David A. Rosenberg Chief Economist & Strategist drosenberg@gluskinsheff.com + 1 416 681 8919
November 16, 2009 Economic Commentary
MARKET MUSINGS & DATA DECIPHERING
Breakfast with Dave
WHILE YOU WERE SLEEPING We finished last week with gains in the major averages despite adverse economic news (see below). Volume was once again very light in a reminder that this goes down as the most non-conviction rally of all time. For example, in the past five weeks the Nasdaq has managed to post just two rallies on higher volume. In fact, households have become net sellers of equity funds once again and continue to focus their attention on bonds, hybrids, and commodities — commodity fund inflows are rising at such a clip that assets under management are fast approaching the peak of $270 billion, which was last seen in 2008 when oil prices were flirting with $150/bbl. Investors across the globe have also bought more than $2.7 trillion of new corporate bonds this year, a record (Dealogic data) — contrast that with the $1.7 trillion in all of 2008. Overnight we have seen solid gains in global equities, with three pieces of news fuelling the rally: 1. The APEC meeting (Asia-Pacific) ended with a Fed-like press statement pledging to maintain government stimulus until there is “durable growth” — this followed the similar message out of last week’s G20 meeting (with the commensurate ‘nudge, nudge, wink, wink’ acceptance of the weak U.S. dollar policy, which has reinforced the global carry trade). Exit strategies are clearly not being contemplated. Bernanke is likely to reiterate that message in a speech today at 12:15 pm (EST). Japanese real GDP came in much better than expected, at +4.8% at an annual rate for Q3 versus consensus estimates of +2.9%. Although it must be noted that this GDP number was skewed by a 2.6% plunge in the domestic demand price deflator; the improvement was bolstered by huge government stimulus and a 6.5% surge in exports; the consumer barely contributed — but all that matters to Mr. Market, just as we saw in the U.S.A. a few weeks ago with the magical to-be-revised 3.5% GDP gain, is the headline. Don’t complicate the issue with details. Moreover, with the help of continued massive government subsidies (the real story behind the global recovery as the public sector becomes a true partner with the private sector everywhere), car sales in Europe rose 11% YoY in October — the fastest pace in three years. U.S. data on outbound and inbound shipments from the Ports of L.A. and Long Beach showed considerable improvement in October (and this followed the export/import bounce in the September trade data) — imports at -14.7% YoY (versus -17.2% in September) and exports at +1% (versus -8.6% in September). IN THIS ISSUE • While you were sleeping — risk trades are back on the table overnight • Lakshman, where are you? The ‘foolproof’ ECRI leading economic index dropped 1.4 points last week and is now at an 8-week low • U.S. consumer confidence takes a big hit • The frugality story just won’t go away • Credit contraction is an ongoing deflationary event • Structural job market changes in the U.S. • Is this the best money can buy? • Class warfare coming your way • Why this is not the onset of a new secular bull market — comparisons with August 1982
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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 16, 2009 – BREAKFAST WITH DAVE
3.
We saw another reminder of how non-existent inflation is even with the commodity surge as the CPI for the EMU came in at +0.2% MoM in October, which was below the +0.3% print that was generally expected (the YoY was -0.1%). It is price data like this that have underpinned the bond market, with yields down across the G7 today from between 1-5 basis points. The only piece of data that was worrisome was the Rightmove survey in the U.K. that showed home prices slipping 1.6% in what was the first decline in three months.
Risk trades are back on the table — emerging markets are up, and commodities on the rise
So to start off the week, risk trades are back on the table. Emerging markets are leading the pack. Commodities are on the rise with gold up 1.3%, to $1,133/oz after doing a very nice job hanging on to its gains as last week drew to a close. Copper and oil are firm as well. It would seem to make sense to see the U.S. dollar embark on some sort of near-term short-covering rally but it is not happening as of this moment with the DXY merely bouncing along the bottom of 75 on the index. The Yen and the Pound are weak today too, but the Euro and resource-based currencies are strong — these are pro-beta ‘carry trade’ signs out of the FX market that cannot be ignored. LAKSHMAN, WHERE ARE YOU? The Economic Cycle Research Institute (ECRI), under the auspices of Lakshman Achuthan, publishes a leading economic indicator for the U.S. — when it was surging in the spring when the ‘green shoots’ were sprouting, this fellow was on bubble-vision practically daily with the good news. Well, this allegedly foolproof leading index dropped 1.4 points last week and now stands at an eight-week low. We’ll see if he gets invited back on TV in the next little while. As an aside, S&P 500 operating earnings are coming in north for $15 for Q3, a quarter in which GDP growth came in at a 3.5% annual rate. Few believe we will sustain that growth rate but think about it for a second, the best we could do with 3.5% growth was an annualized earnings figure of $60 for operating EPS. So where does this thought process come from that we are going to be seeing anything close to $80 of earnings for 2010 — what the equity market has de facto priced in — with a consensus view that we will only see 2.5% GDP growth for next year? In the latest fiscal foray, the Administration is using taxpayer money to subsidize the homebuilders — no other sector in the economy receives so much favorable treatment and yet the industry adds so little to productivity growth. As part of the extension of Fiscal Stimulus 1 (they don’t dare call this Fiscal Stimulus 2 for fear of losing all the independent voters):
• Jobless benefits have been extended a further 20 weeks; • The first-time home buyer tax credit has not only been extended to April but
As part of the extension of Fiscal Stimulus 1, the U.S. Administration is using taxpayer money to subsidize the homebuilders
expanded to include repeat trade-up buyers;
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• And, believe it or not, the homebuilders, the folks who helped get us into the
mess we are in today through their irresponsible overproduction strategies, are going to receive a massive stimulus from the federal government in the form of carry forward provisions allowing the companies to offset losses incurred in 2008 and 2009 against profits booked as far back as — get this — 2004! This is despite the fact that, as Ivy Zelman points out, the homebuilders are sitting on a ton of cash. This is truly a fiscal policy that is trying far too hard to pursue the old ways of over-consumption, over-borrowing and over-building and it is a policy that is doomed to failure. See Home Builders (You Heard That Right) Get a Gift by Gretchen Morgenson on the front page of the Sunday NYT biz section. CONSUMER CONFIDENCE TAKES A BIG HIT The University of Michigan consumer sentiment survey for November flashed a giant red flag over the upcoming holiday shopping season — faltering to 66.0 in November from 70.6 in October and there wasn’t a Street economist who was in the ball park. Sentiment is at its lowest level in four months and barely above April levels — the S&P 500 is up about 60% from the lows but nobody ever said that the stock market and the economy had to agree 100% of the time. What really caught our eye was the fact that the ‘economic outlook’ component, which does have this nasty habit of depicting looming trends in consumer spending, slid badly in November, to 63.7 from 68.6; not to mention the fact that confidence fell across every region, age cohort and income category. This was one miserable report! There were plenty of interesting data-points. Income expectations fell to 118 from 132 in October to stand at a six-month low. This stems from a very downbeat assessment of the labour market landscape because the index measuring higher unemployment expectations climbed to 43 from 36. The spending intentions components were scary in view of all the government stimulus being put into the system. Plans to buy a home slipped to 146 from 156 in October — the lowest reading since April and this is with the extension and expansion of the homebuyer tax credit to beyond first-time buyers (very funky policy). Despite cash-for-clunkers, which helped create that magical 3.5% GDP growth rate in Q3 (soon to be revised to 3.0% in the aftermath of that sharp deterioration in net exports in September) auto buying plans plunged to a 12month low of 118 in November from 124 in October (and the 139 nearby peak during the peak of the C-for-C frenzy in August).
Truly, this is a fiscal policy that is trying far too hard to pursue the old ways of over-consumption, overborrowing and overbuilding; a policy that is doomed to failure
U.S. consumer confidence, as per the University of Michigan consumer sentiment index, faltered in November, to 66.0 from 70.6 in October
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While the UofM poll did show near-universal belief that things are better now than they were a year ago (the index measuring where we are now compared to November 2008 rose to 63 from 59), expectations on how economic conditions will be a year from now eroded sharply, to 115 in November from 118 in October and 127 in September, and that says a lot. A lot in terms of what economists are saying and the actual economic agents who drive the economy are saying about the future. The economists do indeed have the models that the layperson does not have but the problem is that these models are flawed because they contain some linear extrapolation from a typical post-WWII recession that have absolutely nothing to do with a post-bubble credit collapse. As a measure of just how much uncertainty there is over the holiday shopping season, J.C. Penney issued a much wider-than-usual range on its revenue forecast (after a 78% plunge in Q3 profit) and we did see very recently some cautious guidance being offered by the likes of Wal-Mart, Kohl’s and Macy’s. Department stores have posed negative YoY sales numbers now for over a year and “trading down” has emerged as a secular frugal theme that has benefited discounters, such as T.J. Maxx, Marshall’s and Wal-Mart too. THE FRUGALITY STORY JUST WON’T GO AWAY When champagne sales are going down and prices being cut, even in the midst of a 60%+ rally in the stock market, you know that we are into a secular theme of thrift even among the well-heeled among us. Have a look at Champagne Sales are Going Flat on page B1 of the Saturday NYT. And believe me, it’s not just the high-end that is hurting still — according to the NPD Group, restaurant sales in the U.S.A. are down 3.0% since the summer, the steepest decline in decades (see What’s Eating McDonald’s on page 32 of BusinessWeek). CREDIT CONTRACTION IS AN ONGOING DEFLATIONARY EVENT It does appears to me that the biggest difference between our view and the rest of the economic community is that we believe that recovery won’t occur to nearly the extent as the consensus because household credit is in freefall and still has a long way to go, say, down to 60-70% debt/disposable income versus 140% at the peak in 2007. Any talk of economic recovery must assume that credit ratios at least go sideways from here and probably start expanding. The consensus crowd thinks that current debt levels are okay, even if household debt-todisposable income ratios were in the 35% range back in the 1950s. You have to be a maniac to think debt goes down that far, right? The news from last week about the “lease for deed” swap being initiated by Fannie Mae is just the tip of the iceberg for “mortgage (principal) modification” going forward. At the margin, the supply of bank-owned homes should mushroom. Fannie Mae’s new policy rests on the fact that lenders made a bad bet in recent years and they have to pay the price. Keep in mind that bad loans were made for purchases and refinancings, as well as home equity loans.
“Trading down” has emerged as a secular frugal them that has benefited discounters
The biggest difference between our view and the consensus view is that we believe a recovery can only happen once the household sector has significantly lowered its debt burden
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A record share of mortgage borrowers are already “under water" and the numbers will grow until the house price collapse runs its course. Lenders are better off keeping the foreclosed occupant as a tenant for obvious reasons. First, the lender has an asset that generates some revenue. Second, the lawn gets mowed and the plumbing stays. Upside down homeowners gain mobility and are relieved of all that debt, taxes and maintenance expense. The prevailing rental expense is likely to be a fraction of the cost of ownership. Many homeowners are highly motivated to downsize, both for demographic reasons and because the “new era” beliefs on house appreciation that prevailed at the recent bubble peak caused massive over consumption for investment reasons. You can’t pursue frugality with a couple of extra bedrooms in inventory. Once again, at the margin, those households who are over-housed and under water are much more likely to be willing to hand over the keys. Put simply, the lenders are going to have to deal. I can imagine that lenders all up and down the home price spectrum will find themselves offering significant principal reduction to households based on the loan-to-value equation rather than just the ability on the part of the household to service the debt. Most home purchase loans are non-recourse and the IRS has waived the tax liability that used to apply when homeowners defaulted on mortgage debt. What other mechanisms can dramatically reduce the household debt-todisposable income ratio? One primary method is debt liquidation — assets are sold and the proceeds are used to extinguish debt. Obviously, the house can be sold to pay off the mortgage. That leaves the problem of where to live, but once again, if you want to be frugal, rent a nice two-bedroom town house. It’s bound to be much, much cheaper than keeping the four bedrooms on 3/4 of an acre house. Debt can also be liquidated by selling investment assets or drawing down cash balances and paying off debt. This is sounding very deflationary. Another method of reducing household debt is through budgeting. Budgeting to reduce debt takes two forms: 1. Forgoing purchases that involve credit, and; 2. Reducing consumption so that more of the household income can be spent on paying off existing debt. STRUCTURAL JOB MARKET CHANGES IN THE U.S. Again, the consensus of economists who believe that a peak in the unemployment rate is now a first-quarter event will have to end up revising their estimates yet again. It takes two to three months for the unemployment rate to lag the business cycle in a typical post-WWII manufacturing downturn, but 1-2 years in an asset and credit cycle. The jobless rate is going to go much higher — 12% to 13% — and with it new highs in consumer delinquency rates and new highs in terms of government intervention … especially in an election year.
There are many ways households can reduce their debt burden, for example, budgeting
In a typical manufacturing downturn, the jobless rate lags the business cycle by 2-3 months…
… however, in a asset and credit correction, the lag is more like 1 to 2 years
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All anyone needs to do is go to the Kansas City Fed website and have a read of their latest economic report titled How Will Unemployment Fare Following the Recession?. Well, here are some clues (and they lead to deflation, not inflation — but gold is a hedge against both outcomes!): “To the extent that these structural changes in the labor market [editorial note: permanent job losses and a banking crisis] have persisted through the current recessions, it is distinctly possible that unemployment going forward may not decline as rapidly as it did following other severe recessions.” Indeed, we conducted our own research into the matter, and found this: Even with the labour force participation rate at a quarter-century low, we have seen the unemployment rate jump to 10.2% this cycle. If the participation rate had followed the pattern of the economy that is now being depicted by the stock market, the guru after all of all economic forecasting, the jobless rate would be well clear of 11% by now. Count in all forms of under-employment, and the jobless rate is really 17.5%. For every job opening, there are still six unemployed vying for each position — underscoring the magnitude of the excess supply overhanging the labour market. Outright deflation in wages, rents and credit, not to mention consumer and producer prices, are the prime factors explaining why bonds managed to behave so well last week even in the face of record government supply issuance. During this two-year down-cycle, there have been 10.2 million full-time job losses. Normally, recessions eliminate two million of these and at no other time has there ever been more than six million full-time positions eliminated in even the most severe recession. The Household Survey also measures the increase in the ranks of the unemployed owing to non-temporary factors (ie, permanent layoffs) and again, these totaled a record 3.5 million this cycle and accounted for 45% of the swelling in joblessness. On average, these permanent job losers amount to little more than 600,000 or 30% of the total jobless tally. The share of the unemployed who have been looking for work with futility for at least six months has risen to an unheard of 35.6% level. This ratio usually peaks out at 19% and never prior to this cycle did it peak below 26%. The average duration of unemployment, which normally peaks at 16.6 weeks in recessions, is now up to an all-time high of 26.9 weeks. So this recession is deemed to be over because — come again? — the S&P 500 is up 60% from the low and because we have one quarter of positive GDP growth in the face of rampant government intervention? It is incredibly hard to square the end of a recession with both employment and real incomes still hitting new lows, but the National Bureau of Economic Research (NBER) managed to find a way in late 2001.
During this two-year downcycle, we have seen 10.2 million full-time jobs lost; normally we would see a little over two-million eliminated
The percentage of those unemployed who have been looking for work for at least 27 weeks has risen to an unheard of level of 35.6%
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Let’s just say that with there being six job openings for every unemployed worker and with the economy now over 10 million jobs shy of becoming in equilibrium between labour demand and labour supply we feel that deflation pressures will carry the day even with the offsets from a weaker U.S. dollar and higher commodity prices. IS THIS THE BEST MONEY CAN BUY? The OECD already estimates that U.S. federal government stimulus has been so large that it is equivalent to 5.6% of GDP, so if the economy isn’t growing, even artificially, then there is clearly something very wrong. Meanwhile, all the stimulus was supposed to cap the jobless rate at 8.5% and that clearly hasn’t happened, and now the White House is claiming that its actions helped save 640,000 jobs from being destroyed. How exactly are we supposed to get excited about that when we‘ve lost 1.8 million household jobs in just the three months alone, not to mention what drop in the bucket that number is in the context of over 10 million full-time positions being eliminated from the economy since the recession began two-years ago. In fact, the measures to reinvigorate an industry in secular decline like housing has ended up exerting its own distortions because the Federal Housing Administration (FHA) is now facing a 8.24% default rate as it carries out government orders to lend aggressively and with only 3.5% down-payment requirement — the default rate was 6.1% a year ago. We are at the point where capital reserves (0.53%) have fallen below mandated thresholds (2.0%) and there can be little doubt that the agency is going to be the next target for a federal bailout. CLASS WARFARE COMING YOUR WAY We have to admit that we cannot recall a time when the potential returns in Canada looked so attractive compared to the U.S. while the risks are so much lower — fiscal, economic, financial and political. Now we see that Senate Majority Leader Harry Reid is planning a slate of tax rate hikes on the upper class (defined to mean anyone making over $250k) — like a medical payroll tax on high-income earners (a $50 billion drag on purchasing power for this group) not to mention the $460 billion confiscation being planned as part of a new 5.4 percentage point surtax (high-income earners in Ontario will recall those from the early 1990s). No wonder immigration into Canada is running at a 4% annual rate and foreign applications at Canadian universities surging at a 7% annual rate at this time — the reverse brain-drain is in. The state governments are already moving in to tap the “rich” as a source of revenue mimicking the 10.55% surtax that California levels on anyone making over a million bucks. Hawaii has enacted an 11% top rate on those earning over $250,000. New Jersey has brought in a 10.75% rate on those making over $1 million too. As state after state follows suit, we’ve got news for you — Canada is looking more and more attractive each passing day. See States Grab ‘Millionaire’s Tax’ on page B2 of the weekend WSJ.
We cannot recall a time when the potential returns in Canada looked so attractive compared to the U.S.
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Also have a look at today’s USA Today at the growing trend of Americans seeking their fortunes elsewhere — this is new! Fifty-four percent of executives said they would be likely, or highly likely, to accept a foreign post, according to a survey of 114 executives by talent management company Korn/Ferry. Just 37% of those surveyed in 2005 said they'd go abroad. At MIT's Sloan School of Management, 24% of 2009 graduates got jobs overseas, up from 19% last year. WHY THIS IS NOT THE ONSET OF A NEW SECULAR BULL MARKET — COMPARISONS WITH AUGUST 1982 • P/E Multiples were 8x, not 26x.
• Dividend yields were 6%, not sub-2%. • The stock market was trading at a discount to book, not a 2x premium. • Monetary policy was aimed at reducing money growth and inflation rates, not
Indeed, according to a Korn/Ferry survey, 54% of executives said they would be likely, or highly likely, to accept a foreign post
creating both as is the case now.
• Fiscal policy was aimed at reducing nondefense spending, not accelerating it. • Deficits were peaking and coming down, not surging to 10%+ relative to GDP. • Global trade barriers were being torn down; not erected. • Deregulation back then was in; today it is all about re-regulation and
government ownership.
• Union membership was on the way down; today it is back on the rise. • The dollar was entering a Plaza Accord bull market, not a mercantilist bear
market.
• Credit, household balance sheets and participation rates were expanding, not
contracting.
• Tax rates, income, capital gains and dividends, were declining then; rising now.
In 1982, Ronald Reagan was President (two consecutive terms as Governor of California), Don Regan was Treasury Secretary (35 years of financial sector experience), Martin Feldstein as the Chief Economic Advisor to President Reagan (the dean of business cycle determination), and Paul Volcker was Fed Chairman (9 years of prior financial sector experience). Compare and contrast to Barrack Obama (junior senator from Illinois for 3 years); Timothy Geithner (21 years experience in government, three years as a lobbyist); Larry Summers (no private sector experience; 27 years of academia and government) and Ben Bernanke (no private sector experience; 30 years of academia and government). Which team do you think deserved the higher multiple — the one with actual experience in the real world or the one immersed in academia and government? To this end, we could only read with amusement the admonishing that the President took on his trip to Asia over U.S. policies which seem to be aimed at breeding more asset bubbles and blazing a trail for anti-competitive trade frictions — see China’s Blunt Talk for Obama. You can’t make this stuff up.
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Gluskin Sheff at a Glance
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As of September 30, 2009, the Firm managed assets of $5.0 billion.
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$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:
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IMPORTANT DISCLOSURES
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