November 11, 2011

On this week’s Consuelo Mack WealthTrack: one of the few economists to foresee the global economic slowdown. Gluskin Sheff’s David Rosenberg saw signs of trouble as chief economist at Merrill Lynch. Now back in his native Canada at Gluskin Sheff he continues to warn about a prolonged slump with high unemployment in the developed world. He tells Consuelo what it means for investors and where to find growth despite a stagnant U.S. and Europe.

CONSUELO MACK: This week on WealthTrack a Financial Thought Leader who spotted the storm clouds of the credit and housing bubbles early on. Gluskin Sheff’s chief economist and strategist David Rosenberg on the storms he still sees ahead and where investors can seek shelter, next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Are we in a depression? That is the question being raised by this week’s Financial Thought Leader guest. In a recent special report titled “Not Your Father’s Cycle, But Maybe Your Grandfather’s (great grandfather?)”, economist David Rosenberg notes that “an economic depression occurs only once it becomes painfully obvious that the markets and the economy are failing to respond to repeated bouts of policy stimulus.” How are we doing after three years of repeated and in some cases record amounts of fiscal and monetary stimulus? Not great. As Rosenberg points out “no major economic indicator from employment to GDP to industrial production to real incomes has managed to get back to their prior cycle highs in late 2007.”

Those are the unfortunate facts as are some other indicators Rosenberg is tracking, including home sales, which are much lower than they were in late 2009; the S&P 500, which is at the same level it was more than a decade ago; and ten year’s worth of zero employment growth. The vast majority of economists disagree with Rosenberg’s dire assessment, but increasing numbers of them, including those at the Federal Reserve, are lowering their forecasts and predicting several more years of slow economic growth, low interest rates and uncomfortably high unemployment. In other words, the world is just starting to catch up to Rosenberg’s long time predictions.

David Rosenberg is the Chief Economist and Strategist of Toronto-based investment firm Gluskin Sheff. For years, Rosenberg was the influential Chief North American Economist at Merrill Lynch, where Institutional Investor magazine placed him on their coveted “All American All Star Team” from 2005-2008. His daily, “Breakfast with Dave” report is a must read among his many fans. Rosenberg is known for being years ahead of the pack in spotting the housing and credit bubbles and predicting the serious and prolonged damage they would inflict on the U.S. and world economy and markets. But a depression? I asked him why he is using the “D” word.

DAVID ROSENBERG: Well, I’m using the D word because the R word, which is the recession, generally applies to a contraction in the economy in the context of an expansion in credit, which is what we’ve been accustomed to for the better part of the past 50 years. What we’re seeing right now is something different and we actually are not in a period of GDP contraction right now, but we’re still in the throes of what I would say is a modern day depression much like Japan and that what we’re seeing is a secular contraction of credit, especially as it pertains to the household sector.

So when you take a look at other variables- for example, how often in our lives have we gone through a ten year period with no employment growth? Employment in the United States is the same as it was ten years ago. What about the stock market? I mean, there have been peaks and valleys, but it’s no higher today then it was 12 years ago, referring to the S&P 500. I think in the final analysis, we have to sit back and contemplate- what does it mean when the yield on a three month treasury bill is one basis point? Alright? One basis point. And when you have short term interest rates close to zero the money market is telling you something about what the economic outlook is and it’s extremely fragile. And it doesn’t mean that we’re going to continuously backslide into recession, it just means that we’re in this elongated, multi year period of very weak economic growth coming off the credit bubble that burst four years ago.

CONSUELO MACK: So how elongated is it going to be do you think?

DAVID ROSENBERG: Well, most academic pieces of work have shown that when you go through these deleveraging cycles, they can last seven to ten years.

CONSUELO MACK: So we’re four years in.


CONSUELO MACK: And some of people in your profession, other economists, for instance, the Fed Chairman, Ben Bernanke, you know, recently have said that they’ve seen some signs of life in the economy. What’s your analysis of these green shoots that we’re seeing?

DAVID ROSENBERG: Well, I don’t think that the green shoots are universal. Normally, for this stage of the cycle going into the third year of an economic expansion, the numbers are five percent, not 2.5, but 2.5 is certainly better than what we’ve seen over the past couple of quarters. But if I’m not mistaken, this time last year most economists were looking at roughly four percent GDP growth this year and here we’re talking the third quarter was 2.5.

CONSUELO MACK: And they’re happy about it.

DAVID ROSENBERG: And they’re happy about it. Well, people have adjusted their expectations, but 2.5 is actually soft growth in the context of where we are in the cycle. Secondarily, when you average out the year so far- because you can always look at one data point, in one particular quarter, on particular month- but when you average out the year, we’re rarely above one percent on GDP growth. The unemployment rate is still stuck over nine percent. And what was important, I think, wasn’t so much about Ben Bernanke talking about what’s already happened, that the third quarter was moderately better than expected which was true, it was when he said that the outlook has considerable downside risks. The Bank of Canada recently had said something very similar, but what do you know, the ECB cut interest rates unexpectedly. And what does it say? That the downside risks to the outlook are considerable.

CONSUELO MACK: But let me ask you about corporate profits, because the third quarter profits, it looks like they’re going to be up about 17.8%. And again, the people who are trying to be constructive about the economy and the outlook are saying, you know- you’ve heard this argument many times before, and what’s wrong with it- and the argument that corporate balance sheets have never been stronger. That, in fact, corporate profits are still coming in double digits so, therefore, corporate America is healthy and it’s just the consumers deleveraging and that’s a good sign, and the government is going to be forced to get its act together so that’s a good sign too. What’s wrong with the strong corporate profit scenario? I mean, what’s that theory that, in fact, the stock market should be doing better than it is?

DAVID ROSENBERG: Well, I agree, by the way, that corporate balance sheets are in great shape.


DAVID ROSENBERG: But the stock market inevitably is going to be priced off of earnings. Corporate bonds will be hedged to the balance sheets. In so far as the third quarter earnings, you’re right, double digit growth. We’re talking about year on year growth in the third quarter, so by definition looking at year on year growth- looking at where we were vis a vis 12 months ago- we’re just talking about what’s happening in the here and now. So we can drive and just gaze through the rearview mirror, but for our clients what we try and do is look through the windshield.


DAVID ROSENBERG: And so what made this quarter different is the guidance. The guidance was much more mixed so we see the negative than any other time during the past two years during this recovery phase. I would also say, you know, the earnings came in fine, but a lot of the earnings, a lot of the juice came from one time accounting shifts in the banking industry- draw down and reserves, stuff like that- that I would call non-recurring. Actually, if you take a look, there were some bright spots, especially in the capital goods industry, and capital spending is one part of the economy that’s actually doing quite well; but it was rather mixed across sectors, but the guidance, I think, is what made this particularly different.

CONSUELO MACK: From the CFOs and the CEOs, they’re not optimistic about the future.

DAVID ROSENBERG: They don’t have the visibility they had 12 or 24 months ago. That’s the difference.

CONSUELO MACK: So what’s your outlook for the U.S. economy? And I’m looking at the foundation of the health of the U.S. economy is employment. What’s your assessment?

DAVID ROSENBERG: Well, I think that we’re probably going to find employment slowing down. It could even start contracting in the opening months of next year. It wouldn’t surprise me when you take a look at all the layoff announcements that are taking place. And keep in mind that although employment has been growing- when you’re talking about, say, numbers close to 100,000 that’s basically what- .1 percent increase. I mean, it’s better than slipping backwards. The jobless claim numbers right now aren’t pointing towards a contraction, but when you take a look at the layoff announcements, they lead the jobless claims, they lead employment and my sense is that it’s going to be another very tough year as far as job creation is concerned.

We have faced, I’m talking about we, not just in the United States, but globally we have just faced a very significant financial shock coming out of Europe at a time when we had a relatively flat economy. And the financial economy and the real economy, you know, there’s a symbiotic relationship, but the financial economy or what you might call Wall Street, leads the real economy, what you might call Main Street, by anywhere from three to nine months. You know, it was no different when the tech wreck started, say, in the opening months of 2000. It didn’t start to hit the real economy until we were in the opening months of 2001. And the last cycle, all bad stuff happening with the mortgage market was starting really in the opening months of 2007. I remember New Century Financial closing its door, one of the largest subprime lenders. It didn’t start to hit the real economy until December of 2007. So we’re in a situation today where it’s so fast money. If something happens on a Monday and you don’t see it impact anything on a Wednesday, well, it’s not going to happen. But you see, there are long and insidious lags between what happens in the financial economy, the impact on the real economy. But you see, we went into this situation with the economy roughly flat and we got hit with a very major financial shock and tremendous volatility. That’s going to come back, I think, with a lag, and I expect we’re going to see more evidence of this in the opening months of 2012. We’re going to see the economy potentially start to contract at that point.

CONSUELO MACK: So is MF Global, for instance, the bankruptcy of MF Global, is that kind of canary in the coal mine? I mean, is that a harbinger for more troubles to come both in the financial sector and also in the Main Street issues, as you said, in the main economy?

DAVID ROSENBERG: I would put it exactly as you just did. I would just take out the question mark because I think that’s actually more of a statement than a question. So I do think it’s a canary in a coal mine. And I’m wondering whether, say, six or twelve months from now, we’ll be looking back at what happened with MF Global. Was that the Bear Stearns of 2011? I remember people thought after Bear Stearns it was all going to stay contained, and the Fed orchestrated this deal with J.P. Morgan. And who even know back then we were already into a recession? And then who knew that there were going to be more legs along the way? See, one thing about a financial crisis like this is that, you know, there’s never just one cockroach in the messy kitchen. There are usually a few of them. So I would tend to agree with that. That this is actually the one element you can point to as to how the situation in Europe has come back into the United States in a tangible way. Okay? Not just how it affects the stock market with all the volatility, but actually this was the eighth largest bankruptcy in U.S. history.

CONSUELO MACK: Which is kind of being lost in the news coverage.

DAVID ROSENBERG: Fifth largest financial.


DAVID ROSENBERG: Right. Well, but it stays contained and complacent until it doesn’t anymore and that was the situation back in 2008. It wasn’t a straight line down. I remember in the opening months in 2008 when there were bouts of euphoria. People thought it was over after Bear Stearns. I remember we had the Bush tax cuts and the stock market rallied. Nothing is going to move in a straight line. But what’s happening in Europe right now and the global ramifications, I think, are very significant.

CONSUELO MACK: So let’s talk about that because, you know, one of the things is that this deleveraging that is occurring is a global phenomenon and the deleveraging is happening very, very starkly and severely in Europe. So what’s your assessment today of what’s happening in Europe and what the impact is, the long term impact on the economy and markets?

DAVID ROSENBERG: When you think about it, how many monetary unions have ever worked. I mean, we have to go back over a century- there was the East African monetary union. You had the Scandinavian monetary union. You had the East African monetary union. Nobody knows about these monetary unions. You know why? Because they don’t exist anymore. The only monetary union that works is the United States. Well, because we have a central regulatory, central fiscal, central political union.

CONSUELO MACK: And we fought a civil war to get it.

DAVID ROSENBERG: Well, that’s exactly right. Well, before that we had Confederate money.


DAVID ROSENBERG: But as it stands now, the United States- and look, everybody’s got their blemishes, but I think in the final analysis it is going to have to be up to the European Central Bank. It’s going to have to probably radically change its mandate. Look, they just cut interest rates with inflation at, what, roughly three percent- well above their target because now they’re focusing on growth. Well, that’s the Feds mandate. That’s not the ECB’s mandate that modeled itself on the bund. So we have a new head of the ECB. He’s willing, I think, at this point to be a lot more flexible.

CONSUELO MACK: Right. Mario Draghi.

DAVID ROSENBERG: That’s right, than Trichet.

CONSUELO MACK: Than the rigid Trichet.

DAVID ROSENBERG: And maybe the mandates are going to have to change. At some point I think the ECB’s balance sheet in terms of- and we’re talking about quantitative easing, money printing- they’re going to have to play a much larger role in the lender of the last resort. And we’re not talking about just for the traditional banking sector, but for governments. So I think in the final analysis this will end up at Germany’s door when we finally go towards a Euro bond which will have to be hitched to Germany’s credit rating, assuming it’s still AAA by then. But I think that the ECB is going to have to play a much larger role. And that’s why in, again, and this is David Rosenberg being optimistic, maybe this is a good time to have a change in leadership at the European Central Bank.

CONSUELO MACK: If it ends up at Germany’s door what do you think will happen?

DAVID ROSENBERG: Well, that’s a great unknown. That’s a great unknown. I think that this actually gives Germany a great opportunity to really reshape the whole Eurozone and have more control. It may well be that we finish this book and the Eurozone as we currently see it as the northern stronger countries and the southern Club Med countries who maybe in retrospect never should have been allowed into the zone, maybe they go back to their old currencies. But it wouldn’t surprise me that when we come out of this the Eurozone itself is going to be smaller than what we’re seeing right now.

CONSUELO MACK: Markets. Let me ask you, because you had just mentioned the fact that you’re watching the bond markets.

DAVID ROSENBERG: Well, I usually find that the bond market, that’s where the truth lies. The bond market gets it right a lot more often than the stock market does as an example. The bond market is telling you in the United States that we are in a Japanese type situation. Not that any two cycles or any two experiences are ever 100% the same, but the bond market is telling you that we’re going through a very similar post-credit, housing bubble, debt deleveraging cycle and it’s going to be deflationary.

CONSUELO MACK: So that’s my next question for you. Because you said that really, bond yields are really determined by inflation. So while there are a number of people out there, and you mentioned it too, the fact that the Fed has been easing so much and basically expanded its balance sheet so much that it’s going to end up being inflationary at some point possibly. That’s a risk, right? But is deflation really what’s happening in the economy now? And therefore, what does that mean for the bond market?

DAVID ROSENBERG: Here at home in the United States, there’s two curves as an economist that you look at. You look at the Aggregate Demand Curve, you look at the Aggregate Supply Curve. You look at the difference between where the economy is operating today and where would the economy be operating if it was operating flat out at full employment, and that’s what economists call “the output gap.” Everybody at the Fed knows what the output gap. Any economist on Wall Street certainly knows what the output gap is. The difference between what the economy is and where it would be in nirvana, full employment.

CONSUELO MACK: So where is it?

DAVID ROSENBERG: Seven percent of GDP. Like it’s basically when you tack on the excess supply of everything- houses, labor- to a lesser extent capital goods. But certainly what is bigger than the labor market? You know, you talk to a local baker. He’s not going to talk to you about flour necessarily or talk to you about employee theft. He’s going to talk to you about his biggest cost which is still labor costs. When you have a situation where for every job opening in the United States right now there are seven people in the total ranks of the unemployed of the available labor force vying for those jobs-

CONSUELO MACK: So labor costs are down and are going to stay down or go lower possibly?

DAVID ROSENBERG: Yeah. Well, supply and demand works in every market and it works in the labor market, but it works glacially. We’re not used to wage deflation. Right? They never taught you that in the university textbooks, but we are starting to see evidence of that. Because normally there are two to three people out there looking for a job vying for the job openings. Right now that ratio in year three of an expansion is seven to one.


DAVID ROSENBERG: It’s unheard of. And like any other market that’s going to put downward pressure. But when you talk about seven percent of GDP, what does that mean? Okay? What does that mean? It means we have a trillion dollars of excess supply the economy and how doesn’t drive a deflationary process over time? And that is exactly what the bond market is telling you right now.

CONSUELO MACK: So long term bond bull which you have been and correctly so, do you still remain a bond bull? And what do you feel about treasuries?

DAVID ROSENBERG: Well, there is a possibility that treasury yields go lower, but you know, at this point you’re talking maybe they go to 1.5 percent from two percent.


DAVID ROSENBERG: I think if we’re looking at the overall fixed income market, I wouldn’t mind stepping up the risk judiciously and buying corporates. Okay? Because the one thing I will say, and we discussed this earlier, when you’re buying a corporate bond, you are staking a claim on the quality of the balance sheet in the corporate sector and whether I look at debt equity ratios or interest coverage ratios or liquidity ratios or the whole gamut of ratios, the one thing I will say is that the quality of corporate balance sheets in North America are as good as they’ve been in the past 50 years.

CONSUELO MACK: And that’s why you believe that corporate bonds, and North American corporate bonds specifically, right, are the One Investment that we should all own in a long term diversified portfolio at this point?

DAVID ROSENBERG: I don’t think it would be adding a lot of duration, but I think that you can pick up a decent spread going out, say, roughly three years, four years. Yeah, I still like treasuries, but the love affair is over; but I wouldn’t mind owning the high quality corporates that have a decent spread that are mispriced for the economic outlook and that’s what I’d be focused on right now.

CONSUELO MACK: One of the things you’ve told me at other times is that an investment theme of yours is what you call “SIRP.” Which is look for safety in income at a reasonable price.


CONSUELO MACK: You still believe in SIRP?

DAVID ROSENBERG: Absolutely. Corporate bonds would fall that in that category. Munis would fall in that category. So the bond market in general. It doesn’t mean I’m going to necessarily run out and buy Italian bonds right now. Because remember, safety and a reasonable price. I think that in some cases corporate balance sheets are in better sheets than some government balance sheets. But it would also include hybrids. You know, premium income funds that might be equity, but they’re equity provide you with a monthly cash flow. So they could have REITs and they could have preferreds, and they could have bonds. And you’re talking about dividend growth, dividend yield. There are people that would say, well, that’s a crowded trade. That’s what people are talking about. But this is exactly what you want to have in your equity portfolio. You want to be almost like a landlord, and hopefully the capital over time will grow, but you want the monthly cash flows. So even an equity product can be derived that would be under the SIRP umbrella that would be providing income at a reasonable price. And I think that’s what we have got to be focused on right now. You know, remember, this is a stock market that has been doing this. Recently, it’s more doing that. But over the past several years the stock market, you know, in terms of capital appreciation, there hasn’t been any for 12 years. Your total return has been the dividend and I think that’s going to continue for some time.

CONSUELO MACK: Final question. And that is, you’re known as a bear. You just say, “No, I’m a realist.” But you’re short term bearish, but long term you actually could be bullish. So let’s leave this on an optimistic note- why are you long term bullish?

DAVID ROSENBERG: Well, I think that for the same reasons that you would have been in, say, 1980. Back then we weren’t fighting, say, a deleveraging cycle, we were fighting an inflation cycle. That battle was different. It’s not like the French with the Maginot Line. You know, we’re always fighting different battles. But back then, you know, we went through a decade of lost growth and we went through a tremendous volatility and weakness in the capital markets, but it was contingent on political change. And you know, we think of or most people, don’t say everybody, they think of Ronald Reagan a certain way that they didn’t back in 1980. Of course, he was unproven and untested beyond what he did in California. When you go back to that period in 1980, if you were to superimpose that really terrible period from, call it 1966 to 1980 and everything that happened in-between, between Vietnam, Iran, and gas rationing, and everything else- if you superimpose that period into the eighties and nineties, what a big mistake that would have been. But where did the change to the economy and financial markets, what was the root? It was the change at the political level. And that’s why there is reason for hope. It’s going to come from what the configuration looks like post-November 2012.

CONSUELO MACK: We’ll see what happens. In the meantime, we’ll be following your work very closely at Gluskin Sheff. So Dave Rosenberg, such a treat to have you here on WealthTrack. Thanks.

DAVID ROSENBERG: Thanks again. Thank you.

CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point picks up on a long- time theme of Dave Rosenberg’s: it is to “look for safety in income at a reasonable price.” He calls it SIRP. Two recent guests provided us with two different and not necessarily mutually exclusive strategies. For those of you who prefer to own individual stocks, Great Investor guest, Clearbridge Advisors’ Hersh Cohen, shared his “Great Balance Sheets and Dividend Growers List,” of global brand name companies which Hersh believes should be bought on weakness. We will have it for you on our website, wealthtrack.com. For those of you interested in diversifying into emerging market stocks, particularly in rapidly growing Asia, recent guest Robert Horrocks, chief investment officer of Matthews Asia Capital Management, helps oversee the five star rated Matthews Asia Dividend Investor Fund, which focuses on companies that grow their dividends. Two choices for safety in income!

Next week we will have a rare interview with Wall Street’s longtime number one Washington analyst, Financial Thought Leader Tom Gallagher. Understanding policy and politics has never been more critical to investors and no one does it better than Tom. On that note we will conclude this edition of WealthTrack. For those of you interested in seeing our WealthTrack interviews early, subscribers can now see our program 48 hours in advance on our website, along with timely interviews exclusive to WealthTrack web subscribers. This week, in celebration of Veterans Day, we are going to do a podcast with Kiplinger’s Kim Lankford about the things military families can do to build financial security. It was also be available on wealthtrack.com. Thank you for watching and make the week ahead a profitable and a productive one.

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