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

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November 23, 2012 Economic Commentary

MARKET MUSINGS & DATA DECIPHERING

Turkey with Dave

I am pleased to share this free edition of Turkey with Dave containing selected excerpts from some of my popular recent reports IN THIS ISSUE A look back at what Rosie predicted a year ago (not too shabby!)

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, riskadjusted returns together with the highest level of personalized client service. For more information or to subscribe to Gluskin She economic reports, visit www.gluskinsheff.com.

With this being Thanksgiving in the United States and such a slow market day here in Canada, I decided to dust off the year-ahead outlook piece I published around this time in 2011

How to fix the fiscal mess a 10 point plan Back to school

I realized as I was putting my 10-point fiscal plan down on paper that there is an over-riding theme here in terms of what is really hindering the progress of the U.S. economy. It comes down to one word and one number: Education and 40

Please see important disclosures at the end of this document.

November 23, 2012 TURKEY WITH DAVE

Dear Readers, We were inundated with feedback (mostly positive) on three pieces we published in the past couple of BWDs. So in the spirit of Thanksgiving, we decided to share them with you. One has to do with the degree of success we had in our 2012 Year-ahead in terms of the themes we highlighted at the time. Next is our ten-point budget plan to put the U.S.A. back on the road towards fiscal stability. And the third piece is all about the real deficit and how to address it. Education. Enjoy the feast! Dave A LOOK BACK AT WHAT ROSIE PREDICTED A YEAR AGO (NOT TOO SHABBY!) With this being Thanksgiving in the United States and such a slow market day here in Canada, I decided to dust off the year-ahead outlook piece I published around this time in 2011. I realize there is still weeks to go, and Im not one to pat myself on the back, but most of the calls actually came to fruition. Here are the bullet points on Behavioural Change and the 2012 Investment Mission Statement below: Eight Areas of Behavioural Change to Watch for in 2012 1. Frugality on the part of the global consumer (living within our means; retirement with dignity) 2. 3. 4. 5. 6. 7. 8. Austerity on the part of sovereigns (spending cuts/tax reform) Nationalism (an umbrella for protectionism and isolationism: mean reversion for globalization) Political movement along the ideological and fiscal spectrum (from gridlock to change) Geopolitical change (wars, elections and regime changes) Changes in inflationary/deflationary expectations Changes in growth expectations Changes in asset allocation preference (fund-flows/de-risking)

I realize there is still weeks to go, and Im not one to pat myself on the back, but most of the calls actually came to fruition

Investment Mission Statement We believe that the dominant focus in 2012 will still be on capital preservation and income orientation, whether that be in fixed income (bonds and creditrelated strategies), hybrids or alternative strategies such as long/short, and a consistent focus on reliable dividend growth and dividend yield would seem to be in order yet again. We see the range of outcomes in the financial markets and the economy to be unusually wide at the current time.

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But one conclusion we should agree on is the need to maintain defensive strategies and minimize volatility and downside risks as well as to focus on where the secular fundamentals are positive, particularly in fixed income and in equity sectors that spin off a reliable cash flow primarily in noncyclical parts of the market, where earnings have a strong semblance of visibility and predictability. Deflation has re-emerged as the dominant trend not inflation as the deleveraging cycle that is ongoing in the United States has now engulfed much of Europe. Frugality has also reared its head again as it pertains to the broad retail sector, another deflationary force, at a time when the U.S. unemployment rate remains stubbornly stuck above 9%. As such, it is absolutely imperative to remain focused on high-quality investments with preservation of capital attributes, and to use the inherent market volatility that is part and parcel of every post-bubble deleveraging cycle to ones advantage by becoming ever more tactical and opportunistic in long-short relative value strategies. 2012 Outlook: A Year of Transition, Changes at the Margin HOW TO FIX THE FISCAL MESS A 10 POINT PLAN 1. Do not raise top marginal tax rates on income and capital. This will perversely distort the incentive system. It is not good enough to say the Bush tax cuts were always meant to be temporary anything that has been around for a decade is pretty well deemed to be permanent. 2. 3. 4. Broaden the tax base. Limit deductions. This is the way to make the tax system more progressive and more efficient. Reduce corporate tax rates. This will help make the overall revenue neutral and help build incentives to invest, which in turn creates jobs. Means-test entitlement programs. Raise contribution rates, again with progressivity a primary goal too. As for Social Security, it is time to raise the eligible retirement age, especially considering that life expectancy is rising by just under one year every decade, and especially since life expectancy is no longer 60 (try 75) as it was when the program was initiated in 1935. Reforms to immigration that allow foreign students to live and work after graduation. This will help ease the skills shortage besetting small manufacturers. Generating more taxpayers is a better policy than raising tax rates on the most successful entrepreneurs. Promote oil and gas development (leasing on public lands; encourage more pipeline expansion; encourage more shale gas development). A national sales tax. Better to tax conspicuous consumption than incomes (Canada has done both this and entitlement reform, by the way. It can be done). Simplify and clarify financial regulation (as Roger Ferguson put it in the WSJ, be careful not to create a one size-fits-all regulatory environment that could lead to instability). A full-scale war on health care costs. According to the WSJ, three-quarters of the net $10 trillion in the nations debt will be due to the spiralling costs of Medicare and Medicaid. Incentives to contain costs are essential
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Do not raise top marginal tax rates on income and capital. This will perversely distort the incentive system

5.

6. 7.

8.

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November 23, 2012 TURKEY WITH DAVE

no more of this fee-for-service. You cant work on the deficit and not work on this only 20% of the budget is discretionary, after all. 10. A greater shift in resources towards education and R&D. This will do a far better job in stimulating sustainable job creation than maintaining a system that mobilizes finite taxation resources to the housing market. It would take at least as much political courage to phase out mortgage interest deductibility as it would to implement a national VAT. Canada does not have the former and has a higher homeownership rate than is the case state-side; and Canada has the latter and still manages to have an economy where consumers still comprise the largest share of GDP (and vibrant enough to be attracting the likes of Target which is poised to test the Canadian frozen waters). BACK TO SCHOOL I realized yesterday as I was putting my 10-point fiscal plan down on paper that there is an over-riding theme here in terms of what is really hindering the progress of the U.S. economy. It comes down to one word and one number. Education. 40. Why the 40? Because 40% of small businesses right now are saying they have job openings they cant fill because of unqualified applicants (this has doubled in just the past three years). And 40% is the share of the unemployed that has been without work for at least a half year before the Great Recession, the highest this number ever reached was 26%, and that was in the aftermath of the horrible downturn in the early 1980s. This is criminal. The longer these folks are idle, the harder it will be to redeploy them into the workforce. And if and when they do find a job, their productivity will be hampered by the fact that they had been out of the labour market for so long. All the focus is on the fiscal cliff. Fair enough. But not enough on a long-term strategy to generate national income growth on a sustained basis. Far too much emphasis is on GDP, which is all about spending, and not enough on GDI (Gross Domestic Income), which is the true measure of a countrys standard-of-living. Education means skills. Skills bolster productivity. Productivity is a key ingredient for economic success. And the greater the skills, the higher the wages. Here are the embarrassing statistics. The United States scores 14th in the globe in terms of education rankings in mathematics, sciences and reading. The 13 countries ahead of America have an average unemployment rate of around 6%, close to two percentage points lower than in the States. The U.S.A. is now down to 10th in terms of global innovation. And after four years of relative decline, America now ranks 7th in terms of competitiveness. For whatever reason, after decades of increase, the share of the workforce that has a college degree has stalled out at around 33%. This educated share of the workforce has a 3.8% unemployment rate. Imagine then if we could get that

A greater shift in resources towards education and R&D. This will do a far better job in stimulating sustainable job creation than maintaining a system that mobilizes finite taxation resources to the housing market

Far too much emphasis is on GDP, which is all about spending, and not enough on GDI (Gross Domestic Income), which is the true measure of a countrys standard-of-living

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share up and have everyone with that jobless rate. The rest of society has to grapple with an unemployment rate of over 9%. They simply do not have the skills set that employers need in this fast-changing tech-driven world. Not only that, but look at where the jobs in America are being created an evergrowing share in leisure/hospitality and retail. These two sectors now account for a record 21% of the U.S. employment pie and that share is rising over time. This explains why this goes down as the mother of all wage-less recoveries, because the average hourly wage in the leisure/hospitality sector is $13, and in retail it is $16. But in manufacturing, as an example, the average wage is $23 an hour. But manufacturing is just 9% of the employment pie and has not been 21% where the leisure and retail sectors are today in over 30 years. We actually have more than double the number of busboys, bell captains, barmaids and cashiers than we have in industries that actually make things. If this is the information age, then Im sad to report that information services represent a mere 2% share of total U.S. employment. And this is the highest paid part of the labour market 40% above the national average and about double the pay in the leisure and hotel sectors. Professional and technical services account for 6% of the jobs pie and this is the second highest income group. We just dont have enough of these folks, and according to all the small-service business surveys, its not because the demand for people with the necessary skills isnt there. We have a country where there are more real estate agents than there are engineers now how did that ever happen? We all talk about deficits and debts relative to income. Perhaps a very big part of the solution is how to boost the denominator in those ratios. How can the government help the private sector generate the income that in turn can help defray the costs of public sector initiatives? Since better education equates to lower rates of unemployment, since better education equates to improved skill sets that are in demand, since better education equates to stepped-up productivity growth, and since better education equates to higher incomes, this is where the government should be directing its efforts. The war on credit appears to have been won with banks ready and willing to lend. The war on housing appears to have been won as well with housing starts and household formation rates on the rise. But the war on the fiscal front is inextricably linked to the war on unemployment and that war on unemployment can only be won with additional resources being directed towards the education sector. Full stop. This file is not receiving enough attention, in my view. So much focus is on the fiscal deficit when the real deficit is in the labour market the true unemployment rate (U6) is close to 15%, and the principal cause of that is a widening and troublesome deficit in education services. Instead of mobilizing more resources into education, the government sector has actually been withdrawing its relative support in this critical part of human capital stock. As a share of total public expenditures, educational outlays have fallen to 25.8% share, versus the peak of 30% a decade ago. No doubt there are

In over 30 years. We actually have more than double the number of busboys, bell captains, barmaids and cashiers than we have in industries that actually make things

The war on unemployment can only be won with additional resources being directed towards the education sector

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competing pressures on the public purse, especially with regard to defense, pensions and healthcare, but education and training are essential drivers of the future income growth that will be needed to fund these other critical initiatives, so withdrawing support for these drivers is actually self-defeating. Last but not least education needs a revolution from kindergarten on up. We need to reboot to a true education culture and replace the dysfunctional systems that were developed during the post-Vietnam War era and the credit bubble. We need the student body to be more broadly energized and motivated by their educational experience. Public elementary and secondary education, particularly in urban areas, needs a whole new measure of support from parents, teachers and government both state & local and national. On college campuses, the number of non-teaching employees exceeded the number of teachers beginning in 2006. In many cases, universities focus so much on research in the sciences that teaching is a secondary role for many professors. Credit in the form of student loans and parent-funded debt has dramatically inflated the cost of post-secondary education while accommodating an everpoorer student experience. A large part of solving the education dilemma lies in restructuring the institutions along with investing in them. To sum it all up: I said yesterday that the trail towards greater economic growth can be blazed with more emphasis on high-quality education. But that education has to be funded somehow with tax revenues. Tax is not some dirty three-letter word if the proceeds are going into a productive endeavour that will more than pay for itself over time. Tinkering with top marginal rates creates disincentives to save and invest so this is not the way to go. But broadening the tax base and introducing a tax on consumption is far more efficient and does not lead to as much resource misallocation incredibly, the United States is the only advanced country without a national sales tax system. We have choices in this country and the one that has been made for some time now is to subsidize consumption (which is over 70% of GDP), not to mention housing (mortgage interest deductibility AND tax-free capital gains!), at the expense of education which has to compete with other essential areas like health care and social security for precious and finite taxpayer resources. It makes no sense. A sales tax to fund education and redress the skills shortage is my prescription for future durable economic growth. The income that will be created via the stepped-up pace in higher-skill, higher-paying jobs will end up swamping the short-term negative impact on household spending from having to pay a national sales tax on your next iGadget.

Education and training are essential drivers of the future income growth that will be needed to fund these other critical initiatives, so withdrawing support for these drivers is actually self-defeating

A sales tax to fund education and redress the skills shortage is my prescription for future durable economic growth

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OVERVIEW OF THEMES AND STRATEGIES

THEME Frugality

STRATEGY Identify where people spend their money and time in an economic downturn.

SECTOR/ASSET CLASS Dollar/Discount stores Home improvement/ Gardening Tobacco/Beverages/Movies

Non-Cyclical

Focus on special situations that are not correlated with the economic cycle. Buy high-quality corporate and government bonds in non-cyclical sectors; Minimize volatility via alternative strategies such as long/short equity strategies. Focus on reliable dividend growth and dividend yield; Being and staying ahead of the robust demographic (baby-boomers aging) shift towards income oriented investments. Safety and Income at a Reasonable Price (S.I.R.P.). Focus on those firms that benefit from the secular trend surrounding the portability of data and increased consumer usage of smartphones/tablets; Identify and invest in firms that benefit from cloudbased strategies that allow customers to be more efficient and realize cost savings. Gold equities have seen tremendous multiple compression over the past few years and those that can generate growth in production and reserves, while holding the line on costs, should be able to significantly outperform gold bullion.

Defense-aerospace Healthcare

Capital Preservation

Credit of Canadian Banks, Telecom, Retail, Insurance Income-producing equities, preferreds and bonds Canadian and U.S. preferred shares Energy infrastructure Utilities Technology firms

Income Orientation

Mobility/ Connectivity and IT Infrastructure

Cellular carriers/Tower companies

Gold Mining Stocks

Mid- and large-cap producers with low cost structures, visible organic growth, assets in geopolitically safe regions and a focus on dividend growth Gold exploration companies whose assets have high grades, simple metallurgy, significant resource expansion potential and that are located in regions with relatively low geopolitical risk

Other

Invest in hard strategic assets; Focus on burgeoning middle class in emerging markets.

Asian consumers Food products

Updated: November 12, 2012 Source: Gluskin Sheff

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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.
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As of June 30, 2012, the Firm managed assets of $5.5 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.

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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 million2 on June 30, 2012 versus $5.8 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 million on June 30, 2012 versus $5.8 million for the S&P/TSX Total Return Index over the same period. $1 million usd invested in our U.S. Equity Portfolio in 1986 (its inception date) would have grown to $13.9 million 2 usd on June 30, 2012 versus $11.9 million usd for the S&P 500 Total Return Index over the same period.
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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.

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