David A. Rosenberg Chief Economist & Strategist research@gluskinsheff.

com

December 2012 Economic Commentary

SPECIAL REPORT

The Investment Outlook for 2013: Income Outcome

TEN NEAR-CERTAINTIES TO INVEST AROUND IN A SEA OF UNCERTAINTY 1. We remain in a classic post bubble fat-tailed distribution curve, where the range of possible outcomes is much wider than in past recovery phases. This will remain the case in 2013, and until such time as all the major global debt imbalances have been fully resolved. Near-6% U.S. output gap; 3%+ global gap. The world is still awash with excess capacity across labour and product markets. As such, disinflation themes will keep trumping inflation themes. This puts preservation not just of capital, but of cash flows, front and centre in terms of core investment strategies. Fed likely to keep rates near 0% through 2018 (according to our analysis): Interest rate volatility minimized; long-short credit strategies should remain core to any bond strategy. $1.7 trillion in cash on U.S. corporate balance sheets: Even though yields have plunged in the past year, corporate bonds remain a solid investment given prospective low default risks, especially given still-wide spreads relative to the government sector. Fed to replace Operation Twist with outright bond buying: Treasury yields to head even lower, making dividend yield and bond proxies in the equity market that much more alluring. Real interest rates to remain negative: This is a very powerful positive thrust for the precious metals complex, and should help establish a firmer floor under the stock market given the implications for discounted earnings growth (i.e. a lower cost of capital). Stephen Harper around until April 2015 (at the least), Barack Obama around until January 2017: Along with diverging monetary policies, the stark political divide is bullish for the Canadian dollar. Geopolitical tensions Middle East, Chinas political transition, Greek default risks, U.S. fiscal issues, high and rising youth unemployment rates in Europe and Japan-China rift: Exposure to raw materials is a good hedge against these recurring flare-ups. U.S. energy self-sufficiency: Still a forecast, but this has positive implications for the manufacturing renaissance story.

SUMMARY

2.

3.

In a 0% return environment, notwithstanding all the uncertainties across so many levels financial, economic and geopolitical, cash is not king. What is king is cash flow, however The Fed has also completely altered the relationship between stocks and bonds by nurturing an environment of ever deeper negative real interest rates We remain in the throes of a secular era of disinflation, and I expect this theme to become accentuated in 2013 as the global output gap widens further Our primary strategy theme has been and remains S.I.R.P. Safety and Income at a Reasonable Price because yield and growing dividends work in a deleveraging deflationary cycle In an era of slow growth, predictable quality growth equities will also perform well

4.

5.

6.

7.

8.

9.

10. Malthusian population dynamics: That two billion more people to feed in the next 35 years means we need 70% more food; an agrarian revolution is in its infancy stages.

Please see important disclosures at the end of this document.

Gluskin She + Associates Inc. is one of Canadas pre-eminent wealth management firms. Founded in 1984 and focused on serving high net worth private clients and institutional investors, 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

December 2012 SPECIAL REPORT THE INVESTMENT OUTLOOK FOR 2013

THE INVESTMENT OUTLOOK FOR 2013: Another Year Of 0% Policy Rates + Fiscal Austerity + Disinflation = Income The Best Outcome (Once Again) As conservative as we have been over the broad equity market at times, we never advocated cash as an asset class. Cash may be the ultimate in capital preservation, but it earns you nothing and as such offers nothing in terms of generating any future return for you and your family. In a 0% return environment, notwithstanding all the uncertainties across so many levels financial, economic and geopolitical, cash is not king. What is king is cash flow, however. Lets talk about what we know with some degree of clarity. First, we are in a classic post-bubble fat-tail world where the range of outcomes is unusually wide. A wider dispersion of outcomes means more opportunities for active management rather than passive index investing and this augurs for more active portfolio management, not less. Said another way, a wider range of outcomes means those who can identify under-priced securities, or have high conviction ideas/strategies, have a better chance to outperform the market. CHART 1: LIFE AFTER THE CREDIT COLLAPSE FAT TAIL RISK
Normal Distribution versus Fat-tailed Distribution

Distribution of Outcomes before the Credit Collapse

Distribution of Outcomes after the Credit Collapse

Source: Gluskin Sheff

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CHART 2: NOT A TYPICAL CYCLE

United States
Real Estate Deflation
(home price index, 1890 = 100)
200.0 190.0 180.0 170.0 160.0 150.0 140.0 130.0 120.0 110.0 100.0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Down 43%!

Household Credit Contraction

(year-over-year percent change)
20.0

16.0

12.0

8.0

4.0

0.0
Debt deleveraging

-4.0 58 63 68 73 78 83 88 93 98 03 08

Source: Haver Analytics, Gluskin Sheff

CHART 3: UNPRECEDENTED FIVE-YEAR CONTRACTION IN U.S. HOUSEHOLD NET WORTH

United States: Household Net Worth (five-year percent change at an annual rate)
16 14 12 10 8 6 4 2 0 -2 -4 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11
Source: Haver Analytics, Gluskin Sheff

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December 2012 SPECIAL REPORT THE INVESTMENT OUTLOOK FOR 2013

CHART 4: RANGE OF OUTCOMES IS EXTREMELY WIDE

United States: Range of FOMC December 2012 Forecasts (percent)
Real GDP Growth Rate
4.5 4.2 4.0 8.0 7.8

Unemployment Rate
8.5

7.5 3.5 3.2 7.0 2.8 6.5 2.5 2.5 6.0 2.0 5.5 6.9

7.4

6.8

6.1

5.7

1.5 2013 2014 2015

5.0 2013 2014 2015

Source: Federal Reserve Board, Gluskin Sheff

Second, the best advice I can give is to search for sources of relatively secure income. In a disinflationary environment with 0% policy rates, preservation of cash flow is paramount. Third, dividend growth, dividend yield and dividend coverage. This includes Canadian banks and some infrastructure exposure. It also includes large-cap U.S. technology, where growth in dividends is second to none and these are not the same ultra-cyclical cash-burners of the 1990s. Fourth, emerging markets are among the cheapest in the world, governments there have leeway to fiscally reflate given comparatively strong national balance sheets, and many have great demographic backdrops. Not just their stocks, but their bonds look pretty good too, risk-for-reward. Fifth, the Fed has taken out asset price volatility, which is good news for spread product in general. Perhaps Bernanke et al are deliberately pushing investors into risky assets, but the over-riding issue is the acceptable level of risk to take on given the likeliest outcome for the total return potential for any given asset class or security. Certainly being in credit strategies has been a better alternative than cash so far this year and will remain to be so in 2013.

The Fed has taken out asset price volatility, which is good news for spread product in general

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TABLE 1: RATES ON HOLD FOR LONGER

United States FOMC meeting June 22, 2011 The Committee continues to anticipate that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate for an extended period. FOMC meeting August 9, 2011 The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. FOMC meeting January 25, 2012 In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. FOMC meeting September 13, 2012 In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015. FOMC meeting December 12, 2012 In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committees 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
Source: Federal Reserve Board, Gluskin Sheff

Sixth, the Fed is taking real interest rates deeper into negative terrain and there is a time-worn inverse relationship between real yields and the price of gold. We remain bullish on bullion and on the equities of disciplined gold producers. CHART 5: FED DRIVES REAL RATES INTO NEGATIVE TERRAIN
United States: Yields on Treasury Inflation Protected Securities (percent)
5-year TIPS
4.0

10-year TIPS
3.5 3.0

3.0
2.5

2.0

2.0 1.5

1.0
1.0

0.0

0.5 0.0

-1.0
-0.5

-2.0
Jan/08 Jan/09 Jan/10 Jan/11 Jan/12

-1.0
Jan/08 Jan/09 Jan/10 Jan/11 Jan/12

Source: Bloomberg, Gluskin Sheff

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Seventh, given that the yield curve is still historically steep and the Fed has pledged to keep short-term rates near zero for more years, carry-trades in general should remain profitable, and along with that, the solid prospect that the long bond yield grinds its way down towards 2% before the secular market in bonds fully runs its course. Those that are so risk-averse that they feel the need to be in cash would be actually destined to generate negative returns in real after-tax terms and that means they would be confined to a losing investment strategy because what the Fed is doing with its financial repression policy is penalizing acute risk aversion. Sustained low interest rates transcend tax policy in terms of what it means for dividend-payers and dividend-growers, and it also means that companies, already flush with cash, will be able to fund themselves rather easily, which is constructive in terms of what it means for corporate default rates to remain very low. CHART 6: FINANCIAL REPRESSION, CASH IS TRASH
United States: Real Three-Month T-Bill Yield (percent)
8 6 4 2 0 -2 -4 -6 1982
Negative Real T-Bill Yields

What the Fed is doing with its financial repression policy is penalizing acute risk aversion

1987

1992

1997

2002

2007

2012

Source: Haver Analytics, Gluskin Sheff

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December 2012 SPECIAL REPORT THE INVESTMENT OUTLOOK FOR 2013

CHART 7: SEVEN TRILLIONS OF CASH EARNING NOTHING BUT NEGATIVE REAL RETURNS
United States: Savings Deposits plus Money Market Funds ($ trillions)
8

0 75 80 85 90 95 00 05 10
Source: Haver Analytics, Gluskin Sheff

CHART 8: FED LIQUIDITY BOTTLED UP ON BALANCE SHEETS

United States ($ billions)
Non-financial Corps Cash and Cash Equivalents
1500 1400 1300 1200 1100 1000 900 800 700 600 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12
500 250 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 1000 750 1500 1250

All Commercial Banks Cash Assets

1750

Source: Haver Analytics, Gluskin Sheff

Now, I get the question as to whether the end of the Bush tax cuts will have a negative impact on our long-standing income-equity theme and the short answer is no. While Obamas plan (as it now stands) would be to allow the top dividend tax rate to go from 15% presently back to 39.6%. Historically, tax changes like this actually have minimal impact on dividend-paying stocks. For example, when the rate was reduced by President Bush in 2003, there was little evidence of any statistically significant impact. In fact, the deep cyclicals out-returned the

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defensive dividend yielders back then because the economy was starting to boom and interest rates were backing up. The general level of interest and the contours of the business cycle matter much more in cases like this. Speaking of interest rates, imagine if Paul Volcker had said in 1982 that he was going to peg T-bill yields at 13% for the next three years because he was unhappy with where inflation was. Of course, he never did embark on such a radical course. But consider what Ben Bernanke has done. Hes also unhappy with inflation but because it is too low. And as such, he got rid of mid-2015 with regard to the earliest date the Fed would move away from its zero-interest-ratepolicy and replaced it with numerical targets, including a 6.5% unemployment rate (though they will look at a broad range of labour market indicators a drop in the U-rate premised on an ever-declining participation rate is unlikely to impress the FOMC) and near-term inflation expectations of 2.5% or higher. At the same time, the Fed is going to replace Operation Twist, which expires at year-end, with $45 billion of outright buying of Treasury securities. All of the Feds interventions have managed to help drag Treasury bond yields down to extremely low levels, so much so that even the 2.2% dividend yield on the S&P 500 commands a 150-basis-point premium over five-year T-notes, which is a gap we have not seen since 1958 and is one of the positive attributes the equity market has going for it right now. CHART 9: ARGUABLY THE MOST COMPELLING ARGUMENT FOR EQUITIES
United States: S&P 500 Dividend Yield and Five-year T-note Yield
Yield Levels
(percent)
6

Bernanke is also unhappy with inflation but because it is too low. And as such, he has pledged to peg shortterm yields near 0% likely through 2018

Spread
(basis points)
400 Widest since 1958!

5
Five-year T-note Yield

200

4
-200

-400

2
S&P 500 Dividend Yield

-600

-800

S&P 500 Dividend Yield Five-year Treasury Yield Spread

-1,000

0
Jan/02 Jan/04 Jan/06 Jan/08 Jan/10 Jan/12

-1,200

'53

'58

'63

'68

'73

'78

'83

'88

'93

'98

'03

'08

Source: Standard & Poors, Federal Reserve Board, Gluskin Sheff

Its also why the dividend theme has hardly run its course. As the chart below illustrates, the income-starved retiring boomers are being forced to garner income more and more via the equity market, where dividends are up more than 8% over the past year and 55% since August 2009 and in a full-fledged bull market. That first chart is a chart you want to own. And because of ultra-low interest rates, the financial repression thereof has caused interest income growth to collapse down 2% in the past year and over 30% from the peak level in August 2008. If you want income, you have to go to the non-investment grade

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part of the corporate bond market, and even here, it is tough to get even a 7% coupon these days. Or you gravitate towards dividend growth and dividend yield areas of the equity market. T-bills and bank deposits protect capital but do not generate any return at all so that is a non-starter except for the most acute riskaverse folks in our midst. And Bernanke has already told them that in no uncertain terms, they will be punished for their excessive pessimism via negative real after-tax returns (so not even cash is really safe any more!). CHART 10: A TALE OF TWO INCOMES
United States ($ billions)
Dividend Income
850.0 800.0 750.0 1300.0 700.0 650.0 600.0 550.0 1000.0 500.0 450.0 Jan/06 900.0 Jan/06 1200.0

Interest Income
1500.0

1400.0

1100.0

Jan/07

Jan/08

Jan/09

Jan/10

Jan/11

Jan/12

Jan/07

Jan/08

Jan/09

Jan/10

Jan/11

Jan/12

Source: Haver Analytics, Gluskin Sheff

Finally, here is the great anomaly. Back in the early 1980s, investors bought equities for capital appreciation and they purchased Treasury securities for yield. Today it is the complete opposite. As the move into hybrids strongly suggests, people are gravitating to the equity market for a yield in a world where yield is increasingly a scarce commodity. And investors are not buying Treasury notes and bonds for yield any more, but for the capital gain they generate especially with the Feds interventions taking more and more duration out of the private marketplace. Well, there may be much less juice left at the front end after yields there have drifted down to historical low levels, but long bonds still look attractive in terms of potential price appreciation given the still-steep yield curve.

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December 2012 SPECIAL REPORT THE INVESTMENT OUTLOOK FOR 2013

CHART 11: RECORD FLOWS INTO INCOME-GENERATING FUNDS

United States (12-month moving total: US$ billions)
Bond Funds
450 Inflow 400 350 300 250 10 200 0 150 100 50 0 -50 '07 '08 '09 '10 '11 Outflow '12 -10 -20
-150 -100 -50

Hybrid Funds
50 Inflow 40

Capital Appreciation Equity Funds

100 Inflow 50

30 20
0

-30 Outflow -40 '07 '08 '09 '10 '11 '12

-200 '07 '08 '09 '10 '11 Outflow '12

Note: Chart scales are different Source: Haver Analytics, Gluskin Sheff

As for corporate bonds, at least you still get a very decent spread over government bonds, and in a sector where balance sheets are still in very good shape. CHART 12: CORPORATE DEFAULT RATES MATCH STRONG BALANCE SHEET FUNDAMENTALS
United States: High Yield Corporate Bond Default Rates (percent)
16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Jan/96

Historical Average

Jan/98

Jan/00

Jan/02

Jan/04

Jan/06

Jan/08

Jan/10

Jan/12

Shaded regions represent periods of U.S. recession Source: Barclays Capital, Gluskin Sheff

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December 2012 SPECIAL REPORT THE INVESTMENT OUTLOOK FOR 2013

CHART 13: CORPORATE SECTOR FINANCES IN GOOD SHAPE

United States: Nonfarm Non-financial Corporate Business (percent)
Liquid Assets to Short-term Debt Ratio
60 55 50 45 40 35 30 25

Long-term Debt to Credit Market Debt Ratio

80 75 70 65 60 55

20 15 '70 '74 '78 '82 '86 '90 '94 '98 '02 '06 '10

50 '70 '74 '78 '82 '86 '90 '94 '98 '02 '06 '10

Source: Haver Analytics, Gluskin Sheff

CHART 14: CORPORATE BOND YIELDS LOW IN ABSOLUTE TERMS BUT HIGH IN RELATIVE TERMS
United States: BBB-rated Corporate Bond Yields and Spread off Treasury
Yield
(percent) 11

Spread
(basis points)
900 800 700 600 500

10 9 8 7

400

6 5 4 3 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

300 200 100 0 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

Pre-Bubble Average

Shaded regions represent periods of U.S. recession Source: Haver Analytics, Gluskin Sheff

So welcome to the new normal of investing buying bonds for the price, buying equities for the yield. We remain in the throes of a secular era of disinflation, and I expect this theme to become accentuated in 2013 as the global output gap widens further. We also are in a long-term period of sub-par economic growth and below-average returns. This has become so well entrenched that U.K. pension plans, as one example, now have more exposure to bonds than to stocks, as I have previously indicated. This is not about being bearish, bullish or agnostic. Its about being

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realistic and understanding that in our role as market economists, it is necessary to provide our clients with information and analysis that will help them to navigate the portfolio through these stressful times. Our crystal ball says to stick with what works in an uncertain financial and economic climate in other words, maintain a defensive and income-oriented investment strategy. CHART 15: A SUB-PAR U.S. ECONOMIC RECOVERY
United States: 13 Quarters After A Recession Ends
Real GDP per capita
(annualized percent change)
5% 5% 4% 4% 3.1% 3% 3% 2% 2% 1% 1% 0% 61 Q1 70 Q4 75 Q1 82 Q4 91 Q1 01 Q4 Avg. Current Last Quarter of Recession 1.9% 1.9% 1.3% 2.7% 4.4% 4.2% 3.7%

Nominal GDP per capita

(annualized percent change)
12% 10.3% 10%

8%

7.8%

7.4% 6.5%

6% 4.9% 4% 4.0% 4.3% 3.1%

2%

0% 61 Q1 70 Q4 75 Q1 82 Q4 91 Q1 01 Q4 Avg. Current Last Quarter of Recession

Source: Bureau of Economic Analysis, Bureau of Labour Statistics, Haver Analytics, Gluskin Sheff

CHART 16: THE (SLIDING) EVOLUTION OF THE FEDS GDP FORECAST

United States: Federal Reserve GDP Forecast
2012
4.0 4.05

2013
4.5
3.95 3.85 3.50

4.15 4.0 3.90 3.85

3.5

3.0 2.70 2.5 2.45 2.15 2.0 1.85 2.65

3.5 3.25 3.0 3.00 2.90 2.75 2.5

1.75

2.65

2.50

1.5

2.0

Source: Bloomberg, Gluskin Sheff

To reiterate, the conditions for disinflation have already arrived. And in a disinflationary backdrop, there are three investment characteristics that make sense: income, income and income. This is why I continue to favour bonds of most types, long-short fixed-income strategies and dividend-growth stocks in non-cyclical parts of the equity market, denominated by countries with only the highest credit ratings, backed by proven and probable reserves in the ground

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and central banks that are not expanding their balance sheets and not subjecting their citizens to financial repression. From a top-down perspective, what drives inflation is the shape and interaction of two different curves the economys aggregate supply curve and the aggregate demand curve. The movements in these curves tell us where the output gap is at any moment in time the gap between where the economy is actually operating and the level it would be operating at if it were running flat out at full employment. In other words, the gap measures the degree of slack in the labour and product markets, and this gap at 6% currently augurs for fair-value or equilibrium policy rates to be -2.2% according to our research, which is why at the zero bound, the Fed has been and will continue to focus on non-conventional measures aimed at lowering the cost of capital. CHART 17: TREMENDOUS EXCESS CAPACITY IN THE U.S. ECONOMY
United States: U.S. Output Gap as Percent of Potential GDP (percent)
8
Excess demand

-4

-8
Excess supply

-12 '49 '54 '59 '64 '69 '74 '79 '84 '89 '94 '99 '04 '09

Shaded regions represent periods of U.S. recession Source: Haver Analytics, Gluskin Sheff

CHART 18: GLOBAL OUTPUT GAP DEFLATIONARY

OECD Countries: Output Gap as Percent of Potential GDP (percent)
4
Excess demand

-2

-4
Excess supply

-6 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13

Dotted line represents OECDs forecast Source: Haver Analytics, Gluskin Sheff

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CHART 19: EQUILIBRIUM FED FUNDS RATE IS ACTUALLY NEGATIVE

United States: Fed Funds Rate and Taylor-rule Estimate (percent)
12
Taylor Rule Estimate

10 8 6 4 2 0 -2 -4 -6 -8 1990

Actual Fed Funds Rate

1995

2000

2005

2010

Source: Bureau of Economic Analysis, Congressional Budget Office, Federal Reserve Board, Haver Analytics, Gluskin Sheff

CHART 20: UNPRECEDENTED MONETARY EXPANSION

United States
Fed Funds Rate
(percent)
5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 05 06 07 08 09 10 11 12
0.5 05 06 07 08 09 10 11 12 1.0 1.5 2.0 2.5

Fed Balance Sheet Total Assets

($ trillion)
3.0

Source: Haver Analytics, Gluskin Sheff

The Fed has also completely altered the relationship between stocks and bonds by nurturing an environment of ever deeper negative real interest rates. Therein lies the rub. The economy and earnings are weak, and getting weaker, but the interest rate used to discount the future earnings stream keeps getting more and more negative, and that lowers the corporate cost of capital and in turn raises the present value of expected future profits. Its that simple. Against this weak economic growth and low interest rate background, we continue to advocate a relatively high fixed-income orientation in the portfolio
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a focus on S.I.R.P. (Safety and Income at a Reasonable Price). That includes high-quality corporates (and choose those with strong balance sheets, high cash reserves and minimal refinancing needs), cross-over credits and credit arbitrage strategies. And in the equity market, continue to screen for dividend yield and consistent organic free cash flow in non-cyclical industries that enable growing dividends and share buybacks. TABLE 2: INVESTMENT STRATEGY: AN UNCONVENTIONAL DIVERSIFIED APPROACH
1. Focus on S.I.R.P.: High-quality corporates (non-cyclical, high cash reserves, minimal refinancing needs). Corporate balance sheets are in very good shape. 2. Equities: Focus on reliable dividend growth/yield; preferred shares (income orientation). 3. Whether it be credit or equities, focus on companies with low debt/equity ratios and high liquid asset ratios balance sheet quality is even more important than usual. Avoid highly leveraged companies. 4. Even hard assets that provide an income stream work well in a deflationary environment (i.e., oil and gas royalties, REITs, etc). 5. Focus on sectors or companies with these micro characteristics: low fixed costs, high variable cost, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity (utilities, staples, health care these sectors are also unloved and under- owned by institutional portfolio managers). 6. Alternative strategies: Allocate significant portion of asset mix to strategies that are not reliant on rising equity markets and where volatility can be used to an advantage (i.e. true long-short strategies). 7. Precious metals: A hedge against the reflationary policies aimed at defusing deflationary risks money printing, rolling currency depreciations, heightened trade frictions, and government procurement policies.
Source: Gluskin Sheff

With regard to global events, we continue to monitor the European situation closely. Euro zone finance ministers have given Greece an additional two-year lifeline and the Greek parliament just passed another round of severe austerity measures, which I think will only serve to make matters worse there from an economic standpoint, but I doubt that the creditors are going to let Greece go just yet. So this never-ending saga remains a source of ongoing uncertainty, but at the same time, is a key reason why the Fed and the Bank of Canada will continue to keep short-term interest rates near the floor, and all that means is to build even more conviction over income equity and corporate bond themes.

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CHART 21: EUROPE HEADING INTO RECESSION

Euro Area (year-over-year percent change)
Real GDP
4 3 2 1 0

Employment level
2.0 1.5 1.0 0.5 0.0

-1

-0.5
-2 -3 -4 -5 -6 '07 '08 '09 '10 '11 '12

-1.0 -1.5 -2.0 -2.5 '07 '08 '09 '10 '11 '12

Source: Haver Analytics, Gluskin Sheff

CHART 22: AND LIKELY TO REMAIN THAT WAY FOR SOME TIME
Euro Area: Leading Indicator (year-over-year percent change)
6

-2

-4

-6 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

Shaded regions represent periods of U.S. recession Source: Haver Analytics, Gluskin Sheff

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CHART 23: THERE IS NO DECOUPLING

Real GDP Growth (year-over-year percent change)
6.0
r = 0.83

4.0

United States (USD)

2.0
European Union (Euro)

0.0

-2.0

-4.0

-6.0 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05

Source: Haver Analytics, Gluskin Sheff

As for something new, after a rather significant slowdown in China for much of this year that put the commodity complex in the penalty box for a period of time, we are seeing some early signs of visible improvement in the recent economic data out of China and this actually has happened even in advance of any significant monetary and fiscal stimulus. And while the Chinese stock market has been a laggard, if there is one country that does have the room to stimulate, it is China (make no mistake, however, Chinas economic backdrop is still quite tenuous, especially as it pertains to the corporate sector excessive inventories, stagnant profits, rising costs and lingering excess capacity are all challenges to overcome). Keep in mind that much of this slowing in China was a lagged response to prior policy tightening measures to curb heightened inflationary pressures pressures that have since subsided sharply with the consumer inflation rate down to 2% (near a three-year low) from the 6.5% peak in the summer of 2011 and producer prices are deflating outright. What is providing a big assist to this sudden reversal of fortune in China is a re-acceleration in bank lending as a resumption of credit growth and bond issuance has allowed previouslyannounced infrastructure projects out of Beijing (railways in particular) to get incubated. The nascent economic turnaround we are seeing in China, if sustained, is positive news for the commodity complex and in turn resource-sensitive currencies like the Canadian dollar, which Im happy to report has hung in extremely well this year even in the face of all the global economic and financial crosscurrents. Just consider that the low for the year for the loonie was 96 cents you have to go back to 1976 to see the last time intra-year lows happened at such a high level.

The nascent economic turnaround we are seeing in China, if sustained, is positive news for the commodity complex and in turn resource-sensitive currencies like the Canadian dollar

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December 2012 SPECIAL REPORT THE INVESTMENT OUTLOOK FOR 2013

CHART 24: RECOVERY IN CHINA WILL BENEFIT COMMODITY PRICES

CRB Spot Index
600 550 500 450 400 350 300 250 200 150 100 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 China joins the WTO

Shaded regions represent periods of U.S. recession Source: Haver Analytics, Gluskin Sheff

CHART 25: HAS CANADA BEEN RE-RATED?

Canada: Canadian Dollar (C$/US$))
1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 '70 '73 '76 '79 '82 '85 '88 '91 '94 '97 '00 '03 '06 '09 '12
Parity

Source: Haver Analytics, Gluskin Sheff

Beneath the veneer, there are opportunities. I accept the view that central bankers are your best friend if you are uber-bullish on risk assets, especially since the Fed has basically come right out and said that it is targeting stock prices. This limits the downside, to be sure, but as we have seen for the past five weeks, the earnings landscape will cap the upside. I also think that we have to take into consideration why the central banks are behaving the way they are, and that is the inherent fat tail risks associated with deleveraging cycles that typically follow a global financial collapse. The next phase, despite all efforts to kick the can down the road, is deleveraging among sovereign governments,

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primarily in half the worlds GDP called Europe and the U.S. Understanding political risk in this environment is critical. CHART 26: DELEVERAGING PROCESS IN ITS EARLY STAGES
United States: Total Debt to GDP (percent)
400

350

300

250

200

150

100 '51 '56 '61 '66 '71 '76 '81 '86 '91 '96 '01 '06 '11

Source: Haver Analytics, Gluskin Sheff

CHART 27: STILL MORE TO GO BEFORE THE HOUSEHOLD BALANCE SHEET IS REPAIRED
United States (percent)
Household Debt-to-Asset Ratio
23 22 21 20 19 18 17 16 15 14 13 12 11 '72 '77 '82 '87 '92 '97 '02 '07 '12

Household Debt-to-Income Ratio

140 130 120 110 100 90 80 70 60 '72 '77 '82 '87 '92 '97 '02 '07 '12

Source: Haver Analytics, Gluskin Sheff

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CHART 28: THE WORLD IS AWASH IN DEBT

OECD: Gross General Government Debt-to-GDP Ratio (percent of nominal GDP)
115 106 105 98 95 91 102

85 74 74 74 73 75 76 75 73

80 72 73 72

75 69 65 64

70

70

70

55 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12

Shaded bars represent OECD estimates Source: Haver Analytics, Gluskin Sheff

And that is my point. It is not about gross nominal returns as much as riskadjusted returns now more than ever. Getting it right for clients in the wealth management business means striving every single day to spot opportunities, assess them, monitor the risks and most importantly, evaluate the trade-offs in the trade to generate the best risk-adjusted returns. Having an appreciation of the risks doesnt inherently mean you are risk averse; however, what it does do is empower you to make prudent investment decisions that you can reflect on with a greater understanding of how you achieved success. We are entering into a period of stable consumer prices that should last at least for a generation. This will help prevent erosion in real household incomes. There is a strong probability that after years of very solid productivity gains in the industrial sector, that the U.S. will experience a manufacturing renaissance of sorts and re-emerge as a global export leader. This process is already in its infancy stages, aided and abetted by cheap natural gas costs. The move towards frugality and savings will make us less reliant on foreign borrowings and usher in a period of stronger household balance sheets. With regard to the fiscal cliff issue, we have to assume that it will get resolved this year. The only question is one of timing and the configuration of the tax increases and spending reductions. It is also reasonable to assume that as the tax base gets broadened and entitlement reform takes hold, an enormous amount of shared sacrifice will be required. Less government will require a move towards tighter budgets and this will contribute to stress in the job market and after-tax personal incomes, at least for a while. Attitudes are changing radically as there is a growing acceptance among public sector unions and civil servants that the way they spend and save is going to undergo some radical changes in

With regard to the fiscal cliff issue, we have to assume that it will get resolved this year. The only question is one of timing and the configuration of the tax increases and spending reductions

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the future. Furloughs, layoffs, and now less-generous pension benefits for current workers and retirees are occurring for the first time ever. So we will have less government, fewer entitlements and more whisperings that it isnt just the $250,000+ high-income households that are going to experience tax increases and diminished disposable income growth. This is what shared sacrifice is all about, and will end up constraining domestic demand growth as far as the eye can see, nurturing this secular period of ultra-low interest rates and below-normal expected returns in the broad marketplace. CHART 29: THE FISCAL CLIFF
United States: Change in Primary Fiscal Balance to GDP Ratio (percentage points)
4%
Net Fiscal Drag

Record Drag!

2%

-1%

-3%

-5%
Net Fiscal Stimulus

-7% 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

2013 is based on CBO estimates of the fiscal balance Source: CBO, Haver Analytics

CHART 30: A CHALLENGING ENVIRONMENT FOR THE FEDERAL GOVERNMENT

United States: Change in Primary Fiscal Balance to GDP Ratio (percent)
Interest Payments as a Share of Total Revenue
20 18 16 14 12 10 8 6 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15 '20

Debt as a share of GDP

115 105 95 85 75 65 55 45 35 25 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15 '20

Shaded bars and dotted lines represent estimates (interest payments/total revenue estimates by Gluskin Sheff and debt/GDP estimates by the OMB) Source: OECD, U.S. Office of Management and Budget (OMB)

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To reiterate, our primary strategy theme has been and remains S.I.R.P. Safety and Income at a Reasonable Price because yield works in a deleveraging deflationary cycle. Not only is there substantial excess capacity in the global economy, primarily in the U.S. where the output gap is close to 6%, but the more crucial story is the length of time it will take to absorb the excess capacity. It could easily take five years or longer, depending of course on how far down potential GDP growth goes in the intermediate term given reduced labour mobility, lack of capital deepening and higher future tax rates. This is important because what it means is that disinflationary, even deflationary, pressures will be dominant over the next several years. Moreover, with the median age of the boomer population turning 56 this year, there is very strong demographic demand for income. Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible so a reliance on reliable dividend yield and dividend growth makes perfect sense. CHART 31: NOT AGED BUT STILL AGING
United States: Median Age of Baby Boomers
60 55 50 45 40 35 30 25 20 15 10 1974 1980 1982 1990 Recession Years 2001 2009 2012 17 23 25 35 44 55 52

Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible so a reliance on reliable dividend yield and dividend growth makes perfect sense

Source: Haver Analytics, Gluskin Sheff

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CHART 32: DEALING WITH DEMOGRAPHICS

United States: Share of Total Population
Age 25-49
(percent)
40%

Age 50-74
(percent)
Capital appreciation crowd
30%

Capital preservation crowd

29% 28% 27%

39% 38% 37%

26% 36% 35% 34% 33% 32% '80 '90 '00 '10 25% 24% 23% 22% 21% 20% '80 '90 '00 '10

Dashed lines represent forecast Source: Haver Analytics, Gluskin Sheff

Gold is also a hedge against financial instability and when the world is awash with over $200 trillion of household, corporate and government liabilities, deflation works against debt servicing capabilities and calls into question the integrity of the global financial system. This is why gold has so much allure today. It is a reflection of investor concern over the monetary stability, and Ben Bernanke and other central bankers only have to step on the printing presses whereas gold miners have to drill over two miles into the ground (gold production is lower today than it was a decade ago hardly the same can be said for fiat currency). Moreover, gold makes up a mere 0.05% share of global household net worth, and therefore, small incremental allocations into bullion or gold-type investments can exert a dramatic impact. Gold cannot be printed by central banks and is a monetary metal that is no governments liability. It is malleable and its supply curve is inelastic over the intermediate term. And central banks, who were selling during the higher interest rate times of the 1980s and 1990s, are now reallocating their FX reserves towards gold, especially in Asia. With the gold mining stocks trading at near record-low valuations relative to the underlying commodity and the group is so out of favour right now, that anyone with a hint of a contrarian instinct may want to consider building some exposure as we have begun to do.

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CHART 33: TEN GOLDEN YEARS OF CLOSING HIGHS

Gold: Historical December 31st Closing Prices (US $/troy oz)
1,800

1,600

1,400

1,200

1,000

800

600

400

200

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Bloomberg

CHART 34: TWO REASONS TO BE BULLISH ON GOLD

Annual Global Gold Mining Output
(tonnes)
2800

U.S. Adjusted Monetary Base

(US$ trillion)

Global Gold Mining Stagnant

2600 2400 2200 2000 1800 1600 1400 1200 80 85 90 95 00 05 10

2.4

1.9

1.4

Fed Chairman Bernanke was appointed here

0.9

0.4 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: U.S. Geological Survey, World Gold Council, Haver Analytics, Gluskin Sheff

In that light, the bond-bullion barbell continues to make sense to us within a diversified portfolio that includes the parts of the equity market that trade like a bond (i.e. dividend themes in mostly non-cyclical areas of the market with a high degree of earnings visibility), cross-over credits within the fixed-income market to capture those few companies on the verge of a rating upgrade but not as yet priced for the event, as well as long-short strategies that manage to take advantage of the Feds ongoing policy of taking interest rate risk and interest rate volatility out of the market-place. In other words, what broadly worked in terms of delivering high-single-digit risk adjusted returns in 2012, with very few tweaks, should remain intact in 2013. We are in the third wave of the global deleveraging cycle that is likely to hold
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global economic growth in check and keep global equity markets range-bound for the most part, but as always there will be opportunities beneath the veneer and periods where valuations augur for more positive tactical responses. At the same time, while I wouldnt exactly say that I see silver linings, I would say that some clouds certainly appear to be parting as 2012 draws to a close. For one, we are seeing some stabilization of the U.S. data that should prevent further downgrades at least as the Q4 GDP consensus call is concerned (already heading close to a 1% annual rate). In the past month, 48% of the data have come in above expectations versus 43% below. Second, it looks as though we are moving closer to a deal on the fiscal front. The cliff will likely be avoided but Q1 will still be a steep hill. The fact that Boehner blinked with regard to the tax rate issue will hopefully be a quid pro quo for much-needed entitlement reforms. Third, China not only managed to successfully guide its economy into a soft landing, there are now signs of renewal in industrial activity. Fourth, while I am skeptical about the longevity of the U.S. housing cycle in the absence of the first-time buyer, there are experts who I have a ton of respect for seeing sustained strength in 2013. Fifth, Japan just elected a new government that is much more dedicated towards reflation than its predecessor. If both the Japanese and Chinese economies truly swing around, the implications for resource prices, the basic materials sector and the Canadian dollar will be enormously positive. Sixth, we know that the ECB has managed to put a floor in regarding the Euro area crisis which has not suffered a flare-up in a year. At least we know that Germany has a federal election next September, and one would have to presume that Angela Merkel will not allow the apple cart to be upset until then. So its good to have some conviction that Europe will stay off the front pages and as such, mitigate fat-tailed market risks. Be that as it may, most of the world remains on a debt diet, especially within the federal government sectors, and the concept of shared sacrifice that will be needed to redress chronic budgetary imbalances via spending retrenchment and tax increases means, from an investment posture, that the tortoise will again win the race against the hare in the year ahead. In other words, capital preservation first, preservation of cash flows second, and we will tactically position and adjust our portfolios for price appreciation opportunities, but focusing on limiting the downside risks in our portfolios means that the total return generation will remain on securing stable cash flow streams for our clients. Have a healthy and happy new year!

As always, there will be opportunities beneath the veneer and periods where valuations augur for more positive tactical responses

We will tactically position and adjust our portfolios for price appreciation opportunities

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Gluskin She at a Glance

Gluskin She + Associates Inc. is one of Canadas pre-eminent wealth management firms. Founded in 1984 and serving high net worth private clients and institutional investors, 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.
0

OVERVIEW
As of September 30, 2012, the Firm managed assets of $5.6 billion. Gluskin Sheff became a publicly traded corporation on the Toronto Stock Exchange (symbol: GS) in May 2006 and remains 46% owned by its senior management and employees. We have public company accountability and governance with a private company commitment to innovation and service.

INVESTMENT STRATEGY & TEAM

We have strong and stable portfolio management, research and client service teams with best in class talent at all levels. We have a strong history of insightful bottom-up security selection based on fundamental analysis. For long equities, we look for companies with a history of long-term growth and stability, a proven track record, shareholder-minded management and a share price below our estimate of intrinsic value. We look for the opposite in equities that we sell short.

Our investment interests are directly aligned with those of our clients, as Gluskin Sheffs management and employees are collectively the largest For corporate bonds, we look for issuers client of the Firms investment portfolios. with a margin of safety for the payment We offer a diverse platform of investment of interest and principal, and yields which strategies, including Canadian, U.S. and are attractive relative to the assessed International Equity strategies, credit risks involved. Alternative strategies and Fixed Income We assemble concentrated portfolios 1 strategies. our top ten holdings typically represent The minimum investment required to between 25% to 45% of a portfolio. In this establish a client relationship with the way, clients benefit from the ideas in Firm is $3 million. which we have the highest conviction.

Our investment interests are directly aligned with those of our clients, as Gluskin Shes management and employees are collectively the largest client of the Firms investment portfolios.

$1 million invested in our Canadian Equity Portfolio in 1991 (its inception date) would have grown to $9.4 million2 on September 30, 2012 versus $6.2 million for the S&P/TSX Total Return Index over the same period.

PERFORMANCE

$1 million invested in our Canadian Equity Portfolio in 1991 (its inception 2 date) would have grown to $9.4 million on September 30, 2012 versus $6.2 million PORTFOLIO CONSTRUCTION for the S&P/TSX Total Return Index In terms of asset mix and portfolio over the same period. construction, we offer a unique marriage between our bottom-up security-specific $1 million usd invested in our U.S. fundamental analysis and our top-down Equity Portfolio in 1986 (its inception macroeconomic view. date) would have grown to $14.7 million 2 usd on September 30, 2012 versus $12.6 million usd for the S&P 500 Total Return Index over the same period.
Notes:

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.

For further information, please contact research@gluskinshe.com

H

Unless otherwise noted, all values are in Canadian dollars. 1. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation. 2. Returns are based on the composite of segregated Canadian Equity and U.S. Equity portfolios, as applicable, and are presented net of fees and expenses.

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IMPORTANT DISCLOSURES
Copyright 2012 Gluskin Sheff + Associates Inc. (Gluskin Sheff). All rights reserved. This report may provide information, commentary, and discussion of issues relating to the state of the economy and the capital markets. All opinions, projections and estimates constitute the judgment of the author as of the date of the report and are subject to change without notice. Gluskin Sheff is under no obligation to update this report and readers should therefore assume that Gluskin Sheff will not update any fact, circumstance or opinion contained in this report. The content of this report is provided for discussion purposes only. Any forward looking statements or forecasts included in the content are based on assumptions derived from historical results and trends. Actual results may vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision, and no investment decisions should be made based on the content of this report. This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and particular needs of any specific person. Under no circumstances does any information represent a recommendation to buy or sell securities or any other asset, or otherwise constitute investment advice. Investors should seek financial advice regarding the appropriateness of investing in specific securities or financial instruments and implementing investment strategies discussed or recommended in this report. Gluskin Sheff may own, buy, or sell, on behalf of its clients, securities of issuers that may be discussed in or impacted by this report. As a result, readers should be aware that Gluskin Sheff may have a conflict of interest that could affect the objectivity of this report. Gluskin Sheff portfolio managers may hold different views from those expressed in this report and they are not obligated to follow the investments or strategies recommended by this report. This report should not be regarded by recipients as a substitute for the exercise of their own judgment and readers are encouraged to seek independent, third-party research on any companies discussed or impacted by this report. Securities and other financial instruments discussed in this report are not insured and are not deposits or other obligations of any insured depository institution. Investments in general and, derivatives, in particular, involve numerous risks, including, among others, market risk, counterparty default risk and liquidity risk. No security, financial instrument or derivative is suitable for all investors. In some cases, securities and other financial instruments may be difficult to value or sell and reliable information about the value or risks related to the security or financial instrument may be difficult to obtain. Investors should note that income from such securities and other financial instruments, if any, may fluctuate and that the price or value of such securities and instruments may rise or fall and, in some cases, investors may lose their entire principal investment. Past performance is not necessarily a guide to future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or financial instrument mentioned in this report. Investors in such securities and instruments effectively assume currency risk. Any information relating to the tax status of financial instruments discussed herein is not intended to provide tax advice or to be used by anyone to provide tax advice. Investors are urged to seek tax advice based on their particular circumstances from an independent tax professional. Individuals identified as economists in this report do not function as research analysts. Under U.S. law, reports prepared by them are not research reports under applicable U.S. rules and regulations. In accordance with rules established by the U.K. Financial Services Authority, macroeconomic analysis is considered investment research. Materials prepared by Gluskin Sheff research personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Gluskin Sheff. To the extent this report discusses any legal proceeding or issues, it has not been prepared as nor is it intended to express any legal conclusion, opinion or advice. Investors should consult their own legal advisers as to issues of law relating to the subject matter of this report. 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