TODAY’S S&P 500 SET-UP - October 10, 2011


And so it begins… the Dexia Domino falls into a bailout package:  BAILOUT – interestingly, but not surprisingly, Sarkozy is trying his best to nip gravity in the bud and stop Dexia becoming the European domino – this morning’s Dexia bailout is only 61% backstopped by Belgium – France is taking a big piece. Both the DAX and CAC are holding their immediate-term TRADE lines of support (5429 and 3004, respectively) on the news.  As we look at today’s set up for the S&P 500, the range is 24 points or -0.91% downside to 1145 and 1.17% upside to 1169






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  • ADVANCE/DECLINE LINE: -1218 (-3413) 
  • VOLUME: NYSE 1137.24 (+1.77%)
  • VIX:  36.20 -0.19% YTD PERFORMANCE: +103.94%
  • SPX PUT/CALL RATIO: 2.16 from 1.70 (-27.60%)


  • TED SPREAD: 38.60
  • 3-MONTH T-BILL YIELD: 0.01%
  • 10-Year: 2.10 from 2.01     
  • YIELD CURVE: 1.80 from 1.72

MACRO DATA POINTS (Bloomberg Estimates):

  • No material events today


  • House, Senate not in session
  • Government offices closed for Columbus Day holiday
  • Superior Energy to buy Production Services for 29% premium in cash and stock.
  • American Eagle, pilots’ union hit impasse in efforts to agree on a new contract before Eagle is spun off from AMR Corp., the union said.
  • Microchip Technology (MCHP) may be poised to rise to $40, Barron’s said
  • Borrowed shares climbed to 11.6% of stock last month from 9.5% in July, biggest increase since at least 2006: Data Explorers


COMMODITY/GROWTH EXPECTATION                                                                    


COMMODITIES: rallying to lower highs across board this morning; I covered our short Gold position last week; looking to see if $1676 resistance holds.


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  • Hedge Funds Miss Biggest Rally as Short Bets Rise: Commodities
  • Short Sales Rise Most Since ’06 as Stocks Lose $11 Trillion
  • Thailand Bolsters Flood Defenses as Deluge Threatens Bangkok
  • Hedge Funds Cut Bullish Oil Bets for Third Week: Energy Markets
  • BHP Wins Australia’s Approval for Olympic Dam Expansion
  • Gold Climbs as Investors Mull Europe Crisis Amid Merkel Pledge
  • Oil Gains a Fourth Day After European Pledge to Contain Debt
  • Paulson’s Main Fund Said to Lose 47% in 2011 Through September
  • Copper May Drop in London on Concern About Outlook for China
  • Chemical M&A Grinds to Slowest Pace Since 2009 on Growth Concern
  • U.K. Wants EU Farm Payments Cut as Agriculture Policy Reviewed
  • Hong Kong Bourses Decline to Comment on LME Bid-Interest Report
  • Palm Oil Inventories Increase as Production Gains, Exports Ebb
  • Police Say Two Workers Shot Near Grasberg Mine in Indonesia
  • Australia’s Eastern Crops Improve, La Nina May Boost Yields
  • COMMODITIES DAYBOOK: Saudi Oil Minister Sees No Excess Supply
  • Indonesia’s Refined Tin Shipments Extend Drop as Prices Fall
  • Lundin Mining to Consider Possible Merger in Review in 2012
  • Pemex CEO Says Lack of Repsol Collaboration Is ‘Ridiculous’




EURO – cutting off perceived tail risk is bullish for the Euro’s insolvency pricing until it isn’t. TRADE line resistance = 1.36 and the TAIL (that’s broken) of resistance is up at 1.39 – so we’d be shorting Euros and buying US Dollars all day long on the news.


THE HEDGEYE DAILY OUTLOOK - daily currency view





EUROPE: bazooka in play but markets not up as much as socialists would have thought; DAX and CAC look fine; Austria

getting hammered -4.4%


AUSTRIA – domino is as domino does; Erste bank is getting powered and the Austrian stock market is down -4.4% this morning; Greece is down another -4.5% (fresh new lows) and Romania is -2.5% - all of this tells me the interconnectedness of risk is what we think it is and not unlike Bear Stearns, this Dexia moment is not the end (no bailouts in Greece today).


THE HEDGEYE DAILY OUTLOOK - euro performance





ASIA: subdued session with China down -0.61%; HK flat, and KOSPI +0.38% as Asia looks for direction from Europe's bank bailout Part I.


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Howard Penney

Managing Director

The Week Ahead

The Economic Data calendar for the week of the 10th of October through the 14th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.


The Week Ahead - 1. leck

The Week Ahead - 2. dieses


Here is an interesting look at historical sell-side ratings for the restaurant industry.


This post will be short; the chart below says enough.  The sell-side is quite optimistic at the moment, rating over 50% of the stocks in our monitor “Buy”.  The number of “Sell” ratings is also at a low level.  We believe there is significant possibility for downgrades throughout the space this earnings season.  PFCB and CMG were downgraded yesterday but we expect others to follow suit over the remainder of the year.  We may be wrong though; over the past couple of years, the street has been resolutely bullish.


As the first two charts below show, the street is fairly even in its sentiment on casual dining versus quick service.  Given that quick service was more defensive during the ’08 downturn, we would advise clients of the view that a double-dip is likely to focus mainly on casual dining for shorts.  Casual dining has seen multiples come in considerably, however, and while we expect many “bargains” in the category to remain so, we feel BWLD and TXRH have room to move lower.


Within QSR, we like PNRA on the short side.  Sentiment charts on TXRH, BWLD and PNRA are also included below and show zero sells on either name from the sell-side.  






ROSY SELL-SIDE SENTIMENT - casual dining ratings









Howard Penney

Managing Director


Rory Green



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Attempting to Quantify the Headwinds Facing China’s Financial System

Conclusion: The threat local government financing vehicle debt poses to China’s banking system is very real. While there is certainly still time and policy wiggle room to deal with the current headwinds, we do think this issue will hang like a dark cloud over the Chinese economy for as long as it remains officially unaddressed.


To start, we think it’s worth stressing that wrapping one’s hands around the exposures and liabilities of the Chinese financial system is akin to explaining the true cause of gravity – insomuch that doing so remains much closer to “impossible” than physicists would prefer. That said, however, we think this growing issue is at least worth attempting to quantify and color.


By now, the headwinds facing Chinese property developers and local government financing vehicles (LGFVs) are not new news, but for those of you who do not follow our work on the Chinese economy closely, it’s worth re-hashing the numbers:


How Much LGFV Debt Is Out There?

Provincial and city governments in China, which are barred by law from issuing municipal bonds to fund investment in infrastructure projects, had set up 6,576 arms-length corporate entities (local government financing vehicles) by the end of 2010 – a reported 25% increase from 2008.


Arriving at a total amount of LGFV debt obligations is no walk in the park; in the year-to-date, we’ve seen estimates as high as ~14.3 trillion yuan (People’s Bank of China) and as low as 7.7 trillion yuan (China Banking Regulatory Commission). A June report out of the National Audit Office appears to have fixated the market on their 10.7 trillion yuan ($1.68 trillion) estimate as of year-end 2010, so we’ll use that admittedly stale figure in our analysis. For reference, the CNY10.7 trillion total is equivalent to 26.9% of China’s 2010 nominal GDP, which compares to the U.S.’s 24.6% muni-bond debt/nominal GDP ratio (not entirely apples-to-apples, however).


As an aside, we think China’s own inability to quantify these obligations speaks volumes to the convoluted nature of this matter.


How Are LGFV Liabilities are Structured?

Roughly 79% (CNY8.5 trillion) of the 10.7 trillion yuan of LGFV debt was in the form of bank loans, 70% of which will mature over the next five years. Nearly one-fourth (24%) percent of the total outstanding debt comes due in 2011 alone.


In terms of who owes what, the PBOC’s 2010 Regional Financial Performance Report suggests that local governments have the responsibility to repay 6.7 trillion yuan (62.6%) of the CNY10.7 trillion total debt outstanding and provided an explicit backstop for another 2.33 trillion yuan (21.7%), leaving the remaining CNY1.67 trillion (15.6%) hanging in the balance. The NAO’s mid-summer report – which consensus has adopted as the most relevant – suggests that some 60% (CNY6.42 tril.) of the total is the “direct” responsibility of local governments for repayment and another CNY2.55 trillion (23.8%) have an explicit backstop in the form of pledged land sales revenue, leaving CNY1.73 trillion (16.2%) hanging in the balance.


Attempting to Quantify the Headwinds Facing China’s Financial System - 1


How Risky Are LGFV Credits?

As it relates to credit quality, the CBRC’s report on LGFV debt classified half of the loans as “low-risk”, or possessing the ability to be repaid with cash flows, fiscal revenue, or local government land sales (~40% of total local gov’t revenue, per China Real Estate Information Corp). Another 27% of the total was classified as “normal risk”, or possessing the ability to be serviced and repaid with future cash flows. The remaining 23% was classified as “high-risk”, or not backed by collateral or a visible cash flow stream.


Extrapolating these ratios to the NAO’s CNY8.5 trillion figure for total LGFV bank loans, we see that ~CNY4.25 trillion of such loans are of high credit quality, ~CNY2.3 trillion are of average credit quality, and the remaining ~CNY1.96 trillion are of low credit quality.


Attempting to Quantify the Headwinds Facing China’s Financial System - 2


These findings rhyme with a recent China Asset Management Co. study whose results were published by the nation’s official bond clearinghouse. The study found that 28% of LGFVs have negative cash flow from operations and 22% of them had debt-to-asset ratios greater than 70%. Obviously we must absorb these numbers with a grain of salt, as they are indeed from a potentially conflicted source. Moreover, 28% of local government financing vehicles printing negative cash flows doesn’t necessarily mean 28% of the outstanding loan value is likely to go into default, as LGFVs vary in both size and loan guarantees. Still, the numbers are indeed eye-opening and, at face value, they do lend some credence to the widely-held belief that China faces a potential banking crisis should we see a material pickup in defaults across this space.


Attempting to Quantify the Downside

At 8.5 trillion yuan, loans to local government financing vehicles accounted for 17.7% of the total amount of loans held on Chinese bank balance sheets at the end of 2010. For the purpose of using consistent numbers in our analysis, we’ll ignore China’s oft-bandied about off-balance sheet banking assets. Simply put, there isn’t enough consistent data out there to analyze, but, for whatever it’s worth, Fitch Ratings estimates the disclosed off-balance sheet items to be ~25% of total assets (not all being in the form of loans, of course).


Assuming that LGFV bank loans maintained a similar ratio to total bank loans throughout 2011 we can back our way into a CNY9.3 trillion estimate for local government financing vehicle debt as of the latest reporting period, which shows a total of CNY52.4 trillion in outstanding bank loans throughout the Chinese financial system.


Currently, the Chinese banking system in aggregate has a rather healthy 1% non-performing loan ratio, which is the lowest on record (data going back to 1Q04). Over the last seven years, the ratio has fallen dramatically from a peak of 40% for state-owned banks during China’s last banking crisis (per the Cato Institute), which cost the Chinese government nearly 5 trillion yuan (27% of 2005 nominal GDP) in the form of bank recapitalizations, etc. in the eight years though 2005 (per Barclays). Like the current [potential] crisis, which was brought on by the Chinese government’s CNY4 trillion stimulus package introduced in November ’08, China previous banking crisis was brought upon by the government forcing banks to extend credit to  largely unprofitable state-owned enterprises – whose cash flows were under the control of local governments then just as LGFV cash flows are currently.


Attempting to Quantify the Headwinds Facing China’s Financial System - 3


So where could sour LGFV debt take China’s NPL ratio go from here? Well, we’d be lying if we told you we had an official estimate. We’ve seen estimates as high as 12% (Moody’s), which obviously seems quite aggressive. But without data to perform detailed credit analysis on each of the loans, as well as a crystal ball that could provide us a trustworthy estimate of credit conditions and the ability of these borrowers to obtain refinancing over the next five years, all we could do is speculate – which we’d argue isn’t entirely helpful.


What we can do that is helpful is keep you informed of any major developments pertaining to policy remedies and reported credit quality improvement/deterioration, all the while monitoring the health of the Chinese banking system along the way.


What we do know is that, as a result of well-documented government efforts to cool real estate speculation and consumer-price inflation, Chinese property prices have been under assault since 1Q10, which creates a headwind for local government revenue collection (40% of total) – the same revenues that are being pledged to backstop ~84% of LGFV debt. As we’ve outlined in our previous work, Deflating the Inflation will ultimately allow the PBOC to relax monetary policy, which should be accompanied by easing credit conditions, which, in theory, should then provide a boost on the margin to Chinese property prices. Still, a chart of the Shanghai Stock Exchange Property Index (34 developers and financiers) tells us that the headwinds facing the Chinese property market (and, as an extension, Chinese financials) are not going away any time soon.


Attempting to Quantify the Headwinds Facing China’s Financial System - 4


Attempting to Quantify the Headwinds Facing China’s Financial System - 5


As it relates to policy developments, in early August, it was leaked by an unnamed source that the Chinese Finance Ministry was drafting a preliminary plan to allow local governments to issue [long-term] bonds directly to investors. If implemented, this would be quite a constructive development as it would allow for the smoothing of any LGFV asset/liability mismatches arising from negative cash flows over the short-to-medium term. While we do not find that piling debt-upon-debt to be a “solution” that is likely to end well, we’d be remiss to ignore the positive impact this would ultimately have on alleviating any potential liquidity headwinds facing underwater LGFV borrowers.


All told, the threat local government financing vehicle debt poses to China’s banking system is very real.
While there is certainly still time and policy wiggle room to deal with the current headwinds (central gov’t debt/GDP = 33.8% per IMF; deficit/GDP = 2% per Bloomberg), we do think this issue will hang like a dark cloud over the Chinese economy for as long as it remains officially unaddressed.


Moreover, any large-scale “fix” of the issue could potentially be well over a year away if it is likely that it doesn’t occur until after the 18thPolitburo takes the leadership reins in March ‘13. That might potentially work in the Communist party’s favor in two ways: 1) it would allow current leadership to not have to admit it made a consequential mistake with the aggressive stimulus package of 2008-09 and 2) it could provide a “save the day” moment for China’s new leaders.


Net-net-net, a potential Chinese banking crisis is noteworthy risk to keep on your radar, and the likelihood that it hangs sustainably over the both China and the global economy for an extended period of time certainly won’t help investor confidence.


Darius Dale



Attempting to Quantify the Headwinds Facing China’s Financial System - 6


The jobs data released this morning are positive, on the margin, for the restaurant space.


On the surface, the employment data were positive for the restaurant space and it is important to take these data points for what they are.  Nonfarm payrolls came in way ahead of expectations at 103k versus expectations of 60k and an upwardly revised 57k in August.  However, there are some important caveats within the employment report that we think are worth noting for restaurant stocks.

  • The number of people in part-time work for economic reasons ticked up to 9.3 million in September
  • Long-term unemployment ticked up to 6.2 million in September.
  • The unemployment rate is being aided by the fact that the labor force participation rate has not increased meaningfully since the “recovery” began.
  • Manufacturing jobs contracted in August, disappointingly, while construction jobs ticked up from August to September.  Government jobs continued to decline, with local governments shedding jobs heavily, implying that the growth came from the private sector.  We view this as a positive.

More specifically for restaurants, employment growth by age cohort and also by the industry itself provides insight into the state of the industry.  The employment-by-age data is, on the margin, positive for both quick service and casual dining.  For 20-24 year-olds, employment growth in September accelerated to 1.9% versus last year from +0.4% in August.  This is a positive data point for quick service given that this cohort is a frequent customer for the category.  For casual dining, 55-64 year-olds saw employment growth accelerated to +3.4% in September from +2.7% the month prior. 





Hiring within the restaurant industry was less bullish in August (this data series is released on a lag).  Year-over-year growth in limited service hiring picked up in August while hiring in full service was flat.  We will continue to monitor this trend in the coming months.  Within the payroll data, payrolls in “food services and drinking places” increased by 12k in September following a similar sequential increase in August.  Considering the payrolls data, the lagging industry specific data, shown in the chart below, when it is released for August may show an improvement for September.  We remain more positive on casual dining than quick service.





Howard Penney

Managing Director


Rory Green



hiring by limited service restaurants and full service restaurants were

Shorting EUR-USD (FXE)

Positions in Europe: Short EUR-USD (FXE); Short Italy (EWI)

The currency pair EUR-USD remains a volatile trade as every rumor on Europe’s next move to limit its banking and sovereign risk significantly jolts the pair.  Yesterday from a quantitative set-up, the EUR-USD was not able to breakout back above $1.34 which we took as a shorting opportunity. Since early September the EUR-USD has been broken TAIL (long-term duration), and broken TREND (intermediate term), an explicit short-selling signal in our models (see chart below).


Traders may well be betting that concrete action could come from this weekend’s meeting between Merkel and Sarkozy on Sunday to discuss bank finances ahead of the EU summit on OCT 17th (and hence today’s intraday bounce around $1.35), however it’s worth pointing out that any coordinated policy action will need the blessing of the other Eurozone member states, the ECB, and Brussels. While we don’t rule out a possible swift resolution, it probably won’t come this weekend.


It’s worth noting that while we’re not calling for the EUR-USD to hit $1.20 tomorrow, uncertainty on the region’s go-forward policy to contain or limit its banking and sovereign debt risks—either through a multifactor “bazooka” program or some form of Eurobonds and increases in the ECB’s SMP, for example —should incrementally weaken the pair until some form of “clarity” on policy decision is reached.


From a timeline perspective, it’s anyone’s guess on when Europe’s next band-aid will come—however we’re betting that something is in the pipe. A recent quote from European Commission President José Barroso suggest that Eurocrats are coming to terms with the market implications of their policy schedule: "Markets are much faster than our governments and our parliaments. We have to respect the rhythm of democracies, but I think in extraordinary times we must ask for an extraordinary effort.”


We’d expect any policy action to likely come after all member nations vote on the EFSF, which is expected to come by mid-month (Slovakia and Malta must still vote). Below is a calendar of the near-term events around which policy measures could be crafted:


Oct. 13: Euro-zone finance ministers expected to meet, to decide on release of Greece's next aid payment

Oct. 14-15: G-20 finance ministers' meeting. Europe expected to face pressure to act faster on the debt crisis

Oct. 17-18: EU summit to discuss reform of euro-zone economic governance


Matthew Hedrick

Senior Analyst


Shorting EUR-USD (FXE) - mich

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