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May 11, 2010 Economic Commentary
MARKET MUSINGS & DATA DECIPHERING
Breakfast with Dave
ACROSS THE POND – STILL A SEA OF RED Well, I think the turbulent global events of the past few weeks underscore the reason why I have maintained a cautious investment approach for the past year, notwithstanding the massive recovery in risk assets we saw from the March 2009 lows, which from my lens bore a huge resemblance to the bungee jump in the market back in 1930. In fact, at one point two weeks ago, at the highs, the stock market had already achieved, in barely more than a year, what took five years to accomplish in the 2002 to 2007 bull market, and at least that market wasn’t being fuelled by unprecedented government intervention in the economy and incursion into the capital markets. The dramatic government stimulus was global in nature, and this was the primary prop behind the rally in equities over the past year and change, and the message coming out of Greece, and not just Greece but many other governments in the European Union and across the globe, is that governments are probing the outer limits of their deficit finance capacities. History does indeed show that it is quite common to see sovereign default risks follow on the heels of a global banking crisis, which was the story for 2007 and 2008; it took a respite in 2009 and we are now in a new chapter of this prolonged debt deleveraging story. These cycles of balance sheet repair, alternating between the private and public sector, typically lasts 6 to 7 years. We are barely into year three, and what is extremely important in this roller coaster ride is to focus on capital preservation strategies that minimize the volatility in the portfolio, which is one reason why I have favoured long-short income and equity strategies. In my opinion, Greece is the same canary in the coal mine that Thailand was for emerging Asia in 1997, which ultimately led to the Russian debt default and demise of LTCM; the same canary in the coal mine that New Century Financial in early 2007 proved to be in terms of being a leading indicator for the likes of Bear Stearns and Lehman. So, the most dangerous thing to do now is to view Greece as a one-off crisis that will be contained. Even with this new and aggressive EU-IMF financing arrangement that has managed to trigger a wild short covering rally yesterday, the risks are still high that the contagion spreads to countries like Portugal, Spain, Italy and even the U.K., which has already received some warnings from the major rating agencies and is gripped with political gridlock in the aftermath of last week’s uncertain election results. IN THIS ISSUE • Across the pond — still a sea of red • Making PIIGS squeal: we did some indepth analysis on how the economies of the PIIGS would fare if the deficit-to-GDP ratios were to revert back to the criteria of 3.0% • Redefining a treaty: the EMU political elite and the ECB bypassed their charters in order to take the easy road and ensure that bad credits get rewarded • Canadian housing: are homebuilders building inventory?
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
May 11, 2010 – BREAKFAST WITH DAVE
The problem of there being far too much debt on balance sheets globally has not gone away and in many cases has become worse, and the ability to service these debts especially in countries that have weak economic structures like Greece, Portugal and Spain has become seriously impaired. It remains to be seen how Greece and the other problem countries in the euro area will manage to cut their deficits without, at the same time, controlling their monetary policy and their currency, which of course we were able to do here in Canada during the 1990s but with the help of a 30% currency devaluation. Speaking of Canada, the downdraft in our market and our dollar shows once again that we can be doing everything right, and in terms of fiscal policy we still look good on a relative basis. However, being a small open economy sensitive to commodity prices, this is one of those times where sudden shifts in global economic sentiment can hit us disproportionately. Even before this latest leg in the European financial crisis, China was already tightening monetary policy aggressively to lean against what appears to be a property bubble in various urban centers. One has to consider what the outlook is for the global economy in general, and near-term prospects for the resource sector in particular, when the Shanghai equity index is down more than 20% from the nearby highs; yet something else to add to the concern list. Recall that we headed into this latest round of turmoil with the equity markets priced for a return to peak earnings as early as next year, bullish sentiment on the stock market and institutional investor cash ratios at levels we last saw in late 2007 when the market was just rolling off its highs, and measures of volatility at extremely low levels, the VIX index was a mere 15 as an example, a sign of widespread complacency. It is at times like that, when all the good news is priced in and then some, and the exact opposite of what was happening at the lows just over a year ago, that the markets are most susceptible to a pullback. With the benefit of hindsight, it is clear that the time to start to wade into the risk asset pool was a year ago after a 60% plunge in equities. However, 80% later on the upside, it’s time to get more defensive and less cyclical with a keen eye towards taking advantage of this crisis if it presents opportunities in the equity market as the panic in the corporate bond market presented to us back in early 2009. I, for one, am looking forward to having my temptation level tested if this market heads back into undervalued or even fair-value terrain, which it only managed to achieve for a few months early last year. While the coincident economic indicators, such as employment, have improved in recent months, many of the leading indicators have begun to roll over. In fact, these indicators are pointing towards a discernible slowing in economic and earnings growth in the second half of the year and into 2011 when we will see the stimulus shift to significant fiscal restraint in both Canada and the U.S., and the lagged impact of the Chinese policy tightening.
In my opinion, Greece is the same canary in the coal mine that Thailand was for emerging Asia in 1997, and New Century Financial in the U.S. in early 2007
Even before this latest leg in the European financial crisis, China was already tightening monetary policy aggressively to lean against what appears to be a property bubble in various urban centers
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May 11, 2010 – BREAKFAST WITH DAVE
In addition, while the periphery of Europe received a financial lifeline package, the conditions for accessing the funds will require massive fiscal tightening and it will be interesting to see how countries like Spain, let alone Greece, can cut spending and raise taxes at a time when the unemployment rate is at a sky-high 20%. Remember, 20% of the global economy is going to be slowing down going forward, the question is by how much and this in turn will impact North American exports. On top of that, the equity and debt cost of capital, which had been on a declining path for much of the past year and has very supportive of risk appetite, is now going on the opposite path. This is not necessarily a double-dip recession scenario, but I would not rule it out. What’s important from an investor standpoint is that the uncertainty surrounding the macro outlook is much wider now than it was before. Over the near term, there is still more downside but the main message is that one should be prepared to take advantage of the springtime selling by using cash and nearcash as part of a tactical asset allocation strategy because one of the best way to make money in this tumultuous environment is not to lose it, but to have it ready to put to use once things get really cheap. At the same time, we are confronting a deflationary shock at a time when most measured rates of underlying inflation in most parts of the world, especially the U.S. are already extremely low, barely 1%, and in such an environment, having an income theme as a core component of the portfolio makes a whole lot of sense. MAKING PIIGS SQUEAL We did some in-depth analysis on how the economies of the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) countries (and the rest of Europe) would fare if deficit-to-GDP ratios were to revert back to the Maastricht criteria of 3%. The adjustment will be painful for Europe in general, slicing off about 1% GDP growth annually over the next three years, and very painful for the PIIGS specifically. If these countries’ fiscal ratios were return to 3%, Ireland would see four percentage points (ppts) shaved off nominal GDP annually over the next three years, Greece 3.5ppts, Spain 2.8ppts, Portugal 2.2ppts and 0.8ppt for Italy. It would not be a picnic for the rest of Europe, where many countries were running deficits greater than 3% of GDP in 2009. We estimate that fiscal cuts will shave about 1.5ppts off France’s nominal growth, 1.0ppt for Belgium, and 0.8ppt for the Netherlands. Austria and Germany would only have to endure 0.2ppt and 0.1ppt lower GDP growth, respectively, to bring their ratios back in line with targets. Finland is the only country with a GDP deficit under 3% (using 2009 data). Note that the starting point for our analysis was 2009 — the adjustment could be more painful as deficit-to-GDP ratios look to have deteriorated further in 2010.
What’s important from an investor standpoint is that the uncertainty surrounding the macro outlook is much wider now than it was before
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May 11, 2010 – BREAKFAST WITH DAVE
REDEFINING A TREATY Maybe it’s all about false pride. The need to counter-attack those who would dare to attack the Euro. How interesting was it to see the sharpness of the political rhetoric over the weekend from the European political elite. Please, fund our lifestyle, Mr. Market, but don’t hold us to our commitments: “ ... a battle of the politicians against the markets. I am determined to win” (German Chancellor Angela Merkel). “... unfounded off-the-wall suggestions and speculation” (EC President Jose Manuel Barroso). “... confront speculators mercilessly ... know once and for all what lies in store for them” (French Present Nicolas Zarkozy). It is a sad deflationary reality when a trillion dollars can only buy you 400 points on the Dow. What can the politicos do for an encore? The reality of there being far too much debt globally to service relative to income-generating capacity has not changed one iota. Greece, Spain, and Portugal technically do not have to borrow a dime in public capital markets for three years now. How about that, Mr. Potter. But the problem lies in the fiscal discipline these countries have to adhere to in order to secure the EU-IMF financing. Recession to perpetuity. A market desperately in need of an “announcement” got it on Sunday in a stark reminder of all those Sunday announcements coming out of the Paulson-led Treasury Department in 2008 — rallies were whippy, but boy were they ever brief. After the EMU political elite and the ECB bypassed their charters in order to take the easy road and ensure that bad credits get rewarded, it would seem that of the paper currency, the greenback looks pretty good (reserve currency, world’s largest military power — still, and a heck of a lot of gold sitting underneath Fort Knox) and of the hard currencies, gold certificates and bags of silver coins are looking even better. The ECB just stepped down a rung on the ladder of monetary integrity, in the name of the greater good — so to speak. Maybe the general public should have a good look at what has been abrogated, in the name of saving the proverbial system (as if Greece has never defaulted before. Chuckle.) These are the famous “no bailout” provisions of the EU Treaty: Article 101 prohibits “overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of Member States” (ie, Neither the ECB nor other central banks can lend) to “central governments ... or other public authorities.” Period. Prohibited — tsk, tsk, tsk.
It is a sad deflationary reality when a trillion dollars can only buy you 400 points on the Dow. What can the politicos do for an encore?
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As for quantitative easing, it “shall be prohibited as shall the purchase directly from them” by the ECB. (Oh — so we’ll circumvent that by having the national central banks do the bidding — literally.) The ECB is constitutionally prohibited from lending money to the Greek central bank or buying their notes directly. What the central bank has done instead is, in a word, crafty. Where is George Soros when you need him? The Treaty on the Functioning of the European Union (2008/C 115/01) Article 123 (ex Article 101 TEC) 1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.
Article 124 (ex Article 102 TEC) Any measure, not based on prudential considerations, establishing privileged access by Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States to financial institutions, shall be prohibited. Article 125 (ex Article 103 TEC) 1. The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. The Council, on a proposal from the Commission and after consulting the European Parliament, may, as required, specify definitions for the application of the prohibitions referred to in Articles 123 and 124 and in this Article.
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Article 126 (ex Article 104 TEC) 1. Member States shall avoid excessive government deficits.
CANADIAN HOUSING: ARE BUILDERS BUILDING INVENTORY? Another piece of strong housing data out of Canada yesterday with April housing starts edging up 1.3% MoM, to 201.7k annualized units (though slightly missing analysts’ expectations of an increase to 205k). The details were mixed with single-family starts (a good baramoter for underlying demand) dropping nearly 13% while multi-starts (ie, condos) jumped 27% on the month. If we take a step back from the monthly volatility, what is interesting to note is that household formation rates are at about 175K annualized and housing starts have been running at-or-above that level for the past seven months, suggesting that inventories of new homes are building. Using a different approach, housing starts (ie, supply) were up at whopping 80% YoY in April and existing home sales (ie, demand) are running at less than half that rate on a YoY basis. Using this approach, we estimate that supply as been outrunning demand for about 2-3 months, another indication that inventories may be building. In fact, the latest data release for existing home sales showed, on a seasonally adjusted basis, months’ supply in March were higher than in the previous four months. We are likely to see more inventories build, especially as the frenetic demand seen in the first half of the year dries up in the second half due to higher mortgage rates, a more restrictive lending environment and the impending HST — all of which will ultimately pressure home prices downward.
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