"Canadian Corporate Bonds for Their Strong Balance Sheets" (Rosenberg)

The following is a transcript of the Consuelo Mack WealthTrack interview with David Rosenberg, Chief Market Economist, Gluskin Sheff - August 13, 2010

CONSUELO MACK: This week on WealthTrack’s Financial Thought Leader series, an economist who spotted the storm clouds of the credit and housing bubbles early on. What does David Rosenberg see in our future now? Gluskin Sheff’s prescient forecaster is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. It is not easy being a Cassandra, warning of dangers ahead before they actually appear, until you are proven correct that is, as this week’s Financial Thought Leader guest has been again and again. He is David Rosenberg, former Chief North American Economist at Merrill Lynch, which became Bank of America- Merrill Lynch during the financial meltdown. Dave is considered required reading by institutional investors, who voted him on the “All American All Star Team” for the last four years and ranked him the street’s number two economist in 2008. Last year he decided to return to his native Canada, where he is chief economist and strategist at wealth management firm Gluskin Sheff. Dave wrote his first report warning of the developing housing bubble in 2004 and continued to sound the alarm about excess credit, overvalued home prices and markets, and economic peril until the world caught up with him in 2008. He even predicted the massive government intervention that we’ve seen since.
Before we find out his current thinking, I want to share one of his recent charts which tells a market tale few others anticipate. Are you surprised by the stock market’s volatility? Don’t be. In a recent “Breakfast With Dave” commentary, he noted “we are into an unprecedented period of market volatility as the secular forces of deflation bump against recurring rounds of policy reflation.” Showing his readers this year’s chart of multiple “whippy rallies and selloffs,” he notes that the pattern of the last twelve years of “no return but massive swings along the way” are continuing this year. You heard that right- massive swings but no return!
Fasten your seatbelts and also think about Rosenberg’s bullish and contrarian call on bonds, which have and still are leaving stocks in the dust. What about his contrarian outlook for the economy? I asked him.

DAVE ROSENBERG: Well, I think that what we’re starting to see is a very discernable slowing and economic growth take place. It’s tough to discern whether we’re going to get into the classic double-dip recession. I’m not quite there yet, but I do think we’re starting to see visible signs that the economy is moderating and quite rapidly, and really what’s happened, Consuelo, is that we’re seeing the effects of the inventory contribution to the economy start to fade. We’re seeing the effects of all the government stimulus start to fade, and I’ve been saying for a while it’ll be interesting to see once the fiscal benefits start to subside and the impact of what the Fed has done, not just in interest rates but on its balance sheet you start to subside, how does the U.S. economy really look like organically, without the crutch of all the stimulus and getting past this inventory cycle, and I think we’re heading into an environment where GDP growth will be basically 1 to 1.5%, not much better than that. So it might not be a classic double-dip recession, but for a lot of people it’s going to feel like one.

CONSUELO MACK: So let me ask you about that. So 1 to 2%, is that real growth? That’s ex inflation, is that right?

DAVE ROSENBERG: That’s real growth. That’s actually a great question, because we’re heading very quickly now towards a period of price stability where there is no inflation, where real GDP growth and nominal GDP growth are actually one and the same. So we’re talking right now about 1 to 2% real. Maybe we’re talking 2 to 3%in terms of nominal, but it’s the direction that matters for financial markets, and the direction of growth right now is down. It’s not negative, but it is heading in the wrong direction.

CONSUELO MACK: So 1 to 2% growth. What’s that going to feel like?

DAVE ROSENBERG: Well, what it’s going to feel like is a higher unemployment rate, and for a politician, I think that for anybody on Main Street, that’s what really matters. What’s the unemployment rate doing? And you don’t need to have negative GDP growth to have the unemployment rate go up. If the potential growth rate for the economy is, say, 3%, and all you’re really doing is growing at, say, 1.5%, you’re building up excess capacity in the economy. That shows up in the unemployment rate. So you get 1 to 2% growth in the economy- real terms, the unemployment rate by the end of the year is going to be at a new high.

CONSUELO MACK: And let me ask you about the unemployment rate, because right now it’s in the high single digits, but you basically said that the unemployment rate that we all follow is really not the true unemployment rate, that it’s actually probably almost twice that. So how do you look at and measure the true unemployment rate? What is it?

DAVE ROSENBERG: Well, one of the things that business can do, they don’t have to fire you. They can cut your hours in half. So let’s say you get your hours cut in half. You’re still technically counted as employed, but you’re only working half the time. So there is something called the U6 unemployment rate. There’s actually six different measures. The U6 is the broadest form that will take into account, for example, the shift towards part-time and away from full-time, employers cutting hours. This all-encompassing unemployment rate is actually right now almost 17%.

CONSUELO MACK: Dave, inflation. You’re predicting zero inflation or lower. Why?

DAVE ROSENBERG: Well, we’re past the peak rate of growth for the inventory cycle, past the peak of all the stimulus, past the peak rate of growth for the economy. And what are we left with? We’ve got headline inflation, no matter how you measure it, at two percent. The core rate of inflation is below one percent.

CONSUELO MACK: Ex food and energy. Right?

DAVE ROSENBERG: Ex food and energy, and I don’t know where all the inflation-phobes come from. I guess maybe they’re looking what the Fed is doing. The Fed is boosting the money supply. One part of the money supply is going up, the part that the Fed controls, but they’re not doing it in a vacuum. Right? They’re basically boosting the money supply, and it’s almost like fixing a leaky boat, because as they boost the money supply what they’re doing is trying to offset this ongoing credit contraction of the private sector. It’s hard for me to believe that we’re going to get inflation, and we’ve got double-digit unemployment. We’ve got widespread excess capacity in the economy, and we’re in the middle of this post bubble credit collapse with widespread excess capacity. It doesn’t make sense to me that we’re going to get inflation. I think we’re going to get price stability. I actually think that’s a good thing, because it means that there’s going to be room for interest rates to go even lower at the longer end of the yield curve.

CONSUELO MACK: Oh, at the longer end, because I was going to say, what does this mean for Fed policy, first of all, if we’re talking about basically zero inflation?

DAVE ROSENBERG: Well, if we get to zero inflation, the Fed is going to keep interest rates at zero. We get into a deflation, we’ve already seen how aggressive Ben Bernanke can be, and he’ll be more aggressive in terms of expanding the Fed’s balance sheet if we get to a period where prices actually start to go down, but I think we have to understand, people still go back to that period of the 1970s and early ’80s. They think that was the normal experience, inflation. When you look at history, that was actually the anomaly. Okay? And we had a situation where from 1980 to 2007, we had the inflation rate go from 15% down to three. Yet at the same time, when you take a look at the ratio of total debt in society as a share of GDP, it went from 120% to 230%; it almost doubled and yet inflation came down, and that’s because we had all these great supply side developments take place. Right? We had lower marginal tax rates. We had freer trade, deregulation, productivity, technology, and here we are, and the debt to GDP ratio is starting to go down. We’re on the other side of the credit chart.

CONSUELO MACK: Oh, interesting.

DAVE ROSENBERG: And so what’s happening is that this is no longer both supply side-led disinflation. We’re talking about a deficiency of aggregate demand caused by this ongoing credit contraction. So we’ve already got these levels of underlying inflation just barely above zero as it is. So you can’t rule out at this stage, never mind a double dip, you can’t rule out the prospect that we actually go into a deflationary experience. This is what’s on Bernanke’s mind right now, by the way, but I think that in all likelihood we’re going to go into a prolonged period of price stability.

CONSUELO MACK: That’s great. A prolonged period of price stability would be a good thing. Two things. Number one- the people who are the inflation-phobes are looking at the burgeoning Federal debt, which has to be financed. So they’re saying that’s got to be inflationary. Right?

DAVE ROSENBERG: Well, that’s only one part of the pie, because the Federal government debt is going up. It’s no different than looking at the Fed balance sheet. You look at the Fed balance sheet. If you look at the monetary base, you say, “Wow, we’re going to get big inflation,” but you have to take a look at what the Federal government’s been doing and what Ben Bernanke is doing in the context of this epic contraction of private sector credit.

CONSUELO MACK: So that’s it. One is canceling out the other.

DAVE ROSENBERG: One is canceling out the other, exactly. And my concern, or not concern, my forecast actually is that when you take a look historically at debt deleveraging, whether you walk away from your debt and go delinquent, or there’s some people that actually are paying down their debt, these are actually very deflationary trends. My sense is that, and if you look at history, these deleveraging cycles last six to seven years. What have we been through? Maybe the second year. These tend to last six to seven years historically. That’s just an average. Look how long it’s lasted in Japan. Yet look what’s happening in terms of fiscal policy. A year ago, everybody’s begging for fiscal stimulus. All of a sudden we hit a 10% deficit GDP ratio, $1.5 trillion dollars of deficits. Our debt to GDP ratio at the government levels about to hit 100%, and right now the general population is saying no. It’s enough. No more fiscal stimulus.
So my stance is that you’re going to have the deleveraging in the private sector ongoing at a time when you’re going to find that the public sector- look what’s happened to state and local government level. They’re going to be deleveraging as well. So that, to me, I know this is not a consensus forecast. I think that maybe people want to believe that we’re going to have inflation because that’ll be commensurate with booming economy and booming demand, so people want to think that inflation is going to come, but I actually think quite the opposite. I think there’s a greater chance we will actually slip into an outright deflationary experience.

CONSUELO MACK: So what you’re describing, though, to me sounds scary potentially, too, because the other argument that people have about the fear of a double dip is that the Federal government, the Fed specifically, has used its arsenal. And so if we do slip into a deflationary period, and in a time when the population is saying, you know, we don’t want to take on any more debt, isn’t that potentially a dangerous mix?

DAVE ROSENBERG: Well, the reason why I said it’s scary is because it’s something that we haven’t really dealt with in the post World War II experience where we’ve only dealt with inflation. When you take a look historically, and there was an economy and there was a capital market globally going back before World War II- that’s where most of the current data go back to, the monthly data that we pay attention to- but there was an economy and a capital market before 1945, and you take a look at centuries worth of data, and actually you had as many periods of deflation as you had of inflation. It’s scary because it’s something--

CONSUELO MACK: New.

DAVE ROSENBERG: New. What it means is that it is going to be very difficult for companies to raise prices. It means they’re going to have to focus on productivity to make sure that they’re going to be generating profits. So it’s going to be a whole new world in that sense, and it also means that people think that these low interest rates are an abnormality. No. They’re going to be here to stay. So like anything else, in an inflationary world, there’s winners and there’s losers. In a deflationary world, there will be winners and there will be losers, and the reason why it’s scary is because it’s something new, but believe me, it’s something that we will be able to cope with.

CONSUELO MACK: So let’s talk about what some of the winners might be, and I know one of the things that you’ve said is that the most important driver of bond yields is the direction of inflation, and again, one of your most prescient calls has been the fact that you have predicted the Treasury yields, for instance, yields on Treasury bonds, would continue to go lower and, in fact, they have much to everyone else’s surprise. So what’s the outlook for bond yields and for Treasuries?

DAVE ROSENBERG: Well, it’s always been a very interesting debate, but I think the proof of the pudding is in the eating. We’ve come off a $1.5 trillion fiscal deficit, and I think most people would have said, you know, interest rates are just going to shoot up, but they didn’t. The ten-year yields are right back down to 3% or lower. I’m not going to sit here and say, “Oh, no, the supply of bonds and the fiscal policy has no influence on long-term interest rates.” They do. I’ve run the models. They have about a 40% correlation historically. It’s not zero; it’s 40%. But 80% of the direction of bond yields is determined by inflation. It’s got double the impact, and I think that’s the big story here. The big story is this ongoing downdraft in the inflation rate, and my sense is that it’s going to continue for a whole host of reasons.
And for investors what’s important is that in an inflationary environment, go out and buy all the growth stocks you can possibly get. In a deflationary environment, bonds are king. You want to squeeze as much income out of the portfolio as you possibly can, and that’s what we’ve been doing with our clients’ money at Gluskin Sheff, is moving them increasingly into our bond strategies, and it’s working very well.

CONSUELO MACK: Because one of your investment themes is to look for safety in income at a reasonable price, so where can you find safety in income at a reasonable price in today’s markets?

DAVE ROSENBERG: In other words, it’s called SIRP, and we call it from ZIRP to SIRP: zero interest rate policy to safety in income at a reasonable price. There’s different ways that you can do it. People always think that, because I’m very cautious or I’m bearish, that I’m just saying go and just buy Treasuries or just buy Canadian government bonds. No. I’m saying actually in some cases, corporate balance sheets are in better shape than some government balance sheets are.
In fact, and this is something positive that I’m going to offer the viewership, is that this is not 2000, 2001 when there was a corporate balance sheet recession. This, of course, is a household balance sheet recession as it pertained especially to the mortgages. It’s maybe, in some sense, in the state and local governments. It’s a government balance sheet recession, but actually corporate balance sheets are in great shape when you take a look at liquid asset ratios, interest coverage, debt equity. The corporate balance sheets in most cases are in the best shape they’ve been in 50 years. So I take a look at the equity market. The equity market, to me, is a play off the income statement. In a period of disinflation or deflation, I’m not so sure earnings are going to be strong, but corporate bonds are really priced off the corporate balance sheet, so I would say high-quality corporate bonds, a very good place to be.

CONSUELO MACK: Long term? I mean, what maturities?

DAVE ROSENBERG: Yes. I would be say that the higher the quality, the longer the duration. The lower the quality, the shorter the duration.

CONSUELO MACK: This is, as you know, so contrary to just about every other piece of advice that you hear out there- whereas everyone’s saying, you know, shorten your maturities. Interest rates are going up, and don’t be at the long end. That’s where you’re most vulnerable. You’re saying, in fact, that could be the sweet spot, right, of high-quality credit, is the longer maturities.

DAVE ROSENBERG: I’m saying that I’ve spent most of my professional life being a contrarian, and I’m still standing, and my credibility is intact, or so I’m pretty sure it is.

CONSUELO MACK: Yes, it is.

DAVE ROSENBERG: And so nothing wrong. Actually, being a contrarian often is quite profitable, but I do believe that the trend on long-term interest rates are going to be down, not up. Now, if you have an inflation view, and you have a view that the Fed’s going to have to raise interest rates and taking what they call the carry-away, well, then bonds will get carried away, too. If you take a look, when you go into a bear market in bonds, I’m not talking about a periodic spasm. A real, true bear market in fixed income happens when you have inflation and when the Fed is tightening interest rates. I don’t think we’re going to have either, and so I think that corporate bonds are going to be a very good place to be, and I think that’s really what you want to focus on in a deflationary environment. Am I bearish on the entire stock market? Well, of course not. There’s about 20% of the stock market again that we have put our clients into. What are--

CONSUELO MACK: Such as.

DAVE ROSENBERG: Well, like dividend growth, dividend yield, stable income streams, defensive sectors, not overly cyclical sectors.

CONSUELO MACK: And defensive sectors being--

DAVE ROSENBERG: Oh, like staples, for example. Okay, we’re talking staples, talking health care, talking utilities, talking about the parts of the economy that will not be hurt as badly, if at all, by these deflationary pressures. They will tend to hurt more the companies that are dependent on pricing power. That tends to be in the more cyclical segments of the stock market. So there is a segment of equities, and so once again, you can squeeze income, and it’s interesting that this past year one of the themes nobody really talks about are that the dividend payouts have gone up dramatically. The dividend yield has improved. So there are segments, you know. Despite the fact that I’m, say, bearish on equities as an asset class, I would never tell a client, “be zero equities.” I’m not zero equities, but I would say have 20% in the equity market, but make sure that what you’re in are stable industries that also spin off an income stream, because it’s very important in an inflationary environment that you want to secure that income.

CONSUELO MACK: What are some of the other investment themes that you are advocating for your clients? I know one of them is gold and precious metals. Right? It’s so interesting. In a deflationary or at least a flat inflationary environment or disinflationary environment, you’re actually recommending gold. Why?

DAVE ROSENBERG: Right. Well, because gold is a hedge against a lot of things. People just think about inflation because it’s a store value, but look what happened in the 1930s. In the 1930s, we can’t really look at the U.S. dollar price of gold, because FDR fixed it twice. So deflationary experience in the 1930s, the sterling price of gold doubled, and we’ve seen over the course of the past 10 years gold rally in deflationary episodes. We had a couple of inflationary episodes, for example, during that period when the credit bubble was really forming in 2005, 2006, 2007. We had a temporary blip in inflation. We know gold can do well in inflation. Why does gold do well in deflation? Especially in a deflation, when you have these massive debt loads globally, right-- and not just here but also what’s happening abroad. Look at Japan at 200% debt to GDP ration. The level of outstanding debt globally to GDP has never been as high as it is today, but what happens in a deflationary environment is that the real level of debt actually goes up. It makes it that much harder to get these government and household balance sheets into better shape. So it leads inherently to more instability, and so gold.
What is gold a hedge against? Gold is a hedge against these lingering concerns, that aren’t going to go away, over the integrity of the global financial system because of these monumental debt levels that we have in many governments around the world and in many households around the world as well. So that’s why deflation, because it tends to be destabilizing, but the time that you don’t want to own gold is when you have the three Ps: Peace, prosperity and just outright price stability. And that’s what we had, for example, in the 1980s and 1990s.
There’s other reasons why gold is very attractive right now, and this comes down to what economists can do, if they do it correctly, which is draw supply and demand curves. The supply and demand. The demand for gold is going up, and I’m not talking about demand for jewelry. I’m talking about demand by Asian central banks that are diversifying out of dollars, out of euros and moving into gold. And I think gold, just based, you know, you can have your own deflation view, your own inflation view, just based on how the supply and demand curves are shifting over time. I think gold is going to go to new highs over the next several years and will be a very good place to be.

CONSUELO MACK: So gold, that’s the metal. What about gold mining stocks? Is that another way to play it or--

DAVE ROSENBERG: Absolutely. Well, at Gluskin Sheff, we don’t actually buy the physical commodity.

CONSUELO MACK: Oh, you don’t.

DAVE ROSENBERG: No, we invest in securities. So we’d be buying gold and silver mining companies. You know, it could be junior mining companies, or it could be the large caps, and we have, right now in terms of our equity portfolios, the highest share of gold and silver that it’s ever had before. So we are putting our money where our mouth is, and it’s one of the reasons why. You know, people look at Canada as an oil play, but actually if you take a look at the Canadian stock market, 13% of the Canadian stock market right now is comprised of gold and silver, where it’s less than 1% in the U.S. and one of the reasons why that’s adding more allure for the Canadian dollar.
We talked about dividends. We talked about income. We talked about gold and silver, but we should also be discussing what currency should you be in. You want to be in a good currency.

CONSUELO MACK: So tell us.

DAVE ROSENBERG: Well, I think that there’s a handful of them around the world for countries that really have true triple-A government balance sheets, where there was conservative governments. You know, it’s very interesting that in the U.S. the pendulum has shifted to the left. We’ll see after the November elections, mid term elections, how it shifts back to the center. Canada has got a conservative government, a very pro business, pro capitalist government. This is actually very rare that we’ve ever seen a right of center government in Canada.

CONSUELO MACK: In Canada.

DAVE ROSENBERG: Well, for decades, Canada was viewed as almost like European, and so Canada shifted to the right politically and economically, and the U.S. has tilted more to the left. That does not happen very regularly. But you know what? Global capital will flow to where it is treated the best, and when you take a look at where pro business policies are right now, it’s in Canada.

CONSUELO MACK: So one of the things that you’ve told clients, you’ve been quoted saying, is that this is a rent-a-rally market; that you don’t really want to go long for prolonged periods of time. Is that right? Or explain to me what you mean by this is a rent-a-rally market.

DAVE ROSENBERG: Well, it comes down to the title I’ve been using in my presentation package now for over a year. I’ve never done that. I’ve never gone a full year and never changed the title. It’s called “Focus on the Forest, Not the Trees.” So I start first principles. What is the primary trend line? What does that look like? Because if you can get the primary trend correctly, it’s going to look after a lot of other things. So for example, we have to understand that the stock market moves in long cycles. Okay? So we’re getting into the real technical analysis right now, but the stock market has had this historical pattern of moving in long cycles.

CONSUELO MACK: Eighteen years.

DAVE ROSENBERG: Yeah, roughly 18 years, and so, boy, do I wish this was back to 1982 to 2000, 18-year secular bull market. Boy, do I ever. I can’t wait to turn bullish again, but who would have known in 1987, as the stock market went down 23% in one day in October 1987? That was really-- if you look at it today, it’s like a thumbnail on the long-term chart. It was a great buying opportunity. Who knew back then that there was another 13 years to go before we’d hit the peak, and that’s the story. The story is that in the secular primary uptrend in the stock market, sell-offs are opportunities to get in the better price. Now, we’re in a secular bear market where it’s different, and it means you aren’t going to get rallies, but these are rallies that you rent. You don’t own them.

CONSUELO MACK: So the point is, don’t buy on the dip, but should we sell on the rally?

DAVE ROSENBERG: Yes. Even in this treacherous, tumultuous environment, and even though there’s fewer needles in the haystack than there have been in the past, there are still different ways that you could grow your capital prudently, even in today’s environment.

CONSUELO MACK: So Dave Rosenberg from Gluskin Sheff in Canada, thank you so much for joining us here back in the States for Wealth Track.

DAVE ROSENBERG: Thank you for inviting me back.

CONSUELO MACK: We also asked Dave Rosenberg for his One Investment recommendation for a long term diversified portfolio. His answer: Canadian corporate bonds for their strong balance sheets, high quality, income, and that Canadian currency which he believes is going to continue to appreciate against the U.S. dollar for the foreseeable future.
And with that idea, we will conclude this edition of WealthTrack. If you are interested in seeing more of our interview with other Financial Thought Leaders and Great Investor guests, go to our website, wealthtrack.com, and click on our WealthTrack Extra feature. We have added some new ones to our selection. Thank you for visiting with us and make the week ahead a profitable and a productive one.