used — abused — as an automatic bank teller as was the case
during the 2001-07 mortgage cash-out cycle.

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However, as with all bubbles, supply overtook demand. The trajectory of home The trajectory of U.S. home
prices went from straight up, to straight down practically overnight. But that was prices went from straight up to
after 70 years of only brief and regional setbacks, so it is understandable that straight down practically
most people didn’t rush out and put a for sale sign up in 2009. The “experts” overnight
including Ben Bernanke, told the masses that home prices have never declined
over a 12-month period.

In similar fashion, every post-WWII recession had been relatively brief and quickly
followed by new highs in GDP, employment, corporate earnings, and tax revenues.
Due to the severity of the financial collapse, unprecedented fiscal, monetary and
bailout stimulus implemented, followed by a strong and noisy consensus that, due
to the magnitude of the “Great Recession,” believed the subsequent recovery
would be awesome. Much like “pulling on the rubber band.”

But we didn’t get the “rubber band” effect — at least not outside of
manufacturing. Beyond the inventory rebound, the rest of the economy — real
final sales — expanded at a mere 1% at an annual rate, which was
unprecedented for a supposed post-recession recovery. So instead, what we got
was “pushing on a string” effect.

There are costs associated with hanging tough through the valley. Reduced
revenues, whether at the corporate, household or government level, must be Overall household debt to
compensated by increasing debt or reducing savings if cuts in spending are
disposable income has
declined from the peak;
deferred. So, it is reasonable to assume, at the margin, that balance sheets
however, government transfers
have actually suffered in the last three years since the economic contraction
have taken on a much larger
began for entities that have not experienced stable or growing revenues.
role as organic wage and
salary income growth has been
Admittedly, overall household debt-to-disposable income has declined from the anemic
peak. However, government transfers have taken on a much larger role in the
denominator as organic wage and salary income growth has been anemic. Cash
on corporate balance sheets has also ballooned to more than $1.8 trillion, but
this very well reflects a cautious move towards building precautionary balances
as the recent jump to a 6½% savings rate in the personal sector — squirreling
away nuts and acorns ahead of what is likely to be a winter of discontent on the
economic front.

The next question is: What happens if the next recession begins, or the original
contraction resumes, before organic growth has been renewed sufficiently and
balance sheets have been repaired enough to weather the storm? And, what
are the policy options if the Fed can no longer reload the gun and society fully
withdraws its political support for the extreme fiscal stimulus measures that we
know the Administration truly craves — even if the prior rounds of intervention
appear to have been ineffective. (Hey — isn’t the unemployment supposed to be
7% by now?)

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We will soon find out. The reality of this new paradigm of secular credit
contraction will come more into focus by the broad population and behaviour will Will President Obama execute
change. One of the primary tenets of Buddhism is that people will not change an “October surprise” by
until the pain of suffering is greater than the pain of change. This most likely offering an $800 billion
means that household economic behaviour will come more into alignment with “jubilee” to households with
rational solutions for re-establishing financial security. “upside down” mortgages?

As an aside, last week, the latest round of policy response to the credit crisis in
real estate by the mortgage bankers (Fannie and Freddie) entered the rumour
mill. Would President Obama execute an “October surprise” by offering an $800
billion “jubilee” to households with “upside down” mortgages? The consensus is
that such an act would be, among some other really bad things, “stimulative”.
We have been saying for several years that like any other lousy investment,
mortgage lenders would have a lot to write off before this is over. But
stimulative? Come on. This is one more example of asset destruction that is the
bedrock of a credit collapse. It matters not whether a bank or a ward of the
state owned the asset (a mortgage). Excess credit is being extinguished. There
is not one “stimulative” aspect to it — none at all.

Whereas deteriorating household balance sheets were tolerated when the

prevailing wisdom was one of linear economic expansion, it becomes
unbearable when the perception is that the economy is in contraction mode. For
the 55-year olds in 2007 who are now 58, there is no doubt that their household
economies are in secular contraction, regardless of what the global economy
has to offer.

Last year we researched what the 80th percentile 55-year old household looked
like financially and it turned out that it was completely “upside down”! That is to
For the baby boomers in the
say, financial assets available to fund retirement were substantially less than U.S., the evidence is rapidly
mortgage debt. For the baby boomers, the evidence is rapidly becoming becoming unavoidable that a
unavoidable that a change in behaviour toward extreme frugality is the least change in behaviour toward
painful alternative. All the things that home appreciation, or at least the extreme frugality is the least
prospect for wage or stock market gains, used to pay for are being reassessed. painful alternative
In their place, the savings that go along with a tighter budget are likely to be
combined with productive life style alternatives to solve the problems associated
with the legacy of the unsuccessful planning decisions of the past. (These
included leveraging your way to prosperity.)

We have focused on the baby boom cohort — that 78 million “pig in a python” —
for a variety of reasons. The main one is that, along with their traditional role of
driving the fashion for the population as a whole, they have entered the stage in
their lifecycle characterized by maximum political power. Local and national
politics should reflect the mores of this cohort like never before as their
economic behaviour changes. It is difficult to imagine that the political
establishment will not be beset by some revolutionary forces as baby boomers
embrace a strategy of frugality and financial rebuilding. The old paradigm of
conspicuous consumption is yesterday’s story.

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There is much work to be done and none of it will bring back the credit
expansion any time soon. Severe budgeting and the attendant saving will bring Looking ahead, the outlook for
forth the “Savings Paradox.” Retirement will have to be postponed for the baby the U.S. consumer is to “get
boomers, making it especially hard for those at the entry level to find small” at every level of society
employment. In an effort to liquidate debt, home prices will be under extended — in other words, living within
selling pressure. “Pay as You Go” is staging a major comeback. Government their means …
employment will be a major source of economic contraction. Keynesianism will
face a major challenge, as it already has with the Administration’s policy
response, which has been to rekindle growth by relying on demand-side “quick
fixes” to spur the economy rather than supply-side measures aimed at bolstering
productive growth in the nation’s capital stock.

So, there you have it. An outlook that favours saving over conspicuous
consumption. An outlook of “getting small” at every level of society — in other
words, living within our means. This is a highly deflationary outlook that favours
investment strategies that deliver a safe income stream at a reasonable price,
even as asset values come under unrelenting pressure. It is not that farfetched,
but who among us wants to question the quality of the Emperor’s robe? The most
startling possibility is that, even as the vast majority of pundits debate how
“gradual” the recovery will be, we have already entered a period that seems
destined to mark the most severe contraction since the horrible 1937-38 setback.

We are not saying that we are into something that is entirely like the experience
of the 1930s. But at the same time, what we are confronting is nothing at all … This is a highly deflationary
like the cycles of the post-WW era, when recessions were mild corrections in outlook that favours
GDP in the context of a secular credit expansion and when lower interest rates investment strategies that
could always be relied up to revive spending on big-ticket durable goods. As we deliver a safe income stream
said last week, we’re not in Kansas any more. We are in the process of
at a reasonable price
unwinding the excesses of a parabolic credit cycle of the prior decade. The first
of the boomers are now retiring with nobody around to buy their monster homes
and the Fed is now fighting a deflation battle that is prompting comparisons to
Japan for the past two decades.

What the bulls still refuse to see is that we are in an entirely new paradigm and
that the old rules of thumb are rarely, or are ever going to be able to be relied
upon, as was the case in the familiar credit-expansion days of old.

There is simply too much debt overhanging the U.S. household balance sheet —
the largest balance sheet on the planet. And, despite the deleveraging efforts to
date, the process of balance sheet repair is still in its infancy.

The cumulative household debt-income ratio peaked in Q1 2008 at

136%. Currently, this ratio is at 126%. But the pre-bubble norm was 70% (no
wonder 25% of Americans have a sub-600 FICO score). To get down to this
normalized ratio again, debt would have to be reduced by around $6 trillion. So
far, nearly $600 billion of bad household debt has been destroyed. In other
words, we have much further to go in this deleveraging phase.

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Maybe this is why the McKinsey report concluded that this process can and
often takes up to seven years to complete. (As an aside, in the Old Testament, We are a long way off this
“jubilee” or “shmita” is to occur in year seven — so we have five more years to go deleveraging phase from
before the credit contraction ends, that is, if you adhere to this particular portion running its course. Our advice,
of Leviticus). play safe: capital preservation
strategies, deploying hedge
What about debt in relation to household assets? That debt-to-asset ratio is funds that hedge, and an
currently at 20% (the peak was 22.7% set back in Q1 2009) but again, the pre- income emphasis
bubble norm was 12.5%. The implications: classic Bob Farrell mean-reversion
would mean a further $7 trillion of debt extinguishment.

We are a long way off this deleveraging phase from running its course. The
government, along with the Federal Reserve, have expended tremendous
resources to cushion the blow. But now we see first-hand what happens when
policy stimulus fades and a mini-inventory cycle peaks out in a credit
contraction: stagnation in Q3 followed by renewed economic contraction in Q4.

Play it safe. In other words, capital preservation strategies, deploying hedge

funds that hedge, and an income emphasis will all rule in the sort of
environment we are in today and likely to be in for some time yet.

CANADIAN HOUSING MARKET: A LONG, HARD SUMMER

As foreshadowed by earlier-released large-city data, Canadian resale home sales
fell by 6.8% MoM on a seasonally adjusted basis, the sixth decline in seven
months (on a YoY basis sales were down 30%). Vancouver and Toronto saw some
of the largest declines, as the HST kicked in B.C. and Ontario, dampening sales
activity. But even outside of Toronto and Vancouver, other cities saw large YoY
sales decline — Calgary (-41%), Halifax (-26%), Edmonton (-39%) and Winnipeg
(-13%) for example — so it was more than just the HST-effect driving the declines.

Average prices across the country were up 1% YoY on aggregate, the slowest
increase over a year. However, the inventory picture still favours buyers so we
could see outright prices declines for the remainder of the year. While months’
supply has slowly been inching down over the past three months, at 7.3 months, it
is still the highest since March 2009.

HOUSING STUCK IN THE BASEMENT

The National Association of Home Builders housing market index was at 22 in
May, 16 in June, 14 in July and now 13 in August. Moreover, the forward-looking
NAHB index essentially guaranteed that we will be on the hook for another round
soft housing data ahead.

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August 17, 2010 – BREAKFAST WITH DAVE

CHART 1: HOUSING STUCK IN THE BASEMENT

United Stated: NAHB Housing Market Index
(all good = 100)

80

60

40

20

0
85 90 95 00 05 10
Shaded region represent periods of U.S. recession
Source: Haver Analytics

At 13, the NAHB index is now at the low-water mark for the year and the worst
result since the economy was detonating in April 2009. Buyer traffic is barely
showing a pulse even with the bond market working so hard to take mortgage
rates to record lows — the subindex remained at 10 and is just three points away
from matching an all-time low.

CHART 2: BUYER TRAFFIC NOT LOOKING GOOD

United Stated: NAHB Housing Market Index:
Traffic of Prospective Buyers of New Homes
(all good = 100)
80

60

40

20

0
85 90 95 00 05 10

Shaded region represent periods of U.S. recession

Source: Haver Analytics

Sales expectations sank to 18 from 21, well off the nearby high of 27posted last
May ahead of the tax goodie expiry date, and at its lowest level since March
2009 (pre-dating the green-shoot era).

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August 17, 2010 – BREAKFAST WITH DAVE

CHART 3: SALES EXPECTATIONS IS ALSO NOT LOOKING GOOD

United Stated: NAHB Housing Market Index:
Sales of New Single-Family Homes in the Next Six Months
(all good = 100)
100

80

60

40

20

0
85 90 95 00 05 10

Shaded region represent periods of U.S. recession

Source: Haver Analytics

To put the NAHB into some context, in expansions it averages 55.5. In

recessions, it averages 25.0. And today, it is sitting at 13.0. Draw your own
conclusions on what we should label the cycle we are in.

EARLY GLIMPSE OF MANUFACTURING DATA DISAPPOINTING

The Empire Manufacturing Survey for August (one of the first August
manufacturing data points) rose slightly to 7.1 from 5.08, missing expectations for
an increase to 8.0. However, this report was a case where the details were
weaker than the headline implied and some components certainly had a
recession-feel to them. In fact, on aggregate, the sub-indices suggest we could
see another decline in the August ISM, which would be the fourth month in a row
(data due September 1).

New orders components dropped to -2.7 from +10.1 (the lowest since June
2009) and shipments fell to -11.5 from +6.3 (the lowest since March 2009).
Inventories slipped to 2.9 from 6.4. And respondents were also gloomy about
future prospects, with six-month expectations falling to 35.7 from 41.3, the
weakest since June 2009.

The employment sub-indices were firm, with number of employees rising to 14.3
from 7.9 and the workweek jumping to 7.1 from 9.5, pointing to more increases
in manufacturing employment. To be sure, we have see gradual increases in
overall manufacturing employment (up for seven-consecutive months to July) but
the manufacturing sector accounts for less than 10% of total employment and
just over 10% for private payrolls. The key for nonfarm payrolls will be this
week’s initial jobless claims, which coincides with the reference week — and the
latest trend has been troubling with claims hitting 484k last week.

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THE WORLD (EX. CHINA) LOVES U.S. TREASURIES

Net long-term flows into U.S. assets increased by $44.4 in June, rising from
$35.3 billion. Foreigners picked up $33.3 billion worth of Treasuries, up from
near-$15 billion in May. What is telling is that Treasuries managed to hold up
despite the lack of participation by China (who ran down their holdings by $24
billion in June, the second month in a row).

We saw some risk-aversion with as foreigners net sellers of U.S. equities,

reducing exposure by $4.1 billion, the second month in a row foreigners sold
equities. Corporate bonds also took a hit, with net foreign sales at $13.5 billion
on top of the $9 billion in sales in May.

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August 17, 2010 – BREAKFAST WITH DAVE

Gluskin Sheff at a Glance

Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms.
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herein is not intended to provide tax advice or to be used by anyone to
provide tax advice. Investors are urged to seek tax advice based on their
particular circumstances from an independent tax professional.
The information herein (other than disclosure information relating to Gluskin
Sheff and its affiliates) was obtained from various sources and Gluskin
Sheff does not guarantee its accuracy. This report may contain links to
third-party websites. Gluskin Sheff is not responsible for the content of any
third-party website or any linked content contained in a third-party website.
Content contained on such third-party websites is not part of this report and
is not incorporated by reference into this report. The inclusion of a link in
this report does not imply any endorsement by or any affiliation with Gluskin
Sheff.
All opinions, projections and estimates constitute the judgment of the
author as of the date of the report and are subject to change without notice.
Prices also are subject to change without notice. Gluskin Sheff is under no
obligation to update this report and readers should therefore assume that
Gluskin Sheff will not update any fact, circumstance or opinion contained in
this report.
Neither Gluskin Sheff nor any director, officer or employee of Gluskin Sheff
accepts any liability whatsoever for any direct, indirect or consequential
damages or losses arising from any use of this report or its contents.
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