U.S. Federal Budget Deficit . . . Not Getting Better

Conclusion:  The U.S. Federal budget deficit sees little improvement with the December numbers reported today.  The Congressional Budget Office’s estimates for the deficit will likely be going much higher when its new projections come out in the coming weeks.


Positions: Long the U.S. Dollar via UUP; Short 1-3YR Treasuries via SHY


While the U.S. budget deficit for December came in line with consensus at a deficit of -$80BN, the question is really whether consensus matters.  As it relates to the budget deficits, we would argue that where the number comes in versus consensus is really irrelevant as compared to the degree of change sequentially and on a year-over-year basis.  The key takeaway for the first three months of the federal budget year is that deficit issue is not getting better.


As it relates to the key line items for the first quarter of the fiscal year, this is what was reported: 

  • Expenditures continue to grow and for the first quarter are up 3% on a y-o-y basis;
  • Net interest expense on debt is up 9.5% y-o-y and is now almost 7% of total government expenditures (we are seeing the negative impact of more debt and higher interest rates); and
  • Finally, if we normalize for TARP, the overall deficit for the first quarter is -$372BN, which is an increase over -$369BN in the same period last year.

To be fair to the federal government, they offered that a number of timing issues that may be distorting this year’s numbers versus last year (calendar issues and the timing of insurance payments).  From our perspective, we would expect these timing issues to normalize over the course of the year and have no real way of backing them out.  Therefore, when we look at the numbers we normalize for 1-time payments or expenditures only, which in the case of our analysis are TARP and payments to GSEs.


A key take away from this report is that the Congressional Budget Office is going to have to take up its budget deficit projections for fiscal 2011.  The last update on annual budget projections came in August of 2010 and fiscal 2011 was projected to have a budget deficit of -$1,066BN, which would have been more than ~ -$230BN less than the actual budget deficit in fiscal 2010, or a 17% improvement.  Given that we are seeing minimal improvement in the deficit the CBO will likely have to dramatically take up its estimates for this year and perhaps the next couple years.  The new estimates are expected to be released later this month and will be a catalyst to be focused on.


Just as a refresher, the current budget deficit projections for the next three years are: 

  • 2011 - $1,066BN;
  • 2012 - $665BN; and
  • 2013 - $525BN

These projections will be going higher, and likely dramatically so in the coming weeks.


This report and its implications that future estimates need to go higher will be coming at a very opportune time for Republicans in Congress who have made deficit reduction one of their hallmark issues heading into the 112th Congress.  This report only adds more credibility to the case of deficit hawks like Ron Paul who will have the conch in coming weeks.


Daryl G. Jones
Managing Director

The Muni Bond Market: Silent But Deadly

Conclusion: The $2.9 trillion municipal bond market is poised to make headlines and rattle global financial markets in 2011. Keep this threat front and center on your “white board” of interconnected risk.


Position: Short Muni Bonds via the etf MUB


Quite frankly, it amazes us at Hedgeye how little attention investors are paying to interconnected risk over the last 2-3 months. While the trajectory of US economic fundamentals over this time frame can be debated, we don’t see any signs of abatement in some key domestic risks playing out literally right under our collective noses.


Housing Headwinds, originally introduced back in 2Q10 by Josh Steiner, our Managing Director of Financials, continue to matriculate. US housing prices are declining at an accelerating rate in 3 of the 4 indexes we track – even from depressed levels of comparison. We expect something in order of 15-20% further downside by year’s end.


The Muni Bond Market: Silent But Deadly - 1


Identifying the interconnectedness of this risk as it relates to the muni bond market leads us to another interesting chart. Local Government Property Tax Receipts grew +7.7% YoY in 3Q10, the second consecutive quarter of growth. Since their tax assessments and property appraisals operate on a ~3YR lag, this trend is not sustainable, as State & Local Property Tax Receipts correlate positively with a 0.97 r² to the S&P/Case-Shiller Home Price Index when lagged three years.


The Muni Bond Market: Silent But Deadly - 2


The Muni Bond Market: Silent But Deadly - 3


Given that local governments collect roughly 97% of all Property Tax Receipts, representing ~26% of their revenue, we smell trouble on the way for already-strained municipal budgets. Further exacerbating budgetary headwinds is the accelerating amount of fiscal austerity going on at the State and Federal levels, roughly 30% and 4% of municipal government revenues, respectively.


Since January 1st (LESS THAN TWO WEEKS), we’ve seen a drastic amount of fiscal conservatism and budget-slashing proposals at the State & Federal level. Some highlights include (not at all limited to): 

  • FEDERAL: $100B in spending cuts proposed by House Republicans from non-defense, discretionary spending;
  • CA: $12.5B in spending cuts proposed by new Governor Jerry Brown which targets: $1.7B in healthcare, $1.5B in welfare, $1.4B in public universities and community colleges, 10% of all employment costs – each with the intention of approval by March; Additional proposal pushing an extension of 2009’s “temporary” tax increase ($9.3B); Recently ordered the recall of ~48k government-paid mobile phones, which could save ~$20M;
  • IL: Just passed a +67% income tax increase, upping the State income tax rate to 5% from 3% through 2014;
  • OH: Pushing legislation that would ban strikes by public school teachers and a proposal to prevent State-financed social workers from forming unions;
  • NJ: Proposal to undue a 9% pension increase which was enacted in 2001;
  • NY: Proposal to save $200-$400M by implementing a one-year freeze for State workers and a proposal to cut $2.1B in Medicaid outlays in FY12;
  • TX: Plans to cut $4.3B from spending on education and health & human services; and
  • WI: Pushing legislation that would prevent public sector employees from forming unions and bargain contracts. 

Just last week, House Budget Committee Chairman Paul Ryan (R. WI) had this to say on the prospect of a Federal bailout for a distressed States:


“We are not interested in a bailout… Should taxpayers in frugal states be bailing out taxpayers in profligate states? Should taxpayers in Indiana, who have paid their bills on time, who have done their job fiscally, be bailing out Californians, who haven’t? No, that’s a moral hazard we are not interested in creating… If we bailed out one state, then all of the debt of all of the states is not just implied, it’s almost explicitly put on the books of the federal government.” 


In all reality, the likelihood of the Federal government having to bail out a US State in this fiscal year or the next is extremely low (no disrespect to Meredith Whitney, who is calling for 50-100 “meaningful defaults in 2011 on the order of “hundreds of billions of dollars”). In fact, no State has defaulted since Arkansas did back in 1933.


Where this hard line on future aid really impacts the US economy is at the municipal level, where both State aid and Federal support are running dry after two years of stimulus spending. Given this headwind and the upward trajectory of interest rates, we do believe there is a substantial risk for a meaningful amount of local governments and local authorities to default or declare bankruptcy in 2011. By meaningful, we mean enough to make negative headlines and rattle the US debt market, which has far-reaching implications beyond that.


The Muni Bond Market: Silent But Deadly - 4


According to Chapman & Cutler, as Chicago Law firm, only five municipalities sought bankruptcy protection in 2010 (-50% YoY), with the largest being a South Carolina toll road restructuring $300M. We are essentially witnessing (with some ignoring) the calm before the storm. It’s important to note that we don’t think all municipal issuers are created equal; there will certainly be a dichotomy formed amongst issuer credit quality – much like there is in Europe’s Sovereign Debt Dichotomy (PIIGS vs. Germany, Sweden, and Norway).


In light of the Municipal Debt Dichotomy, some of the biggest buyers of municipal debt (including Berkshire Hathaway, Liberty Mutual and Allstate Corp.) have been using the current “calm” as an opportunity to decrease their exposure, unloading muni bonds to some investors who view the 5.67% average YTM as “an excellent source of yield” and “a terrific bargain”.


The Muni Bond Market: Silent But Deadly - 5


When it all said and done, everything has a price. What makes this game fun is figuring out what that price will be at the end of a specified duration. Over the intermediate-term TREND, we at Hedgeye think muni bond yields are poised to continue their upward trajectory at an accelerating rate in the face of material deteriorations in their fundamentals. How much this shakes global financial markets is a question we will attempt to answer each day along the way.


Darius Dale


Greek-Turkish Border Issues

As the world is tuned in to Europe again this week due to the numerous bond auctions and the region’s ever-present sovereign debt risks, an important policy decision was reached on Monday regarding the looming issue to contain the influx of illegal immigrants to Europe via Greece along its border with Turkey.


While Greece had outlined a plan over the weekend to construct a fence or wall along its 206km (or 128 mile) border with Turkey, a stretch of land where the majority of refugees enter the EU, on Monday Greece revised its plans and said it will construct a defense barrier along a 12km stretch prone to the most illegal crossings located in the north-east of the country.


Greece has already made it clear to the EU that it cannot cope with the numbers of migrants (in particular from Asia and Africa) arriving illegally. The European Commission estimates that more than 80% of illegal immigrants enter the EU via the border with Greece, and according to Frontex, the EU border agency that patrols the area, there was a 369% increase in the number of illegal immigrants crossing the northern Greek border in the nine months through September 2010 versus the previous year.


Obviously, the figures are staggering and the problem is real. As it relates more broadly to Europe, we’d expect governments to push measures to limit illegal immigration as growth forecast are strained in 2011 and 2012 and as governments push through budget consolidations (austerity) over the next years. 


While this subject can be debated from a number of angles, the German publication Der Spiegel did a wonderful job presenting commentary from various German media sources that express differing viewpoints, all of which help to frame the debate. We include this commentary below:


The center-right Frankfurter Allgemeine Zeitung writes:


"The fact that Athens is considering the construction of a massive wall along its border with Turkey is absurd, given that both are members of NATO. It gives us a foretaste of what would happen if Turkey is, one day, accepted into the European Union. Europe's doors would be thrown wide open. At the same time, no one should kid themselves that a fence would stop people wanting to cross the border."


The weekly Die Zeit writes:


"This is a trouble spot: More than 100,000 illegal immigrants crossed the border here last year. Nine out of every 10 refugees fleeing poverty arrive in the EU via this route. The placement of 200 border guards here in November has stemmed the number of immigrants but not halted it. Now around 200 illegal immigrants arrive every night, but before the deployment of European Frontex guards, that figure was as high as 450."


The center-left Süddeutsche Zeitung writes:


"The Greek plan was clearly an act of despair… There are clear signs that the erection of a fence or a new wall at the Evros border river will not solve the core problem but rather shift it elsewhere. Illegal immigration does not take place along clearly defined routes; it is controlled by those criminal gangs for whom people smuggling is a profitable business."


"Illegal immigration is closely connected to organized crime -- that is the sad reality. Mafia groups in Turkey, Ukraine and Italy run their human trafficking as an industry. Propagating illusions is a key part of the industry, illusions about what awaits an African or Asian in the rich European countries of France, Germany or England, which are the end destinations of most immigrants. In addition, there is also the fact that people smugglers rarely operate without the complicity of corrupt border officials, who gladly turn a blind eye to some things for the right money. From this perspective, the European Commission is correct to react skeptically to Athens' construction plans and to demand that the Greeks first do something to deter and discourage the traffickers."


But the law is clear: (...) asylum applications can only be made in the country of entry. And so Greece continues to cram more and more refugees into its overflowing camps..."



Clearly, Greece and the EU are just at the tip of the iceberg in determining solutions to the inflow of illegal immigrants via Greece. As Greece is now known for its excessive public debt, we thought this topic is additive to the larger assessment of Europe’s economic health and the issues surrounding the union and policy making of unequal states.


Matthew Hedrick


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Playing Japan

Conclusion: Japanese equities are looking good on the short side once again. We think market expectations regarding the yen-weakness tailwind have become substantially overblown, as global fundamentals don’t support a meaningful rebound in Japanese export growth. Further, both economic fundamentals and earnings need to surprise to the upside in Japan in order to sustain this rally in a meaningful way from here.


Since the start of November, long Japanese equities have definitely been one of the top ways to play increasing global demand for US Dollars as US Treasury yields backed up. To the tune of +14.8%, the Nikkei 225 has been the fifth-best performing global equity market since 11/1, showing only marginal abatement in the face of: 

  1. Global growth slowing;
  2. Inflation accelerating globally; and
  3. Interconnected Risk compounding 

Essentially, we have an overrun equity market propped up on the hopes of accelerating US growth and yen weakness aiding Japanese export growth (JPYUSD down -3.5% since 11/1).


Playing Japan - 1


Since we unveiled our Japan’s Jugular 4Q10 Macro Theme on October 5th, we’ve been managing risk around our yen and Nikkei short positions, oscillating between the two. While we remain bullish on the USD over the intermediate-term TREND, we think market expectations regarding accompanying yen-weakness as a tailwind to Japanese exporters have become substantially overblown. Moreover, global economic fundamentals don’t support a meaningful rebound in Japanese export growth: 

  • We don’t see US economic growth accelerating meaningfully from these levels, with decelerating US consumer demand and a slowing inventory cycle becoming headwinds to US growth in 1H11 (US = 16.4% of Japanese export demand); and
  • We are seeing explicit signs of slowdowns across Asia with several key countries on deck to tighten monetary policy meaningfully throughout 1H11 (China, Hong Kong, Korea and Taiwan = 39% of Japanese export demand). 

Playing Japan - 2


One area a weaker yen can “help” Japan with is choking off domestic consumption. Japan is an island economy that imports roughly ~60% of its food needs and roughly ~107% of its crude oil needs. With world food prices at all-time highs and crude oil prices poised to remain comfortably elevated on a YoY basis, we find bullish hope surrounding a weak(er) yen to be misguided at best.


Playing Japan - 3


Playing Japan - 4


Consensus estimates for Japanese 4Q10 GDP growth are closer now to where our expectations were back in October (-0.75% QoQ SAAR). Forecasts for 1Q11 and 2Q11 are +0.50% QoQ SAAR and +1.25% QoQ SAAR, respectively. After a +14.8% equity market move in less than 2.5 months, the Japanese economy likely has to blow-out these low expectations to keep equity investors from getting nervous. It is in our expectation they won’t. Japan, an economy overleveraged to manufacturing and exports, will disproportionately feel the three-factor pain outlined at the onset of this report.


Of course we could be wrong on global growth and the Nikkei’s recent run could be pricing in stronger growth both domestically and abroad. Even still, given the overwhelmingly bullish bias in Japanese and US equity markets, earnings from 1Q11 and 2Q11 (in both markets) need to be phenomenal if this rally is to be sustained meaningfully from here.


Darius Dale


Stocks of Stalks Stumble


Position: We sold out of our LONG corn position (the ETF CORN) in the Hedgeye Virtual Portfolio after this morning’s USDA crop report for an immediate term TRADE gain.




The USDA reported today that inventories of corn in the US as of December 1st were 10.04B bushels, an 8% decrease from last year’s level of 10.90B bushels.  The agency also revised down its estimate for the 2010 total corn crop to 12.45B bushels from 12.54B bushels, taking the 2010 crop yield 5% below last year’s.


Looking ahead, the USDA expects that corn stocks will fall to 745MM bushels before the 2011 harvest begins, revised down from a projection of 832MM bushels made last month and below the consensus estimate of 779 MM bushels.  The downward revision is due to US corn production seen to come in 93MM bushels lower than previously expected in 2010-11, as a 1.5 bushel/acre reduction in the national average yield outweighs an 183,000 acre increase in harvested land.  On trade, the USDA is projecting a 5MM bushel increase in corn imports – only a minor dent in the domestic production decline.




Demand for the grain appears to be holding strong – corn consumption in the US for the three months ending in November was 6.5% greater year-over-year.  Globally, the USDA tempered its worldwide consumption estimate by 0.2% to 836.1B bushels, still a 2.9% increase year-over-year.




The report sparked corn prices – corn futures for March delivery jumped 22 cents this morning to $6.29/bushel – the highest level since July 2008.


Going Forward


We expect corn prices to trend higher this winter.  While current prices are at a two-year high, domestic stockpiles are at a four-year low – thus, the supply fundamentals are bullish for price.  Demand for the grain, which is more inelastic than supply, is sticky in the US and the rest of the world, evidenced by the USDA’s report today.  These factors, coupled with exogenous events like the extreme flooding in Australia and dry weather in Brazil and Argentina, lend to a tight floor of support for corn prices in the intermediate term.  


Stocks of Stalks Stumble - corn1


Stocks of Stalks Stumble - corn2


Kevin Kaiser





January 12, 2010





  • In the latest customer service survey out of BIGresearch, and took the top spots overtaking both LL Bean and coming in at #3 and #4 respectively this year. It appears that Tony Hsieh’s customer focused culture is taking hold at the online giant even sooner than some expected.
  • Customers may actually know best.  According to a Motorola study, 55% of consumers believe that “the shopper today is better connected to consumer information than store associates”.  Might be time for retailers to step up their training or at least mandate that their employees spend more time online researching the products they sell.
  • Following in Best Buy’s footsteps, Apple has announced that it will discontinue charging for restocking fees on returned product. Given the timing with company’s new Verizon iPhone launch, waiving the 10% penalty is not only likely to help conversions, but will also be viewed favorably for the loyal Apple consumer who might still be unaware of such fees.



Sears Brings on the “Kardashian Kollection”  - The seemingly ubiquitous reality television sisters, Kim, Kourtney and Khloe, are set to unveil merchandise on a bigger retail stage when the Kardashian Kollection launches exclusively at 400 Sears doors in August with in-store shops. The brand, which is produced under license by Australian designer Bruno Schiavi’s Jupi Corp., is a critical component of Sears Holdings Corp.’s strategy to energize its contemporary clothing and accessories segment. The market will get an initial jolt at the store with the introduction of the French Connection-Sears hook-up UK Style by French Connection in March. <WWD>

Hedgeye Retail’s Take:  Just when you thought 2010 was the year of the Kardashians, 2011 starts off with yet another collaboration.  If only there was a way to merchandise every Kardashian product under one roof.


Versace to Re-Enter Japan - Versace is reentering the Japanese market and, to spearhead its development in the region, has tapped Hiroshi Saito as chief executive officer of Versace Japan. Gian Giacomo Ferraris, ceo of Milan-based Versace SpA, said he was excited about the appointment, adding he had worked with Saito in the past. Between 2007 and 2010, Saito was president of Jil Sander Japan. Ferraris joined Jil Sander from Gucci in 2004, when the German fashion house was still owned by the Prada Group, and left in 2009. “He is one of the best managers in the Japanese luxury business, and he understands Italian fashion brands better than anyone else,” said Ferraris. Saito, 60, has worked for more than 30 years in the Japanese luxury fashion market, for companies such as Ermenegildo Zegna, Gucci, Giorgio Armani, Prada and Donna Karan. <WWD>

Hedgeye Retail’s Take:  Versace’s absence in Japan was short-lived, having shuttered its 4 stores only two years ago.  Expect the re-launch to include denim, and The collection in select department stores by Fall ’11.


Collective Licensing International Signs Airwalk - Collective Licensing International is boosting its Airwalk brand.The Engelwood, Colo.-based company announced a licensing deal with Wiesner Products Inc. to license select apparel and accessories for Collective’s skate brand. Under the three-year agreement, Wiesner will hold Airwalk’s license for infant and newborn apparel, women’s, juniors and kid’s swimwear and sleepwear in the United States. Accessories including bags, headbands, underwear and socks are also included in the design and manufacturing deal.<WWD>

Hedgeye Retail’s Take: While not a needle mover, Collective’s licensing biz clearly has an eye towards growth and growing the portfolio beyond its core product categories. 


Cabela's Launches Mobile Website - Cabela’s launched an optimized mobile website that will allow customers to easily search and purchase items when they visit on popular mobile devices including the iPhone/iPod Touch, BlackBerry and Android. Key features of the new mobile website include: rich product photographs, complete product descriptions, customer-submitted product reviews, shop by category, shop by brand, store locator, e-mail and a complete site search. The website was developed by Digby on its Digby Mobile Commerce Software platform. Digby has used the same platform to develop mobile commerce sites for Toys “R” Us, Costco, The Home Depot, Lilly Pulitzer, Wet Seal, Godiva, 1800-Flowers, Golfsmith, Orvis and many other retailers.<SportsOneSource>

Hedgeye Retail’s Take:  Soon the development of a mobile e-commerce platform for any retailer will no longer be news, but rather a prerequisite for remaining competitive.


Katie Holmes is the New Face of Ann Taylor - Katie Holmes has been tapped as the new face of Ann Taylor, succeeding Heidi Klum, in the 280-store chain’s spring advertising campaign. Developed in-house by the Ann Taylor creative team and photographed by Tom Munro, the campaign breaks in March magazines. “I applaud women who are doing their best to be the best versions of themselves and who are working really hard. And I’m glad that there is a store like Ann Taylor that can offer amazing styles for the many different roles that women play,” Holmes, 32, told WWD exclusively. The media buy includes fashion magazines such as Vogue, Harper’s Bazaar, Elle, Marie Claire and InStyle. Outdoor ads will go up in major metropolitan areas. Holmes is contracted to Ann Taylor for one season. <WWD>

Hedgeye Retail’s Take: It’s tough to position this move an upgrade for the company – while Holmes may be younger, I’d argue she’s not as relevant as Klum, especially of late. Perhaps the company has arranged for Tom to be a part of future campaigns, which is more likely to catch both headlines and the company’s ‘core’ demographic attention.


Financo Panel Touts the Store - Online sales are booming and dominating the retail dialogue. But even as social networking, smartphones and mobile marketing build momentum, some executives believe brick and mortar will always be king. And what better place to stick up for the old format than the annual Financo Forum, which, on Monday night, drew a balance of veteran retailers, Web geeks, social networkers and executives from private equity, real estate, headhunting and fashion firms. “Even if we do triple the business online in the next five years, 59th Street will still be a bigger business,” said Bloomingdale’s chairman and chief executive officer Michael Gould, in a reference to Bloomingdale’s Manhattan flagship.<WWD>

Hedgeye Retail’s Take: The company can downplay the impact of its e-commerce business all it wants, but the reality is that they are investing heavily here and it’s one of the few if only growth engine they have.