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Year of the Chinese Bull

This note was originally published at 8am on May 13, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“If you do not change direction, you may end up where you are heading.”

-Lao Tzu

 

Lao Tzu, born in the sixth century B.C., is known as the founder of Taoism and the author of Tao Te Ching.  In this book, Lao Tzu describes the Tao “as the mystical source and ideal of all existence”.   Interestingly, in some legends he was born after being in the womb for 62 years – as a grown man with a grey beard and long ear lobes (a sign of wisdom).

 

The quote above from the founder of Taoism is apropos as it relates our investment views of China over the past couple of years.  Early last year we introduced the Chinese Ox in a Box theme, which encapsulated our view that Chinese central banking authorities would be forced to raise interest rates due to broad measures of inflation, which would lead to a negative delta in Chinese growth and the likely underperformance of Chinese equities.

 

This theme played out according to plan as China led the world in tightening monetary policy and the Chinese stock market was one of the worst performers last year, finishing down -14.3%.  Of course, markets trade on future expectations, not trailing facts.  With China’s dismal equity performance in the rearview mirror, it is now time to focus on those future expectations.  Our view is that those expectations are sufficiently low versus the potential upside in Chinese equities.  That is, we see asymmetric risk / reward in being long of China.

 

This “change in direction”, has also led to change in theme name, which we introduced in April on our Q2 Theme Call as Year of the Chinese Bull.  That’s right, the hockey heads in New Haven are all bulled up on China.  Giddy up! On a serious note, as our subscribers well know, we are far from being cowboys when it comes to managing risk and making recommendations.  In fact, there is an omnipresent sense of accountability standing behind all of our research at Hedgeye.  As such, the key tenets of our latest thesis on China are outlined below and predicated on a lengthy research trip that Analyst Darius Dale took to Asia last fall.

 

Firstly, expectations are subdued for Chinese equities.  This is reflected in two measures, the performance of the Chinese equity market last year and the valuation, broadly speaking, of Chinese equities.  Last year the Shanghai Composite was down -14.3%, which was a negative outlier amongst the world’s largest economies.  Despite this, China continued to grow, and so did the earnings of Chinese companies.  As a result of lower prices and higher earnings, the Chinese stock market, based on the Shanghai Composite, is trading at roughly14x NTM earnings, which is at the bottom of its long run valuation range.

 

Second, China is at an inflection point in growth versus global growth more broadly.   After five quarters of Chinese growth narrowing versus global growth, Chinese growth bottomed on comparative basis in Q3 2010 and is now reaccelerating versus the rest of the world.  In our view, this will primarily come from global growth slowing, as seen in the United States last quarter, versus Chinese growth necessarily accelerating.  Even so, as global growth slows, Chinese growth will become much more attractive on a relative basis.  In the Chart of the Day below, we highlight this graphically.

 

Finally, we believe both of the key factors of monetary policy and inflation will begin to work to benefit equities.  On the first point, China is not starting to tighten monetarily, but in fact is likely closer to the end of its tightening regime.  In fact, as of yesterday’s increase, Chinese banks’ reserve requirement ratios are now at an all-time high of 21.5%, with some exceptions.   In addition, China has been raising rates steadily since October 2010.  The impact of this proactive tightening can be seen in declining money supply growth in China.  Not surprisingly then, our models see tightening being reflected in a gradual decline in the year-over-year growth rates of Chinese CPI.

 

Now we certainly get that there are risks to being long of China, but on our factors of growth, monetary policy, and inflation, the Chinese equity outlook looks promising over intermediate term.  The obvious pushback we get on this thesis relates to our willingness to be long of a Communist nation that formally utilizes central planning.  We get that, but also get that things aren’t all that different in many Western nations as it relates to governments trying to influence the economy.  In fact we stumbled upon the following quote in our morning grind this morning:

 

“I absolutely see a continuation of QE2 in some form; the economy certainly isn’t strong enough to survive on its own.”

 

This quote came from Keith Springer, president of Springer Financial Advisors.  Now we don’t know Mr. Springer, so we’ll leave it at that, but admittedly we do find it sad that this nation has gotten to a place where investors legitimately believe the “economy can’t survive” without another dose of Keynesian Kryptonite.  Last time I checked my Yale history books, the economy of this great republic has survived – and thrived – over the 230+ years that preceded The Quantitative Easing.

 

As you head off into the weekend, I’ll leave you with a quote from Confucius to contemplate:

 

“Men's natures are alike; it is their habits that carry them far apart.”

 

Or in hockey speak: back check, fore check, pay check.

 

Enjoy the weekend with your friends and family,

 

Daryl G. Jones

Managing Director

 

Year of the Chinese Bull - Chart of the Day

 

Year of the Chinese Bull - Virtual Portfolio


THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - May 18, 2011


US stocks have been down for the last 3 days and the last 3 weeks – and after taking a good hard looking at the intermediate term TREND line of 1319 in the SP500, we should see another low-volume bounce to lower-long-term highs; resistance = 1340.  As we look at today’s set up for the S&P 500, the range is 17 points or -0.75% downside to 1319 and 0.53% upside to 1336.

 

SECTOR AND GLOBAL PERFORMANCE


THE HEDGEYE DAILY OUTLOOK - levels 518

 

THE HEDGEYE DAILY OUTLOOK - daily sector view

 

THE HEDGEYE DAILY OUTLOOK - BEST PERFORMING GLOBAL

 

THE HEDGEYE DAILY OUTLOOK - WORST PERFORMING GLOBAL

 

 

EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: -483 (+584)  
  • VOLUME: NYSE 971.43 (+7.07%)
  • VIX:  17.55 -3.78% YTD PERFORMANCE: -1.13%
  • SPX PUT/CALL RATIO: 1.89 from 1.88 (+0.77%)

 

CREDIT/ECONOMIC MARKET LOOK:

  • TED SPREAD: 22.96
  • 3-MONTH T-BILL YIELD: 0.04%
  • 10-Year: 3.12 from 3.15
  • YIELD CURVE: 2.57 from 2.61 

 

MACRO DATA POINTS:

  • MBA mortgage applications index up 7.8% week ended May 13; Refis up 13%, largest gain in 10 weeks;  Purchases fell 3.2%; Avg. 30-yr fixed rate 4.60%, lowest since end Nov., vs 4.67% prior week
  • 10:30 a.m.: DoE Inventories
  • 11:30 a.m.: U.S. to sell $5b 56-day cash mgmt bills
  • 2 p.m.: FOMC Minutes
  • 7 p.m.: Fed’s Bullard speaks in New York  

 

WHAT TO WATCH:

  • U.S. Treasury Secretary Geithner said the IMF needs to name an interim leader because Strauss-Kahn is “obviously not in a position” to run the fund; Europe seeks to keep top position
  • EU Commission completes quarterly review of EU/IMF financial assistance program to Ireland; authorizes the release of the second installment
  • Bullish sentiment decreases to 45.6% from 51.1% in the latest US Investor's Intelligence poll
  • Banking groups opposed to simpler mortgage forms - Bloomberg
  • Fed wants to subject US banks to annual stress tests - FT
  • Russian President Dmitry Medvedev says he doesn’t exclude that some oil companies are colluding to increase prices for gasoline on the domestic market.
  • Google’s First Bond Sale Drew Orders Exceeding $10b: WSJ 

 

COMMODITY/GROWTH EXPECTATION

 

THE HEDGEYE DAILY OUTLOOK - daily commodity view

 

 

COMMODITY HEADLINES FROM BLOOMBERG:

  • Milk Rally Causing Higher Prices at Wal-Mart Also Spurring Gains in Output
  • Commodities Rebound on Outlook for Stronger Demand From Emerging Markets
  • Oil Rises From Three-Month Low as Supplies of Cushing Crude, Gasoline Drop
  • Copper Climbs to One-Week High as Commodities, Equities Rebound From Drops
  • Corn Advances for Fifth Straight Day as Wet Weather May Delay U.S. Seeding
  • Gold Gains for First Day in Four on Weaker Dollar, European Debt Concern
  • Drought in China’s Hubei Withers Rapeseed, Wheat Crops, Delays Plantings
  • Oil, Gold Will Drive Rebound in Commodities on Shortages, JPMorgan Says
  • Coffee Rises on Concern About Limited Supplies; Sugar, Cocoa Prices Gain
  • Silver May Slide 16% After Breaching 100-Day Average: Technical Analysis
  • Drought Spells EU Power Squeeze as Nuclear Reactors Halt: Energy Markets
  • Copper Demand From China’s Cable Makers May Double as Cities, Grids Expand
  • Bunge Offers $138 Million for Tully Sugar, Above Louis Dreyfus-Backed Bid
  • India Shipping to Gain From Japan $30 Billion Steel Bill: Freight Markets

 

CURRENCIES

 

THE HEDGEYE DAILY OUTLOOK - daily currency view

 

 

EUROPEAN MARKETS

  • UK Mar ILO unemployment rate +7.7% vs consensus +7.8% and prior +7.8%; UK Apr claimant count +12.4k vs consensus unchanged
  • BOE keeps 6-3 vote in May to hold rates at record low
  • Greek Banks Surge as ECB Officials Rule Out Debt Restructuring
  • Irish Household Wealth Rises 6% in Q4 2010 , Central Bank Says


THE HEDGEYE DAILY OUTLOOK - BEST PERFORMING EURO

THE HEDGEYE DAILY OUTLOOK - WORST PERFORMING EURO

 

 

ASIAN MARKETS

  • Asia was strong overnight
  • Vietnam was a negative divergence down 2.03%
  • Japan March tertiary activity index (6.0%) m/m – the biggest drop in 22 years -- to 93.5.

 

THE HEDGEYE DAILY OUTLOOK - BEST PERFORMING ASIA

 

THE HEDGEYE DAILY OUTLOOK - WORST PERFORMING ASIA

 

 

MIDDLE EAST

 

THE HEDGEYE DAILY OUTLOOK - MIDEAST PERFORMANCE

 

 

 

Howard Penney

Managing Director


THE M3: MGM IPO INVESTORS; RWS FINED

The Macau Metro Monitor, May 18, 2011

 

 

MGM CHINA'S IPO SECURES FOUR CORNERSTONES WSJ, SCMP

John Paulson's firm plans to invest up to US$75MM in the MGM JV; through his company Tracinda Corp, Kirk Kerkorian has agreed to subscribe for up to US$50MM; property developer Asia Standard International, controlled by HK businessman Poon Jing, has pledged to invest up to US$40MM; and Dornbirn Inc, owned by Hong Kong real-estate developer Walter Kwok, will chip in up to US$25MM—Kwok is the former chairman of blue chip developer Sun Hung Kai Properties Ltd.

 

Like the other cornerstone investors, Paulson & Co. has agreed not to sell its shares for at least six months after the listing.  The public offering runs from May 23 to 26 with pricing due to be announced on May 27. The shares are set to begin trading on June 3 under stock code 2282.


RWS FINED S$530,000 FOR FOUR BREACHES Channel News Asia

RWS was fined S$200,000 for reimbursing the entry levy payable by Singapore citizens and permanent residents.  On July 15 last year, a senior management staff of RWS gave cash to media representatives - who are Singapore citizens and permanent residents - to help them pay the entry levy payable by them to enter its casino premises to cover the launch of the Ladies Club.  Also, RWS was fined S$330,000 for 3 separate cases of casino surveillance non-compliance.


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CONSUMER OUTLOOK

We have put together a slide deck that illustrates my outlook on the consumer. 

 

The consumer's propensity to spend has exceeded expectations over the last nine months even as underlying fundamentals such as housing and confidence that have flat-lined.  Income has improved somewhat, albeit artificially, while the jobs picture has been moving in the wrong direction for weeks now.

 

Please click here or copy and paste the link into your web browser and refresh if presentation does not appear right away:

http://docs.hedgeye.com.s3.amazonaws.com/HedgeyeConsumerOutlook.pdf

 

 

Unemployment

 

The slow improvement in employment levels in the U.S. since 2009 has almost become ingrained in people's economic analysis.  However, what many analysts seem to ignore is the established reversal in this trend that has been in place for much of 2011.  Without initial claims declining to approximately 375k, according to Financials Sector Head Josh Steiner, we cannot expect material improvements in the unemployment rate.  Despite a labor force participation rate at record lows, the unemployment rate has not meaningfully declined and even ticked up in March to 9%. 

 

 

Consumer Credit

 

The consumer's appetite for credit is not what it used to be.  Households are retrenching in order to build up savings and pay off debt.  While the consumer is deleveraging at a slower rate than before, the year-over-year growth in revolving debt outstanding remains negative.

 

 

Spending

 

Spending data has been strong of late with PCE trending higher over the past nine months.  However, a sharp increase in gas prices is negatively impacting consumer spending and S&P revenues.  While temporarily reduced payroll tax withholding is buttressing income for now, wage income needs to pick up the slack in order to make the trend sustainable.  Recent ISM manufacturing employment indices' data has pointed to a slowdown in growth.

 

 

Retail Sales

 

Retail sales are showing signs of fragility as April retail sales recorded their slowest pace of growth this year as sales outside of gasoline stations increased a meager 0.2%.  Higher energy prices are weighing on retail sales and chain store sales, according to recent releases. 

 

 

Confidence

 

Consumer confidence has been soft following an upward trajectory that began in 4Q10 abruptly ended with the March disappointment.  In general, the rebound in consumer sentiment has been driven by expectations while current attitudes have remained depressed.  In the absence of a pickup in wage income and hiring levels, expectations may decline.  Small businesses' confidence levels are also low at present.  Importantly, as the NFIB Small Business Optimism survey reveals, expectations among small businesses for economic improvement have been declining. 

 

 

Housing

 

House prices have been an important metric for consumers but, of late, the impact of housing market jitters has not manifested itself strongly in consumer behavior.  That said, we believe that it is early days in this regard, and the consumer is far from immune from the ongoing slide in property prices.  Hedgeye's Financials team, in mid-2010, was out with a call for a decline in house prices of approximately 20% in 2011.  The data continues to corroborate with that thesis, this morning's housing starts and permits numbers being the latest confirming data points.  When this begins to matter for the market, the impact should be significant.

 

 

 

Howard Penney

Managing Director


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