David A.

Rosenberg June 18, 2009

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

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
Very quiet overnight
• Screening for actual
European equities flat-ish and Asian markets down for the most part: Nikkei pricing power from the PPI
down 1.4%, Hang Seng off 1.7%, Kospi down 1.1%. the CPI and the capacity
utilization (CapU) reports
Commodities generally firm — outlook now wholly dependant on whether China’s • No credit, no inflation
fiscally-induced recovery is sustainable (the World Bank just raised its GDP
• Era of the ‘green shoots’
growth forecast to 7.2%, — but is that enough?); also see the article on page 24
is over
of the FT (China’s import demand has soared this year for steel, copper and a
host of other raw material). • Bonds still have potential,
in our view
Little action in bond-land, but in the U.S.A., it is absolutely glaring how cheap • Gas pains for the U.S.
bonds have become with the de facto real yield on the 30-year now a snick consumer
above 550 basis points. Real yields at these levels, notwithstanding the supply • Mortgage applications
backdrop, are simply unsustainable — the last time we were anywhere close to a falling out of bed
5½% percentage point inflation-adjusted long bond yield (November 1994, July
1986, and January 1982) the nominal 30-year yield ended up rallying in the next
six months each time and by an average of 75 basis points.

While fiscal policy is a clear hurdle, the headwinds for bonds include a record
output gap, which should help bring down inflation expectations; flat to low
single digit nominal growth, which is the most important factor in interest rate
determination; the lack of bullish sentiment, which is a contrary positive; the low
ownership of Treasuries in domestic portfolios (less than 7% of the U.S.
household balance sheet is comprised of fixed-income securities compared with
12% cash, 25% equities and 30% real estate); and the huge positive carry (aka
steep yield curve) offered by the Fed and this is not likely to change until after
the unemployment rate peaks and that could easily be 1 to 2 years away.
Pundits who cling to the inflation view should have a read of Boston Paper Plans
Talks (see page B4 of today’s Wall Street Journal) and tell the inflation story to
the workers who are facing a 23% pay cut.

Note too that even as the fiscal shortfall hit new highs, the U.S. current account
deficit is slip sliding away (to $101bln in 1Q or 2.9% relative to GDP, which is the
lowest since 1999) which means that, at the margin, there is less need for
foreign investors to fund the budget gap (we just need an awful lot of PIMCOs!).

Please see important disclosures at the end of this document.

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June 18, 2009 – BREAKFAST WITH DAVE

On the data front, it looks like the green shoots are turning yellow in the U.K. as
well where we see that retail sales fell 0.6% MoM in May — first setback in three
months (consensus was +0.3%, so wrong digit and wrong sign). On top of that,
the U.K.’s CBI industrial survey came in weak with export orders down to their
lowest level since October 1998! Needless to say, the British Pound took a
pounding on the release of the data.

SOME IMPORTANT ITEMS TO NOTE REGARDING ENERGY SPACE/UTILITIES

1. Both the NYT and WSJ ran with articles today on the amount of natural
gas that is going to be available for production in the next few years — up
something like 58% over the past four years. A Senate panel just voted in
favour of an energy bill that is going to also open up new areas for
offshore drilling.
2. The House democrats are pushing for the Department of Energy to sell 70
million barrels of light sweet crude (and replace with cheaper heavier
crude) out of the Strategic Petroleum Reserve (SPR) — a bill was just
introduced to this effect.
3. The utilities sector is probably going to like the fact that a Senate panel
just approved an energy bill that is going to impose less stringent
mandates on utilities. The WSJ reports today that environmental groups
are very upset over the less stringent renewable energy requirements —
that’s always a good sign for the utilities space.
SCREENING FOR THE CPI
The consumer price index rose by a much lower than expected 0.1% in May and
this, like the PPI, took the YoY trend to a five-decade low, of -1.0%. We are going
to see some larger monthly prints due to higher gasoline prices but because of
the huge base effects of a year ago, when oil hit $150/bbl, we could still very
likely see the YoY headline inflation rate sink to as low as -2.0% by the end of
the summer. It is very clear that we are either in an extremely benign inflation
environment or on the precipice of a deflationary environment. Either way,
pricing power is confined to relatively few sectors. These would include:

! Restaurants — up 0.2% MoM in May and 4.2% on a YoY basis.

! Alcoholic beverages — much like the PPI, up 0.3% MoM in May and +3.0% YoY.

! Sweets — as we said above in the PPI, chocoholics don’t mind paying higher
prices, even in a borderline depression — pricing is up a solid 6.0% on a YoY
basis.
! As the PPI also illustrated from the producer standpoint, at the retail level the
CPI showed a 0.8% monthly rise and a 7.7% bubbly inflation rate for soft
drinks.
! Prescription drugs — 0.6% MoM and 3.5% on a YoY basis.

! Pets/pet products — as with PPI, huge pricing power (+10.0% YoY).

! Telephone services — steady-as-she-goes with a 0.2% monthly increase in May

and a decent YoY pricing trend of 2.4%.

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June 18, 2009 – BREAKFAST WITH DAVE

Items that are in clear deflation mode are personal care products/services, toys,
sporting goods, hotels, air fares, delivery services, apparel, jewelry, home
improvement, appliances, recreation and grocery stores (across every category from
bread, to meat, to poultry — restaurants are seeing much better pricing growth).

WHO HAS GOOD PRICING TRENDS AT A TIME OF -5.0% PPI?

We also ran sector screens on actual pricing power using the PPI and as the
chart below illustrates, the YoY trend is running at -5.0%, the most pronounced
deflation rate in 50 years. As is the case with capacity utilization (CAPU) rates,
the key is to identify the sectors whose pricing is not deflating, let along making
new 50-year lows.

CHART 1: PRODUCER PRICES ARE DEFLATING AT A 5% YOY RATE

United States
PPI: Finished Goods
(year-over-year percent change)

20

15

10

-5

-10
50 55 60 65 70 75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

So what is hanging in well?

! How about soft drinks? Pricing growth is slowing but still positive at 3.0% YoY.
In relative terms, that is a 500bps premium to the rest of the market. The
chart of Coca-Cola is looking just fine (and looking at the intermediate PPI, it
looks like a lot of the run-up in soft drink beverage base costs is behind us).

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June 18, 2009 – BREAKFAST WITH DAVE

CHART 2: PRICING GROWTH FOR SOFT DRINKS REMAIN POSITIVE

United States
PPI: Soft Drinks
(year-over-year percent change)

-2
90 95 00 05

Source: Haver Analytics, Gluskin Sheff

! Beer/spirit prices are holding in great, at 3.8% YoY and the chart of the group
also looks decent.

CHART 3: PRICING FOR BEER/SPIRITS ALSO HOLDING UP WELL

United States
PPI: Alcoholic Beverages
(year-over-year percent change)

-2

-4
90 95 00 05

Source: Haver Analytics, Gluskin Sheff

! Chicken producers are seeing 5.0% pricing growth (Tyson chart looks
wonderful).
! Confectionary products is seeing solid 6.0% pricing (Hershey does not look
inspiring on the charts, though) — again, looking at the intermediate PPI, sugar
and confection costs seem to be peaking out; should provide some support
here for margins because this group does indeed have pricing power (dairy
products, on the other hand, are getting roughed up — PPI down 16.0% YoY).

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June 18, 2009 – BREAKFAST WITH DAVE

! Not sure who populates the pet food space but it is seeing ripping pricing
power (11.0% YoY) and I have been reading in many reports that this is
actually a staple in a recession — people will cut back on their own eating
before they put their pets on a diet.
! Drug producers are seeing 6.0% pricing trends and producers of sanitary
products/health products are also seeing 6.0% pricing trends, which is solid.
! The PPI for toys/games is running at 6.6% and deserve a look — not
everything is looked at as a cyclical this cycle either. Anything related to capex
— construction machinery, rail stock, computers, tools/dies, power
transformers are losing pricing momentum.
CHART 4: AMPLE PRICING POWER IN
TOYS, GAMES AND CHILDREN’S VEHICLES
United States
PPI: Toys, Games, and Children's Vehicles
(year-over-year percent change)

10.0

7.5

5.0

2.5

0.0

-2.5
90 95 00 05

Source: Haver Analytics, Gluskin Sheff

NO CREDIT, NO INFLATION
As long as bank credit continues to contract and household balance sheets
shrink, the Fed’s moves to boost the money supply will be little more than
throwing spaghetti against the wall. Not much of it is going to stick — not with
the Treasury telling us that in April, the 21 largest recipients of TARP funds
actually saw their loan book slide 7%, with weakness across all lending
categories.

ERA OF THE GREEN SHOOTS IS OVER

It was fun while it lasted but if the latest set of data couldn’t kybosh the ‘green
shoot’ theory, then FedEx sure did when it posted earnings results that fell well
short of target and the CEO announcing that the economic backdrop was
“extremely difficult”. On top of that, UAL stated that its 2Q traffic is expected to
drop as much as 10.5% YoY on a 9.0% decline in available seats.

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June 18, 2009 – BREAKFAST WITH DAVE

Not only have the transports rolled over but so have the banks — the group that
led the rally since early March — with a huge 3.3% loss yesterday (and now the
group is down 20% for the year). Due to mounting concerns over commercial
real estate exposure, S&P cut the ratings and/or outlooks on 22 banks
yesterday (the regional banks of course — the ones that the Fed, Treasury and
White House don’t believe are too big to fail. As an aside, to see how the U.S.
government’s behaviour is dramatically altering private sector incentives, see
Too Big to Fail, or Succeed in today’s op-ed section of the WSJ.) We also see in
today’s FT (page 28) that Moody’s is considering a wave of bank downgrades of
its own premised on its concerns surrounding the quality of subordinated debt
on bank balance sheets.

BONDS MIXED BUT THERE IS STILL POTENTIAL

Treasuries had an up-and-down day but ended up selling off as the street
prepares for another huge slate of supply next week with the 2-year, 5-year and
7-year auctions beginning June 23. But there is still quite a bit of residual Fed
tightening priced in to the Treasury market that can still come out. The market
is priced 40% of the way for a Fed rate hike by year-end, down from 65% a week
ago but still some 40 basis points above what sanity would suggest those odds
should be.

GAS PAINS FOR THE U.S. CONSUMER

Retail gasoline prices have now risen for 40 consecutive days, the longest streak
since the records began in 1996. Over the past month alone, gasoline prices
have jumped 50 cents a gallon to stand at $2.68 (national average — this is
equivalent to a $65 billion annualized cash drain on the household sector —
about a 1.0% pay cut equivalent). The fact that this is happening just as the
incremental effects of the tax stimulus begins to wane tells us that this is going
to be a long hot summer for retailing stocks.

One other factor that could end up suppressing the consumer is the escalating
restraint at the lower levels of government — state income tax receipts plunged
26% YoY in the first four months of 2009, forcing state legislatures to
dramatically revise their budget outlooks for the coming year. See State Income
Tax Revenues Sink on page A4 of today’s WSJ.

MORTGAGE APPLICATIONS … FALLING OUT OF BED

Higher mortgage rates in the last few weeks are now affecting mortgage activity,
which does not bode well for housing at all. The MBA’s applications, purchases
and refinancing indices all fell during the week ending June 12. Mortgage
applications tumbled for the fourth week in a row, down 15.8% to 514.4 — its
lowest level since mid-November 2008. Applications for mortgages are now
down 59% from their nearby peak, which we saw back during the week of April
3rd. After rising three straight weeks, the purchase index sagged 3.5%, setting
us up for a new home sales setback for this month. As for refinancing, the
subindex lunged 23.3% for the week and is down 70% from the recent peak we
saw back in mid April.

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June 18, 2009 – BREAKFAST WITH DAVE

As for rates, the 30-year fixed mortgage rate did fall 7bps last week to 5.50% but
it is still 89bps higher than the rate posted back in late March. The one-year
ARM rate did fall 21bps to 6.54%, but even with this decline the one-year rate is
still 65bps higher than where it was in mid-January too.

CHART 5: REFINANCING BOOM IS LONG GONE

United States

MBA: Volume Index: Mortgage Loan Applications for Refinancing

(March 16, 1990 = 100)

8000

6000

4000

2000

0
07 08 09

Source: Haver Analytics, Gluskin Sheff

CHART 6: NO TRACTION ON NEW PURCHASES INDEX EITHER

United States
MBA: Volume Index: Mortgage Loan Applications for Purchase
(March 16, 1990 = 100)

600

500

400

300

200
00 01 02 03 04 05 06 07 08 09

Source: Haver Analytics, Gluskin Sheff

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June 18, 2009 – BREAKFAST WITH DAVE

CAPU SECTOR SCREENS

Aerospace/Defence; Telecom Equipment; Food/Beverage Producers;
Oil/Gas Extraction Screen Best
As Chart 7 shows, industry capacity utilization rates in the United States fell to a
record low of 68.3% in May from 69% in April — the seventh decline in a row.

Chart 7: CAPU RATE AT A RECORD LOW — 68.3%

United States
Total Industry Capacity Utilization Rate
(percent)

92

88

84

80

76

72

68
70 75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

This is a key barometer of corporate pricing power and the key is isolating those
sectors whose CAPU rates did NOT hit a new low this cycle. These are the ones
to focus on in terms of the ability to pass on cost increases and protect margins.
These sectors include food/beverage producers (who will need the ability to
pass on higher feed costs), aerospace/defense, oil/gas extraction, and
communications equipment (see charts below).

Except for energy, these sectors did not outperform during the whippy bear
market rally even though they arguably possess the most solid demand-supply
characteristics at this time (on a relative basis).

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June 18, 2009 – BREAKFAST WITH DAVE

CHART 8: CAPU RATE FOR COMMUNICATIONS EQUIPMENT HOLDING UP

United States
Capacity Utilization: Communications Equipment
(percent)

100

90

80

70

60

50

40
75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

CHART 9: THE CAPU RATE FOR AEROSPACE REMAIN HIGH

United States
Capacity Utilization: Aerospace & Misc Transportation
(percent)

100

80

60

40

20
50 55 60 65 70 75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

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June 18, 2009 – BREAKFAST WITH DAVE

CHART 10: CAPU RATES FOR FOOD/BEVERAGE

PRODUCERS NEED TO REMAIN HIGH
United States
Capacity Utilization: Food, Beverage, & Tobacco Products
(percent)

87.5

85.0

82.5

80.0

77.5

75.0
70 75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

CHART 11: CAPU RATES FOR ENERGY PRODUCTS SOLID

United States
Capacity Utilization: Petroleum and Coal Products
(percent)

105.0

97.5

90.0

82.5

75.0

67.5
50 55 60 65 70 75 80 85 90 95 00 05

Source: Haver Analytics, Gluskin Sheff

Page 10 of 12
June 18, 2009 – BREAKFAST WITH DAVE
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