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STORMY SAILING

This note was originally published at 8am on January 12, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“The dogmas of the quiet past are inadequate to the stormy present. The occasion is piled high with difficulty, and we must rise with the occasion. As our case is new, so we must think anew and act anew.”

-Abraham Lincoln

 

I recently pulled off the shelf Doris Kearns Goodwin’s book "Team of Rivals" which looks at the political genius of Abraham Lincoln.  It’s an amazing account of how Lincoln, as president, was able to bring his “disgruntled opponents” together to complete the task of saving the Union.  As Lincoln did, Barack Obama must pull together a team of rivals and win the respect of his competitors to help us navigate the stormy seas ahead. 

 

If the United States’ economy were a vessel, it could be said that she has held up quite well over the past couple of years.  Through the Great Recession, government bailouts, flash crashes, and the most contentious political climate in some time, the United States keeps cruising. 

 

How much secular damage was sustained in the “economic storm” or was simply deferred by the Fed grabbing its cavernous bucket and bailing water from inside the ship back overboard is unknown. 

 

Consumers don’t know, politicians don’t know, CEO’s don’t know, and you can bet a dollar, I don’t know.  What I can tell you with certainty is that at some point the structural problems with the U.S. economy need to be addressed sooner rather than later.  Fans of Big Government enjoy preaching the folly of applying long term solutions to short term problems. 

 

While not ideal, clearly long term solutions that ensure economic progress in the long term, notwithstanding short term pain, are preferable to short term solutions that never address the long term, leaving us and our posterity to forever bail buckets of water over the side of the ship while we hope and pray for a miracle. 

 

All the while, the long term problem grows larger, but politicians and policymakers keep their jobs.  The mounting of debt upon debt by governments around the globe is leading to inflation on a global basis. 

 

I would be remiss to ignore the various supply-side shocks that have occurred around the world related to weather and other factors.  However, simply stated, the inverse correlation between the dollar and commodities denominated in dollars remains high and the U.S. consumer is feeling the effect of that.  U.S. consumers are not alone; India, Brazil, China and many other countries around the world have seen inflation break out to the upside recently. 

 

Food inflation, in particular, is causing significant social unrest in some countries which is drawing political attention.  India’s government has adjourned to address the problem of rising food costs there and Algeria saw riots yesterday over food costs.  For now, consumers’ wallets in the U.S. have been relatively shielded from the impact of food costs increasing over the past 6 months.  However, if and when these costs are passed along in addition to the backdrop of high gas prices, it could greatly impair the “recovery” that is now consensus.

 

Today, Thailand joined the party and raised its benchmark raised interest rates for the fourth time in seven months and signaled it will boost borrowing costs further to contain inflation.  And this morning, officials from Mozambique to China are signaling their belief that rates in their respective countries will be raised in the near-term. 

 

On a more granular note, one company that will begin to feel the pain of higher food inflation in 2011 is McDonald’s and I don’t believe the bullish consensus has fully accounted for this.  Last year McDonald’s saw its basket of commodities decline by 5-6% and, accordingly, restaurant level margin rose by over 200bps from lower food costs alone.  I have other concerns which are more structural in nature and those will be addressed, in detail, on a conference call with clients on Friday. For qualified prospective institutional subscribers, please email sales@hedgeye.com for more details.     

 

Also on Friday, the Hedgeye Macro team will be discussing its three themes for the first quarter of 2011 and they are:

 

(1)    American Sacrifice - We are bullish on the USD and we will focus on how the Q1 macro calendar of events (Ron Paul auditing Bernanke, midterm election spending cut promises, the debt ceiling debate and debt/deficit commission decisions) are supportive of a strong USD as the country begins to address its long-term fiscal problems.

(2)    Trashing Treasuries – We are bearish on US Treasuries.  The breakout in global inflation, sovereign, State, and municipal risk and rising global interest rates are a problem for treasuries.

(3)    Housing Headwinds Phase II – We remain bearish on housing and continue to believe that a decline in home prices will be a governor on consumer consumption in 2011.  We will update our view on how much further home prices have to fall over the next 12-months according to the supply and demand issues facing the industry.

 

It’s now just under two hours before the market opens and equity futures are trading higher in a continuation of yesterday’s modest gains with the early focus centered on Portugal's bond auction which went better than expected.  Also overnight, bullish sentiment increased to 57.3% from 54.5% in the latest Investor's Intelligence poll, while the ABC consumer comfort index improved to -40 from -45; it is now at its highest level since 2008. 

 

While all of this is good news for equity markets, it’s an ominous sign that all of the early dogs of the S&P 500 so far this year (YTD price changes below) are predominately consumer names that have been impacted by either weaker-than-expected consumer spending or inflation pressuring margins or a combination of both.  I expect this list to grow as debt mounts, sovereign debt concerns accumulate, and inflation is passed through to the consumer.

 

SCRIPPS NET: -7.79%

MACY'S: -8.14%

TARGET: -8.22%

GAP: -8.22%

ABERCROMBIE & FITCH: -8.24%

VULCAN MATERIALS: -8.70%

GAMESTOP: -11.76%

FAMILY DOLLAR STORES: -13.02%

CONSTELLATION BRANDS: -13.18%

SUPERVALU INC: -21.18%

 

I’m not the only one using a “stormy” metaphor today as the snowstorm continues outside and CNBC started Squawk Box today with the Doors classic song “Riders on the Storm.” 

 

“Into this house we're born
Into this world we're thrown
Like a dog without a bone
An actor out alone
Riders on the storm”

 

Function in disaster; finish in style

Howard Penney    

 

STORMY SAILING - EL chart of day 1.12.11


The Week Ahead

The Economic Data calendar for the week of the 17th of January through the 21st is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.

 

The Week Ahead - calll1

The Week Ahead - calll2


Ten Ways to Play the Spike in Global Inflation

This note was originally published January 14, 2011 at 14:31 in Macro

Conclusion: Accelerating inflation globally has been a key factor in our bearish outlook for emerging market bonds and equities over the past three months. Despite our cautious stance, there are several key, non-consensus ways to play this theme on the long and short side over the intermediate-term TREND and long-term TAIL.


This morning, we came across an article that highlighted some key broker sentiment regarding emerging market investments. The article points out how Goldman Sachs and JPMorgan have been reneging on their bullish EM bets over the past few weeks and months as a result of hawkish monetary policy, instead opting for predicting outperformance by US equities.

 

Their retreat from emerging markets offers a tactical backboard for alpha-generating investment opportunities. Below, we’ll highlight some of the ideas we’ve been fond of on both the long and short side over the intermediate-term TREND and long-term TAIL.

 

For the sake of keeping this note short, we’ll be brief; simply email us if you’d like to see the research reports behind the ideas below:

 

COMMODITIES: FOOD – As we last saw in summer of ’08, deadly riots are breaking out globally in protest of rising food prices, currently at all-time highs. Perpetuated by global supply shortages, we anticipate a meaningful increase in import demand for many food products throughout the course of the year as developing nations look to rebuild domestic stockpiles. 

  • Long Sugar: Between flooding and droughts, adverse weather is causing key producers and exporters to revise down their production and export estimates (Brazil, Australia, Thailand, etc.). Further, we think market expectations of Indian stockpile rebuilding have gotten too hopeful. India is shortly removed from a major supply shock; if domestic production falters in any way, expect India to act quickly and resume imports as a way of alleviating any potential scarcity within its domestic market.
  • Long Corn: Current prices – at a two-year high – are supported by a global supply/demand imbalance. Domestic stockpiles are at a four-year low and demand for the grain, which is more inelastic than supply, is sticky in the US and the rest of the world. We anticipate accelerated import demand from China in the coming months in an effort to help ease domestic food inflation, currently trending at a 28-month high of 11.7% YoY. 

Ten Ways to Play the Spike in Global Inflation - 1

 

COMMODITIES: OTHER – Severe weather is adversely affecting many key agricultural-producing regions globally (flooding in Australia, mudslides in Brazil, etc.). Getting ahead of growing supply/demand imbalances is key, as agencies like the USDA tend to be rather hopeful with their production estimates, leading to downward revisions to their forecasts in subsequent reporting. 

  • Long Cotton: Because of severe supply-side issues, cotton prices have gone parabolic. Our best-in-class Retail/Apparel/Footwear Team tells us management teams have been delaying purchases of new inventory, citing high cotton prices. Last we checked, retailers need stuff to sell, so we anticipate an acceleration of corporate demand over the coming quarters as, which will only add to the current supply/demand imbalance. 

Ten Ways to Play the Spike in Global Inflation - 2

 

CURRENCIES – As monetary policy tightens globally, several countries will see their currencies move as a result of: a) slowing global growth; b) the direction of global interest rates and rate differentials; and c) key moves in their basket of counterparts. 

  • Long Chinese yuan: The last time China experienced a food-price shock, it revalued its currency roughly +20% over the next three years. We look to history to remind us that nothing gets Chinese officials more nervous than food inflation/food shortages. China’s desire to curb food inflation and prevent domestic riots and famine far exceeds their desire to support exporters with an undervalued currency. China has been adverse to hiking interest rates to fight inflation of late, but should prices get further out of hand, we expect them to implement a more forceful tightening cycle. Lastly, as China revalues the yuan upward, it gives them more purchasing power of things priced in US dollars, so expect all commodities to act accordingly and appreciate, lest China soak up the world’s supplies.
  • Long US dollar: Rising Treasury yields, which are being dragged higher by rising global bond yields and heightened inflation expectations are supportive of a stronger US dollar. In addition, the combination of a growing fear of emerging market tightening mentioned above and an illusion of accelerating US growth has many investors opting for US equities instead. Further, the dollar receives incremental bids as investors cash out of EM investments and into US stocks.
  • Short Gold: With real interest rates trekking steadily upward and the US dollar following close behind, gold prices come under pressure as this commodity is forced to join the competition for yield. Further, sober fiscal policy in the US (or at least the talk thereof) keeps a lid on the “Fear of Government” trade – at least for now.
  • Short the Japanese yen: After being trapped in a deflationary spiral since the early 90’s, Japan might be the only country in the world that welcomes inflation with such earnest. In fact, Japan may opt for additional monetary easing over the next three months if domestic growth comes in at the low end of our estimates. Japan, an economy leveraged to manufacturing and exports, will feel the brunt of a slowdown in global growth which is being perpetuated by global tightening. Lastly, as a key constituent in the yen basket, a strong US dollar lends support to this thesis. 

Ten Ways to Play the Spike in Global Inflation - 3

 

EQUITIES – As we have seen many times in financial market history, inflation can erode returns on equities by reducing company earnings via margin squeezes or by investors discounting slowdowns in growth as central banks tighten monetary policy. Despite this, there are ways to play this on the long and short side depending on the type of tightening measures implemented. 

  • Long Brazilian Infrastructure (BRXX): Like many countries globally, Brazil has been struggling with its own catch-22 in trying to balance the tightening of monetary policy with their desire for a weak(er) currency. Given, Brazil, like China, has been “cute” with its tightening measures, opting for fiscal conservatism among other things. This push has led newly-elected President Dilma Rousseff to loosen Brazil’s public sector hold on infrastructure development and opt for private sector involvement. The current mudslides in Rio present a major opportunity for her to prove she’ll let capitalism take hold in this burgeoning industry. Key long-term catalysts are Brazil hosting the World Cup in 2014 and the Summer Olympics in 2016.
  • Short Indian equities: Simply put, India is way behind the ball with fighting inflation. As we called for back in November, WPI inflected and accelerated in December to +8.43% YoY. The central bank’s recent efforts to add liquidity to its banking sector only exacerbate this headwind. Of all the countries we monitor, India is likely to have to tighten monetary policy the most in 2011, crimping domestic growth alongside a compression in corporate margins from higher input costs.
  • Short Japanese equities: As mentioned prior, Japan is an economy leveraged to manufacturing and exports, so it will disproportionately feel the brunt of a slowdown in global growth which is being perpetuated by global tightening. Many think a weak yen is beneficial to Japanese exporters, and it is – to a point. When commodity inflation takes off globally, input costs rise because of Japan's propensity to import inflation via a weak(er) yen. This compresses margins in Japan because neither Japanese retailers nor exporters are willing to take up price as a result of their deflationary mindsets. 

Ten Ways to Play the Spike in Global Inflation - 4

 

Please keep in mind that these are merely ideas to have on your screens and do not represent tactical calls to run out get long/short right this minute. When Keith returns from recovering from achilles surgery next week, we’ll be able to provide quantitative levels should you look to get involved with any of these ideas.

 

 Have a great long weekend,

 

Darius Dale

Analyst


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Ten Ways to Play the Spike in Global Inflation

Conclusion: Accelerating inflation globally has been a key factor in our bearish outlook for emerging market bonds and equities over the past three months. Despite our cautious stance, there are several key, non-consensus ways to play this theme on the long and short side over the intermediate-term TREND and long-term TAIL.


This morning, we came across an article that highlighted some key broker sentiment regarding emerging market investments. The article points out how Goldman Sachs and JPMorgan have been reneging on their bullish EM bets over the past few weeks and months as a result of hawkish monetary policy, instead opting for predicting outperformance by US equities.

 

Their retreat from emerging markets offers a tactical backboard for alpha-generating investment opportunities. Below, we’ll highlight some of the ideas we’ve been fond of on both the long and short side over the intermediate-term TREND and long-term TAIL.

 

For the sake of keeping this note short, we’ll be brief; simply email us if you’d like to see the research reports behind the ideas below:

 

COMMODITIES: FOOD – As we last saw in summer of ’08, deadly riots are breaking out globally in protest of rising food prices, currently at all-time highs. Perpetuated by global supply shortages, we anticipate a meaningful increase in import demand for many food products throughout the course of the year as developing nations look to rebuild domestic stockpiles. 

  • Long Sugar: Between flooding and droughts, adverse weather is causing key producers and exporters to revise down their production and export estimates (Brazil, Australia, Thailand, etc.). Further, we think market expectations of Indian stockpile rebuilding have gotten too hopeful. India is shortly removed from a major supply shock; if domestic production falters in any way, expect India to act quickly and resume imports as a way of alleviating any potential scarcity within its domestic market.
  • Long Corn: Current prices – at a two-year high – are supported by a global supply/demand imbalance. Domestic stockpiles are at a four-year low and demand for the grain, which is more inelastic than supply, is sticky in the US and the rest of the world. We anticipate accelerated import demand from China in the coming months in an effort to help ease domestic food inflation, currently trending at a 28-month high of 11.7% YoY. 

Ten Ways to Play the Spike in Global Inflation - 1

 

COMMODITIES: OTHER – Severe weather is adversely affecting many key agricultural-producing regions globally (flooding in Australia, mudslides in Brazil, etc.). Getting ahead of growing supply/demand imbalances is key, as agencies like the USDA tend to be rather hopeful with their production estimates, leading to downward revisions to their forecasts in subsequent reporting. 

  • Long Cotton: Because of severe supply-side issues, cotton prices have gone parabolic. Our best-in-class Retail/Apparel/Footwear Team tells us management teams have been delaying purchases of new inventory, citing high cotton prices. Last we checked, retailers need stuff to sell, so we anticipate an acceleration of corporate demand over the coming quarters as, which will only add to the current supply/demand imbalance. 

Ten Ways to Play the Spike in Global Inflation - 2

 

CURRENCIES – As monetary policy tightens globally, several countries will see their currencies move as a result of: a) slowing global growth; b) the direction of global interest rates and rate differentials; and c) key moves in their basket of counterparts. 

  • Long Chinese yuan: The last time China experienced a food-price shock, it revalued its currency roughly +20% over the next three years. We look to history to remind us that nothing gets Chinese officials more nervous than food inflation/food shortages. China’s desire to curb food inflation and prevent domestic riots and famine far exceeds their desire to support exporters with an undervalued currency. China has been adverse to hiking interest rates to fight inflation of late, but should prices get further out of hand, we expect them to implement a more forceful tightening cycle. Lastly, as China revalues the yuan upward, it gives them more purchasing power of things priced in US dollars, so expect all commodities to act accordingly and appreciate, lest China soak up the world’s supplies.
  • Long US dollar: Rising Treasury yields, which are being dragged higher by rising global bond yields and heightened inflation expectations are supportive of a stronger US dollar. In addition, the combination of a growing fear of emerging market tightening mentioned above and an illusion of accelerating US growth has many investors opting for US equities instead. Further, the dollar receives incremental bids as investors cash out of EM investments and into US stocks.
  • Short Gold: With real interest rates trekking steadily upward and the US dollar following close behind, gold prices come under pressure as this commodity is forced to join the competition for yield. Further, sober fiscal policy in the US (or at least the talk thereof) keeps a lid on the “Fear of Government” trade – at least for now.
  • Short the Japanese yen: After being trapped in a deflationary spiral since the early 90’s, Japan might be the only country in the world that welcomes inflation with such earnest. In fact, Japan may opt for additional monetary easing over the next three months if domestic growth comes in at the low end of our estimates. Japan, an economy leveraged to manufacturing and exports, will feel the brunt of a slowdown in global growth which is being perpetuated by global tightening. Lastly, as a key constituent in the yen basket, a strong US dollar lends support to this thesis. 

Ten Ways to Play the Spike in Global Inflation - 3

 

EQUITIES – As we have seen many times in financial market history, inflation can erode returns on equities by reducing company earnings via margin squeezes or by investors discounting slowdowns in growth as central banks tighten monetary policy. Despite this, there are ways to play this on the long and short side depending on the type of tightening measures implemented. 

  • Long Brazilian Infrastructure (BRXX): Like many countries globally, Brazil has been struggling with its own catch-22 in trying to balance the tightening of monetary policy with their desire for a weak(er) currency. Given, Brazil, like China, has been “cute” with its tightening measures, opting for fiscal conservatism among other things. This push has led newly-elected President Dilma Rousseff to loosen Brazil’s public sector hold on infrastructure development and opt for private sector involvement. The current mudslides in Rio present a major opportunity for her to prove she’ll let capitalism take hold in this burgeoning industry. Key long-term catalysts are Brazil hosting the World Cup in 2014 and the Summer Olympics in 2016.
  • Short Indian equities: Simply put, India is way behind the ball with fighting inflation. As we called for back in November, WPI inflected and accelerated in December to +8.43% YoY. The central bank’s recent efforts to add liquidity to its banking sector only exacerbate this headwind. Of all the countries we monitor, India is likely to have to tighten monetary policy the most in 2011, crimping domestic growth alongside a compression in corporate margins from higher input costs.
  • Short Japanese equities: As mentioned prior, Japan is an economy leveraged to manufacturing and exports, so it will disproportionately feel the brunt of a slowdown in global growth which is being perpetuated by global tightening. Many think a weak yen is beneficial to Japanese exporters, and it is – to a point. When commodity inflation takes off globally, input costs rise because of Japan's propensity to import inflation via a weak(er) yen. This compresses margins in Japan because neither Japanese retailers nor exporters are willing to take up price as a result of their deflationary mindsets. 

Ten Ways to Play the Spike in Global Inflation - 4

 

Please keep in mind that these are merely ideas to have on your screens and do not represent tactical calls to run out get long/short right this minute. When Keith returns from recovering from achilles surgery next week, we’ll be able to provide quantitative levels should you look to get involved with any of these ideas.

 

 Have a great long weekend,

 

Darius Dale

Analyst


CITYCENTER GETS IT DONE AND OTHER MGM CATALYSTS

Valuation may be high but the short side looks way too dangerous.

 

 

Today’s CityCenter refinancing is certainly a positive for MGM.  Other upcoming catalysts include a likely decent Q1 owing to easy convention comparisons in Vegas and sustainable, estimate-beating profitability in Macau.  We acknowledge the hefty valuation and leverage, negative cash flow, and still uncertain intermediate term in Las Vegas.  However, a huge short interest and upcoming positive catalysts leave us on the sidelines, for now. 

 

MGM just completed its refinancing of CityCenter and announced it this morning.  As most investors know, City Center’s existing $1.8BN credit facility needed some reworking given the ‘onerous’ covenants that are set to kick in June 2011.  

 

This morning MGM announced the pricing of $1.5BN first and second lien notes. 

  • $900MM First lien bond deal, 7.625%
  • $600MM Second lien bond deal – PIK/Toggle (10.75% cash pay, 11.5% PIK)
    • There are 3 payment options: 100% cash, 50/50, and  100% PIK.  Payment elections are made every 6 months.

MGM also completed extension (2015) and amendment of its bank deal – which is currently being papered.  Earlier this week, the talk was to do a $500MM first lien deal and a $900MM first lien bank deal.  However, demand for the bond deal was strong, and therefore the bank deal got reduced to $500MM with pricing at L + 650bps (1% Libor floor), for an aggregate ‘New’ City Center financing of $2BN. 

 

The reason why the ‘New’ deal is larger than the existing deal is because of the negative cash flow of the City Center assets, MGM needs to set aside approximately $160MM in escrow for interest payments.

 

Other details of the new financing include:

  • Excess cash sweep– 75% of excess cash goes to reduce principal of the first lien bank piece.  Excess cash also includes any proceeds from asset sales.
    • If they sell Crystals – proceeds go to the banks
    • Proceeds from the sale of condos, after repaying MGM’s ~$200MM intercompany loan, go to the banks

Given the strong demand for the notes, the pricing came in about 100bps tighter than price talk.  We’re also surprised that given the superior terms of the first lien bank deal that the pricing is only 12.5bps wider than the 1st lien bonds, however, this is because the bank piece was only offered to relationship banks.  Looks like MGM/CityCenter got a pretty good deal.


European Data Download: Inflation Pushing Higher

Position: Long Germany (EWG); Short Italy (EWI) and Euro (FXE)

 

European equity markets are trading down today across the board after two days of strong performance. FTSE -0.7%; DAX -0.3%; CAC -0.1%. The PIIGS are currently trading higher than their morning open of ~ -100bps, however Portugal’s equity market is flashing a negative divergence at -1.1%.

 

 

The Key Story is the Inflection in Inflation Expectations:

 

Today European Central Bank council member Axel Weber said the "economic outlook in the euro area has improved markedly and inflation risks could increase." This comes on the heels of ECB President Jean-Claude Trichet saying yesterday that he’s willing to raise rates to fight inflation.

 

CPI Data out today confirms these inflationary pressures: Spain saw a significant gain and inflation pushing higher in the UK will put further pressure on the BOE to act (see chart below). 

 

Germany CPI: 1.9% in Dec. Y/Y (Final Reading)   vs. 1.6% in November (the fastest acceleration in more than two years)

 

Spain CPI: 2.9% Dec. Y/Y (Final Reading)   vs. 2.2%

 

Eurozone CPI : 2.2% in Dec Y/Y (Final Reading)    vs. 1.9%

 

UK PPI Input: 3.4% in Dec. M/M     vs 0.9%

                                12.5% in Dec. Y/Y    vs 9.2%

 

UK PPI Output: 0.5% in Dec. M/M    vs 0.4%

                                4.2% in Dec. Y/Y   vs 4.1%

 

European Data Download: Inflation Pushing Higher - UKPPI

 

 

EU Car Demand Low:

 

In contrast to Weber’s economic outlook, a report on EU (25 countries) New Car Registrations out today fell -3.2% in December versus -7.1% in November and largely reflected difficult comps due to strong demand last year associated with country-specific “cash (subsidy) for clunkers” programs throughout Europe, according to the European Automobile Manufacturers’ Association.

 

The highlights of the report include:

  • Ford Motor Co., Fiat SpA and Toyota Motor Corp. led a ninth consecutive monthly drop in European auto sales
  • Ford’s registrations plunged -26% in December Y/Y; Fiat’s -19%; and Toyota’s -7.6%
  • Demand in the region fell 2.7% percent to 1.05 million, however December registrations rose 6.9% in Germany, Europe’s biggest market

We continue to remain bullish on Germany, and are currently long the country via the etf EWG in the Hedgeye Virtual Portfolio.

 

 

Euro Strengthening:

 

The euro got a further lift today against major currencies, including the USD, currently trading at $1.3386, after comments today from French Finance Minister Christine Lagarde that Europe is "looking at raising the EFSF (the bailout fund) and is considering broadening the scope of the fund’s powers."

 

From a catalyst perspective we continue to believe that European markets and the euro will be supported over the near-term by discussion next week in Brussels by European finance ministers on initial details of a more "comprehensive (bailout) package". Further, German Finance Minister Wolfgang Schaeuble said yesterday that the EU member states will assemble this package by March when EU leaders are schedule to meet for a summit. 

 

We’ll continue to keep you ahead of Europe’s sovereign debt issue. As soon as next week we could learn considerably more about funding for future country bailouts.  

 

Have a nice long weekend,

 

Matthew Hedrick

Analyst


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