The Economic Data calendar for the week of the 24th of October through the 28th 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.
Conclusion: Given the current state of emerging market external debt levels and maturities, King Dollar puts many emerging market corporations at risk of earnings erosion, balance sheet deterioration, and, at worse – bankruptcy.
Asian equity markets had another soft week, closing down -1.2% wk/wk on a median basis. Losses were led by China (-4.7%) and Thailand (-4.1%), as both struggled with heightening domestic risks. Asian currencies had a slightly negative week as well, closing down -0.3% wk/wk on a median basis vs. the USD. India’s rupee led the way to the downside (-2%), while gains were led to the upside be the Japanese yen – a clear sign of regional stress based upon our analysis of the mechanics driving JPY appreciation.
Asian sovereign debt markets were fairly mixed; perhaps the most notable divergence came on the short end of India’s and Indonesia’s maturity curve. Indian 2yr yields increased +12bps wk/wk after the government affirmed that it will buck the developing trend of monetary easing across the emerging market space and maintain its hawkish bias until inflation is under control. Their commentary was taken literally in the swaps market, as India’s 1yr on-shore interest rate swaps widened +15bps wk/wk. As it relates to Indonesia, expectations of further monetary easing drove 2yr yields down -27bps wk/wk.
Sovereign credit default swaps throughout the region were fairly flat on the week. A notable decliner to the downside was Hong Kong, which saw its swaps trade -7bps (-7.4%) tighter wk/wk.
***price tables can be found below***
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Net-net, we continue to flag FX risk as a reason to remain cautious on both emerging market equities and credit broadly. We are of the view that a great many EM issuers are likely un-hedged, given consensus forecasts for broad-based EM currency appreciation as recently as 2Q. We’ve done a fair amount of work on this topic in recent months and we’re happy to follow up should you like to dig in further. Simply email us for more details.
While by no means a cure-all (the property market is still showing signs of cracking), allowing the local governments to issue bonds directly to investors will: a) diversify financial risk away from the banking system and b) smooth the systemic balance sheet mismatch that stems from issuing short-term paper to fund longer-term infrastructure initiatives.
As we have seen for the latter part of the past twenty years, the Japanese government continues to be the only source of incremental demand in the ailing Japanese economy. Our secular debt and demographic work on Japan suggests that this phenomenon is likely to continue as growth remains structurally depressed over the long term.
These comments echo RBI Governor Duvvuri Subbarao’s statement last week which read: “As much as we look at what other central banks are doing, we take into account our own domestic circumstances and the domestic context in formulating policy,” – suggesting that India is unlikely to follow suit and join the rate cutting cycle anytime soon, given that, while slowing, WPI is likely to remain elevated on an absolute basis over the intermediate term.
These floods, particularly if they breach the capital of Bangkok (Oct 29-31 projection) could have a lasting impact on Thai economic growth. As it stands currently, they are already having an impact on global supply chains. Thailand is the world’s largest producer of hard-disk drives, the largest exporter of rice and rubber, and the second-largest exporter of sugar. Companies like Apple, Toyota, Tohsiba, and Hitachi have all been forced to suspend production of key parts and/or move the assembly elsewhere.
We don’t expect BYI to report a truly impressive quarter until FQ3 but the near-term bar has been lowered too much.
As we wrote about on October 5th “BYI: WE’VE GOT THAT GOOD FEELING,” we think BYI will produce an estimate-beating quarter. Management resets expectations at significantly lower levels on their last call. They weren’t expecting it but the stock resets much lower as well. Since we wrote our note about 2 weeks ago, expectations have crept up by a penny to 43 cents for BYI’s F1Q12 and the stock has moved much higher (up 21%), so the quarter may not be the catalyst it was.
More importantly, we are inching closer to a big pick-up in new openings beginning in the March quarter. More are on the way. Visibility on Italy and Canada should get clearer in the next few months and we expect all of the suppliers to discuss potential opportunities in MA, FL, Greece, Taiwan, Japan, Vietnam, South Korea, and other markets. The new market thesis may come back into investor focus.
BYI should see strong flow through not only in their new unit sales but also in their systems business – an important differentiating factor for the stock in our opinion. Their systems business is a critical lynchpin in our positive BYI thesis as visibility and growth should improve dramatically in calendar 2012. Despite higher margins and a recurring component to systems revenue, that segment has been viewed as a bit of a black hole by investors due to the unpredictability. We expect that to change next year.
We estimate that BYI will report $191MM of revenue and $0.45 cents of EPS after close on 10/26.
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We expect an in-line Q which may be good enough. A refi announcement could be a big catalyst.
We are projecting break even EPS, $593MM of net revenue, and $120MM of EBITDA. BYD reports Q3 results next Tuesday. Our estimates are slightly below consensus, but given the negative sentiment around the name, we think actual results in-line with our numbers will be good enough, assuming a stable outlook.
Perhaps more importantly, we think there is a chance BYD announces a refinancing. Part of BYD’s credit facility comes due in May of 2012 so it needs to be refinanced before the 2011 10k is issued to avoid a going concern letter from the accountants. While the high yield market would not be favorable for BYD, we believe the bank market is. Any announcement or comfort level given surrounding the prospects of a refinancing would remove a major overhang on the stock. We do not believe that is fully priced into the stock.
Here are our estimates:
Conclusion: Our analysis of derivative positioning and its impact on the FX spot market as a leading indicator strongly suggests that it likely won’t pay to fade consensus as it relates to being bullish on the U.S. Dollar over the intermediate-term TREND. Further, the math supports our fundamental stance of being bearish on things that are inversely correlated to the Greenback over the same duration.
Position: Long the U.S. Dollar (UUP); Short the Euro (FXE).
Themes at Play: King Dollar; Deflating the Inflation; Correlation Crash; Eurocrat Bazooka.
Much to-do is being made about how crowded the Euro-short position is and we agree that this is an acute immediate-term risk to manage. As it relates to the amount of open interest in the futures and options market, those speculators large enough to meet the minimum reporting requirements of the CFTC are net short the Euro by a total -69.8k contracts as of the latest reporting period (Oct 11). Just off of the late-September highs in short interest of -79.6k and 1.8x standard deviations below the 5yr average of +17.1 net long, it’s pretty clear that this is a fairly one-sided trade.
Does it pay to fade the market here? The short answer is “no”. As indicated by both our fundamental outlook and the marked-to-market positioning within our Virtual Portfolio, we expect consensus to remain right on this currency play over the intermediate term TREND.
Speaking of trends, one of the reasons we rely heavily on the foreign exchange as a real-time leading indicator of both market prices and economic fundamentals is because of its sheer size ($4 trillion in daily turnover = the world’s largest mkt.) and its reflexive nature. To the former point, we are of the belief that an investor’s greatest source of conviction lies with where he plays his chips. To the latter point, the highly-levered nature of many FX market transactions (in some cases 250:1) causes the basic risk management of gains and losses to perpetuate any given pattern of trading. Moreover, currency pairs trade on their relative economic fundamentals – data that tends to be more glacial and self-sustaining in nature.
Turning to King Dollar specifically, we continue to believe strength in America’s currency will be supported over the intermediate term by a combination of three factors:
We’ve been harping on each of these themes in various reports and presentations over the past couple of quarters, so we’ll leave it there for the sake of brevity. Email us if you’d like us to follow up with more details regarding any of these points.
Is a Big Appreciation in the U.S. Dollar Index Forthcoming?
Performing a similar futures + options analysis on the U.S. Dollar Index as we did with the Euro above yields a surprisingly more interesting conclusion. Interestingly enough, open interest from large speculators reached +47k contracts net long as of the latest reporting period (Oct 11) – the highest on record, which dates back to 1995.
Surely, we must fade this consensus positing?
A resounding “no” would be our answer here. Analyzing the open interest with the U.S. Dollar Index’s spot price provides a shocking conclusion: the derivative positioning tends to lead the action in the spot market by 2-6 months – particularly when pushed to an extreme in either direction.
Given that the most recent reporting shows the net long positioning at the highest on record, we would expect to see a pronounced move to the upside in the U.S. Dollar Index’s spot price over the intermediate term. The current futures + options positing registers as a +3.9x standard deviation move “off the lows”. A commensurate move in both size and historical median duration in the U.S. dollar index from April’s cycle-low of $72.93 would put the DXY at $89.30 by mid-February.
The principles of chaos theory driving our research at the most basic level would never allow us to subscribe to the Old Wall Street model of throwing out a price target and a target date for any market (let alone the #1 factor in our Global Macro model); we do, however, think the above scenario analysis is one of many risks to at least respect as probable. Moreover, a sustained and measured breakout in the U.S. Dollar Index may prove particularly bearish for asset classes inversely correlated to the DXY (immediate-term TRADE duration regressions):
Conversely, it may prove particularly bullish for things positively correlated to the DXY, like:
As with all of our research, the purpose is not to fear monger or be alarmist. Rather, we hope we are equipping you with the differentiated analysis that allows you to both manage risk and preserve your client’s hard-earned capital throughout volatile times like these. As always, we’re here if you have any follow up questions.
Have a great weekend with your respective families,
THE HEDGEYE BREAKFAST MONITOR
German business sentiment index dropped for a fourth consecutive month to 106.4 in October from a revised 107.4 in September. French business confidence fell to 97 in October from 99 in September.
MCD: McDonald’s reported strong 3Q earnings this morning. EPS came in at $1.45 versus expectations of $1.43 on the back of strong global comps with strength in France, Russia, Germany and the U.K. being particularly encouraging. U.S. comps came in at 4.4% versus 3.8% expectations. Europe came in at 4.9% versus 3.3% consensus and APMEA also beat, printing a 3.4% comp versus the Street at 2.7%. The company said that October comparable sales are expected to be up 4% to 5%.
CMG: Chipotle Mexican Grill reported $1.90 versus $1.85 on the back of 11.3% comparable restaurant sales growth. Margins were slightly negative in the third quarter, year-over-year, as chicken, beef, cheese, and sour cream costs were higher than expected. The company sees mid-single digit inflation in 2012.
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