breakfast with dave 081910

8/9/2019 Breakfast With Dave 081910

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David A. Rosenberg August 19, 2010Chief Economist & Strategist Economic [email protected]+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with DaveWHILE YOU WERE SLEEPING

Asian equities were higher today but the action in Europe is broadly mixed. The

Nikkei bounced 1.3% to 9,362 and JGBs sold off on mounting speculation that the

Bank of Japan is going to reverse the yens strength and thereby stimulate export

growth. It seems these days that nobody wants a strong currency, hence the

sustained uptrend in gold the yellow metal is riding a five-day winning streak.

Government bond markets are selling off in this morning. The news is all good

with the Bundesbank raising its 2010 growth forecast for Germany, to 3% from

1.9%, but frankly, this was just a mark-to-market exercise after those blowout Q2GDP numbers last week. Corporate bond risks are fading in Europe as per the

improvement in the CDS market and we are seeing 3-month euro LIBOR/OIS

spreads come in sharply today helping today was the EU stating that Greeces

efforts to rein in its budget deficit are surpassing expectations, as a result, the

country is on track to receive more EU financing.

The U.K. also printed some solid industrial data, as per the CBI survey for August

across-the-board improvement in exports, output, orders and pricing. And, oil and

copper are both firming alongside the better tone to the European data as well as

the positive tone to the Chinese stock market, which is a decent leading indicator

for the commodity group.

What doesnt square with all this pro-risk trading is the strength in the USD at thecurrent moment usually risk trades are being pulled off the table and the U.S.

dollar is bid so far today.

Another piece of news that does not totally fit the bullish bill is the move in the 30-

year German bund yield to below the 3% mark (2.96%). Deflation odds would still

seem to be nontrivial based on that move alone. As for the major U.S. averages,

yesterdays tenuous up-move took them to their 50-day moving averages but

resistance may be setting in and the missing link in many of these positive-action-

sessions is still the lack of volume. In other words, conviction levels are low

regarding the sustainability of any rally.

If there is good news out there it is that the hard work from Mr. Bond (see more

below) has taken key borrowing costs for households down to levels that havetouched off a decent increase in mortgage refinancings up 17% last week and

at their highest levels since the green shoot days of May 2009 every penny in

consumer pocketbooks counts in these frugal times. Morgan Stanley estimates

that there is potential for $46 billion of cash-flow for the U.S. consumer that

would be the equivalent of a 0.5% pay increase; modest perhaps but better than

a kick in the pants.

Please see important disclosures at the end of this document.

Gluskin Sheff + Associates Inc. is one of Canadas pre-eminent wealth management firms. Founded in 1984 and focused primarily on high networth 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,

visitwww.gluskinsheff.com

Bond yields must go downmore

Credit strains linger: bank-wide loan delinquencyrates actually rose in Q2,

to a new high of 7.32%from 7.26% in Q1 and6.44% a year ago

IN THIS ISSUE

While you were sleeping:Asian equities werebroadly higher today but

the action in Europe isbroadly mixed; governmentbond markets are sellingoff this morning

The bond bubble debaterevisited: One Rosie

takes on Two Jeremies

Frugality gaining moreacceptance

Investor sentiment swingsThe polls dont lie: the

latest polls showed thatonly 41% of the publicapprove of PresidentObamas handling of theeconomy, down from 44%in April


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August 19, 2010 BREAKFAST WITH DAVE

And while deflation is still not part of anyones base-case scenario save for us,

Gary Shilling, Doug Behnfield, Robert Spector, Albert Edwards, Lacy Hunt and

Van Hoisington (we need one more for two tables of bridge) the risks are rising

nonetheless. For a real-world example, look no further than page B8 of todays

NYT, Pizza Hut Cuts Prices again to Counteract the Slow Recovery. A large pizza

is now going to sell for ten bucks and we have pundits out there talking about

hyperinflation stop eating at the French Laundry!

Also, have a look at what P&G is up to on the front page of todays WSJ as it

moves to recapture share of the global market for consumer goods

Consumers might be willing to shell out for iPads, but their day-to-day

spending reflects an entrenched frugality that often means leaving P&Gs

relatively inexpensive products on the shelf. Nearly two-thirds of U.S.

consumers said they switched to a cheaper substitute for at least one basic

household product, food or beverage, in the past year This probably

includes saki and sashimi because this was definitely the pattern that

emerged in post-bubble Japan (oh, but were different right).

Meanwhile, if you are looking for where the next proverbial shoe is going to drop,

look no further than public sector pension funds and how their actuarial

liabilities estimated between $1 and $3 trillion are going to have to be

addressed and it is not going to be through a federal bailout and the PBGC

only covers private plans. Big reforms and shared sacrifice are coming soon

have a look at the op-ed article on this topic on page A17 of the WSJ.

THE BOND BUBBLE DEBATE REVISITED:

ONE ROSIE TAKES ON TWO JEREMIES

I was desperately trying to resist the temptation to retort to yesterdays op-ed piece

on page B13 of the WSJ (The Great American Bond Bubble by Jeremy Siegel and

Jeremy Schwartz). But alas, I have succumbed, for the following reasons:

1.I was inundated with emails from our readership to respond. I finally said,enough is enough.

2.Since I already took on the Two Jimmies (Grant and Caron) in the spring ontheir 5% forecasts on the 10-year Treasury note yield, I thought, in thename of acting in a consistent manner, that it would only be fair to refute thearguments made by the Two Jeremies.

3.Almost three months ago, I submitted an op-ed piece to the WSJ for itsconsideration titled Bond Bubble but my request was turned down. Not

that this is a case of sour grapes because the FT went ahead and published it.But, the fact that the WSJ turned my piece down while printing the diatribe by

Messrs. Siegel and Schwartz goes to show that for whatever reason, thereseems to be this bias on Wall Street against the bond market (the enemy).

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If you are looking for where

the next proverbial shoe isgoing to drop, look no further

than public sector pension

funds

I was desperately trying toresist the temptation to

retort to yesterdays op-ed

piece on page B13 of the

WSJ (The Great American

Bond Bubble) alas, I have

succumbed


3/15


The move to fixed-income

assets may indicate that Ma

and Pa Kettle are adjusting

their balance sheet to

capture more income, limit

their risks and preserve their

capital

4.Finally, after such a tortuous read, I simply felt that the assertions made inyesterdays WSJ op-ed piece could not go unchallenged. Everybody is

entitled to their opinion but if I had to make the case that bonds were a poorinvestment and someday I will, believe me I surely would not lean on thespurious reasoning provided in yesterdays column. The case against thebond market that was made was pretty weak, which goes to show that justbecause you have the pedigree of being a professor from Wharton doesntnecessarily mean your call on the Treasury market will prove to be any moreprescient than your call on Stocks for the Long Run.

Heres why.

The Two Jeremies stated that from January 2008 through June 2010,

outflows from equity funds totalled $233 billion while bond funds have seen a

massive $559 billion of inflows. They describe this as a rush into bonds.

The question is: so what? If anything, this shows that the retail client has

developed some real financial acumen considering that Treasury bonds have

generated a total return of 13% over that timeframe versus -21% for equities. In

fact, both the absolute and risk adjusted return on Treasury bonds have been

spectacularly superior to equities for the last 10 years. To be sure, past trends

cannot be relied on for future performance, but what is not mentioned in the

WSJ piece is that households may be deliberately rebalancing their asset

allocation because 27% is represented by equities, another 27% in real estate,

but a mere 6% is in fixed-income securities.

So maybe Ma and Pa Kettle are moving to correct this mismatch on their

balance sheet and adjusting it to capture more income, limit their risks and

preserve their capital. We do know with certainty that the median age of the

baby boom cohort is approaching 55. As strategists we have to come to theunderstanding that a powerful demographic trend is gathering momentum,

which is generating this insatiable appetite for yield an era of correcting the

underweight in bonds in the aging (but not aged) boomer asset mix while

correcting the lingering overweight in equities. This may prove to be a secular

shift and it just makes sense to come to grips with what is likely to be a

continued divergence in bond and stock performance in the future.

The Two Jeremies compare this apparent bond bubble to the technology

mania a decade ago. Some bizarre comparisons, using an estimate of a P/E

multiple on the Treasury market of 100x, were cited but were far too opaque for

me to fathom. At the same time, it is a legitimate question as to how to quantify

whether bonds are overvalued or undervalued at any given point in time. What

is more important to identify, at least in my opinion, is what the critical forcesare that drive yields up or down. Its nice to compare what we are seeing in

bonds today to what the dotcoms did a decade ago but its hardly relevant

because the variables that influence speculative stocks are completely different

than those that affect the direction of long-term interest rates. Alan Greenspan

thought that growth stocks were irrationally exuberant six years before the bull

market ended.

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The Two Jeremies compare

this apparent bond bubble

to the technology mania a

decade ago


4/15


What finally did end it was not any particular valuation metric but perhaps Cisco

missing by a penny on the other side of consensus expectations, leading to a

dramatic reassessment of the earnings landscape. If there is one thing we do

know, equity prices will track earnings-revision-ratios very closely. Then of

course, we had a capital spending-induced recession that practically nobody saw

coming in 2001, and weve never had a recession without cyclically-sensitive

equities enduring a severe bear market.

So lets fade valuation comparisons between bonds and growth stocks. Its such

a silly argument. Nortel did go bankrupt, as did a slate of tech stocks. Your

capital wasnt preserved it was extinguished. Nortel was the darling of the

day, at one point representing more than 30% of the Canadian stock market

capitalization. Equities, by their nature, are riskier than Treasury bonds some

more than others. Obviously, the Bill Millers, Warren Buffetts and Ira Gluskins of

this world have in their professional lives managed to find some real gems that

generated significant returns for their unit holders. But at no time was your

capital guaranteed. So how can anyone compare that to a government

obligation with an ironclad guarantee of interest and principal payments? Do we

use a tech stock as the risk-free benchmark for funding actuarial liabilities? Or

is it the long Treasury Strip? Does a tech stock, or any piece of equity paper, tell

you with full certainty what you are going to be paid upon maturity? Or is that

the long Treasury Strip? Why even bother comparing these two investment

vehicles, they serve completely different purposes and are purchased by two

very different mandates.

Furthermore, I feel strongly that this notion that the U.S. government, with all its

taxing power and vast holdings of the national assets and treasures (dare we

say, including what lies beneath Fort Knox) is going to default someday iscompletely ludicrous. All we seem to talk about is the gross debt burden. This is

not to downplay the fiscal situation, which is dire, but becoming hysterical could

lead to poor judgment and decision-making.

Canada faced similar structural deficits in the early 1990s, had its credit rating

downgraded several times, and there were hues and cries back then as well

over Canadas ability to service its debts. However, years of shared sacrifice

cured those ills and there were no defaults, late payments, haircuts or even a

move to inflate the liabilities away. So give me a giant break on U.S. sovereign

credit risks. Talk of default is complete and utter nonsense and frankly, its

obnoxious. More likely, America is going to go on a multi-year path towards

fiscal probity, which will involve more taxation, sharply lower spending on non-

essential services, and shared sacrifice, as was the case in the 30s and north ofthe border in the 90s.

So lets go back to first principles. It matters little what level Treasury yields are

sitting at. You could be sitting there with a 10% coupon but if yields, for

whatever reason, were to jump to 20% and stay there, you would likely suffer a

huge loss if you had to sell before maturity. So the fact that yields are at 10% or

3% matters little in this debate.

Page 4 of 15

But really, lets fade

valuation comparisonsbetween bonds and growth

stocks. Its such a silly

argument

I feel strongly that this

notion that the U.S.government, with all its

taxing power and vast

holdings of the national

assets and treasures is

going to default someday is

completely ludicrous


5/15


To reiterate, it was the macro economic landscape, not the valuation backdrop,

that proved to be the undoing for tech stocks in the opening months of 2000. It

is far more relevant and useful to discuss what the triggers would possibly be to

drive yields higher and on a sustained basis.

I did the research on this long ago. Budget deficits (and surpluses) have a 40%

correlation to bond yields. Just as a deficit of $1.5 trillion did not prevent bonds

from staging an impressive rally this year, surpluses in 1999 did not stop the

Treasury market from enduring its second worst year in recorded history, in total

return terms. You see, in 1999, we had the Fed tightening policy and inflation

pressures percolating. In 2010, we had the Fed reiterating its commitment to

keep policy rates to the floor. At the end of last year, the consensus was

convinced the Fed would be hiking rates by now ... the fact that the central bank

hasnt done that, let alone start to shrink its pregnant balance sheet, has to be

one of the biggest surprises so far this year.

We are rapidly running out of disinflation and we are staring deflation in the face

the year-on-year trend in the core CPI (which excludes food and energy) is just

88 basis points away from breaking below the zero-line. Our research show that

Fed policy has a near 90% correlation with the direction of bond yields you just

dont go into a sustainable bear markets when the Fed is not taking the carry

away. Moreover, inflation as measured by the year-over-year change in the CPI,

for all its blemishes and imperfections, commands a near 80% correlation with

the Treasury market.

Yet in this whole discussion of the bond market, nowhere do the Two Jeremies

talk about their forecasts on the Fed and on inflation. These are the two most

vital components of interest rate determination and they are not even discussed

in this bond bubble piece.

Look, instead of debating bubbles maybe it is more appropriate to identify where

bond yields could go before they ultimately bottom. This would seem to be more

relevant for investors than lamenting how low they already are as if that would

have helped anybody figure the JGB market out over the past decade (and with

a Japanese government debt-to-GDP ratio of 200%!). Well, the Fed just told us

that it has no intention of hiking rates for a long, long time. So, Fed tightening

risks are off the table and at a time when the policy rate is almost zero. And we

have a long bond yield of 3.6%. That is a 360 basis point curve from overnight

to 30 years, and historically, that spread averages out to be 200bps.

As we invoke Bob Farrells Rule 1, which is about reversion to the mean, weshould see the long bond yield approach or even possibly test the 2% threshold

before its final resting stop is reached. If we are right on -1% to -2% deflation in

coming years as the post-bubble excesses continue to unwind, nominal yield will

actually be quite juicy in real terms.

Page 5 of 15

We are rapidly running out of

disinflation and we arestaring deflation in the face


6/15


Interestingly, when Ben Bernanke gave his What If speech in November 2002,

he mentioned that in a 0% funds rate world where deflation risks intensify, he

would begin to target long-term rates and cited how in the decade to 1951,

the Fed established an explicit ceiling on the long bond yield at 2.5%.

The Two Jeremies go on to then bash the purveyors of pessimism and in a

manner we can only describe as convoluted. Admittedly, I couldnt comprehend

their thought process. They are of the view that no matter what, U.S. economic

growth is likely to accelerate. No mention is made of the fact that the mini-

inventory cycle has run its course and that we are past the peak of the

monetary, fiscal and bailout stimulus. The economy slowed to stall-speed in the

second quarter and is on the precipice of contracting in the current quarter.

What do the Two Jeremies see that the Fed didnt see when it cut its macro

forecast last week for the second time in the past six weeks? What is the

exogenous positive shock to the economy that turns the tide back to one of

positive momentum?

At least in 2003 the Fed could cut rates and Bush could dramatically cut taxes. On

top of that, we had the proliferation of subprime mortgages, interest-only

mortgages, no-doc loans, low-doc loans, liar loans as well as the feel-good effect of

a 20% annual home price appreciation. The securitized loan market that blazed

the trail for that wonderful leveraged ownership society bull market and

economic expansion from 2003 to 2007 is 60% the size today of what it was three

short years ago. Do the Two Jeremies realize that a huge chunk of the credit

market that financed the false prosperity of the last great bull run in risk assets

and the economy is no longer around? Nowhere in the article is there a convincing

case for above-trend growth, which will be needed at some point to chip away at

the widespread excess capacity and touch off the inflation and Fed tighteningcycle that would truly make the bearish case for bonds a compelling one.

There was emphasis in the article on dividend yield and dividend growth and

indeed, this is part of our own Safety and Income at a Reasonable Price strategy

(S.I.R.P.). This is an era of income orientation, and to be sure there are many

areas of the market in which an income stream can be derived REITs, trusts,

corporates, munis, oil and gas royalties, preferreds, and reliable dividend

growth. Agreed.

But the Two Jeremies use this as an argument against the Treasury market.

We dont get it. Okay, theres an average 4% dividend yield in the blue-chip

stocks they cited. That's fine. But why not complement the bonds in your

portfolio with these income-oriented equity investments? Why do the TwoJeremies make it sound like its one or the other? Why cant they co-exist

within the S.I.R.P. thematic? The fact that AT&T has a decent dividend yield is

the reason theres a perceived bond bubble? How does that make any sense?

Page 6 of 15

As we invoke Bob Farrells

Rule 1, which is aboutreversion to the mean, we

should see the long bond

yield approach or even

possibly test the 2%

threshold before its final

resting stop is reached


7/15


As an aside, there was no mention of where the bonds trade for these blue-

chip companies we only read in the article about the dividend yield and the

earnings yield. Nothing on their bonds, which are probably also alluring with

the added bonus that you line up in a better part of their capital structure.

Keep in mind that no matter how safe an equity investment is, it is all

relative your capital is not guaranteed. No equity is totally safe. Even in the

corporate bond space mortgages too investors face call risk and that can

certainly be a nuisance. In a period when interest rates are falling and

corporate and household debtors move into refinancing/prepayment mode

even non-Treasury debt has its risks. Nowhere in the WSJ op-ed piece is there

a word mentioned about the unique non-callable nature of government bonds,

and that investors may well be putting an increasing price premium on

Treasuries in light of this feature that is practically non-existent in other

segments of the fixed-income universe.

This really appears to be a case of ones assumptions driving ones conclusions (or

maybe in this particular case, the conclusions drove the assumptions). The Two

Jeremies cite stellar productivity growth (almost twice the long-term average) as

a reason for their bullish view on the economic landscape. But there is no mention

of what role this productivity is playing in keeping the unemployment rate so

elevated and as a result dampening wage pressures. Why?

Moreover, there was no mention as to the huge role this productivity has played

in depressing unit labour costs, which, in fact, is deflating at a record pace.

These guys are bullish on productivity and yet bearish on bonds, even though

the productivity they cherish is one big reason why inflation is melting and bond

yields are rallying to the levels they are at today! Think about the logic in that.

The comment that households are pouring money into bond funds also

ignores the fact that much of this inflow was not directed into Treasury bonds

(see Investors Buy Consumer Debt on page C14 of yesterdays WSJ not

everything the retail client did this cycle necessarily dovetailed with our S.I.R.P.

theme). In fact, over the past two years, less than $60 billion or only 12% of the

net inflows to bond mutual funds were devoted to Treasuries these retail

investors ploughed in nearly twice as much into corporates. This fact was not

mentioned in that op-ed piece.

Moreover, the implicit assumption here is that retail investors (the general

investing public) dont know what they are doing they always do the wrong

thing at the wrong time. It is a comforting refrain, but keep in mind that retail

investors were actually shedding their equity exposure at a faster rate thaninstitutional investors were raising cash levels going into the financial crisis. You

just cant look at the flows without also looking at the stock and as we

stressed above, what we are likely witnessing is a deliberate asset mix shift.

Page 7 of 15

Then there is the one-sided comment that if the 10-year note yield were to rise

back to 3.15% in the next year, total returns would be nil. Fair enough, if that

were to happen.


8/15


Now interest rates will of course fluctuate, but if the intermittent spasms occur

alongside a primary trendline that is down (in yields) then there should hardly be

concern about these periodic setbacks. If we are correct that we are still in the

throes of a secular bull market in bonds, even if in the mature stage, then

moves to 3% or above, should they occur, will prove to be great buying

opportunities, not unlike the repeated tests of 4% that saw over the past year

(and as early last April).

If the conditions for a continuation of the bull market in bonds is intact, then

think of what the potential returns would be if the long bond yield were to grind

down towards 2.0% or 2.5%. The Two Jeremies failed to mention that such a

move would generate total returns of around 30% for long coupon bonds and

65% on the long strip! Ah, the power of convexity at low levels of interest rates

every basis point move magnifies the total return. The same bearish arguments

about the bond market being overvalued could have been made at the start of

the year, and to be sure, they were made in various circles, which is why the

broad consensus was for equities to outperform Treasuries again this year.

Meanwhile, even in the face of low yields, the price appreciation has been so

powerful that the long-dated Treasury Strip (30-year) has generated a net

positive return of nearly 30% so far this year versus -2% for the S&P 500. It may

be a mistake to argue with success.

In sum, there is no bond bubble. The latest Commitment of Traders (CoT) report

show there to still be a small net short position among non-commercial accounts,

as far as the long bond is concerned, and basically flat for the 10-year T-note. The

long-standing net short position has been closed but one can hardly look at this

data and conclude that there is rampant bullishness among speculators.

So, while there may be a technically overbought technical condition and while

bullish sentiment readings are very high, indeed according to some recent

surveys, we are still a long way from capitulation (epiphany?) by Wall Street

economists and strategists. One critical element missing is the speculative

fervour, which hit the dotcoms in 2000 and real estate by 2006. Be assured

that you know the lows in yield have been turned in when the CoT report shows

there to be massive amounts of net speculative longs.

Page 8 of 15

Fundamentally, what we have on our hands is a powerful demographic appetite

for yield at a time when income is under-represented on boomer balance sheets.

At the same time, while fiscal deficits are very high, they are unlikely to expand

any further given the recent political backlash against more expansion of the

government debt-to-GDP ratio. All the while, the two most significantdeterminants of the trend in long-term bond yields Fed policy and inflation

continue to flash green, and at a time when the yield curve is still historically

steep and destined to flatten. With the process led by ever-lower long-term rates

since the central bank has already assured us that short-term rates will remain

at rock-bottom levels for as long as the eye can see.


9/15


FRUGALITY GAINING MORE ACCEPTANCE

Page B1 of yesterdays WSJ ran with Retailers Are Sold on Frugalityand the

opening line went like this:

American retailers are becoming as frugal as their shoppers, cutting expenses

to maintain stable profits through what is increasingly looking like another

challenging holiday season.

I cant help but smirk a little bit because it was two years ago that I invoked this

as part of my deflation theme and hopefully some will recall my old chart

package dubbed The Frugal Future. To be honest, when I marketed that view

in my last 18 months at Merrill Lynch, people thought I had really lost my

marbles. Back then, it was universally believed that one should never ever

count out the never-say-die, shop-till-you-drop American consumer. Indeed, old

habits die hard but at some stage, denial will turn to acceptance. Who in the

economics community was calling for a 6% personal savings rate by now?

And its not over.

While Wal-Mart managed to beat its EPS targets, its U.S. same-store sales

numbers have been negative on a YoY basis for five quarters in a row. Retailers

are only managing to scrape by via reductions in employee hours, maintaining

very tight inventory controls, gaining concessions from suppliers in other

words, aggressive cost-cutting.

Here is what Wal-Mart CEO Mike Duke had to say about the consumer spending

environment:

The slow economic recovery will continue to affect our customers, and we

expect they will remain cautious about spending.

Home Depot CEO Carol Tome had this to say the firm just sliced its full-year

sales growth forecast to 2.6% from 3.5% (even as it raised its EPS guidance).

How in the heck can you increase earnings with tighter revenues? The answer

is that we expect some expense relief.

And the CEO for Urban Outfitters, Glen Senk, said this:

I am not bullish about the second half. We're facing a slow and lengthy

recovery that will be punctuated by periods of uncertainty.

Targets CEO Gregg Steinhafel added this:

Page 9 of 15

Its clear that the second quarter marked a change in recent trend. Following

stronger results in the last two quarters, gross domestic product growth

softened considerably and our sales trends leveled off as well.


10/15


Target managed to post a 14% YoY profit gain but this largely reflected the

benefits of luring its debit/credit-card holders into its stores with 5% discounts (no

deflation, eh?) as well as a general improvement in delinquency rates (debtors

today only stop paying their mortgages the credit card has ostensibly become a

consumer staple). In any event, Q3 sales expectations right now is a mere 1%.

On Monday, Lowes also managed to raise its 2010 profit forecast but at the

same time lowering its annual revenue projections. Abercrombie & Fitch is

another case in point sales are up even with average prices for its

merchandise down 15%. Call it deflationary growth.

However, for some retailers it is just deflationary even for discounters like TJX,

which is forecasting second-half sales to be flat to down. And, companies like

Wal-Mart are reporting that they are detecting the return of the paycheck cycle.

In fact, the NYT reported (page B3 of yesterdays paper) that steeper price-

slashing did not lure customers into spending more at Wal-Mart, while shoppers

at Home Depot spent less and put off big home improvement projects of big-

ticket items like appliances.

That last comment had a certain Japanese feel to it and is a reason why Ben

Bernanke is so concerned about deflation the distorting impact it can have on

economic behaviour. In inflationary times, like the 1970s and early 1980s,

when everyone begins to expect more inflation, households and businesses tend

to buy more now and stockpile to get ahead of the next round of price increases.

But the very action to buy more now boosts demand and fuels the very

inflationary pressure that economic agents are attempting to bypass. So

inflation becomes deeply embedded in expectations and leads to tremendous

distortions and resource misallocation.

The same is true but in reverse in deflationary times as we are seeing take

place at Wal-Mart. In this condition, people put off their spending plans in the

hope of getting a better bargain down the road. This reduces demand, leaves

unwanted inventory on the shelves in the retail sector, and this in turn reinforces

the downtrend in pricing.

Page 10 of 15

Finally, part and parcel of our frugality theme two-years ago was the need the

desire, in fact to get small: smaller homes, smaller cars, smaller credit lines,

smaller workforces, smaller budgets for discretionary goods and services. This

is why the article on how commercial tenants are finding ways to economize on

space in yesterdays WSJ was so fascinating (Office-Leasing Rebound Could

Be Deceivingon page C6). Just another example of the new normal.


11/15


SENTIMENT SWINGS

Equity and market sentiment is swinging wildly week to week, but in the most

recent Investors Intelligence Poll, there is at least a sparkle of capitulation

(though we likely need to see a lot more). The bulls lost ground, to 36.7% from

41.7% last week, and the bear camp expanded, to 31.1% from 27.5%. We

suppose it says something that the landscape is still populated with more bulls

than bears, but it is only fair to point out that the bull/bear spread shrank a

considerable 8.6 points this week.

We have also been hearing that bullish sentiment towards Treasuries is now 98%,

according to some surveys, approaching the incredible 99% on December 16,

2008, right as yields were plunging to their trough (the 10-year note approaching

2%). It was at that time that I wrote a report (while still at Merrill) titled Saying

Goodbye to an Old Friend in which I had suggested that Treasuries were

overbought and that there were better opportunities in the fixed-income market (in

mortgages, corporates and even munis). I never turned outright bearish on T-

notes and bonds but thought we could be in for a correction, which we endured for

about a year and almost 200 basis points on the 10-year. The rally in late 2008

also took place right after the Fed made an announcement to buy bonds, and to

some extent we have seen a dj vu in the past week. Although, back then the

bond market did a lot of the rally off the April high in yields all on its own without

any help from Ben Bernanke or China for that matter.

But there are some differences. The bounce in yields off the December lows

occurred as depression talk was rampant, not to mention the implosion of the

banking system. All it took was for the government to safeguard the financials and

come up with a massive fiscal stimulus program to prompt a major short-covering

rebound in the stock market and a shift out of the safe haven provided by theTreasury market. Back then, all we had to do was take GDP growth from negative

terrain to flat and green shoots would sprout across the economic garden. So,

we had the stimulus to look forward to, we had the peak in growth still ahead of

us, and a new activist government that had everyone excited over a new path,

both politically and economically. We had the shorts running for cover.

Page 11 of 15

So, it may well be the case that bond market sentiment has swung to extreme

levels. At the Grants Conference in April, Jim labelled the event we closed down

together on stage as Bonds are for losers. Even in June, the Barrons poll

showed the vast majority of forecasters calling for higher yield activity. Now

every bond bear, from the 5.5% yield projectors at Morgan Stanley, to my old

shop who are now broadly filled with perma-bulls (now are calling for a 2.5%

yield on the 10-year note) outside of Mary Ann Bartels, have thrown in the towel.


12/15


So yes, we could well see a near-term reversal in this impressive bond rally. But

no, it wont be nearly as severe as it was in 2009 and there is still a very strong

likelihood that yields out the Treasury curve do what the front end has already

done and move down to new lows. The peak in growth is behind us, not ahead

of us anymore. There is nothing to be excited about politically, unless you think

the GoP winning the House and the Senate in November by default and with no

articulated vision of its own is a reason to be bullish. When leadership is

wanting, sorry, gridlock is not good. Not at all.

And, there are no more fiscal rabbits to be pulled out of the hat the majority of

Americans are saying enough is enough on this experiment in testing the outer

limits of our deficit financing capabilities as government debt relative to GDP

approaches a game-changing 100% ratio. Remember, back in early 2009, all it

took was a move to zero percent growth just stop the economy from falling off

a cliff! to prompt a multi-month bond selloff and an equity rally. That says

something about expectations back then.

Fast forward to today, and imagine if yet again we move to zero percent growth

we doubt we will get the same investor reaction this time around, especially

with the market primed for over 20% earnings growth over the course of the next

4-6 quarters.

THE POLLS DON'T LIE

There are 11 weeks to go before the November 2nd mid-election in the U.S. and

based on the just-released Associate Press poll, one would never have thought

that 1) the Fed had cut the funds rate to zero, 2) tripled the size of the balance

sheet all in the name of regenerating a credit cycle, 3) the federal government

would have initiated at least eight different housing programs to underpin thereal estate sector, and 4) would have embarked on a historic fiscal stimulus

plan. The latest poll showed that only 41% of the general public approve of

President Obamas handling of the economy, down from 44% in April. Fully 56%

disapprove. And get this, 61% think the economy has worsened since he took

office. How is that possible?

In June, 72% believed the economy was poor or very poor and just two months

later than share has risen to 81%. In June, 19% said the economy was

improving; that number is now down to 12%.

BOND YIELDS MUST GO DOWN MORE

Page 12 of 15

We dont understand it. The equity bulls hate the Treasury market and seem as

though they are fanatic in their calls for higher rates. Yet if you are bullish inequities, wouldnt it make more sense to want the cost of credit to go down to

stimulate economic growth (and last we say, the earnings that equity investors

pay for are part of the economy)? The bond market is now the only game in

town with policy rates at 0% and tapped out on the fiscal front. Its all up to

the bond market long-term interest rates and at least Ben Bernanke

understands this even if most portfolio managers and market commentators do

not.


13/15


Page 13 of 15

The bond market has worked hard without the rally in Treasuries, mortgage

rates would not have tumbled 60 basis points in the past year. The problem in a

credit contraction is that it is difficult to revive demand unless interest rates

decline to microscopic levels. But, as we saw in Japan, even then there is no

certainty that spending will turn around.

What we know is that mortgage applications for new home purchases these are

not approvals but rather a true proxy for home purchases, slid 3.4% last week

even in the face of the huge bond rally and they are now down 38% from

depressed year-ago levels. Again, this is a sign, to us at least, that the bond

market is going to have to work that much harder. This in turn means that long-

term rates will head even lower, and not until they do the job in generating

sustainable growth will this bull phase in the Treasury market fully run its course.

CREDIT STRAINS LINGER

Here we were led to believe by all the analysts that we had somehow moved to a

new and better inflection point as it pertained to U.S. credit quality, but that

doesnt seem to be the case. At least not if the reported Q2 data out of the Fed is

accurate.

Bank-wide loan delinquency rates actually rose to a new high of 7.32% in Q2 from

7.26% in Q1 and 6.44% a year ago. While there were improvements in credit

cards and C&I loans, there was significant deterioration in the real estate sector

the delinquency rate for residential mortgages climbed to 10.05% from 9.74% in

Q1 and 8.21% a year ago; and commercial real estate loan delinquency rates

edged up to 8.79% from 8.65% in Q1 and 7.85% in 2009 Q2.

Yesterdays NYT ran with a nifty little article that came up with solutions for the

future in terms of reining in credit bubbles before they start (see Rein in

Borrowers to Fix Mortgages). For example, repealing the sacred cow that

allows mortgage interest deductibility (this goodie costs Uncle Sam about

$100 billion every year); giving banks full recourse (as we have in Canada); more

aggressive down-payment requirements; limits on mortgage refinancing; and

more stringent underwriting criteria.


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Gluskin Sheffat a Glance

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

As of June30, 2010, the Firm managedassets of$5.5 billion.

1

Gluskin Sheff became a publicly tradedcorporation on the Toronto StockExchange (symbol: GS) in May2006 andremains54% owned by its senior

management and employees. We havepublic company accountability andgovernance with a private companycommitment to innovation and service.

Our investment interests are directlyaligned with those of our clients, asGluskin Sheffs management andemployees are collectively the largestclient of the Firms investment portfolios.

We offer a diverse platform of investmentstrategies (Canadian and U.S. equities,Alternative and Fixed Income) andinvestment styles (Value, Growth and

Income).2

The minimum investment required toestablish a client relationship with theFirm is $3 million for Canadian investorsand $5 million for U.S. & Internationalinvestors.

PERFORMANCE

$1 million invested in our Canadian ValuePortfolio in 1991 (its inception date)

would have grown to $11.7million2

onMarch31, 2010 versus $5.7million for theS&P/TSX Total Return Index over the

same period.$1 million usd invested in our U.S.Equity Portfolio in 1986 (its inceptiondate) would have grown to $8.7millionusd

3on March 31, 2010 versus $6.9

million usd for the S&P500TotalReturn Index over the same period.

INVESTMENT STRATEGY & TEAM

We have strong and stable portfoliomanagement, research and client serviceteams. Aside from recent additions, ourPortfolio Managers have been with theFirm for a minimum of ten years and wehave attracted best in class talent at all

levels. Our performance results are thoseof the team in place.

Our investmentinterests are directlyaligned with those ofour clients, as Gluskin

Sheffs management andemployees arecollectively the largestclient of the Firmsinvestment portfolios.

$1 million invested in our

Canadian Value Portfolio

in 1991 (its inception

date) would have grown to

$11.7 million2 on March

31, 2010 versus $5.7

million for the S&P/TSX

Total Return Index over

the same period.

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 andstability, a proven track record,shareholder-minded management and ashare price below our estimate of intrinsic

value. We look for the opposite inequities that we sell short.

For corporate bonds, we look for issuers

with a margin of safety for the paymentof interest and principal, and yields whichare attractive relative to the assessedcredit risks involved.

We assemble concentrated portfolios our top ten holdings typically representbetween 25% to 45% of a portfolio. In this

way, clients benefit from the ideas inwhich we have the highest conviction.

Our success has often been linked to ourlong history of investing in under-followedand under-appreciated small and mid capcompanies both in Canada and the U.S.

PORTFOLIO CONSTRUCTION

In terms of asset mix and portfolioconstruction, we offer a unique marriagebetween our bottom-up security-specificfundamental analysis and our top-downmacroeconomic view.

For further information,

please contact

[email protected]

Notes:

Page 14 of 15

Unless otherwise noted, all values are in Canadian dollars.1. Preliminary unaudited estimate.2. Not all investment strategies are available to non-Canadian investors. Please contact Gluskin Sheff for information specific to your situation.3. Returns are based on the composite of segregated Value and U.S. Equity portfolios, as applicable, and are presented net of fees and expenses.


15/15


IMPORTANT DISCLOSURES

Copyright 2010 Gluskin Sheff + Associates Inc. (Gluskin Sheff). All rights

reserved. This report is prepared for the use of Gluskin Sheff clients andsubscribers to this report and may not be redistributed, retransmitted ordisclosed, in whole or in part, or in any form or manner, without the expresswritten consent of Gluskin Sheff. Gluskin Sheff reports are distributedsimultaneously to internal and client websites and other portals by GluskinSheff and are not publicly available materials. Any unauthorized use ordisclosure is prohibited.

Gluskin Sheff may own, buy, or sell, on behalf of its clients, securities ofissuers that may be discussed in or impacted by this report. As a result,readers should be aware that Gluskin Sheff may have a conflict of interest

that could affect the objectivity of this report. This report should not beregarded by recipients as a substitute for the exercise of their own judgmentand readers are encouraged to seek independent, third-party research onany companies covered in or impacted by this report.

Individuals identified as economists do not function as research analystsunder U.S. law and reports prepared by them are not research reports underapplicable U.S. rules and regulations. Macroeconomic analysis isconsidered investment research for purposes of distribution in the U.K.

under the rules of the Financial Services Authority.

Neither the information nor any opinion expressed constitutes an offer or aninvitation to make an offer, to buy or sell any securities or other financialinstrument or any derivative related to such securities or instruments (e.g.,options, futures, warrants, and contracts for differences). This report is notintended to provide personal investment advice and it does not take intoaccount the specific investment objectives, financial situation and theparticular needs of any specific person. Investors should seek financialadvice regarding the appropriateness of investing in financial instrumentsand implementing investment strategies discussed or recommended in thisreport and should understand that statements regarding future prospectsmay not be realized. Any decision to purchase or subscribe for securities inany offering must be based solely on existing public information on suchsecurity or the information in the prospectus or other offering documentissued in connection with such offering, and not on this report.

Securities and other financial instruments discussed in this report, orrecommended by Gluskin Sheff, are not insured by the Federal DepositInsurance Corporation and are not deposits or other obligations of anyinsured depository institution. Investments in general and, derivatives, inparticular, involve numerous risks, including, among others, market risk,counterparty default risk and liquidity risk. No security, financial instrumentor derivative is suitable for all investors. In some cases, securities andother financial instruments may be difficult to value or sell and reliableinformation about the value or r isks related to the security or financialinstrument may be difficult to obtain. Investors should note that incomefrom such securities and other financial instruments, if any, may fluctuateand that price or value of such securities and instruments may rise or fall

and, in some cases, investors may lose their entire principal investment.

Past performance is not necessarily a guide to future performance. Levelsand basis for taxation may change.

Foreign currency rates of exchange may adversely affect the value, price orincome of any security or financial instrument mentioned in this report.Investors in such securities and instruments effectively assume currencyrisk.

Materials prepared by Gluskin Sheff research personnel are based on publicinformation. Facts and views presented in this material have not beenreviewed by, and may not reflect information known to, professionals inother business areas of Gluskin Sheff. To the extent this report discussesany legal proceeding or issues, it has not been prepared as nor is itintended to express any legal conclusion, opinion or advice. Investorsshould consult their own legal advisers as to issues of law relating to thesubject matter of this report. Gluskin Sheff research personnels knowledgeof legal proceedings in which any Gluskin Sheff entity and/or its directors,officers and employees may be plaintiffs, defendants, co-defendants or co-plaintiffs with or involving companies mentioned in this report is based onpublic information. Facts and views presented in this material that relate to

any such proceedings have not been reviewed by, discussed with, and maynot reflect information known to, professionals in other business areas ofGluskin Sheff in connection with the legal proceedings or matters relevant

to such proceedings.

Any information relating to the tax status of financial instruments discussedherein is not intended to provide tax advice or to be used by anyone toprovide tax advice. Investors are urged to seek tax advice based on theirparticular circumstances from an independent tax professional.

The information herein (other than disclosure information relating to GluskinSheff and its affiliates) was obtained from various sources and GluskinSheff does not guarantee its accuracy. This report may contain links to

third-party websites. Gluskin Sheff is not responsible for the content of anythird-party website or any linked content contained in a third-party website.Content contained on such third-party websites is not part of this report andis not incorporated by reference into this report. The inclusion of a link in

this report does not imply any endorsement by or any affiliation with GluskinSheff.

All opinions, projections and estimates constitute the judgment of theauthor as of the date of the report and are subject to change without notice.Prices also are subject to change without notice. Gluskin Sheff is under noobligation to update this report and readers should therefore assume thatGluskin Sheff will not update any fact, circumstance or opinion contained in

this report.

Neither Gluskin Sheff nor any director, officer or employee of Gluskin Sheffaccepts any liability whatsoever for any direct, indirect or consequentialdamages or losses arising from any use of this report or its contents.

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