The Economic Data calendar for the week of the 23rd of May through the 27th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
Positions in Europe: Long Germany (EWG)
"Free movement is to Europe what foundations are to buildings. Remove it and the whole structure is undermined."
- Jose Manuel Barroso, President of the European Commission
With the European diaspora an ever-present and important topic, over the last month we’ve witnessed a few critical policy decisions and events in Europe that are worth revisiting: 1.) Denmark’s decision to close its borders with Germany and Sweden (in opposition to the Schengen agreement); 2.) the lifting of restrictions on foreign workers from Eastern Europe by Germany and Austria; and 3.) unemployment protests in Spain this week.
Certainly, the global recession and current austerity programs throughout Europe have left governments and citizens with less jobs, purchasing power, confidence, and increasingly we’re seeing rising nationalism and populism in response. Concerning Denmark—but more broadly in relation to all European countries—we believe the decision to guard and limit movement across borders is the wrong tact: not only are immigrants increasingly critical to head off demographic headwinds and promote growth, but with the EU the largest trading partner of most member countries, tighter borders threaten the exchange of goods and services.
The Germans, despite their haste in opening its borders to the East, should understand the need for immigration the best—they have the oldest population across the region, followed by Italy, and need a younger workforce and generation to pay for its social welfare state. Separately, the case of unemployment protests in Spain reveals the importance of managing growth within an economy. The boom to bust housing bubble in Spain created tremendous growth (and a large influx of immigrants), but now the country is faced with the longer term prospects of low growth and high unemployment. Our chart of youth unemployment shows the tail impact of these imbalances.
Where appropriate within these topics we also splice in analysis from the European Commission’s 2010 Demography Report, which offers a wide breadth of analysis but critically notes that Europe’s population growth is, and will remain, predicated on net migration. While the ultimate challenge for governments remains creating the right mix of an open door immigration policy to fuel growth while not straining the social system, a main take-away of the report is that as Europe’s population ages (think Baby Boomers), younger generations of foreigners will be increasingly needed to support them.
A Danish Fort: Porous Borders Assaulted
Late last week Denmark made a bold move in the eye of many European officials—it decided to reinstate guards on its borders with Germany and Sweden. The decision went against the open border principle of the Schengen agreement, a treaty signed in 1985 by five of the ten member states of the European Economic Community that officially went into effect in 1995 (and was later adopted by all EU countries, excluding the UK and Ireland) and holds the Schengen Area as a single state for international travel with border controls for travelers entering or exiting the area, but with no internal border controls.
In Denmark, the decision on border controls became a political bargaining chip: the right-leaning Danish People’s Party agreed to sign off on PM Lars Lokke Rasmussen’s center-right minority government’s plan to raise the retirement age, cut retirement benefits and issue additional austerity measures.
The agreement was branded by the Danish government as a necessary measure to “fight the rise in cross-border crimes.” Yet the European community quickly called foul, stating that while under Article 23 of the Schengen Borders Code, a member can in fact reintroduce controls at inner EU borders "in the event of a serious threat to public order or national security for a maximum of 30 days or as long as the "serious threat" persists”, there was no evidence of a “serious threat” in Denmark.
Importantly, Denmark’s pronouncement came in the context of heightened worries about immigration across Europe in recent weeks, mainly from Italy and France, two main destination countries of an estimated 25-30K Northern Africans, mainly Tunisian, fleeing unrest at home. France and Italy clashed in mid and late April after France stopped a train from Italy carrying Northern Africans and tensions again flared after Italian authorities gave undocumented migrants (many of them French-speaking Tunisians with their eye on France) temporary residency permits, effectively allowing them to travel freely to other European countries.
Relations have improved since Italian Prime Minister Silvio Berlusconi and French President Nicolas Sarkozy signed a joint letter to the EU in late May to demand that the Schengen agreement on border controls be amended to take into consideration the "exceptional" migration from North Africa, yet an agreement remains in limbo until a formal decision is concluded at a summit meeting of EU leaders on June 24th.
Hedgeye’s Take: We’re of the opinion that the migration of Northern Africans is an “exceptional” event. Temporary border controls must be considered to control this influx and the EU must shoulder the burden for funding additional personnel. Ultimately, discussions must include funding for temporary and permanent shelter and resettlement facilities as well as quotas for arriving migrants. Clearly, no one country, due to its geography, should solely be responsible for dealing with these exceptional circumstances, however, unfortunately it looks like it will be some weeks before we get clarity.
Returning to Denmark, we do not think there is credible evidence of serious threat from its borders with Sweden or Germany; the move is solely a populist concession to the Danish People’s Party. Interestingly, the European Commission’s 2010 Demography Report notes that in 2009, there were about 1 million cross-border workers within the EU, representing 0.4% of the working population. While the number of persons crossing borders for work appears de minimis, the transfer of goods and services is not, with the EU the largest trading partner of most member countries. Temporary to permanent borders controls for anything less than a “serious threat” within the EU/Schengen Area would hugely impact trade.
Looking East and Germany’s Demographic Drivers
On May 1, Germany and Austria lifted restrictions on migrant laborers from Eastern Europe, which will allow the “new” (post 2004) EU member states of Poland, Czech Republic, Slovakia, Hungary, Estonia, Latvia, Lithuania, and Slovenia access to the labor markets of Germany and Austria.
Stepping back and looking at the 2010 Demography Report, what’s clear is that the population of the EU -27 is growing, while the age structure of the population is becoming older. That said, the rate of population growth has been gradually slowing in recent decades from 8 per 1000 inhabitants per year in the 1960s to 3.2 per 1000 per year in the period of 1. A turning point came in the early 1990s, when net migration became the main driver of population growth and has since far outpaced natural change in the population.
In context, Germany has the oldest population in Europe, with a median age of Nationals at 44.5, whereas the Total Foreigners, which made up 11.6% of the population in 2009, averaged median age of 34.3 years (a consistent spread across most major western European countries). Below we provide a table of average median ages of nationals and foreigners across Europe. Noteworthy is that citizens of Italy (43.9), Luxembourg (43.0) and Greece (42.6) follow Germany for the oldest nationals on the continent.
Further the report shows that Germany has the oldest population aged 65 and older (20.7%), and the country’s aging is set to “proceed at a sustained pace until 2040 and then to almost halt in the 2040s and the 2050s.” As we show in the chart below based on the growth rate projections from the report (and here we focus on the main western European economies, plus Denmark given the write-up above)—it’s clear that short of the UK, all major western European economies will experience negative population growth by 2060.
Turning to Germany’s increasing dependence on foreign labor as the population ages, the magazine Spiegel Online published an interesting article with Polish migration expert Krystyna Iglicka, who expects between 500K and 1 MM people to leave Poland for Germany in the next two years as a result of the lifted restriction. Citing demographers’ estimate that Germany needs 300,000 extra workers every year if the country is to maintain growth at 2 to 3%, Iglicka believes that given the geographical proximity of the two countries, Poles are more likely to work in Germany than they were in Ireland or Britain, where hordes moved in 2004 when Poland joined the EU.
And given the often cited fear that cheap labor from the East will steal jobs and push down wages, Iglicka said, “experiences with immigrants in Britain and Ireland have shown that this is absolutely not the case. Poles often take on the dirty, difficult jobs that Germans don't want to do themselves. In addition, Poles and other Eastern Europeans can assimilate much more easily than other ethnic groups. After all, they come from a Christian background, do not form ethnic enclaves and generate far less fear than immigrants from, say, Africa or Bangladesh.”
Hedgeye’s Take: With Germany’s aging population, more porous borders and lenient work and residency permits will help Germany maintain its competitive edge and drive growth. As the Demography Report states, immigrants will increasingly take a larger share of European populations, with estimates suggesting that in 2008 12.7% of the EU residents aged 15-74 were foreign-born or had at least one foreign-born parent, while in 2060 this group may more than double and exceed 25% of the population.
As is well documented, the “Spanish Nightmare” is Spain’s slow transition from a decade-long boom to bust as a result of the leverage cycle finding her dark side. In particular, Spain's housing industry, which fueled much of the country's prosperity in the late 1990s to mid 2000s, has been turned on its head and prices continue to depreciate. As it relates to unemployment, many of the unskilled construction workers that fed the boom are now out on the street (or have returned home), with companies across all industries cutting jobs as the government struggles to issue austerity to cut a budget deficit of 9.3% of GDP.
This week saw unemployment demonstrations across the country ahead of regional and municipal elections this Sunday. Forecasts suggest PM Jose Zapatero and his Socialist Party are bracing for a crushing defeat. In any case, the discontent in Spain is commensurate with the highest unemployment rate in the industrialized world, at 21.2%, and frankly we’re a bit surprised the protests took this long!
As the two charts below present, not only is Spanish unemployment a full 10% higher than the EU average, but when we look at unemployment of individuals less than 25 years of age, the data is even more staggering. (And a similar argument could be made for Spain’s peripheral peers). While the data could be massaged in any number of ways, it’s fairly obvious that Spain faces a long tail of unemployment, and the probability of a lost ‘generation’ of youth is a very real threat that will weigh on the country’s social net for decades to come.
To understand the context of the influx of workers to Spain we turn to the European Commission’s 2010 Demography Report, the Institute for the Study of Labor (IZA), and a 2009 IMF report on Spain. The charts below from the IMF clearly show the demographic ingredients that fueled the relationship between population growth and house prices and construction. Interestingly, Spain was second only to Ireland in average annual population growth, however immigrant growth in Spain on an aggregate basis far exceeded Ireland over the period. IZA notes that between 1 the foreign-born share in the working age population increased from 2 to 16%. In absolute terms, the foreign-born population increased from barely half a million to 5 million over the course of the decade, while the total (working-age) population increased from 26.7 to 31.3 million, implying that immigration was responsible for 98% of total population growth during the period. Based on IZA projections, this influx helped construct roughly 2 million new housing units!
However, when the bubble burst in 2007, the overall decrease in the flow of immigrants to Spain was substantial. The Demography Report shows that the foreign population declined -31% from 2008 to 2009 and was mainly due to the reduced inflow of non-EU immigrants (down 35%) and fewer immigrants from the other EU-27 member states (down 25%).
While immigrants may continue their exodus from Spain, which may lessen unemployment rates and reduce the tax on the social state, Spain’s housing market is still far from the right track.
Two stories out this month caught our eye:
Firstly, Bloomberg reported that about 50,000 owners of beachside properties in Spain have lost rights to their homes after Spain’s coastal law was amended and applied retroactively to increased restrictions on coastal developments passed in 1988. According to PNALC, a group representing owners affected by the coastal law, as many as 500,000 could eventually be affected by the law. And even should homeowners win the right to keep their home, the law stipulates that owners of the homes in question can apply to extend their stay in the property for as much as 60 years, though they can’t sell it or pass it on to children, which clearly leaves the owner in a perilous state indeed.
While the law attempts to correct extensive cases of developers building on unclassified lands without appropriate permits, often for cash or other incentives, the pain is levied squarely on home owner who were often led to believe that they had proper documentation. According to a report by the savings bank Cajamar, Spain built 675,000 homes a year from 1997 to 2006, more than France, Germany and the U.K. combined. Further, the development ministry estimates that British nationals account for about 31% of all foreign-owned homes in Spain.
Hedgeye’s Take: The implications of this law are naturally huge for the housing market. What foreign national is going to want to buy a home (and a significant amount want a coastal one) given the uncertainly if the home belongs to you? And according to RR de Acuan & Asociados, a Madrid-based research company, the country has a surplus of more than 1 million empty homes, both new and existing—that’s a supply headwind that will have an impact for the years ahead!
Secondly, the FT reported this week that Banco Santander, BBVA and Caja Madrid, Spain’s three largest banks by assets, along with the cajas of La Caixa, CAM and Bancaja are offering “mortgages for repossessed residential properties with loan to value ratios of up to 100%, for up to 40 years.” [According to the Bank of Spain, high loan to value mortgages, those above 80%, comprised 11.9% of all house loans in 2010, and were similar to levels in 2008.]
Hedgeye’s Take: The willingness of banks to essentially provide the entire loan for repossessed properties at such long maturities reflects how much pressure these institutions are under to remove direct exposure to homes on their balance sheets.
While the consolidation of banking sector over the last 18 months in Spain is a positive development, it’s clear there will continue to be pain ahead for the banking sector as unsold homes weigh on the economy at large. Spain printed a Q1 GDP number of +0.3% Q/Q or +0.8% Y/Y. We think this could be its best quarter of 2011. With the trifecta of rising unemployment, continual strain from the housing market, and a shaky government that must prove to the market that it can cut its fiscal deficit, we’re bearish on Spain’s outlook. And it too may be next in line for a European lifeline.
As the face of Europe changes, we’ll be changing along with it. Given persistent sovereign debt contagion across Europe, we continue to like Germany as a defensive name with a healthy growth profile for this year. While we’ve indicated that German fundamentals are slowing marginally, the DAX maintains its momentum above its intermediate term TREND line of support at 7100.
Have a great weekend,
We’ve spoken ad-nauseam about how the spread between supply and demand would start to buckle in May/June and take margins lower. Gap pretty much confirmed this last night. The call from here, however, is not on Gap. But it’s to press the JC Penney short. On the flip side, we’re changing our tune, and are getting positive on Target after being bearish there all year. This is the TREND and TAIL call. And as always, Keith will manage the TRADE.
The fact that we’re already seeing some people come out and defend their perma-faves by saying that the GPS blow-up is ‘company-specific’ is just flat out intellectually irresponsible. We weren’t shocked by the magnitude of this miss by any means – as outlined in our “4.5 Below” thematic piece from earlier this year where we quantified a 4.5 point margin hit for the industry – and don’t necessarily think it will be the last for GPS. Fortunately, they have the good grace of Eddie Lampert to financial engineer their way out of the worst operating environment in decades.
We’re not making a call on Gap here.
We think that there’s much more money to be made in shorting JC Penney, and (gasp!) going long Target. What?!? We can hear the feedback already…”You guys have been so negative on Target all year, and you turn positive just as the industry thesis is starting to work?”
The short answer is ‘Yes’ and for very good reason.
We hate to point to Ackman as being the main factor – but the reality is that it is the fallout/windfall that we expect to see at JCP/TGT, respectively as the heavy hand of activism spanks the other cheek will create opportunity for real investors to make money here. We didn’t believe in the half-baked financial engineering story with Target in 2008, and we certainly won’t believe it now that Ackman has blown out of his TGT and shifted his focus to JCP.
One consideration here is that Target is actually a solid company. The concept is a winner, management is proven, it has square footage growth ahead, and has the benefit of the incremental shift towards its Membership Rewards model and P-Fresh rollout. More loyal customers and more consumables = more traffic.
While that’s all fine and good, our prior problem with it dates back to that fateful turn of events that started in 4Q07 when Ackman started his ‘assault’ in ultimately owning 3.55% of the company by the end of 2009. The proxy battle begins!
Then on Target’s May 7 sales release in 2009, comps were in-line, but more importantly TGT noted that tight expense controls and better gross margins will lead EPS to be “well above estimates". Credit quality also came in line vs. a trend of coming in slightly below plans. Then, four days later, TGT issued a press release titled “Questions That Attendees May Want To Ask At The Pershing Town Hall.’ In other words, TGT started to pull out all the stops to make Billy go away. Ultimately, Billy took it on the chin, and lost his proxy battle on May 28 of 2009 after it was clear that the momentum of the business was going against him.
The ‘strong cost control’ is particularly notable to us. Being cost-conscious is something most great companies have embedded in their DNA. But this is a company that has added $1.5bn in revenue (2.5% over 2 years) since The Ackman Assault, but has held SG&A dead even. And yes, that’s despite 9.5% square footage growth over that same period. Last we checked, a new store requires a few bucks.
Similarly, let’s look at capex. TGT had its precipitous decline in capex over that same exact time period. Any way you cut it, relative to prior trends, growth capex was cut by over a half such that total capex actually ran below D&A for three quarters.
Now it’s clearly headed higher. So at the same time the activist thorn in TGT’s side is removed, it starts to behave rationally again and invest to reaccelerate share gain. One thing we’ll give TGT credit for is being good stewards of capital – at least when they don’t have an activist dog barking in their ear.
We’re still concerned with near-term earnings quality (i.e. credit accounting for an outsized portion of the latest qtr eps) and will be watching that accordingly. But ultimately, our issue with TGT had been that lack of reinvestment around all this noise would preclude the company from hitting both sales AND margin goals. We’d give ‘em one or the other. But not both. That call has proven to be the right one.
Now, we’re approaching a point where the lag from TGT’s reinvestment and revenue growth has caught up. We think that numbers have stopped going down, and we’ll see a reacceleration in top line over the next 12 months.
In nearly every way that Target is a good company, JC Penney is not. It has a poor legacy real estate profile, over-exposure to apparel (in the worst apparel environment in decades), and over 50% private label/exclusive mid-tier brands that most consumers would not notice if they simply went away. One of the keys there is that JCP’s more vertical model relative to most other department stores (where it sources directly in Asia) means that it has fewer touch points between manufacturing and final retail sale to share cost pressures with partners. In times of excessive stress, JCP bears the pain.
On the flip side, to be fair, it also garners the upside as the environment improves. But in this space, the soonest we’ll see that will be 2013.
Keep in mind that when we see events like Gap missing plan/blowing up, this has a ripple effect. Was Gap planning on this? No. Nor were their vendors, the competitor down the hall in the mall that sells similar product, etc… this is where the chain reaction begins. JC Penney does not have a whole lot to stand on. Liz Claiborne might be great – but is really just a splash in the bucket for JCP (it’s much more meaningful for LIZ). Also keep in mind that JCP has been serially in and out of restructuring mode for the past decade. The ‘low hanging fruit’ has been largely picked.
As was the case with Target, we think that the diversion of management’s attention – especially at a time when industry and Macro factors will demand it most – will also hurt on the margin.
Our industry call all along had been that we’d start to see the dominoes fall relative to expectations in May/June – and we’re sticking to our guns. We do not – by any means – think that GPS is one-off. It is just the beginning.
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Notable news items and price action from the past twenty-four hours, as well as our fundamental view on select names.
The Macau Metro Monitor, May 20, 2011
MGM HOPEFUL OF COTAI GREEN-LIGHT THIS YEAR Macau Daily Times
Pansy Ho said, “We have been very hopeful that this [Cotai approval] obviously could happen within the year.” Ho would like to maintain a strategic role in MGM China, saying, “I believe that to be an MVP, most valuable player, like when you are in a ball game you do not always have to be the one kicking the goals, you would like to be there to be the best assistant."
Asides from opening an MGM Grand hotel this year in Hainan Island, MGM wants to enter Taiwan with non-gaming and leisure projects.
CONSUMER PRICE INDEX FOR APRIL 2011 DSEC
Macau's Composite CPI for April 2011 increased by 4.88% YoY and 0.10% MoM.
S'PORE RESIDENTS LOST EVEN MORE ON GAMBLING LAST YEAR Today Online
Data on levies collected for entry into the casinos at Marina Bay Sands and Resorts World Sentosa suggests 5,400 Singaporeans go to the casinos every day.
This note was originally published at 8am on May 17, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“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):
For us, this is good. In terms of how I am positioned in May, that is.
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 $1474-1499, $93.67-$100.12, and 1327-1336, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.