Conclusion: We are firm believers in the year-end Santa Claus rally – in the long-end of the U.S. Treasury bond market.
Earlier today, Keith reopened a long position in the iShares Barclays 20+ Year Treasury Bond Fund (TLT) in our Virtual Portfolio. We’ve been trading around the volatility in long-term U.S. Treasury bonds with a bullish bias since 2Q and we continue to have conviction in our belief that U.S. growth is slowing from a cyclical perspective and structurally impaired from a secular perspective absent a shift towards strong dollar policy in D.C. This is a position that has worked throughout much of 2011 and our research suggests it will continue to work over the intermediate term.
Today, our quantitatively-driven risk management process signaled to us that, while consensus remains hopeful for a year-end Santa Claus rally in equities (SENTIMENT), domestic and international economic growth is still slowing from an intermediate-term TREND perspective (DATA/CATALYSTS). But don’t just take our word for it:
“Rather than saying interest rates are too low, investors should be more concerned about what low rates are telling them about economic growth and expected returns on risky assets.”
- Robert Mead, Portfolio Manager at PIMCO
Treasuries are “expensive” for a reason and a great many stocks appear “cheap” for similar reasons. Moreover, as Keith penned in his Early Look this morning, Dynamic Risk Management (i.e. fluid asset allocation and trading the ranges) has been the winning strategy in 2011. Buy & hold isn’t the best short-to-intermediate term P&L risk management strategy with a VIX > 30 (yes, performance pressures do exist in our business). Eventually, the time will come to get really long of U.S. equities – our models are merely suggesting that time is not now.
Conclusion: The concurrent events and associated risks of King Dollar strength continue to be showcased across Asian financial markets and economic data.
Inclusive of today’s global short squeeze, Asian equities had another soft week (11/21-11/28), closing down nearly a full percent on a median basis. The spread between the best performer (Thailand; +2%) and the worst performer (Australia; -2.5%) was a healthy 450bps.
Asian currency markets were generally flat on the week, closing down -0.1% on a median basis. Gains were led by the Queen’s currencies (Aussie and Kiwi dollars), which closed up +1.2% and +1.3% wk/wk vs. the USD, respectively. The Japanese yen closed down -1.4% wk/wk vs. the USD and JPY weakness slightly lead today’s rally in global beta.
Asian sovereign debt markets were generally weaker on the week, as a combination of ratings threats (Japan), better-than-expected economic data (Hong Kong) and illiquidity (Asian Tigers) drove up yields on various issues. Indonesia saw its 10yr yield back up +51bps wk/wk; Japan and Hong Kong also saw double-digit gains (+10bps and +12bps, respectively). Australia’s bond market continues to price in additional monetary easing: 2yr yield down -12bps wk/wk; China’s swaps market continues to price in the commencement of easing in the mainland: 1yr O/S swaps rates down -13bps wk/wk.
Asian 5yr CDS had a generally mixed week, highlighted by the +15bps widening of Japanese swaps on the rumors of an eventual S&P downgrade.
CHARTS OF THE WEEK
THE LEAST YOU NEED TO KNOW
If you didn’t get a chance to review our 11/22 research note titled “Asia Isn’t Buying Into Santa Claus”, please email us for copies. The analysis below picks up where that piece left off.
- HSBC’s preliminary manufacturing PMI for China (85-90% of responses) ticked down to 48 in Nov vs. a final reading of 51 in the month prior. The final HSBC and official CFLP readings are due out this Wednesday evening and could shock global macro markets if they are in-line with the aforementioned sneak peek.
- Japanese small business confidence ticked down in Nov to 45.8 vs. 46.4 prior.
- The Reserve Bank of India cut its domestic growth forecast for the current fiscal year to +7.6% YoY from +8% prior. While it’s easy to say they were a step closer to easing as a result, India’s domestic inflation situation is set to remain among the least accommodative in the world over the next 3-6 months based on our models and imprudent monetary policy (i.e. implementing QE with WPI > +9.5%). “Inflation is a regressive tax that hurts the poor the most in a country like India where food is a large share in the consumption basket,” per RBI Governor Duvvuri Subbarao. Moreover, the FX depreciation detailed below suggests he might be forced to hike rates again and risk slowing Indian economic growth incrementally from here.
- On the heels of slowing commercial sales and industrial production growth (to +1.8% YoY and +1.4%, respectively – the latter at a 26-month low), Taiwan’s statistics bureau cut its 2011 and 2012 growth forecasts to +4.51% and +4.19% (from prior estimates of +4.56% and +4.38%, respectively).
- At face value, Singapore’s Oct industrial production growth looked quite healthy (+24.4% YoY vs. +11.3% prior). Peeling back the curtain, however, we see that the pickup in growth was entirely driven by pharmaceutical output (+117.5% YoY), while electronics production (iPad and Kindle parts, etc.) slumped -20% YoY.
- Though largely a function of nationwide flooding which shuttered factories and caused capacity utilization to tick down to an all-time low of 46.4% in Oct, Thailand’s manufacturing production growth tanked in Oct to -35.8% YoY vs. -0.3% prior. Hard disk drive production (of which Thailand is the world’s #1 supplier) fell -52.4% YoY and electronics parts fell -45.5%. Thailand’s Office of Industrial Economics added that it may take 1-2 months before plants can resume normal operations after the flood waters recede.
- The PBOC said in a statement last week that it will continue to implement “prudent” monetary policy. Sticky inflation that remains well above target continues to slow China’s monetary easing process, despite their pledge to promote “reasonable growth” in credit and money supply. While the PBOC will do what it can in the interim (last week it cut RRRs in Zhejiang and 20 rural credit cooperatives), we remain of the view that substantial monetary easing in China is 1-2 quarters out absent a strong deflationary shock (i.e. a dramatic, expedited breakout in King Dollar).
- Chinese industrial profit growth slowed in October to +12.5% YoY, which was less than half the YTD run-rate of +27% (Jan-Sep). The impact(s) of slowing growth on top line trends, inflationary margin compression, and credit tightening continues to weigh on industrial activity in China.
- Hong Kong CPI held at +5.8% YoY in Oct.
- The Chinese yuan continues to gradually weaken, closing down -0.3% wk/wk vs. the USD and is now trading at a ~30bps discount to 1yr non-deliverable forward rates. Expectations of yuan weakness continues to be a headwind for the dim sum bond market as investors demand more interest rate return to offset less FX appreciation; average yields rose +32bps in the month-to-date and +197bps over the last six months. We saw this play out via growth in offshore yuan deposits in Hong Kong, which slowed in 3Q to +69.6 billion QoQ vs. +102.2B in 2Q.
- Japanese CPI slowed in Oct to -0.2% YoY from 0.0% prior; core CPI slowed to a -1% YoY from -0.4% prior. This easing of inflation, particularly on the core side, is one more supportive data point for additional easing out of the Bank of Japan – which just recently shifted its tone on the margin towards supporting incremental accommodation. Per BOJ Governor Masaaki Shirakawa: “In the current time of high uncertainty regarding the future prospects of overseas economies, due attention is necessary to the risk that the yen’s appreciation will dampen future growth… This is the very reason that the bank has embarked on monetary easing measures twice since this summer.” Speaking at an anti-strong yen groupthink convention in Nagoya today, this the third time over the last few weeks the governor has spoken out regarding the threat Europe’s sovereign debt crisis poses to the Japanese economy. His comments were delivered to us this morning concurrently with data that shows the BOJ capital adequacy ratio hitting a 32yr-low of 7.23% after suffering a $1.2 billion loss from its asset-purchase program in the six months through September.
- Last week, India’s rupee touched an all-time low of 52.375 per USD, prompting the Reserve Bank of India to pledge managing the associated FX volatility via intervention in the spot market. On the flip side, R. Gopalan, secretary of economic affairs at the finance ministry, suggested last week that the RBI’s ability to aggressively stem the rupee’s slide is limited because of the tightness of interbank liquidity and the likelihood that USD-selling would lead to an even higher call-money rate (30-day average of 8.49% is a near 3yr-high). Another sign of interbank illiquidity in India: banks borrowed an average of 1.13 trillion rupees per day from the RBI’s overnight lending facility over the last week – the highest rolling 7-day average since January. The rupee weakness is being fueled by a foreign investors dumping of Indian assets (bond holdings down -$213 million wk/wk; equity holdings down -$1.8 billion since July) and a near closure of India’s dollar debt and international syndicated loan markets (the latter down -87% MoM in Oct in terms of issuance). In recent weeks, the RBI and central gov’t have implemented new rules designed to spur dollar inflows, including increasing the cap on foreign investor rupee debt ownership by a total of +$10 billion, loosening rules for overseas corporate borrowing, and removing a $100 million limit on corporate FX sales via currency swaps . King Dollar manifests itself in many ways across the Global Macro landscape.
- Singapore CPI slowed in Oct to +5.4% YoY vs. +5.5% prior – inching the Monetary Authority of Singapore a mere 10bps closer to another currency band compression.
- Jesse Wang, executive vice president of China Investment Corp, the nation’s sovereign wealth fund, recent comments affirm our conviction in the view that China will not be a source of dumb, unlimited capital to finance the Eurozone bailout, but rather a source of smart money looking for attractive investment opportunities in distressed real assets: “The fund wouldn’t be the main channel if China helps tackle the sovereign debt crisis... However, if during such a process there are good investment opportunities in Europe and if CIC’s investment helped the destination company or country to recover and developed the economy, that would be indirect support.” Commerce Minister Chen Deming shared those views in his recent remarks: “While China has always been supportive of Europe’s rescue efforts, these will mainly depend on the euro zone itself… China will definitely be a part of any help offered by the global community… We are willing to further reform and further open our market, but other economies must be more open to us in return.”
- Analyzing commentary out of China and Australia, it appears the global community is growing increasingly tired of Europe’s inaction on adequately addressing its sovereign debt crisis. Per China’s Commerce Minister Chen Deming: “So far we have yet to see a step towards success… We have only seen a reshuffling of leaders in some European countries.” Per Australian Treasurer Wayne Swan: “EU politicians have been frustratingly slow in tackling the region’s sovereign-debt crisis that has dragged on global economic growth and cut Australian government revenue, causing asset prices to fall and households to spend less… Europe needs to understand that financial markets don’t work on political timelines, and they are already a long way behind the curve. The global economy has already paid a very high price for the failure of Europe to get its house in order.”
- Japanese asset managers are blowing out of European sovereign debt (including German and French paper) in the year-to-date, opting for U.K. gilts instead – +$19.1 billion in direct purchases and another +$37.4 billion channeled through the Cayman Islands.
- Bucking the recent trend of slowing export growth domestically and across Asia, Hong Kong saw an acceleration in export growth in Oct to +11.5% YoY vs. -3% prior.
- Philippines real GDP growth accelerated in 3Q11 to +3.2% YoY – after a downward revision to the 2Q report to +3.1% from +3.4%. Growth still slowed outright on a QoQ basis, which may add to pressure on Bangko Sentral ng Pilipinas to ease monetary policy later this week.
- A read-through on the weakness of China’s property market (absent more-reliable official price data): 80% of construction companies said developers were behind on payments, per a recent Credit Suisse survey.
- Standard & Poor’s said the leadership in Japan, led by recently-elected Prime Minister Yoshihiko Noda, hasn’t made enough progress in tackling the nation’s public debt burden. “Japan’s finances are getting worse and worse every day, every second,” according to Takahira Ogawa, director of sovereign ratings at S&P in Singapore. “[Consensus] may be right in saying that we’re closer to a downgrade. But the deterioration has been gradual so far, and it’s not like we’re going to move today.” Be it S&P, Fitch, or Moody’s, which all have Japan’s long-term, local currency sovereign debt rated at some form of AA-, the next downgrade of Japan is likely to trigger capital raises across Japan’s banking system to the tune of $75-81 billion based on Basel II requirements and Hedgeye calculations. Perhaps that’s yet another reason why the Topix Bank Index is trading a mere +1.6% off its 20yr-low (established on Friday).
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Conclusion: There’s so much more to this story than the NBA. While there’s still much to like, the negative fundamental factors are lingering that the consensus might be missing.
It’s time for a serious update on Foot Locker. With two upgrades today – largely timed around the mitigated risk of a hit from the NBA strike – we think that people are glossing over some larger issues. Some are bullish, but for the first time in two-years, some bearish factors are starting to enter the equation. From a TRADE perspective (30-days or less), this name is still in a bullish formation and is one of the more attractive retailers based on Keith’s models. But as we head into 2012 and look at how the fundamentals are stacking up, our bull-case is no longer a slam dunk by any means.
About the NBA strike… Ok, the risk is gone. I get it. But was there really any implied risk in FL from a strike in the first place? There’s a lot of noise week to week, but my answer is that – in aggregate -- the market has had this about right all along, and there really shouldn’t be a go-forward adjustment.
The timeline is important for a couple of reasons…
- The lockout started on July 1, but there was still perceived to be ample time to negotiate a deal. The stocks did nothing. But as talks cooled throughout July, FL underperformed the market by about 8%, and the broader retail space (MVRX) by 12%.
- Let’s not forget that the market simply melted down in August. On a relative basis, FL was a great place to be. By the time September 30 rolled around, FL had largely recouped all its losses (again, relative to the market and retail).
- Once the NBA cancelled the first two weeks of the season in October, the stock stalled, but only gave up 2-3%.
- But near the end of October, the market looked into the quarter, the health of its inventories, comp sales, ability to side-step basketball risk, and it was subsequently one of the better performing names in retail.
- Now we’re at a point where it has come full circle, and then some. It outperformed all relevant peers, comps, and broader benchmarks over the lockout period. Ironically, the only name that has performed better is Nike, which has greater basketball exposure. Yes, FL has printed good numbers in the interim, but at a decelerating rate relative to what we’ve seen in the past.
As much as Ken Hicks is running such a good ship and is rethinking the model, the fact is that the numbers simply get tough. We’ve had 10% comps over the past year, 40% EBIT growth, and seven consecutive quarters of improvement in the sales/inventory spread. It’s worth noting that over this precise seven quarter period, FL has beaten every quarter by a weighted average of 32%.
So what now? Product costs from the Nike’s of the world (even if only Nike) are being passed through to a far greater extent, and anemic levels of product in broader athletic channels will be refilled (note order books for all brands). FL will have a harder time keeping inventories in check, which definitely jeopardizes (peak) margins. Also, let’s not forget Europe, which is about 25% of sales, and is about 33% of EBIT. These stores are more productive and profitable than US counterparts. There’s a bit of a tug of war on the P&L between comp and SG&A, but net/net, the Euro had been a tailwind for the past 3-quarters. Economies aside…it becomes a headwind in 1Q13 (Feb 2012). The Olympics in London might be a jolt, but it will need to be a big one to offset the impact of a weaker pan-European consumer.
But might the company be a victim of his own success? Hicks delivered on his 5-year plan 3-years ahead of schedule. That in itself is so impressive – as has been the reward. Hicks made $2.475mm in cash last year ($1.1mm base with 125% target bonus – which he hit). That’s in-line with peers. The real kicker for him is in his incentive comp. He has 500,000 shares of restricted stock, and 900,000 outstanding options with strike prices between $10.1 and $15.1. The value of his vested equity at today’s $23 price is $8.6mm. The remainder vests by March 2013, and is worth approximately $21mm at today’s price. Every $1 fluctuation in FL’s price equals about a $1.2mm change in Mr. Hicks’ net worth. While he is a very accomplished retail executive, I’m going to assume that with a history at JC Penney and Payless, this kind of wealth creation is a huge deal for him, and something that he won’t let evaporate. This story is unlikely to crumble over the next 18 months when the rest of the options vest and the restricted stock balloon is up. But a risk that can’t be ignored is that these numbers are just so big and comfortable, and that he becomes complacent running a slow moving company in a business that is sub-par at best. In other words, that he becomes Matt Serra. Not likely, but we need to monitor it.
They’re hosting an analyst meeting in March to outline the new strategic plan. It might be foolish to bet against them. I don’t like betting against good management teams (it’s a long time since I’ve said that about FL). But numbers don’t lie, and the order of magnitude of additional changes will be difficult to engineer. Sales per square foot should break $400 this year, and prior peak flirted with $362. Margins are peak, and let’s not forget that this is a zero-square-footage-growth retailer with 33% exposure to Europe.
If the consensus numbers are right, and we actually think that they’re within a nickel of reality, then we’re looking at 14% EPS growth for next FY13, which is a sharp deceleration from the 61% FL is on track to print this year. The today’s two upgrades, there are officially no sells on the stock, and short interest remains relatively low at 6.1% of the float.
No Active Positions in Europe
Manic Europe is again trading on rumors out this weekend and the fumes of optimism that Europeans can issue a bazooka to cure the region’s structural ills in one blast. Our outlook is overweight Eurocrats dragging their feet to maintain the fabric of the Eurozone without answering the harder structural choices over the near term. Here we’d expect the EUR/USD cross and Europe’s equity markets to trend lower so long as there are no clear details or intentions of a bazooka in the works. (We covered our positions in the EUR/USD (FXE) and France (EWQ) in the Hedgeye Virtual Portfolio on 11/23).
Remember, the German and ECB position remains that the ECB will not be a vehicle to leverage or expand the ECB and the Germans stand against the issuance of Eurobonds. However, we think these positions will have to be amended as there’s a lack of additional options: the IMF is not in a position to solely boost the EFSF and individual parliaments of the member states will not give the political vote to expand the taxpayer’s contribution to the facility.
Official discussions of Europe’s next major step will begin as soon as tomorrow’s two day Eurogroup/ECOFIN Finance Ministers’ meeting and could focus on establishing a fiscal union, essentially a German-French and/or Brussels-based babysitter to monitor the fiscal (namely budget) choices of member states, basically the Growth and Stability Pact 2.0, with the intentions of actually being adhered to this time around. Other calendar catalysts to be aware of are:
2. December - German Chancellor Merkel delivers a speech on the crisis to the lower house of parliament in Berlin
8. December - ECB Interest Rate Decision
9. December - EU Summit
Perhaps further down the road this fiscal union could be integrated/amended into the EU treaties, but this “Fast Track” approach would seek short-term implementation to send a positive signal to the market that Europe is on the road to improving its fiscal house with the fiscally stronger states calling the shots (in particular Germany). Longer term, this fiscal union could be amended into EU treaties. However, we don’t think that a fiscal union alone will support a sustained rally in European capital markets, but will be one step in the right direction. Logistically there’s a ton of unanswered questions about such a fiscal union, so communication will be essential.
While it’s hard to size up the look and feel of this “Fast Track” approach, it’s clear that Eurocrats are feeling the pressure of tied hands when responding to the market’s movements. As the spotlight shifts towards the risks of the Eurozone’s larger nations of Italy and Spain and talk of Greece’s exit from the Eurozone, headline risk will continue to weigh substantially. Over the weekend it was rumored by the paper La Stampa that the IMF may make a €400B-€600B loan to Italy at below market rates of 4%-5%. The IMF has squarely denied this article, and this rumor is easy to refute as the sum represents over half of the IMF’s existing lending capacity, nevertheless many European equity indices finished today’s session up +250 to 500bps and intraday the EUR/USD is bid up 0.50%.
Given the volatility of the rumor mill we’re pleased with our decision to cover the EUR/USD on 11/23 near our oversold level of $1.32. We see the EUR/USD trading up to an immediate term resistance level of $1.34 and should it run through $1.37, we’d change our bearish outlook.
Below we present our weekly risk monitors.
European Equity and Currency Moves – European markets today largely made up for loses last week, however week-over-week (Friday-over-Friday) indices fell 3-5% with negative divergence from Italy’s MIB -8.5%; Greece’s Athex -6.8%; and Austria’s ATX -6.5%. Over the same duration, the EUR/USD was down -2.1%.
European Sovereign Yields – European 10YR yields were mostly higher last week. Of note is the sustained move of German yields. The 10YR was up +41bps week over week to 2.30%, a clear risk signal that even the region’s fiscally strongest nation is under threat.
Greek yields declined -115bps as the sovereign debt spotlight shifted more squarely on Italy and Spain. Portuguese yields widened the most, +209bps to 13.38%, followed by Italy (+39bps to 7.09%). To round out the PIIGS, Spanish yields rose +6bps to 6.62%. As always, we’re keying off the 6% Lehman line as a critical breakout line. Italy and Spain have held tight above the 6% for the last five weeks.
In its SMP bond purchasing program, the ECB bought €8.6 Billion in secondary bonds last week (vs €8.0B in the week prior), taking the total program to €203.5 Billion. Look for Super Mario (Draghi) to increasing buying alongside heightening Italian yields.
European Sovereign CDS – European sovereign swaps mostly widened last week. German sovereign swaps widened by 15.3% (+15 bps to 111.5) and American swaps by 7.8% (+4 bps to 55.5).
European Financials CDS Monitor – A Sea of Red. Bank swaps were wider in Europe last week for 35 of the 40 reference entities. The average widening was 5.4% and the median widening was 16.1%. Bank swaps remain below 300 in Norway, Sweden, Switzerland, and the UK. Across the 29 banks in Austria, Belgium, Denmark, France, Germany, Greece, Italy, Portugal, Russia, Scotland, and Spain, there is only one bank with swaps trading below 300 bps. While no one needs reminding that the systemic risk in the European banking system is extraordinarily high, this morning's data serves as a reminder nonetheless.