You are on page 1of 8

David A.

Rosenberg May 11, 2010


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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave


ACROSS THE POND – STILL A SEA OF RED
IN THIS ISSUE
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, • Across the pond — still a
sea of red
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 • Making PIIGS squeal: we
the market back in 1930. In fact, at one point two weeks ago, at the highs, the did some indepth analysis
stock market had already achieved, in barely more than a year, what took five on how the economies of
the PIIGS would fare if the
years to accomplish in the 2002 to 2007 bull market, and at least that market
deficit-to-GDP ratios were
wasn’t being fuelled by unprecedented government intervention in the economy to revert back to the
and incursion into the capital markets. criteria of 3.0%
• Redefining a treaty: the
The dramatic government stimulus was global in nature, and this was the
EMU political elite and the
primary prop behind the rally in equities over the past year and change, and the ECB bypassed their
message coming out of Greece, and not just Greece but many other charters in order to take
governments in the European Union and across the globe, is that governments the easy road and ensure
are probing the outer limits of their deficit finance capacities. History does that bad credits get
indeed show that it is quite common to see sovereign default risks follow on the rewarded
heels of a global banking crisis, which was the story for 2007 and 2008; it took • Canadian housing: are
a respite in 2009 and we are now in a new chapter of this prolonged debt homebuilders building
deleveraging story. These cycles of balance sheet repair, alternating between inventory?
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.

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
In my opinion, Greece is
gone away and in many cases has become worse, and the ability to service
the same canary in the
these debts especially in countries that have weak economic structures like coal mine that Thailand
Greece, Portugal and Spain has become seriously impaired. It remains to be was for emerging Asia in
seen how Greece and the other problem countries in the euro area will manage 1997, and New Century
to cut their deficits without, at the same time, controlling their monetary policy Financial in the U.S. in
and their currency, which of course we were able to do here in Canada during early 2007
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 Even before this latest leg
on the upside, it’s time to get more defensive and less cyclical with a keen eye in the European financial
towards taking advantage of this crisis if it presents opportunities in the equity crisis, China was already
market as the panic in the corporate bond market presented to us back in early tightening monetary policy
2009. I, for one, am looking forward to having my temptation level tested if this aggressively to lean
market heads back into undervalued or even fair-value terrain, which it only against what appears to
managed to achieve for a few months early last year. be a property bubble in
various urban centers
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.

Page 2 of 8
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 What’s important from an
it will be interesting to see how countries like Spain, let alone Greece, can cut investor standpoint is that
spending and raise taxes at a time when the unemployment rate is at a sky-high the uncertainty
20%. Remember, 20% of the global economy is going to be slowing down going surrounding the macro
forward, the question is by how much and this in turn will impact North American outlook is much wider now
exports. On top of that, the equity and debt cost of capital, which had been on a than it was before
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 near-
cash 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.

Page 3 of 8
May 11, 2010 – BREAKFAST WITH DAVE

REDEFINING A TREATY
Maybe it’s all about false pride. The need to counter-attack those who would
It is a sad deflationary
dare to attack the Euro. How interesting was it to see the sharpness of the
reality when a trillion
political rhetoric over the weekend from the European political elite. Please,
dollars can only buy you
fund our lifestyle, Mr. Market, but don’t hold us to our commitments:
400 points on the Dow.
What can the politicos do
“ ... a battle of the politicians against the markets. I am determined to win”
for an encore?
(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.

Page 4 of 8
May 11, 2010 – BREAKFAST WITH DAVE

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.
2. 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.
2. 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.

Page 5 of 8
May 11, 2010 – BREAKFAST WITH DAVE

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.

Page 6 of 8
May 11, 2010 – BREAKFAST WITH DAVE

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.

OVERVIEW INVESTMENT STRATEGY & TEAM


As of March 31, 2010, the Firm managed We have strong and stable portfolio
assets of $5.6 billion. management, research and client service
teams. Aside from recent additions, our Our investment
Gluskin Sheff became a publicly traded
Portfolio Managers have been with the interests are directly
corporation on the Toronto Stock
Firm for a minimum of ten years and we
Exchange (symbol: GS) in May 2006 and aligned with those of
have attracted “best in class” talent at all
remains 54% owned by its senior our clients, as Gluskin
levels. Our performance results are those
management and employees. We have Sheff’s management and
of the team in place.
public company accountability and employees are
governance with a private company We have a strong history of insightful collectively the largest
commitment to innovation and service. bottom-up security selection based on client of the Firm’s
fundamental analysis.
Our investment interests are directly investment portfolios.
aligned with those of our clients, as For long equities, we look for companies
Gluskin Sheff’s management and with a history of long-term growth and
employees are collectively the largest stability, a proven track record,
$1 million invested in our
client of the Firm’s investment portfolios. shareholder-minded management and a
Canadian Value Portfolio
share price below our estimate of intrinsic
We offer a diverse platform of investment in 1991 (its inception
value. We look for the opposite in
strategies (Canadian and U.S. equities, date) would have grown to
equities that we sell short.
Alternative and Fixed Income) and $11.7 million2 on March
investment styles (Value, Growth and For corporate bonds, we look for issuers
1 31, 2010 versus $5.7
Income). with a margin of safety for the payment
million for the S&P/TSX
of interest and principal, and yields which
The minimum investment required to Total Return Index over
are attractive relative to the assessed
establish a client relationship with the the same period.
credit risks involved.
Firm is $3 million for Canadian investors
and $5 million for U.S. & International We assemble concentrated portfolios —
investors. our top ten holdings typically represent
between 25% to 45% of a portfolio. In this
PERFORMANCE way, clients benefit from the ideas in
$1 million invested in our Canadian Value which we have the highest conviction.
Portfolio in 1991 (its inception date)
Our success has often been linked to our
would have grown to $11.7 million on
2

long history of investing in under-


March 31, 2010 versus $5.7 million for the
followed and under-appreciated small
S&P/TSX Total Return Index over the
and mid cap companies both in Canada
same period.
and the U.S.
$1 million usd invested in our U.S.
Equity Portfolio in 1986 (its inception PORTFOLIO CONSTRUCTION
date) would have grown to $8.7 million In terms of asset mix and portfolio For further information,
usd on March 31, 2010 versus $6.9
2
construction, we offer a unique marriage please contact
million usd for the S&P 500 Total between our bottom-up security-specific
Return Index over the same period. questions@gluskinsheff.com
fundamental analysis and our top-down
macroeconomic view.
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.
2. Returns are based on the composite of segregated Value and U.S. Equity portfolios, as applicable, and are presented net of fees and expenses. Page 7 of 8
May 11, 2010 – BREAKFAST WITH DAVE

IMPORTANT DISCLOSURES
Copyright 2010 Gluskin Sheff + Associates Inc. (“Gluskin Sheff”). All rights and, in some cases, investors may lose their entire principal investment.
reserved. This report is prepared for the use of Gluskin Sheff clients and Past performance is not necessarily a guide to future performance. Levels
subscribers to this report and may not be redistributed, retransmitted or and basis for taxation may change.
disclosed, in whole or in part, or in any form or manner, without the express
written consent of Gluskin Sheff. Gluskin Sheff reports are distributed Foreign currency rates of exchange may adversely affect the value, price or
simultaneously to internal and client websites and other portals by Gluskin income of any security or financial instrument mentioned in this report.
Sheff and are not publicly available materials. Any unauthorized use or Investors in such securities and instruments effectively assume currency
disclosure is prohibited. risk.

Gluskin Sheff may own, buy, or sell, on behalf of its clients, securities of Materials prepared by Gluskin Sheff research personnel are based on public
issuers that may be discussed in or impacted by this report. As a result, information. Facts and views presented in this material have not been
readers should be aware that Gluskin Sheff may have a conflict of interest reviewed by, and may not reflect information known to, professionals in
that could affect the objectivity of this report. This report should not be other business areas of Gluskin Sheff. To the extent this report discusses
regarded by recipients as a substitute for the exercise of their own judgment any legal proceeding or issues, it has not been prepared as nor is it
and readers are encouraged to seek independent, third-party research on intended to express any legal conclusion, opinion or advice. Investors
any companies covered in or impacted by this report. should consult their own legal advisers as to issues of law relating to the
subject matter of this report. Gluskin Sheff research personnel’s knowledge
Individuals identified as economists do not function as research analysts of legal proceedings in which any Gluskin Sheff entity and/or its directors,
under U.S. law and reports prepared by them are not research reports under officers and employees may be plaintiffs, defendants, co-defendants or co-
applicable U.S. rules and regulations. Macroeconomic analysis is plaintiffs with or involving companies mentioned in this report is based on
considered investment research for purposes of distribution in the U.K. public information. Facts and views presented in this material that relate to
under the rules of the Financial Services Authority. any such proceedings have not been reviewed by, discussed with, and may
not reflect information known to, professionals in other business areas of
Neither the information nor any opinion expressed constitutes an offer or an Gluskin Sheff in connection with the legal proceedings or matters relevant
invitation to make an offer, to buy or sell any securities or other financial to such proceedings.
instrument or any derivative related to such securities or instruments (e.g.,
options, futures, warrants, and contracts for differences). This report is not Any information relating to the tax status of financial instruments discussed
intended to provide personal investment advice and it does not take into herein is not intended to provide tax advice or to be used by anyone to
account the specific investment objectives, financial situation and the provide tax advice. Investors are urged to seek tax advice based on their
particular needs of any specific person. Investors should seek financial particular circumstances from an independent tax professional.
advice regarding the appropriateness of investing in financial instruments
and implementing investment strategies discussed or recommended in this The information herein (other than disclosure information relating to Gluskin
report and should understand that statements regarding future prospects Sheff and its affiliates) was obtained from various sources and Gluskin
may not be realized. Any decision to purchase or subscribe for securities in Sheff does not guarantee its accuracy. This report may contain links to
any offering must be based solely on existing public information on such third-party websites. Gluskin Sheff is not responsible for the content of any
security or the information in the prospectus or other offering document third-party website or any linked content contained in a third-party website.
issued in connection with such offering, and not on this report. Content contained on such third-party websites is not part of this report and
is not incorporated by reference into this report. The inclusion of a link in
Securities and other financial instruments discussed in this report, or this report does not imply any endorsement by or any affiliation with Gluskin
recommended by Gluskin Sheff, are not insured by the Federal Deposit Sheff.
Insurance Corporation and are not deposits or other obligations of any
insured depository institution. Investments in general and, derivatives, in All opinions, projections and estimates constitute the judgment of the
particular, involve numerous risks, including, among others, market risk, author as of the date of the report and are subject to change without notice.
counterparty default risk and liquidity risk. No security, financial instrument Prices also are subject to change without notice. Gluskin Sheff is under no
or derivative is suitable for all investors. In some cases, securities and obligation to update this report and readers should therefore assume that
other financial instruments may be difficult to value or sell and reliable Gluskin Sheff will not update any fact, circumstance or opinion contained in
information about the value or risks related to the security or financial this report.
instrument may be difficult to obtain. Investors should note that income
Neither Gluskin Sheff nor any director, officer or employee of Gluskin Sheff
from such securities and other financial instruments, if any, may fluctuate
accepts any liability whatsoever for any direct, indirect or consequential
and that price or value of such securities and instruments may rise or fall
damages or losses arising from any use of this report or its contents.

Page 8 of 8

You might also like