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Russia from 30,000 ft

Positions in Europe: Long Germany (EWG); Short Spain (EWP)


Sizing up Russia is never an easy task. Political risk runs high, its banking industry is largely opaque, and the country’s outsized leverage to the price of commodities makes its economy sensitive to price cycles.


Of the fundamental risks to the economy, below we highlight rising inflation, mixed fundamentals, a downside price target on oil, declining oil production, rising tariffs that shun foreign investment, and over the longer term TAIL a declining population, judicial challenges, and the struggle to transform the economy beyond its leverage to commodities. In the past, we’ve recommended playing Russia via the etf RSX, which is overweight Energy (40%), Basic Materials (27%) and Financial Services (13%).


Our models suggest that Russia’s equity index (the RTSI) is broken on immediate term TRADE and intermediate term TREND durations (see chart below).


Russia from 30,000 ft - Russia RTSI


Based on the IMF, Russia has a growth profile of 4.8% this year and 4.5% next year and a budget deficit of 1% of GDP this year. However, stripping out oil and gas revenues, the deficit would be as high as 11% of GDP, which owes to Russia’s reliance on oil revenues to balance its budget and therefore increases its vulnerability to external shocks, namely the price of oil. It’s worth noting that the IMF forecasts are based on an average price for Russia’s crude blend Urals, the country’s main export blend, at $104 per barrel in 2011 and $103 in 2012. Given our bullish stance on the USD and our longer term downside level on oil (WTI) to $89, a sustained pullback in oil could bring Russia short of its forecasts.




Pressing Inflation


The real pressing threat in Russia remains its exceptionally high inflation rate. Inflation, as measured by the CPI, recorded 9.6% in MAY Y/Y, with food stuffs and other agricultural goods leading the upward charge. These prices, particularly on a year-over-year basis, have been significantly influenced by the severe drought in Russia last summer that affected the harvest of key food staples, like potatoes and grains. Domestic food price inflation coupled with the spill-over of global price inflation from its import partners to make up for lost yields have only further stoked prices.  Also, given that the consumer weight of foodstuffs in Russia’s CPI basket (similar to the other BRICs) is higher than for developed economies, like the US, inflation figures appear even loftier in comparison. 


Producer Prices, the input costs that typically drive up Consumer Prices, have remained elevated, at 19.2% in MAY Y/Y, off slightly from 20.2% in the previous month.


While Russia is poised to lift its grain export ban July 1st and the Central Bank has stated that it does not expect rising prices as more producers export more grain than they sell at the local market, it’s another risk worth considering.


The Russian Central Bank has hiked the main refinancing rate twice year-to-date (in February and May), currently at 8.25%, to stave off inflation. The Bank continues to state that as the year progresses inflation should fall to the Bank’s official target of 6% to 7%, but it has shown little indication on the timing of a hike. 



Mixed Fundamentals


Of the positive releases in recent high frequency data, MAY showed that the Unemployment Rate fell to 6.4% versus 7.2% in APR. and Retail Sales gained a healthy 5.5% Y/Y. Domestic investment in Russian business surged 7.4% in MAY Y/Y versus 2.2% in APR yet disposable income fell -7% and real wages increased only 2.6%, a signal that inflation is squeezing the consumer and wage inflation is not keeping up with the headline figures.


The most forward-looking indicators of PMI Services and Manufacturing showed that Services have held up well each month year-to-date, with the most current reading at 57.6 in MAY vs 55.8 in APR. In contrast to Manufacturing, we expect the more domestic-oriented Services to hold up in the coming months. Manufacturing, on the other hand, may continue to tail off as the important export market of Europe remains mired in sovereign debt contagion. PMI Manufacturing fell to 50.7 in MAY vs 52.1 in APR and has trended down ytd, teetering just above the 50 line, separating expansion (above 50) from contraction (below).



The Mighty Petrodollar and the “One-Trick Pony”


One major concern to monitor in Russia is the so-called oil curse of oil-rich countries. While Russia should have learned its lesson from 2008-9, governments of oil-rich countries have a disposition to issue unjustified government expenditures (and therefore lower budget discipline) when oil prices are elevated due to optimism over the additional revenues from oil profits. Russia’s Finance Minister Alexei Kudrin has said that the “government expects the budget to remain in deficit through 2014 based on an average price for Urals crude oil of $75 this year and $78 in 2012. Russia may balance its budget this year if oil averages about $115 a barrel, or more than 50 percent above the government’s target price.”


As a point of reference, oil and gas exports accounted for roughly two-thirds of all Russian exports by value, with oil and gas revenue contributing ~1/3 of general government revenue. Further, reviewing estimates on the marginal tax rate on petroleum, the government pulls in an average of 90 cents on every dollar of exported crude selling above $25/barrel. [Note: under $25 the government also receives its share, albeit a proportionally smaller one on a tiered basis].


It’s Russia’s leverage to energy in particular that has lent our naming of the country a “one-trick pony.” In short, the chart below shows the tight correlations between the price of a barrel of oil, foreign direct investment in Russia, the RUB-USD, and GDP over the last 10 years. Over one year we see a correlation between RTSI and Urals Crude of 0.95 and between RUB-USD and Urals Crude of 0.91! So watch out as the USD strengthens against the RUB and oil falls! 


Russia from 30,000 ft - Russia Mixed



Given that we’re making a bullish call on the USD over the intermediate term, which should cool oil price appreciation, we’d expect to see even less foreign direct investment, and decreased oil revenues, and lower growth—all cause for concern on Russia’s economic outlook. 



Oil Constraints and Government Intervention


Over the last 12 months there has been much talk from President Dmitry Medvedev about diversifying the country away from its sole leverage to energy. Implicit with the goal is his understanding that the country is 1.) bumping against its outer bound of oil production, and 2.) that being solely reliant on energy leaves the country in a  vulnerable position to external disruptions.


To the first point, it’s worth noting that Russia A.) doesn’t have spare oil production capacity, and B.) the government has announced that it expects Russian domestic oil production to remain flat at roughly 10 MM bbl per year through 2020. Attaining production levels will be challenging as higher crude prices trigger higher oil export tariff rates which discourage foreign investment in Russia’s oil and gas sector that is essential for the country’s future exploration projects. Additionally, state limitations on foreign ownership rights in Russia’s oil and gas sector, lack of financial transparency and minority shareholder rights make investment in Russia a high risk venture.


Other Key Points To Consider, from our Energy Team:  

  • Export Tax: Russia has a punitive export tax levy upon domestic producers that seriously impairs operating cash flow to fund development investment.
  • Significant Spending: Flat production at 10 MMb/d will require capital spending of roughly $280 billion from 2010 to 2020.
  • Mature Fields High Depletion Rate: Traditional production areas, such as Western Siberia, are nearly 60% depleted, with high decline rates and high water cuts, requiring significant investment for secondary recovery efforts to maintain current production levels.
  • Capital Constrained: Russian companies relative to western peers have low dividend yields and low internal cash flow generation.

Russia from 30,000 ft - russia production 1


Russia from 30,000 ft - russia production


Recent Headlines on additional Energy levies

  • Russian government plans to increase tax burden on the country’s gas sector over the next three years, impacting Gazprom in particular. The tax burden on the industry will increase by 150 Billion Ruble ($5.4 billion) in 2012, by another 170 Billion RUB in 2013, and by another 185 Billion RUB by 2014 (from Platts, June 3, 2011). 


To the second point, there’s little evidence that private consumption can offset the loss of foreign investment. On a slight tangent, we’d also question grouping Russia in with the rest of the BRICs, for unlike the others, Russia shows no clear prospects for a domestic growth story, especially considering its declining population (more below) and lesser growth profile over the next couple of years so long as energy costs retreat from abnormal highs witnessed in the earlier part of the year.



Longer Term Headwinds


As mentioned above, Medvedev has called for the country to transition away from its sole reliance on energy to grow the economy, however it’s important to stress that this will neither be an easy nor quick process. In late March of this year Medvedev unveiled a 10-point program to make the nation more attractive to investors. The measures included removing senior officials from the boards of state companies they oversee, approving a state-asset sale program for the next three years and proposing a law on minority shareholders’ right to information.


In mid June Medvedev further unveiled at the St. Petersburg annual economic forum a $10 billion sovereign fund to stimulate domestic private equity and indicated plans for a $30 billion asset sale program to help lure investors and revive investment interest in the country. One asset considered for this program is OAO Sberbank, the country’s largest lender, in a transaction worth as much as $7 billion, while the government also asked Morgan Stanley, JPMorgan and Deutsche Bank to manage an IPO of OAO Sovcomflot, Russia’s biggest shipper.


At the core is Medvedev’s understanding that foreign capital is fleeing Russia based on the country’s reputation for government and business corruption. Russia is estimated to have total net outflows of $30 billion to $35 billion for 2011, roughly equal to the $35.3 billion of capital that left last year, according to the Central Bank. Countering this force is obviously critical, however our position is that short of oil reaching levels seen over the summer of 2008, we won’t see investors barreling into Russian investments.


A further consideration when sizing up Russia on the tail are the headwinds facing the country based on its grim demographic outlook.  The World Bank reported that by the end of 2009, 17.4% of the population (24.6 Million) will live beneath the subsistence level of $185 per month, about 5% more than before the global recession. The Economy Ministry said Russia’s working population will annually decrease by ~1 Million every year over the next three years, and the population has been in decline over the last 14 years, falling to 141.0 Million in 2010.





As inflation remains elevated, and the price of oil is squeezed with a rising US Dollar, we’re cautious on Russia’s investment outlook as the country is highly dependent on oil prices to generate revenue (and therefore balance the budget) and grow the economy. Longer term, the country will attempt to diversify economic growth, but this process will take many years and frankly we have our doubts on its success—changing a culture of corruption is after all a long road.


One of the largest threats is the flight of foreign investment over recent years.  The biggest impediment to foreign investment in Russia is its lack of a strong “judicial” system of judicial recourse not just for Russian domestics, but critically for foreign rights – shareholders providing foreign capital inflows. On this front we’re unlikely to see much (if any) near term change.


Further, Russia is in direct competition with other BRIC nations for foreign investment, so what is its competitive edge – the advantage that will prompt foreign investors to choose Russia over say China or Brazil that have more upside potential due to their more diversified economies.


Finally, demographic headwinds, forces not facing the other BRICs, play against Russia, and will force the need for more foreign investment and stronger ties with China, factors which Russia may not easily or directly be able to control.


In aggregate, these factors leave us cautious on Russia.


Matthew Hedrick



Notable news items and price action from the restaurant space as well as our fundamental view on select names.




U.S. corn futures tumbled to the one-day limit on losses Wednesday and wheat futures fell more than 4% as concerns over low supplies eased.


According to the Financial Times, Google Executive Chairman Eric Schmidt is bullish on the growth of mobile payments in the coming year; he believes one-third of all restaurants and retail outlets will allow for mobile payments within the next year.




  • SONC reported solid 3QFY11 earnings after the close yesterday but, given that May and June saw slower trends, the momentum is unlikely to be quite as strong in this current fiscal quarter. 
  • Lavazza CEO Antonio Baravalle said that it is “premature” to say that the company will raise its stake in Green Mountain Coffee Roasters from 6%.  Lavazza will consider acquisitions in markets where it doesn’t already operate, including China.
  • JACK management sees potential for 2,000 stores in the U.S.
  • CMG announced yesterday that it is increasing its use of local produce.
  • DPZ - Domino's Pizza Enterprises Ltd is fast becoming one of Australia's top e-commerce companies with more than $1million in mobile sales recorded in one week. This milestone comes just one week after the official launch of Domino's Mobile Ordering Site which can be used to order pizza from any internet enabled mobile device. Domino's CEO Don Meij said topping the $1million in sales milestone in such as short space of time was an incredible achievement. - Foodservice.com
  • McDonald’s Corp.’s planned sale of its business in South Africa to Cyril Ramaphosa’s Shanduka Group is at risk because the suspension of part of a tax law in the country may lead to lenders withdrawing funds, Business Day reported, citing Shanduka spokeswoman Maureen Mphatsoe.





  • EAT - TableTop Media has signed a multi-year contract with ERJ Dining, LLC. and completed the first phase of deployment for its Ziosk touchscreen devices to 30 Chili’s locations in St. Louis, Chicago and Central Illinois.

  • CAKE’s Rock’s Sugar employees are being sued for sexual harassment 



TALES OF THE TAPE - stocks 623


Howard Penney

Managing Director


Initial Claims Still Stuck Well Above 400k

Initial Claims rose 15k last week to 429k (+9k after the revision to last week's print).  The rolling 4-week average was flat for a third week in a row at 425k. Our analysis shows that initial claims need to drop below 375-400k to get an improvement in unemployment, levels that we have not achieved since February/March of this year.  As the charts below show, QE has been tightly correlated with improvement in claims, suggesting that the coming weeks may see a very choppy period.    














2-10 Spread Widens Slightly

We track the 2-10 spread as a proxy for NIM.  This week the spread level widened by 2 bps to 261 bps from 259 last week.  Thus far in 2Q, spreads are 12 bps tighter than the average of 1Q, posing something of a headwind to margin expansion in the quarter. 






Financials Subsector Performance

The chart below shows the price performance of subsectors over four durations.




Joshua Steiner, CFA


Allison Kaptur

Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.


TODAY’S S&P 500 SET-UP - June 23, 2011


As our CEO, Keith McCullough, said today about Ben Bernanke's performance, the poor guy is confused.   “If my forecasts were wrong by a half-bagger this year, I'd be too.”  Ultimately, Mr. Bernanke Keynesian Experiment is failing - and markets are figuring that out.  As we are seeing in the Eurozone today growth continues to be lower than hopeful expectations, and the Fed's estimates for growth remain too high.  We shorted the S&P500 ahead of Bernanke walking down his forecasts. 


As we look at today’s set up for the S&P 500, the range is 40 points or -2.34% downside to 1257 and 0.77% upside to 1297.






THE HEDGEYE DAILY OUTLOOK - daily sector view


THE HEDGEYE DAILY OUTLOOK - global performance




  • ADVANCE/DECLINE LINE: -521 (-2688)  
  • VOLUME: NYSE 856.36 (+0.61%)
  • VIX:  18.52 -1.80% YTD PERFORMANCE: +4.34%
  • SPX PUT/CALL RATIO: 2.01 from 1.57 (+27.44%)



  • TED SPREAD: 23.54
  • 3-MONTH T-BILL YIELD: 0.02%
  • 10-Year: 3.01 from 2.99
  • YIELD CURVE: 2.62 from 2.59 



  • Initial Jobless and Continuing Claims at 08:30 ET
  • Bloomberg Consumer Comfort Index for w/e 19-Jun at 09:45 ET
  • May New Home Sales at 10:00 ET
  • EIA Natural Gas Inventories for w/e 17-Jun at 10:30 ET


  • ECB President Trichet said risk signals for euro-area financial stability are flashing “red” as the debt crisis threatens to infect banks
  • IMF chief candidate Lagarde expected to speak to reporters
  • Supreme Court rulings expected
  • BJ's Wholesale wants $55/share from Leonard Green/CVC - NY Post
  • Regulators look at freight-rail industry - WSJ
  • 'Shadow housing inventory' declines in the US - FT



THE HEDGEYE DAILY OUTLOOK - daily commodity view




  • Commodities Tumble After Federal Reserve Cuts Growth, Employment Forecasts
  • Zinc Production Dropping in Japan to Double Imports to Highest in 11 Years
  • France’s Sarkozy Urges Action Against the ‘Plague’ of Food Price Surges
  • Mitsubishi Materials Agrees Annual Processing Fees for Copper Ore With BHP
  • Crude Declines on Demand Concerns After Fed Lowers U.S. Economic Forecast
  • Corn Futures Drop to Three-Month Low as Better U.S. Weather Reduces Risks
  • Lending Crackdown Sidestepped as Soybeans Become Collateral: China Credit
  • Gold May Decline From Seven-Week High as Fed Damps Stimulus Speculation
  • Rubber in Tokyo Drops to Six-Week Low on Demand Concerns, Expanding Supply
  • Copper May Drop for a Second Day as Europe’s Debt Crisis Threatens Banks
  • Silver’s 74% Surge Creates ‘Headwind’ for Solar Rivalry With Fossil Fuels
  • Tea Exports From India to Climb as Output Rebounds, African Supplies Drop
  • Cargill, Royal DSM Are Said to Make Bids in $2.6 Billion Sale of Provimi
  • K + N Pushes Maersk to One-Click Shipping in Ryanair Mold: Freight Markets




THE HEDGEYE DAILY OUTLOOK - daily currency view




  • EUROPE: flat out ugly; Spain and Italy -1.5% each (were short Spain) on the realization that the sovereign debt default cycle is in early innings
  • Eurozone Jun preliminary Manufacturing PMI 52.0 vs consensus 53.8 and prior 54.6
  • Eurozone Jun preliminary Services PMI 54.2 vs consensus 55.5 and prior 56.0
  • Eurozone Jun preliminary Composite PMI 53.6 vs consensus 55.1 and prior 55.8


THE HEDGEYE DAILY OUTLOOK - euro performance




  • ASIA: dazed/confused but Chinese stocks up for the 3rd consecutive day, closing +1.5%, and we like that because we are now long China.


THE HEDGEYE DAILY OUTLOOK - asia performance








Howard Penney

Managing Director


The Macau Metro Monitor, June 23, 2011



GALAXY MAY RECOUP INVESTMENT WITHIN 6 YEARS Macau Daily Times, Macau Business, Intelligence Macau

Galaxy CFO Robert Drake said it expects annual returns of 14-19% at Galaxy Macau and may recoup its HK$ 15.5BN (US$ 2BN) investment in Galaxy Macau within 6 years.  Yesterday, Galaxy Chairman Lui Che-woo estimated Galaxy's market share at 17%.


IM believes that Phase 2 of Galaxy Macau could be completed before Macau Studio City and Lots 5 & 6 come online in 2013.


Taiwan has lifted a decades-old ban on travel to the island by individual Chinese tourists.  Initially, Taiwan will allow 500 individual arrivals from the mainland per day.  Chinese visitors would act as “peace ambassadors" to Taiwan.


Travel between the island and mainland stopped at the end of the civil war in 1949, and mainland tourists have so far only been allowed to visit Taiwan in groups due to official concerns they might otherwise overstay their visas and work illegally.



Visitor arrivals totaled 2,295,551 in May 2011, up by 9.4% YoY.  In the first five months of 2011, visitor arrivals increased by 7.2% YoY to 11,065,180.  Visitors from Mainland China increased by 16.8% YoY to 1,326,627 in May 2011, and the majority came from Guangdong Province, Fujian Province and Zhejiang Province. Mainland visitors traveling to Macau under the Individual Visit Scheme totaled 531,167, up by 18.0% YoY.





Singapore May CPI increased by 4.5% YoY and 0.6% MoM. The MAS (Monetary Authority of Singapore) core inflation measure, which excludes the costs of accommodation and private road transport, rose 2.1% YoY and 0.1% MoM.

Asking For More

This note was originally published at 8am on June 20, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

"I could not have asked for anything more... I played great for four days and couldn't be happier."

-Rory Mcllroy


Feel-good fans couldn’t have asked for more in Rory McIlroy’s victory at the 2011 US Open yesterday. Irish eyes were smiling on the 22 year old European as he bear-hugged his Dad on Father’s Day.


And then, Europe decided not to bailout Greece…


As a result, Global Macro markets are Asking For More this morning. Unfortunately, more debt is not enough. While I am not sure who remains sober enough to realize that this time isn’t any different than most of the sovereign debt crises of the last 600 years (they end in restructuring and/or default), it seems there are at least a few fiscally conservative members of the Fiat Fool Coalition who are willing to concede that point.


On the heels of the Irishman’s victory, German Finance Minister, Wolfgang Schaueble, delivered the tough love concession to world markets this morning: “If the Greeks can’t or don’t want to make the necessary decisions, then we can’t move forward on this track.”


Risk Manager’s translation: first, deliver on the promises you made on spending cuts and selling assets, or stop Asking For More.


Fair enough Germany. Greece, play the ball as it lies.


Confusion is starting to breed contempt across asset classes this morning: 

  1. CURRENCIES: EURO/USD is re-testing it’s critical intermediate-term TREND line of $1.42 support
  2. COMMODITIES: Oil prices are getting hammered down to 4-month lows on US Dollar strength ($91.61/barrel)
  3. COUNTRIES: Spanish and Italian stocks are getting tagged (down over 2%) as peripheral contagion concerns mount 

This, of course, should all make sense to everyone who has been in Hedgeye’s camp that The Correlation Risk associated with La Bernank debauching the US Dollar can start as the US Dollar stops going down.


As a reminder, into and out of La Bernank’s last rock-star presser (April), the US Dollar Index was down -17% since Obama & Geithner started overseeing Nixon/Carter Deficit/Devaluation life in America (2009). In April, the USD was testing its all-time lows.


Today, the US Dollar Index is bidding for its 3rd consecutive UP week, and it’s up a full +3.8% since the beginning of May. Again, if you didn’t know what The Correlation Risk to an up US Dollar looks like, look at the prices of virtually everything priced in US Dollars (housing, stocks, commodities, etc.) since, well, the beginning of May!


Hedgeye calls this Deflating The Inflation (Q2 Macro Theme).


And, yes, like Growth Slowing As Inflation Accelerates (which we called for 6 months ago), we will be extra sure to remind our competition that we called this first too. As Rory Mcllroy reminded us yesterday – it’s ok to be young, confident, and on your risk management game.


What could continue to strengthen the US Dollar from here (and Deflate The Inflation)? 

  1. Quantitative Guessing (QG2) ending 10 days
  2. US Debt Ceiling compromise within 3-6 weeks
  3. European Contagion (ongoing) 

No, this Global Macro Risk Management setup isn’t very difficult to understand. It’s pretty simple to get right – if you get the US Dollar right. And since we have been right on 21 of the 22 calls we have made on the US Dollar since the founding of Hedgeye in 2008, we think we get this.


We also get being in Cash.


Here’s how the Hedgeye Asset Allocation Model flushed out week-over-week: 

  1. Cash = 49% (down 3% week-over-week from 52% last Monday)
  2. Fixed Income = 18% (Long-term Treasuries and US Treasury Flattener- TLT and FLAT)
  3. International Currencies = 18% (Chinese Yuan – CYB)
  4. International Equities = 6% (Germany and China – EWG and CAF)
  5. Commodities = 6% (Gold – GLD)
  6. US Equities = 3% (US Healthcare – XLV) 

As US Dollar strength Deflates The Inflation, we’ll be in a very good position to buy things on sale. The key will be to be patient on prices. Ultimately, a strong US Dollar is the only way out of this Keynesian mess. Lower-prices are going to be an important catalyst for Global Consumption. In terms of bullish catalysts for Chinese, German, and US Equities, I couldn’t Ask For More than that.


My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1532-1549, $91.60-98.29, and 1259-1276, respectively.


Best of luck out there this week,



Keith R. McCullough
Chief Executive Officer


Asking For More - Chart of the Day


Asking For More - Virtual Portfolio

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