David A.

Rosenberg December 10, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Lunch with Dave

FRUGALITY THEME INTACT
IN THIS ISSUE
It’s interesting that so many pundits lay claim to how great the shopping season
is going – and yet nobody is using credit! Have a look at On Christmas Shopping • Frugality theme intact: It’s
Lists, No Credit Slips on the front page of today’s NYT. A mere 17% of shoppers interesting that so many
pundits lay claim to how
have relied on plastic since the Thanksgiving weekend — half of last year’s level great the shopping season
and lowest in the 27-year year history of the American Research Group survey. is going – and yet nobody
Britt Beemer, who heads up America’s Research Group, had this to say: is using credit!
• Some scattered thoughts
“The consumer really feels a lot of pressure from previous debts, and they just for 2011 as we flesh out
aren’t going to dig themselves into that kind of hole.” That sounds pretty our themes for the year
disinflationary to us. end
• U.S. Flow of Funds for Q3
To be sure, the University of Michigan consumer sentiment index did pick up in was a mixed bag of data:
December, to 74.2 from 71.6 in November — well ahead of consensus household balance sheet
estimates of 72.5. Before you uncork the champagne, this is still shy of the 76 repair continues;
nearby peak reached in June, but it is the second increase in a row. How corporate balance sheets
fascinating that it is still below where we were when the last two recessions remain in good shape but
there are cautionary flags
began.
worth watching

CHART 1: HOUSEHOLD REDUCING DEBT • Two offsets to the tax-cut

package: run-up in
United States: Household Credit Market Debt Flows mortgage rates and
($billions, seasonally adjusted at annual rate)
increase in gasoline prices
120 could offset total effect of
the new tax package

100
• Trade lift off: encouraging
international trade figures
came out in U.S. and
80 Canada
• We are seeing a
disturbing trend in Asia’s
60
inventory-to-shipment
ratios
40
99 00 01 02 03 04 05 06 07 08 09 10

Source: Haver Analytics, Gluskin Sheff

The home buying intentions segment actually slipped to 151 from 154 — not
good news for the sector that got the economy into this mess to begin with. And
equally fascinating was that even with the recent jump in commodity prices,
both the 1-year and 5 to 10 year median inflation expectations components
dipped a tenth of a point (to 2.9% and 2.7% respectively).

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
December 10, 2010 – LUNCH WITH DAVE

SOME SCATTERED THOUGHTS FOR 2011 AS WE FLESH OUT OUR THEMES

FOR THE YEAR AHEAD:
1. Consensus views of 1,350 on the S&P 500 and 4% real GDP growth are
far too high. Not one strategist polled by Bloomberg is bearish on Negative divergences are
equities. So we have a complacency problem on our hands, the exact increasingly apparent and
opposite of what we experienced at the March 2009 and the July 2010 momentum is actually
lows. For that reason, the outlook for at least the first half of 2011 is less subsiding
than positive.
Moreover, equities are at the high end of the range and are priced for
good news on earnings and economic growth. Valuations are not at
extremes (however, according to the Shiller normalized P/E ratio the
market is still on the expensive side) but sentiment is. Negative
divergences are increasingly apparent and momentum is actually
subsiding. We see better buying opportunities ahead but continue to
favour companies that are “special situations” — consistent dividend
growth, undervalued, strong balance sheets, and non-cyclical in the sense
that they have low correlations with the direction of North American
growth.
2. In my view, real GDP growth in the U.S.A. is set to slow from around 3% in
2010 to 2% in 2011, or possibly even lower. This is not a double-dip but
it is a slower growth profile. We went to 3% in 2010 from -2.6% in 2009
so the second derivative was positive. But for the coming year, the
second derivative is likely going to decline. This augurs for a non-cyclical
exposure; more defensive and still yield-oriented. As the Bank of Canada The fiscal and sovereign
strongly suggested, global growth is going to slow and hence a sense of credit problems in Europe
caution over global multinational cyclicals is warranted. are not going away
3. The fiscal and sovereign credit problems in Europe are not going away.
Neither is the instability in the U.S. state and local government sector.
Policy tightening in China is also a source of uncertainty. Volatility is likely
to intensify with this outlook.
4. The U.S. dollar is likely to strengthen, particularly versus the yen (the
Bank of Japan and Ministry of Finance want the overvalued yen to
weaken) and the euro (they need it since Eurozone is tightening fiscal
policy more dramatically).
5. Emerging markets will struggle as central banks move more forcefully to
curb accelerating inflationary pressure. The Chinese stock market may
have already signalled that a major top in the region has been achieved.
6. The U.S. fiscal borrowing need for 2011 is no higher than it was for 2010.
As such, fiscal concerns in terms of what it means for lower long-term
rates are misguided. The yield curve is too steep and will flatten, led by
lower bond yields. The recent increase in long-term rates is very similar to
what we saw happen in December 2009 and helped ensure that bonds
would enjoy a year of positive returns in 2010.
7. The Canadian dollar is overvalued by at least five cents and is likely to The Canadian dollar is
succumb to a softer profile for commodity prices. Basic materials appear
over-owned in the short-term and bullish sentiment is at a high. The
overvalued by at least five
policy tightening effect out of emerging Asia is an obstacle, especially at cents and is likely to
current price levels. There is likely an election in Canada and the U.S.A. succumb to a softer profile
will not be beset by political uncertainty until 2012. Hence some caution for commodity prices
as it pertains to the outlook for the loonie (though I would look to get
more positive at 93 cents).

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8. Deflation remains the primary intermediate risk for the U.S.,

notwithstanding the prospect of a near-term follow-through from the The multi-decade era of
recent surge in many commodity prices. Money velocity remains dormant homeownership is over
despite the Fed’s reflation efforts. There remains far too much excess
capacity in the labour market. This requires an ongoing focus on SIRP
(safety and income at a reasonable price) strategies for investors.
9. Corporate bonds are no longer inexpensive but within this space,
financials and utilities screen best for value in terms of sectors, the 5-7
year part of the curve in terms of duration, and the BBB-BB area in terms
of ratings.
10. One of the most pronounced macro risks is another leg down in U.S.
home prices, which actually seems to be underway but is currently
receiving very little attention.
Our preferred “buy list” are out-of-favour groups that are not priced for
accelerating growth: Utilities, pipelines, oil income, pharmaceuticals (dividend
focus as well as being out of favour), food products, and grocery stores.

U.S. FLOW OF FUNDS FOR Q3 – A MIXED BAG

The U.S. household balance sheet is in better shape in Q3, courtesy of a $232
billion net debt decline (annual rate) and a $939 billion rebound in equity
valuation courtesy of Ben Bernanke.

CHART 2: HOUSEHOLD REDUCING DEBT

United States: Household Credit Market Debt Flows
($billions, seasonally adjusted at annual rate)
1600

1200

800

400

-400
55 60 65 70 75 80 85 90 95 00 05 10
Source: Federal Reserve Board /Haver Analytics
Source: Haver Analytics, Gluskin Sheff

Household net worth jumped $1.2 trillion after a $1.4 trillion slide in Q2. Real
estate valuation did deflate by $650 billion, the steepest decline since the first
quarter of 2009. Owners’ equity in real estate fell from $7.0 trillion to $6.4
trillion as more and more people lost their homes or chose to leave; as a share
of real estate valuation, it fell back near historic lows of 38.8% from 40.8% in
Q2. The multi-decade era of homeownership is over.

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December 10, 2010 – LUNCH WITH DAVE

CHART 3: OWNERS’ EQUITY IN REAL ESTATE FALLING AGAIN

United States: Owners’ Equity in Household Real Estate
($billions)
15000

12500

10000

7500

5000

2500

0
55 60 65 70 75 80 85 90 95 00 05 10
Source: Haver Analytics, Gluskin Sheff

Households remain concentrated on deleveraging having seen their outstanding

credit liabilities decline now at an unprecedented 10 quarters in a row and by
nearly $500 billion. Lord only knows how you can possibly squeeze an inflation
forecast out of this secular development.

CHART 4: STILL MORE TO GO BEFORE THE HOUSEHOLD BALANCE SHEET

IS REPAIRED – BUT HEADING TO THE RIGHT DIRECTION
United States: Household Debt/Disposable Personal Income
(percent)
140

120

100

80

60

40

20
55 60 65 70 75 80 85 90 95 00 05 10
Source: Haver Analytics, Gluskin Sheff

The personal saving rates, as measured by the Flow of Funds, plunged 11.6%
Q2 to 4.0% in Q3 — the lowest in the year. Excluding consumer durables, the
slide in the savings rate was even bigger — from 10.5% in Q2 to 2.9% in Q3, the
second lowest level in the past three years. Just in case you were wondering
what’s really underpinning U.S. households, it wasn’t solid employment
fundamentals, it was the very large drawdown in the saving rates.

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Corporate balance sheets remain in good shape but there are some yellow flags
that need monitoring. Despite an active new-issue calendar, companies in the
nonfarm nonfinancial sector retired $368 billion of equity (the most in three
years). This helped take the debt/equity ratio down 56.6% in Q3 from 62.9%.
Debt continued to be termed out with a record 74.3% of outstanding credit now
long-term, up from 73.8% in Q2. The liquid asset to short-term debt ratio also
rose to 52.6% from 49.6% and stand at the highest level since 1956 Q1.

CHART 5: CORPORATE BUSINESS BALANCE SHEET

REMAIN IN GOOD SHAPE
United States: Nonfarm Nonfinancial Corporate Business:
Credit Market Debt/Equity
(percent)
120

100

80

60

40

20
55 60 65 70 75 80 85 90 95 00 05 10
Source: Haver Analytics, Gluskin Sheff

CHART 6: CORPORATE BUSINESSES MORE LIQUID

United States: Nonfarm Nonfinancial Corporate Business:
Liquid Assets/Short-term Liabilities
(percent)
70

60

50

40

30

20

10
55 60 65 70 75 80 85 90 95 00 05 10
Source: Haver Analytics, Gluskin Sheff

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December 10, 2010 – LUNCH WITH DAVE

This goes a long way in explaining how it is that the speculative grade default
rate in November fell to 3.5% from 14.7% a year ago and why there are fewer
and fewer distressed situations. The Moody’s distress index, the share of
issuers trading in excess of 1,000 basis points over Treasuries, sank to 11.5% in
November from 14.1% in October and 24.2% a year ago.

CHART 7: CORPORATE BUSINESSES ARE INCREASING LONG-TERM DEBT

United States: Nonfarm Nonfinancial Corporate Business:
Long-term Debt/Credit Market Debt
(percent)
76

72

68

64

60

56

52
55 60 65 70 75 80 85 90 95 00 05 10
Source: Federal Reserve Board/Haver Analytics
Source: Haver Analytics, Gluskin Sheff

Overall, corporate credit quality remains very good but some areas bear
watching. Internally-generated funds did decline in Q3 by $20 billion at an
annual rate. This hasn’t happened since the economy was bottoming out in
2009 Q2. With capital spending turning up, the corporate ‘financing gap’ turned
positive — $128 billion at an annual rate compared with -$104 billion a year
ago. This means that companies are spending more on capex now than they are
bringing in with respect to cash flows.

CHART 8: COMPANIES ARE NOW STARTING TO SPEND ON CAPEX

United States: Nonfarm Nonfinancial Corporate Business: Financing Gap
($billions)

400

200

-200

-400
85 90 95 00 05 10
Source: Federal Reserve Board /Haver Analytics
Source: Haver Analytics, Gluskin Sheff

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December 10, 2010 – LUNCH WITH DAVE

TWO OFFSETS TO THE TAX-CUT PACKAGE

Remember, all the new “fiscal stimulus” does (assuming it passes) is leave the
U.S. gasoline prices at the
federal government as a neutral economic force in 2011. But what are possible
pumps is spiking — this alone
overhangs: (i) the recent run-up in mortgage rates, to 4.61% from 4.17% a month
will drain $40 billion from
ago, and (ii) the spike in gasoline prices to $2.97/gallon (over $3/gallon now in 20
household cash flow into the
states). The gas effect alone will drain $40 billion from household cash flow into gas tank
the gas tank — a headache to be sure but we would probably have to see the price
break to $5/gallon to have the total effects of the tax package reversed.

TRADE LIFT OFF

We got some encouraging international trade figures from the U.S. and Canada
this morning. In the U.S., the October trade deficit shrank to $38.7 billion from an
upwardly revised $44.6 billion level in September. In real terms, exports surged
3.3% MoM, erasing two months of prior weakness. Even more impressive was
that the strength was broad-based, with all categories up, including a 4.5% real
jump in autos. Yet, it was another disappointing performance from real imports,
which slid 1.5% MoM after the 0.9% decline in September. Most of the import
components were weak as well, although consumer goods did jump, nearly
reversing the drop in September, supporting the positive chain store numbers we
saw in November. Trade is very volatile but at this point we feel much more
comfortable with the idea that trade will be a net contributor to GDP and have
factored in a percentage point contribution. After yesterday’s better-than-expected
wholesales inventories, we are now tracking 2.7% QoQ (at an annual rate) for Q4,
up from our previous estimates of 2.5%.

Similarly in Canada, it looks like Q4 GDP will also get a boost from net trade.
The October trade deficit narrowed to $1.7 billion from a $2.3 billion gap in
September. We saw a huge 4.9% MoM surge in real exports, the largest monthly
increase in nearly 18 months, with most components up big. Real imports rose
1.8% and most sectors were positive with notable mention to machinery and
equipment (real M&E +1.2% MoM, the ninth straight monthly increase, taking
the YoY rate to 27% since July 1997 — all good news for Canadian productivity).
All in, we are looking at a 0.2% monthly real GDP increase in October but even CHART 9: ASIAN INVENTORY-TO-SHIPMENT
with strong growth rates for the rest of the quarter, it’s likely that Q4 GDP will still RATIOS RISING
fall short of the BoC’s 2.6% expectation (they did note that the second half of the (percent)
year was coming in weaker than anticipated in their latest communiqué).

ASIAN INVENTORY-TO-SHIPMENTS RATIOS

We dug through some global economic data and noticed some worrying trends in
Asia. The inventory-to-shipments (I/S) ratios for Korea and Taiwan have been on a
steady rise since early this year. Korea’s I/S ratio is now at the highest level since
March 2009 as inventories surged to two-year highs. In Taiwan, the I/S ratio is
hovering near one-year highs and inventories are also near-two year highs. Given
that both these countries are export-intensive, it makes us worry about global
demand and the lofty GDP forecasts penciled in for 2011 by analysts (currently at
Source: Haver Analytics, Gluskin Sheff
4.2% for real GDP in 2011).

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December 10, 2010 – LUNCH WITH DAVE

Gluskin Sheff at a Glance

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 the
prudent stewardship of our clients’ wealth through the delivery of strong, risk-adjusted
investment returns together with the highest level of personalized client service.

OVERVIEW INVESTMENT STRATEGY & TEAM

As of September 30, 2010, the Firm
managed assets of $5.8 billion.
Gluskin Sheff became a publicly traded
corporation on the Toronto Stock
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remains 49% owned by its senior
management and employees. We have
public company accountability and
governance with a private company
commitment to innovation and service.
Our investment interests are directly
aligned with those of our clients, as
Gluskin Sheff’s management and
employees are collectively the largest
client of the Firm’s investment portfolios. shareholder-minded management and a
We offer a diverse platform of investment
strategies (Canadian and U.S. equities,
Alternative and Fixed Income) and
investment styles (Value, Growth and
1 September 30, 2010
Income).
The minimum investment required to
establish a client relationship with the
Firm is $3 million.
PERFORMANCE
$1 million invested in our Canadian
Equity Portfolio in 1991 (its inception
date) would have grown to $9.1 million
on September 30, 2010 versus $5.9 million
for the S&P/TSX Total Return Index
over the same period.
$1 million usd invested in our U.S.
Equity Portfolio in 1986 (its inception
date) would have grown to $11.8 million
usd on September 30, 2010 versus $9.6
2 In terms of asset mix and portfolio
million usd for the S&P 500 Total
Return Index over the same period.
Notes:
Unless otherwise noted, all values are in Canadian dollars.
1. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation.
2. Returns are based on the composite of segregated Value and U.S. Equity portfolios, as applicable, and are presented net of fees and expenses.
We have strong and stable portfolio
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teams. Aside from recent additions, our Our investment
Portfolio Managers have been with the interests are directly
Firm for a minimum of ten years and we
aligned with those of
have attracted “best in class” talent at all
our clients, as Gluskin
levels. Our performance results are those
Sheff’s management and
of the team in place.
employees are
We have a strong history of insightful collectively the largest
bottom-up security selection based on client of the Firm’s
fundamental analysis.
investment portfolios.
For long equities, we look for companies
with a history of long-term growth and
stability, a proven track record,
$1 million invested in our
Canadian Equity Portfolio
share price below our estimate of intrinsic
in 1991 (its inception
value. We look for the opposite in
date) would have grown to
equities that we sell short.
$9.1 million2 on
For corporate bonds, we look for issuers
with a margin of safety for the payment
versus $5.9 million for the
of interest and principal, and yields which
S&P/TSX Total Return
are attractive relative to the assessed
Index over the same
credit risks involved.
period.
We assemble concentrated portfolios -
our top ten holdings typically represent
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way, clients benefit from the ideas in
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2
Our success has often been linked to our
long history of investing in under-
followed and under-appreciated small
and mid cap companies both in Canada
and the U.S.
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For further information,
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fundamental analysis and our top-down
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December 10, 2010 – LUNCH WITH DAVE
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