Strategy

Economic forecast: Burden of truth

David Rosenberg has returned. Too bad he still thinks the United States is in a depression.

In September 2008, venerable Lehman Bros. was slipping beneath the waves, creating turmoil in credit markets. The prospect of another Wall Street titan going under along with it seemed too horrible to comprehend. So few people publicly questioned the wisdom of government forces who steered the struggling Merrill Lynch — the world’s largest retail brokerage — into the welcoming, solvent arms of Bank of America.

But now Ken Lewis, the CEO of Bank of America, seems to have changed his mind. The Merrill deal, which cost B of A $50 billion, didn’t turn out as well as he’d hoped. And Lewis, under pressure from shareholders (who voted him out of the chairmanship of the company), turned around in late June and blamed the whole thing on Ben Bernanke, whom he claims forced B of A to acquire Merrill through some very un-American governmental pressure. Bernanke denied any such thing. But the whole messy scene blew up at rancorous congressional hearings in which Republicans, seemingly forgetting their brush with electoral death last November, turned on Bernanke with rare intensity.

The ripple effects of the Merrill deal have been felt worldwide — especially in Canada and its financial services industry. For one, a fair number of ML investment bankers decided they didn’t want to be lumped in with the retail bankers (glorified toaster salesmen, according to one documentary on the breakdown) of B of A, and so a steady drip of talent away from that institution has been underway over the past few months.

There have been changes at B of A–Merrill’s Canadian ops, too. Sheryl King, a former ML economist in New York, took over the top forecaster spot after David Wolf (a longtime Canadian Business contributor) left in April to become special adviser to Governor Mark Carney at the Bank of Canada. But the big coup was at Gluskin Sheff + Associates Inc., Toronto-based money manager for the wealthy, which has pulled in the rock star of Wall Street economists: David Rosenberg.

An omnipresent figure in the U.S. business media, the Canadian-born Rosenberg has polished his reputation through this downturn by deftly calling it closer and more accurately than just about anyone else. His contrarian take, unfurled over the course of the past decade in his daily market commentary for ML, was that an increase in consumer credit would lead to a housing bubble and then to actual declines in home prices. Right on that one. And his take on what’s to come — an era of lower consumer spending — is rapidly becoming mainstream assumption. So it’s no surprise that when rumours began floating late last year that Rosenberg was thinking of coming back to Toronto, GS made a play for him. “We weren’t looking for an economist,” says Bill Webb, GS deputy chief investment officer. “But when we heard Rosenberg was thinking of coming back here, I knew that if we didn’t try to get him away from one of the big banks, we would regret it. I think he’s the most respected forecaster out there right now.”

The pairing of Rosenberg and Gluskin Sheff already seems to be propitious. Some 16,000 potential clients have registered for his morning commentary in just two months. Analysts have been favourable, upgrading estimates for GS and naming Rosenberg in recent reports. “He is viewed as one of North America’s leading economists and is a huge win for the Gluskin Sheff franchise,” Scotia Capital’s Phil Hardie wrote in a note to clients.

But if Rosenberg’s predictive powers really are so godlike as to move the opinions of stock analysts, it’s hard to see what there is to get excited about beyond the business of GS. Rosenberg’s outlook is dark. He thinks this recession is more than just a part of the business cycle. He thinks this is more like a depression, and we’re staring down long-term changes in consumer spending that mean the mess is going to be with us for years to come.

Want a positive take on the economy, something to make you feel good? Don’t ask Rosenberg. He’s built a reputation on calling it as he sees it. And he sees it bearishly.

Stepping off the elevator and into the dark-wood interiors of the GS offices, visitors are confronted with what’s probably the financial district’s most perfectly framed floor-to-ceiling view of the Toronto islands. The panorama befits a fancy homegrown firm like GS, which celebrated its 25-year anniversary on July 1.

Such offices, in a country that avoided the worst of the downturn, must offer a pleasant respite from the chaos that engulfed Wall Street this past year. Sitting in the well-appointed dining room of GS, Rosenberg offers some tales from that dark winter. “I remember walking to a presentation in midtown in December, and people were just catatonic,” he says. “It was Christmas in New York. The bright lights were on, but there was a different psychology. It would be something like it must be walking through Detroit, or Silicon Valley after the tech wreck. There was tremendous angst, and tremendous uncertainty.”

By Christmas, Lehman had gone under, Merrill was part of B of A, and the big question was whether the federal government was going to nationalize the banks. It was a low point in the history of American capitalism. But as someone who chose to go to work as a forecaster at a big firm on Wall Street, Rosenberg had to step up, rallying the troops even though the company was shedding employees and shrinking rapidly. “It didn’t feel good,” he recalls. “You woke up every day not knowing if you were still going to be employed. But there were still financial markets, and there are people internally and externally relying on your advice. It’s difficult to see your colleagues lose their jobs, and see your firm contract that sharply. But those are the times you need to be there for your clients.”

Since then, Merrill’s CEO, John Thain, has left the company. After negotiating a 70% premium on the stock price in the sale to B of A, Thain came under a cloud over bonuses he handed out and the lavish office he installed, as the culture of royally paid investment bankers clashed with that of a government-controlled retail bank. But Thain was one among many. Spurred by Washington’s desire to curb compensation in the banking industry, a migration of talent has occurred away from Wall Street. Firms from Florida to Chicago and worldwide have been busy picking up ex–Wall Streeters.

Eventually, rumours began floating around Toronto that Rosenberg was considering a move back home. Through a client relationship between GS and ML, Rosenberg has been visiting the Toronto firm’s offices for almost a decade now. “I think he’ll like it,” says Webb. “He doesn’t have to go through 13 levels of bureaucracy when he wants to publish something, and there will be no worries about offending potential corporate finance clients with his research,” says Webb.

Rosenberg will also be near his family, as Toronto is the place where he began his climb from middle-class Canada to the height of Wall Street. As the son of a kindergarten teacher and Environment Canada civil engineer, he was not exactly someone you’d peg for a big career on Wall Street. “It’s clearly not genetic,” he says, deploying his well-known deadpan humour.

He lets it slip that he actually dropped economics in Grade 11. “I hated it,” he says. It looked like law, an MBA or accounting was the likely outcome when he started in the B.Comm. program at the University of Toronto. But by third year, he realized he had taken all the courses he would need for a degree in economics. “It was staring me right in the face,” he recalls. “I realized I’m going to be an economist.”

The discipline matched his temperament and skill set. He liked the report writing, the research, the statistics, the history and the psychology. But graduating into the recession of the early ’80s made it hard to find a job. Luckily, he had taken a housing economics course and did a small stint at Clayton Research Associates, a well-respected Toronto-based housing consultancy. That job led to one at Canada Mortgage and Housing Corp., and that eventually landed him an interview at Bank of Nova Scotia, where he became a housing-policy analyst.

His first day on the job? Oct. 19, 1987. Black Monday. For Rosenberg, it turned out to be the lesson of a lifetime. “It was the first time I saw the trading floor,” he says. “It was wild. I’m sure if you would have offered me a return trip on the Voyageur Colonial bus down the 401 to my cushy civil servant job in Ottawa, I would have taken it.” His task that day was to follow around chief economist Bill Mackness, and Rosenberg developed an appreciation for what an economist does. “We saw everyone that day, from the most junior trader to the CEO, and it really gave me a feeling of this overwhelming responsibility, to be giving advice at every level of the firm on one of the biggest days in the market.”

After Scotia, Rosenberg went to Nesbitt Burns in September 1994. A few years later, Merrill Lynch opened a macroeconomic strategy shop in Canada, and in the early months of 2000 hired Rosenberg. There he built his reputation for well-informed reports that coupled a sense of history with a strong dose of common sense. He put in long hours, wrote a lot, and built a name as a guy who would return the phone calls of even the lowliest scribes (as this reporter remembers it). Eventually, the call from the majors came, and in late 2002 he moved to New York, where he was installed as ML’s chief North American economist.

His big call — that the housing boom was unsustainable — began to take shape as he noticed a widening disparity between gross domestic product (GDP) accounts and gross domestic income (GDI) accounts. That is, a gap was forming between the value of the amount of stuff being produced and the amount of money coming into American households. The bump in income couldn’t be coming from wages (since GDP would have risen too), and so the increase must have been coming from somewhere else. Rosenberg twigged to the fact that it was coming from leverage. “And it wasn’t just leverage, but leverage on top of leverage,” he says.

We all know the story from there. Mortgages had been extended to people who never qualified before; that raised demand and prices. Because people felt richer, they spent more; corporate earnings benefited. The rise in house prices allowed new borrowing, and everyone began using their home as an ATM. All of it led to an illusory boom.

In 2005, Rosenberg came out and said house prices in the United States would fall — and not simply stabilize, as was the consensus. It was a scandalous notion. “I can tell you that travelling around the country back in 2005 and 2006, and telling a client that their house price was going to fall, was akin to telling them their kid was ugly,” he says. “But to me, that was a real critical mistake, to think home prices were going to miraculously stabilize.”

Since then, of course, he’s been proven correct. But what Rosenberg is talking about now might be even more important — if, as is their habit, events fall in line with his forecasts.

It will be a world of less consumption. There will be long-term changes in consumers’ attitudes toward discretionary spending, credit, and home ownership. And these changes will begenerational. “This is at least a mild form of depression — it has to be, because it’s not a plain-vanilla, garden-variety recession,” says Rosenberg. “The last nine postwar recessions were relatively simple to forecast — they were part of the business cycle. But this wasn’t part of the business cycle. This wasn’t about expunging excessive manufacturing inventories and the Fed fighting inflation. This was about the end of the 25-year secular credit expansion that had gone parabolic between 2001 and 2007. It’s the end of a secular trend, and that makes this a different animal.”

GS, which began life in the early part of the 1982–2007 bull run as a single equity fund run by Ira Gluskin and Gerald Sheff, has recently expanded its investments. The firm has moved into investment-grade bonds and credit arbitrage in a big way, going from no investments to hundreds of millions of dollars’ worth. Partly on Rosenberg’s advice, GS is preparing for a period in which stocks are volatile but move generally sideways; return will be more about income than cap gains.

Rosenberg thinks it’s going to be a long, tough slog before the economy and the markets really start looking up. “Government intervention is an attempt to cushion the blow, to maintain social stability, prevent destabilizing deflation,” he says. “That’s what governments around the world are trying to do. But if we’re talking about getting to the next sustainable cycle — and sustainable is the operative word — it’s going to be five or 10 years.” Current stimulus measures, he thinks, are not an attempt to create a recovery: they’re simply a rearguard action to avoid a complete cratering of the world’s installed economic capacity.

Of course, that’s the kind of prediction few will want to hear — just like his last big call. Did Rosenberg get any sense of satisfaction in seeing his prediction come true? “I’ll take the compliment that I called it,” he allows. “But there is absolutely no joy in being correct in a forecast like this. It is two different things to forecast this and then live through it. This is one time where I wasn’t happy that I was right.”

Bob Farrell’s rules …

Farrell was the chief stock market analyst at Merrill Lynch for 25 years, a legend and a “hero” of Rosenberg’s. Herewith, his Top 10 market rules.

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an opposite excess in the other direction.

3. There are no new eras — excesses are never permanent.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

5. The public buys the most at the top and the least at the bottom.

6. Fear and greed are stronger than long-term resolve.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.

8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend.

9. When all the experts and forecasts agree — something else is going to happen.

10. Bull markets are more fun than bear markets.