David A.

Rosenberg June 12, 2009

Chief Economist & Strategist Economics Commentary
[email protected]
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave

WHILE YOU WERE SLEEPING
IN THIS ISSUE
In the markets, we see that equities are mixed to higher, the dollar is bid,
commodities are undergoing some profit-taking, but the big news is the rally in • Japan’s Finance Minister
government bonds (see more directly below). What happened was that Japan’s openly defended the U.S.
Finance Minister openly defended the U.S. debt market by saying that Japan’s debt market … we are
faith in Treasuries is “unshakable” and that current yield levels are “attractive”. seeing a rally in bonds this
morning
We’ve been saying the same thing but the key difference is that Japan actually
owns $687 billion of U.S. govies (not far off China’s $768 billion cache). What • In four of the past five
else was interesting was the 49% indirect bidding share at yesterday’s long bond years, we saw Treasury
yield peak in June … could
auction — a proxy for foreign central bank participation. This should help allay
we see a bond rally take
fears that Russia’s decision to diversify out of Treasuries into IMF bonds is not a hold in the second half of
case of follow-the-leader. We also saw on the data front a pretty stinky weed — the year if this pattern
industrial production in Euroland collapsed a record 21.6% YoY in April reasserts itself
(consensus was for a 19.8% decline). • The rally in the equity
market appears to be
INTERESTING SESSION YESTERDAY getting exhausted
Nice rally in bonds and for a change, a late-day selloff in equities. Besides
• No sails in retail sales
valuation and sentiment, the rally looks to be getting exhausted as volume
wanes and the S&P 500 struggles with a serious breakout of the January 6 intra- • For those who doubt the
deflation theme, may we
day high of 943.85. To recap:
suggest that you read the
latest Beige book
• June 1st: 942.87
• June 2nd: 944.74
• June 3rd: 931.76
• June 4th: 942.46
• June 5th: 940.09
• June 8th: 939.14
• June 9th: 942.43
• June 10th: 939.15
• June 11th: 944.89

Remember, the intra-day high on January 6 was 943.85. Notice the pattern
here? There isn’t one — it is a flat, trendless market, and the question is that
when it breaks, which direction will it be?

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June 12, 2009 – BREAKFAST WITH DAVE

Part of the market’s dilemma is sentiment — it’s far too bullish at this juncture, Part of the market’s
which means that buying power could be diminishing. The latest Investors’ dilemma is sentiment;
Intelligence survey shows bullish sentiment at 47.7% (versus 42.5% last week) it is far too bullish at
and bearish sentiment all the way down to 23.3% (from 25.3%). There are more this juncture
than twice as many bulls as there are bears. The whole credit collapse and
recession must have been a hoax. Even those in the ‘correction camp’ have
thrown in the towel and now total just 29.0% (down from 32.2% a week ago).
Net inflows into U.S. equity funds have been positive now for 12 consecutive
weeks — $2.83 billion alone last week — another sign of exuberance for the
contrarians among us.

Meanwhile, the surge in oil prices, to $72/bbl from the lows, is equivalent to a
two-percentage point drag from real GDP growth and on top of that we have
seen mortgage rates spare 80 basis points in just the past two weeks to 5.8%
and against that backdrop the once-promising refinancing wave has not only
been snuffed out but has reversed course.

A SEASONAL PEAK IN BOND YIELDS?

This may sound uncanny, but in four of the past five years, we saw the yield on
the 10-year Treasury note hit the peak right in June, and while the experts each
time were lamenting about inflation, fiscal policy, growth and beta-assets, not to
mention the oft-called-for end of the secular bull market in bonds, the second
quarter selloff that culminated in a classic blow off in June proved to be a great
buying opportunity. Consider:

• June 14th, 2004: 4.89%. The 10-year note closed the year at 4.24%.
• June 26th, 2006: 5.25%. The 10-year note closed the year at 4.71%.
• June 12th, 2007: 5.26%. The 10-year note closed the year at 4.04%.
• June 13th, 2008: 4.27%: The 10-year note closed the year at 2.25%.

But as the data above illustrate, after the June peak in yields, the 10-year note,
on average, went on to rally 111 basis points (in 2005, it did look as though the
bond market was looking to peak in terms of yield into June, but then we had the
volatility amidst the Katrina hurricane, which begat a quick rally and then a huge
selloff during the fall). So we should be seeing a nice little bond rally take hold
in the second half of the year if this pattern reasserts itself.

We also ran some correlations and found that the 10-year note yield has the
highest relationships with the ‘carry’ (funds rate) at 88%; inflation (68%); fiscal
deficits (46%) and the dollar (but with a positive 60% correlation — in other
words, bonds tend to rally when the dollar is weak, not the other way around!).
So, if the problem for Treasuries is fiscal deficits and the dollar, then we can rest
assured that the far more important drivers are the Fed, which is not raising
rates any time soon, and inflation, which is hardly going anywhere on a
sustained basis, until the dramatic amount of excess capacity gets mopped up
and the debt-strained household balance sheet begins to re-expand. Fiscal
policy comes in a distant third in the bond yield-determination process and the
dollar has the “wrong” sign as far as the inflation-phobes are concerned.

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June 12, 2009 – BREAKFAST WITH DAVE

But we still have to shake our heads at how fiscal forecasts are made. Not only
in the U.S., but in Canada — where a pledged balanced budget a little more than The U.S. consumer is
six months ago turns into a $50 billion+ deficit as auto sector bailouts become again benefiting from
the intervention du jour. The U.S., though, really takes the cake. In January huge fiscal stimulus…
2001, believe it or not, the Congressional Budget Office was forecasting budget
surpluses of over $800 billion annually from 2009 to 2012. That was under Bill
Clinton. Fast forward to Barrack Obama, and we now have projected deficits of
$1.2 trillion on average over those three years. That is cause for pause, even for
old bond bulls like us.

NO SAILS IN RETAIL SALES

The U.S. consumer is yet again, for the first time in two years, benefiting from
huge fiscal stimulus (tax relief and extra social security receipts) and yet the … yet ‘core’ retail
‘core’ retail sales index that feeds directly into GDP was flat as a pancake in May sales, which feeds
and down at a 4.0% annual rate over the last three months. We have no idea directly in GDP, come
how that gets translated into a ‘green shoot’ unless we want to compare that to in flat as a pancake in
the -10.0% trend at the end of 2008 when the post-Lehman collapse economy May
went into free-fall.

Much like the tax rebates last year, the stimulus is having very little effect on
consumer spending. The message from the retail sales report is that while
spending is not collapsing, it is still very soft and there is still a clear trend away
from discretionary towards essentials.

• Furniture sales fell 0.4% MoM in May and are down in each of the last three
months — a 14.0% annualized collapse.
• Electronics/appliance stores are also under downward pressure after a brief
January-February countertrend bounce — down 0.5% MoM in May, also down
three months running, and sliding at a 33.6% annual rate over that time
frame.
• Clothing sales did hook up 0.4% in May but that followed two months of big
declines and left the trend since March running at a -9.0% annual rate.
• General merchandise stores (ie, department stores) posted a 0.2% drop, the
third decline in a row (sound familiar?) and running at a -4.8% annual rate
over the last three months.
• Sporting goods/music/books sales fell 0.8% in May and off at a 3.3% annual
rate over the last three months.
• Nonstore retail sales (online sales) fell for the fourth month in a row — down
0.4% in May and the three-month trend is at a -5.6% annual rate.
• Restaurants did turn in a 0.2% gain in May but sales here are on a -2.5%
trend over the last three months.
The positives: Food/beverage stores saw retail sales rise 0.4% in May and
have advanced at a 2.7% annual rate over the last three months. Pharma
stores jumped 0.7% MoM and up at a ripping 8.0% annual rate over the last
three months.

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June 12, 2009 – BREAKFAST WITH DAVE

FOR THOSE WHO DOUBT THE DEFLATION THEME … Yes, the equity market
…may we suggest that you read the latest Fed Beige Book. Specifically, these is on wheels but for all
passages: the talk of it being a
leading indicator,
“With few exceptions, the District Banks reported that prices at all stages of sometimes it takes
production were generally flat or falling. Manufacturers in Philadelphia, months for reality to
Cleveland, Atlanta, Chicago, Dallas, and San Francisco said that overall input catch up to stocks
prices were stable or declining, although in Kansas City those declines were
said to be moderating. In contrast, Richmond noted that prices of raw materials
had increased at a quicker pace … Reports from a number of Districts indicated
that pricing at retail remains very soft. The Cleveland and Dallas Districts
indicated that retail prices were stable; San Francisco said that they were held
down by discounting, and Philadelphia noted that steady input costs were
holding retail prices in check. In Kansas City, retail prices were declining and
expected to soften further. Richmond's retail prices continued to rise, albeit
more slowly than in the past.”

“Labor market conditions continued to be weak across the country, with wages
generally remaining flat or falling. Kansas City, Dallas, and San Francisco
reported that businesses were cutting or freezing wages, and Boston cited wage
freezes in the retail sector. The Chicago District reported that the downward
pressure on wages was abating somewhat there, as firms turned instead to
cutting hours or jobs outright to contain labor costs. Firms in the Atlanta and
Dallas Districts also reported having to cut hours to reduce costs. In addition,
the Boston and San Francisco Districts also mentioned employers' plans to
scale back employee benefit programs.”

After three years of relentless fiscal largesse, two years of massive interest rate
cuts and a year of monumental balance sheet expansion at the Federal Reserve,
this is the best we can show for it? Wages and prices “flat or falling”? The
monetary base that Arthur Laffer was lamenting in Wednesday’s Wall Street
Journal op-ed has been ballooning since last August, and if anything, the
deflationary rhetoric in the Beige Book (this one went to early June) has become
even louder. The Fed has been boosting the money supply to meet burgeoning
demands for cash at all levels of the economy, and it surprised us to see Mr.
Laffer’s claim that money demand was subsiding because if that were true,
would one and three-month Treasury bill yields still be trading at 7bps and 16
bps respectively? Those are normal levels of T-bill rates that characterize a
normal demand for cash? We fail to see it.

Yes, yes, the equity market is on wheels but to tell you the truth, for all the talk
of it being a leading indicator, sometimes it takes months for reality to catch up
to stocks. After all, it was the same stock market in 2002 that took 10 months
to figure out the recession was over. It was the same stock market that took 10
months in 2007 to realize that yes indeed, New Century Financial did close its
doors and we were in fact in the throes of a major credit collapse.

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June 12, 2009 – BREAKFAST WITH DAVE

The market was so forward-looking that it gave investors less than two months
warning in October 2007 that the worst recession in 70 years was on its way in
less than two months.

LEADING INDICATOR, INDEED

Global Trade Flows Reversing Course: After a couple of ‘green shoots’ after
global trade finance was revived in the opening months of the year, it seems as
though everyone’s exports are taking it on the chin again. The latest data on
China’s outbound shipments showed renewed hints of slowing. Same for Korea.
German exports plunged 4.8% in April and are off 28.7% from a year ago.
Canadian export volumes sank 5.1% in April — and this transcended the
problems in the auto sector — on top of 2.3% slide in March, taking Canada into
a deficit position of $178 million in what is a vivid sign of a hugely overvalued
loonie. U.S. export volumes also dropped 4.3% in April after a 0.5% decline in
March, taking the YoY trend down to a new all-time low of -20.4% from -13.8% in
March.

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June 12, 2009 – BREAKFAST WITH DAVE

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June 12, 2009 – BREAKFAST WITH DAVE

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