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Europe’s Crisis in Confidence

“I work all the time. I sometimes take the liberty of looking at a beautiful woman’s face. It’s better to be passionate about beautiful women than gay men.”

-Silvio Berlusconi, 11/2/2010

 

If the quote above didn’t get your attention this morning, we’re not sure what will. What has been getting our attention over the last few weeks is heightening risk across Europe, especially in the region’s peripheral countries of Portugal, Ireland, Italy, Greece, and Spain, affectionately named the ‘PIIGS’.  This inflection in risk, which we’re measuring via government bond yields and CDS spreads, has re-emerged following a reduction in risk in the month of September and most of October.

 

We believe that this rise in risk is a reflection of the Crisis in Confidence, namely the continued inability of Europe’s peripheral governments to instill investor and public confidence that they can cut bloated fiscal imbalances and resolve internal political disunity.

 

Currently, Italy’s PM Berlusconi is the region’s poster child for this renewed Crisis in Confidence, including his latest scandal surrounding an 18-year-old belly dancer that he allegedly gave €7K to and helped free from a theft charge. Elsewhere, poor leadership in Europe, from Greece, Portugal, Ireland to Hungary and Romania, continues to propel market risk upward. Interestingly, economic indicators reveal that current levels of risk, in particular in Ireland and Portugal, resemble levels last seen shortly before Eurozone finance ministers were forced to issue a €110 Billion bailout for Greece on May 2, 2010 and days later, along with the IMF and World Bank, a €750 Billion package to rescue troubled European nations. 

 

Given this risk inflection in Europe, we took the explicit tact to short the EUR-USD via the etf FXE in the Hedgeye Virtual Portfolio on 11/3/2010 with the currency pair trading at our immediate term TRADE resistance level of $1.42. (From here we see TRADE support at $1.39 and intermediate term TREND support at $1.33). While we’re cautious on the region as a whole, we are positioned long Germany via EWG (bought on 11/8/10) and remain short Italy (EWI) as a way to play the developing Sovereign Debt Dichotomy.  Below we highlight the risks we see mounting and elaborate more on our positioning given the region’s outlook.

 

Risk is ON!

 

While the excessive public deficit and debts of the PIIGS are well understood by the capital markets, we believe that the recent heightening in the risk trade is a reflection of the perceived threat that these countries will NOT be able to meet their targeted debt and deficit reduction plans via austerity alone. While Greece was the first to report that its 2009 deficit must be revised up to 15.1% of GDP from 13.8% and debt to 127% of GDP versus a previous calculation of 115.1%, we don’t think it will be the last country with upward revisions.  But if you don’t want to take our word for it, the hockey stick curves in the charts of both government 10YR bond yields and sovereign CDS spreads (see chart below), might convince you that the market is pricing increased risk ahead.

 

Europe’s Crisis in Confidence - ell1

 

Europe’s Crisis in Confidence - ell2

 

It’s worth noting that the slight decline in Greece’s 10YR yield over the last days is a reflection of the support PM Papandreou’s socialist Pasok party got over the weekend in local elections. Despite the victory, we still believe there is a void of confidence in Greek leadership from a domestic and international perspective.  Also, we’d note in the CDS chart that the 400bps line has been an important indicator for us as a breakout line. Clearly, Ireland and Portugal are treading dangerously above this level.

 

As we’ve shown in our research since 4Q09 when we started to track Greece’s rising risk premium, Europe’s periphery has wholly “earned” its reputation: after pigging out on low interest rates for nearly a decade, many countries (and in particular Spain and Ireland) continue to deal with the flip side of that leverage coin in the form of ongoing housing price declines, high unemployment and slack growth.  Now with these governments overextended deficits-- and we’ll use Ireland as an example with a deficit/GDP ratio forecast to balloon to 32% this year--it’s increasingly clear that despite all efforts by the country to implement another €6 Billion in spending cuts and tax relief, investors aren’t buying a smooth recovery ahead, and rightfully so!  As yields push up so too does the cost of capital which further handcuffs a country’s ability to refinance and raise debt, which in turn snowballs the perceived sovereign default risk.

 

Finally, as the chart below drives home, the PIIGS are truly running up against a wall of debt, especially next year, compared to their more fiscally conservative neighbors. These are headwinds to keep front and center.

 

Europe’s Crisis in Confidence - ell3

 

Pants Down versus Pants On: Short Berlusconi versus Long Merkel

 

While we applaud countries focusing on trimming fiscal fat now to benefit long-term “health”, there’s clearly near- to longer term downside risk to growth across the region from austerity measures. In particular, we expect to see spending and confidence slow across much of Europe as such austere measures as increases in VAT, wage and benefit freezes, and job destruction impact these economies over the next 1- 4 years. To position ourselves in an environment of Sovereign Debt Dichotomy we’re long Germany (EWG) and short Italy (EWI) in the Hedgeye Virtual Portfolio. Again, here it’s worth considering the leadership differences that weigh on economic performance.

 

While it’s worth a laugh, and certainly worthy of Page 6 in the NY Post, the scandalous actions of Italy’s PM Berlusconi, including photos of him literally with his pants down at a vacation villa last year, have severe political and economic implications for country. While we’ll spare you the intricate political dealings, Berlusconi’s rule is in checkmate since he expelled his speaker of the Parliament, Gianfranco Fini, back in July. Now Fini, who has enough backers in the legislature to deny Berlusconi a majority and bring down the government, faces his own political impasse. Even if he were to bring a defeat to Berlusconi he would likely be forced into further political gridlock for competing coalition rule. So even in the best case, if there is one, we expect further prolonging of the “paralysis” that is Italian politics. 

 

With authoritarianism, inefficiency, and back-handedness hallmarks of Berlusconi’s rule, we also worry about the risks associated with the country’s public debt levels.  In 2009, public debt equaled 115% of GDP, the second highest in Europe behind Greece, and the country is rolling up against €500 Billion of government debt maturities (principal +interest) over the next three years--a level equivalent to Germany’s obligations, yet from an economy 1.6x larger than Italy’s. Equally, strong foot power (strikes) against the government’s proposed €30 Billion in austerity cuts remain and the country’s aging population is a longer term headwind worth considering. Statistics show that Italy will have the oldest population by 2015 and 2020 in the Eurozone, with a population >65 at 21.9% and 23.2%, respectively.  So, as Italy’s population ages its government will face increased outlays and reduced receipts, which will add additional economic headwinds.

 

On the other hand, while the Germans will also have to deal with an aging population, we continue to like the country’s intermediate term set-up. Germany’s growth profile of 3.3% this year and 2.0% next year outperform many of its peer countries, with inflation expected to be around the 2% level, a budget deficit projected around -3.5% of GDP in 2010, and strong export demand from Asia. Of note is the latest export data that shows a monthly increase of 3.0% in September, with sales to Asia 2x that to America.

 

From a policy standpoint, be it from Chancellor Angela Merkel to Finance Minister Wolfgang Schaeuble or Bundesbank President Axel Weber, the Germans continue to tout fiscal conservatism, most recently running a position to mandate that European states trim deficits to -3% of GDP or better and public debt to less than 60% (the current position of the EU’s Stability and Growth Pact) or else bear a tax (as a % of GDP) for the violation.  We think longer term this could be a viable strategy.

 

Putting fundamentals aside, there’s a clear divergence between Europe’s fiscally conservative and fiscally bloated counties on an equity basis. Year-to-date equity markets in Denmark and Sweden are up +27.7% and +17.2%, with the German DAX up +14.0%, while the PIIGS are some of the worst performers across all global indices: Greece’s ASE -31.0%; Spain’s IBEX -13.0%; Italy’s FTSE -7.3%; and Ireland’s ISEQ -7.1%. 

 

This Time Is NOT Different

 

We continue to note the seminal work of Reinhart and Rogoff, who in their book “This Time is Different”, show historically (across 800+ years) that countries reach a crisis zone of fiscal imbalance when their debt ratio is north of 90% and deficit ratio is greater than 10%. With the PIIGS largely in violation on both measures, the threat of sovereign default remains one to keep front and center.

 

While the case could be made that countries like Ireland, Portugal and Greece make up too little a share of Eurozone GDP (roughly 6.3%) to drag down the region’s outlook, two points are worth considering:

  1. Greece’s sovereign debt “crisis” in the 1H10 led to a 20% deterioration in the EUR-USD, so small economies can indeed have a significant impact, and
  2. Should Spain and Italy, economies representing ~ 28.7% of Eurozone GDP, run up further against a Sovereign Slide, we could see far greater repercussions for the region as a whole. 

Keep your risk management pants on.

 

Matthew Hedrick

Analyst

 


SBUX: VIA HOLIDAY CATALOG

Starbucks has launched a Christmas blend of their Via Ready Brew.

 

Conclusion: Starbucks Via line of ready-to-drink coffee has been a resounding success, that generating approximately $135 million in global sales for the company in retail and CPG channels in its first year.  The company continues to innovate, drive traffic, and build brand loyalty.

 

Starbucks is promoting a “Christmas Blend” of their popular Via line of instant coffee.  The product has been rolled out in some international markets, including Canada, and will be released in the U.S. soon.  I expect this to drive sales in the fourth quarter.

 

SBUX: VIA HOLIDAY CATALOG - sbux via xmas

 

SBUX: VIA HOLIDAY CATALOG - sbux via packaging

 

SBUX: VIA HOLIDAY CATALOG - sbux via xmas 1

 

SBUX: VIA HOLIDAY CATALOG - sbux via xmas 2

 

SBUX: VIA HOLIDAY CATALOG - sbux xmas via 3

 

 

Howard Penney

Managing Director


RESTAURANTS TRENDS

Conclusion:  A number of factors that influence restaurant sales trends and despite a numbers of cautious signs that should normally impact sales trends, a number of concepts continue to show improving trends. 

 

Sysco Corporation executives shared some important insight on their conference call today:

“So I think we are beginning to see some things that would hopefully lead to more positive growth for the industry.  With that said, I think what we're also continuing to see is the strongest operators are doing the best.  So it's definitely better than what it was a year ago, and it's certainly better than what it was six months ago.  I'd say it's still somewhat tenuous, but if you're a good operator out there today, you're starting to see some good signs of late despite.”

 

We also need to consider the following:

  1. The October employment numbers suggest the economy regained momentum early in the fourth quarter and sentiment certainly reflects that.  However, there were seasonal adjustments that were incorporated into the payrolls number that exaggerated the true level of job growth.
  2. Another factor limiting the upside of my perspective for restaurant stocks is the fact that both personal income and spending weakened in September.  Personal income fell 0.1%: the first decline since last September.
  3. The most recent consumer credit data also suggests that some caution may be warranted.  Restaurants have shown resilience in sales trends of late but a deleveraging consumer is a concern going forward.  The continuation of low price points despite the relatively strong sales performance of late indicates that management teams appreciate that the consumer is still under pressure.

 

Margins in the restaurant industry remain relatively robust and this is surprising to me given the high levels in food prices and the CRB foodstuffs index.   Another insightful comment from SYY today was that they are seeing 10% inflation in meat, dairy, and seafood.

 

RESTAURANTS TRENDS - knapp vs con credit

 

Howard Penney

Managing Director



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COSI - BEVERAGE INNOVATION THAT WILL GET ATTENTION

Conclusion: I continue to like COSI from a long-term perspective.  Management continues to follow through on focused revenue-driving strategies such as the “Freestyle” beverage dispensers and continued development of online systems.

 

Cosi Restaurants and Coca-Cola recently hosted a blog event in Chicago where Cosi was introducing their fall sandwiches and Coca-Cola was demonstrating their Freestyle beverage machine.

 

Coke has selected COSI to launch the Freestyle equipment in the Midwest (currently COSI has it in three locations.) The Freestyle dispensers each contain 30 cartridges of flavorings that mix up 100 different drink combinations.  The new system will give COSI more accurate inventories of the beverages they serve.   The stores will be able to view graphical drink consumption reports that rank drinks sold during specific day-parts on an e-business portal Coke has set up.  Traditionally, most fast-food restaurants collect data using point-of-sale systems that only capture beverage cup size and the number of cups sold each day.

 

For the short-term, at least, the new Coke freestyle machines will give the concept an unique advantage over the competitors in the Midwest. 

 

COSI is due to report earnings on November 11th after the market close.  The company also reported that that system-wide same-store sales for 3Q10 increased 5.2%; company-owned stores rose 6.6% and franchise-operated stores rose 2.9%.  Late in the third quarter, the company started rolling out online ordering for the company store base with which will likely accelerate growth in same store sales during 4Q.  For the quarter, we expect the company breakeven on an EPS basis and possibly even register a modest profit.  The stock is currently trading at $1.29, registering a 9% gain over the past week.

 

COSI - BEVERAGE INNOVATION THAT WILL GET ATTENTION - cosi beverage

 

Howard Penney

Managing Director


Eye on Obama: Reviewing President Obama’s Comments on 60 Minutes

Conclusion: President Obama’s post mortem on the midterm elections on 60 minutes on Sunday night provided some insight into policies that we could see evolve over the next couple of months as it relates to taxation, stimulus, and housing.

 

In the note below, we’ve highlighted some key takeaways from President Obama’s recent interview on 60 minutes with Steve Kroft.  Below are the actual quotes, and we’ve provided our interpretation of the President’s statements.  We would expect more insight in our discussion with Peter Orszag tomorrow, but it does seem that the President intends to shift more towards the middle on a fiscal basis.

_____________________________________________________________________________________________________________________________

 

PRESIDENT OBAMA: There are some sincere Republicans in the Senate like Tom Coburn, Oklahoma, who is about as conservative as they come, but a real friend of mine and somebody who has always had the courage of his convictions and not, you know, bringing pork projects back to Oklahoma. 

 

Hedgeye Interpretation:  President Obama seems to have learned the lessons of the midterms and will make a concerted effort to reach out to the Republicans.

 

PRESIDENT OBAMA:  You know I think what I would have done is to be more scrupulous about sticking to some of the commitments I had made in how to get it done. For example, I made a commitment that I was gonna make sure that the key negotiations around health care were on C-SPAN. And the truth of the matter is that, you know, you have five different committees over there that are working on it.

 

Hedgeye Interpretation:  President Obama believes one of the failures of his first two years was the promise of transparency, so look for more transparent governing in the coming two years.


PRESIDENT OBAMA:  I had a conversation here in the Oval Office with Warren Buffett, who remains very optimistic about America's long term prospects. And he said, "Look, let's take the housing market, which is about as big of a drag on the economy as anything." He said, "We overbuilt for a lot of years. Now, we're underbuilding to soak up that inventory over the course of several years. More new families are gonna go out there and start buying homes. And slowly housing prices are gonna stabilize. And these foreclosures are gonna end and things are gonna pick up." So, some of it is just a matter of the economy recovering from a real trauma, a real body blow.

 

Hedgeye Interpretation:  It seems that President Obama may be leaning towards a more market based solution to a recovery in housing, which is that over time supply and demand will come back into balance; rather than further government intervention.

 

KROFT: Congressman Boehner is the next Speaker of the House, most likely, offered you a compromise back in September. He suggested extending the tax break for the wealthiest for two more years. And rolling back discretionary government spending to levels before the bailout in 2008. Is that something that you could live with?

PRESIDENT OBAMA: I think that when we start getting specific like that, there's a basis for a conversation. I think what that means is that, you know, we can look at what the budget projections are. We can think about what the economy needs right now. Given that it's still weak. And hopefully, we can agree on a set of facts that leads to a compromise. But my number one priority coming into this is making sure that middle class families don't see their tax rates go up January 1st.”

 

Hedgeye Interpretation:  Taxation policy will likely include some form of an extension of the Bush tax cuts, and will likely be more to the middle than we would have expected even a couple of months ago.   We would expect Obama to give in to Republican wishes and kick the can down the road over the next two years.

PRESIDENT OBAMA: The truth is that the way this thing works out, it's folks who are millionaires and billionaires who get the biggest breaks. And, you know, if you talk to Warren Buffett, he'll tell you, "I'm not gonna buy somethin' because of a tax break, because whatever it is I need, I can already afford." And the same is true for me. And the same is true for you.

 

Hedgeye Interpretation: While Obama might cave to the Republicans on taxation, it will be a negotiation and he will have the likes of Warren Buffett supporting his case.

 

PRESIDENT OBAMA: Well, it wasn't because The Recovery Act didn't work; it's because the modeling, in terms of what to expect where unemployment would go to, turned out to be wrong. So, you know, I don't wanna pretend like I've got a crystal ball.

 

Hedgeye Interpretation:  If you want to know why Christina Romer is back at Stanford, now you know.  Her models were wrong.  This explicit call-out suggests that Obama will hold more of his cabinet accountable to specific goals, especially on the economic front. 

 

Daryl G. Jones
Managing Director


Brazilian Consumer Update

Conclusion: All told, we continue to remain favorably disposed to the Brazilian consumer, which is being supported by a significant confluence of tailwinds. We are, however, not currently invested in Brazil at this current juncture, as the outperformance looks to be in the rear view for the immediate term.

 

Consumer Credit Demand Falls in October, though Still Robust

Credit analyst agency Serasa Experian reports the number of consumers seeking credit fell 3.2% MoM in October, after setting a record in September.  Experian says this decline does not represent a shift in the trajectory of consumer credit, as it is primarily a calendar effect because of the observance of Children’s Day in September, and because October had two fewer business days.  Year-over-year, demand for consumer credit was up 15.2% in October and up 15.7% YTD, versus the year-ago period.

 

Brazil’s Relatively High Cost of Living

A report in O Globo finds common articles in Brazil can cost as much as six times as much as in other countries.  Examples include PlayStation 3, which costs R$ 2,000 in Brazil, four times the US price of US$300 (R$ 510).

 

A comparison of automobile prices found the Toyota Corolla XEI costs R$ 75,000 in Brazil, versus the equivalent of R$ 58,740 in South Africa, R$ 33,782 in Japan, and R$ 32,797 in the US.  Consumer advocates say this is largely attributable to high taxes and import duties, as well as to a corporate culture of maintaining exorbitant profit margins.

 

We think there may be significant market inefficiencies at work, as the O Globo report notes the nation’s consumer market is still evolving and lacks broad reference prices.  Also, there is still a cultural bias that foreign manufactured products are more luxurious than domestic manufacture.  Brazilians have a penchant for buying certain items overseas – even paying the 50% duty to bring in items over the US$ 500 personal limit on dutiable purchases.

 

Vehicle Production Rises, Sales Fall

Brazilian auto manufacturers produced 321,800 vehicles in October, 5.5% higher than September and up 1.5% over last year.  Sales for October fell 1.3%, to 303,200 units, which is still 3% higher than October 2009. 

 

All told, we continue to remain favorably disposed to the Brazilian consumer, which is being supported by a significant confluence of tailwinds. Brazil’s unemployment rate fell 50bps MoM to a record low in August, coming in at 6.2%. Average real incomes also increased +1.3% MoM and +6.2% YoY and the latest data (April-July) show Brazilian consumer borrowing rates are at the lowest level since 1995 (6.74% per month).

 

We are, however, not currently invested in Brazil at this current juncture, as the outperformance looks to be in the rear view for the immediate term. As of the end of last week, the six largest Brazilian retailers had P/E ratios that were over 3x those of the underlying Bovespa Index, suggesting there is some mean reversion to be had to the downside.

 

Moshe Silver

Managing Director

 

Brazilian Consumer Update - 1


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