“When one door closes another door opens; but we so often look so long and so regretfully upon the closed door, that we do not see the ones which open for us.”
-Alexander Graham Bell
Keith is both back home in Canada this week. He is taking some family vacation time at his cottage on Lake Superior and I’ll be back in Alberta with my family later this week as well. For the first few days, it will be Uncle Duty for me as I apply my risk management skills to babysitting my two nieces and nephew (ages 9, 7 and 5, respectively). After that I will be headed to my hometown of Bassano, Alberta to celebrate its one hundredth birthday. That’s also a long winded way of saying I thought it was apropos to start this morning’s Early Look with a quote from one of Canada’s most famous sons, Alexander Graham Bell.
While Bell received many patents during his long career, the most famous by far was patent 174,465. This patent was issued by the U.S. Patent Office on March 7th, 1876 and covered:
“. . . the method of and apparatus for, transmitting vocal and other sounds telegraphically . . . by causing undulations, similar in form to the vibrations of the air accompanying the said vocal or other sound.”
This was, of course, the patent for the telephone. The majority of us would consider this the second most important communication related invention after the iPad (that was a joke.)
The basis of Bell’s invention was that he replicated sound waves electronically. The precursor to this was discovering the nature of sound and how it travelled. Like many discoveries related to the physical sciences, the foundation of the telephone is based on certain immutable laws of physics.
The physical sciences of course stand in stark contrast to social sciences, in particular economics. While generally agreed frameworks exist for studying economics, immutable laws are much more difficult to come by. This is an important point to consider when studying statements from preeminent economists, especially those tasked with setting monetary policy.
As the Federal Reserve provides us more transparency with press conferences and in releasing their internal projections, the fallibility of economics has become increasingly obvious.
Our research team has spent the last few weeks meeting with some of our top subscribers around North America. As usual, the discussions were lively and thoughtful. One of the key ideas that we've been floating, which has generated a significant amount of debate, is the idea that the next move by the European Central Bank could be to lower interest rates, instead of increasing them. This view is actually in contrast to the most recent statements by the ECB.
On June 9, 2011 the ECB stated the following in their monthly statement prior to Q&A with ECB President Trichet:
“On balance, risks to the outlook for price stability are on the upside. Accordingly, strong vigilance is warranted. On the basis of our assessment, we will act in a firm and timely manner. We will do all that is needed to prevent recent price developments giving rise to broad-based inflationary pressures. We remain strongly determined to secure a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term.”
While this is only an excerpt, the gist of the statement overall is that the main risk to the European economy is in not being diligent on inflation. Therefore, the general consensus is that the ECB will continue leading the Federal Reserve in tightening monetary policy. The Hedgeye Consensus is slightly different.
While the Federal Reserve has continued to ease in 2011 via Quantitative Easing, in contrast, the ECB has both raised its benchmark interest rates by 25 basis points in April of 2011 to 1.25% and, as outlined above, continued to talk hawkish as it relates to future policy. From our perspective, there are a number of factors that will likely cause the ECB to alter their rhetoric and potentially cut rates this year. These are:
1) Accelerating sovereign debt issues – We’ve been early on global sovereign debt issues and continue to remain pessimistic on an orderly resolution, particularly in Europe. A Greek debt restructuring seems all but a foregone conclusion. Meanwhile, Spain and Italian yields continue to widen versus benchmark rates, specifically 10-year Spanish yields are now at 5.7% versus 4.5% a year ago and Italian 10-year yields are at 5.0% versus 4.1% a year ago. As it relates to Spain, the impact of the collapse of its real estate bubble continues to be felt and El Confidencial is reporting this morning that Spanish banks may have $50BN in unrecognized problematic real estate loans.
2) Inflation in Europe may be close to peaking for the cycle - Eurozone CPI was at +2.7% in May year-over-year, which was a sequential deceleration from +2.8% in April. While certainly only one data point, this sequential decline in inflation will be increasingly driven by a Deflation of the Inflation, as evidenced by the CRB Index now being down -0.8% for the year, and tough compares in late 2011 / early 2012. Collectively, CPI should gradually decline over the next couple quarters, and perhaps even start to look like deflation.
3) Economic growth set to sequentially slow – Similar to the Federal Reserve, the ECB provides economic growth projections for the Euro area. Also similar to the Federal Reserve, those projections have proven to be inaccurate and often backward looking. Currently, the ECB’s GDP projections for the euro area are for 1.5% - 2.3% in 2011 and 0.6% - 2.8% for 2012. From our perspective, these growth projections will likely have downward bias.
Collectively, we believe these factors will make it difficult for the ECB to raise rates in the short term and, if anything, we see bias to easing emerging. Of course, this does stand in stark contrast to ECB President Trichet’s recent statements, but as it’s famously been said about economists:
“The economy depends about as much on economists as the weather does on weather forecasters.”
Daryl G. Jones
Director of Research
TODAY’S S&P 500 SET-UP - June 27, 2011
Ahead of the likely sluggish income and spending numbers, futures are modestly higher. Asia-Pacific stock markets posted losses overnight except China (we are LONG) and Europe was higher in the early morning. As we look at today’s set up for the S&P 500, the range is 20 points or -0.82% downside to 1258 and 0.75% upside to 1278.
SECTOR AND GLOBAL PERFORMANCE
- ADVANCE/DECLINE LINE: -838 (-352)
- VOLUME: NYSE 1740.41 (+55.74%)
- VIX: 21.10 +9.38% YTD PERFORMANCE: +18.87%
- SPX PUT/CALL RATIO: 2.11 from 2.41 (-12.30%)
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: 23.61
- 3-MONTH T-BILL YIELD: 0.02%
- 10-Year: 2.88 from 2.93
- YIELD CURVE: 2.53 from 2.58
MACRO DATA POINTS:
- 8:30 a.m.: Personal income, est. 0.4%, prior 0.4%
- 8:30 a.m.: Personal spending, est. 0.1%, prior 0.4%
- 10:30 a.m.: Dallas Fed, est. (-3.2), prior (-7.4)
- 11 a.m.: Fed’s Kocherlakota speaks on leverage in Montana, audience Q&A
- 11 a.m.: Weekly export inspections (corn, wheat, soybeans)
- 11:30 a.m.: U.S. to sell $27b 3-mo. bills, $24b 6-mo. bills
- 1 p.m.: Fed’s Hoenig speaks in Washington, audience Q&A
- 1 p.m.: U.S. to sell $35b in 2-yr notes
- 4 p.m.: Crop conditions
WHAT TO WATCH:
- Greek lawmakers begin 3-day debate on austerity package
- “Cars 2” from Disney’s Pixar opened as the top film in U.S., Canadian theaters this weekend, collecting $68m in ticket sales
- President Obama meets with Senate leaders to see if they can restart the deficit/debt talks that fell apart last week
COMMODITY HEADLINES FROM BLOOMBERG:
- Longest Losing Streak Since 2008 Ending for Commodities as Futures Surge
- Bread in Japan Becoming Costlier May Curb Purchasing Power, Slow Recovery
- Commodities Tumble to Five-Month Low on Basel Rules, Greek Austerity Vote
- Oil Slides on Outlook for Slower Demand as IEA May Release More Stockpiles
- Copper Falls as Greece’s Debt Crisis May Curb Demand for Industrial Metals
- Smithfield Foods’ Hunger for Bacon Makes Sara Lee Merger Target: Real M&A
- Gold Pares Drop After Reaching 1-Month Low on Dollar’s Gains Against Euro
- Cocoa Climbs as Purchasers Secure Mid-Crop Supplies; Sugar Prices Decline
- Wheat, Corn Drop as Greek Debt Woes Cut Investor Appetite for Commodities
- Food Crisis Cooperation ‘Doomed’ Unless Action Taken, Warns Kofi Annan
- Shanghai Sea-Cargo Volume to Increase 10% Annually as Plants Move Inland
- Speculators Cut Agriculture Bets as Improving Weather Eases Supply Concern
- Copper-Alloy Product Output From Japan Climbs as Demand Begins To Recover
- Europe is generally higher lead by Span (we are short) and Italy.
- Asian market are generally weaker (we are short Japan down -1.03%) and LONG China up +0.44%
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.
Conclusion: As Slowing Growth gets incrementally priced into equity markets globally, we are starting to uncover some interesting opportunities across emerging markets on the long side.
As a point of clarification on how we manage Global Macro risk, we don’t typically subscribe to the convenience of lumping together random economies for storytelling purposes. That being said, however, we’re happy to step outside of our shell on a late Friday afternoon to quickly illustrate a point that you’re going to hear us make with increasing volume in the coming weeks and months:
Deflating the Inflation is especially good for those emerging markets which have underperformed on a 6-12 month basis – from both an economic and equity market perspective.
Less simplistically, we are of the view that as commodities continue to break down across the board (particularly in the food and energy complexes), downward pressure will be applied to emerging market CPI readings, which are typically more levered to food and energy prices than their developed counterparts. That provides cover for those central banks which have proactively tightened monetary policy over the last 12-18 months to become dovish on the margin. As Keith pointed out in today’s Early Look, China remains our go-to in this setup.
Be it coincidence or Chaos Theory, it’s no surprise to us that the CRB Index peaked YTD on the exact same day as the US Dollar Index found its YTD bottom (slightly above its all-time low). From a quantitative perspective, the CRB Index remains broken on our intermediate-term TREND duration, while the US Dollar remains bullish on our immediate-term TRADE perspective.
Regarding the US Dollar specifically, it remains the dominant factor in our Global Risk Management Model and we have been fortunate in making many accurate calls on the US Dollar since our firm’s inception over three years ago. Now, we are bullish on the US Dollar from a research perspective and this view is supported by the following factors:
- The end of QE2 means the growth of the Fed’s Balance Sheet will no longer be a headwind (positive on the margin);
- We don’t believe QE3 is in the cards, but assuming that consensus will clamor for more “stimulus”, the timing of any hint from the Fed is likely six-plus months away (refer to our Indefinitely Dovish and What’s Next for the Fed? presentations for more details);
- A shift on the margin towards fiscal sobriety in Washington, D.C. via a Debt Ceiling Compromise is also a bullish catalyst for America’s currency;
- Slowing growth in the Eurozone will have the FX market pricing in less and less hawkishness out of the ECB relative to the Fed on a go-forward basis (don’t forget that the socialist Mario Draghi takes over in November and the Europeans have a full 125bps of potential interest rates to cut). EUR bearishness is USD bullish (57.6% of DXY basket).
Net-net-net, we’re bearish on commodities and bullish on the continued unwinding of the Inflation Trade (the naming of which we appropriately authored in 4Q10).
As Slowing Global Growth continues to get priced into equity markets broadly, we expect investors to stop paying a premium for growth they hope is there (US equities) and to start paying a premium for whatever growth they can find. Hope is not an investment process. Neither is relative value from a longer-term perspective, but we agree that such a strategy can indeed work on shorter durations between cycles.
The price action we’ve seen on a global basis throughout the last week is supportive of our call. Of the 95 equity indices we track (75 countries, 9 S&P 500 large-cap sectors, the MSCI EM Index, and 10 MSCI EM sectors), China’s Shanghai Composite is leading the way at +3.9% on a week-to-date basis. In full disclosure, we are long Chinese equities in our Virtual Portfolio (since June 16). More broadly speaking, the top quartile of wk/wk performance is dominated by EM exposure at 71% of the total. We expect that number to creep higher in the months and weeks to come – particularly as bombed-out markets like India’s SENSEX and Brazil’s Bovespa (down -12.7% and -16.4%, respectively, since the start of QE2) start to recover after deceleration in their domestic growth rates is fully priced in.
As the charts above suggest, now is not the time to cannonball into emerging markets broadly from a quantitative perspective. Each country will initiate its own bottoming process based on the slope of growth, inflation, and monetary policy within its borders. For now, we think China represents the best opportunity on the long side. We’re happy to walk through our Year of the Chinese Bull thesis and/or any other countries with you; just shoot an email to .
One final point we want to make before we wrap up is that it will likely prove prudent to stay away from those emerging markets whose economies are levered to rising commodity prices on the long side. If anything, we would be looking to short petrodollar markets like Russia. For more details on our bearish thesis on Russia, refer to Matt Hedrick’s June 23rd post titled, “Russia From 30,000 Feet”.
Best of luck out there,
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