TODAY’S S&P 500 SET-UP - January 27, 2011

Equity futures are trading slightly above fair value, having traded modestly lower following news S&P has downgraded Japan's credit rating to 'AA-' from 'AA' due to concerns Japan's debt ratio will grow by more than previously forecast. The move came after the Nikkei had closed and the yen has fallen sharply.  As we look at today’s set up for the S&P 500, the range is 12 points or -0.67% downside to 1288 and +0.26% upside to 1300.



  • 8:30 a.m.: Net export sales (cotton, corn, soy meal, soybeans, wheat), Jan. 20
  • 8:30 a.m.: Chicago Fed national activity index, Dec., est. 0.11%, prior -0.46%
  • 8:30 a.m.: Durable goods orders, Dec., est. 1.5%, prior - 0.3% (capital goods non defense ex. air est. 1.2%, prior 3.6%)
  • 8:30 a.m.: Initial jobless claims, Jan. 22, est. 405k, prior 404k; continuing claims, Jan. 15, est. 3872k, prior 3861k
  • 10 a.m.: Pending home sales, Dec., est. 1% M/m, prior 3.5%
  • 10:30 a.m.: EIA natural gas storage change, Jan. 21, est. -170, prior -243
  • 10:45 a.m.: Fed nominee Peter Diamond speaks at MIT symposium
  • 1 p.m.: Fed sells $29b 7-yr notes


  • Align Technology (ALGN) sees 1Q EPS 15c-17c vs est. 19c
  • Amylin Pharmaceuticals (AMLN) reported 4Q loss-shr 8c vs est. loss 31c; also says Bydureon study to begin in Feb.
  • Citrix Systems (CTXS) sees 1Q adj. EPS 40c-41c vs est. 48c, rev. $470m-$475m vs est. $470.5m
  • Covidien (COV) will to replace McAfee in S&P 500
  • Crown Castle International (CCI) sees 1Q EPS as much as 12c vs est. 9c
  • E*Trade Financial (ETFC) reported 4Q loss-shr 11c vs est. profit 4c
  • Motorola Mobility Holdings (MMI) sees 1Q loss-shr 9c-21c vs est. profit 1c
  • Netflix (NFLX) sees 1Q EPS 90c-$1.13 vs est. 87c
  • Owens-Illinois (OI) reported 4Q adj. EPS 45c vs est. 47c
  • Qualcomm (QCOM) sees 2Q adj. EPS 77c-81c vs est. 68c
  • Starbucks (SBUX) sees 2Q EPS 32c-33c vs est. 35c
  • Symantec (SYMC) sees 4Q rev. $1.59b-$1.61b vs est. $1.58b
  • Varian Medical Systems (VAR) forecast 2011 adj. EPS $3.39-$3.45 vs est. $3.38
  • Almost half of investors in Bloomberg global poll say they think a default by a U.S. state or major city this year is likely, though most say govt. would probably step in with a bailout.
  • AIG former chairman Harvey Golub says the bailed-out insurer should be broken up eventually because the firm’s two main businesses have “no strategic fit between them”
  • Sara Lee board meets for second day today to discuss strategic options without new bids from JBS or PE group led by Apollo Global, two people with knowledge of matter say
  • ProLogis is in talks with rival AMB Property on an all-stock merger that would create a $14b REIT
  • Russian TNK-BP shareholders request injunction to halt share swap, Arctic exploration deal between BP and Rosneft, according to copy of filing read by Bloomberg News
  • Delegates at World Economic Forum in Davos identified rising food prices, North African unrest and competing remedies for global recovery as evidence of increasing global economic discord. Forum continues until Jan.


  • Tyco Electronics (TYC) 6 a.m., $0.68 
  • Potash of Saskatchewan (POT CN) 6 a.m., $1.62 
  • Polaris Industries (PII) 6 a.m., $1.51 
  • Time Warner Cable (TWC) 6 a.m., $1.01 
  • Danaher (DHR) 6 a.m., $0.66 
  • Ball (BLL) 6 a.m., $0.92 
  • Lockheed Martin (LMT) 6:30 a.m., $2.10 
  • Newell Rubbermaid (NWL) 6:30 a.m., $0.32 
  • Eli Lilly (LLY) 6:30 a.m., $1.10 
  • Eaton (ETN) 6:49 a.m., $1.67 
  • Procter & Gamble (PG) 6:55 a.m., $1.09 
  • Altria Group (MO) 6:58 a.m., $0.44 
  • DR Horton (DHI) 7 a.m., $(0.03)
  • Raytheon Co (RTN) 7 a.m., $1.16 
  • Ametek (AME) 7 a.m., $0.47 
  • Motorola Solutions (MSI) 7 a.m., $1.08 
  • Zimmer Holdings (ZMH) 7 a.m., $1.19 
  • EQT (EQT) 7 a.m., $0.40 
  • Stanley Black & Decker (SWK) 7 a.m., $0.91 
  • Baxter International (BAX) 7 a.m., $1.10 
  • Colgate-Palmolive Co (CL) 7 a.m., $1.23 
  • Xcel Energy (XEL) 7 a.m., $0.31 
  • Consol Energy (CNX) 7 a.m., $0.54 
  • Mead Johnson Nutrition Co (MJN) 7 a.m., $0.56 
  • L-3 Communications Holdings (LLL) 7:07 a.m., $2.31 
  • Caterpillar (CAT) 7:30 a.m., $1.28 
  • AT&T (T) 7:30 a.m., $0.54 
  • JetBlue Airways (JBLU) 7:30 a.m., $0.05 
  • Celgene (CELG) 7:30 a.m., $0.73 
  • Bristol-Myers Squibb Co (BMY) 7:30 a.m., $0.48 
  • Invesco Ltd (IVZ) 7:30 a.m., $0.40 
  • Precision Castparts (PCP) 8 a.m., $1.80 
  • Janus Capital Group (JNS) 8 a.m., $0.21 
  • Royal Caribbean Cruises Ltd (RCL) 8:29 a.m., $0.13 
  • Franklin Resources (BEN) 8:30 a.m., $1.91 
  • Nucor (NUE) 9 a.m., $(0.11)
  • Chubb (CB) 4:01 p.m., $1.57 
  • (AMZN) 4:02 p.m., $0.88 
  • ResMed (RMD) 4:05 p.m., $0.37 
  • VeriSign (VRSN) 4:05 p.m., $0.30 
  • PMC - Sierra (PMCS) 4:05 p.m., $0.15 
  • SanDisk (SNDK) 4:05 p.m., $1.09 
  • Monster Worldwide (MWW) 4:10 p.m., $0.06 
  • Compuware (CPWR) 4:12 p.m., $0.16 
  • Microsoft (MSFT) 4:12 p.m., $0.68 
  • KLA-Tencor (KLAC) 4:15 p.m., $1.05 
  • Varian Semiconductor (VSEA) 4:22 p.m., $0.87



9 of 9 sectors positive on TRADE and 9 of 9 sectors positive on TREND.

  • One day: Dow +0.07%, S&P +0.42%, Nasdaq +0.74%, Russell 2000 +1.76%
  • Month/Quarter/Year-to-date: Dow +3.52%, S&P +3.10%, Nasdaq +3.27%, Russell +1.29%
  • Sector Performance - (5 sectors up and 4 down): - Energy +2.40%, Materials +2.12%, Industrials +0.59%, Tech +0.57%, Consumer Disc +0.16%, Financials (0.19%), Healthcare (0.12%), Consumer Spls (0.25%), Utilities (0.38%)  


  • ADVANCE/DECLINE LINE: 1161 (+942)  
  • VOLUME: NYSE 1087.57 (+3.93%)
  • VIX:  16.64 -5.40% YTD PERFORMANCE: -6.25%
  • SPX PUT/CALL RATIO: 1.06 from 2.44 (-56.59%)



Treasuries were weaker today with the pickup in risk appetite and the lack of details in President Obama's State of the Union address regarding deficit reduction measures.

  • TED SPREAD: 15.53 + 0.609 (4.081%)
  • 3-MONTH T-BILL YIELD: 0.16%      
  • YIELD CURVE: 2.83 from 2.73


  • CRB: 332.83 +1.61%  
  • Oil: 87.33 +1.32% - trading -0.89% in the AM
  • COPPER: 426.70 +0.97% - trading +1.03% in the AM
  • GOLD: 1,330.72 -0.18% - trading +0.51% in the AM


  • Food-exporting countries are “strongly advised” not to restrict shipments to prevent “more uncertainty and disruption” in world markets, the United Nations said. Governments in Egypt, Algeria, Morocco and Yemen have faced protests amid rising costs and high unemployment, and a revolt toppled Tunisia’s leader.
  • Crude oil climbed as new-home sales in the U.S. beat forecasts and traders bet the Federal Reserve will keep stimulus measures to bolster the U.S. economy.
  • Gas futures were steady as a midday update to the National Weather Service’s Global Forecast System weather model showed below-normal temperatures in the eastern and central U.S. from Feb. 5 through Feb. 9. Earlier forecasts had shown mostly normal temperatures in those regions.
  • Investors put 41% less into gold-backed exchange-traded funds and sister exchange-traded notes in 2010 than the previous year, according to a new report by the World Gold Council. 
  • Copper extended gains in New York after a government report on housing added to evidence the U.S. economy is improving without requiring the Federal Reserve to raise interest rates. 
  • Algeria agreed to buy 800,000 metric tons of wheat today and ordered the state-run grain agency to speed up imports, Reuters reported
  • Hog futures touched their highest prices in 14 years amidst heightening Asian demand for pork exported from the U.S., Bloomberg reports.
  • Ethanol futures gained the most in two weeks in Chicago on concern that export demand for corn will rise and increase the cost of making the fuel.  The biofuel climbed for the first time this week. Corn surged to the highest in more than a week on speculation that food riots from Egypt to Yemen will boost demand for the grain, the primary ingredient in U.S. ethanol production.


  • EURO: 1.3683 +0.30% - trading +0.38% in the AM
  • DOLLAR: 77.898 -0.13% - trading -0.18% in the AM


  • FTSE 100: +0.30%; DAX: +0.47%; CAC 40: +0.16% (AS OF 6:15 AM EST)
  • European markets opened modestly lower following mixed results from European heavyweights including AstraZeneca, Novartis and H&M and news that Standard & Poor's cut Japan's sovereign credit rating to AA- from AA. Declining sectors lead advancers 10-8. Food, media and banks down (0.5%) lead fallers whilst basic resources +1.4% and autos +1.1% lead gainers 
  • Indices recovered early losses in choppy trading and are currently mixed.
  • Spain, Ireland, Greece and Portugal will probably remain “stuck in recession” for the next 18 months and be the laggards in a three-speed European recovery, Standard & Poor’s said.
  • Spain's government and unions reach a preliminary pact on pension reform.
  • France Jan Consumer Confidence 85 vs prior revised 86
  • Eurozone Jan Consumer Sentiment (11) vs consensus (11) and prior (11)
  •  Germany Jan preliminary CPI due around 7:30ET


  • Nikkei +0.74%; Hang Seng (0.27%); Shanghai Composite +1.49%
  • Most Asian markets rose today.
  • Property shares fell as China announced new moves to cool the market, but commodity and telecom stocks still powered the index to a gain.
  • Japan went up on a weaker yen and expectations for good earnings reports. Inpex rose 3% on higher crude oil futures. Mitsubishi Heavy rose 4% on a report operating profit will likely rise by more than forecast for the FY. Post-close, S&P downgraded Japan, and the yen weakened.
  • Indonesia rose even after the government priced Garuda Indonesia’s IPO at the low end of its indicative range yesterday.
  • In South Korea, Daewoo Shipbuilding & Engineering rose 3% on a report it signed a $1.2B agreement to build ships for Aker Drilling.
  • Australia finished flat, with retailers lower after the government announced a new income tax to pay for rebuilding after the country’s flooding. Downer EDI plummeted 20% on announcing a write down on a train-building contract.
  • Hong Kong fell slightly. China property stocks dragged the market down, erasing early gains. China Overseas Land lost 5%, and China Resources Land fell 4%; both stocks were heavily short-sold.
  • Japan December trade surplus +34.1% y/y to ¥727.7B vs cons ¥469.6B.


THE HEDGEYE DAILY OUTLOOK - 1 27 2011 6 26 46 AM

Our Deficit Gift Just Increased

Conclusion: Earlier today, the Congressional Budget Office took their deficit estimates up dramatically for the next three years.  They are now estimating a combined budget deficit for 2011, 2012 and 2013 of $3.28 trillion.  This is up from their prior estimate released in August 2010 of $2.3 trillion. 


Positions: Short U.S. Treasuries via the etf SHY


“The future is not about a gift, it is about an achievement.”

-Robert Kennedy


The aforementioned quote was used by President Obama in his State of the Union address last night.  There is no doubt President Obama’s oratory skills are second to none and, at times, that’s what a nation needs – a President who speaks well and gives the electorate a good feeling about the future.  Unfortunately, we are a now in a period where the nation, from a fiscal perspective actually needs what President Obama campaigned on . . . change.   In fact, for the future to be an “achievement”, we need a dramatic change in the path of the deficit.


On the other hand, change in the political sphere in the United States is certainly on the way. An interesting takeaway from last night was that there were two responses to President Obama.  One from up and coming Republican Congressman Paul Ryan (Wisconsin)  and another response from Congresswoman Michele Bachmann (Minnesota), representing the Tea Party.   Congresswoman Bachmann’s address was short, to the point, and fact based.   While some of it was certainly political in nature, I think she framed up the economic debate over the next couple years very effectively with the following statement:


“After the $700 billion bailout, the trillion-dollar stimulus, and the massive budget bill with over 9,000 earmarks, many of you implored Washington to please stop spending money that we don't have. But instead of cutting, we saw an unprecedented explosion of government spending and debt. It was unlike anything we have seen in the history of the country.”


In the coming weeks and months, this drum beat will get louder and louder.  As a result, spending will be a focus on this current Congress.


Earlier today the Congressional Budget Office took up their deficit projections dramatically for the next three years.  In the table below, I’ve compared their estimates versus their prior estimates and our Hedgeye estimates (which are pending an upward (larger deficit) revision).


Our Deficit Gift Just Increased - 1


It is amazing the difference six months can make.  Primarily due to changing their view of future revenue(i.e. taxes), the CBO has increased their aggregate estimate for the budget deficit in the next three years by +46%. 


While on some levels we do applaud President Obama’s call for $400BN in deficit cuts over the next ten years, the number is way too small to matter or “change” our current path to escalating debt on the federal balance sheet.  In fact, this aggregate reduction of $400BN over ten years isn’t even half of the increase the CBO just made for the next three years in their deficit projections.


Further, from 2012 to 2021, the CBO projects an aggregate deficit in the United States of $6.9TN, so while $400BN in spending cuts over the same time period is something, it is not change.  In fact, President Obama’s proposal only cuts 5.8% of the CBO’s projected budget deficit over the next ten years.  That is, the proposal is really “pocket change”, as it relates to the deficit issue.


To see any meaningful appreciation in the dollar, we will have to see a plan implemented that takes a serious shot at reducing the deficit.  Unfortunately, $400BN over ten years is not that plan.  That’s not a political statement, that is just fact.


Daryl G. Jones
Managing Director


In preparation for Royal Caribbean’s Q4 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from RCL’s Q3 earnings release/call.




  • “Book-to-load factors are higher than same time last year for the fourth quarter and for all four quarters of 2011.”
  • “Our developmental itineraries continue to show the most improvement with Europe and the Caribbean both demonstrating improving trends.”
  • “Pullmantur has been buffeted by the worst recession of the any of the countries in which we operate and unfortunately, the recession in Spain shows no signs of abating anytime soon.”
  • “I would like to point out that we currently have fuel hedges covering 58% of our forecasted consumption in 2011 as well as 55% and 22% for 2012 and 2013 respectively.”
  • “And for the first time in the brand’s history we will sail with a higher percentage of guests coming from outside the U.S. on our European products. We continue to see the results of our efforts to build our brand beyond the U.S. market. Our long Caribbean itineraries from South Florida are benefiting from the increased international sourcing as well.”
  • “The overall mix of our company is trending more in the direction of guests coming from outside of the United States and for example, with Royal Caribbean International moving from eight ships in Europe next summer to eleven, that will propel that trend forward, so while our guests still come more than 50% from the United States, we’re getting closer and closer and actually quite close to our business mix overall being half of our customers coming from inside the United States and half coming from outside. That’s across all the brands of the company.”
  • “I think included in our guidance is not a huge uptick in on-board spending. We’re seeing most of the accretion that we’re forecasting and we’ve experienced more recently as really being driven by the ticket revenue.”
  • “We’ve baked in some assumptions here around the pressures on food costs. But we continue to be relentlessly focused on cost and I think our brands are doing a great job really trying to figure out how we can squeeze more costs out of our P&L without compromising our guest experience.”

4Q 2010

  • Guidance
    • Net Yields: 5% constant currency or 4-5% as reported
    • NCC: 2% as reported or 3% on a constant currency basis
    • $0.05 negative impact from operational disruptions on Pullmantur's Pacific Dream and the Celebrity Century
    • Fuel cost: $167 MM, 50% hedged
    • EPS: $0.08-0.12
  • “4Q cost increase is really driven by timing, mainly of things like marketing and some maintenance and repair expense that had originally been forecast in the third quarter that shifted to the fourth.”
  • “Virtually all itineraries are booked at higher load factors with better APDs than a year ago.”


  • Guidance
    • Net Yields: 4-5%
    • NCC: 1%
    • EPS: $2.43-2.47
  • “First quarter bookings are off to a solid start and at today’s exchange rates, we are estimating yield improvement of between 2 and 4%. Our current thinking is that the second and third quarters should provide the greatest opportunity for yield improvement in 2011.”
  • “While we are beginning to see some cost pressures, especially with food prices, our brands and department heads continue to relentlessly focus on costs. Accordingly, based on current fuel prices and currency exchange rates, we are encouraged that 2011 could be a year of record profits for our company.”
  • “We have seen early signs that Europe and Alaska are strong next year.”
  • “Our capacity mix is pretty similar to what it was this year, but we are seeing growth in Europe.”
  • “We have a little over a third of our business on the books for 2011.”
    • “Generally speaking, we say we tend to end the year around 50%. So we are now running above the 2010, the ‘09 levels and even the fall of ‘08. But we’re not quite back to where we were pre-recession levels.”
    • “Length of booking curve is 4 months.”


  • “This evening, we depart for Turku, Finland, to take delivery of Allure of the Seas, sister ship to Oasis of the Seas, from the STX shipyard on Thursday.”
    • “As we have already experienced with Oasis, Allure will provide a boost to our revenue yields. With her arrival, the percentage of our brand’s capacity that is either Oasis or Freedom class will be over 33%.”
  • “We announced the name of our fifth and final Solstice class ship, Celebrity Reflection, slated to launch in fall 2012. In addition, we will be Solsticizing both Infinity in fall of 2011 and Summit in Q1 of 2012.”
  • “When Silhouette comes out next year, which will be our newest Solstice class ship, it will go right into service in Europe.”
  • “We said previously that we don’t expect to do any more Oasis class ships.  We do think that the rate of growth of new capacity has slowed.”
  • “But at this point, it’s getting more likely that [building a ship] would be something more like 2014.”

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FL: Debating a Weak Week

In the absence of hard data in between the longest reporting period drought of the year, speculation on Foot Locker’s sales trends reached a fever pitch at mid-day today.  In part due to the release of the NPD weekly athletic footwear data and in part due to a large bulge bracket firm making a call that sales have slowed materially in the second to last week of the company’s fiscal fourth quarter.  Speculating on one week alone can be dangerous and as such we don’t normally spend too much time supporting or refuting “channel checks” or weekly scan data.  However, the facts in this situation are worth exploring in greater detail.


Fact 1:  Weekly athletic footwear sales for the athletic specialty/sporting goods channel were down 9.4% for the week as per NPD data.  This clearly marks a meaningful deceleration over the past two weeks.


FL: Debating a Weak Week - Fw App FW Table 1 1 26 11


FL: Debating a Weak Week - FW App Ind 1Yr 1 26 11


Fact 2:  Foot Locker reported same store sales have been tracking in a range of 100-200 bps HIGHER than our blended NPD/Sportscan Index.


FL: Debating a Weak Week - FL CompTrack 1 26 11


Fact 3:  Apparel accelerated this past week to up 3.2% y/y from +2.3% in the prior week.  Nothing heroic here but not nearly as challenging as footwear.


FL: Debating a Weak Week - FW App App Table 1 26 11


The Math: 


If we assume that Foot Locker outperformed the industry for the week in question, as it has recently, then we put the week’s performance at down 7%.  Next, we must estimate what “weighting” the week in question represents as a percentage of the total quarter.  Clearly January is the smallest volume month of the fiscal quarter, suggesting that an equal weighting of week 51 at 8.33% would be overstating the importance of the said week.  So in making realistic assumptions (in this exercise for which we may never know precisely what one weeks of sales momentum really did), we assume that the week is worth 4-5% to the quarter.  All in, this results in a hit to overall quarterly comps of 28-35 bps on our modeling assumption that same store sales will end the quarter up 6%.  


Importantly, the same weekly trend underpinning this analysis is being used by a competitor to adjust estimates down by 100 bps.  Of course these are all just estimates, but by our math it isn’t practical to assume that week 51 of Foot Locker’s year is big enough, or bad enough to derail the topline expectations by a meaningful amount. 


Additional Points to Consider:

  •  It’s no secret that the weather has had some impact on business across all of retail this month, not just the athletic channel.  However, we must also consider the flipside which is the opportunity FL has to clear its boot/cold weather offering at a healthy margin aided by the tough weather backdrop.  This cannot be quantified, but qualitatively bad weather during “normal” winter months can be good for sell throughs of cold weather product.
  •  Promotional activity remains benign, which bodes well for margins.  For anyone that has been tracking their inbox over the past couple of months, we challenge you to email us a copy of a coupon good for an in-store discount.  Yes, we’re aware of the constant barrage of promos centered on Eastbay or .com only, but the effort to drive sales via price has been noticeably absent of late.  And yes, this applies in particular to the last couple of weeks. 

Overall, we remain comfortable with our 6% same store sales estimate and $0.44 above Street estimate for FL’s fourth quarter.  One week in late January does not change our thesis one bit.  As such we’ve taken this opportunity to use the noise out there to add the position to Hedgeye’s virtual portfolio.  Speculation is likely to remain high until the company reports in early March, however the momentum in the underlying business remains solid and on track to meet our admittedly bullish expectations.


Eric Levine


FOMC: Burning Bone Update

POSITION: Sold US Dollar today


Like Jimmy Carter had former 1970s Fed Head Arthur Burns’ back on this, the President of the United States has Ben Bernanke’s. In the last 24 hours neither Obama or Bernanke did as much as mention the US Dollar. These are both sad and fascinating times in American history.


Don’t forget that Burns was the last Federal Reserve Chairman who tried to monetize the debt as President Carter tried to convince the American people that real-world inflation was a mirage.


According to The Ber-nank’s FOMC statement, there is no inflation. Or at least according to his conflicted and compromised US government calculation of “core” CPI (which they’ve changed 9 times since 1996) says so…


Given what happened to market prices in December, this is a reckless and/or politicized conclusion: 

  1. Stocks went straight up
  2. Commodities went straight up
  3. Interest rates went straight up 

The corollary to all of this inflation being marked-to-market has, of course, been the headwind that inflation usually is for bonds and emerging markets (they went down).


On the news, the Bone is Burning alongside the Fed’s credibility.


Best of luck trading the inflation casino,



FOMC: Burning Bone Update - 1

Top Emerging Market Short Ideas: Indian Equities

Conclusion: If you agree with our October call that EM assets will come under pressure and remain that way over the intermediate-term TREND, then you’re likely looking for short ideas. If so, we think Indian equities are among the top short ideas in this space, supported by the fundamental backdrop of slowing growth, accelerating inflation and interconnected risk compounding.


Position: Bearish on Indian equities and bonds.


When we last published on India (1/6 note titled: “India’s Two-Factor Squeeze”), we highlighted a two-pronged setup that leads us to be bearish on Indian equities: slowing growth and accelerating inflation. Over the last 48 hours, rhetorical, economic and price data are all contributing to that “squeeze” getting tighter.


India’s central bank, led by Governor Duvvuri Subbarao, hiked its benchmark interest rates by +25bps yesterday, increasing the Repo Rate to 6.5% and upping the Reverse Repo Rate to 5.5%. This is the first rate hike since their self-imposed moratorium starting in November.


Top Emerging Market Short Ideas: Indian Equities - 1


Despite inflation running twice the pace of the government’s target, the Reserve Bank of India (RBI) elected to purchase government securities from banks to ease a domestic liquidity shortage. Money Supply (M3) growth, though up sequentially in December and off its summer lows, remains near a five-year low. Moreover, the India National Stock Exchange Interbank Offer Rate, a measure of liquidity via interbank funding availability, averaged a full +90bps higher in 4Q10 vs. 3Q10. Relative to the 1H10, the rate averaged a full +250bps higher.


Top Emerging Market Short Ideas: Indian Equities - 2


Top Emerging Market Short Ideas: Indian Equities - 3


The cash crunch was facilitated by an elongated trend of credit growth far outpacing deposit growth, as Indian citizens elected to protect their capital from inflation by shunning bank deposits. In 2010, loan expansion (+24.4% YoY) outpaced deposit expansion (+16.5% YoY) by 790bps!


Despite this demand-side inflationary pressure, the RBI felt it both prudent and necessary to help ease the cash crunch by repurchasing government bonds on the open market and stepping up its reverse repo operations. All told, Indian banks borrowed an average of 1.2T rupees per day in December, up from 854.8B in November. January is off to a hot start as well, with lenders borrowing an average of 909.4B rupees per day from the central bank in an effort to maintain the pace of credit expansion amid weak deposit growth.


Top Emerging Market Short Ideas: Indian Equities - 4


The aforementioned inflationary pressure has become such an issue in India, we’re even starting to see bankers and asset managers (people who get paid on inflation) come out against the RBI’s Quantitative Guessing scheme:


“For the time being, inflation takes the driver’s seat… I think the time has come to stop repurchases, as it is inflationary” – Manoj Swain, CEO at Morgan Stanley India


“Inflation is becoming an increasingly huge worry at this point in time and the RBI will need to do a major part of the firefighting in containing inflation… The monetary policy needs to be much tighter than it is now, given the building up of inflationary pressures.” – Sonal Varma, Economist at HSBC Holdings Plc.


“The RBI shouldn’t do anything more to add cash to the system… There was some logic for doing it earlier because the liquidity deficit had gotten excessive, but at that time inflation looked like it was moderating.” – Prasanna Ananthasubramaniam, Chief Economist at ICICI Securities


Unfortunately, this marginal backlash leaves the RBI between a rock and a hard place. If they continue the repurchases, they risk inflation getting out of control – even more so than it already is at ~400bps higher than the target (+8.4% YoY in Dec).  Should they elect to stop the repurchases, they risk exacerbating government borrowing costs, as Indian banks, the largest buyers of Indian sovereign debt, don’t have the excess cash to make purchases right now. In fact, Indian lenders sold 288.3B rupees ($6.4B) of Indian sovereign debt last quarter – the highest sales rate since 4Q05!


Top Emerging Market Short Ideas: Indian Equities - 5


The recent backup in yields hurts the central government’s efforts to narrow its budget deficit to 5.5% of GDP by the end of FY11 (March 31), after a near doubling in three-year’s time. Currently, interest payments alone consume almost one-fifth of government expenditures. That leaves little else for developing India’s woeful infrastructure after 10% is spent on food and fertilizer subsidies, 14% on defense and an additional 25% is divvied up amongst Indian States.


One area India can look to for cost savings is the subsidies it is currently paying to hold down the prices of certain foodstuffs and fertilizers. RBI governor Subbarao is calling for the central government to remove the subsidies and allow the prices to appreciate in an effort to reduce the demand-side inflationary pressure. This morning, he reiterated his call for fiscal conservatism, saying, “Monetary policy works most efficiently while dealing with an inflationary situation when the fiscal situation is under control”.


Unfortunately, fighting inflation with more inflation doesn’t work in a country where nearly 828 million people live on less than $2 per day.


Luckily for India’s citizenry, Prime Minster Manmohan Signh is learning from the mistakes of Tunisian and Egyptian politicians and is getting marginally serious about fighting inflation, as evidence by his recent cabinet reshuffle. In the move, he appointed K.V. Thomas to head the Ministrity for Food and Consumer Affairs, a position formerly held by now-departed Agriculture Minister Sharad Pawar. Facing elections in five States over the next five months, Singh’s coalition government cannot afford to lose the ~40-42 seats predicted by a recent poll published by the India Today news magazine.


Still, the move to put in place someone who’ll be directly responsible for reeling in India’s inflation rate may be more of an empty scapegoat than it appears. Keep in mind that the Food & Beverage component of India’s benchmark Wholesale Price Index is only 14%, one of the lowest in the world by our calculations/estimates. Given that, we’ll continue to take the other side of Governor Subbarao’s claims that inflation is currently being driven by “excessive food price increases, which look to subside in coming months”.


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Even Subbarao himself is backtracking on this stance, saying recently, “The rise in food inflation in India has not only persisted for more than two years now, the increase has been rather sharp in the recent period. This cannot but have some spillover effects on generalized inflation.”


Indeed it does; recent examples of the spillover effects from higher input costs include Hero Honda Motors Ltd. (the producer of roughly half the motorcycles sold in India) recent plans to raise wages. Godrej Consumer Products Ltd. (the second-largest producer of bath soap in India) plans to increase prices for the third time in three months, citing “reduced profits from higher input costs”.


Tactical Setup


Many equity investors cheer on inflation, particularly in economies with growth profiles as robust as India’s, as rising input costs can be passed through to consumers. By all means, India had an excellent year in 2010, growing at an average +8.85 YoY rate in the three quarters through 3Q10. An easy comp in 4Q suggests that growth rate could potentially be higher when it’s all said and done:


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The problem with that is that it’s in the rear view. Many investors, particularly emerging market portfolio managers point to lagging growth data points as justification for their long positions. Given, you need a go-forward outlook to be short India here and our call is for growth to top out in 4Q10. While we’re not calling for a significant draw-down in Indian growth, we do think the confluence of tough comps, accelerating inflation, tighter monetary policy and a general erosion of financial liquidity could cause Indian GDP growth to slow sequentially by a full (-100bps) in 1H11.


Since 11/9, when we called out the aforementioned setup and turned bearish on Indian equities in a note titled “India’s Two Big Problems”, India’s SENSEX Index has declined  (-9.4%). Further, the index is the second-worst performing global equity market (down (-7.5%) YTD), so one would assume much of the juice has been squeezed already.


Not so fast. India’s SENSEX’s long-term TAIL line of support lies some (-2.4%) below at 18,511. Should we choose to get involved, we’d likely wait for a rally up to the immediate-term TRADE line of resistance at 19,462. There’s more resistance to be found at the intermediate-term TREND line of 19,991. Shorting there would be most ideal.


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Analyzing India from a global risk management lens, we see that the US dollar remains comfortably broken, trading below its intermediate-term TREND line of $78.66 for nearly three weeks on weak promises of austerity and an upward surprise to the US federal budget deficit.  While the inverse correlations between the DXY and many commodities have come down in recent months, we do anticipate them to pick up should the dollar exhibit further weakness from here. Such an event would exacerbate India’s already “desperate” inflation situation (as termed by Subbarao himself).


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Make no mistake about it, India has a major inflation problem, and, as we’ve seen time and time again throughout the history of emerging markets, inflationary spells are typically a much larger headwind than initially predicted. Indian officials are aware of this, subtlety ratcheting up their inflation expectations over the last few months. Their target for YoY WPI growth by March 2011 has increased from +5% in early 4Q10, to 6% on December 14th, to 6.5% in early January, to 7% yesterday. A +200bps jump in inflation expectations over a ~3-month period is certainly cause for alarm.


The alarm bells have been met with foreign investor redemptions, pulling $1B from Indian stocks over the last three weeks. If such redemptions were to mean revert to flat on a two-year basis, there’s $28B more redemptions waiting to be accounted for in 2011. Keep in mind that the 2008-09 crash of the SENSEX was predicated by just $14.8B in foreign investor redemptions in 2008.


While we’re not calling for a crash right here and now, we do think Indian equities will continue to experience further downside in the face of slowing growth, accelerating inflation and interconnected risk compounding.


Darius Dale


Early Look

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