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… But, Dude, What About Brazil??

Key Takeaways:

 

  • There is a strong fundamental case to be made to back up the truck on the long side of Brazil.
  • That being said, however, a slew of policy pitfalls remain.
  • As such, we’d only sign off on getting long Brazil to the extent the Rousseff impeachment process goes as consensus expects it will; we would be buyers of a “sell the news” event in the face of a positive outcome.

 

In response to this morning’s Early Look in which we detailed our latest thoughts on country-picking in emerging markets, we received a number of replies asking for our thoughts on Brazil, which itself failed to make the cut in our most overvalued/undervalued analysis. Given the level of interest, we thought we’d share our revised outlook for the Brazilian economy and its financial markets more broadly.

 

It’s easy to recap where we’ve been on Brazil lately: wrong (at least until we closed all of our positions in EM last Tuesday). Specifically, as part of the thematic investment conclusions outlined on slide 94 in our 3/16 presentation titled, “Is This a Generational Buying Opportunity in Emerging Markets?”, we were explicitly negative on LatAm equities and FX, which we expressed through the currency un-hedged SPDR S&P Emerging Latin America ETF (GML). That instrument moved -18.4% against us throughout the course of our bearish bias.

 

Mitigating this disaster is the fact that we’ve been the axe on the bear side of Brazil since mid-July ’14. Inclusive of its +65.9% YTD return, the iShares MSCI Brazil Capped ETF (EWZ) still declined -30.8% from 7/14/14 through last Tuesday. For reference, the MSCI All-Country World Index declined only -2.6% over that timeframe. I’ll take +2820bps of long-term alpha generation any day.

 

… But, Dude, What About Brazil?? - 1

 

With all that baggage and glory now squarely in the rearview mirror, we can now focus on our call on Brazil from here: patience. Specifically, we think it’s best that uninvolved investors remain neutral for now. To the extent an investor is currently involved on the long side, we believe the best course of action is to book gains and look to redeploy capital upon further notice.

 

In GIP Model terms, Brazil has definitely earned its outperformance in the YTD; in fact, it’s one of the best GIP setups I’ve ever seen (more on this below). Moreover, the confluence of a material rally in commodities and the Rousseff impeachment saga have proven particularly positive for a sharp reversal of what had been pervasively bearish sentiment.

 

… But, Dude, What About Brazil?? - EM Scatter

 

… But, Dude, What About Brazil?? - BRAZIL

 

… But, Dude, What About Brazil?? - Brent Crude Oil vs. EWZ

 

… But, Dude, What About Brazil?? - CRB Raw Industrials Index vs. EWZ

 

Supporting Brazil’s sexy GIP Model setup are:

 

  • Consumer spending growth that appears to be breaking out of its YTD basing pattern from historically depressed levels;
  • Industrial production growth that is accelerating on a sequential and trending basis off of historically depressed levels;
  • Export growth that is accelerating on a trending basis off of historically depressed levels;
  • Composite PMI readings that appear to be breaking out of their YTD basing pattern from historically depressed levels;
  • Consumer and business confidence readings that have each completed full-cycle bearish-to-bullish reversals… both are now accelerating on a sequential and trending basis off of historically depressed levels;
  • Headline and core inflation readings that have each completed full-cycle bullish-to-bearish reversals… both are now decelerating on a sequential and trending basis off of historically elevated levels;
  • A currency that is down -25% on a REER basis, which goes a long way towards mitigating the “Dutch Disease” we highlighted several years ago;
  • A current account deficit that has improved +190bps off of its 1Q15 cycle-trough of -4.4% through 1Q16; and
  • An improving primary deficit picture per the latest monthly data… (R$10.1B) in JUN vs. a Bloomberg consensus estimate of (R$15.3B).

 

… But, Dude, What About Brazil?? - HOUSEHOLD CONSUMPTION

 

… But, Dude, What About Brazil?? - INDUSTRIAL PRODUCTION

 

… But, Dude, What About Brazil?? - EXPORTS

 

… But, Dude, What About Brazil?? - COMPOSITE PMI

 

… But, Dude, What About Brazil?? - CONSUMER CONFIDENCE

 

… But, Dude, What About Brazil?? - BUSINESS CONFIDENCE

 

… But, Dude, What About Brazil?? - CPI

 

… But, Dude, What About Brazil?? - CORE CPI

 

<chart14>

 

… But, Dude, What About Brazil?? - REER

 

… But, Dude, What About Brazil?? - BUDGET BALANCE vs. CURRENT ACCOUNT BALANCE

 

But are Brazilian financial markets priced to perfection? No one knows the answer to that, but my inclination is to side with the “yes” camp. I do know one thing’s for sure, however: I don’t bet on “open-the-envelope risk”, which is effectively what you’d have to do to put a positon on today given the uncertainty surrounding the outcome of Rousseff’s impeachment trial (which will be held across four sessions spanning AUG 25-26 and AUG 29-30). A two-thirds majority (i.e. 54 out of 81 senators) is needed to fully remove her from office, which would allow interim president Michel Temer to remain in power through 2018.

 

Indeed, the confluence of the market-friendly leadership style of Temer, the bold fiscal reform drive of his acting finance minister Henrique Meirelles and the steady hand of CBR governor Ilan Goldfajn has been a boon to Brazilian capital and currency markets in the YTD. Key reform initiatives include:

 

  • Narrowing the primary deficit to (R$139B) in 2017 from a projected [record] (R$170.5B) in 2016;
  • Capping the growth rate of public expenditures to CPI;
  • Implementing a broad-based freeze on tax hikes; and
  • Changing the structure of the Finance and Planning ministries in order to put the offices responsible for budget planning, government spending and tax collection all under the purview of Meirelles.

 

The major issue we see with each of these reforms is that Rousseff’s Workers Party (PT) may not acquiesce to the fiscal reform demands of Temer, who hails from the Brazilian Democratic Movement Party (PMDB). Recall that her own fiscal reform drive fizzled out amid PT infighting over what were widely viewed as draconian fiscal consolidation measures despite near-peak sovereign indebtedness and a slew of ratings downgrades.

 

… But, Dude, What About Brazil?? - DEBT TO GDP

 

Moreover, the tax hike freeze isn’t set to be decided upon until the end of this month; a failure to implement the proposed changes would go a long way towards resetting Brazil’s economic recovery expectations structurally lower given its existing status as one of the world’s most over-taxed economies; the World Economic Forum’s 2016 Doing Business Report ranks Brazil’s tax efficiency 178th out of 189 countries.

 

… But, Dude, What About Brazil?? - Brazil WEF DBR 2016

Source: World Economic Forum 2016 Doing Business Report

 

All told, there is a strong fundamental case to be made to back up the truck on the long side of Brazil. That being said, however, a slew of policy pitfalls remain. As such, we’d only sign off on getting long Brazil to the extent the Rousseff impeachment process goes as consensus expects it will; we would be buyers of a “sell the news” event in the face of a positive outcome.

 

Best of luck out there,

 

DD

 

Darius Dale

Director


Macrocosm 2016 | Important Date Change!

We are changing the date of Macrocosm 2016 to Wednesday, November 16th in light of a religious calendar conflict. The good news is that America will have just elected a new president. Our speakers will discuss the Election Day outcome and its implications for investors around the globe.

 

In the coming weeks, we will release our full speaker roster and how to reserve your spot at this exclusive investor event.

 

The event will be held at the Yale Club of New York City.  Please mark your calendar now – November 16th!  

 

-Your Macro Team

 

Macrocosm 2016 | Important Date Change! - macrocosm2016 banner graphic email


Re-visiting Volatility's Asymmetry

Takeaway: Below we expand on our recent conversations and empirically supported evidence that investors are increasingly more bullish.

In the summer of 2014 we introduced our #volatilityasymmetry theme for our Q3 deck which turned out to be a, at minimum, a good call-out at all-time lows in cross asset volatility. Below we revisit that theme with a series of charts and tables outlining current behavioral bullishness (or lack of conviction on the short-side).

 

Highlights:

  • Total U.S. market short-interest has been cut by 13% to a new YTD low currently (Feb. 2016 was the top, and July 2015 was the most recent trip to current levels).
  • With the market at all-time highs on peak forward multiples, realized shorter-term volatility in the S&P is at a level not seen since the summer of 2014 when the CBOE skew index was signaling a much more cautious market than it is now.
  • Looking passed the VIX and S&P 500 implied volatility which is subject to ETF structuring and rebalancing ativity, implied volatility premiums over realized ranges have tightened further on a relative basis among a sample of S&P 500 constituents - this, despite realized volatility testing cycle low 2014 levels depending on the lookback window. 
  • The MOVE Index is at level not seen since 2014. Looking at high-yield credit in resource-related sectors, spreads have nearly tightened to broader indices when indexed to July 2014 (pre-USD breakout). With commodity-linked spreads tightening, net futures and options positioning among the 17 commodities we track on a weekly basis is registering a z-score >1x net long in 9 out of 17 commodities.

----------

We speak of S&P 500 net non-commercial futures and options positioning regularly. Index + e-mini positioning has been cut the last couple of weeks, but it’s still pinned near a multi-year high. Along with futures and options positioning, total U.S. market short-interest has been cut 13% since February and the CBOE skew index indicates a market that is positioned much less cautiously than it was in the summer of 2014, at least in volatility terms:

 

Re-visiting Volatility's Asymmetry  - S P CFTC Net Futures and Optons Positioning

 

Re-visiting Volatility's Asymmetry  - Total U.S. Market Short Interest

 

Re-visiting Volatility's Asymmetry  - CBOE Skew Index

 

Re-visiting Volatility's Asymmetry  - S P EV EBITDA Multiple

 

Along with equity market volatility not far off cycle-lows, implied volatility across the treasury curve (MOVE INDEX) is at a new low not seen since 2014. Looking at commodity-leveraged sectors, spreads have reverted to the broader index since breaking out with the USD in July of 2014. Following the S&P and asset price reflation in general, of the 17 commodities for which we track net futures and options positioning on a weekly basis, 9 are registering net positioning a >1x on a TTM z-score basis (and that’s with the bearish seasonality affect at this time of year in grains):

 

Re-visiting Volatility's Asymmetry  - Treasury Bond Volatility and Spreads

 

Re-visiting Volatility's Asymmetry  - HY OAS

 

Re-visiting Volatility's Asymmetry  - CFTC Table

 

And perhaps the most notable call-out, the following table looks at a random sample of 23 S&P 500 members, with a collective beta of 1.22. Short-interest has been cut over the last 6-months in 17 of those 23. Looking at Equity market skew, bombed out protection always has a bid, ESPECIALLY in the S&P. We realize it’s a more liquid and easier to trade in size. However, looking at overall levels of volatility (at-the-money implied vs. realized), realized vol. in the S&P is looking at taking out 2014 lows, and with it has gone the VIX.

 

Yet despite anemic volume and tightening ranges to all-time equity market highs, implied volatility in many of the names below has been hit harder than realized vol on a relative basis. The yellow columns furthest to the right look at the premium that implied is bid over realized ranges. Right now, despite the move to near cycle lows in realized volatility on the S&P (of course this depends on duration), 19 of 23 have implied volatility premiums that are >1x TIGHTER than 60D realized volatility. So forward-looking volatility premiums (over realized) are much tighter depsite near-cycle lows in trading ranges. We may expand the 23 to look at this more closely, but some of the offers look interesting if you’re skeptical this lasts.  

 

As we mentioned in this morning’s early look, valuation multiples, while important, can look illogical for long periods of time, but getting a grasp on consensus positioning and sentiment is a key part of our the process. Whether by capitulation or forward-looking opinion, the move to beta is becoming increasingly a reality. 

 

Re-visiting Volatility's Asymmetry  - S P Sample Dashboard

 

Re-visiting Volatility's Asymmetry  - Realized Volatility

 

Ben Ryan

Analyst

 

 

 

 

 


The Inflation Boogeyman’s Flight Got Delayed In July

On Friday, we published a research note titled, “Here Comes the Inflation Boogeyman” in which we thoroughly detailed our hawkish outlook for reported inflation over the next three quarters, as well as the implications therein for both investors and policymakers.

 

With the advent of today’s soft inflation data for the month of JUL, one could make the case that we’re 0-for-1 in pending 9-month forecast period:

 

  • Headline CPI decelerated to +0.8% YoY from +1.0% prior, missing Bloomberg consensus expectations of +0.9%;
  • Core CPI nudged down to +2.2% YoY from +2.3%, missing Bloomberg consensus expectations of +2.3%; and
  • Looking to our proprietary “Essentials Basket”, which is comprised of non-discretionary items like food and shelter, the annual inflation rate ticked down -40bps sequentially to +0.6% YoY; this is right in line with the TTM average.

 

The Inflation Boogeyman’s Flight Got Delayed In July - CPI

 

The Inflation Boogeyman’s Flight Got Delayed In July - CORE CPI

 

The Inflation Boogeyman’s Flight Got Delayed In July - CPI ESSENTIALS PLOT

 

All that being said, however, we’re not in the business of playing pin-the-tail-on-the-donkey for any single economic data release. Our process is specifically designed to forecast inflections or continuations in trending (i.e. multi-quarter) rates of change across growth and inflation, with the express intent of forecasting how policymakers might respond to those deltas. Indeed, understanding the interplay between these three principle components of factor exposure performance has helped us make more than our fair share of lucrative and often contrarian macro calls over the years: http://docs3.hedgeye.com/macroria/An_Introduction_to_the_Hedgeye_Macro_Research_Product.pdf.

 

Going back to domestic consumer price inflation specifically, we are still anticipating a trending acceleration over the intermediate term. There is, however, one important development that we think is worth calling attention to – i.e. the divergence between commodity price changes and Headline CPI.

 

As we outlined in Friday’s note, our analysis has shown fluctuations in commodity prices have been the primary driver of the marginal rate of change in reported Headline CPI for nearly a decade now. But with this relationship breaking down, at the margins, throughout 2016, Core Goods CPI and Core Services CPI may be slated to become increasingly important as drivers of trending changes in rates of Headline CPI – something that would certainly imply less upside in our outlook for the latter (particularly as we start lapping trough energy compares in 1Q17).

 

  • Correlation between the rate of change of our commodity price basket and Headline CPI from JAN ’08 through DEC ’15: +0.78; correlation 2016-to-date: -0.61;
  • Correlation between the rate of change of Brent crude oil and Headline CPI from JAN ’08 through DEC ’15: +0.84; correlation 2016-to-date: -0.49;
  • Correlation between Core Goods CPI and Headline CPI from JAN ’08 through DEC ’15: +0.25; correlation 2016-to-date: +0.43; and
  • Correlation between Core Services CPI and Headline CPI from JAN ’08 through DEC ’15: +0.23; correlation 2016-to-date: -0.54.

 

The Inflation Boogeyman’s Flight Got Delayed In July - INFLATION MODEL

 

The Inflation Boogeyman’s Flight Got Delayed In July - BRENT CRUDE OIL MODEL

 

The Inflation Boogeyman’s Flight Got Delayed In July - Core Services Inflation Less Core Goods Inflation

 

All told, it’s too early to tell whether or not the aforementioned divergence between commodity price changes and Headline CPI is here to stay, but it bears watching and reacting to to the extent we don't see a meaningful "catch-up" reversal in Headline CPI in the AUG/SEP timeframe. Moreover, the jury’s still out on Core Goods CPI and Core Services CPI taking over as key drivers of inflation from here.

 

As of now, we don’t either of these observations is sustainable and still anticipate a trending acceleration in Headline CPI – likely alongside wages – over the intermediate term.

 

The Inflation Boogeyman’s Flight Got Delayed In July - NFP YoY vs. YoY Wage Growth

 

All the best,

 

DD

 

Darius Dale

Director


Here Comes the Inflation Boogeyman

Takeaway: Reported inflation is set to rise materially over the next 3 quarters. This has important implications for investors and policymakers alike.

Earlier this week Keith and I had a dialogue with some über-thoughtful macro investors regarding our outlook for inflation and how the Fed is likely to respond to it. Below is a detailed summary of the key takeaways, which we think are especially pertinent for all investors.

 

 

Q: "Do you agree with our belief that inflation is being systematically underreported in order for the Fed to remain hyper-accommodative and make rich people richer? Also, any thoughts on the GS analysis which shows a historically-elevated divergence between reported inflation and inflation expectations?"

 

A: The GS analysis you cite conspicuously omits commodity prices – energy prices in particular. Our analysis has shown fluctuations in commodity prices have been the primary driver of the marginal rate of change in reported headline inflation (which breakevens are designed to track) for nearly a decade now. As such, the ~15% decline in WTI from its early-JUN peak can explain away much of the -32bps decline in the 5Y breakeven rate since its late-APR peak.

 

Here Comes the Inflation Boogeyman - INFLATION MODEL

 

Here Comes the Inflation Boogeyman - BRENT CRUDE OIL MODEL

 

Here Comes the Inflation Boogeyman - WTI vs. 5Y Breakeven

 

Your assumption that inflation is being systematically underreported is more than likely correct, though it’s difficult to prove. Even the PriceStats aggregate inflation series is not showing much of a spread between its calculus and the official data.

 

I think what we intuitively feel is the systematic underreporting of big-ticket core services inflation (i.e. housing, healthcare, education, transportation, etc.) relative to core goods inflation, but because prices are sticker and less volatile in the former category, the latter category has an outsized impact on the marginal rate of change in headline CPI.

 

Here Comes the Inflation Boogeyman - Core Services Inflation Less Core Goods Inflation

Source: Bloomberg L.P.

 

And yes, the Fed is well aware of where the U.S. economy’s proverbial “bread” is buttered (i.e. high-end consumer spending). This is why they aim to protect the stock market at all costs (e.g. in lieu of their policymaking credibility, bank NIMs, the active fund management industry, etc.).

 

Here Comes the Inflation Boogeyman - Share of PCE by Income Decile

 

Here Comes the Inflation Boogeyman - Ownership of Wealth and Financial Assets

 

Q: "At the same time we still believe in a crisis/risk premia decompression scenario with the 10Y Treasury yield going to 1%. Are we talking out of both sides of our mouths? Is it possible to believe in both scenarios and how would you reconcile that? Also, do you agree with us that demographics are the primary driver of lower yields across many advanced economies?"

 

A: There's no question that demographics is the tail wagging the dog here. Slides 4 and 6 of our #DemographicYields presentation cite and IMF study that empirically shows how population ageing is inversely correlated to trend rates of both GDP growth and inflation to a statistically significant degree.

 

Here Comes the Inflation Boogeyman - G7 Old Age Dependency Ratio

 

Here Comes the Inflation Boogeyman - G7 35 54 YoY

 

Given these dynamics, I do not think you’re talking out of both sides of your mouth. Specifically, trend rates of GDP growth and inflation have continue on their secular path lower in order for the Fed to remain perpetually accommodative, which we’ve learned is bullish for the SPY until it isn’t (i.e. during recessions).

 

Q: "Crude oil really has to fall hard in Sept and onward to keep pace with the move last year. Our energy team sees it unlikely that prices will fall to the degree they did last fall/winter – we're thinking the price floor is in the low 40s/high 30s. If that’s the case, reported inflation will rise simply due to the mechanical effect of lapping easy compares. How are you incorporating energy price dynamics into your forecasts?"

 

A: We’re largely on the same page here. In terms of when we’ll see the impact of higher YoY energy prices on CPI, our models point to t-minus “now” and the effects should intensify markedly over the next 6-8 months. Specifically, the YoY rate of change in crude oil prices linearly trends from -22% in JUN ‘16 to +36% in JAN ’17.

 

Here Comes the Inflation Boogeyman - BCOM2

 

All else being equal, we could see headline CPI more than double from here; the high end of our forecast ranges expect CPI to average +1.2% YoY in Q3, +2.1% in Q4 and +2.7% YoY in Q1.

 

Here Comes the Inflation Boogeyman - GIP Model High CPI

 

For reference, the low end of said forecast ranges are +1.2%, +1.4% and +2.0%, respectively.

 

Here Comes the Inflation Boogeyman - GIP Model Baseline

 

My gut feeling is that the latter set of numbers is too low, given our quantitative view on the ultimate floor in crude oil – which, at $36/bbl. is within your target range.

 

Here Comes the Inflation Boogeyman - Energy Price Scenario Analysis

 

Q: "It's amazing that a pickup in reported inflation could have a real effect on monetary policy given we are seeing the lowest nominal GDP growth rate since the 1950s including all other recessionary periods ex GFC. Assuming the preconditions are met and NGDP does not pick up materially, then we will be in recession technically. Thoughts on this?"

 

A: Regarding how this will play out in recession probability and policy response terms, there are three very important things to keep in mind here:

 

  1. The Fed sees all major changes in the rate of headline CPI as “transitory”;
  2. The Fed’s preferred measure of inflation (i.e. PCE Core Price Index) won’t capture much of the aforementioned base effect dynamics; and
  3. The Fed’s “price stability” mandate is very much secondary to its “maximum employment” mandate and are likely to let inflation run a little hot if they don’t see a commensurate acceleration in wage growth (Hedgeye's very own Don Kohn – former Vice Chairman of the Fed – confirmed this on his latest call).

 

RE: #1: The Fed did the exact opposite of what headline inflation implied they should be doing by easing in 2008, easing in 2011 and then tapering and tightening in 2014-15. Last price in the SPY is a more relevant indicator than headline CPI in terms of their propensity to adjust monetary policy.

 

Here Comes the Inflation Boogeyman - Fed Response to Headline CPI

Source: Bloomberg L.P. 

 

RE: #2: In the face of some fairly material deltas in commodity prices, the PCE Core Price Index has been remarkably stable in the +1.3% to +1.8% range for over three years now. The U.S. government appears to have found a great deal of “stability” in [suspected] price manipulation.

 

Here Comes the Inflation Boogeyman - Brent YoY vs. Core PCE

 

RE: #3: The wild card here is that we just might start to see an acceleration in wage growth over the next 2-3 quarters. That would be consistent with previous cycles that show a consistent decoupling of employment growth and wage growth into the onset of recession.

 

Here Comes the Inflation Boogeyman - NFP YoY vs. YoY Wage Growth

 

All told, I don’t know what the catalyst is for nominal GDP to pick up materially this late in the economic cycle – absent a big run-up in energy prices that permeates throughout the manufacturing sector. That said, however, improving inflation dynamics – even if largely a function of receding base effects – is supportive of not necessarily seeing lower-lows for now.

 

Your point that we’ve never seen nominal GDP this low outside of recession is well-taken. This largely explains the disconnect between all-time highs in the SPY and pervasively negative sentiment among all-types of fundamentally-oriented investors who see the corporate profit cycle for what it is – recessionary with a ton of downside risk if we actually enter a real economic downturn.

 

Here Comes the Inflation Boogeyman - Nominal GDP and Recessions

 

Q: "Just to crystallize this, how do you think about CPI impacting Core PCE? You note Core PCE has been remarkably consistent. Should we expect it to stay consistent? Is it too difficult to predict PCE given the Fed’s apparent discretion?"

 

A: Core PCE is likely to move higher from here, given its historical correlation with headline inflation on both an absolute level and delta basis:

 

Here Comes the Inflation Boogeyman - 17

Source: Bloomberg L.P.

 

Here Comes the Inflation Boogeyman - 18

Source: Bloomberg L.P.

 

That said, however, it would be unwise to expect a material jump in the PCE Core Price Index over the next 2-3 quarters. Assuming our most aggressive scenario for upside in headline CPI (i.e. an average of +2.7% YoY in Q1) only gets you to about +1.9% on the PCE Core Price Index, assuming little change to the historical relationship. That’s only +30bps higher than the most recent print and still below the Fed's +2% "price stability" mandate – where it has been for 50 months and counting.

 

Here Comes the Inflation Boogeyman - CPI vs. Core PCE

 

Here Comes the Inflation Boogeyman - CPI vs. Core PCE  2

 

To your question regarding the difficulty of forecasting the PCE Core Price Index, the series is not particulalry volatile, which makes it easier to predict than headline CPI. Specifically:

 

  • Standard error (trailing 5Y): 10bps for PCE Core Price Index vs. 31bps for headline CPI
  • Directional hit rate (trailing 10Y): 73% for PCE Core Price Index vs. 70% for headline CPI
  • Correlation between the high end of our forecast range and the actual reported data (trailing 10Y): 0.86 for PCE Core Price Index vs. 0.85 for headline CPI
  • Correlation between the low end of our forecast range and the actual reported data (trailing 10Y): 0.86 for PCE Core Price Index vs. 0.73 for headline CPI

 

Q: "It looks like “Quad 3” is going to become more pronounced given sustained weak nominal GDP and rising inflation. What sectors typically do best at “Quad 3” extremes?"

 

A: The sectors which have historically performed best in #Quad3 are as follows (in descending order):

 

  1. Utilities (good in both relative and absolute performance terms)
  2. REITS (good in relative performance terms; decent on an absolute basis)
  3. Energy (good in relative performance terms, but not necessarily on an absolute basis)
  4. Health Care (good in relative performance terms, but not necessarily on an absolute basis)

 

The sectors which have historically performed worst in #Quad3 are (in ascending order):

 

  1. Materials (bad in both absolute and relative performance terms)
  2. Financials (bad in both absolute and relative performance terms)
  3. Consumer Discretionary (bad in both absolute and relative performance terms)

 

We hope you found this discussion helpful to expanding upon your respective investment motifs. As always, feel free to email us with any follow-up questions.

 

Happy Summer Friday,

 

DD

 

Darius Dale

Director


Chasing the Curve

Takeaway: Outlining a key Q3/Q4 debate with regard to an energy sector recovery.

The reflexivity of the back of a debt-funded peak capital spending boom in resource-heavy sectors looks much tamer than it did in February and March. High-yield energy OAS has been more than cut in half since February (+720 from +1600 in Feb), with the BGG high-yield energy index +42% off the 2016 lows.

 

Relief in spot prices and a continuing flattening in the yield curve have been large drivers, but credit has been largely immune to the most recent leg-down in crude since June 8th. High-yield energy OAS is 100bps tighter over the same period and has nearly reverted back to cumulative high yield spread levels since the dollar broke out in July of 2014:

 

Chasing the Curve  - Commodity Producer Interest Expense

 

Chasing the Curve  - High Yield OAS Indexed to 100

 

Below we offer a short outline of a key Q3/Q4 debate with regard to the large amount of capital getting behind a recovery in the energy sector.

 

Is the consensus opinion short a capacity-driven turnaround at current levels, or is there room for another leg down?

  • More than $100Bn has been raised from buy-out firms and distressed debt funds over the last 2 years  - BBG  
  • According to an E&Y survey in June, the 100 PE firms that partook in a survey had ~$1T of dry powder to sink into the oil & gas sector – 25 said they planned to get something done by year-end 2016

 

The space as a whole looks more levered, much shorter of the credit cycle, and longer of an industry recovery than it was 6 months ago. To hold current levels into year-end, S&P 500 energy companies may have to demand much higher multiples, looking more levered in the process without a sustained commodity price recovery.

  • Corporate leverage broadly (median debt/ EBITDA) reached record highs this week as reported by S&P:  LINK  
  • With negative operating margins for S&P 500 energy constituents, EV / Forward EBITDA multiples and Net Debt / Forward EBITDA multiples touched a cycle peak today
  • Expectations do not look completely blown out yet. Reporting season is finished for the 37 energy companies in the S&P, and earnings growth missed estimates by -9.5% vs. the S&P as a whole which has beaten estimates by 4.1% this far
  • With regard to expectations, embedded in that peak cycle forward EV / EBITDA multiple is triple digit consensus earnings expectations for Q1 and Q2 of 2017

Chasing the Curve  - S P 500 energy Operating Margin

 

Chasing the Curve  - S P Energy EV EBITDA Multiple

 

Chasing the Curve  - Net Debt to EBITDA

 

Chasing the Curve  - S P Rev.   Earnings omps

 

While cyclicals do tend to look most expensive when it’s time to look for opportunities:

 

1)      Expectations that recover sharply by the end of 2016 may need to be taken down first

2)      Year-end 2016 will bring another round of impairments, write-downs, and balance sheet contraction without a +10-20% rebound in prices in short order

3)      Mgmt. guidance, realized prices, and 2015 price levels for the regulatory treatment of assets signals the worst could be over with the capital flush unless the bottom falls out in crude for the duration of the year (see the charts below for a sample of XLE members)

4)      Capital in play per unit of production has shrunk which we called out in January as a #creditcycle catalyst before the first big round of asset revaluations. Given that domestic production has just started to roll, even many of the largest producers will need to fill the funding gap into 2017 (second chart below) - the need for incrementally cheaper funding or sustained lack of credit market deterioration would be necessary tailwind. 

 

Chasing the Curve  - Earnings Expectations

 

Chasing the Curve  - PP E per oz. 15 in xle

 

From a pure base effects GIP modeling perspective, energy and inflation comps broadly are much easier in the latter part of the year (our GIP model is currently tracking to Quad 3 and Quad 2 for Q3 and Q4 respectively). And given where forward rate hike expectations are currently, we’re wrestling internally with the next policy catalyst for the U.S. dollar that doesn’t involve some kind of “quantitative easing” in front of it.

We’re sticking to the top-down quantitative signals with regard to reflationary assets, and WTI has failed to breach its bearish TREND resistance level in recent weeks – to weigh in, we’re fine continuing to sit out a position when the market is trading at all-time highs and peak forward multiples with expectations that we continue to view as optimistic (consensus expects positive earnings growth in every sector by Q1 2017).

 

See the link for the most recent updated thoughts from our energy policy team with regard to renewed production freeze talks: Freeze September Sequel Will Have Similar Ending: No Agreement

 

Chasing the Curve  - Net PP E vs. Production YY 15 in XLE


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