breakfast_with_dave_2011_02_24

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David A. Rosenberg February 24, 2011 Chief Economist & Strategist Economic [email protected]+ 1 416 681 6013

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 networth 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, visitwww.gluskinsheff.com

MARKET MUSINGS & DATA DECIPHERING

Breakfast with DaveWHILE YOU WERE SLEEPING

Global equity markets are taking it on the chin again as the civil war in Libyarages on and investors are left wondering which country is next in line. Algeria?Bahrain? Saudi Arabia? The geopolitical risk premium in the oil price continuesto expand with Brent pushing towards a 30-month high of $120 a barrel - up13% so far this week. It is estimated that as much as 1 mbd of output has beentaken out of the system from the Libya crisis and the outsized move in the oilprice is testament to the view of just how tight the global supply-demandbackdrop has been. Imagine where the price would be if it weren’t for the spare

capacity out of Saudi Arabia. Analysts at Nomura are saying $220 a barrel isachievable if more production is halted in Libya and Algeria.

What is fascinating is to see what the bond market is telling us. Yields continueto fall and are now down around 20 basis points for the long Treasury from thenearby high even in the face of mountains of supply ($29 billion of seven-yearnotes today) and the news of how Bill Gross at PIMCO radically cut his exposurerecently. The bond market is telling you something very important here thatrather than being a permanent source of inflation, what we are witnessing is aglobal exogenous deflationary shock (the impact on discretionary spending inAmerica will be considerable consumers use 140 million gallons of gasolineannually and prices are already up 30 cents so far this year and the run-up is farfrom over). The price of copper is telling you the exact same thing as it rolls over

to a four-week low, though security of supply and hoarding of raw materials ingeneral should help establish a firm floor for all non-oil commodities. The surgein wheat, corn, and soybean prices is also being unwound.

It would seem that the stock market is echoing that sentiment. Europeanbourses are down for a fifth day running that hasn’t happened since lastOctober. The Asian markets are in the loss column for the fourth day in a row the longest losing streak in three months and as a group is now down for theyear.

In the FX market, the Swiss franc and Japanese yen appear to be safe-havensright now the U.S. dollar is actually softening today (the former just made anew high against the greenback). The euro is soft and the sterling just sagged to

a three-week low against it on the back of some very poor retail sales data thatwere released today. And gold is flirting near a seven-week high and again,acting as a hedge against uncertainty in any event on concerns that theturbulence across North Africa spreads as opposed to anything related toaccelerated inflation expectations.

IN THIS ISSUE

•

While you were sleeping:global equity markets aretaking it on the chin againas the civil war in Libyarages on; yields continueto fall

•

Will the oil price be agame changer?

•

Sales up, prices down:existing home sales up2.7% at a seasonallyadjusted rate, medianhome prices collapsed5.9% in January



February 24, 2011 – BREAKFAST WITH DAVE

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Beyond the turmoil that has dramatically raised the price of oil and lifted riskpremia in general, the equity market is also contending with a chorus of Fedofficials who are hinting at an end or at least a pause to the quantitative easings

Charles Plosser from Philly was the latest (and Fisher from Dallas just before).That could mean additional hurdles for Messrs. Dow and Jones because by ourestimation, the U.S. stock markets have tracked the movements in the Fed’sbalance sheet with an 86% correlation since the beginning of 2009.

One last item, the fact that the S&P 500 dipped below the 1,300 thresholdyesterday (intra-day) was very likely a major deal from a technical perspective.The problem of course is that everyone today considers themselves to be anexpert and the memories of 2008-09 have completely faded with sentiment atcycle highs and cash ratios at cycle lows as even the last of the bears threw inthe towel late last year. And because the two extreme emotions fear andgreed will never vanish, the latter took over at the recent highs. We have everyreason to believe that initially, as we saw in the summer of 2007, many folks willmistakenly either stay too long at the top or even buy the dips, because theyhave been conditioned to by Federal Reserve policies, which have been overt intheir objective in bolstering risk appetite and asset values above their intrinsicvalues all in the name of generating an acceleration in consumer spending growth. It’s not fun sitting out a 100% rally as was the case in the past twoyears. But few recall how much more awful it is to partake in a 60% plunge, andthat was barely more than two years ago too. Funny how memories fade.

If you are of the view that a new secular bull market began in March 2009, thenplease follow your beliefs. Secular bull markets tend to last between 16-18years. It will be the first time a secular bull was born from printing money and

the onset of state capitalism.

But if you are of the opinion that what we just witnessed since March 2009 wasa typical cyclical rebound within the confines of a secular downtrend, well, thesetend to last two years (Ned Davis found 34 of these since 1900) and seeaverage gains of 86%. This time around, it was just a month under in durationand 13 percentage points over in magnitude.

Also, if you’re playing the odds, and with all deference to the election cycle, only20% of all the cyclical bull markets from 1900 lasted three years. Again,averages are useful only to an extent. But you know where we stand we havebeen advocating a relatively conservative asset mix which includes a focus ongetting paid an economic rent until the next phenomenal buying opportunity

takes hold. Since so many managers are already long the wazoo and will beforced to ride out this corrective phase, that when the intense selling doescome, we will be able to opportunistically capitalize on the situation.

Everyone today considersthemselves to be an expertand the memories of 2008-09have completely faded withsentiment at cycle highs andcash ratios at cycle lows aseven the last of the bearsthrew in the towel

If you’re playing the odds, andwith all deference to theelection cycle, only 20% of allthe cyclical bull markets from1900 lasted three years




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WILL THE OIL PRICE BE A GAME CHANGER?

First it’s Tunisia.

Then Egypt.

And now Libya.

What makes Libya different from a market’s perspective is that we are nowtalking about an oil exporter in the sudden grips of political upheaval.

In this domino game, the next critical country we have to keep an eye on isBahrain. It is home to the U.S. Navy’s 5 th Fleet. A new regime there could in turnseriously impair America’s ability to patrol and monitor developments in thePersian Gulf and surrounding areas. Bahrain is ruled by a Sunni monarchy andyet the majority of the population is Shiite (and Art Cashin at UBS says that thereis Iranian intelligence that has been planted within the civilian population).

I was in a discussion with an individual from a U.S.-based policy research firmand they are adamant that Bahrain is absolutely critical. If that country falls, itwould generate legitimate concerns about the stability of eastern Saudi Arabiaand further complicate the political backdrop in the Middle East. Remember, theIranians did send in two vessels into the Suez Canal for the first time since 1979with the approval of the new military government in Egypt. This interimgovernment has also allowed a radical mullah back into the country and isreportedly considering opening Egypt’s border with Gaza all the while, Israel isfacing U.N. resolutions on its settlement policies.

I recommend that everyone have a good look at page A8 of yesterday’s NYT more than 100,000 demonstrators turned out at a rally for pro-democracyreforms in Bahrain yesterday. Never before has the monarchy faced such aprotest (the nation itself has a population of 500,000, so 20% showed up for theprotest).

Saudi Arabia has the capacity to fill the void left by Libya, but that misses thepoint. The risk of further unrest is rising, especially with sectarian issues in fullforce in Bahrain. This means that oil prices at a minimum will retain ageopolitical risk premium most oil experts now peg this at $10-$15 a barrel. If countries start to stockpile more crude in light of current events, one can expectthe oil price premium to rise even further even if the situation calms downoverseas. So no matter what, barring a sudden downturn in demand, and the

one thing about oil (food too) is that demand is relatively inelastic over the near-term, the risk is that we will see further increases in the price of crude even fromcurrent lofty levels.

So the bottom line is that there is still more near-term upside potential thandownside risk for the oil price (and most energy stocks). This then will act as atax on consumers and as a margin squeeze for non-oil producers and only whenglobal demand sputters, as it did in the summer of 2008, will the oil price break

Never before has the monarchyfaced such a protest thenation itself has a populationof 500,000, so 20% showed upfor the protest

What makes Libya differentfrom a market’s perspective isthat we are now talking aboutan oil exporter in the suddengrips of political upheaval




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down although it is likely to settle in a new and semi-permanently higher rangeas it did coming out of the global credit collapse.

I believe we are getting closer to the point where the surge in oil prices could tipthe global economy back into recession (we may have already reached thatpoint anyway). My reading of Wall Street research shows that the trigger point forrecession calls would be somewhere around $120 a barrel. As it stands, boththe move in the oil price on a two-year basis and the current level in real termssuggest that the “odds” based on past performance would certainly be betterthan 50-50 as it pertains to the U.S. economy in any event.

We must also look at what is happening from the lens of soaring food costs asonly three times in the past four decades have we confronted a double-digit run-up in both food and fuel prices at the same time. Good news for gas stationsand maybe food stores but not for other retailers.

Twice before the economy landed in a contraction in real terms and once it wasavoided but that was in 1996 after Netscape went public and unleashed the lastleg of the tech mania and the roaring bull market in new-economy equities. Rightnow, we have the food and energy bill siphoning off over 12% of personaldisposable income in the United States, on a decisive uptrend rising aboutthree-quarters of a percentage point since last summer (spending in nominalterms surged at a 22% annual rate in the three months to December whilepersonal income rose by less than 5% - and all that 22% surge in nominalspending did was buy around 7% of groceries and gas in “real unit” terms).

In terms of who are net losers, it pays to see which countries are net exportersand net importers. The U.S., China, Japan, Germany, India, and Korea are thelargest net oil importers in the world. They will get hit the most in terms of negative growth impact. Outside of the Gulf region and other political hot spots,the biggest net exporters are Russia, Norway, Kazakhstan, and … Canada. On arelative basis, these are the winners.

No doubt there will be cries from the crowd that we will be entering a period of stagflation and a return to the 1970s. Statistically perhaps and for a short whilewe will see higher headline inflation and slower economic growth without adoubt. But for a host of reasons, this will not be anything like the 1970s.

For one, organized labour is losing its clout, as we are seeing at the state andlocal government levels south of the border. So without wages exceeding

productivity, which was a 1970s phenomenon, it is unlikely that any inflationarypressure from commodities will last much more than a few months or quarters,as was the case in 2007-08. Unit labour costs declined at a 0.6% annual rate inQ4 and have fallen now in five of the past six quarters. America’s full-employment unemployment rate (NAIRU) may have risen to 6%, but the postedrate is still north of 9%. There is too much excess labour, not in every sector butenough, and much more than we had in the 1970s or early 1980s.

I believe we are getting closerto the point where the surge inoil prices could tip the globaleconomy back into recession

For a short while we will seehigher headline inflation andslower economic growthwithout a doubt, but for a hostof reasons, this will not beanything like the 1970s




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The Fed has printed money like there is no tomorrow, to be sure, but the moneyis still sitting in over one trillion dollars of excess cash reserves on commercialbank balance sheets. The demand for loans by the household sector is in asecular decline as the Fed’s own surveys illustrate, and as such banking sectorcredit contracted at a 4.8% annual rate in January, 5.5% in December, and 0.4%in November. It is very difficult to spread any sort of commodity-related inflationthrough the pricing system with labour costs and bank credit in contractionmode. If we approach 6% unemployment and/or begin to see classic measuresof money velocity (turnover) or the money multipliers begin to expand in ameaningful way, it will be a different story. But those catalysts for a truestagflation cycle are probably years away.

CHART 1: NO INFLATION UNTIL BANKS PUT CASH TO WORK AS CREDIT

United States: Cash Assets – All Commercial Banks ($ billions)

1009080706050403020100

1400

1200

1000

800

600

400

200

Source: Haver Analytics, Gluskin Sheff

CHART 2: DIAL US UP WHEN BANK CREDIT STOPS CONTRACTING

United States: Loans & Leases in Bank Credit: All Commercial Banks ($ billions)

1009080706

Source: Federal Reserve Board /Haver Anal tics

7 6 0 0

7 2 0 0

6 8 0 0

6 4 0 0

6 0 0 0

5 6 0 0

5 2 0 0

Source: Haver Analytics, Gluskin Sheff




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Furthermore, we still have significant pockets of deflation in home prices, whichsank at an 11% annual rate in December and down now for five months in arow. If that persists in the absence of a turnaround in the equity market, thenrest assured that the renewed downdraft we would see in the household networth/income ratio would push the savings rate back on an upward trajectory,largely at the expense of cyclical spending.

So what we are going to likely face is a decline in real personal incomes barring a more decisive recovery in the U.S. labour market. And there is unlikely to beany appetite in Congress to expand the record fiscal deficit to offset thiscontraction so it would be entirely appropriate to expect real spending to benegatively impacted as well. The accelerated cutbacks in spending and highertaxes at the state and local government levels will only serve to aggravate thestress. This, as far as I can tell, is far from being priced into consumerdiscretionary stocks at the current time.

Countries that will at least experience a positive terms of trade effect likeNorway and Canada and as such better currencies will at least see domesticeconomic conditions cushioned somewhat, especially for the consumer.

But for investors more generally, what is key is the prospect of sustainedincreases in commodity prices in the near- and intermediate term, coupled withgreater risk aversion. At a time when the just-released Investors Intelligencereading on market sentiment showed 53.3% bulls and 18.9% bears (lowestsince April 2010), the odds of a significant pullback here in the U.S. equitymarket are fairly sizeable, in my view. Even a 10% correction would only take theS&P 500 back to where it was at the end of November when the market wasgetting all whooped up over renewed acceleration in the economy, QE2 stimulusand post-election euphoria.

SALES UP, PRICES DOWN

Wow. Existing home sales in the United States plunge 30% on a raw basis inJanuary and that somehow shows up as a 2.7% increase at a seasonallyadjusted rate. It would be one thing if the typical seasonal decline in Januarywas smaller than normal but in fact the 30% slide was the fourth steepest in thepast twelve years. It does make you wonder if you should begin believing inconspiracy theories. Furthermore, first-time buyers accounted for only 29% of sales last month whereas a number that generally resembles a well-functioning market is closer to 40%.

At least prices can’t be fudged. With distressed sales making up 37% of theturnover and at bargain basement levels, median home prices collapsed 5.9% inJanuary and at $158,800, now stand at the lowest level since April 2002 anddown over 30% from the 2006 peak.

The unsold inventory at 7.6 months’ supply still reflects a buyers’ market andsuggests that there is more potential for house price deflation. The long-runaverage is closer to six months. While sales turnover has been improving, the

There is unlikely to be anyappetite in Congress to expandthe record fiscal deficit tooffset this contraction so itwould be entirely appropriateto expect real spending to benegatively impacted

Median home prices collapsed5.9% in January and at$158,800, now stand at thelowest level since April 2002and down over 30% from the2006 peak




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