“I love playing ego and insecurity combined.”
There is a good article in this week’s The Economist titled “Return to Maastricht” where Charlamagne interviews locals in the Dutch town that gave birth to the Euro in 1991. Frans Timmermans has a concise quote on page 68 that summarizes the Eurozone today:
“Europe seems to be an agent of insecurity. The benefits are invisible; the downside is very visible indeed.”
The French know this. The Belgians know this. The Germans and the Dutch know it too – but the question remains as to whether or not they need to swallow Bear Stearns like exposures whole to the extent that the French and Belgians do.
On that score, this morning’s #1 Most Read Story on Bloomberg tells you all you need to know about what matters to interconnected Global Macro markets today:
“Merkel, Sarkozy Pledge Bank Recapitalization”
And while there are very different definitions of the size and scope of this “recapitalization” (coined first at Hedgeye as the Eurocrat Bazooka), this morning’s Global Macro market action tells you all you need to know about dominos.
Dexia, as we wrote last week, is the domino.
Dexia is a Belgian/French bank that is being bailed out this morning by, drum-roll, Belgium and France. Sure, the fine lads in Luxembourg appear to be throwing in some Europig Paper too – but, ultimately, this is a Belgian and French thing. A really big thing for those 2 countries in particular (relative to Germany and the Netherlands), because Belgium and France have marked their Pig Paper at par!
Qu’est ce qui se passe avec le marking of le Pig Paper at par?
Put simply, this is what Bear, Lehman, Morgan, etc. did in 2007-2008. They called it “level 3 asset pricing.” And Bailout Bankers around the world can call it whatever they want in Europe this morning, but there is one thing it is not – marked-to-market!
The most important move in all of Global Macro for the past 3 weeks has been that the US Dollar Index has been up for 3 consecutive weeks. In the end, I think this is the most bullish development there has been for the US economy. Strong Dollar = Strong America.
With the US Dollar Index up +7.8% since La Bernank tested Burning The Buck to a 30-year low in April of 2011, this has been good for the 71% of America that matters – Consumption (C) as a % of US GDP – and bad for dysfunctional debtors who are begging for bailouts.
This isn’t a consensus view. But I’m not really a consensus kind of a guy. And neither should you be. If the last 3 years has taught you anything about common sense, one is that Keynesianism is not for the commoner. If you are a debt laden aristocrat, sorry – can’t help.
Of course the US Dollar strengthening has nothing to do with Ben Bernanke or Tim Geithner changing their Keynesian policies (yes, It’s The Policy, Stupid). It has everything to do with the Europeans trying to do exactly what our Too Big To Perform financial system had Americans do in 2008 – bailout bad banks with tax payer backed fiat currency.
Perversely, with the “news” of the Dexia Domino in motion this morning, the Euro is rallying to another lower short-term and lower long-term high. This has more to do with the mechanics of the EUR/USD pair being the most widely held short position on planet hedge fund right now, so don’t let it stress you out.
Across all 3 of our risk management durations (TRADE, TREND, and TAIL), the Euro (versus the USD) remains bearish/broken:
- TRADE resistance = $1.36
- TREND resistance = $1.42
- TAIL resistance = $1.39
When all 3 of our risk management durations are bearish/broken, we call this a Bearish Formation. Those are not good.
And neither is Austria or Greece seeing their stock markets get hammered for -4.5% moves to the downside this morning. I guess that’s what you get when your Eurocrat Bazooka isn’t big enough, yet. Size matters. Insolvent European banks are seeing their marked-to-market stock prices fail. Insecurity’s Ego is going to have to have another European emergency bailout meeting about that…
My immediate-term support and resistance ranges for Gold, Oil, the German DAX, and the SP500 are now $1, $80.66-84.66, 5, and 1145-1169, respectively. My Cash position in the Hedgeye Asset Allocation Model dropped to 64% from 73% week-over-week.
Happy Canadian Thanksgiving and best of luck out there today,
Keith R. McCullough
Chief Executive Officer
THE HEDGEYE DAILY OUTLOOK
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.
SECTOR AND GLOBAL PERFORMANCE
- 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%)
CREDIT/ECONOMIC MARKET LOOK:
- 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
WHAT TO WATCH:
- 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
COMMODITIES: rallying to lower highs across board this morning; I covered our short Gold position last week; looking to see if $1676 resistance holds.
MOST POPULAR COMMODITY HEADLINES FROM BLOOMBERG:
- 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.
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).
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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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.
The stocks used in this analysis are AFCE, BAGL, BJRI, BOBE, BWLD, CAKE, CBOU, CBRL, CHUX, CMG, DIN, DPZ, DRI, EAT, GMCR, JACK, KKD, KONA, MCD, MRT, MSSR, PEET, PFCB, PNRA, PZZA, RRGB, RT, RUTH, SBUX, SONC, TAST, THI, TXRH, WEN & YUM.
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.
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.
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.
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.
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.
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