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DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE

 

The following is an in-depth look at consumer credit published by Hedgeye's Financials team.  If you're expecting a meaningful pickup in consumer leverage you may want to think again-

 

 

Consumers Are Delevering, Make No Mistake ... Importantly, This Will Go on For Years to Come

For those unclear on whether the consumer is delevering, relevering or just taking a breather, we offer some data below aimed at clarifying the matter. There are three pieces to consumer debt: mortgage debt, credit card debt and installment debt (auto loans and student loans). We take a look at each one below for clues on what the trend is and where things are likely headed.

 

Overall Debt

The place to start is looking at total household debt. We've combined household mortgage debt, credit card debt and consumer installment debt in the charts below to show the trend.

 

The first chart shows total household debt rose sharply from 2004 to 2Q08, increasing 31.6% in just three and a half years to a record $13.8 trillion dollars. Since 2Q08, every quarter has been marked by a reduction in household debt. In total, consumers have shaved some $701 billion or 5.1% off the 2Q08 total in the last two years.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - Total 1

 

The second chart is arguably the most interesting chart in this report. It shows the year-over-year change (%) in total household debt looking back over the last seven quarters. The trend is unambiguous. Total household debt is declining, and it is declining at an accelerating rate. For 2Q10, total household debt was falling at a rate of 3.4% year-over-year, the fastest rate of decline since the start of the recession.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - Total 2

 

Next, we look at the three components of total household debt independently and offer our view and interpretation of each series.

 

Mortgage Debt

Mortgage debt is the largest piece of consumer debt.  Out of approximately $13 trillion in total consumer credit, mortgage debt represents $10.6 trillion, or 81.5%.

 

This first chart shows the evolution of the housing stock in America on which there is mortgage debt. The blue line represents the total value of the encumbered housing stock, while the red line represents total mortgage debt. The green line at the bottom is the difference, or the aggregate equity value of that housing stock. The purple line is the Case-Shiller 20-city index included to explain the change in the value of the encumbered housing stock.

 

The takeaways are twofold. First, as this chart shows, just because housing values fall doesn't mean that the debt that was incurred to buy them goes away - it doesn't. It sticks around for a long time, as this country is finding out. Second, there is relatively little collective equity backstopping the housing market. A relatively small 12% decline in home prices from here would wipe it out completely.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - mortgage debt

 

The next chart highlights just the debt portion of the above chart. Household mortgage debt rose 35.4% ($3.0 trillion) to $11.2 trillion in 1Q08, and has since fallen 5.0% ($556 billion).

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - mortgage debt 2

 

Next we show the aggregate equity position and LTV for the encumbered housing stock of America. For a frame of reference, let's think about how long it will take for LTV ratios to come back simply to where they were five years ago, circa 2004-2005. This seems like a reasonable yardstick, as this was a period of profligate consumer spending - what the market is hoping we'll see a return to. Currently the aggregate LTV of all mortgage holders is 88.4%. We are bearish on the outlook for home prices, and, as such, we assume there is unlikely to be any material appreciation, even in nominal terms, for a long time.

 

Consider the following example. Imagine that the US encumbered housing market is an analog to one household with one big mortgage. Assume that their home wasn't going to rise in value for many years. Assume that they have a 30-year mortgage that they're 3-4 years into at a 5.5% rate. The home is worth $175,000 and they have a $154,700 mortgage (88.4% LTV). Assume they aren't interested in taking on more debt until that LTV gets back to where it was in 2004-2005, namely in the 60-62% range. Calculating the amortization, you'll find that it will be 14-16 years before this household pays down its mortgage to levels consistent with a 60-62% LTV. We're aware that this analysis relies on several key assumptions. The point, however, is that even with modest inflation in home prices it will be many years before these LTVs get back to levels consistent with even those observed in the middle part of this past decade.

 

Ultimately, we expect 10-15 years could pass before LTVs get back down to a level where releveraging can begin. This conclusion is profoundly different than most other predictions about when leverage will resume.  

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - mortgage debt 3

 

For those who think that mortgage debt doesn't matter as a growth channel for the commercial banks, think again. The oft-held assumption that most of the mortgages in America are at Fannie and Freddie is missing the point. As the chart below shows, of the $10.6 trillion in household mortgage debt outstanding, roughly 27%, or $2.86 trillion is held by commercial banks. For reference, commercial banks hold $6.2 trillion in total loans, so to anyone who would argue that a prospective decade-long deleveraging in household mortgage debt doesn't matter to the growth prospects of the banks we would suggest otherwise.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - mortgage debt 4

 

 

Credit Card Debt

Credit card debt is an important piece of the puzzle, but at $822 billion it now only represents 6.4% of the total, down from 7.6% in 2004.

 

The first chart shows that credit card debt, in aggregate, has fallen 15.5% since Lehman's bankruptcy, a cumulative decline of $151 billion dollars.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - credit card 1

 

The second chart shows the year-over-year growth rate of total credit card debt. While there was a clear inflection point in February, 2010, we would caution strongly against getting overly excited here. Extrapolating the trajectory over the last six months, it will take two years for credit card debt to stop shrinking, and we doubt that growth thereafter will exceed GDP growth.  Our firm expects that in light of the United States' high and rising debt to GDP, GDP growth will remain in the low 1% range for many years to come. Now some might point out the positive marginal benefits of a less bad year-over-year reduction in revolving consumer credit, and there's truth in that. However, it's a long way from assuming that balances stabilize to assuming that growth returns to pre-Lehman rates.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - credit card 2

 

The next chart shows the magnitude of the reduction of credit card debt over a longer time period - going back to 1968 - the inception of the series. We've never seen anything even remotely comparable to the paydown being seen today. This should tell you that there is a wholesale consumer mind shift taking place with respect to their attitudes around credit.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - credit card 3

 

The following chart shows the rate of change expressed as month-over-month annualized. This is the way in which the Federal Reserve reports the data.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - credit card 4

 

 

Installment Debt (Auto Loans & Student Loans along with Miscellaneous, i.e. RV loans, etc)

Finally, installment debt is $1.6 trillion, or 12.2% of total consumer debt, with auto loans the vast majority of that (~80%). Installment debt has remained steady throughout this recessions principally because of the auto piece. A car has become a mainstay of today's economy. The vast majority of Americans need a car to work or to do anything, outside of a handful of densely-populated cities. As such, it is not surprising to see installment debt remain relatively stable during recessions. It's also worth pointing out that an important driver here may be the fact that the much smaller piece of installment loans, namely student loans (~15%), is still growing so fast that it offsets a nominal rate of decline in auto loans leading the overall installment loan category to appear flat to down only slightly.

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - installment 1

 

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - installment 2

DEBUNKING MYTHS ABOUT CONSUMERS RETURNING TO LEVERAGE - installment 3

Conclusion

We doubt that consumers will come back to the debt trough anytime soon.  The ultimate gate on further consumer relevering is the housing market. Consumers conceptualize their debt in totality, taking all the pieces in aggregate, and they evaluate their debt relative to their income and their wealth. The lost value in their housing wealth is profound for most families across America. This will, on the margin, keep them wary of taking on more debt for many years to come. For those who believe that old habits will swiftly return, we think the above analysis offers reasonable doubt. We wouldn't bank on a return to profligate, debt-fueled consumer spending anytime soon.

 

 

Joshua Steiner, CFA

 

Allison Kaptur


OUTLOOK FOR BRAZILIAN INTEREST RATES: READ THE FINE PRINT

Conclusion: We see Brazilian interest rates increasing over the intermediate term as president-elect Dilma Rousseff will likely fail to contain inflation early in her term.

 

Brazil’s CPI accelerated meaningfully in October to +5.2% YoY from +4.7% YoY in September, marking the second straight monthly acceleration from its August low of +4.5% YoY. Driven largely by gains in food prices (57% of the increase), October’s CPI report comes in line with our expectations for accelerating inflation globally on the heels of QE2-based speculation, as Bernanke dares investors to lever up and chase yield globally.

 

OUTLOOK FOR BRAZILIAN INTEREST RATES: READ THE FINE PRINT - 1

 

More specifically as it pertains to the Brazilian economy, we’re starting to see interesting commentary out of president-elect Dilma Rousseff regarding the direction of public spending and fiscal policy. Moreover, two blatant shifts in rhetoric have her playing right into our expectations that she will be unable to contain public spending and debt accrual early in her term:

 

On the campaign trail, Rousseff vowed to reduce Brazil’s public debt to 28-30% of GDP from the current 42% by 2014. Now she is only committing to a more modest 400bps reduction over an unspecified period. Also, as recently as 11/3, she said she is seriously considering raising the monthly minimum wage to more than 700 reais ($412) by 2014 for a CAGR of 8.2%, which is greater than the 5.5% increase in 2011 under current President Lula’s budget. Further potential strains to the government’s budget include her commitment to reducing payroll taxes, levies on investment and taxes on prescription drugs, sanitation and electricity.

 

The Brazilian bond market has reacted in line with the aforementioned shifts in rhetoric. Yields on Brazil’s most actively traded debt due in 2017 have hiked 74bps since 10/15, which is roughly around the time it became evident that Rousseff would win the runoff presidential election set for 10/31. In addition to the Dilma factor, the Brazilian bond market has been correctly pricing in accelerating inflation since foreign investor participation became marginalized as a result of the central bank’s recent tax hikes on foreign inflows of capital. The Brazilian bond market is no longer just an attractive market for foreign yield-chasing capital; as such, the domestic investor base is re-pricing Brazilian government bonds as a result of their more-informed outlook for Brazilian inflation.

 

OUTLOOK FOR BRAZILIAN INTEREST RATES: READ THE FINE PRINT - 2

 

Further supporting the outlook for accelerated inflation is a healthy and robust Brazilian consumer base, which is being supported by a significant confluence of tailwinds: Brazil’s unemployment rate decelerated 50bps MoM to a record low in September, 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).

 

All told, the direction of fiscal policy and consumer demand will continue to put upward pressure on Brazilian inflation and interest rates over the intermediate-to-long term, necessitating the need for future rate hikes. While we don’t currently have a position, we remain favorably disposed to the Brazilian real against the U.S. Dollar over the long term, largely based on diverging growth prospects. Furthermore, we remain bullish on the Brazilian consumer as one of the top long-term TAIL consumer plays in global macro. The intermediate term inflation and interest rate headwinds are, however, something to consider as it relates to the entry/exit timing on any investments.

 

Darius Dale

Analyst


Europe’s Crisis in Confidence

This note was originally published at 8am this morning, November 09, 2010. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“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

 


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JCP, JNY, CRI, SKX? 2007 All Over Again

Predictably, we’re seeing the 13D/F filings pick up meaningfully in Retail. Why not??? We’re at the point where average/poor CEOs are facing the music as it relates to negative organic growth due to poor planning and investment in growth during the recent downturn. They’re either blowing up, buying growth, or both. With the cost of borrowing just about as close to Japan as it can get, and the M&A cycle at the lowest level in almost 2 decades, M&A activity seemingly has only one way to go. That’s higher.

 

We’re seeing that with weak companies like JNY that need to add opacity to its model by doing deals. Anyone see the Cramer segment where he asked Wes Card (JNY CEO) why he is not buying back stock? Wes answered by saying that he’d rather buy other businesses than his own. I kid you not.

 

Yes, it’s 2007 all over again.

 

With that, we’re seeing investors get a step ahead of the game. Three that come to mind are JCP, CRI, and SKX – all of which represent different approaches.

 

JCP and CRI are two of our favorite fundamental shorts. Both are at peak margins, and face a material unfavorable change in secular, cyclical as well as near-term headwinds. We’ve been vocal about this in our work. I guess Ackman and Berkshire Partners don’t care as it relates to JCP and CRI, respectively.

 

SKX (Tiger Consumer) is an example of an investor stepping up in the face of management shooting itself in the toning shoe. This is going to be a long healing process for SKX – at least 3 quarters. But the reality is that it has a relevant brand in a more defendable space with far less exposure to raw material cross currents (esp cotton). Again, we think it’s too early to get involved here. But ultimately, there is value. It’s all about duration.

 

 JCP, JNY, CRI, SKX? 2007 All Over Again - 11 9 10 post

 

 


THE CONSCIENCE OF A HEDGEYE

Ignoring real-time data is not part of our process and we would suggest that you make sure it does not become part of yours.

 

The constant pace of the posting on the topic from one certain academic is enough to tell you that the inflation-deflation debate is here to stay.  What is not here to stay, it seems, is basic common sense.  All the accolades in the world (deserved or not) are merely noise when simple logic is cast to one side for the sake of an unyielding loyalty to one idea.

 

Yes, our favorite – and most dogmatic – correspondent from the Ivory Tower is apparently dissatisfied with the focus on commodity prices as an indication of inflation.  Today, Professor Krugman has enlightened us to the fact that “commodity prices are a global phenomenon, driven by world demand” and that the “United States doesn’t drive these things”.  Looking at the math instead of paying heed to dogma, we have seen on a daily basis over the last number of months that the inverse correlation between the dollar and commodity prices has been extremely high during the recent melt up in commodity prices.  The prices of oil, copper, cotton, and other key commodities are denominated in dollars.  When Federal Reserve policy debases the dollar, the prices of commodities denominated in dollars go up.  Other factors also impact commodity prices, of course, but to ignore the real-time prices and the fact that commodities are denominate in dollars is – in my view – ridiculous. 

 

We are maintaining our stance that the Federal Reserve’s policy of Quantitative Guessing will result in inflation.  QG=i.  The world is not waiting hear the selection-biased views of academics on this.  The World Bank, Dai Xianglong, Chairman of China’s National Council for Social Security Fund, and German Finance Minister Wolfgang Schäuble have all recently expressed strong reservations about QE2 and its impact on the dollar and global asset bubbles.

 

Since the Bernanke speech in Jackson Hole in August, the eight commodities and two commodity indices shown in the chart below have gained an average of 40% in price and 26% if you exclude the 170% move in Cotton.  No, it’s not “core” inflation; it’s “real” inflation that reflects a significant portion of what every US consumer consumes.  More importantly, it’s a regressive tax on consumer spending, especially for the middle class.  So who is going to pay the inflation tax?  A segment on NPR Radio yesterday morning outlined the hindrance that rising gas prices poses for the U.S. economy.  One commentator on the segment quantified a $10 rise in oil prices as a $200 million tax on the economy per day.

 

As it stands, the earnings and guidance from corporate America are not reflecting a slowdown in demand from the inflation tax or any significant pressure to margins.  The past earnings season has been one of the strongest in recent memory as measured by Bloomberg’s forward guidance index.  The index looks at the comparison between the companies forecast and the consensus analyst estimate.  The trend of companies reporting positive guidance versus negative guidance has accelerated for four straight weeks.

 

In the upcoming quarters, something will need to give way and it will likely not be The Conscience of a Liberal.  Ironically, The Conscience will be in New Haven today and will likely be hearing from The Conscience of a Hedgeye!

 

Howard Penney

Managing Director

 

THE CONSCIENCE OF A HEDGEYE - jackson hole inflation

 

THE CONSCIENCE OF A HEDGEYE - strong earnings


India’s Two Big Problems

Conclusion: We expect inflation to continue to be a major headwind for the Indian economy and we see further tightening on the horizon. In addition, the potential for destabilizing withdrawals of foreign investment has breached its 2007 highs, which suggest Indian equities could experience major declines should global markets come under pressure.

 

Position: Bearish on Indian Equities

 

In line with our call that 1) global growth is slowing 2) inflation is accelerating and 3) global interconnected risk remains near all-time highs, we’ve been making a series of contrarian calls of late – none larger than our recent decision to short U.S. Equities (SPY) and go long the U.S. dollar (UUP). We don’t wake up every day trying to be perpetually bullish or bearish; rather our proprietary risk management models are signaling to us deterioration in the economic fundamentals of several key countries globally.

 

India is one of the countries we’ve had our eye on of late. While we tip our hats to India’s long-term TAIL outlook for growth and development, we are becoming increasingly cognizant of the two near-to-intermediate-term risks to Indian equities. Those risks are: 

  1. The potential for accelerating inflation and further tightening; and
  2. The potential for destabilizing withdrawals of foreign investment 

On the inflation front, there are several factors at play here. India, like many other countries in the developing world has been struggling to contain inflation, which is currently running at more than double the target rate (+8.6% YoY in September). Accordingly, India’s central bank has hiked its benchmark interest rates six times this year to the current 6.25% (RBI Repo Rate) and 5.25% (RBI Reverse Repo Rate).

 

Central bank governor Duvvuri Subbarao said at a recent press conference that India probably won’t raise interest rates in the immediate future barring any shocks, which suggests they are comfortable with letting their actions take effect for now. Further, they expect inflation to decelerate to a more tolerable +5% YoY rate by March 2011.

 

We are much less comfortable with that projection, given the recent global speculation brought on by QE2 and Bernanke’s dare for investors to chase yield. That dare has been and is continuing to be an issue for the Indian economy, given the recent price moves in many commodities globally. Since Heli-Ben called his shot in Jackson Hole on 8/27, the Reuters CRB Commodities Index is up nearly 20%. Even more astonishing are the price moves in many agricultural commodities over the same period: Soybeans (+26%); Rice (+32%); Corn (+36%); Oats (+41%); and Sugar (+65%). If commodity prices stay at/near current levels, we don’t see any reason for India’s benchmark WPI index to decelerate in any meaningful way.

 

India’s Two Big Problems - 1

 

Despite India having  roughly 816 million citizens who live on less than $2/day at PPP – with food being their largest expense – India’s central bank has shifted its stance on the margin towards supporting Indian manufactures and investors by choosing not to support further rupee strength via additional rate hikes (up  4.7% vs. the U.S. dollar YTD). Rather, it has chosen to embark on its own version of QE2, buying back 83.5 billion rupees of government bonds on 11/4 to help ease a cash shortage among Indian banks – an action not taken since September 2009.

 

In recent weeks, Indian banks have been borrowing anywhere between 500 billion and 1.2 trillion rupees per day in overnight loans from the central bank to meet record demand from investors for loans, as well as new capital requirements. Bank lending has accelerated to +21% YoY through October, buoyed in part by investor demand for state asset sales (i.e. Coal India Ltd’s recent IPO) and Indian banks and corporates’ demand for dollar-denominated borrowing, which are at ten year highs, according to Bloomberg data. On 11/2, the RBI asked commercial banks to increase provisions for home loans of 7.5 million rupees and above and for floating rate mortgages as well.

 

All told, the cash shortage has dampened Indian lenders’ ability to fuel burgeoning speculative demand for Indian assets; as such, Money Supply (M3) has fallen to a near-five-year low (+15% YoY) in the two weeks through mid-October:

 

India’s Two Big Problems - 2

 

What irks our Hedgeye’s is the RBI’s recent decision to aid the speculation by helping banks raise cash in their recently-announced version of QE2-lite. We understand the India is a robust and growing economy with a great deal of internal demand; nevertheless, we see the RBI’s recent actions and tone shift as a major potential hindrance in their bout with inflation. As such, we expect a) inflation to continue to dampen Indian corporate profits as both COGS and borrowing costs remain elevated (rates on three-month commercial paper issued by Indian companies have nearly doubled this year to 8.16%) and b) further monetary policy tightening on the horizon once the RBI grows uncomfortable with the growth rate of speculative lending.

 

On the global speculation front, the yield-chasing frenzy inspired by dovish monetary policy in the developed world (namely the U.S. and the E.U.) and QE2 speculation has prompted foreign investors to buy a total of $35.5 billion of Indian equities and bonds YTD – up 93% YoY vs. the full-year 2009 total of $18.4 billion. In recent months we’ve seen India get more comfortable with foreign participation in their capital markets, as evidenced by Prime Minsiter Manmohan Singh’s recent decision to increase the overseas investment cap on Indian government and corporate bonds by $5 billion to $30 billion each. In light of such favorability, foreign holdings of India’s corporate and government debt has more than doubled in 2010 to a record $17.4 billion as of September.

 

Two things here are cause for alarm in our opinion: 1) foreign investor participation is volatile and can be withdrawn in a heartbeat and 2) India itself may eventually clamp down on yield-chasing capital seeking to enter the country as it did in October 2007 – just three months before the prior peak in the Sensex. Keep in mind that foreign investors withdrew $14.84 billion from Indian equities in 2008, which contributed to the 2008-09 crash in the Sensex. At $15.62 billion through September of this year, foreign investors have plowed capital back into India equities, which suggests a substantial amount of damage could be done should they feel compelled to withdraw for any reason.

 

As we mentioned at the outset of this report, interconnected global risk continues to remain quite elevated and global risk aversion will surely lead to a major correction in the Sensex, which is trading near its all-time high. To that point, since Bernanke dared the world to lever up and take on risk in Jackson Hole on 8/27, the Sensex is up +16.3% and has an inverse correlation of 0.91 to the U.S. dollar. Should the dollar catch a meaningful bid over the near-to-intermediate term, which we believe it will for a variety of reasons (not the least of which are accelerating sovereign debt concerns out of Europe’s periphery), expect to see a major correction in Indian equities.

 

Darius Dale

Analyst

 

India’s Two Big Problems - 3


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