Breakfast With Dave Jan:25:2012

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David A. RosenbergChief Economist & [email protected]

January 25, 2012Economic Commentary GluskinSheff

MARKET MUSINGS & DATA DECIPHERING

Breakfast with DavePlease note there will be no Breakfast with Dave tomorrow due to business travel.MEET THE NEW PARADIGM, SAME AS THE OLDPARADIGMThe best part about a flight to L.A. is the uninterrupted time for reading, thinkingand writing.I first perused the update of the deleveraging cycle that the McKinsey GlobalInstitute published a few weeks ago (Debt and Deleveraging: Uneven Progresson the Path to Growth). Now that I had a chance to dig deep into the report, Ithought it would be a good idea to highlight the major conclusions, based on thehistorical record of the other 32 post-credit bubbles of the past century and howthe current episode stacks up.1. The deleveraging process that began in 2008 "is proving to be long and

painful". Not only that, but so far "the deleveraging process is in its earlystages in most countries". Indeed, total debt has actually risen among the"ten largest mature economies since the 2008-09 financial crisis, duemainly to rising government debt."

2. The U.S., along with Australia and Korea, are furthest along the path whileFrance, Japan and Spain have deleveraged the least. For the 10 largesteconomies, the aggregate private-sector debt elimination since 2008 hasamounted to $1.5 trillion (2% decline), but governments have run up theirdebt tab by $7.8 trillion (a 26% surge). In this vein, total debt/GDP ratioshave actually risen in seven of the 10 largest economies that wereassessed in the report.

3. U.S. household debt has shrunk $584 billion (or 4%) over the past threeyears. Defaults accounted for between 70% to 80% of that - up to 35% ofthat were "strategic decisions by households to walk away from theirhomes". What a country stiff your creditor!

4. Historical precedence suggests that U.S. households are about halfwaythrough the deleveraging phase, meaning that they have about two yearsleft. But if the classic Swedish example is the appropriate template, thenwe are talking about being one-third complete and perhaps four years ofconsumer and mortgage debt contraction left before this pernicious belt-tightening cycle expires.

5. Even after the deleveraging phase ends, Amer ican consumers "won't be aspowerful an engine of global growth as they were before the crisis". Thereason: because the mortgage refinancing cash-out craze that provided$2.2 trillion of non-traditional income to the household sector is gone cash flow that provided a one percentage point annualized boost toconsumer spending from 2003 to 2007.

IN THIS ISSUE: Meet the newparadigm,

same as the old paradigm:We take a look at thehistorical record of theother 32 post-creditbubbles of the pastcentury and see how thecurrent episode stacks up

Canadian retail sales fatigue is setting in:Fatigue is setting into theCanadian consumer asthe pace of increases inretail sales have sloweddown

Rich in Richmond:Manufacturing activity inthe Richmond Fed areacame in stronger thanexpected inJanuary

Please see important disclosures at the end of tnis document.Gluskin Sherr + Associates Inc. s one of Canada's pre-eminent wealth management firms. Founded in 1984 and focused on serving high net worthprivate clients and institutional investors, we are dedicated to meeting the needs of our clients by delivering strong, risk-adjusted returns together withthe highest level of personalized client service. For more information or to subscribe to Gluskin Sheff economic reports, visit www.gluskinsheff.com


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January 25 , 2012 - BREAKFAST WITH DAVEGluskinSheff

Then there was the ad ded reality check from the Bank of Canada 's MonetaryPolicy Report that was published last week. This is highly relevant because theBank of Canada is currently being headed by someone with practical inancialsector experience rather than just having academic credentials, has a balancesheet that has not been jeopardized by taking on toxic paper via repeatedquantitative easing programs, has a chief who I can say first-hand had, for themost part, a handle on the looming crisis in late 2007 and 2008 far earlier thanmany at the Fed did at the time, has been accurate on the overall macroforecasts in recent years, and finally, represents a country that is acutelysensitive to the global economy.Here is what last w eek's Report had to say and please, don't shoot themessenger. Just heed the m essage:

1. The recession in the eu ro area is now expec ted to last longer and to besomewhat deeper than anticipated; owing to tighter credit conditions,additional fiscal austerity measures and more negative confide nce effects.2. Grow th in U.S. econ omic activity is expected to be relatively modestthrough 2013, owing to ongoing household deleveraging, fiscalconsolidation and negative spillover effects from the European crisis.3. Thus far, the impact on global f inancial conditions from the strains inEurope has consisted mostly of a general retrenchmen t from risk-taking.Over the projection period, the impact is expected to become morewidespread, howev er, wil l take the fo rm of increased funding pressures,adverse confidence effects and reduced availability of credit. In particular,deteriorating funding conditions are projected to push banks to restrictaccess to credit for households and businesses in Europe and the U.S.,adding to the drag on economic growth.4. Balance sheet deleveraging by European banks is projected to affect

financial and econo mic conditions, both in the euro area and globally, withEuropean banks accounting for a noticeable share of total lending in theU.S., especially for bu siness c redit. The U.S. supply of cred it is alsoexpected to d ecline. This drop, in com bination with c onfidence effects, isprojected to constrain growth in business investment.5. Overall, the crisis in the euro area is projected to dampen global economicgrowth by more than 1% by the end of 2012, including reduc tions of 0.8%in the U.S. (Ed note: this would shave the pace we endured in 2011 byhalf!).6. Fiscal consolidation is expected to exert a drag on U.S. real GDP growthamounting to about 0.8 percentage points in 2012 and about 2.5percentage points in 2013, reflecting the impact of spending cuts that areassumed to take place.Folks, these are bold forecasts. The baseline trend in real GDP heading into2012 was 1.6%. According to the BoC, half that trend goes away this year fromthe European recession effect and the other half from domes tic fiscal drag.There had better well be a big housing bounce coming or a pickup in businessspending (why would there be, though, with the 100% bonus depreciationallowance lapsing at the end of 2011 and with profit growth now trendinglower?). As such, the consensus may be for 2%-plus GDP growth this year but

The impact on global financialconditions from the strains inEurope has consisted mostly ofa general retrenchment fromrisk-taking. Over the projectionperiod, the impact is expectedto become more widespread,however, will take the form ofincreased funding pressures,adverse confidence effectsand reduced availability ofcredit

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January 25, 2012 - BREAKFAST WITH DAVEGluskinSheff

the he adwinds could well make it flat. Even if we assum e that margins canremain at their record highs, a flat econom y alone would, in our estimation, trima further $10 from consensus earnings forecasts for 2012.As for 2013, if the fiscal withdrawal is as big as the BoC projects, then the U.S.economy is going to have to manage to grow abo ve potential to prevent anoutright recession from taking place (then again, recessions after a presidentialelection isn't altogether that rare-think 1973,1981, 2001,2009).I then went ba ck to read over the brilliant Welling@Weeden interview with thevenerable Lacy Hunt from January 20th. Lacy has been in the foreca stingbusiness forever and is the chief econo mist for Hoisington InvestmentManagement out of Texas (just as an aside, legendary is not a strong enoughword to describe Van Hoisington). There wa s plenty of really good stuff in theinterview, bu t what rea lly spoke to me the most was at the end he true valueof long-term macro strategies and investing around these sec ular themes. Towit:

In economic analysis, there are two things that are important. First andforemost, you have to have some understanding of how the world worksand then you have to evaluate the incoming data in terms of the way inwhich the world works ... the indicators have to be interpreted in light of amore fundamental structure ... short-term trading is really dominated bythese whole hosts of psychological and behavioral characteristics, whichare very difficult to sort out ... To know when you're moving towardequilibrium and in which direction the equilibrium exists, requires thisbroader understanding of the fundamental economic relationships ... Yes,and the thing about it is, it's counterintuitive. You might assume that we 'dhave greater knowledge about the short run and less knowledge about thelong run. But in our approach, the only know/edge that we think we havepertains to these longer term fundamental considerations, not to the sriort-term trading. So we're looking at the world through an entirely differentprism ... trying to sort the short-term noise is an impossible task ... youcannot react to these short-term swings. If you do that, you'll generally bebuying at the wrong time and selling at the wrong time.

Noise an d short-term trading bumps against fundamentals an d equilibrium.Love it!Which brings m e now to the next point: tying all of this together.The people I speak to tell me that the extreme volatility and general marketweakness last year was the aberration. The normal was the bounce we saw in2009 and extension into 2010 even though that extension was in dire need ofa late-year round of QE2 intervention.

If the fiscal withdrawal is asbig as the BoC projects, thenthe U.S. economy is going tohave to manage to grow abovepotential to prevent an outrightrecession from taking place

The people I speak to tell methat the extreme volatility andgeneral market weakness lastyear was the aberration ... I'mactually wondering if it isn'tthe opposite. That last yearwas normal and what we sawin 2009 and 2010 a doublein the S&P 500 from the low tothe nearby high was theaberration

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January 25, 2012 - BREAKFAST WITH DAVEGluskinSheff

I'm actually wondering if it isn't the opposite. That last year was normal andwhat wesaw n 2009 and 2010 - a double in the S&P 500 from the low o thenearby high was the aberration.Or maybe, us t maybe, the entire three years of angst turned to euphoria turnedback to angst (and back to euphoria in the first three weeks of 2012?) is thenew normal. After all, we had market angst from 1929 to 1932 then ebulliencefrom 1933 to 1936 and back to despair in 1937-38.If there is one thing to take away from the McKinsey report, it is that we are intoa completely different set of post-recession realities than what we wereaccustomed to through the post-WWII era. The prior 10 recessions before theepic 2007-09 downturn were nothing more than brief and small corrections nreal GDP n the context of what was a generational secular credit expansion an expansion that went asymptotic from 2002 to 2007. But make no mistake this was a multi-decade debt boom and will take years to mean revert. As theMcKinsey report concluded, we are still in the early stages of the globaldeleveraging cycle, and once it starts in the government sector, absent a notableupturn in private sector spending, recession risks will remain acute, if not areality.This is the lens from w hich we have to assess the economic base-case scenario,understanding that the range of outcomes are extremely wide, but theprobabilities still skewed more towards the downside. What is to be considered"normal" should not be through the prism of the post-WWII period, when thesecular credit expansion ensured that recessions were short and shallow andexpansions long and strong to the extent that central banks started to believetheir own press that they had managed to defeat the business cycle and withthat in mind, coined their own term of success: "The Great Moderation".Indeed.Today's "normal" is seen through the prism of the McKinsey report what lifelooks like after a post-credit bubble collapse. And so far, what we have seen inthe ma rkets and the m acro economic data an initial sharp bounce, then astalling out, wide fluctuations, ultra-low policy rates and bond yields, endlesssigns of economic fragility and recurring double-dip risk s indeed quite normalin this context.This by no means suggests that investment themes have vanished and that youcan't make money and preserve capital in this sort of environm ent. There wer eplenty of ways to generate returns in 2011 hey just didn't really exist thatmuch within the equity market universe. But let's go through where to prudentlyput money to work in the current and prospective backdrop, since we have toface up to the reality that you will not build up wealth or savings in T-bills, bankdeposits or money market funds at today's ne ar-zero percent interest rateenvironment:

But make no mistake thiswa s a multi-decade debt boomand will take years to meanrevert. As the McKinsey reportconcluded, we are still in theearly stages of the globaldeleveraging cycle

This by no means suggeststhat investment themes havevanished and that you can'tmake money and preservecapital in this sort ofenvironment. There wereplenty of ways to generatereturns in 2011 they justdidn't really exist that muchwithin the equity marketuniverse

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1. Market volatility is part and parcel of every post-bubble deleveraging cycle.This means an ongoing focu s on long-short relative value strategies thathave little directional exp osure with the overa ll market but take advantageof the inherent mispricing across sectors during these periods ofheightened volatility.2. Deflation trumps inflation as the primary trend in a deleveraging cycle. Thismeans an emphasis o n defensive sectors with earnings stability andpredictability characteristics. It also means a focus on squeezing as muchincome as possible out of the portfolio. This is why "income equity"strategies make so much sense.3. Balance sheet quality becomes so much more important in cycles likethese. Already, we have seen the amount of AAA-rated government paperplunge 70% in the past three ye ars from $19 trillion to $6 trillion. As such,emphasis on good quality corporate bonds in noncyc lical sectors, attractivespreads, high net free cash flow yields, low debt ratios, high liquidity ratiosand light refinancing calend ars make prudent sense. Our good friend andtop-ranked credit analyst Marty Fridson told me yesterday that even in thehigh-yield space, spre ads off of government bonds have more than 100basis points of tightening potential based on the current set offundamentals.4. Always be on the lookout for assets priced for recession. Not only are wideswaths of the credit market priced for such, but so are parts of thecommodity complex and segments of the ex-North Americ an equity marketwhere P/E ratios are in single-digits and PEG (P/E to growth) ratios belowunity.5. In this post-bubble environmen t, policy rates will remain near the floor foryears. As such, the risks of any sustainable bear market in bonds are verylow since the cost of carry is so vitally important to the fixed-incomemarkets, esp ecially for longer duration product (keeping in mind that yieldcurves are still steep by historical standards).6. Keeping policy rates low means that real rates will remain negative. Even ifthe CPI turns negative, the cen tral banks aro und the world will de factoease policy by printing money. In this sense, the secular bull market in goldbullion remains intact and, as such, dips should be bought (especially dipsbelow the moving averages).7. Global deleveraging cycles almost invariably bring on heightened geo-political tensions. This is why the oil price has such a high floor e stablishedunderneath it. Protectionism will continue to emerge as a new normal, aspart of the globalization trend gets reve rsed. Exposure to crude oil andmaterials makes good sense from a strategic point of view.8. Populist policies win the roost in these types of cycles. The 99% extract

their pound of flesh from the 1%. Conservatives like Newt end up soundinglike Krugman when debating the likes of Romney. Luxury retailing, or anyother fashion that benefits from the spending trend of the upper class, isprobably a good shorting opportunity.CANADIAN RETAIL SALES - FATIGUE IS SETTING INCanadian retail sales came in better than expected in November, up 0.3% MoMversus consensus expectations of a 0.2% increase. But, it does seem thatfatigue is setting into the Canadian consumer as the pace of increases in retailsales have slowed down: August = 0.6% MoM, September = 1.0%, October =0.9% and now 0.3%, which is the worst performance in four months. The year-

Deflation trumps inflation asthe primary trend in adeleveraging cycle. This meansan emphasis on defensivesectors with earnings stabilityand predictabilitycharacteristics

Global deleveraging cyclesalmost invariably bring onheightened geo-politicaltensions. This is why the oilprice has such a high floorestablished underneath it

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January 25, 2012 - BREAKFAST WITH DAVEGluskin"Sheff

over-year rate is now running at 3.1%, which is the slowest since March. Expectthis deteriorating trend in retail sales to continue amid concerns regardingconsumer debt burden, a slowingjob environmen t, and elevated recession risksin Europe.However, having said that, real retail sales did com e in strong now up 0.5% inNovember and October and has put together a four-month winning streak. So farin Q4, real retail sales is up 5.1% at an annual rate suggesting that we could seea pop in real personal spending, which rose just 1.2% annu alized rate in Q3. Forcomparison, in Q4 2010, volum e retail sales wer e also up 5.1% and real PCEcame in at 4.4%.Looking at the details, more segments of retail sales were in the flat/negativecolumn than the positive nine w ere up on the month and 11 were flat or down.November's gain was led by a 2.9% rise in sporting goods/hobb y stores, thelargest monthly increase since September 2010 and is now up four months in arow, and during this period, sales rose a record 27% a.r. pace. Clothing,pharmaceutical and miscellaneous stores saw gains of just under 1%. Thehousing-related furniture (home furnishing stores down 3.1%), electronics(-0.3%), and building m aterials (-0.1%) sectors saw the declines as well asdepartment store (-0.7%) and grocery stores (-0.3%).As for auto sales, it rose 0.3% in November, which was a surprise given that lastweek Statistics Canada reported that motor veh icle sales were down 1% inNovember. However, if it weren't for the 5.1% increase in sales at auto partsdealers (the largest increase since April) auto sales wou ld have declined 0.1% inNovember. Nonetheless, excluding autos, retail sales held in, rising 0.3% on themonth, which is half the pace we saw in October. Moreover, despite lower pumpprices, gasoline station sales also saw a healthy gain in November, up 0.8% ontop of the 1.6% increase in October. Excluding autos and gasoline, retail salesgained 0.2% in November compared to 0.4% in Oct, and the YoY pace is slowing,now at 1.1%, which is the slowest pace since June.RICH IN RICHMONDManufacturing activity in the Richmo nd Fed area came in stronger thanexpected in January, rising to +12 versus consensus views of an increase to +6from +3 in Decem ber. This was the best level we have seen since Ma rch 2011.Components were strong with the shipments index up 14 points to +17 inJanuary, a big improvement from -17 back in August; new orders jumped to +14from +7 in December and a turnaround from -17 in September; capacityutilization rose to 8 from 0 in December and -14 in August; the number ofemployees index swung to +4 from -4 in Decemberbest reading sinceSeptember; and average workweek is inching higher, now at +4 from +3 inDecember he best leve l since April of last year.As for wages and inflation, they were well contained. Wages remain sticky at+10 now since Novem ber. Prices paid did rise to 2.53% in January from 1.55%in December, but lower than the 3.42% rate we saw in November. Prices

So far in Q4, real retail sales isup 5.1% at an annual ratesuggesting that we could see apop in real personal spending,which rose just 1.2%annualized rate in Q3

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received plunged to 0.57% in January from 1.34% in December and 2.64% inNovember. This is the lowest reading since December 2009.As for the service sector survey, the result was not as bright as themanufacturing survey. The Richmond Fed service sector revenues fell to 18 from22 in December. The index of product demand in the next six months fell to 17from 19 in December. And, although the number of employees index is holdingup, now at +8 from +5 in December, the average wage index fell to +5 from +15in December. In the retail subsector of services, what was troubling to see wasthe huge decline in big-ticket sales, which plunged to -52 in January rom -5 inDecember and is the lowest we have seen since February 2011.

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January 25 , 2012 - BREAKFAST WITH DAVE GluskinSheF

OVERVIEW OF THEMES AND STRATEGIES

THEMEFrugality

Non-Cyclical

CapitalPreservation

IncomeOrientation

Other

STRATEGYIdentify where people spend theirmoney and time in an economicdownturn

Focus on special situations that arenot correlated with the economic cycle

Buy high-quality corporate andgovernment bonds in non-cyclicalsectors;Minimize volatility via alternativestrategies such as long/short equitystrategiesFocus on reliable dividend growth anddividend yield;Being and staying ahead of the robustdemographic (baby-boomers aging)shift towards income orientedinvestments. Safety and Income at aReasonable Price (S.I.R.P.)Invest in hard "strategic" assets;Focus on burgeoning middle class inemerging markets

SECTOR/ASSET CLASSDollar/discount storesHome improvement/GardeningTobacco/Beverages/MoviesDefense-AerospaceHealthcareCredit of Canadian Banks,Telecom, Retail,MunicipalitiesIncome-producing equities,preferreds and bondsCanadian and U.S. Preferre dsharesEnergy infrastructureUtilities

Asian consumersFood products

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GluskinSheff

Gluskin Sheff at a GlanceGluskin Sheff + Associates Inc. is one of Canada's pre-eminent wealth management firms.Founded in 1984 and serving high net worth private clients an d institutional investors, we arededicated to meeting th e needs of our clients by delivering strong, risk-adjusted returns togetherwith th e highest level of personalized client service.OVERVIEWAs of December 31, 2011, the Firmmanaged assets of $5.3 billion.Gluskin Sheff became a publicly tradedcorporation on the Toronto StockExchange (symbol: GS) in May 2006 an dremains 45 % owned by its seniormanagement an d employees. W e havepublic compa ny accountabili ty an dgovernance with a private companycommitment to innovation an d service.O ur investment interests ar e directlyaligned with those of our clients, asGluskin Sheff s management an demployees are collectively the largestclient of the Firm's investment portfolios.We offer a diverse platform of investmentstrategies, including Canadian, U.S. an dInternational Equity strategies,Alternative strategies an d Fixed Incomestrategies. 'The minimum investment required toestablish a client relationship with th eFirm is $3 million.PERFORMANCE$i million invested in our CanadianEquity Portfolio in 1991 (its inceptiondate) would have grown to $9.0 millionon September 30, 2011 versus $5.7 milli onfor the S&P/TSX Total Return Indexover th e same period.$i million USD invested in our U.S.Equity Portfolio in 1986 (its inceptiondate) would have grown to $11.7 millionUSD 2 on September 30, 2011 versus $9.7million USD for the S&P 50 0 TotalReturn Index over the sam e period.

INVESTMENT STRATEGY & TEAMW e have strong and stable portfolioman agem ent, research and client serviceteams with best in class" talent at alllevels.We have a strong history of insightfulbottom -up security selection based onfundamental analysis.For long equities, we look for companieswith a history of long-term growth an dstability, a proven track record,shareholder-minded management and ashare price below ou r estimate of intrinsicvalue. W e look for the opposite inequities that we sell short.Fo r corporate bonds, we look fo r issuerswith a margin of safety for the paymentof interest and p rincip al, and yields whichare attractive relative to the assessedcredit risks involved.We assemble concentrated portfolios -our top ten holdings typically repres entbetween 25% to 45% of a portfolio. In thisway, clients benefit from th e ideas inwhich we have th e highest conviction.Our success has often been linked to ourlong history of investing in under-followed and under-appreciated smalland mid cap comp anies both in C anadaan d the U.S.PORTFOLIO CONSTRUCTIONIn t e rms of asset mix and portfolioconstruction, we offer a unique marriagebetween our bottom-up security-specificfundamental analysis and our top-downmacroeconomic view.

Our investmentinterests are directlyaligned with those ofour clients, as GluskinSheff s management andemployees arecollectively the largestclient of the Firm'sinvestment portfolios.

$1 million invested in ourCanadian Equity Portfolioin 1991 (its inceptiondate) would have grown to$9.0 million 2 onSeptember 30, 2011versus $5.7 mill ion for theS&P/TSX Total ReturnIndex over the sameperiod.

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Breakfast With Dave Jan:25:2012