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Chinese Exposition

Conclusion: Below we’ve compiled our take on several key discussion points which have arisen in the wake of our 2Q Key Macro Themes Call, specifically as it relates to our Year of the Chinese Bull theme (email us if you need the replay podcast and presentation materials). 

Position: Long Chinese equities (CAF); Long Chinese yuan (CYB)


Q: In the U.S. a tightening cycle is usually not great for equities.  Why are you not more concerned about Chinese equities given that the Chinese government is tightening in an effort to deal with inflationary pressures? 


A: The point we we’re attempting to make on slide 16 in the presentation is that the bulk of the Shanghai Composite’s earnings either benefit from, or are insulated from tightening. In fact, if you look back to the last period of Chinese tightening back in 2006-07, we saw that China’s equity market put on an over +200% move to the upside. Obviously no two periods of time are the same and we certainly aren’t making the case for a similar move, but, as the graph below shows, Chinese equities can indeed work amid a tightening cycle.


Chinese Exposition - 1


One of the key tenets to the call we are making now is for Chinese CPI to top out and decelerate in the coming months – and Friday’s +5.4% CPI reading could indeed be a cycle top. That would potentially allow the PBOC to ease off the brakes and allow the growth premium to return to China’s long-term interest rates. A widening yield spread is explicitly bullish for nearly one-third of the index’s earnings and higher growth expectations are good for the majority of the rest of the market. Further, China’s yield curve is now at/near pre-financial crisis, pre-recovery levels. A higher spread from here would be bullish for Chinese bank earnings, while a lower spread would likely be an ominous signal for the global economy.


Chinese Exposition - 2


If we’re wrong and China’s CPI continues to rip to the upside like it did in early ’08, we still have mean reversion (bear case is a known-known), accelerating relative growth vs. slowing US/EU growth, and cheap valuations relative to their own historical range. This three-factor setup alone makes Chinese equities interesting from an institutional fund flow perspective –remember Chinese equities went no-bid for nearly 2/3rds of last year.


If we’re really wrong on the slope of Chinese inflation and it causes the PBOC to either: a) significantly tighten far beyond any current expectations, or b) revalue the yuan significantly in an expedited manner, the resultant effects of scenario “a)” would be very negative for global growth and a significant, expedited appreciation of the yuan as outlined in scenario “b)” would bring about many unwelcome consequences for the global supply chain – particularly from an import price perspective in China’s export markets. Such a scenario would be bad for anything equity-related, in our opinion.


As we pointed out in a research note on 2/16/11 titled “China: Stuck Between a Rock and a Hard Place”, political consensus’ demands for China to quickly revalue the yuan are misguided at best. It would likely take most companies 2-3 years to offset the resultant lack of price competitiveness from a higher FX rate by installing manufacturing capacity in other markets. Near to intermediate-term, a major yuan revaluation would likely result in an import price shock in China’s export markets.


Addressing the “relative” aspect of the question, with regard to the U.S., China is not nearly as sensitive to interest rates in one direction or the other. China’s gross national savings rate is north of 50% of GDP and consumption still hovers around 35-38% of GDP – about half of what it is in the U.S. What this means is that as interest rates increase, Chinese consumers and corporations actually have more income from which to consume given their already high savings rate.


Chinese Exposition - 3


From a investment perspective, rising interest rates don’t have quite the same impact in China because the hurdle rate for capital expenditures is much lower than in the U.S., given China’s historically elevated economic growth rates. Essentially, China’s robust growth profile creates a wide spread between expected returns on capital projects and the project’s weighted average cost of capital. Therefore, China has a lot of hay to bale from an interest rate hike perspective if they are going to have a meaningful impact on slowing the growth of capital expenditures.


In China, a great deal of household wealth sits in a shoebox in the family plot (not kidding). Relative to the massive oversupply of savings, China’s bond market (~$3T) isn’t quite liquid enough to accommodate that kind of an influx of funds out of its ~$6T equity market or the ~$6T economy, so net-net, more attractive rates of return don’t have nearly the same flow of funds impact in China than they do in a more advanced economy such as the U.S. Moreover, with China’s household consumption as a percent of the overall economy at about half of the U.S. rate and with Chinese consumers being significantly less levered than their U.S. counterparts, rate hikes simply don’t have the same impact of slowing aggregate growth by deterring consumption in China as they do in the U.S.


Q: What is your call on falling inflation in China predicated on? I guess the argument could be made that as the government allows the currency to appreciate quicker, that will naturally put the brakes on inflation, but does that fully offset rising labor costs associated with urbanization and normalization of salaries or commodity pressures (esp. oil) which when combined make up more than 1/3 of headline inflation?


A: The projections on slide 14 are the outputs of a quantitative model we use to forecast the slope and amplitude of a YoY economic data series. While it back-tests with an r² greater than 0.8-0.85, we do understand that it is purely a mathematical exercise and not to be fully trusted without quantifiable catalysts. Understanding that, our confidence in the slopes of those lines is derived from on a confluence of factors that stem from China’s proactive response to inflationary pressures.


While much of the media has been focused on China’s four rate hikes since October, the reality is that China’s been tightening since last January and recent moves by the PBOC to force banks to bring off-balance sheet assets back onto their balance sheets will make China’s ten reserve requirement ratios since Jan. ’10 start to actually have some measurable effects. In all, Chinese banks’ reserve requirements have increased +500bps in the last 15 months. We’re already seeing the effects of that in the form of slower Money Supply growth, slower Credit growth, and negative YoY Total National Financing growth in 1Q11.


Chinese Exposition - 4


The yuan has and will continue to be used as a tool to combat inflation – perhaps even more so than before, judging by PBOC governor Zho Xiaochuan’s commentary this past weekend. The yuan has risen +4.5% vs. the USD since it was de-pegged last June and his latest commentary was that the PBOC has grown increasingly concerned about the spread of Chinese rates vs. U.S./global rates. The spread between China’s 1Y Deposit Rate and the Fed Funds Target Rate and the ECB Main Policy Rate is now at levels last seen since just before the Asian Financial Crisis of 1997-98. They are legitimately concerned about the potential for destabilizing capital inflows and that will likely shift their policy stance towards favoring additional yuan appreciation and reserve requirement hikes for now – at least on the margin.


Chinese Exposition - 5


Lastly, to the extent the confluence of China’s tightening measures fully offset recent and anticipated wage growth does indeed remain to be seen. At this point, that remains one of the key risks to the thesis – accelerating inflation perpetuated by consumer demand – and no longer just monetary expansion. That would, however, be bullish for China’s near-term consumption figures and incrementally positive for overall Chinese growth in the near-term. And, as we’ve seen with WMT recently, China has the power to limit and/or outright deny price hikes for finished goods. It’s food and energy prices that makes the PBOC’s fight difficult; so to the extent we continue to see higher-highs in food and oil prices, we’ll likely see elevated levels of Chinese CPI and incremental yuan strength.


At the end of the day, it is important to remember that Chinese CPI itself is a mathematical series that is subject to: a) the Chinese government making up the number (like we do domestically); and b) its own base of comparison. We’d have to see an acceleration in the velocity of food and energy price increases for Chinese CPI to “comp the comps” and that’s not something we have in our forecasts for 2H11 – the dollar can and will be burnt only to a point before it snaps fervently off its lows. For now, that’s something we see as a 2Q/ early 3Q phenomenon.


Q: Also as a follow-up, we have seen more and more automation in China as more of a LT solution to rising wages. In 2011, I think more and more companies will be taking that route. The break-even point between manual and automation may be 3 years, but the first year or so the cash costs from implementing automation is much greater than running the business on manual labor. Is there a possibility this may serve as a ST positive inflation shock, as these costs have to get passed through somehow?


A: Great point and to be honest, we haven’t done the work here specifically so we’ll hold off for now. The only thing we’d say is that from a probability weighting perspective, this would rest more on the tails rather than in the heart of the bell curve of probable scenarios. From our vantage point, there’s more lower-hanging fruit to analyze when attempting to forecast Chinese CPI over the next 6-9 months.


Darius Dale


European Risk Monitor: Peripheral Risk Pops as Finnish Elections Inflect

Position in Europe: Long British Pound (FXB)


As is typical for Mondays, we release our weekly European Risk Monitor. This morning peripheral risk premiums have popped dramatically in response to 1.) ongoing concerns that Greece must restructure its debt, 2.) Finnish elections over the weekend that saw the anti-bailout/euro-skeptic True Finns party gain significant share, 3.) widening yields from a Spanish bond issuance, and 4.) Moody’s decision to downgrade long-term deposit ratings of five Irish banks to junk.


As we’ve seen over recent weeks, European sovereign debt contagion fears have accelerated.  While Greek leadership continues to deny that its public debt needs restructuring (a position also held by French finance minister Christine Lagarde), the Germans under finance minister Wolfgang Schaeuble continue to press in opposition. As the debate heightens, the market is sending a clear signal, with Greek sovereign CDS jumping a full 112bps day-over-day to 1262bps as the Greek 10YR bond yield gained 65bps to an all-time high of 14.5% today! (see chart below)


European Risk Monitor: Peripheral Risk Pops as Finnish Elections Inflect - CDS11


European Risk Monitor: Peripheral Risk Pops as Finnish Elections Inflect - yields22


Finnish parliamentary elections on Sunday further weighed on the region as the True Finns more than quadrupled its share of the vote to 19% (to place third) under a platform opposed to Eurozone bailouts.  According to exit polls, the conservative National Coalition Party of current finance minister Jyrki Katainen leads with 20.2%, followed by the opposition Social Democratic Party (which also opposes further bailouts unless private investors and lenders are forced to take financial losses) with 19.4%. While the weeks ahead will bear out the structure of a coalition government, the True Finns’ gain under the leadership of Timo Soini puts into play an inflection in Finland’s traditional pro-Europe stance, and complicates a potential bailout for Portugal assuming a new Finnish government rejects further bailouts and unanimous approval must be reached by all Eurozone member states to grant new rescue loans.


Rounding out a thick flow of European news this AM, Spain sold €3.51 Billion of 12M bonds at an average yield of 2.770%, far outpacing the previous issue a month ago of 2.128%, and €1.15 Billion of 18M bills at 3.364% versus 2.436%.  Additionally, Moody’s downgrade the long-term deposit ratings of Allied Irish Banks, EBS Building Society, and Irish Life & Permanent Group Holdings by two notches to Ba2, and ICS Building Society and Bank of Ireland (one and two steps respectively) to Ba1, the highest junk rating. This follows Moody's decision last Friday to downgrade Ireland's debt two notches to Baa3.


In response, Spanish CDS jumped 13bps to 246bps and Irish CDS rose 30bps day-over-day to 589bps. Our weekly European Financial CDS monitor indicates that bank swaps in Europe were wider week-over-week, widening for 34 of the 39 reference entities and tightening for 5 (see chart below).


As yields push up and credit ratings deteriorate, it will be more and more difficult for Europe’s periphery to (re)finance its debt. This should spell underperformance, in particular from the peripheral capital markets, yet associated weakness could also spill over to the region’s most stable countries, and in particular the common currency that up until this week was pushing against $1.45 versus the USD on higher benchmark interest rates form the ECB and a continued drag on the USD from weak US fiscal and monetary policy.


We covered our position in Spain today in the Hedgeye Virtual Portfolio with the country getting hammered down to our immediate-term TRADE support level. Our long-term TAIL view of Spain remains bearish.


Matthew Hedrick



European Risk Monitor: Peripheral Risk Pops as Finnish Elections Inflect - banks333


As we wrote in our preview on 4/7/2011, we believe WYNN had a big Q1 in Vegas and Macau.  In preparation for WYNN’s Q1 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from WYNN’s Q4 earnings call. 





  • “We’ve been adding junket operators, and we’ve got one or two more coming this spring [2Q].”
  • “With two additional junkets, you could see that ratio [10-15% direct] go to the lower side, for sure. But the direct business is still up, well over 50% for the year, and is continuing to grow. But Linda grows them one customer at a time.”
  • “In Macau, the credit balances outstanding with our associates in the junket business are very large. We, on our own account, reserve 3% or 4% for bad debt.”
    • “Our reserve as a percentage of receivables is 47% right now in Macau, which is very, very comfortable.”
      • Q: How does that compare to the other operators?
        • A: Much higher
  • “And I’m hoping that we can get started in March, or April, at the latest. It’s a landfill, as you know, at Cotai, and so there’s remediation that takes place for the foundation work that adds six or seven months to normal construction time.”
  • [Cotai opening] “I think late ‘14, early ‘15 would be my best guess.”
  • [2011] “Somewhere between 20% and 22% of our room nights will be convention this year.”
  • [Wynn Encore Macau] “There’s actually still room to grow there. So, especially on the weekends, we were always capacity-constrained with our rooms, so adding the 414 rooms and suites really helped us out. Another thing that we’ve done is, as everybody’s mentioned, we’ve added some junkets. And, in fact, we continue to modify our floor, to increase capacity with both our VIP and, especially, also our high-limit mass areas. That’s been extremely well received.”
  • “We actually built spaces [in Wynn Encore Macau] that were smaller on purpose. And you just heard what Matt said, what’s the multiple?....Three-and-a-half times for fourth quarter and two-and-a-half times for the year…. Also, there’s a lot of opportunity in our slot revenue. We’ve restructured our slot operation for 2011. It will be completed here in a few days, and we’re going to have a jump there.”
  • [Cotai] Well, now that the plans are finished, it’s in the hands of Wynn Design & Development to create a construction budget, and that process has just begun, and I’m not quite ready to say, but I think $2.5 billion is a comfortable number for us. We’d have no compunction about spending that kind of money on the facility, with all of its entertainment potential. And so – and as far as I mentioned a few minutes ago, as far as when we get started, that’s up to the government. They’ll tell us. And I expect that it’s not very far away.” 
  • “I would not tell you that our credit has loosened. I would say that our business volumes have increased. We’ve kept our reserve methodology the same throughout, and we’ll continue to do so in the future. We continue to be very prudent about junket partnerships. We have more people interested than we require, and we add very organically. We’re very careful in our due diligence, and the relationships we have with our junket partners are true partnerships.” 
  • “I think if you look at the very peak times that happen in the city over the Golden Week holidays, everybody manages to get in. We’re able handle incredibly high volumes. I think the infrastructure side of things is a bit over talked about. There are good things happening in the next 18 to 24 months. We have the Pac-On Ferry Terminal goes through a considerable expansion. The Gongbei border gate is increasing capacity of daily arrivals by up to 60%. And there’s more ferry services being put online to Macau. So the market seems to be able to handle the additional customer arrivals, so I don’t foresee an imminent problem. And the beauty of Cotai coming on stream in late ‘14, early ‘15, is the monorail system will be up and running from the Pac-On Ferry Terminal around our property on two sides. So the government has reacted. There’s more taxis in the marketplace. Macau is a small city. When it’s very busy, it does get a little bit choked at key times, but that’s the same everywhere in the world.” 
  • [Galaxy Macau impact] “It should be good for the market, too, because the market does not have enough hotel rooms to accommodate the people on the weekends. So I think it will be good for Cotai and good for the market overall.” 



  • “Our room rates are up a little. Our occupancy is okay. Our convention bookings are ahead of last year. I’m saying that these indicators are pointing up. Slots are still weak, but the indicators about visitation and room rate and convention bookings, which are very important for the mid-week period, are pointing up.”
  • “In terms of areas of opportunity for growth in 2011, we’re continuing to see improvements in domestic business, and so we’re seeing lots of opportunity there. Obviously, Matt already talked about the convention opportunities that we have here in Las Vegas. We’re expecting that to really help us on the room side this year.”
  •  “We raised rates – we have just remodeled the entire Wynn facility.  We have between 2% and 3% of our rooms still under remodel. We finish by April, the end of April. And the amount of rooms that are out of order – suites and villas – is down to 2% or 3% now, so it really doesn’t matter a lot.”
  • “We are running at around 9,300 FTEs right now, and we think that is a good run rate, even if business volumes do increase. So our fixed costs right now, we feel pretty comfortable with, and any increase in cost should really be more on the variable side. So that’s the beauty of these hotels with operating leverage, as things get better, your margins get better.” 



  • [Corporate expense] “Better run rate is closer to the third quarter – which was, excluding stock-based comp, around $18 million – as a run rate going forward.”
  • “So at 12/31, about half of the cash is at the parent – a little more than half – and the rest is at subsidiaries, mainly Wynn Macau, which was $1.3 billion.”
  • [Q] “I believe you said that it would be a very long time before you would develop anything in the United States again, and I wondered if you still think that’s true.”
    • [A]I don’t still think it’s true. I changed my mind.”

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Breakdown: SP500 Levels, Refreshed...



Life is good. Risk management is hard.


Given the heightening probability of a US Currency Crisis (see slides and replay from our Q2 Global Macro Themes call we hosted on Friday), it shouldn’t be a conceptual surprise to see the SP500 slicing through both our immediate and intermediate-term levels of risk management support: 

  1. TRADE = 1319
  2. TREND = 1302 

As I wrote on Friday, citing Baupost’s Seth Klarman, “There’s an invisible tipping point – when we get there, it’s far too late.”


We didn’t need a ratings agency to remind us of that.


The long-term TAIL of support for the SP500 is still intact, but it’s a lot lower – down at 1186.



Keith R. McCullough
Chief Executive Officer


Breakdown: SP500 Levels, Refreshed... - 1


Trending +HK$20BN for April



Macau continues to defy expectations with this past week actually accelerating from already strong weekly revenues.  Through April 17th, total table gaming revenues were HK$11.7 billion and average daily revenue exceeded HK$688 million month to date.  Total April gaming revenues including slots are now on pace for HK$20.0-21.0 billion, up 52-59%, and that assumes a pre-holiday slowdown the rest of the month.


In terms of market share, MPEL and WYNN are the standouts while Galaxy and SJM are “struggling”.  Of course, with market numbers like these, market share probably isn’t such a concern.  Here is the data:




Notable news items from the past few days, Friday’s price action, and our fundamental view on select names.

  • PZZA President and Co-CEO Jude Thompson resigned from the pizza chain Friday, leaving the company in the hands of founder and co-CEO John Schnatter.
  • PZZA was cut to Hold from Buy at Stifel Nicolaus.
  • PZZA shares gained prior to the news announcement (AMC) by 1.9% on accelerating volume.
  • MSSR many delay its AGM if Tilman Fertitta has his way.  Fertitta is calling for shareholders of the company to sign a gold proxy card giving LSRI, a subsidiary of Fertitta’s Landry’s Restaurants Inc., power over their share for the meeting.  This would prevent a quorum being reached, effectively impeding the company from addressing its business at the meeting until first discussing LSRI’s unsolicited tender offer.
  • DRI made the cut for JPM’s “Best Equity Near-Term Ideas” report led by Thomas Lee.  JPM's price target is $56.
  • WEN gained on accelerating volume on Friday.
  • BJRI shares gained 2.82% on accelerating volume.



Howard Penney

Managing Director

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