“Faith is an island in the setting sun, but proof is the bottom line for everyone.”
My wife Laura and I had a wonderful time at a fundraiser in Greenwich, CT last night. Our good friends were raising money for The Bowery Mission. Founded by Albert Gleason Ruliffson in 1879, it was one of the first missions established for the homeless in America.
The United States of America is one of the most generous lands that our world has ever known. If you give Americans an opportunity to give, they often will. If you give them a chance to lead, many of them do so by example. There is a faith in this country that cannot be centrally planned out of our hearts.
Faith, accountability, and trust. While these principles may not always resonate intuitively with being “bearish” about a market price, there’s an important investment point to be made here. You have to be able to separate your patriotism, religion, and confirmation biases from the daily risk management discipline that will separate you from the flock. You either have faith in your process, or you don’t.
In his morning tweet, the Dalai Lama complimented this point by reminding us that, “reliable and genuine discipline comes not from repression, but from an understanding of all the whys and wherefores of our actions.”
The Whys and Wherefores of what gets you to buy, sell, and hold; the Whys and Wherefores of what gets you to trust, love, and give; the Whys and Wherefores of what it is that gets you out of bed every morning to do what it is that you do…
It’s all there.
No matter what we do in this profession. No matter where we go in this life. The answers to these questions define and shape not only our individual character, but our collective culture.
Back to the Global Macro Grind…
Having authored the Global Macro theme of Growth Slowing As Inflation Accelerates, I know exactly why it is that I have been taking down my gross exposure and tightening my net exposure (longs minus shorts) for the last 3 weeks.
Last week I sold all of our Oil. This week I sold all of our Gold. We now have a zero percent allocation to Commodities in the Hedgeye Asset Allocation Model.
We’ve written and talked about the similarities between the US Currency Crashing to lower-lows in Q2 of 2008 and 2011 for enough time now that you know that I will not move away from my risk management discipline of respecting The Correlation Risk between US Dollars and everything that’s highly correlated to them.
If you are a Risk Manager, the month of May has reminded you of the following realities associated with a US Dollar arresting its decline (USD Index TRADE line of $74.41 resistance is now immediate-term support – do not be short the USD here):
- Stocks stop going up
- Commodities stop going up
- US Treasuries stop going down
For us, this is good. In terms of how I am positioned in May, that is.
- US and International Equity Exposure = 9%
- Commodities Exposure = 0%
- US Treasury Exposure = 15%
The Whys and Wherefores as to what got me into these positions are reconciled every day with the same repeatable mechanism that got us to make our US crash call of 2008 and the “May Showers” correction call that we made in April of 2010. Whether I am grumpy or glad, our research and risk management process stays the course.
Are the inverse correlations associated with US Dollar moves going to hold forever? Of course not – correlation risk is never perpetual. Could they matter for far longer than the biggest net long position in hedge fund history can be rationally unwound? Mr. Macro Market is going to have to tell us the answer to that – and, in the meantime, I have plenty of time to buy things back.
Why and Wherefore should I have faith in this process?
Because when it works for me, I know why – and when it doesn’t, I understand wherefore I should evolve it.
My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1, $93.67-$100.12, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Conclusion: The fierce grip of sovereign debt on Japan’s Jugular just got a little bit tighter. Below we explore the limited options Japan has to keep its government functioning and economy afloat in this fiscal year and beyond. Further, we use Japan's current situation as an example to highlight some of the many perils of ZIRP.
Position: Still bearish on Japanese equities for the intermediate-term TREND and long-term TAIL. Bullish on the Japanese yen for the intermediate-term TREND as our Q2 Macro Theme of Deflating the Inflation continues to percolate in the global marketplace.
Much like the US, Japan remains in a state of unmitigated disaster from a political leadership standpoint. Just two months following the greatest natural disasters in the country’s history Japanese bureaucrats have regressed to their longstanding ways of finger pointing and fear mongering on the job. Both opposition-led as well as internal calls for the resignation of current prime minister Naoto Kan have trumped the desire to pass financing legislation for the recently enacted ¥92.4T FY11 budget (which began on April 1st, 2011).
Net of the world’s second-finest political posturing (you know which country is in first place), the Diet essentially has two feasible options to finance the current budget: raise taxes or Pile [more] Debt Upon Debt – especially considering the recently enacted ¥4T supplementary relief budget is being financed in part by ¥1.5T in savings from just about all the cuts the DPJ was willing to stomach from the FY11 budget (additional packages summing ~¥21T will have to be financed with additional debt sales, however).
On the debt issue, the LDP continues to stand behind its refusal to approve legislation to sell the necessary amount of bonds which would stand to cover roughly 48% of the ¥92.4T FY11 budget. With GDP growth likely to come in quite soft for the first 1-2 quarters of FY11 due to the impact from the recent crises, it’s likely that Japan will be forced to issue additional deficit financing bonds along the way as tax receipts trail initial projections of ¥40.9T.
To this point, the BOJ has recently downgraded its domestic GDP forecast (-100bps) to 0.6% for the fiscal year ending March 31, 2012 due to the prolonged impact of supply constraints resulting from the disasters. Even without factoring in any mid-year supplementary JGB issuance, Japan is likely to finish FY11 with its Debt/GDP ratio at a whopping 212.4% – far and away the highest in the developed world and well past the Rubicon of 90% whereby sovereign debt burdens begin to structurally impair economic growth. As we have shown throughout our long-term work on Japan via our Japan’s Jugular thesis, the JGB market is setup to endure a major supply/demand imbalance as the population continues to age aggressively causing the Household Savings Rate to turn negative over the next decade or so. Furthermore, Japanese pension funds will have a hard time meeting the coming wall of payouts so long as they continue to devote a large percentage of their assets to low-yielding JGBs (another way ZIRP hurts economies in the long run).
On increasing taxes, Kan is considering raising the national consumption tax from 5% to 8% for three years starting in 2012, though his party maintains a reluctant stance considering the last consumption tax hike back in 1997 sent the economy into a recession. The LDP along with both the Economy and Fiscal Policy Minister (Kaoru Yosano) and the Financial Services Minister (Hakuo Yanagisawa) don’t think a +300bps hike is enough, calling for an increase to beyond 10% (more than double the current rate).
As recently as last month, 38% of Japanese voters approved of higher taxes to finance the rebuilding effort, according to the Nikkei newspaper. It remains to be seen whether or not they approve of structurally higher tax rates to finance deficits that now appear locked in above 10% of GDP in perpetuity (10.7% in FY11) as Japan’s ageing population commands more and more public spending on welfare in the coming years.
We do, however, have clarity on the impact of higher taxes in Japan – depressed growth rates. With all the emphasis on Japan’s Export and Manufacturing numbers, it’s easy to forget that Private Consumption accounts for 57% of GDP on the island economy (vs. 5% for Net Exports). Given this setup, it isn’t a stretch to say that, over the long-term TAIL, as the Japanese consumer goes so goes Japan. With Overall Household Spending trending negative on a YoY basis since October (coincidentally when we introduced our Japan’s Jugular thesis), we remain skeptical of the ability of the Japanese consumer to absorb higher prices after ten-plus years of deflation and stagnant wage growth.
As such, we remain bearish on the long-term TAIL of Japanese economic growth as the confluence of Japan’s suffocating sovereign debt burden or higher taxes depress consumption and limit investment for the foreseeable future. For this reason, we remain bearish on Japanese equities for the long-term TAIL. Reconstruction garbage aside, earnings forecasts for FY12 and beyond will prove much too high given Japan’s long-term growth potential (or lack thereof). To the former point, we remain disheartened by some of the actors within our industry when we come across data points like these:
- According to the latest Bloomberg Global Poll, 15% of Global Investors said Japan gave investor the best opportunity among global equity markets over the next 12 months in May, up from 8% in January. Incidentally, 15% was the highest reading in seven such polls dating back to October 2009.
- Supporting this uptick in sentiment is the belief that Japan experiences an uptick in economic growth in the wake of the recent crises: “The Japanese equity market is largely discounting the reconstruction story… We expect the Japanese economy to have an uptick in activity within the next six to 12 months as reconstruction spending rises.” – Manoj Wanzare Senior PM at Plato Investment Management in Sydney, Australia.
As we continue to maintain, REPLACING what was LOST due to EARTHQUAKES, TSUNAMIS, and a pending NUCLEAR MELTDOWN certainly doesn’t fall within our definition of ECONOMIC GROWTH. At the bare minimum, it’s not the kind of economic growth we think rational investors would be willing to pay for. The Japanese agree, with Consumer Confidence plunging 5.5 points in April to a two-year low of 33.1. We contend the current batch of bullish bets on Japanese equities are nothing more than another manifestation of The Bernank’s Dare to Chase Yield by marking the risk-free RoR to model via ZIRP. It’s amazing to see the kind of storytelling investors come up with when they are forced to chase returns due to their inability to earn a competitive yield on sensible investments.
Perhaps they are bullish on Japanese stocks for another reason – additional easing out of the BOJ. As we have seen throughout Japan’s history and even with the US’s own recent history of QE1 and QE2, central bank easing has a powerful way of inflating asset prices, particularly those of the stock market. It would seem that international investors are positioning themselves to take advantage of any potential easing of financial conditions made possible by the BOJ reacting to what are likely to be incredibly depressed economic growth rates over the intermediate-term. In the two weeks following the initial temblor, the BOJ added ¥40T of additional liquidity to the financial system and it certainly wouldn’t be a stretch to see them go at it again, given their long history of being Indefinitely Dovish.
Not so fast, we contend. BOJ governor Masaaki Shirakawa has repeatedly rejected desperate pleas for additional easing from his own board members, Japanese bureaucrats, and Japanese investors alike. Citing academic doctrines taught to him by Milton Friedman himself, Shirakawa has become increasingly concerned with the propensity of Japan’s repeated monetary accommodation to spur rampant inflation and fuel asset bubbles (we are too). As such, he’s overseen a (-10%) reduction in the size of the BOJ’s balance sheet since the March 11 earthquake as well as rejecting political calls for outright JGB monetization, saying Japan’s current slowdown is attributable to supply-side pressures – something that Shirakawa contends cannot be remedied by additional easing.
In late March, the now marginally hawkish Shirakawa had this to say about embarking on a large scale effort to underwrite JGB issuance on the primary market:
“If a central bank starts to underwrite government bonds, there may be no problems at first, but it would lead to a limitless expansion of currency issuance, spur sharp inflation and yield a big blow to people’s lives and the economy, as has happened in the past.”
To his point, in the last round of outright JGB monetization which occurred during the Great Depression era, Japan’s CPI and PPI eventually peaked at YoY growth rates north of +40% and Real GDP growth slowed sequentially for nearly 15 years. We believe Shirakawa is correct in highlighting this risk to further dovishness out of the BOJ. The last thing the Japanese government wants to deal with is a structural re-pricing of JGB yields (higher). Currently, Debt Service eats up 44.8% of Japan’s combined Tax and Fee Revenue.
As such, Shirakawa has been surprisingly hawkish on the margin in recent weeks, likely augmenting recent gains in the yen (up +5.9% since it bottomed on April 6). As the yen strengthens, we expect more carry trades to be forcefully unwound, potentially driving up the USD which would support additional weakness in the commodity complex. Obviously, we wouldn’t anoint the traditionally dovish BOJ as the key catalyst behind a bullish intermediate-term bet on the yen; as such, we’ll continue to rely on our call for Global Growth Slowing to continue to get priced into global bond markets and compress global interest rate differentials relative to short-term Japanese swap rates (bullish for the yen). Certainly intervention out of global Central Planners remains the predominant risk to being long here – a risk we very much welcome (better entry price).
No matter how you slice it, Japan is in a box from both a political and economic perspective. It can’t organically grow fast enough to offset the growth of its sovereign debt burden, yet it can’t ease enough to artificially grow without risking a backup in JGB yields in the face of a structural decline in JGB demand. For years, investors have been predicting the fall of the Japanese economy, only to watch it resiliently tread water year after year. Could now, however, finally be the time long-term Japan bears start to get validated?
As we called out just days after the first quake hit, the most important take away from the recent string of disasters wasn’t blindly going along for a brief, reconstruction-fueled relief rally; rather it was Japan’s fiscal and political ineptitude being exposed on a global scale for the first time in many years. As Japan is pushed closer to the Keynesian Endgame as a result of the associated costs with said reconstruction efforts, we expect the world to start paying attention. As we are finding out with Greece currently, earnings don’t matter when an economy is imploding. Japan will have its turn in the long-term cycle we’ve appropriately named the Sovereign Debt Dichotomy before this dance is over.
The fierce grip of sovereign debt on Japan’s Jugular just got a little bit tighter. Perhaps that explains why Japanese equities remain broken from a TRADE and TREND perspective.
Risk Managed Long Term Investing for Pros
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.
It appears that every manufacturer survey out of late indicate more downward pressure on profit margins as producers are still having some difficulty passing “inflation costs” thru the supply chain.
As a result, we continue to believe that EPS expectations embedded in S&P 500 (which is a lagging indicator) are too high; inflation slows growth, raises the cost of goods sold and lowers margins. The resulting stagflation implies a lower multiple for the S&P 500. As the chart below shows, expectations are past all-time highs in terms of EPS forward twelve-month earnings and actual earnings are also at peak levels. While expectations are pressing higher and higher (the red line below shows the Street’s expectations roaring higher and higher), actual earnings have been lagging higher but – as I stressed earlier – earnings are cyclical lagging indicators. They were in early 2009 when Hedgeye’s market-view was bullish and they remain so today. Inflation, and its impact on earnings, cost of sales, and multiples, is the factor to watch at this juncture.
The evidence of this was made clear in today’s Empire Manufacturing Index. The report showed that prices paid (highest level since mid-2008 and the second highest ever) for inputs rose by a “median 5%” over the past 12 months, with manufacturers only planning to raise their own prices by a “median 4%.” And that’s assuming they can get away with it!
As the economic recovery has progressed, and the easy-money policy in Washington has been unrelenting, the rise of cost pressures has been inevitable and manufacturers are feeling that pressure in the supply chain. This time around it is occurring at a time when consumer confidence is stagnating and improvements in the labor markets are slowing. Further complicating things is the inventories index which climbed to 10.8, its highest level in a year.
On the positive side, the survey revealed that managers were more upbeat about the future and the hiring index climbed to the second-highest level on record. This consistent with a number of consumer confidence readings we see that points to “future expectations” being well ahead of the reality of the “current conditions.” However, expectations have been outstripping current conditions for some time now.
Positions in Europe: Long Germany (EWG)
A court today denied IMF head Dominique Strauss-Kahn bail and remanded that he be placed in custody until the next grand jury hearing on May 20th under claims he sexually assaulted a chamber maid in a Manhattan hotel room over the weekend. The IMF preempted the court’s decision and replaced Strauss-Kahn with first deputy John Lipsky as acting Managing Director yesterday; however, the timing of the incident collides with the beginning of two day meetings of Eurozone finance ministers to discuss additional funding for Greece and existing loan terms for Ireland and Portugal. With the IMF funding around one-third of European bailout packages, the departure of Strauss-Kahn creates near-term consternation as the region’s periphery remains mired in sovereign debt contagion. We expect the EUR-USD to trade in a band of $1.41 to $1.44 over the immediate term TRADE, and maintain a support level around $1.40 over the intermediate term TREND as the European community continues to fiscally backstop the Eurozone (see chart below).
The EUR-USD declined -1.4% week-over-week in a week that showed increasing inflation readings and strong Q1 GDP reports versus expectations, particular in Germany and France, gaining 1.5% and 1.0% quarter-over-quarter, respectively. However, the common currency remains volatility against a backdrop of headline risk, including current negotiations that hint Greece could receive another €60 Billion on top of the €110 Billion bailout issued in May 2010. Our stance remains that kicking the can of debt down the road doesn’t end well, however that won’t spell decimation for the common currency over the near to intermediate term.
A few near-term catalysts to keep on your screen as it relates to the EUR-USD pair that may influence its movement within a band include:
- Any decision, if any, on additional Greek funding from the Eurozone finance ministers’ meeting beginning today
- State elections in Spain on May 22nd that could jeopardize PM Zapatero’s power
- The ongoing US debt ceiling debate (May 16 until the end of June = White hot political calendar for USD)
Our European Risk Monitors continue to reflect a significant risk premium to own Europe’s periphery, however risk has largely abated over the last week. Greek 10 year bond yields are hovering around 15.5%, and gained 14bps day-over-day, however sovereign Greek CDS backed off 165bps w/w (see chart below). Further, risk continued to fall into the announcement of Portugal’s €78 Billion bailout package and recent confirmation that the Finns will acquiesce to the bailout terms. The 10YR Portuguese government bond yield fell 74bps w/w.
Our European Financials CDS Monitor shows that bank swaps in Europe were evenly split last week, widening for 19 of the 39 reference entities and tightening for 19, with one flat.
Strauss-Kahn’s ruling will also impact French politics, as he was expected to announce his presidential candidacy under the Socialist Party at the end of the month. Going into this weekend, Strauss-Kahn was the most popular candidate to challenge Sarkozy into April/May 2012 presidential elections, with approval polls suggesting he led Sarkozy by as much as 5%.
We remain constructive on German fundamentals and expect the country to lead the region. We’re long Germany in the Hedgeye Virtual Portfolio via the etf EWG and believe the country’s fiscal conservatism leaves it in a strong defensive position as sovereign debt contagion within the region persists. Over the last days we’ve seen Greece and Spain break their TRADE and TREND lines, with the UK’s FTSE breaking its TRADE and TREND lines just today. Our models show TREND support for the FTSE at 5,953 and TREND support for the DAX at 7,100. Stay tuned.
Slowing growth is the story. Hold-aided Genting increasing its market share lead.
The Singapore gaming market generated US$4.9BN (S$6.5BN) in gross gaming revenues over the 4 trailing quarters. Over the same period, Macau casinos took home US$25.7BN and Las Vegas casinos reported US$5.8BN in gaming revenues. On an EBITDA basis, S’pore market cashed in S$3.0BN (US$2.3BN). Relative to 4Q, S’pore 1Q revenues jumped almost 10% to a new quarterly record of S$1.9BN, the highest QoQ growth rate among the three markets. However, Rolling Chip (RC) hold was high (3.3% vs a TTM rate of 3%) during the quarter which contributed virtually all of the QoQ growth.
In terms of market share, Genting came out on top again in Q1. As the charts below show, Genting increased its lead over LVS in EBITDA and revenue share since Q4 due mainly to high hold. However, LVS regained 10 percentage points in VIP RC share after Genting reported an 18.5% sequential drop in VIP RC. The company blames high hold for some of the sequential drop explaining that players wager less when they are losing.
So where do we go from here? Expectations have been so high for the S’pore market in 2011 that modest growth (5-10%) for the rest of the year may not be enough to satisfy the Bulls. The 5% sequential drop in market VIP RC in Q1 is concerning (comparatively, Macau has not seen a QoQ drop in VIP RC since Q4 2008), and the junket licensing catalyst may not happen any time soon. Mass has been relatively flat since the sequential jump in 3Q 2010. Slots have exhibited decent sequential growth but that growth rate has slowed substantially. Of course, Golden Week may reverse these trends temporarily, but we would not be surprised to see some disappointed bulls expecting Macau type growth.
get free cartoon of the day!
Start receiving Hedgeye's Cartoon of the Day, an exclusive and humourous take on the market and the economy, delivered every morning to your inbox
By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.