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A Tale of Two Budget Battles

If we look at recent rhetoric from both the Democrats and Republicans, it seems that an agreement on the 2011 budget is not close.  In fact, according to Michael Steele, Speaker of the House John Boehner’s spokesperson, “the Speaker repeated to the president that there is no ‘deal,’ and he will continue to push for the largest possible spending cuts.”  This was in response to a summary briefing from the White House Press Office that stated:

 

“The President made clear that we all understand the need to cut spending and highlighted the progress that has been made to agree to all work off the same number — $73 billion in spending cuts in this year alone.”

 

Like any good political battle or negotiation, neither side is, at least publically, going to shift their position.  In this battle, the deadline is Friday to pass the budget to fund the government though this fiscal year, which ends in September 2011.

 

Both sides agree that cuts are needed, but the issue is both the size and location of cuts.   Currently, the Republicans are looking for $61BN in discretionary budget cuts, while the Democrats have proposed $33BN in budget cuts.  Further, some Democrats actually believe they have already agreed on the $33BN in cuts.   As Nevada Senator Harry Reid said over the weekend, “We’ve agreed on a number.”  Republicans, as emphasized by the comments from Speaker Boehner’s office above, do not concur that a number has been agreed upon.  A larger issue could be the nature of the cuts, as the Republican-proposed cuts focus on a number of areas of popular left-leaning spending, such National Public Radio, Planned Parenthood, and the Environmental Protection Agency.

 

Interestingly, and not surprising given the dire fiscal outlook of the United States, cutting the budget is becoming increasingly popular amongst the electorate.  In fact, according to a recent poll from Rasmussen, not only do the majority of voters support spending cuts, but 53% actually believe that the cuts proposed by the Republicans are too small.    This poll coincides with a number of polls that have shown President Obama’s approval rating on decline from its highs earlier in the year.

 

According to the Real Clear Politics poll aggregate, President Obama’s approval hit 12-month high on January 24th and has since been in steady decline since.  As of today, Obama’s approval rating was 46.4.  The rapid decline in approval rating in the Real Clear Politics aggregate is underscored by certain polls as well.  Specifically, the most recent poll from Quinnipiac University showed  that U.S. voters disapprove of President Obama’s performance by a margin of 48 to 42 percent and oppose his election by a margin of 50 to 41 percent.  According to the poll, the most negative areas for Obama were his handling of the economy, the budget deficit, and foreign policy.

 

In the budget decision that must be made by Friday, it is unlikely that President Obama wins many political points.  Regardless if a resolution is reached, it will not do much to cut the overall budget and will likely be less than the proposed Republican cuts, which, if we believe the Rasmussen poll, is a smaller budget cut than would lead to approval from the broad electorate.  In the longer term, though, coming out strongly in support of budget cuts, even if this means going along with Republican proposals, could help Obama's approval rating.

 

As it relates to the Republicans and the Tea Party component in particular, they likely won’t be satisfied with any reasonable outcome this week.   For many of the first term Republicans in Congress, the debt and deficit are indeed personal.  As Republican Congressman Blake Farenhold from Texas’s 27th District put it:

 

“The people who seem to be afraid of a government shutdown are worried about getting elected in two more years. I’m worried about having to go home and tell the folks I grew up with, and intend to spend the rest of my life with, that I’m a liar.”

 

Ultimately, though, it will be a political decision for the Republicans, and in particular the Tea Party wing, about winning the larger fiscal battles that loom in front of them.  While the 2011 budget is important, and even personal, the 2012 budget debate begins in earnest this week and the need to extend the debt ceiling begins shortly thereafter. Given this, it is likely that a compromise is reached this week, but, really, the battle is just beginning. Stay tuned.

 

Daryl G. Jones
Managing Director


A Less Consensus Way to Stay Long of The Inflation

Conclusion: The global currency market is telling us to remain long of The Inflation, which, among many things, includes being short emerging market debt. Relative to consensus, we ascribe greater probability for accelerated EM rate hikes over the intermediate term.

 

Position: Short EM local currency debt via the etf ELD.

 

On Friday afternoon, we initiated a short position in WisdomTree’s Emerging Markets Local Debt Fund (ELD) within the Hedgeye Virtual Portfolio. While certainly not a new idea (we’ve been bearish on EM bonds since early November), we did see an attractive entry point on the short side, with the ELD trading at just over 1% below its TAIL line of resistance at $52.75.

 

A Less Consensus Way to Stay Long of The Inflation - 1

 

As a recap, the core tenet of our bearish thesis on EM local currency bonds primarily stems from the intense commodity reflation we’ve seen since Jackson Hole. Such increases in commodity prices apply significant upward pressure on the reported inflation rates of developing nations, as food, energy, and other primary goods typically garner higher weightings in their CPI calculations (relative to developed nations).

 

As such, we’ve seen central banks from Asia, to Latin America, to Emerging Europe tighten monetary policy over the last six months or so; China, Indonesia, South Korea, Thailand, Brazil, Russia, and Poland are notable countries currently engaged in a rate-hiking cycle.

 

As crude oil prices continue to inch higher on weak US dollar policy and MENA instability, we anticipate the transposing effects of higher energy prices to continue percolating throughout their economies, as cost increases get increasingly passed through to consumers. That is likely to result in an accelerated pace of rate hikes, as traditionally dovish EM central banks like Mexico are forced to react to inflationary forces that are less transient in nature.

 

It is our official call that crude oil continues higher over the intermediate term, with potenital upside beyond $120 on WTI. We stick by our long-held view that the situation in MENA will not be short lived, contrary to many pundits who incorrectly predicted near-term resolution earlier in the year. In addition, we don’t see any meaningful-enough shifts in US monetary and fiscal policy capable of stabilizing the dollar above its TREND line of resistance.

 

A Less Consensus Way to Stay Long of The Inflation - 2

 

The US Dollar Index is in a Bearish Formation from a quantitative perspective, which suggests that inflation is more than likely here to stay over the intermediate term. While that is subject to change with more price, volume, and volatility data, for now, the global currency market is telling us to remain long of The Inflation, which, among many things, includes being short emerging market debt. And given the XLE’s run-up YTD (+17.5% vs. only +6% for S&P 500), we suspect some investors might want to start looking for less consensus ways to play this trade.

 

Darius Dale

Analyst


European Risk Monitor: Leaders Bowing Out

Positions in Europe: Long British Pound (FXB); Short Spain (EWP)

 

The week in Europe leads off with two leadership announcements:  Spain’s PM Jose Zapatero said over the weekend that he will not seek a third four-year term with elections scheduled for March 2012 -- a not so surprising decision given his lack of popularity. And Guido Westerwelle, German Foreign Minister and head of Chancellor Merkel’s coalition partner the Free Democrats (FDP) resigned from his position as FDP party chair. We view Westerwelle’s move as a net positive for Merkel’s camp as his popularity has cratered since 2009 and more recently torn her coalition’s credibility - the outcome witnessed by the lack of support for Merkel’s CDU-FDP party in recent state elections.

 

The major headline data point today is Eurozone PPI at 6.6% in February Y/Y vs 5.9% in January. 

 

Keith had this to say in our morning macro commentary:

 

“Interestingly, but not surprisingly, Inflation Accelerating in Europe has both expectations for an ECB rate hike this week (Thurs) and the Euro pushing higher. This is not good for debtors (another way to be long The Inflation), and I think this is most obviously expressed in Greek stocks. They are down a full -2.1% this morning but, more impressively, down -12.9% since a lot of the “reflation” mean reversion trades peaked on FEB 18th.

 

What goes up with Big Government’s help, can come down – and quickly.”

 

From our Risk Monitor we note no great changes in European CDS week-over-week, however the trend continues to rise for Greece, Ireland, and Portugal while falling for Spain and Italy. Our European Financial CDS Monitor showed that bank swaps in Europe were mostly tighter week-over-week, tightening for 30 of the 39 reference entities and widening for 9 (see charts below).

 

We think that the increased likelihood of the ECB to hike interest rates this Thursday (as Eurozone inflation jumps to 2.6% in March Y/Y) will put upward pressure on the EUR-USD this week.

 

Matthew Hedrick

Analyst

 

European Risk Monitor: Leaders Bowing Out   - CDS Europe

 

European Risk Monitor: Leaders Bowing Out   - bank1

European Risk Monitor: Leaders Bowing Out   - bank2


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TALES OF THE TAPE: MCD, SBARRO, MSSR, OUTBACK

Notable news items from the past few days and Friday’s price action.

  • MCD is experiencing difficulty in its efforts to attract jobseekers as Starbucks, Panda Express and Chick-fil-A have built credibility in recent years according to the Chicago Tribune.
  • MCD’s Jan Fields appeared on CNBC and refused to comment on Joe Kernen’s questions regarding 1Q11 sales trends.
  • MCD’s Ronald McDonald is back in the spotlight, not long after industry watchers had speculated that McDonald’s advertising for adult-focused menu items and activists’ criticism would marginalize the character.
  • Sbarro sought Chapter 11 bankruptcy protection after sales slowed, cheese costs rose, listing assets of $471m and debt of $486.6m, in documents filed today in bankruptcy court in New York.
  • MSSR is a target of Tilman J. Fertitta as the investor intends to commence a (low-ball) cash tender offer for McCormick & Schmick’s Seafood Restaurants at $9.25 per share.  We see fair value for the stock closer to $11.
  • OSI Restaurant Partners LLC said it planned to remodel as many as 150 Outback Steakhouse units and focus new unit development on the Bonefish Grill brand.  Chief executive Liz Smith said OSI is planning to renovate about 400 Outback units over the next several years and would explore similar remodeling strategies for its other brands.
  • KKD declined 21% on accelerating volume after the company said late Thursday that it had lost 2 cents per share in the fourth quarter versus street expectations of a gain of $0.04.

 

TALES OF THE TAPE: MCD, SBARRO, MSSR, OUTBACK - stocks 44

 

Howard Penney

Managing Director


WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS

This week's notable callouts include financial company swaps tightening and the Baltic Dry Index falling.  It's also worth pointing out that the government's temporary budget expires this Friday, potentially setting the stage for a government shutdown thereafter if no budget agreement is reached. We consider this an underappreciated risk factor facing the markets in the short term (for more details see this morning's Early Look from our Macro team).


Financial Risk Monitor Summary (Across 3 Durations):

  • Short-term (WoW): Negative / 2 of 11 improved / 4 out of 11 worsened / 5 of 11 unchanged
  • Intermediate-term (MoM): Negative/ 3 of 11 improved / 5 of 11 worsened / 3 of 11 unchanged
  • Long-term (150 DMA): Neutral / 4 of 11 improved / 4 of 11 worsened / 3 of 11 unchanged

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - summary

 

1. US Financials CDS Monitor – Swaps were mixed to positive across domestic financials, widening for 11 of the 28 reference entities and tightening for 17. 

Tightened the most vs last week: MET, XL, HIG

Widened the most vs last week: JPM, PMI, RDN

Tightened the most vs last month: UNM, MMC, WFC

Widened the most vs last month: RDN, ACE, MBI

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - us cds

 

2. European Financials CDS Monitor – Banks swaps in Europe were mostly tighter, tightening for 30 of the 39 reference entities and widening for 9.

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - euro cds

 

3. European Sovereign CDS – Sovereign CDS were mixed across Europe, rising in Greece, Portugal, and Ireland, but holding flat in Spain and falling in Italy. 

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - sov cds

 

4. High Yield (YTM) Monitor – High Yield rates fell slightly to close a volatile week, ending at 7.85, 2 bps lower than the previous week.  

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - high yield

 

5. Leveraged Loan Index Monitor – The Leveraged Loan Index rose last week to end the week at 1617.   

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - lev loan

 

6. TED Spread Monitor – The TED spread rose last week, ending the week near a new high at 23.6 versus 22.0 the prior week.

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - ted spread

 

7. Journal of Commerce Commodity Price Index – Last week, the JOC index fell to end the week at 32.9, 2.2 points lower than the prior week.

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - JOC

 

8. Greek Bond Yields Monitor – We chart the 10-year yield on Greek bonds.  Last week yields rose 17 bps.

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - greek bonds

 

9. Markit MCDX Index Monitor – The Markit MCDX is a measure of municipal credit default swaps.  We believe this index is a useful indicator of pressure in state and local governments.  Markit publishes index values daily on four 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. Our index is the average of their four indices.  As of Thursday, the most recent data available, spreads rose to 138. 

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - markit

 

10. Baltic Dry Index – The Baltic Dry Index measures international shipping rates of dry bulk cargo, mostly commodities used for industrial production.  Higher demand for such goods, as manifested in higher shipping rates, indicates economic expansion.  Early in the year, Australian floods and oversupply pressured the Index, driving it down 30%. Since then it has bounced off the lows.  Last week it fell slightly, dropping 65 points to 1520. 

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - baltic dry

 

11. 2-10 Spread – We track the 2-10 spread as a proxy for bank margins.  Last week the 2-10 spread tightened to 265 bps. 

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - 2 10

 

12. XLF Macro Quantitative Setup – Our Macro team sees the setup in the XLF as follows:  0% upside to TRADE resistance, 1.1% downside to TREND support.

 

WEEKLY RISK MONITOR FOR FINANCIALS: FINANCIALS SWAPS TIGHTEN AS US GOVT SHUTDOWN RISK LOOMS - xlf

 

 

Joshua Steiner, CFA

 

Allison Kaptur


Shutdown

“Sometimes we stare so long at a door that is closing that we see too late the one that is open.

-Alexander Graham Bell

 

Finally, we’re here. This week we’re finally going to see US Professional Politicians face the door that’s closing on their conflicted and compromised careers of debt-financed-deficit-spending. This isn’t the time to give into their fear-mongering. This is going to open he door for a generational opportunity in America. This is great news.

 

On Friday, the stop-gap bill to keep the US Government open for business expires. With $14,272,778,776,442 in US Debt + another $55,800,000,000,000 in unfunded Medicare and Medicaid liabilities, I say shut these politicians down. The biggest risk to America today isn’t what’s happening in the Middle East or Japan – it’s the 112th Congress.

 

And no, Mr. Jaime Dmon, we don’t measure America’s risk solely in terms of the price of its stocks and bonds. America is bigger than that. America is a place that puts a higher multiple on liberty than it does the sustainability of your earnings. America is a place where The People who stand up for the truth will be heard.

 

From a fiscal and monetary policy perspective, the sad truth about last week in Global Macro markets was more of the same. The US Dollar Debauchey continued – and, as a result, The Inflation that’s priced in US Dollars pushed higher.

 

With the US Dollar Index closing down for the 10th week out of the last 14, here’s what else happened to prices week-over-week:

  1. Euro = +1.4% to $1.42 versus the USD closed out the best quarter that it’s had since it started trading in 1999
  2. Canadian Dollar = +2% to $0.96 versus the USD and continues to ake higher-highs
  3. CRB Commodities Index (19 commodities) = +0.3% to 360, testing its highest weekly closing highs since The Inflation of 2008
  4. West Texas Crude Oil = +2.4% to $107.94, making a fresh 30-month high just in time for your weekend at the pump
  5. Gold = +0.10% to $1428, closing just a hair inside its highest weekly closing price ever – ever is a long time
  6. Copper = -3.6% to $4.25/lb as the world comes to realize that Global Growth Slows As Inflation Accelerates
  7. Volatility (VIX) = -2.7% to 17.41 as month and quarter-end trading volumes slowed to a pay-day halt
  8. 2-year US Treasury Yields = +9.5% to 0.80% as the politicization in the short end of the curve comes under global pressures
  9. Yield Spread (10-yr yields, minus 2-yrs) = -7 basis points on the week, upsetting the piggy banker’s net interest margin spread

US Equities ralliedto another long-term lower-high because, well… as Gordon Gekko might say, debt-financed-deficit spending “is good”…

 

Until it isn’t.

 

Interestingly, but not surprisingly. It was all good for Greek Equities too … until the Free-Moneys-Forever monetary policy of the European Central Bank (ECB) stopped playing the music.

 

With the ECB set to raise interest rates on Thursday, Euroe’s currency and interest rates continue to strengthen. This is great news for the conservative Euro dweller who has cash in that old tickle trunk that we old fashioned folks call a savings account. It’s really bad news for the Greek Gekkos out there who are laden with deficits and debts.

 

Greece’s stock market is down another -2.1% this morning, taking its cumulative swoon to -12.9% since what Wall Street called the “reflation” trade sarted to morph into The Inflation problem on February the 18th. Interestingly, but not ironically, that was the same day that the SP500 peaked for 2011. This should remind us all that what goes up with Big Government’s help, can come down – and quickly.

 

If you want to look at The Inflation being priced into Global Market prices for the YTD, it’s pretty straight forward: TOP Global Stock Market YTD = Russia +17.2% versusBOTTOM Global Stock Market YTD = Egypt -23.0%.

 

I know - which one of the affluent American Senators of the Fiat Republic really cares about starving young people in the Middle East or the 44,000,000 Americans (new all-time high) on food stamps anyway? Social revolutions be damned. Obama’s got the guns.

 

In the US stock market, The Inflation trade continues to be the only one that’s really getting people paid: S&am;P Sector Performance YTD: Energy (XLE) = +17.2% versus Consumer Staples (XLP) = +2.6%.

 

Of course, everyone on Wall Street and in Washington knows this – we just don’t like to talk about it so plainly. The Inflation is a policy to get the stock market “going” – The Bernank has all but told you that. Now it’s time for us to start dealing with its unintended societal consequences.

 

In the edgeye Asset Allocation Model, I drew down my Cash position week-over-week. Here are the allocations ahead of this week’s trading:

  1. Cash 46% (down from 52% last week)
  2. International Currencies = 27% (Chinese Yuan, Canadian Dollar, British Pounds – CYB, FXC, and FXB)
  3. Fixed Income = 12% (Long-term Treasuries and US Treasury Flattener – TLT and FLAT)
  4. Commodities = 9% (Oil and Gold – OIL and GLD)
  5. International Equitie = 6% (China – CAF)
  6. US Equities = 0%

That’s right. At this stage of the game, I have the same policy as The Bernank in trusting the 112th Congress with The Inflation – ZERO. That’s marked-to-market with a zero percent allocation to US Equities until the US Dollar stops being debased. If it takes a Shutdown of these professional politicians and the storytelling they employ – so be it. In the long-run, wersquo;ll all be better off with them just stopping what they’ve been doing anyway.

 

My immediate-term support and resistance levels for the SP500 are now 1314 and 1339, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Shutdown - Chart of the Day

 

Shutdown - Virtual Portfolio


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