David A.

Rosenberg January 20, 2010

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
European equities are fractionally lower and Asia is down pretty well across the
board overnight – concerns over China’s policy tightening moves (regulators • While you were sleeping —
there are now pressuring the banks to shrink their lending books) at play here as overseas equity markets
were down; election
the Shanghai index slid 2.9%. U.S. equity futures are in the red but they were in results, flight to safety and
the negative column yesterday at this time too and the S&P 500 still managed to fiscal concerns propelling
break to a new recovery high in the face of some spotty earnings and economic U.S. dollar, inflation
data. Go figure. subdued in Canada
• Housing market still in a
Although IBM did, for the most part, post solid results (save for its consulting depression
services sales), the fact that the stock is down is testament to the view that all
• No change in Bank of
the good news is priced in. Citigroup, like JP Morgan before it, posted very soft
Canada statement
Q4 top-line growth. That said, it was a big surprise to see the homebuilders
edge higher despite a very poor Home Builders housing market index (see more • Brazil may be the most
attractive on a risk-return
below). Maybe investors are hopeful that an extension of the government’s and
basis
Fed’s support for housing is now in order! (Perverse reasoning perhaps, but this
is Mr. Market after all.)

Treasuries have a modest bid as they should coming off the Scott Brown victory
since the end of the Democrat supermajority in the Senate likely means that we
are not going to see endless fiscal stimulus packages to spur consumption and
further congest the bond supply calendar. This also means that the health care
reforms are going to be altered and so this is one sector that stands to benefit;
ditto for dirty oil plays like the tar sands and coal-fired utilities or any other area
of the market that had a bull’s eye on its forehead from the time President
Obama was elected with a landslide congressional victory, to boot. As was the
case when Jimmy Carter was turfed out in 1980 and when the ‘Contract With
America’ emerged victorious in the mid-term elections in 1994, U.S. voters know
how to push their left-leaning politicians back towards the center when they
move astray.

The combination of the election result in Massachusetts, a flight to safety bid,

and escalating concern over the fiscal dilemma in Greece (bond yields there
soared 40bps today!) which has sent the Euro to a five-week low, is propelling
the U.S. dollar, which is up over 50 ticks this morning – the DXY index is about to
challenge the 200-day moving average for the first time in 18 months! This
could be critical. The commodity complex is slipping today as a result, as are the
resource-based currencies; and we do see that the Baltic Dry Index is rolling over
again – quite often a leading indicator for raw material prices.

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
January 20, 2010 – BREAKFAST WITH DAVE

The Yen is also firm on the back of this moderate flight-to-safety move in the
markets (it is an interesting concept that the Yen is viewed as a ‘defensive
currency’ for a country whose flagship airline carrier just went into bankruptcy
proceedings – again! And it’s certainly not as if the Japanese macro backdrop is
deserving of a firm currency either – the government just kept its economic
assessment unchanged and warned over deflation pressures, and the Japan
tertiary index slipped 0.2% in November underscoring a still-weak
economy.) But besides the Yen, the real odd man out here is the VIX index. We
doubt that 17x is going to be sustainable given the post-stimulus risks to the
economic outlook that are inherent in a deleveraging cycle.

We just received the January CPI data for Canada and as is the case south of the
border, inflation is subdued with a capital “S”. On a seasonally adjusted basis,
headline CPI was down 0.1% MoM and the core rate (excludes food and energy)
was up 0.1%.

The YoY trends are being influenced by depressed year-earlier base effects and
that will continue for several months but even with that skew, the headline
inflation rate, at 1.3%, and the core, at 1.5%, are hardly growth rates that will
cause the Bank of Canada to tighten policy prematurely. This is all constructive
news for the Canadian government yield curve; muted inflation, a stable-to-firm
currency, and the prospect that the Bank will not be raising rates as quickly as
what is currently priced in (see more below).

Today’s must-read is the Martin Wolf column on page 9 of the FT – The Greek
Tragedy Deserves a Global Audience. The question will ultimately be whether
the Euro will prove, like so many other currency and monetary arrangements in
the region in the past, to be a failed experiment. After all, if countries like
Greece can’t enjoy German-style interest rates, and is subject to a tight EC policy
stance (relative to other areas around the globe) and without the ability to
devalue its way out of its fiscal morass, then can an exit strategy not be
plausible? As Martin Wolf calls this prospect -- “the unthinkable would be
thinkable” and would generate a “lethal contagion”.

At the same time, a Euro-zone “bailout” would unleash “monstrous moral

hazard” and let’s face facts, it’s not just Greece (with a 12.7% fiscal deficit/GDP
ratio it has to close), but Ireland (12.2%), Spain (9.6%) and Portugal (6.7%). Italy
looks downright austere with a 5.5% deficit ratio (though its debt is sky-high at
97% of GDP). While it is fashionable to be bearish on the U.S. dollar, at least
against the Euro, the greenback may well be a safer place to be until these fiscal
storms pass across the pond.

Finally, while we have been a big fan of “income” there comes a time when the
risks and potential rewards are no longer aligned. What comes to mind is how
credit spreads are behaving in the face of what is still a very uncertain economic
outlook and massive amounts of new supply – especially in the high-yield space
where there was a record $11.7 billion of new issuance in the second week of
the year; and often this is not a good sign. Issuers are placing bonds at a

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January 20, 2010 – BREAKFAST WITH DAVE

frenetic pace because they realize that now is the time to strike because later
on, being able to raise new money (mostly to term out short-term debt) is
probably not going to be as inexpensive.

For investors, that is a reminder that they should be concentrating on buying low
and selling high later on. But alas, the ‘greed factor’, less than a year after
everyone was wringing their hands and clenching their fists over the prospect of
a full-scale financial meltdown, are now keeping their hands wide open in what
now seems to be some pretty indiscriminate buying. Junk bond yields have
plunged from a high of 22.6% a year ago when they were pricing in a 10% GDP
contraction to 8.7% today where they are suddenly discounting a near 4%
nirvana GDP growth landscape. While the temptation to stretch for yield may be
understandable, keep in mind that interest rates in the high-yield bond space
are now around 100 basis points shy of retesting the 7.6% pre-crisis lows when
bubbly growth was also being priced into perpetuity. Have a look at the The
Short View on page 13 of the FT for more.

CHART 1: HIGH YIELD NO LONGER

United States: Merrill Lynch High Yield Corporates: BB-B Rated
(percent)

20.0

17.5

15.0

12.5

10.0

7.5

5.0
97 98 99 00 01 02 03 04 05 06 07 08 09
Source: Haver Analytics, Gluskin Sheff

HOUSING STILL IN A DEPRESSION

It is truly a sad state of affairs when an extension of a housing tax credit, super-
low interest rates and the incursion of the Fed balance sheet into the mortgage
market all translate into a down housing backdrop. The NAHB index fell for the
second month in a row, to 15 in January from 16 in December, 17 in November
and the nearby high of 19 in September, which takes the headline down to June
2009 levels. In fact, this is the fourth lowest reading ever.

What was really striking was the dip in the ‘prospective buyer traffic’ sub-index to
12 from 13 – the lowest this has been since last March when everyone seemed
to think the world was coming to an end. And the stimulus for housing, if not
renewed, could add some uncertainty to the outlook – the Fed’s purchases stop

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January 20, 2010 – BREAKFAST WITH DAVE

at the end of March and the deadline for the $8,000 tax credit for first-time
buyers (and $6,500 for move-up buyers) is April 30, in terms of when the
purchase contracts have to be signed, and the deal must be completed by June
30.

But the first kicker is expected to come today, as the FHA comes out with its new
(and higher) fee schedule (to 2.25% from 1.75% according to the New York
Times) and tightened lending standards too (though amazingly, the 3.5%
minimum down-payment requirement is not expected to be touched; but a
minimum FICO score of 580 established – this is largely for “show”) because
what few people realize is the losses the government agency faces and the
extent to which a taxpayer bailout lies ahead.

CHART 2: HAS THE DOUBLE-DIP ALREADY ARRIVED?

United States: Home Builders Housing Market Index
(All good = 100)

80

60

40

20

0
85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

What is apparent is that the builders are still competing against a wave of
foreclosed properties being dumped back onto the market. RealtyTrac estimates
that a record three million homes will be repossessed this year and that this flood
of supply will seriously curtail new home sales and construction activity. And, it is
the government’s own policies that are creating these strains – go back to that
FHA article from yesterday’s WSJ and re-read the last part. It’s all so surreal:

“Mr. Stevens says first-time buyers are key to clearing inventory in markets such
as Las Vegas, James Smith, a 42-year old air-conditioning repairman, might not
have been able to buy a $188,000 home out of foreclosure recently in Henderson,
Nev., were it not for the low FHA downpayments. To make the 3.5% downpayment,
he used around $4,300 of his own money and borrowed the rest from his father-
in-law. “It was actually a great thing”, he says. He repaid his father-in-law after
receiving an $8,000 tax credit for first-time home buyers.”

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January 20, 2010 – BREAKFAST WITH DAVE

Isn’t this what makes America great? This guy could only buy a foreclosed home --
a home that the prior owner couldn’t afford, either – with FHA financing and his
father-in-law; to only then use the public purse to pay “dad” back.

BONDS HAVE MORE FUN!

For all the talk of a failed U.S. auction and a foreign buyers’ strike, all we see is
continued global interest in the safety and liquidity of the U.S. Treasury market.
Foreign investors gobbled up a net $118.3 billion of T-notes and bonds in
November which was a record – and in stark contrast to the $1.4 billion of buying
in U.S. spread product and the $9.7 billion net inflow to equities.

CHART 3: THAT $118 BILLION OF FOREIGN BUYING OF

TREASURIES IN NOVEMBER WAS A RECORD
United States: Net Foreign Purchases of Long-Term Treasury Notes & Bonds
(billion $)

120

80

40

-40
99 00 01 02 03 04 05 06 07 08 09

Source: Haver Analytics, Gluskin Sheff

POST-BANK OF CANADA MEETING SYNOPSIS

There was no really big change to the Bank of Canada press statement yesterday,
but what I did glean was dovish enough to leave me with a view that the central
bank will not be raising rates until mid-2011, at the earliest. This is critical to the
outlook for the Canadian money market and bond yields since futures have priced
in nearly 100% odds of a 25bps BoC rate hike this June; and another 25bps by
September of this year.

The Bank told us yesterday that its base-case is for 2.9% real GDP growth this year
and 3.5% next year, with the starting point on the “output gap” being 3.25%
(“output gap” is the gap between the actual level of real GDP and where real GDP
would be if the economy were operating at full capacity). Keep in mind that an
output gap that big in any given quarter classifies as a 1-in-20 event. Moreover,
base-lining these expected growth rates against the latest estimates of ‘potential
growth’ (which the BoC will update on Thursday), puts the output gap at a smaller
level of 1.55% this year and then narrowing further to 0.25% in 2011.

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January 20, 2010 – BREAKFAST WITH DAVE

The history of the Bank of Canada is such that, outside of past periods when it had
to defend the Canadian dollar, it typically does not embark on its tightening phase
until the “output gaps” is close to closing – even during the aggressive John Crow
era, the Bank’s modus operandi was to time the first rate hike just as the spare
capacity was being eliminated, and not much before – on average, the first BoC
rate hike following a recession takes place one quarter before the output gap
closes (there is still a gap, but it is small at 20bps). If this strategy is replicated this
time around, and the cause for being on pause longer in the context of a historic
de-leveraging cycle is certainly quite strong, then the very earliest the Bank will
move is the second quarter of 2011.

Under this scenario, based on some back-of-the envelope calculations, the

unemployment rate at no time declines below 7.5% through to the end of 2011.
The peak in the jobless rate was 8.7% back in August 2009. Going back to prior
recessions, the BoC does not begin to tighten rates until the jobless rate is down
an average of 150bps with a range of 130bps to 170bps. Unless the Bank wants
to be pre-emptive, which is highly unlikely when it acknowledges that “the recovery
continues to depend on exceptional monetary and fiscal stimulus” [emphasis
added] and that “the overall risks to its inflation projection are tilted slightly to the
downside”, then to go and raise rates before the middle part of 2011 would be
totally inconsistent with its own forecast as it stands right now.

More to the point, while bored Bay Street economists spend time trying to assess
every verb, adjective and noun to see if the Bank is more or less ‘hawkish’ than
the prior meeting, what is important for investors to assess the official forecast
and determine what means for the degree of excess capacity in the economy
going out and what that in turn implies for the future inflation rate. The bottom
line is that even with the fragile recovery, the Bank sees more downside than
upside risk to its inflation projection; and to reiterate, for the Bank to start
tightening policy until the jobless rate breaks below 7.5% would be a real break
with how it has behaved in the past coming out of prior recessions.

And whatever “policy tightening” is needed in the future could also come via the
overextended loonie, limiting any need for an interest rate adjustment in the time
horizon that the markets have discounted. While this is a source of debate on Bay
Street, the Bank is still sensitive to the growth-dampening impact of an exchange
rate that is too firm for its own good. To wit:

“…the persistent strength of the Canadian dollar and the low absolute level of U.S.
demand continue to act as significant drags on economic activity in Canada.”
[emphasis added]

In a nutshell, the Canadian market is already braced for 50bps of BoC tightening
by September. With that in mind, it is difficult to believe that there is any
significant rate risk here; if anything, the surprise will be that the Bank is on hold
for longer and it that proves to the case, then there is actually more downside than
upside potential to Canadian bond yields, particularly at the front end of the
coupon curve.

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January 20, 2010 – BREAKFAST WITH DAVE

The reason why the markets think the BoC may pull the trigger is because of this
one sentence that shows up in every press statement:

“Conditional on the outlook for inflation, the target overnight rate can be expected
to remain at its current level until the end of the second quarter of 2010 in order
to achieve the inflation target.”

So the BoC has really only given a pledge to keep rates where they are until mid-
year. But June is only five months away and so one would have to think that one of
the next three meetings, the Bank is going to have to update this particular
sentence or just take it out entirely and leave the market without a de facto time
commitment. Either way, the moment the BoC changes this sentence is the
moment that Mr. Market will push into the future its expectations of a new rate-
hiking cycle coming our way.

BRAZILIAN BONDS? GET REAL!

Brazil may well be the most attractive on the planet on a risk-return basis. Here
are seven reasons why:

• It is just about the only investment grade country where inflation is slowing,
the central bank has been easing, and where you can pick up a yield of over
12% for 10-year paper.
• Its most recent change was a credit upgrade last September (Moody’s) and
overall the rating agencies are generally favourable over the outlook.
• The inflation rate is 4%, slowing down and at the low end of the range of the
past decade.
• The current account is in very small deficit, at just over 1% of GDP.

• The debt ratios are very well contained – 12 % gross external debt and 43%
government debt as a share to GDP (the US comparables are 95% and 62%
respectively).
• The real is on an appreciating track (+27% in the past year) and that is
because Brazil’s terms-of-trade (export price to import price ratio) is flirting
near a 12-year high.
• Given that real short-term rates are around 4.5% and the consensus view is
5% real growth this year, there would be little reason to be bearish on the
currency outside of a currency setback (and FX reserves at $240 billion are up
15% in the past year and 30% in the past two years.
The biggest risk is if there is a global relapse that drags Asia into the vortex and
impair the commodity complex as this would undoubtedly reverse the impressive
gains made in the currency -- after all, it’s not coffee that is Brazil’s primary export
but iron ore; and it is not the USA but China that is the country’s largest customer.

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January 20, 2010 – BREAKFAST WITH DAVE

Gluskin Sheff at a Glance

Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms.
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Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to the
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As of September 30, 2009, the Firm
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We offer a diverse platform of investment
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1 September 30, 2009
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Portfolio in 1991 (its inception date)
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We have strong and stable portfolio
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We have a strong history of insightful collectively the largest
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date) would have grown to
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long history of investing in under-

September 30, 2009 versus $9.7 million
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January 20, 2010 – BREAKFAST WITH DAVE
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