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.




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.




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


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



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




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



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



India’s Two Big Problems - 3


Conclusion:  There is no near-term upside for Burger King Franchisees as the brand is being hit with both weak top-line trends and higher beef costs.  The recent sale of the company has more than angered a number of key franchisees.  Guess what, they want out!


TAST’s Burger King trends decelerated during the third quarter, with same-store sales coming in -3.2% versus -6.1% a year ago.  On a two-year average basis, this implies a 160 bp slowdown from the prior quarter.  And, comparable sales growth continued to be weak in October, -3.5% (relatively flat on a two-year average basis with 3Q10 level). 


Making matters worse for the Burger King franchisee, beef costs were up 17.5% YOY.  Profitability was also hurt during the quarter by the concept’s promotional offerings.  Beef usage was actually up 9.1% YOY due to the increased mix of lower priced burgers.  Given the company’s outlook for comp sales to be down 3 to 4% in FY10 (implies -1 to -5% in 4Q10) and commodity costs at Burger King to be up 4 to 5% in FY10 and up about 3% FY11, there does not seem to be any near-term upside. 


The only seemingly good news for the brand stemmed from Burger King’s breakfast daypart as sales have improved following the concept’s new breakfast offering, supported by advertising.  The results are still early as the new breakfast promotion only launched in mid-September, but breakfast sales have grown to 16 to 17% of sales from 13 to 14%.  The stronger breakfast trends, however, have been offset by continued weakness during lunch and dinner.  That being said, TAST management stated that it remains cautious with respect to a near-term turnaround at Burger King, but they are “hopeful” that they are nearing the bottom of the cycle.



Management highlighted the recent ownership and management changes at Burger King Corporation and said they are awaiting the brand’s new marketing plans.  Specifically, TAST management said they expect Burger King’s new management should be able to revitalize the brand. 



Although the last comment seems to express some level of confidence in Burger King’s new management and the future success of the brand, what followed was less than bullish commentary about the Burger King brand, at least as it relates to its security as a brand within Carrols Restaurant Group, Inc:


“We, as I said are basically a company that is in transition, we recognize that our inventory of business is being a franchisee in the Burger King system and being owner operator of two very vibrant Hispanic brands may appear, and probably is, somewhat unnatural in terms of attracting investors and it becomes a very high priority for us to make ourselves look a little more natural for the investor public and will continue to pursue that possibility. We're very bullish on our Hispanic brand and their ability to provide long-term sustainable growth. “


Given that management thinks they need to make the company “look a little more natural for the investor public,” will pursue that opportunity and is bullish about its Hispanic brands, implies to me that the company would be happy to exit the Burger King franchising business if offered the right price.


These comments also highlight the broader Burger King franchisee community’s anger with Burger King Corporation, particularly as it relates to the company’s recent sale.  Franchisees are fed up!


Howard Penney

Managing Director

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