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Pax Canadiana

Me debunk

An American myth?
And take my life
In my hands?
Where the great plains begin
At the hundredth meridian.”

- The Tragically Hip


There is no doubting American global dominance in both military and economic affairs. The United States is the world’s reigning superpower and has been really since before the end of the Cold War. While the Soviet Union was considered a rival to the United States for many years, this was primarily due to the nuclear arms race and MAD, or mutually assured destruction. In reality, the Soviet Union was never really on par with the United States from an economic perspective.


The term Pax Americana is used to describe the relative peace enjoyed by the Western World due to the preponderance of power held by the United States over the last century. Since World War II, the idea of Pax Americana has manifested itself in the many international institutions backed by American influence and finance. Initially, this began with the Marshall Plan and the rebuilding of Japan, and eventually transitioned to the UN, NATO, the IMF, and the World Bank.


Immediately following World War II, the United States was responsible for roughly half of the world’s industrial output, held 80% of the globe’s gold reserves, and was the sole nuclear power. Even if America has lost share over time, she remains the world’s dominant economic power at 25% of the world’s output, so it is with some jest that I use the term Pax Canadiana to characterize the growing role of Canada in the global economy. But today is July 1st, or Canada Day.


In his book, "The World in 2050: Four Forces Shaping Civilization's Northern Future", the UCLA Geographer Laurence C. Smith highlights some of the key forces driving economic share gains of the Northern Rim Countries, or as he calls them NORCs. Ironically, global warming will potentially be a major positive for the NORCs. Some of the key points that Smith highlights, which I’ve excerpted from the Globe and Mail, include:

  • New shipping lanes will open during the summer in the Arctic, allowing Europe to realize its 500-year-old dream of direct trade between the Atlantic and the Far East, and resulting in new access to and economic development in the north;
  • Oil resources in Canada will be second only to those in Saudi Arabia, and the country's population will swell by more than 30 percent, a growth rate rivalling India's and six times faster than China's;
  • NORCs will be among the few place on Earth where crop production will likely increase due to climate change; NORCs collectively will constitute the fourth largest economy in the world, behind the BRIC countries (Brazil, Russia, India and China), the European Union and the United States; and
  • NORCs will become the envy of the world for their reserves of fresh water, which may be sold and transported to other regions.

Keith has previously mentioned Smith’s work and the NORC theme is one you will likely see us revisiting in the coming years.


Interestingly, Canada is actually starting to show some subtle shifts in its economy versus the United States. Coming out of the depression of 2008 / 2009, Canada has had much more stable and even economic growth. A primary driver of this is the relative health of Canadian banks, which didn’t underwrite as many bad loans during the housing boom of the late 2000s and therefore still have the ability to broadly extend credit to consumers.


From a fiscal health perspective, Canada is in very strong shape versus its southern neighbor, and really much of the Western World. Canadian debt-to-GDP is estimated at 42%, which is roughly half of that of the United States. Further, Canada’s current budget, which was passed by the Conservatives in the fall of 2010, projects a balanced budget by 2015. Currently, not even in its long term projections, through 2035, does the Congressional Budget Office anticipate a balanced budget in the United States.


Finally, from a longer term perspective, the United States has literally always had a lower unemployment rate than Canada, or at least going back as far as World War II. In the chart of the day, attached below, we’ve charted relative unemployment rates comparing the United States and Canada. Currently, Canada’s unemployment rate is 7.4%, while the United States’ is 9.1%.


Much like the excerpt from the iconic Canadian band, The Tragically Hip, I’m not going to take “my life in my hands” and “debunk an American myth”, but I would advise keeping Canada and the rest of the NORCs front and center in the coming years as you and your colleagues scour the globe for investment ideas.


While Canadians are certainly excited about the economic prospects of their nation, all Canadians respect the long standing special relationship shared with the United States. President John F. Kennedy perhaps summarized this relationship up best when he said in an address to Canadian parliament in 1961:


“Geography has made us neighbors. History has made us friends. Economics has made us partners. And necessity has made us allies. Those whom nature hath so joined together, let no man put asunder. What unites us is far greater than what divides us.”


Both Canadian and Americans should be proud of this special relationship and the good it does in the world.

Happy Canada Day! Happy July 4th! And happy 100th birthday Bassano, Alberta!


Keep your head up and stick on the ice,


Daryl G. Jones

Director of Research


Pax Canadiana - Chart of the Day


Pax Canadiana - Virtual Portfolio

The Long Run

This note was originally published at 8am on June 28, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Avoiding danger is no safer in the long run than outright exposure.  The fearful are caught as often as the bold.”

Helen Keller


It is difficult to invest for the long term.  In order to do so, the key characteristic an investor must have is permanent capital.  The best example of permanent capital is Berkshire Hathaway, Warren Buffett’s investment vehicle.  Since Berkshire recently hit a 52-week low, in the short run, it has been a bad investment.  In the long run, of course, Berkshire has been a fabulous investment.


From December 31st, 1987 to the close yesterday, Berkshire “A” shares have returned ~3,770%+.   Over the same period, the SP500 has returned ~415%+.  In the long run, it is obviously difficult to debate Buffett’s success as an investor.  Unfortunately, very few investors can operate for the long run because of a lack of permanent capital and an unwillingness of those that provide the capital (limited partners) to suffer volatility. 


Naively many investors attempt to emulate Buffett’s performance by purchasing stocks that emulate his criteria.  In aggregate, studies show that cheap stocks with clean balance sheets will outperform over time if bought well.  Obviously, the challenge when emulating Buffett, though, is to assess the moats of a company and barriers to entry of an industry.


As Buffett wrote in his 1992 letter to Berkshire Shareholders:


“An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management.  Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.”


The challenge of finding a long term economic franchise is that very few exist, or are sustainable.  At one point, the newspaper industry was a prime example of an economic franchise.  The newspaper was needed, in many markets had limited competition (think the Buffalo News), and pricing of newspapers was not regulated by the government.  While arguably the newspaper industry did represent franchise-like investments during periods, those investors that held these franchises in perpetuity are likely not happy today. 


The key way to “avoid danger in the long run” is to remain flexible, not duration specific.  I appeared on the Kudlow Report a few months back and one of the other guests was extolling on the virtues of being a long term investor and indicated that his firm has an average holding period of four years.  In theory, that’s fine if you have the process and team to execute on a long term holding period.  If you are investing for the long term, which for this discussion we’ll just consider beyond three years, it requires just as much work, if not more, than if you are an intraday trader.


The primary reason investing for the long term requires more work is because in the short term, assets will get mispriced.  Much of this can be attributed to behavioral finance and fear.  When assets get mispriced, such as in the market dislocation during the subprime debacle, it requires strong conviction in the research process to believe the fundamental story and to continue to buy, or even hold, as an investment is dramatically underwater.  While many fund managers claims to be adept at buying while there is “blood in the streets”, very few actually can effectively time purchases.  The world is replete with studies that show both professional and individual investors classically sell at the bottom and buy at the top.


Given the challenges with true long term investing and the reality that most cannot do it, we emphasize three investment durations in our research: TRADE (3 weeks or less), TREND (3 months or more), and TAIL (3 years or less).  In theory, at least based on how we analyze timing and risk, they are all related, so a TRADE idea can become a TREND idea and so on. Thus, a rigorous daily research process is critical to our success (hence the early mornings).


Shifting to the short term, there are a number of data points from the last 24 hours that I wanted to flag as fundamental to some of Hedgeye’s key investment views:


First, the European sovereign bond markets continue to signal that the worst is yet to come for sovereign debt on the continent.  Even as equity markets seem to be lightly cheering positive developments yesterday, bond yields have barely budged.  In fact, Greek 10-year yields are at 16.5%, Irish are at 12.1%, Portugese are at 12.1%, Spanish are at 5.7%, and finally Italian 10-year yields are at 5.0%.  Specific to Greece, civil unrest continues to accelerate as Greek trade unions are planning a 48-hour strike to protest austerity measures that will be voted on Thursday.  We remain long German equities via the etf EWG and short Spanish equities via the etf EWP.


Second, Premier Wen Jiabao provided us an early view on Chinese inflation for the full year yesterday.  He indicated on Hong Kong-based Cable TV that while he sees difficulties in reaching a full year inflation target of 4 percent, inflation “can still be kept below 5 percent”. This supports our view that the proactive monetary tightening that China has implemented will lead to steadily decelerating inflation in the back half of 2011 and marginal dovishness out of the People’s Bank of China.  We are long Chinese equities via CAF.


Finally, New Jersey officials are purportedly in negotiations to secure a temporary $2.3BN bank loan to cover a state cash shortfall.  New Jersey needs the cash to pay various bills between the start of its fiscal year on July 1st and the mid-summer bond offering.  We’ve been consistently negative on State and Local level finances and this provides incremental support to the view.  While many States are constitutionally obligated to balance budgets, it will be challenging and will likely require additional municipal bond issues as federal government support will be largely non-existent in fiscal 2012.  Further, State and Local level austerity will be a drag on economic growth more broadly.  We currently have no position in the municipal bond market.


Good luck “avoiding danger” out there today,


Daryl G. Jones

Director of Research


The Long Run - Chart of the Day


The Long Run - Virtual Portfolio


Early Look

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The Macau Metro Monitor, July 1, 2011



June GGR came in at MOP 20.792BN (HK$ 20.186BN, US$ 2.593 BN), up 52% YoY.



Insiders claim Caesars Entertainment is hot for Kinmen and reportedly interested in building a comprehensive recreation and entertainment facility on one of the county’s islands.  MPEL CEO Lawrence Ho also made a recent trip to Kinmen.  Casino rules may be finalized by the MOTC (Ministry of Transportation and Communications) in late 2011.  A local referendum will follow.


According to Soufun Holdings, China home prices growth in June slowed to +0.4%, from +0.5% growth in May.  This is the 10th straight month of gains. Shanghai home prices rose 0.1% MoM (+0.3% MoM in May), while those in Beijing dropped 0.1% MoM (+0.2% MoM in May).

Chicago PMI? A Golf Clap at Best

Conclusion:  Our interpretation of the Chicago PMI is that it is a golf clap at best.  We are adding to our short position in U.S. equities (via SPY) and long position in U.S. Treasuries based on better prices created by today’s PMI story telling.


There is no disputing that the headline Chicago PMI number reported today was better than expectations.    The median forecast of analysts was for 54.0, and the number came in at 61.1.  This was also a sequential improvement from May, which was a 56.6 reading.  So, is this positive on the margin? Sure, but if we look at the longer term, even a 61.1 PMI isn’t overly exciting.


While not exactly the long term, we have attached below a chart of PMI going back twelve months.  The key take away from this chart should be the dramatic decline of both May and June from the first four months of 2011.  The PMI reading for January to April of 2011 ranged between 66.8 and 71.2.  So, the Chicago area economy continues to trend well below economic levels from earlier in the year.


There are a number of details within the report that are worth flagging:

  • Order backlog in June dropped to 49.1, which was a sequential decline from May’s reading of 51.7 and the first drop below neutral since September 2010;
  • Inventories saw a “precipitous decline” from May and came in at a reading of 46.9 in June versus 61.6 in May;
  • Prices paid are still expanding, albeit at a slower rate and declined to 70.5 in June from 78.6 in May (Deflation of the Inflation). 

A number of comments from the survey are also worth highlighting:

  • “Incoming orders have definitely slowed down. Several orders we expected to see are currently on hold. Hopefully something will break or the 4th quarter is going to look sad”;
  • “It looks as if manufacturing is showing signs of slowing down”; and
  • “There may be a little softening coming but it’s too early to tell.” 

While the headline number is better than expected, which is getting equities going today along with quarter end window dressing, the key perceived positive is a drawdown in inventories.  This suggests that there could be some inventory building in the coming months, which would drive overall economic activity.  That said, the last time we saw the inventory reading drop precipitously was June 2010 when the reading dropped from 54.2 in May 2010 to 47.2 in June 2010.  In the ensuing months, not only did we not see economic activity pick up, more broadly Chicago PMI actually began to decline into August 2010.


Suffice it to say, we don’t find today’s Chicago PMI all that exciting.  In fact, we actually find the drop in orders to below 50 outright concerning, along with the selected commentary.  As a result, we are using the over reaction of both the equity and bond markets today to add to our short positions in the SP500 and long position in U.S. Treasuries.  Short high, buy low.


Daryl G. Jones

Managing Director 


Chicago PMI? A Golf Clap at Best - 1


We decided to let our intern, Allen Davis, away from the desk for a few hours to check out some Chipotle locations.


Despite the heat, he was enthusiastic about the idea of visiting as many Chipotle stores as possible in Manhattan.  While he likes to eat, being a Yale football player, he wasn’t being sent to sample the food.  His job was to speak to store employees about the impact on traffic, if any, of the recently reported $0.50 increase in prices implemented at the company’s NYC restaurants.  Below is his account of the experience.


“Wednesday was a big day for me. I had squat clean and bench for my workout after market close, but a day long warm-up walking the streets of New York (not in the classical sense). My mission: visit every Chipotle on the island of Manhattan in an effort to gain some insight into recent traffic trends following the reported $0.50 increase in prices at New York City Chipotle restaurants. Major roadblocks would include annoyed managers, midday lunch rushes, and a general fear of subways.  In the end, it was impossible to make it to every store on Manhattan but I managed to survey 19 stores and got a response 74% of the time.  The general consensus was that, following the price increase, not much had changed.           


The $.50 price increase, partially necessitated by Chipotle’s continued commitment to buying as much of its meat and produce as it can from local organic sources, didn’t seem to be a headwind to traffic, according to the managers I spoke with.  None reported a decrease in sales and the only location that would provide me with a rough weekly sales average said that they had done 1-2k incremental sales following the price increase.  While a lot of this is probably just the $.50 price jump pushing revenue, it does suggest that traffic is staying consistent, another point that many managers made. This makes sense when you consider the consumer that Chipotle typically services and, of course, the location of the stores I surveyed.


As the CEO of Taco Bell recently admitted via a now-infamous BMW vs Hyundai metaphor, CMG doesn’t have a product that sells to the same people that would run out to Taco Bell and get 8 burritos for a buck each (source). They sell a higher quality product to a more upscale, and perhaps more eco-conscious, consumer. Before CMG took price, a burrito with guacamole, which costs $2.25 extra, was around $8.50 for chicken, closer to $9.00 for steak. While this isn’t an extravagant expense for some, it isn’t a totally insignificant one either. $8 is more than an hour’s work for many workers and, in cities like NYC where the cost of living is high, many may balk at paying such an amount for a meal.  On aggregate, though, people who spend $8-$10 at Chipotle in New York seem to be loyal to the brand, have the willingness and ability to pay the price.   In fact, many of the managers I discussed the price increase with told me that the majority of customers did not notice the change and, among the small number that did, very few complained.


Just today, the results of an Eco Pulse survey found that, when asked “Which is the best description to read on a food label,” the terms “natural,” “organic,” and “grown in the USA” accounted for 76% or responses (source).  From a marketing perspective, this bodes well for CMG even when they bump their prices because, since the Chipotle customer is willing to go to the expense to buy the product, the company can reap the benefits of touching on all of these target marketing terms. They can afford to pass off price to a greater extent, and do it in a more up front manner, than a company like McDonald’s. When MCD started charging $.19 more for the second slice of cheese on double cheeseburgers, the reaction was negative, but that wasn’t indicative of reactions to all price increases. MCD had bumped the price of a favored item by almost 20% to a lower income-bracket consumer. CMG’s change was blanket and on a more upscale consumer which I think is the reason it is having little effect on anything according to the managers."




Howard Penney

Managing Director


Rory Green


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