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European Risk Monitor: Blood in the Ring

EUR/USD breaks TREND and TAIL as Greek Concerns Flair


If we were to relate the European Sovereign Debt contagion to a boxing match, Germany (represented as the long-standing heavyweight champion) would be facing-off against numerous competitors in a league that includes the countries of France and the PIIGS, the latter of which collectively belong to the featherweight and welterweight divisions. The obvious mismatch would see Germany handily defeat the PIIGS—blood would spray deep into the 10th row and the sea of German fans would cheer!


Yet now consider that while Germany would happily throw the knock-out punch to see at least its featherweight competition never rise to its feet again (call them Greece, Ireland, and Portugal), Germany has ulterior motives, influence both by its fan club (the German populous and Merkel’s reelection efforts) and the Boxing Commission (think: ECB and Eurocrats from Brussels).


Firstly, Germany intuitively understands that it’s happy to beat up on its competition, but ultimately if it wants to fill the seats (think: export markets) it needs competition week in and week out. Secondly, Germany is being pressured by the Boxing Commission that so long as it doesn’t “finish off” its competition, the Commission will help split the PIIGS’ medical bills (think: bailout packages; SMP bond purchases; and EFSF) to ensure there are future rounds to fight.  


Germany, however, soon realizes that the competition is so mismatched that its weakest competition can hardly stand up straight, let alone see straight to protect (help) itself, and upset with the rising medical costs to “fix” its competition, the share of which is increasingly rising. Further, the game is so mismatched, that Germany fears it will lose not only its fan base who cannot justify the ticket price for such a match, but also that its poor competition will drag down its championship form (GDP).


Germany, the Boxing Commission, and the badly injured adversaries are at an impasse--what should be done?  German fans aren’t returning (Merkel’s popularity tanking); Greece, Ireland, and Portugal are in the ICU; and Spain and Italy need extra doses of morphine to deal with the pain.  The Boxing Commission and Germany are at odds. Germany’s only other competition, France, has caught a nasty cold with whispers of pneumonia. While Germany isn’t willing to let the league disintegrate, it’s also not in the position to continue to pay the lion’s share of the medical bills to fight another week. And so far Boxing Commissioner (Trichet) has yet to indicate that he’s willing to cover the rising medical bills should Germany skirt the bill. 


On the 29th of September the German team will hold a vote to see if they want to continue to pay the medical bills to insure future matches. Heading into the vote, many of the team’s strong voices feel that paying the bills accomplishes little: even with a healthy Greece, Ireland, and Portugal, there’s no competition for Germany. Further, fears percolate that should France be down and out for a long period and Italy and Spain require care, Germany will not be able to fit the bill. The larger question before the team remains: is it a larger risk for Germany to let the league disintegrate and lose its championship form, or continue to support its competition at a heavy cost so it at least has a body to throw punches at in the ring?  The fans seem unwilling to let this decision linger.


The “boxing tale” above presents some of the larger issues regarding European sovereign debt contagion and Germany’s leading position in the issue, all of which have heightened since the German government considered the impact of a Greek sovereign default on its banks over the weekend. While there are numerous moving parts in crafting “solutions” to this contagion issue, including political conflicts and solving for known unknowns on the sovereign and banking sides, what’s clear is that Germany’s vote on the 29th, a change in the ECB’s willingness or unwillingness to provide more fiscal support, and/or market forces may all have significant impact on the direction of this contagion.


We’re not currently invested in Europe via our Hedgeye Portfolio and don’t expect a quick fix to European debt and banking contagion risks and expect to see more downside in European capital markets from here as:

  1. Eurocrats refuse to accept default of member countries
  2. The EU Constitution does not account for measures to let a member country leave the Eurozone
  3. Stronger nations will likely vote against Eurobonds
  4. Countries (like Finland) will demand collateral for funds posted to the EFSF which will pinch the Greek state which doesn’t have the assets to cover the EFSF
  5. There’s no European-wide banking plan to recapitalize/write down peripheral exposure, or simply to let banks fail

Obviously the region’s common currency hangs in the balance. Our immediate term TRADE levels on the EUR-USD cross are $1.36 to $1.39. As Keith has stated recently, from “The Correlation Risk perspective, this cross remains the most important relationship in all of Global Macro. We like to say, “get the EUR/USD pair right and you’ll get a lot of other things right.” Both the TAIL ($1.39) and TREND ($1.43) for the Euro have broken expeditiously here in September.”


As we show in the 3 year chart below, we don’t see any longer term support in the EUR-USD until $1.20. From a calendar perspective, the Germany’s EFSF vote at the end of the month remains a critical catalyst, as does Troika’s report on Greece’s fiscal consolidation measures, the report of which is expected to come out at the end of the month and the findings of which will determine if Greece receives its next tranche of funding of 8B EUR, monies it’s desperately relying on to pay its bills.


European Risk Monitor: Blood in the Ring - 1. monday


European equity indices, especially banking stocks took it on the chin in August and are off to a bad start in September. The heavy weight German DAX is down a full -33% since its early May highs!  The point here is that no country is immune despite how impressive its right hand (balance sheet) is.


Below we include the Weekly Risk Monitor report from our Financials sector head Josh Steiner. It shows in particular the rising risk premium, reflected by CDS spreads, across the sovereigns and banks of Europe. Directly below we refresh our chart of 10YR yields of the periphery.  In particular, Italy has move back to 5.50%, and therefore is flirting closer to the 6% breakout level. Italy’s 54.5B EUR austerity program, which could pass the lower house as soon as this week, is weighing on this yield—both that the package gets passed and the terms are bold enough to arrest the country’s severe debt levels. Whether or not the Chinese come to Europe or Italy's aid (FT rumors today), we’re sure there are no short term fixes to Europe's  debt "crisis", especially if Eurocrats have their way.


European Risk Monitor: Blood in the Ring - 2. monday



European Financials CDS Monitor – Banks swaps also widened in Europe last week.  35 of the 39 swaps were wider and 4 tightened.   The average widening was 5.9%, or 25 bps, and the median widening was 21.3%.  Tightening was concentrated in the Greek banks, where swaps are already trading well over 1,000 bps. 


European Risk Monitor: Blood in the Ring - j1


European Sovereign CDS – European sovereign swaps went parabolic last week.  All the countries we track, with the exception of Ireland, hit a new high as of this morning.  Greek swaps are up 56% WoW as of this morning, rocketing to 3500 bps.  French CDS rose 23% WoW to a new high of 191 bps. 


European Risk Monitor: Blood in the Ring - j2


European Risk Monitor: Blood in the Ring - j3


Matthew Hedrick

Senior Analyst






Looking at Greece and the Other Dominoes

With the market now saying a Greek default is upon us, we're revisiting a post we first published on July 18 of this year called  "European Debt: Where the Bodies are Buried". In that post we reverse engineered the EU stress tests and published the precise sovereign holdings and loan exposure by EU bank across each PIIGS country. We broke this out in a series of tables, which we are republishing below. Bear in mind that a limitation here is that we're looking at holdings as of year-end 2010.


By way of example, one area of market concern this morning is French bank downgrade risk. As the table below shows, both Soc Gen and BNP held approximately 10% of their Tier 1 Capital in Greek Sovereign Exposure as of YE2010, while Credit Agricole holds around 1%. Other highly exposed non-Greek EU banks as of YE10 were Banco Comercial Portugues (Portugal: 60 billion euros RWA) with 21% of its capital directly exposed to Greek sovereign debt, Dexia (Belgium: 140 billion euros RWA) with 20% of its capital directly exposed to Greek sovereign debt, and Commerzbank (Germany: 268 billion euros RWA) with 11% of its capital exposed. 


Investors can consider these tables a reasonable starting point in assessing interconnected risk across the EU banking landscape.












GREECE: A REMINDER OF WHO HOLDS GREEK DEBT - greece portugal ireland







Summary Conclusions: 13 of the Top 40 EU Banks Hold Over 200% of their Capital in PIIGS Exposure

We find that there are numerous European banks with over 100% of their Core Tier 1 Capital committed to either PIIGS commercial loans or PIIGS sovereign debt holdings. For example, we found that 18 of the 40 largest European banks held 100% or more of their Core Tier 1 Capital in PIIGS sovereign debt or commercial loans. In 14 of these cases, the banks held more than 200% of their Core Tier 1 Capital in PIIGS sovereign debt or commercial loans. 


As a general rule we found that the Nordic banks are the least exposed to PIIGS debt, typically holding less than 20% of their Core Tier 1 Capital, putting them at considerably less risk than the group as a whole.  


Joshua Steiner, CFA


Allison Kaptur


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Short Covering Opportunity: SP500 Levels, Refreshed

POSITION: Long Utilities (XLU), Long Healthcare (XLV)


This morning’s rally “off the lows” didn’t surprise us. Neither did the selloff from the intraday highs. Bottoms, like tops, are processes - not points. And this one looks to be finally establishing a manageable immediate-term TRADE range at higher-lows (versus the YTD closing low of 1119).


To review the lines/levels that matter most across our risk management durations: 

  1. TAIL (long-term) resistance remains up at 1265
  2. TRADE (immediate-term) resistance is now 1173
  3. TRADE support = 1135 

In other words, trade the 1135-1173 range.


Interestingly, but not surprisingly, pre-market open downside support signaled a line of 1126 and now my immediate-term TRADE line of support is 9 points higher than that at 1135. So even when I really tighten up the duration, volatility, and standard deviation scenarios in my model, I’m coming to the same conclusion.


This is a Short Covering Opportunity, much like the one we called on August 8th, 2011.




Keith R. McCullough
Chief Executive Officer


Short Covering Opportunity: SP500 Levels, Refreshed  - SPX


"Hide your brightness; bide your time"

-Deng Xiaoping


On the second day of my trip to Shanghai, I turned to a person sitting next to me and remarked that one can easily lose sight of the fact that China is a communist country.  At that point, I was told about Richard McGregor’s book, The Party: the Secret World of China’s Communist Rulers.  As Richard McGregor says in his book, China’s economy is one that appears on the surface to be a “uniquely unbridled form of capitalism.”  Travel in China with two global restaurant companies and that comment becomes very clear.


There are few companies better positioned than YUM to capture the “unbridled form of capitalism” which is growing rapidly alongside the megatrend of the urbanization of China.  This is not new, but it’s also not going to slow down any time soon.  Driving away from China’s east coast, as I did last week, presents the chance to witness firsthand the phenomenon of urbanization in the country.  YUM and MCD are pointing to the significant number of retail spaces and transportation centers that are going to be built to accommodate the concentrated consumer demand that will partly define this trend. 


The “megatrend of urbanization” is a critical aspect of the China story for YUM.  YUM’s operations are accordingly focused on the opportunity; the company has roughly 700 people on the development team focused on, among other things, any possible changes that “The Party” may make as they continue to spend on new infrastructure projects.  For the time being, 35% of KFC and 25% of Pizza Hut new unit development is coming from the central and west provinces which represents about 50% of the population.


Suffice to say, my first “YUM China” experience was truly eye opening.  In a small part, I also feel better about Hedgeye’s macro call to be bullish on China.  My view of China is somewhat impacted by two of the biggest restaurant companies there anticipating significant unit growth potential over the next 10 years.   In addition to this, the companies will also benefit from a doubling of the minimum wage over the next 5 years.  This is a challenge from a P&L perspective, but will certainly help to further efforts of “The Party” to stimulate and diversify the Chinese economy.    


The YUM presentation on China was very different from MCD’s, stemming from the face that YUM gives detailed financials every quarter about the trends in the business in China.  This point does not make one better than the other, it's just a function of the level of commitment to the country.  Looking at the whole, YUM needs China to work now more than MCD does.  China is an important part of the MCD story, just less so given the strength of the overall business in nearly every region of the world. 


The read on current YUM China trends:

  • The company previously stated, “we are experiencing double-digit comps in 3Q11." I believe that commentary still stands today!
  • 1H 11 Chinese businesses was strong across all brands and across all tiers; the business is stronger in smaller cities.
  • 50% of KFCs units and 73% of Pizza Hut delivery units are being built in T1/T2 cities.
  • In 2Q SSS grew 18%, driven by an 21% increase in transactions.  KFC was up 17% and Pizza Hut up 22%.  System-wide sales growth was 28% with operating profit growth of 25%
  • SSS were driven by transaction growth through strategic initiatives like breakfast (13% of transactions), delivery (1,600 units) and 24-hr operations (1,300 restaurants)
  • Average guest check in 2Q was RMB 26 ($4) at KFC and RMB 122 ($19) at PH
  • Inflation is a net positive for YUM in China as stronger brands flourish in an inflationary environment.  For YUM, the ownership of the supply chain gives the company increased flexibility
  • YUM experienced inflation of 5% and 6% in Q1 and Q2, respectively.  Over Q3 and Q4, the company expects to see inflation of 9% and 12%, respectively, in China.  The company has chicken locked for the next three months and expects priced to decline from current levels. 

Two decades ago Deng Xiaoping set the tone for how China should enter the world of capitalism - hide your brightness; bide your time.  Today, the trends in China are very bright and YUM is extremely well positions to capitalize on the current trends.    





Howard Penney

Managing Director


Rory Green



Here are some tidbits we've been hearing:


  • Singapore: MBS could be tracking for a 30% increase QoQ on RC volume. Through July and August, they may have already made up 2Q volumes and Formula One could provide an extra boost for September.
  • Sun City is fairly committed to opening at Venetian.
  • Neptune may be getting spread too thin as it struggles to find good room managers and hosts.  The junket operator could be overcommitted and may not contribute that much to Venetian.
  • Starworld seems to be having some luck issues.  Also, some players came across from Galaxy Macau to play at MPEL this past week.
  • Wynn had better hold this week but they will have a tough time catching up.  September likely to be disappointing
  • Moon Festival holiday starts tonight – family time – but tomorrow will be a bit busier than usual on a typical Tuesday
  • October Golden Week: starting October 1, we may get a 10BN week
  • Wynn Cotai got their land approval.  They can start piling work late this year/early next year. They should be open in 3.5 years, at the latest.
  • SJM Cotai approval may not come until year end.
  • Macau Studio City:  The guys at MPEL have gone really quiet due to their potential listing on the exchange.
  • A MPEL project in the Philippines looks dead.  MPEL may be requiring PAGCOR to maket an MPEL license the last.  Also, MPEL would likely require PAGCOR to step down as an operator. 

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