David A.

Rosenberg December 13, 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
From an economic data perspective, there was no major earth-shattering news
today, but the risk-on trade remains in place and today’s action is being • While you were sleeping:
underpinned by the fact that contrary to some expectations, China refrained from an economic data
perspective, there was no
from raising interest rates in the face of some accelerating inflation numbers major earth-shattering
and some decent economic reports as well. Let ‘er rip. The MSCI Asia Pacific news today, but the risk-
index is up 0.5% today and the Nikkei jumped 0.8%. In the meantime, U.S. on trade remains in place
Treasury yields are making fresh six-month highs. Commodities are on the move
• One over extended stock
— as is the Canadian dollar — with copper firming roughly 2% so far today. Gold market: this has indeed
and oil are following suit. been a U.S. stock market
in need of good news
In our opinion, the equity market is overbought and overextended and optimism announcements for its
is reaching extreme levels. Perceptions over the sustainability of U.S. economic success
growth are proving tough to break and investors are cheering on the latest round • Policy discord: The U.S. is
of fiscal easing coming out of the White House. There is growth of course, but of busy fighting deflation and
very low quality given the level of government intervention and surging public easing fiscal policy
sector debt burdens and is deserving more of single-digit P/E multiples than whereas the emerging
market countries are busy
anything in the 14x areas, which many Wall Street strategists see as fair-value. fighting inflation and
There is an inverse relationship, over time, between structural government moving towards austerity
deficits and market multiples and the current trend augurs for lower valuations,
• Perception versus reality: I
not higher.
have been a secular bond
bull and am not yet
The added perception that the pace of U.S. economic activity is as pervasive as changing my view of the
it was this time last year. But when the Fed stopped expanding its balance fixed-income market, but
sheet and investors awoke to the deep-rooted problems in Europe, the pace of the perception that the
growth slowed and a healthy dose of caution crept back into the marketplace. economy will grow
vigorously is now
Those memories have faded but we would expect to see the U.S. economy to
extremely strong
come in below the lofty expectations that are currently embedded in market
valuations. If things were that strong beneath the surface we wouldn’t have
needed QE2 or this latest round of fiscal easing.

Even the ballyhooed upwardly revised Q3 real GDP data in the U.S. was a bit of
an overstatement. If not for the wealth-effect-induced decline in the savings
rate, real GDP growth would have been closer to a 2.0% at an annual rate rather
than 2.5% — and in a quarter that historically at this stage of the recovery when
it should be at least 4%. What has the growth bulls all in a tizzy is the downtrend
in initial jobless claims. Yet, someone has to explain how in the latest week we
could have the level of “insured unemployment” soar 523k to 4.2 million and
somehow construe that as something good.

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
December 13, 2010 – BREAKFAST WITH DAVE

We have a busy week ahead: U.S. retail sales and inflation data, the Fed
The latest U.S. fiscal package
meeting, the German ZEW and Ifo sentiment data, RIM and BestBuy earnings,
has caused most economists
President Obama has called for a CEO Summit for Wednesday, and on Thursday
to revise up their real GDP
we have the Irish vote over its IMF-led assistance package. Could be ripe for
forecast for Q4 and 2011
some renewed volatility.

Just a word on the U.S. fiscal package that has caused every economists, and
his/her mother, to revise up Q4 and 2011 real GDP forecasts. This could be
very premature based on past U.S. consumer responses to tax relief that is
perceived to be temporary as opposed to permanent (as is the case with this
latest package of goodies).

Remember back in early 2008, President Bush cobbled together, along with
Congress, a $168 billion economic stimulus plan to help reverse the recession.
The bill includes tax rebates, a rescue plan for distressed mortgages, and tax
breaks for small businesses. The first cheques arrived in homes during the last
week of April 2008. Here is what the President declared at that time:

“These rebates will begin reaching American families in May. And when the
money reaches the American people, we expect they will use it to boost
consumer spending, and that will spur job creation, as well.”

For a brief period, the bond market sold off (the U.S. 10-year yield jumped 60
basis points) and the stock market took off for about two months (the Dow
surged around 1,300 points) — led by the consumer discretionary group. This The stock market run-up in
had to have been the greatest head-fake of all time because of the fact that 2008, which was caused by
these tax cuts (as opposed to the semi-permanent cut in tax rates in 2003 or the Bush economic stimulus
the Reagan tax cuts of the mid-1980s) were deemed to be temporary. What
plan, was probably the
greatest head-fake of all time
households did instead was save the proceeds. As a result, the savings rate
went from 2.7% in Q1 to 4.8% in Q2 of 2008, and even as real personal
disposable income jumped an epic 9% annual rate, real consumer spending was
flat and real GDP barely expanded (+0.6% at an annual rate).

That was actually the second time that George ‘W’ tried a temporary tax
reduction — to no avail. Go back to the 2001 recession and the government
started to mail out $95 million refund checks in July of that year. Single
individuals got $300, single parents received $500 and married couples saw a
$600 rebate gift from their politicians in Washington, all for the sake of getting
the consumer to spend more. Well, again, it was viewed as a temporary
windfall, and despite all the forecasts at the time for an economic turnaround,
the savings rate doubled to 4.2% in the third quarter of that year and despite a
fiscally-induced 10.6% surge in real personal disposable income, real GDP
actually ended up contracting at a 1.1% annual rate and the consumer again
was very quiet that quarter (1.8% annualized growth — that’s it).

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It’s completely normal for the majority of economists to get excited over these
periodic fiscal shifts like we saw last week. But as they upgrade their numbers, It’s completely normal for
what they don’t bother to take into account is the nature of the tax shifts and the economists to get excited over
extent they will actually motivate consumers to spend the windfall as opposed to periodic fiscal shifts, like we
saving it. The recent history of these transitory tax changes is pretty clear, and saw last week …
the reaction of the economics community conjures up the memory of Albert
Einstein’s famous definition on insanity: doing the same thing over and over
again and expecting different results. In the lead-up to the temporary tax cuts in
both 2001 and 2008, the consensus was looking for at least 2% growth for the
quarters in which the relief began and acceleration thereafter — much to the
chagrin of the forecasting community. The problem is that there are no lasting
multiplier impacts from these types of fiscal gimmicks that are working their way
through the Senate and House.

We fail to see how the People’s Bank of China (PBOC) allowing itself to fall
further behind the inflation curve is a good thing, but only time will tell the extent
to which more tightening moves will be required. The inflation problem there
transcends food — credit, real estate and labour costs must be added to the
worry list.

Moreover, the situation in Europe remains fluid, to say the list. Just to show how
… But what these economists
incestuous it all is, here we have the just-released update on the BIS data
don’t take into account is the
showing that German banks have massive exposure of $217 billion to Spanish
nature of the tax shifts, and
debt and yet Spanish banks have $98 billion of exposure to Portuguese
the extent they will actually
sovereign debt. German banks have total exposure of $65 billion to Greece and motivate consumers to spend
France is even larger at $83 billion. Both German and U.K. banks have just this windfall as opposed to
under $190 billion apiece in overall exposure to Ireland and it would be a very saving it
big mistake to assume that the emerald country won’t, at some point, do the
logical thing for its citizenry and demand some “shared sacrifice” out of its
creditors. See Spotlight on Banks’ Exposure in Europe on page C1 of today’s
WSJ for more on this saga.

We remain long-term secular bulls on commodities, but as the charts below

reveal, the net speculative position in gold, oil and copper are far too high right
now for comfort. Oil is at a record high in terms of speculative net longs on the
New York Mercantile Exchange.

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December 13, 2010 – BREAKFAST WITH DAVE

CHART 1: SPECULATIVE LONG POSITION IN OIL — AT A RECORD HIGH

United States: Noncommercial Long minus Short Position in Oil
(contracts of 1,000 barrels, thousands)
225

150

75

-75
95 00 05 10

Source: Haver Analytics, Gluskin Sheff

CHART 2: SPECULATIVE INTEREST IN GOLD AT NEAR-RECORD TOO

United States: Noncommercial Long minus Short Position in Gold
(contracts of 100 troy oz, thousands)
300

200

100

-100
95 00 05 10

Source: Haver Analytics, Gluskin Sheff

We also remain long-term bulls on bonds but the difference between bonds and
commodities is that the former is now the most detested asset class on the
planet — see Dealers See Higher ‘11 Yields (that could have been written a year
ago, and even with the Bernanke/Obama led stock market rally in recent
months, bonds still rivalled stocks in total return terms) on page C2 of the WSJ.
Of the 18 forecasters polled, only one sees the yield on the U.S. 10-year T-note
coming back below the 3% mark next year – 10 forecasters are expecting 3.5%
or higher. Talk about groupthink. Meanwhile, the latest Commitment of Traders
data show that open interest in U.S. Treasury bond contracts are at their lowest
levels in more than five years — another sign of total disinterest in the fixed-
income market. As contrarians, we sort of like that.

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December 13, 2010 – BREAKFAST WITH DAVE

CHART 3: OPEN INTEREST IN TREASURY BONDS AT A FIVE-YEAR LOW

United States: Futures & Options: U.S. Treasury Bonds: Open Interest
(millions)
1.4

1.2

1.0

0.8

0.6
05 06 07 08 09 10
Source: Haver Analytics, Gluskin Sheff

ONE OVER EXTENDED STOCK MARKET

This has indeed been a U.S. stock market in need of good news announcements
for its success. The QE2 program, the mid-term election, the repeated bailout
proclamations in Europe, the Bernanke appearance on 60 Minutes and the
most recent tax package (indeed, tax cuts at a time when the U.S. has to borrow
even more). Incredible.

• Market sentiment indices are at their most bullish levels since the April highs
or since the 2007 highs. Take your pick. Optimism abounds.

CHART 4: OPTIMISM ABOUNDS

American Association of Individual Investors (AAII) Sentiment: Bullish
(percentage of respondents)
60.0

52.5

45.0

37.5

30.0

22.5

15.0
07 08 09 10
Source: Haver Analytics, Gluskin Sheff

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December 13, 2010 – BREAKFAST WITH DAVE

CHART 5: BEARISH SENTIMENT LEVELS ON EQUITIES ARE AT ITS

LOWEST LEVEL SINCE THE APRIL HIGHS OR THE 2007 PEAKS
American Association of Individual Investors (AAII) Sentiment: Bearish
(percentage of respondents)
80

70

60

50

40

30

20
07 08 09 10
Source: Haver Analytics, Gluskin Sheff

• Negative divergences are evident in the declining share of stocks making

new highs and the percent that are above their moving averages.
• The Chicago Board Options Exchange (CBOE) equity put-call ratio has
declined to low levels last seen in April and adds further credence to the view
that the market is overextended at the current time.
POLICY DISCORD
The U.S. is busy fighting deflation whereas the emerging market countries are
busy fighting inflation.

The U.S. is busy easing fiscal policy and running up an unprecedented debt tab
at a time when Europe is moving towards austerity.

Page 14 of the Economist said it best:

“The West avoided depression in part because Europe and America worked
together and shared a similar economic philosophy. Now both are obsessed
with internal problems and have adopted wholly opposite strategies for dealing
with them. That bodes ill for international cooperation. Policymakers in
Brussels will hardly focus on another trade round when a euro member is about
to go bust. And it looks ill for financial markets, since neither Europe’s sticking
plaster approach to the euro nor America’s ‘jam today, God knows what
tomorrow’ tactic with the deficit are sustainable ... a more divided world
economy could make 2011 a year of damaging shocks.”

What the equity market rally and the economic recovery belie is the tremendous
amount of fragility beneath the veneer. See Kicking the Can Down the Road on
page 35 of the Economist for the story behind that story of unsustainability.

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December 13, 2010 – BREAKFAST WITH DAVE

Vitaliy Katsenelson, a Denver-based money manager who recently wrote a bible

of a book on investing (we had the honour of reading the manuscript) is featured I have been a secular bond bull
on page 14 of Barron’s. He stated that he is looking for a “sideways” market and am not yet changing my
and screening for “companies that have a lot of cash.” He himself has a ton of view of the fixed-income
cash too — a 35% cash position and lays out the reason very clearly — nobody market, but the perception
“can win buying an overvalued asset and hoping it will appreciate.” Well, at that the economy will grow
least there are a couple of seasoned professional investors out there who vigorously is now extremely
understand what the risks are.
strong

PERCEPTION VERSUS REALITY

I have been a secular bond bull and am not yet changing my view of the fixed-
income market, but the perception that the economy will grow vigorously is now
extremely strong. The view that Europe will solve its problems is pervasive and
that the emerging economies will propel global growth despite the need to
tighten policy. I think that the U.S. economy will only grow about 2% next year
and that core inflation will remain on a declining trend. I can see some
European countries having to undergo a debt restructuring causing a rise in risk
premia in general, but the reality is that this will likely take more time to play out
than I had thought before. For the time being, I would expect upward revisions
to Q4 and by extension Q1 2011 GDP and hence earnings; therefore, over the
near-term, it may not be a bad idea, tactically, to lighten up on the bearishness.

As I mentioned above, I am not changing my view, but think of it as a company

lifting the bottom end of its revenue forecast.

I continue to see these as primary downside risks, but again, likely not
immediate threats:

1. The U.S. Treasury market becomes unglued.

2. Further sharp increases in energy prices.
3. Renewed fiscal problems in Europe.
4. Bad inflation news out of emerging markets.
5. U.S. state & local cutbacks become more severe.
6. Latest down-leg in home prices accelerates.

Let’s examine each one of these.

The U.S. Treasury market

The bond market has clearly overreacted to the so-called fiscal stimulus. This is
a clear case of perception and reality going through a temporary separation.
The market perceived this to be a stimulus, but all the government has done is
to ensure that there is no federal withdrawal in 2011. Fine. This means that
Treasury borrowings will be about the same next year as it was in 2010. As far
as we can tell, the yield on the 10-year T-note ranged between 2.4% and 4.0% in
2010, so there is no reason to believe there will be a breakout from that range
in the coming year.

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That said, it is also true that every action has an equal and opposite reaction
(thank you Sir Isaac Newton). The fact that Obama was so quick to ink a deal There is some risk of added
that included a hand in the Social Security cookie jar without even a sketch of a upward pressure in yields over
medium term fiscal plan to reduce the deficit has created a bit of a stir among the near-term, but it will not be
some of the previously comatose bond vigilantes. There is some risk of added sustained, in our view
upward pressure in yields over the near-term, but it will not be sustained. And,
as we saw last year, if the 10-year note yield approaches 4%, then we can
expect the equity market to roll over. Recall that we have not seen the Tea Party
in action yet — if you are long bonds, these folks are your friends. Stimulus is
not on their vernacular. Moreover, wait until Ron Paul gets his hands on
Bernanke (see the Sunday NYT business section for more) when he begins to
lead the House panel’s domestic monetary policy subcommittee.

Economists are as busy raising their economic forecasts now with the stock
market at a high as they were cutting them last July and August when the market
was testing its lows for the year. There is a whiff of contrarianism in the air.

The fiscal package sounds pro-growth, but in fact it remains to be seen how
The fiscal package sounds pro-
much of the relief is going to be saved or spent — especially the payroll tax cut
growth, but in fact it remains
which, frankly, is very poor fiscal policy. It is no different than the attempt by
to be seen how much of the
President Bush to get the economy moving in the winter of 2008 with the
relief is going to be saved or
massive tax rebates, which fell far short of ending the recession. There is spent
tremendous econometric evidence, which strongly suggests that only tax cuts
that are perceived to be permanent contribute to spending — people do not alter
their behaviour based on changes to their income, wealth or job situation that
are considered to be temporary. Temporary tax cuts, which the payroll reduction
is, go into savings. This is where the economists who are aggressively boosting
their forecasts — as they did in early 2008 — are likely to be wrong yet again.

So while the spending multiplier is likely to be as weak now as it was back in

2008, the impact of the jobless benefit extension will also be seen more in a
further increase in the unemployment rate since these folks will be paid to be
out of work at a time when the number of job openings has risen to a post-crisis
high of 3.4 million. Moreover, providing stimulus to businesses in the form of
accelerated depreciation allowances at a time when the nonfarm nonfinancial
business sector is sitting on a $1.93 trillion cash hoard (7.4% of assets, the
highest in 52 years) is a little nutty. At most, it is a waste of time and public
resources. Go figure. The one thing that the market should realize is that this
really is the last kick at the can at fiscal and monetary easing for at least the
next two years.

Energy prices
The energy price run-up is no shock, but it is a drag on real growth. While oil
The recent energy price run-up
prices would have to go back to their 2008 highs to offset the recent fiscal is not shock, but it is a drag of
boost, the run-up towards $90/bbl has already done its damage. Gasoline real economic growth
prices at the pump are now over $3/gallon in 20 states and the surge has
effectively drained $40 billion out of household cash flow. So, a good part of
that Bush tax cut extension is going to be siphoned into the gas tank.

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December 13, 2010 – BREAKFAST WITH DAVE

Renewed fiscal problems in Europe

The perception is that the U.S. economy will now grow strongly; that Europe will The reality is that the U.S.
solve its problems and that emerging economies will continue to propel global economy is going nowhere
growth. But the reality is that the U.S. economy is going nowhere without without government life
government life support. This remains an extremely fragile recovery with few support. This remains an
organic underpinnings.
extremely fragile recovery with
few organic underpinnings
We believe that the U.S. economy will barely expand 2% next year and that
deflation will remain the primary risk. Some European countries will default
causing a sharp rise in risk premia — witness the sharp erosion in the Spanish
bond market last week. Moody’s just said it is putting 10 Portuguese banks
under review for possible downgrade. In the wake of the Fitch downgrade,
Ireland’s CDS spreads (550bps) now trade above the Ukraine! And the Ukraine
has a B rating, not BBB as Ireland still clings to, but not for long.

Meanwhile, the typical investor has totally taken his/her eye off the ball as it
pertains to the prospect of a deflationary shock coming from the other side of
the Atlantic. There is apparently a very heavy debt refinancing calendar in
Europe in the first quarter of the new year and of course there is also the Irish
election (have a look at Debt Refinancing Sparks Fears of Deeper Euro Crisis on
page 3 of today’s FT). The eurozone has to refinance a record $750bln of debt
in 2011, and this pressure is likely to force Portugal into the unenviable position
in following Ireland and Greece on the road towards emergency funding.
Headline risk from that part of the world promises to usher in a heightened
period of volatility and safe-haven movements in various asset markets and
currencies, which is why now is the time to buy insurance against a possible
market correction, to expect a reversal in the bond yield run-up and flows into
currencies like the U.S. dollar and the Swiss franc during the first quarter. But
start planning now. There is no better signpost of what is to come than the
litany of growth upgrades from the economics community, which is the hallmark
of a market top.

The good news for the bond market actually comes from a survey cited on page
15 of the weekend FT — conducted by Knight Capital — which found that 54% of
respondents believed the backup in yields was due to U.S. fiscal fears. These
fears are unwarranted as far as what they mean for providing anything more
than a brief lift to growth, and remember, this new Congress is going to be chock
full of folks who are fiscal hawks and who also want to rein in a Federal Reserve
that has likely gone way too far in pursuing its multiple mandates. Only 29% of
the respondents see the increase in yields as having anything to do with
inflation, and it was equally encouraging to see consumer inflation expectations
recede a notch in last Friday’s University of Michigan Consumer Sentiment
survey for December. Without inflation, any bond selloff will prove to be
temporary, not to mention a great opportunity to add some more income to the
portfolio.

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As an aside, and we have mentioned this repeatedly, our long-standing SIRP It’s perplexing that the latest
theme is not exclusive to bonds, but also hybrids, royalties, MLPs, trusts, REITS down-leg in U.S. home prices
and income-equity. After all, 299 U.S. companies in Q3 boosted their dividend has gone virtually unnoticed by
payouts, up 56% from a year ago (just 35 companies cut, a 74% slide). the media and the markets

Bad inflation news out of emerging markets

Meanwhile, inflation is becoming more entrenched in the emerging market world
— China’s CPI jumped 1.1% MOM in November, which was well above expected
and pushed the headline YoY rate to a 48-month high of 5.1% (consensus was
at 4.7%). The YoY trend in producer prices just spiked to 6.1% from 5.0% in
October, and is nearly 2% now even after stripping food out. This comes right
after the government raised banking sector reserve requirements for the third
time in the past month; however, it is increasingly becoming obvious that more
aggressive action is going to be required such as interest rate hikes and
currency appreciation. The concerns that the PBOC is behind the inflation curve,
and will have to clamp down that much more on growth, is singularly the most
pronounced risk for the commodity price outlook for the coming year.

U.S. state & local government

With regard to state and local governments, the pressure is going to be more
intense with respect to funding as the “Build America Bond” program draws to a
close. Much of last year’s fiscal stimulus went into state government coffers
and that source of assistance is now gone. The sector has laid off 250,000
people in the past year and more is to come as this crucial 13% chunk of the
economy moves further into downside mode.

Latest down-leg in home prices accelerates

It’s perplexing that the latest down-leg in U.S. home prices has gone virtually
unnoticed by the media and the markets. The Case-Shiller index is down in each
of the past three months and there is still roughly two years’ of unsold inventory
overhanging the market once the “shadow” foreclosure backlog is included.

Meanwhile, as we saw in the latest UofM consumer sentiment survey, demand

is dormant as homebuying intentions slipped in December to a level that can
only be described as anaemic. Mortgage applications remain near decade-low
levels and part of this reflects lingering caution among private lenders who are
still maintaining fairly stringent credit guidelines — have a look at Housing Shaky
as Lenders Tighten on page A4 of the WSJ. Interesting enough, the banks are
once again sending out credit cards en masse — perhaps because borrowers
this cycle have ensured that they stay current on their plastic even as they fall
behind on their mortgage payments — see Lenders Return to Big Mails on Credit
Cards on the front page of today’s NYT.

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Gluskin Sheff at a Glance

Gluskin Sheff + Associates Inc. is one of Canada’s pre-eminent wealth management firms.
Founded in 1984 and focused primarily on high net worth private clients, we are dedicated to the
prudent stewardship of our clients’ wealth through the delivery of strong, risk-adjusted
investment returns together with the highest level of personalized client service.

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As of September 30, 2010, the Firm
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We offer a diverse platform of investment
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1 September 30, 2010
Income).
The minimum investment required to
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Firm is $3 million.
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$1 million invested in our Canadian
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over the same period.
$1 million usd invested in our U.S.
Equity Portfolio in 1986 (its inception
date) would have grown to $11.8 million
usd on September 30, 2010 versus $9.6
2 In terms of asset mix and portfolio
million usd for the S&P 500 Total
Return Index over the same period.
Notes:
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.
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For corporate bonds, we look for issuers
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of interest and principal, and yields which
S&P/TSX Total Return
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December 13, 2010 – BREAKFAST WITH DAVE
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