We don’t like UA around tomorrow’s print – either into it or out of it. Let me be crystal clear on duration…

TAIL (3 years): Luv you long time, UA. These guys are pulling one right out of Nike’s playbook. The growth profile is unquestionable to us. Though they have yet to get any ancilarry categories right – such as Women, Footwear, and International – they will. Of that, I am near certain. But that is also one of the reasons why the team and I don’t like this name on a TREND (3-month) duration.


TREND: The fact of the matter is that even through all the ebbs and flows of revenue, UA has been printing an operating margin of 10-11%. It could have easily been printing something in the mid-high teens. But no, instead it opted to plow the capital into the model to stimulate top line growth. I like that. But’s a double edged sword…

  1. On one hand , I am extremely confident in the top line trajectory. When Plank stands up there and says that the company will double in sales over 3-years, I believe him (and I’m a natural cynic).
  2. But the reality is that there have been several initiatives that simply have not panned out yet. Footwear has been a zero. Granted, the original structure of the company was insufficient for anything but failure in this category), and the current team will tread slowly (no pun intended). They probably won’t mess it up, but we’re very very close to the point where people won’t simply give the Gene McCarthy organization the benefit of the doubt. If footwear does not work, this company won’t double.
  3. Charged cotton was a good launch. Definitely better than footwear. But it was a shadow of its core performance product. This is not a savior for UA.
  4. UA is spending like a drunken sailor. That’s probably a bit dramatic. But with growth in retail stores accelerating, endorsing Michael Phelps, Lindsay Vonn, Kemba Walker, Derrick Williams (#2 NBA draft – ahead of Kemba at #9) and some dude named Tom Brady, the reality is that UA is in investment mode. They’ll play this like Nike in that they will make it work – but will spend more along the way to ensure their success.

If you have a 3-year+investment time horizon, then you have nothing to worry about. They’re doing the right thing.

But we’re paid to point out the potential landmines along the way.


With the stock at $78, 40x+ earnings, 16x+ EBITDA and very little controversy on the name, we’re simply wary – if not flat-out negative given that cash flow is headed the wrong way.








Italy Cancels August Bond Auction Citing Fat Wallet

Position: Short Italy (EWI)

Both Italy and Austria today announced they were putting off plans to borrow cash in the coming month. Neither of them cited market conditions.


As picked up by the Dow Jones Newswires:


Italy will cancel its mid-month (August 12th) auction for medium and long-term bonds, known as BTPs, “considering the large cash availability and the limited borrowing requirement,” the Treasury said in a statement Monday.


This news is deeply concerning given the critical nature of the country’s funding needs. In the next months alone (see chart below) Italy will be burning through 134 Billion EUR in principal and interest payments coming due. This means that the country will have to rely even more on successful future bond auctions (ie sufficient demand at yields not significantly over previous auctions) to fund its costs. This is a risk set-up we don’t like considering that bond auctions across the periphery have trended higher throughout most of the year, and that both the ECB and China have been forced or cajoled into being “hidden” actors to ensure demand. 


Italy Cancels August Bond Auction Citing Fat Wallet - 1. H


The country’s funding issues come on the backdrop of PM Berlusconi’s government that is mired in scandal, including his finance minister Tremonti; an economy 3X the size of the combined economies of Greece, Portugal, and Ireland with some €1.9 Trillion of debt, or 120% of GDP (ranking Italy second behind Greece (144%) for the largest debt as a % of GDP in the Eurozone) that current bailout facilities are not prepared to handle; and a banking industry that was largely unscathed by the bank stress tests, but is highly levered to the rest of the periphery.


While yields on the 10YR Italian government bond have come down from the 6% level in recent days (historically an important breakout line for Greece, Ireland, and Portugal that necessitated bailouts) and Italian CDS took a massive dive (-55bps) on Friday following late Thursday’s announcement of a second Greece bailout, we by no means think Italy is out of the sovereign debt spotlight, and today’s signal from Italy’s Treasury does more harm than good to a very fragile investment community.  


We remain short Italy via the etf EWI in the Hedgeye Virtual Portfolio.


Matthew Hedrick



Will Obama Cede On Duration?

Conclusion:  Despite fear mongering from the political class about adverse reactions from global markets to a lack of agreement on the debt ceiling in Washington, the U.S. Treasury market is largely shrugging off the drama in Washington.  A true default on U.S. debt is highly unlikely in almost any scenario.  Further, we believe that a deal will be reached on the debt ceiling and that it will be some derivative of Speaker Boehner’s two-step process.


On Friday, Speaker of the House John Boehner walked away from discussions with the White House over the so called “Grand Bargain” on the deficit.  The rationale given by Boehner for walking away from talks with the White House was that President Obama was attempting a last minute tax increase, an issue that Boehner had considered stare decisis.  By walking away from discussion with the White House, Boehner has relegated Obama to the sidelines, at least for now. 


Following this action by Boehner, the Sunday morning political talk shows were replete with a fear mongering rebuke from administration officials.  White House Chief of Staff William Daley called into question the very faith of global investors in the credit of the United States with the following statement on Meet the Press:


“I don’t think there’s any question there’s been enormous damage done to our creditworthiness around the world.”


Daley was only to be one-upped by Treasury Secretary Geithner who said the following on Fox News Sunday:


“We do not have the ability to protect the American people from the consequences of not raising the debt limit.  We write 80 million checks a month.  There are millions and millions of Americans who depend on those checks coming on time.”


Boehner and the Republicans did not cede ground despite the strong language from administration officials on Sunday morning.  As of midday, most global markets are effectively ignoring the political theater in Washington as well.  Treasury markets are basically flat today despite the weekend’s collapse in discussions.  In the credit default market, swaps are up slightly from Friday’s close, but, as noted in the chart below, still within a normal range.


Will Obama Cede On Duration? - 1


Will Obama Cede On Duration? - 2


The market obviously understands, despite attempts at fear mongering by the political set in Washington, that a default on U.S. government debt is unlikely.  We could certainly debate whether the U.S. should be rated AAA, or whether ratings agencies should be relevant for that matter, but the actual coverage ratio, as calculated by revenue divided by interest rate, is a very healthy 8.5x for the federal government fiscal year-to-date.    The interest payments of the United States have ample coverage.


Will Obama Cede On Duration? - 3


As the August 2nddate looms, the key outstanding point in the debate appears to be related to duration.  The Republicans, led by Speaker Boehner, have proposed a two-step process.  Under this process, the debt ceiling would be extended by $2.5 trillion, but in two tranches.  The first tranche would be $900 billion and would fund the federal government into early 2012.  This tranche would be paired with $1.2 trillion in deficit cuts over ten years, which would be comprised largely of discretionary spending cuts.


The next tranche of $1.6 trillion in debt ceiling extension would be tied to another stage of deficit cuts.  These cuts would attack the more difficult entitlement programs like social security, Medicare, and Medicaid.  Under Boehner’s plan, a bi-partisan committee of elected representatives would be tasked with finding another $3 trillion in deficit reduction over 10 years (with presumably some credit for a wind down of the wars in Iraq and Afghanistan) and in reporting back by November 1st2011.  The next extension of the debt ceiling would be tied to the second round of deficit reduction being passed.


Taken in good faith, Boehner’s proposal is reasonable in that the natural two-part process of cutting spending largely matches his proposal.  The first part is comprised of more identifiable discretionary spending cuts, while the second part involves longer term entitlement spending cuts and tax code restructuring.  The Gang of Six plan had its day in the proverbial sun last week as a perceived “Grand Bargain”, but the plan’s lack of detail related to entitlement cuts and core tax assumptions made it short lived.  The two-part process proposed by Boehner should enable greater detail to be put around the proposed deficit reduction.


The Democrat leadership of President Obama, Senator Reid, and Congresswoman Pelosi are currently united against Boehner’s proposed two-part process.   Obama has indicated that he would veto such a proposal.  From the Democrat’s perspective, the two-part process extends the debate into 2012, a Presidential election year.  In addition, according to Democrat leadership, the extension of the debate would create incremental risk to the U.S. economy and global markets.  The chart below of Michigan Consumer Confidence provides some credence to this view as this proxy for broad consumer confidence has declined meaningfully alongside a heightening of the debt ceiling debate.


Will Obama Cede On Duration? - 4


Given it is just over a week before the August 2nddebt ceiling deadline, it seems unlikely that any unique solutions will be introduced in the coming days.  The Democrats in Congress have largely ceded to Republican demands to match debt ceiling increases to spending cuts and to not raise taxes in the traditional sense.  As evidenced  by the Senate’s 51 – 46 vote against Cut, Cap and Balance late last week, the Democrats have also shown that while they will cede much of this debate to Republicans, much to the chagrin of leftist groups like, a balanced budget amendment to the Constitution is a non-starter. 


Conversely, the McConnell-Reid plan with a lower level of spending cuts and a proposal to shift the power to raise the debt ceiling up to $2.5 trillion to the President appears to be a non-starter for most Republicans.  The McConnell-Reid would limit tax increases, but does not incorporate matching deficit cuts with a commensurate increase in the debt ceiling.  The plan does provide Republicans the ability to vote three times on a motion of disapproval related to the $2.5 trillion debt ceiling increase.   Not surprisingly, for the Tea Party caucus, a motion of disapproval is clearly unsatisfactory due to its lack of materiality.


It is somewhat ironic that the debt ceiling debate is coming down to a debate over duration given that in almost all proposed plans there is a duration mismatch between increasing the debt ceiling (short term) and implementing spending cuts (long term).  Short term fixes for long term issues are typically not sustainable.  Europe has provided ample evidence of this on the fiscal front over the last year.


In conclusion, we would expect Boehner and the House to push through a two-part process this week. Interestingly, Senator Thomas Carper (Democrat from Delaware) on CNBC this morning ceded to the idea of a short-term bump up in the debt ceiling and implied that some of his Democrat colleagues would support it.  This suggests that a two-part Boehner type process could pass the Senate, even though Cut, Cap and Balance could not garner a majority in the Senate.  At that point it would then be up to President Obama to decide whether he would truly veto a bill that has been passed by both Houses.  In our view, an Obama veto after a bill passed both Houses is unlikely.  


Daryl G. Jones

Director of Research

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.52%
  • SHORT SIGNALS 78.70%


In preparation for the LVS Q2 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from LVS’s Q1 earnings call and subsequent conferences/releases.



Sands China Ltd. Announces US$3.5 Billion Refinancing (June 15, 2011)

  • Terms:
    • US $3.0BN Term Loan A, matures 2016; L+2%
    • An undrawn US$500 million Revolver, matures 2016; L+2%
  • Proceeds used to retire the outstanding balances and commitments on Sands China's existing US$2.7 billion Venetian Macau Credit Facility and its US$1.75 billion Venetian Orient Limited Credit Facility as well as fund the completion of construction of the first two phases of Parcels 5&6 on the Cotai Strip in Macau
  • Will have the option to raise an incremental US$1.0 billion of new senior secured credit facilities under existing baskets within the new credit facilities.

Post Earnings Commentary (Sanford C. Bernstein & Co Strategic Decisions Conference)



  • [Galaxy Macau impact] “So far the Venetian has not felt any change in their business. If anything our business has been very, very good in May so we haven’t felt anything there. We felt a little tiny bit of leakage in the Sands on the peninsula, which I think was normal. People coming over to see it; Galaxy has been pretty aggressive in terms of how they sign ups are going for mass market play. So we have to do some work at the Sands in that area, but anything that comes to Cotai now, in the short term is probably going to pull business from the peninsula. In the long term, we think Galaxy will add to the Cotai as being the number one destination.”
  • [Sites 5 & 6] “There’s actually two casinos, one with site five for those two hotels, and one between the two Sheraton Towers on site six so we’ll have a full casino complement. Most of consensus is saying they’re counting about somewhere around 300 million of EBITDA out of that situation for 2012. So that’s a pretty easy target for us to make, and we think we’ll do that.”
  • [Site 6 opening date] “The first tower of Sheraton, if we get the first tower and the casino and the food and beverage complement, we can open that facility without the second tower, which is way at the end so it wouldn’t bother that first tower. So that could be at the end of ‘12.”
  • [Inflation target] “We still have some difficulties in imported labor, but those are going to be loosening, I believe, for the  loosening for Galaxy and us in five and six and others because there just isn’t enough people. So that might help to keep some of the inflation down, but I think consistently it would be in that 5% to 6% area.”
  • [Cotai capex] “To complete Cotai, well, we have about $1.5 billion of debt left to spend to finish five and six. And then after that, there will be some, a little bit of after burn but we don’t – we predict very low capital expenditure from a new product standpoint in ‘12. We have operating capital that we’ll do for rehab for Las Vegas and others. That’s probably in the $150 million to $200 million a year which is pretty easy for us to do.”
  • [Legal issues] “It could take six months to a year to do and we certainly won’t finish it in ‘11; maybe some time and hopefully by next year this time we’ll be coming to conclusion.”



  • [Singapore/non-Singapore mix] “So you’re going to see that 70/30 ratio go 75/25, I think, by the end of ’11.”
  • [Margins] “Well, margins in Singapore should be north of 50%, but the margin in Singapore, most people, if they really take our numbers and take them apart would find that when you have a higher hold and 2.85% on your rolling volume your margin goes up; when you have a lower hold than 2.85%, your margin goes down. For example, last night in Singapore, we held at 4.85%, our margin was – on the total building and whatever it was in the 70s, so that will vary. If you hold higher, your margins go up. So if you hold 2.85%, our margin should be in the low-to-mid – low 52%, 53%, 54%.”
  • [Rebate] “That commission that comes back to a player varies with the amount that’s played, so it can range from 1.1% to 1.4% or sometimes 1.5%. We believe that Sentosa – we don’t know for fact, but we do believe that they are slightly higher in their commission in that range. And we have – but it also depends upon how much each player plays. So generally, we’re programmed to run about 1.2% to 1.3%. We’ve have the same commission structure from the very beginning and the trend has been the same.”
  • [Win per day] “When we opened, we were doing $2 million a day of win. We’re now running around $4 million or $4 million plus of win, and that’s still growing as we manage the floor better, which is really a science and an art combined. And we think that has upside potential. In the VIP, our roll continues to improve, continues to go up. We have 110 people in the field now finding customers at the high-end level. That’s $10,000 to $1 million of play per hand, going up with large credit customers. And we’re not having trouble with our collections and that continues to grow.”
  • [MICE/slots] “The bookings have been good. They’re getting better. The demand for the property is going up. Our room capacity is running in the high 80s at close to US$300 which is one of the highest rates in Singapore. And a lot of that is MICE business and group business coming in as well. So we’re running out of space in MICE. We’re running out of rooms. We’re running out of slot capability, because we’re only allowed 2,500 slots. I mean, they’re great problems to have, but there are some locations around our building that we’d like to talk to the government about us taking and doing some expansions. But it’s a little early yet so right now, things are growing in every area.”
  • [F&B, retail] “Our retail business, our mall is supposed to be 300 stores. We expect that to be a 200 million EBITDA business. It’s running in the low 100s now after one year and many stores were not open. We think we can make that target sometime in ‘12; by the end of ‘12, after the subway connects. Theaters are now open. We’re doing business there. And our food and beverage has been quite successful.”
  • [Capex] “This year we planned a couple of hundred million. I think by 2012 we have no more capital, other than the capital we’re doing on Tower 3, which would be capital coming out of the building; there’s no extra capital.”
  • [VIP share] “We are capturing a lesser share of the VIP market because – I don’t want to get into details about junket reps or anything, but they seem to like to pay higher commissions than what we want to pay."


  • [Group rates] $180 in ‘11 for the group rate and it’s close to $200 in ‘12 so far. We dropped a lot of money in the first quarter. We’ve done better lately in Las Vegas. Our group business is solid, our weekend business is solid. It’s back in terms of volume, but it’s not back in terms of money. Room rates still are behind 2007 and that’s going to be awhile ‘til that recovers in both group and transient market.”
  • [LV as % of EBITDA] “The future in Vegas, Vegas and Bethlehem, which is our U. S. business, is about 12% of our profitability as a company, 88% being in Asia. That’ll probably go to 90/10 next year.”
  • [Group %] “Our group percentage is going to be in the high 30s this year, 30% of our business. We’d like to get it at 40% because almost all of that is mid-week business where Vegas has widened demand. The weekends in Vegas have been strong this year. It’s just that the rate, the average room rate, and the average daily spend per guest is not what it used to be.”
  • [Aria impact] “Aria in City Center impacted us more because the rate flexibility in that product and some of their group business that they could take even if they have the smaller facilities affected our group rate.”



  • [Taiwan MICE] “Taiwan is just getting into the gaming situation, but we don’t want to be on an island. We prefer to be in Taipei because we want to do MICE business and we think that’s really important to our concept.”
  • [Spain] “Sheldon’s vision for the strip, so to speak, he calls the strip, in Spain which is a European, which is located in Spain, would be approximately 12 properties built in three phases. One phase with four properties in all of the support facilities; and then after that is built, that the cash flow from that would generate the next four and then the next four after that. The land surrounding the strip would be developed by developers in partnership with us if we want to. That’s the way we’ve structured that deal. So we’re looking for a rather large site.”


Youtube from Q1 Conference Call




  • [EBITDA target] “The expectation is that we’ll hit $3 billion plus in EBITDA this year. And some people are saying that we might hit $4 billion. I can’t make any comment about 2012. I won’t make any comment about that, but I will say that we feel quite confident that the $3 billion mark will be breached.”


  • [Bookings] “Based on our existing bookings, we expect to do more than 700,000 group room nights in 2011, with an expectation of 1 million total group nights in 2012.”
  • “Our cumulative hold percentage in Las Vegas on Asian Baccarat play exceeds 27%.”


  • [Margins]I don’t think we’ll see change in April or May or beyond. If anything, I see increasing margins in mass table and slot as we grow there. I don’t see the margin getting a whole lot better on the Roll as well. It’ll still be in the low 30% because you’re still paying out. Most of the business is on the very high end and you’re be paying as high as 1:4. So I don’t see how we get that much beyond 32%, 33%. But I do see a little bit of appreciation as we grow on the slot, table mass side.”
  • [# of junkets] “I think junkets, there’s now 31 companies in the queue as we speak. I think that will grow to 40, 50 by the time the summer rolls around.”
  • [Slot rev guidance] “If you look at the slots, we’ve gone from the first full quarter which is Q3 ’10, we’ve approximately won about $79.5 million then jumped to $96 million there and then jumped to $108 million. Can we get to $120 something million next quarter? I believe we can. We believe the market can grow you know easily we can see 1.8, 1.9 next year as a cumulative mass slot.”


  • [Sites 5&6 opening date] Although we have made significant progress on parcels 5 and 6, our anticipated opening of Phase I could slip to the first quarter of 2012 if we do not secure increases in our present construction labor force.”
  • [Junket/Direct %] “Our Roll will continue to be probably spread 80/20, 85/15 junket versus direct. We’ve said it before and we’ll say again, there’s a market for the direct VIP, but the primary market in the Macau has been and continues to be on the junket business because of the obvious reasons that we’ve talked about in the past. And… it won’t diminish.”
  • [Sites 5&6 workers] “We have roughly about 5,500 on the site now. We’re running about five weeks behind on the December target. We met there last week. We need to pick up another 1,000 to 1,500 employees in some of the specialty areas like mechanical, electrical, plumbing, et cetera, which is where the problems are. And we’re still hopeful we can make that target. But the reason we’re talking about possible slipping is if we don’t get that extra 1,500 or so, we will have difficulty meeting the target. And we’re gradually increasing. Last week we got 400 to 500 more and we’re hoping as Galaxy opens we’d get some more, particularly in that area from MEP.”
  • [Galaxy impact]  "As to the promotional issues, I think the Galaxy people are going to be focused on making money and watching the margins, and I don’t think it’s going to be an issue."


  •  [Spain/North Africa]  “We just had a team of people over to Spain. We are continuing to lay the groundwork for that. We have constant meetings about planning and programming; that is, how much space we’re going to allocate to which of the properties. We’ve talked to builders. We’re in discussions with both the governments and land acquisition, both in Madrid and Barcelona. And it’s not a Spanish development per se. This will be a development where the primary market is all of Europe: Western Europe, the former Warsaw Pact countries, Western former Soviet Union countries, even into Moscow and St. Petersburg, down to the Middle East, Turkey, with 85 million people, and North Africa. Nobody’s talked about North Africa. There’s a lot of haves there and there are far more have-nots. So we’re hope that North Africa will help to fatten up the market there. But it’s for 700 million, 800 million people in the catchment area, so it’s not just Spain. And we’re moving forward on that. We’re not ready to break ground. We don’t have the grants and incentives finalized yet, but we’re in heavy discussion."
  • [Massachusetts/Rhode Island] “If Massachusetts allows three full casinos, Rhode Island is considering converting their two slot parlors into full fledged casinos. The two, the Mashantucket Pequot and Mohegan Sun in Connecticut, are still there. It all depends where they allow them. I think with three, there might be too small of a market up there so it may not justify the kind of money that we’ll have to spend to show our best, to flex our muscles the best.”


In preparation for IGT’s FQ3 earnings release tomorrow, we’ve put together the pertinent forward looking commentary from its FQ2 earnings release/call.



Youtube from FQ2 Conference Call

  • “We expect our current trends of moderate revenue and earnings growth to continue for the remainder of this year and into fiscal year 2012.”
  • “I am quite enthusiastic about our international business opportunities.”
  • “Our [Gaming Operations] yields should continue their modest sequential improvement, assuming normal seasonal trends continue.”
  • “Approximately 82% of our install base is comprised of variable-fee games that earn a percentage of machine play levels rather than a fixed daily fee. For the remainder of the year, we expect our Gaming Operations’ installed base to continue its moderate growth.”
  • “Given the current selling environment and volume levels, we expect average selling prices to rebound modestly from this quarter’s levels, mainly due to mix, but margins to be under pressure for the remainder of the year.”
  • “Internationally, the average selling price was up 10% year-over-year to $13,000, due to favorable geographic mix, specifically higher shipments in Argentina and Australia.”
  • “We expect a modest, upward trend in SG&A for the remainder of this year as we invest in people and processes necessary to take advantage of new business opportunities.”
  • “The new facility will reduce interest expense including deferred offering costs, amortization, by about approximately $13.5 million on an annual basis. Additionally in April, we entered into arrangements to swap fixed rate interest for variable rate interest, which is expected to save an incremental $7 million in annual interest expense at today’s rates.”
  • “Roughly 12 months ago, we installed our very first Center Stage platform, and we now have over 500 units on that platform with another 500 units on order."
  • “We expect our International unit sales to keep pace with our North American sales for the remainder of the fiscal year, which is another testament to the strength of our global reach. We will combine that with growth in international Gaming Operations, to further enhance our strengths outside North America.”
  • “We have been deploying Wheel of Fortune Triple Spin onto the Center Stage platform and in many instances seeing meaningful increases in daily play levels versus older versions.”
  • “On a macro level, we are still very much in a promotional environment for the replacement business, and it may become more so in the upcoming quarters. To date, we have had some well received promotions that generally speaking have increased our ship share and generated sales in other areas as we bundle our offerings. To help offset these promotions, we continue to gain efficiencies in our manufacturing processes.”
  • “For the remainder of fiscal year 2011, we see very limited opportunities for new and expansion shipments in the for sale business. For fiscal year 2012, there is more optimism, but still no certainty.”
  • “Our systems business is also performing well. Year-to-date our consolidated systems revenues have grown in the high single-digit range. We currently have 65 sbX contracts in our sales funnel from all over the world, indicative of potential future revenue opportunities. This is another area of our business that we anticipate seeing earnings leverage as the overall gaming environment improves.”
  • “For the current fiscal year 2011, we are raising our earnings guidance to $0.84 to $0.90 per share, excluding the $0.04 of special items for the first quarter.”
  • “We have seen the WAP installed base start to stabilize and improve slightly in terms of the installed base. Performance obviously is much better with a new line-up of great performing games and a little help from the macro environment. I think on the margin we see consumers freeing up a little more money.”
  • “On the margins and Product Sales, I think you’re probably safe if you assume a run rate domestically of say 52%. Somewhere in that, plus or minus, probably seems like a good range. And then on, as far as R&D spend, I think we’re working hard to try and keep that relatively flat.”
  • “We are seeing some of our competitors’ price lower than our for-sale games are in the market at. What we find is our promotional activity is very disciplined, and we stick to a particular formula.”
  • “Our guidance, at the low end, assumes kind of flattish to the first half. At the higher end, it’s assumed some uptick there, but it also assumes at the higher end, some uptick in both the units and the play levels in the Game Operations business. But still, I think relatively modest.”

European Risk Monitor: Risk On/Risk Off

Positions in Europe: Short EUR-USD (FXE); Spain (EWP); Italy (EWI); UK (EWU)

We don’t subscribe to the theory that securities or countries have “risk on” or “risk off” profiles, rather risk is always “on”. Over the last 24 months European capital markets (particularly the PIIGS) have shown a pattern of underperformance alongside sovereign debt contagion, with positive performance in the days directly preceding discussions or announcements on bailout and austerity packages followed by renewed underperformance after the event. Credit rating downgrades from the rating agencies have also done a number to drag down performance following the announcement. 


And Greece’s second bailout announced last Thursday (7/21) follows this mold to a “T”: buy the rumor sell the news, and sovereign debt contagion is far from over. And just today Moody’s chummed the water further by downgrading Greece’s debt from Caa1 to Ca. [For more on the terms of the bailout see our post from 7/21 titled “Framework of Greek Bailout Part II: Skepticism Abounds”].


Now we appear to be playing a game of semantics in determining if Greece is in default.  What’s clear is that these short term “band-aid” bailouts or obfuscating language will not solve Europe’s longer term fiscal imbalances and therefore we expect peripheral capital markets to trend lower over the intermediate term.



The Semantics of Default

The big debate is whether or not Greek debt is in default and the pricing of risk based on this rating. The International Swaps and Derivatives Association (ISDA), which governs CDS pricing, has ruled that the Greek restructuring does not constitute a credit event, which means that CDS will not be triggered. 


However, the credit rating agencies have said that under technical definitions, any restructuring of debt is a default, so the current plan (as defined under Greece’s second bailout) for banks to roll over shorter term Greek debt into long term debt (~ 15 to 30 year maturities) should constitute a default. In fact, the language has morphed into an “orderly” default and “partial” default, and is expected to be rated as such only during the window of late August and early September when the banks may voluntarily decide to participate in this bond swap.  Thereafter, the expectation would be that a rating above default would be returned.


Further, ECB President Trichet refuses to recognize any member state in default and does not see Greece’s newest package triggering a credit event (default). In fact, Trichet along with other EU officials went so far as to say they’ll rely less on the ratings from the main ratings agencies, without indicating a surrogate rating source.


Certainly these results leave plenty of gray areas, including how risk is priced. It appears CDS swaps will be a useless instrument for pricing default or hedging default. Conversely, bond yields may flip around in the next weeks and months depending on the “success” of the bank swap, the actions of the ratings agencies (including their language); and the general psychology of the market which over the last 18-24 months has turned violently against those peripheral countries in the spotlight.



More Kinks in the Chain

To add more fuel to the fire, amendments to the European Financial Stability Facility (EFSF), which to date has provided the bailout funding to Ireland and Portugal, must receive approval from all EU countries, which cannot happen until mid-September when the parliamentary returns from summer break.   Therefore the risk profile of the peripheral is further heightened as indecision about increasing the facility and the terms of debt could arise, and not until mid-September.



Risk Swings

Of note is that sovereign bond yields and cds across the periphery fell off a cliff last week on a week-over-week basis. Over this period 10YR government bond yields fell -323bps in Greece; -208bps in Ireland; -168bps in Portugal;-50bps in Italy; and -46bps in Spain. On Friday (7/22) alone, following Thursday’s late day announcements, 5YR CDS fell a monster -644bps in Greece; -261bps in Portugal; -249bps in Ireland; -59bps in Spain; and -55bps in Italy!!! Our call remains that despite these massive dips, the trend line will resume up and to the right.


European Risk Monitor: Risk On/Risk Off - 1. HHa


European Risk Monitor: Risk On/Risk Off - 1. HHb


Our European Financials CDS Monitor showed that bank swaps in Europe were mostly tighter last week, with 34 of the 38 swaps tighter and 4 wider, which rhymes with the “risk-off” trade following the announcement of Greece’s second bailout package.


European Risk Monitor: Risk On/Risk Off - 1. HHc


We remain short the EUR-USD via the etf FXE in the Hedgeye Virtual Portfolio and expect the pair to trade in a range of $1.41 to $1.43. The EUR-USD is dancing around our TREND line of $1.43, an important momentum level. We’ve position ourselves to take advantage of downside in the periphery, being short Italy (EWI) and Spain (EWP). Further, with stagflation sticky in the UK, we’re short the country via EWU.


Matthew Hedrick


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