David A. Rosenberg Chief Economist & Strategist drosenberg@gluskinsheff.com + 1 416 681 8919
November 10, 2009 Economic Commentary
MARKET MUSINGS & DATA DECIPHERING
Breakfast with Dave
WHILE YOU WERE SLEEPING Most European and Asian equity markets are up so far today (China up now for 8 days in a row!) though US futures are fractionally in the red. Bonds continue to rally, which is still highly unusual considering the pro-beta and pro-risk strategies that seem to be deployed by the institutional investor base. Or perhaps like the lack of volume, the failure of bonds to sell off and indeed the move in TIPS yields (the “real rate”) to new lows may be in fact a giant non-confirmation over the recovery in the stock market. Valuations remain less than compelling, in our view — according to Bloomberg data the forward P/E is now 17.4x, which is 17% higher than the average of 14.9x. Commodities and the resource-based currencies are taking a bit of a breather today as the USD consolidates at what looks to be the very low end of the recent trading range. On the news flow front, Fitch had some rather unkind words for the U.K. credit rating outlook. Can the U.S.A. be far behind given its fiscal train wreck? But Moody’s did upgrade China’s outlook (currently A1) citing “resilient and robust growth” as well as signs that its banking system has emerged from the credit crisis in relatively good shape. On the data front, there is not much to report on the positive side of the ledger. The German ZEW index of investor sentiment dropped to 51.1 in November from 56.0 (consensus was looking for 55.0). This sets the stage for a weak Ifo reading ahead as enthusiasm morphs into realism. Meanwhile, global deflation is still the name of the game with the German CPI surprisingly dipping 0.1% MoM in October even in the face of higher oil prices, and this followed on the news of the 0.4% MoM deflation in Germany’s PPI too. Italy posted a woeful 5.3% slide (-15.7% YoY) in September industrial production. Japan’s forward-looking ‘economy watchers’ index fell to 40.9 in October from 43.1 in September as consumers there are turning more cautious. Those hoping for a job market revival in the U.S.A. had their expectations dashed overnight with the news that Sprint Nextel is about to slice 6% from its payroll (2,000-2,500 jobs affected) and Electronic Arts plans to cut 17% of its workforce. Economists are now quickly adjusting their estimate of where the unemployment rate is going to peak (and when) — a week ago, it was supposed to be 10% by the first quarter of next year — we now see that folks like Mark Zandi at Moody’s.com just lifted his forecast to 11% by the mid-point of next year. IN THIS ISSUE • While you were sleeping — most European and Asian stock markets are up today; bonds around the globe are rallying; Moody’s upgrades China’s outlook, while Fitch had some unkind words for the U.K.’s credit rating outlook • These belong in Ripley’s — the U.S. 3-year Treasury note auction yesterday was well received, gold soars to a record high, U.S. equity markets rallying once again • Another myth and reality diatribe — the Fed’s Loan Officer Survey suggests a thawing out in lending guidelines, but what is apparent is that credit demand is contracting • Frugality still intact in the U.S. • Deflation pressures also remain intact • U.S. corporate earnings … the good and the bad • A bond cult? Retail investors have plowed a record $214bln into bond funds • Something big is about to happen — just take a look at the latest Commitment of Traders report • Cash ratios have sagged in high yield and equity funds
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
November 10, 2009 – BREAKFAST WITH DAVE
In any event, the last leg of the rally in risk assets seems to have come from the comments last week from the Fed and over the weekend from the G20 that government stimulus remains the name of the game. The punchbowl is intact — imagine the desperation involved in expanding a housing tax credit from a firsttime buyer to a trade-up buyer at a time when the fiscal deficit is already 10% relative to GDP! It is hard to tell how far this is going to go but it is not sustainable. This symbiotic relationship between the markets having come to rely exclusively on government stimulus measures to bolster economic and earnings expectations on the one hand, and governments offering up repeated rounds of intervention in order to generate asset inflation as an antidote to a jobless recovery on the other hand, is unstable, in our opinion. We can’t see this ending well — this is definitely not a private-sector led secular bull market circa 1982; that much we know. Moreover, for a look at the challenges facing not only the government sector, but also banking sector finances, have a look at these two “looming” articles in today’s FT (Threat From Large Budget Deficits Looms on page 25 and Banks Face High Costs as $7,000bn Short-Term Debt Refinancing Looms on the front page). There is a 70% historical inverse correlation between the direction of government deficits-to-GDP and the price-earnings multiple in the equity market. So we will make no bones about the government’s ability to create growth by either borrowing money or taxing the public in the future, but the major point is that government-led growth deserves a lower-than-average multiple, not an above-normal multiple. And yet, even on a Shiller normalized basis, we have a market that is still overvalued by roughly 20%. While momentum and speculation are keys to the current rally, these are never alluring or enduring features for a fundamental economist and strategist. There remains too much risk in equities for our liking, as impressed as we are with the Dow managing to just reach a 13-month high. THESE BELONG IN RIPLEY’S Ahead of a record week of new government supply in the U.S., the demand for the 3-year Treasury note at yesterday’s auction was unbelievable. It drew a 1.40% yield, which was 3bps through the auction bid deadline level. And indirect bidding also took up 68.6% of the auction, which in part reflects a very healthy foreign central bank appetite for Uncle Sam’s obligations. At the same time, gold, the antithesis of U.S. government credit quality, shot up to yet a new record high. Then we have the equity market, which, despite ongoing contractions in credit and employment, is approaching its bear-market-rally highs (in fact, the Dow has already accomplished that). But the rub remains that these distribution sessions where the gains are exaggerated by light volume (barely over a billion shares on the Big Board? Are you kidding? After a 16.6% plunge on Friday, volume in yesterday’s session was still far below normal and the second lowest in the past two weeks). This is a sign that conviction over the current rally remains unusually light.
We can’t see this ending well — this is definitely not a private sector led secular bull market circa 1982
Gold, the antithesis of U.S. government credit quality, shot up to yet a new record high
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November 10, 2009 – BREAKFAST WITH DAVE
The U.S. dollar traded down to a 15-month low, which may help partly explain the continued run-up in gold, though bullion is in a bull run against most currencies; and the weak dollar is widely considered as the genesis for the ‘carry trade’ rally in risk assets, though many countries outside the U.S.A. also have their funding costs near zero. It would seem that investors are optimistic on the future insofar as governments and central banks around the globe are going to damn-thetorpedoes-and-go-full-steam ahead and act as the consumer of first and last resort for their economies. The fact that the U.S. government, at a time when the deficit/GDP ratio is already at record levels of 10%, feels compelled to:
• Extend jobless benefits for up to two years (why not just put these folks on the
The U.S. dollar is now down to a 15-month low, which may help partly explain the continued run-up in gold
government payroll? At least the unemployment rate will start to go down).
• Expand the homeowner tax credit. • Provide tax breaks to homebuilders (the ones who helped get us in to this
mess).
• Provide businesses with tax credits for new hires. • And bump up social security payments once again.
All this really attests to how rotten things are beneath the surface. No doubt that all the government stimulus is going to provide some impetus to corporate profits, but what exactly is the fair-value P/E multiple in a period of state capitalism is a legitimate question. ANOTHER MYTH AND REALITY DIATRIBE The Fed’s latest Loan Officer Survey was released yesterday and suggested a bit of a thawing-out in the excessively tight lending guidelines within the banking sector over the past several quarters. Roughly 15% of commercial banks, on net, were still tightening loan standards for businesses but this is about half the share of three-months ago (even credit standards to small companies, while still tight, are less so). On consumer loans, again there were 15% of banks, on net, that were still tightening their standards, but that figure was at 35% back in July. However, what did catch our eye was that even with nascent recovery signs in housing, a net 26% of the banks polled had tightened residential real estate loans for “prime” borrowers over the past three months — actually higher than the 22% who had done so in the three months to July. And, 30% of the banks stated that they had tightened guidelines on home-equity lines of credit (about the same as three months ago), ostensibly not sharing the widespread view among mainstream economists that home prices have necessarily turned the corner. The Fed’s survey did suggest that while still tight, bank lending standards are becoming less tight, and what is apparent (especially since aggregate bank credit is still contracting at nearly a 15% annual rate) is that the demand for credit is in decline. This is totally consistent with our view that frugality and cash-conservation have indeed become secular themes. Some examples may be in order (and check out today’s USA Today for more on this file):
The latest Fed Loan Officer Survey suggests that bank lending guidelines are getting less tight …
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November 10, 2009 – BREAKFAST WITH DAVE
At Bank of America, total commercial loans fell to $330 billion in Q3 from $345 billion. According to CEO Ken Lewis, “clients are obviously conserving cash ... they’re not using their lines … in some cases, people are actually permanently cutting down.” The word “permanently” resonated with us — this is what a secular trend is all about. At SunTrust, commercial loans contracted $3 billion or 8% last quarter, prompting CEO Jim Wells to say “the sustained economic weakness has reduced the demand for loans as many clients have focused on capital preservation.” It is painfully obvious that companies are cutting credit lines to preserve cash and also as an expression over their economic outlook even with all the government incursion. Even the larger retailers are cutting back — J.C. Penney just reduced the size of its credit facility to $750 million from $1.2 billion earlier this year. Two years into the credit collapse, the name of the game for many companies, maybe not the large ones with global exposure and can benefit from the artificial competitive boost a weak U.S. dollar provides, but for many companies nonetheless, is survivability. FRUGALITY STILL INTACT It’s all on page B2 of the USA Today – Companies Cut Back on Holiday Gift Giving (a third of small business owners are giving their workers a gift this year, down from 46% last year; only 47% are giving presents to customers and this compares to 52% a year ago ... amazing); and Fewer Fliers Likely For Turkey Day — passenger traffic is expected to be down 4% from a year ago this coming U.S. Thanksgiving holiday. DEFLATION PRESSURES INTACT This may be one reason why government bonds refuse to sell off despite the surge in the equity market. The Wall Street Journal reports that companies like Clorox is keeping prices stable on items like its new and improved trash bags. Campbell’s Soup is cutting prices on select beverages (like V8). Burger King is selling double cheeseburgers for a buck. And, what’s this about RIM starting up a smartphone price war? According to a new holiday season poll taken by Deloitte, 74% of respondents intend to only buy items on sale or with discount coupons. The same survey indicates that holiday shopping will be flat year-over-year this year, which at one point would have been amazingly bullish but at this stage is likely a setback for the stock market. Keep in mind that Wal-Mart is now expecting 1.0%-2.0% sales growth into January 2010 whereas a year ago that expectation was in a 5.0%-7.0% range. If there is some good news for retailers, it is that they are heading into the shopping season with fairly lean inventories — that won’t prevent but should help limit ultra-steep markdowns this year.
… But the reality is that demand for credit is in decline
Good news for the retailers going into the holiday shopping season is their lean inventories
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November 10, 2009 – BREAKFAST WITH DAVE
CHART 1: SAVING GRACE FOR RETAILERS — RECORD LOW INVENTORYTO-SALES RATIO HEADING INTO THE HOLIDAY SHOPPING SEASON
United States: Retail Sector, excluding autos, Inventory-to-Sales Ratio (ratio)
1.6
1.5
1.4
1.3
1.2 98 99 00 01 02 03 04 05 06 07 08 09
Source: Haver Analytics, Gluskin Sheff
EARNINGS ... THE GOOD AND THE BAD First the good, U.S. companies are beating their Q3 earnings estimates by a record pace thus far (at least in the past 15 years). Fully 80% of the universe is beating their targets. What is normal is that companies “beat” their estimates, on average, by 1.9% — but with 440 of the S&P 500 reporting, the “beat” has averaged 14.9%, which is unprecedented. As for the bad, cost-cutting and productivity enhancements are still dominating the trend — only 58% have managed to surpass revenue expectations. A BOND CULT? Over the past six months, retail investors have plowed a record $214 billion into bond funds. Add in hybrids, and that number becomes $236 billion. And in the face of the temptation from a 60%+ equity rally, how much has the private client put into equity funds, on net, in the past six months? Try $45 billion, and less than $20 billion for capital appreciation funds. This is a golden age for fixedincome, as the boomers become coupon clippers. As Chart 3 shows, the fixedincome share in household assets has risen to just over 6% but still has a ways to go before it gets back to the old peaks when diversification was in (real estate is still 30% of household assets and equities 25%). So the potential in terms of dollars and cents is another $1.3 trillion of fixed-income exposure after the near $800 billion that has already been added by Ma and Pa Kettle since the credit crisis began two years ago. At least that’s enough to cover a year’s worth of U.S. government deficits!
Retail investors have plowed a record $214bln into bond funds; only $45bln went into equity funds
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November 10, 2009 – BREAKFAST WITH DAVE
CHART 2: RECORD INFLOWS TO BOND FUNDS
United States: ICI All Bond Funds: Net Cash Inflow (6-month moving total, US$ millions)
225000
150000
75000
0
-75000 99 00 01 02 03 04 05 06 07 08 09
Source: Haver Analytics, Gluskin Sheff
CHART 3: BOND SHARE OF U.S. HOUSEHOLD ASSETS AT 6% AND RISING
United States: Household Credit Market Assets as a share of Total Assets (4-quarter moving total, percent)
8.25
7.50
6.75
6.00
5.25
4.50
55
60
65
70
75
80
85
90
95
00
05
Source: Haver Analytics, Gluskin Sheff
SOMETHING BIG IS ABOUT TO HAPPEN Looking at the latest Commitment of Traders (COT) report, we can see some pretty interesting (and potentially disturbing) trends taking place (data for November 3rd):
• The only areas where the speculators (non-commercial accounts) are net
short are in Treasuries and in the U.S. dollar. Everything else has massive net speculative longs and hence near-term vulnerable to a reversal.
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November 10, 2009 – BREAKFAST WITH DAVE
• There is still a NET speculative short position in both the 10-year Treasury
note of 85,551 contacts (on the Chicago Board of Trade). There are 95,648 net short contracts on the long bond too.
• But there are 29,608 net LONG positions on the 30-day Fed funds contract —
down from the highs, but it means that Fed tightening is completely off the radar screen. At the same time, there are 152,311 net longs on the 2-year Treasury note, so it would seem as though we have a crowded trade among the speculators on a bear curve steepening trade. contracts on the Chicago Mercantile Exchange (CME).
• There is a significant net long position on the S&P 500 to the tune of 208,448 • There is also a huge net speculative short position on the U.S. dollar (the
‘carry trade’). For example, on the CME, we have 24,389 net speculative long CAD positions; 50,264 net speculative long contracts on the Australian dollar, and 28,036 net longs on the Euro. These are huge numbers. What happens if/when the U.S. dollar ever undergoes a countertrend rally? near-term bearish) … 271,564 gold contracts (a record) on the Commodity Exchange (COMEX); 44,312 net longs on silver (near-record but not quite), West Texas Intermediate oil contracts on the New York Mercantile Exchange (also a record); 10,871 net long copper contracts (a new cycle high); 5,538 net speculative long contracts on the Goldman Sachs Commodity Index.
• The largest speculative long positions are in the commodity space (this is
CASH RATIOS HAVE SAGGED IN HIGH YIELD AND EQUITIES, BUT INVESTMENT GRADE CORPORATE BOND MANAGERS HAVE SURPLUS CASH U.S. corporate bond fund (investment grade) managers have around 8% cash which is a 19-year high. These guys have ‘buying power’ – spreads may come in further given this dry powder. CHART 4: Corporate Bond Fund Managers Have About 8% Cash
United States: ICI: Corporate Bond Funds: Liquidity Ratio (percent)
16
12
8
4
0
-4 85 90 95 00 05
Source: Haver Analytics, Gluskin Sheff
Those PMs managing high-yield bond funds have used up half their cash during this rally – could be more left but this is a clear gap versus the ‘excess cash’ in the investment-grade space.
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November 10, 2009 – BREAKFAST WITH DAVE
CHART 5: PORTFOLIO MANAGERS MANAGING HIGH YIELD BOND FUNDS HAVE USED HALF THEIR CASH
United States: ICI: High Yield Bond Funds: Liquidity Ratio (percent)
12.5
10.0
7.5
5.0
2.5 85 90 95 00 05
Source: Haver Analytics, Gluskin Sheff
As for equities, cash ratios have sunk to 3.8%, where they were at the Oct/07 market highs (at the market lows, the ratio was 6%). CHART 6: THE CASH RATIO FOR PORTFOLIO MANAGERS MANAGING EQUITY FUNDS Have Sunk To 3.8%
United States: ICI: All Equity Funds: Liquidity Ratio (percent)
14 12
10
8 6
4
2 85 90 95 00 05
Source: Haver Analytics, Gluskin Sheff
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November 10, 2009 – BREAKFAST 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
As of September 30, 2009, the Firm managed assets of $5.0 billion.
INVESTMENT STRATEGY & TEAM
We have strong and stable portfolio management, research and client service teams. Aside from recent additions, our Gluskin Sheff became a publicly traded Portfolio Managers have been with the corporation on the Toronto Stock Firm for a minimum of ten years and we Exchange (symbol: GS) in May 2006 and have attracted “best in class” talent at all remains 65% owned by its senior levels. Our performance results are those management and employees. We have of the team in place. public company accountability and We have a strong history of insightful governance with a private company bottom-up security selection based on commitment to innovation and service. fundamental analysis. For long equities, we Our investment interests are directly look for companies with a history of longaligned with those of our clients, as term growth and stability, a proven track Gluskin Sheff’s management and record, shareholder-minded management employees are collectively the largest and a share price below our estimate of client of the Firm’s investment portfolios. intrinsic value. We look for the opposite in We offer a diverse platform of investment equities that we sell short. For corporate strategies (Canadian and U.S. equities, bonds, we look for issuers with a margin of Alternative and Fixed Income) and safety for the payment of interest and investment styles (Value, Growth and principal, and yields which are attractive 1 Income). relative to the assessed credit risks involved. The minimum investment required to establish a client relationship with the Firm is $3 million for Canadian investors and $5 million for U.S. & International investors. We assemble concentrated portfolios — our top ten holdings typically represent between 25% to 45% of a portfolio. In this way, clients benefit from the ideas in which we have the highest conviction. Our success has often been linked to our long history of investing in underfollowed and under-appreciated small and mid cap companies both in Canada and the U.S.
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.
$1 million invested in our Canadian Value Portfolio in 1991 (its inception date) would have grown to $15.5 million2 on September 30, 2009 versus $9.7 million for the S&P/TSX Total Return Index over the same period.
PERFORMANCE
$1 million invested in our Canadian Value Portfolio in 1991 (its inception date) 2 would have grown to $15.5 million on September 30, 2009 versus $9.7 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 $11.2 million 2 usd on September 30, 2009 versus $8.7 million usd for the S&P 500 Total Return Index over the same period.
Notes:
PORTFOLIO CONSTRUCTION
In terms of asset mix and portfolio construction, we offer a unique marriage between our bottom-up security-specific fundamental analysis and our top-down macroeconomic view, with the noted addition of David Rosenberg as Chief Economist & Strategist.
For further information, please contact questions@gluskinsheff.com
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November 10, 2009 – BREAKFAST WITH DAVE
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