David A.

Rosenberg September 3, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Lunch with Dave

DODGING A BULLET, YES — OUT OF THE WOODS, NO
IN THIS ISSUE
The U.S. employment report for August, much like the previously released ISM
and chain store sales numbers, had the “muddle through” thumbprints all over • Dodging a bullet, yes; out
of the woods, no: the U.S.
it, which is why an equity and bond market bracing for a “double dip” scenario
employment report for
have reacted so violently in recent days. The data are hardly strong but August was hardly strong,
admittedly are not consistent with the economy contracting this quarter. But the but admittedly, is not
data do not alter our outlook for a double-dip scenario unfolding before year-end consistent with the
as the policy stimulus continues to fade and the inventory cycle subsides. economy contracting this
quarter. Nonetheless, this
data alone does not alter
While capital spending remains a lynchpin as businesses replace obsolete
our macro outlook
machinery and equipment, its contribution to overall growth is actually showing
signs of receding and we see nothing really in the consumer, housing, • U.S. productivity, a tad less
commercial construction, net exports or State & local government sectors to get miraculous: nonfarm
business productivity is
us excited over the macro backdrop.
weakening, actually falling
in Q2 in the steepest falloff
Now that the financial market sentiment is moving away from the “double dip” in four years
outcome, equity investors still have to confront what a “muddle through”
• Sales boom? Chain store
scenario is going to mean for corporate profits because we had such a “muddle
sales in the U.S. came in a
through” in the second quarter with 1.6% volume GDP growth, which translated, ripping 2% MoM in August;
at a time of cycle-high margins, into virtually flat sequential corporate earnings however, keep in mind
growth. So, it would stand to reason that if there is vulnerability, it is highly that this comes off a
unlikely that we will see profits rise 20% in the coming year as is currently the dismal July
consensus view in the marketplace. • Putting initial jobless
claims in perspective: the
The jobs report was uninspiring in the aggregate but the bright spots cannot be key is the four-week
readily dismissed. First, the private payroll number came in at +67,000, which moving average, which is
was above the consensus estimate of +40,000, not to mention the ADP print of stuck at a level that is
typically consistent to a
-10,000. This, along with the upward headline revisions of 123,000 and the
jobs market that is either
0.3% MoM gain in the wage number has the bulls rather excited. stagnant or contracting

But there were many other parts of the nonfarm report that left much to be • U.S. pending home sales
desired. Here’s an unlucky seven examples of softness beneath the surface: bounced in July, but there
may be some seasonality
1. Aggregate hours worked were flat. problems with the data

2. All the employment gains were part-time — full-time employment, as per the
Household Survey, plunged 254,000.
3. Those working part-time for “economic reasons” surged 331,000 — the
biggest increase in six months.
4. While private payrolls were better than expected, 10,000 of that +67,000
tally reflected returning construction workers who had been on strike.

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
September 3, 2010 – LUNCH WITH DAVE

5. Manufacturing employment was down 27,000 and total goods producing In August, the entire
jobs were flat — hardly signs of a robust economic backdrop.
increase in private sector
6. The diffusion index for private payrolls actually fell to 53.0 from 56.7 in July employment in the U.S. was
— a seven-month low. It was 68.0 at the April high, which is consistent with mostly in health and
an economy slowing down to stall-speed. education, which says little
7. The labour market gap widened with the all-inclusive U6 unemployment rate about the cyclical state of
rising to a four-month high of 16.7% from 16.5% in July. This is why the the economy
odds are stacked against a sustained acceleration in wages.
There are a few more takeaways.

The latest batch of data has been highly confusing, to say the least. The chain
store sales data were skewed by one-offs, such as retroactive jobless benefit
checks that were mailed out in early August and the growing number (17 this
year) of States offering sales tax holidays. We estimate that absent these
influences, year-on-year sales growth would have been closer to 1% than 3%.

The spending data also belied the information contained in the Conference
Board’s consumer confidence survey, as the facts-on-the ground ‘present
situation’ index sagged to 24.9 in August from 26.4 in July — only 5% of the time
in the past has it been so low. The ISM manufacturing index, which really got
the ball rolling on this ‘take out the double-dip’ trade, managed to spike even
though the three leading sub-indices — new orders, backlogs and vendor
performance — all declined in what was a 1-in-100 event.

Not only that, but the employment component of the ISM surged to its highest
level since December 1983, and yet the manufacturing employment segment of
the payroll survey fell 27,000 — the first decline this year and the sharpest falloff
since last October. Furthermore, the manufacturing diffusion index slumped to
a seven-month low of 47 from 53 — in other words, fewer than half of the
industrial sector was adding to staff requirements last month. It begs the
question as to what exactly the ISM is measuring.

The list of inconsistencies in the data didn’t stop there. The entire increase in
private sector employment in August was in the service sector — mostly health
and education, which says little about the cyclical state of the economy. Yet 90
minutes after the jobs number was released, we got the ISM non-manufacturing
survey and it flashed a contraction in services employment to a seven-month low
of 48.2 from 50.9 in July.

Just a tad confusing, but the newly found bullish view of the economy is sort of
corroborating evidence.

The employment report did not detract from the view that the economy is losing
steam. The fourth quarter of a recovery typically sees real GDP growth of over
6% at an annual rate, but in this post-bubble credit collapse, what we got this
time was 1.6% at an annual rate in Q2.

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Moreover, there is nothing in the data to suggest anything but a further slowing
in Q3, and the only reason why there is no contraction this quarter is because it One can easily draw the
looks as though we are getting another lift from inventories — though now the conclusion from the data
buildup looks involuntary, which will cast a cloud on fourth-quarter GDP barring a that we have dodged a
sudden reversal in the declining trend in real final sales. bullet. But that does not
mean we are out of the
Private payrolls were +247,000 when the equity market peaked in April, it woods
slowed to +107,000 by July and was +67,000 last month. What does that
suggest about the trend? Ditto for goods-producing employment, which was
+67,000 in April, subsequently softened to +37,000 by July, and in August was
the grand total of zero.

One can easily draw the conclusion from the data that we have dodged a bullet.
But that does not mean we are out of the woods. Employment is a coincident
indicator. Leading indicators, such as the ECRI, continue to deteriorate and to
levels still consistent with nontrivial double-dip risks. Keep this in mind —
private payrolls came in at +97,000 in November 2007 and the “Great
Recession” began the next month. In other words, the +67,000 tally we saw
today basically tells you nothing about how the pace of economic activity is going
to unfold as we move into the fall.

PRODUCTIVITY A TAD LESS MIRACULOUS

The revised Q2 U.S. data showed real nonfarm business output growth throttling
Since businesses slashed
back to a 1.6% annual rate in Q2 from 5.0% in Q1 and from the 6.7% peak in
the workweek this cycle to
the fourth quarter of 2009. Since businesses slashed the workweek this cycle
record lows, they have the
to record lows, they have the luxury of saving on costs by having their existing
luxury of saving on costs by
staff work longer before embarking on a hiring spree; hence the continued high having their existing staff
level of jobless claims. work longer before
embarking on a hiring spree
As a result, hours worked did jump at a 3.5% annual rate, the fastest since Q1
2006. The difference is that back then, with the housing and credit boom in full
swing, output growth was 6.8% — not 1.6%. Of course, at that time too the
labour market was drum tight, so compensation per hour (in nominal terms!)
was running at a 5.3% annual rate; in Q2 of this year, it deflated 0.7% at an
annual rate after a 0.9% dip in Q1. Wages are indeed deflating in each of the
last two quarters.

Meanwhile, productivity is weakening — declining actually at a 1.8% annual rate

in Q2, the steepest falloff in four years, and double the decline initially reported.
Keep in mind that this followed four quarters of unprecedented growth. What
this means is that unit labour costs swung to a +1.1% annual rate in Q3 from
-4.6% in Q1, -4.2% in Q4 and -3.3% in Q3 of last year. We can’t get worked up
about +1.1% unit labour cost growth from an inflation standpoint, but this swing
is affecting profit margins, which the nonfarm business sector tried to cushion
by raising prices at a 2.6% annual rate. However, the spread between the
growth rate in prices and costs narrowed to +1.5% from +5.8% in Q1 and this
was the narrowest margin since the “green shoots” began to sprout in the
second quarter of last year.

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September 3, 2010 – LUNCH WITH DAVE

This showed through loud and clear in the Q2 national accounts profits data
(pre-tax without inventory valuation and capital consumption adjustments), U.S. chain store sales in
which slowed dramatically to a 2.3% quarter-over-quarter rate from 14.5% in Q1, August rose 2.0% MoM;
13.1% in Q4, 12.3% in Q3 of last year, and the lowest pace since earnings were however, keep in mind that
declining sequentially in the fourth quarter of 2008. As an aside, after-tax July saw dismal results and
profits completely flattened on a quarter-over-quarter basis last quarter after a that there are more states
five quarter run in double-digit terrain. giving sales tax holidays this
year than last
So, while national account profits show a healthy YoY pace of +49%, this masks
an underlying erosion on a quarterly sequential (and seasonally adjusted) basis.
The YoY trend actually peaked at +80% in Q1 and +57% in Q4 for those who like
to focus on “momentum” or second derivative movements.

This is the prime reason why the equity market has sputtered, profits are doing
likewise, and overly optimistic earnings estimates are coming down and there is
more to come on this score.

SALES BOOM?
Chain store sales came in at a ripping +2.0% MoM, so the +3.2% YoY trend in
August actually understated things. Keep in mind, however, that we came off a
dismal July (-0.3%) and that 20% more of the U.S population were on the
receiving end of a sales tax holiday this year compared to last (18 states this
year versus 15 last year and the new states included Florida, Illinois and
Massachusetts).

Sales are still 3% below the pre-recession peak, so let’s keep this slow-motion
recovery in some context. Sales are actually no higher today than they were in
January 2007 — ditto for the retailing stocks.

In addition to the stepped up sales tax holidays, we also had $1 billion of cash
coming in the form of retroactive jobless benefits in August. After sifting through
the Fed’s Survey of Consumer Finances and drawing assumptions on spending
propensities and how much goes into chain store sales, coupled with the
estimated effects of the sales tax holidays and the amount of spending activity
that was essentially brought forward, sales were actually flat MoM and only up
1.2% YoY.

PUTTING CLAIMS IN PERSPECTIVE

The key is that the four-week moving average is stuck at a level that is typically
consistent to a job market that is either stagnant or contracting. It is difficult to
pinpoint, barring a major policy shock, what causes a spark for improvement.
But let’s put 485k on jobless claims into context:

• The four-week moving average was 445k after Lehman collapsed.

• It was 350k after Bear Stearns failed.

• It was 400k when Enron failed.

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September 3, 2010 – LUNCH WITH DAVE

• Right after 9/11 and with the economy seven months into recession, claims
were sitting at 415k. Putting the 485k on jobless
claims into context; it is
• When the tech wreck began in early 2001, claims were 350k.
actually worse than what we
• Finally, in the summer of 2008, when the capital markets completely froze up saw in past crisis
due to LTCM and Russia, claims were hovering near 300k.
Hopefully that puts 485k into some sort of perspective. It is actually worse than
what we saw in past crisis. The difference now is that there is no panic, there is
no crisis. Basically, it’s a crummy economy, barely expanding at all, in classic
ho-hum Japanese style.

PENDING HOME SALES BOUNCE

Pending home sales jumped 5.2% MoM in July, much better than analysts
feared (who had collectively estimated that sales would fall by 1%). The breadth
of the increase was widespread, with all regions up on the month. A downward
revision of the June data (taken down to -2.8% from -2.6%) took a (slight) shine
off the impressive headline line.

Remember that pending home sales is a leading indicator for resale home sales.
So, assumingly contracts are not cancelled, we could see some positive resale
home numbers over the coming months.

While the increase in pending home sales is encouraging, we did dig through the
data and found that the not seasonally adjusted numbers (the raw numbers) fell
by 7%, with declines across the country. This makes sense as July is usually a
slower month for homebuying activities.

We wonder if there is a chance that the seasonal adjustment factors could be

overstating the monthly increase given that we have seen such huge volatility in
the housing numbers in the recent year making the seasonal adjustment
process more difficult. Recall that Standard and Poor’s issued a note about the
Case-Shiller home price index saying that “the turmoil in the housing market in
the last few years has generated unusual movements that are easily mistaken
for shifts in the normal seasonal patterns, resulting in larger seasonal
adjustments and misleading results.” The question is whether the seasonally
adjusted increase was for real. We believe that the housing market still has a
way to go before recovery, especially given a very weak employment background
and the huge amount of unsold inventories.

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September 3, 2010 – LUNCH WITH DAVE

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