Giant Defense

This note was originally published at 8am on February 06, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Defense is superior to opulence.”

-Adam Smith


If your 2012 defense can shut down both Aaron Rodgers and Tom Brady in back-to-back playoff games, evidently you deserve to win the Super Bowl. Opulent offensive statistics often win awards. Giant Defenses win Championships.


Anyone who has followed my hockey or professional career closely knows that I take pride in playing defense. Blocking shots and not losing money on market down days may not get my name in the paper – but that’s ok, I don’t read the Old Wall’s paper.


In a consciously conservative move to defend against both US and Global Growth Slowing again sequentially in February, I shorted the US stock market twice last week (at 1327 and 1343 in the SP500). This week, we’ll see if I played defense too early.


Back to the Global Macro Grind


Being early in this business is also called being wrong. For me, since I’m usually buying on red and selling on green, that happens a lot. After seeing the US stock market fall for 4 consecutive days after Ben Bernanke imposed an Inflation Tax on Consumers and Savers, most of last week’s squeeze came in 4 hours of Friday’s trading.


How do you defend against that? It’s not easy. And since there are tens of thousands of fund managers who are in the business of the stock market going up, that doesn’t make explaining why I decide to go on defense any easier.


To review my Global Macro Risk Management Process, when I think about countries and probability-weighing the bullish or bearish momentum of their respective economies, I heavily weight the following 3 factors:

  1. Growth (slowing or accelerating?)
  2. Inflation (slowing or accelerating?)
  3. Policy (perpetuating or fighting inflation?)

Most Deflationistas don’t agree with me on this because they are either academics who are not accountable to trading daily, weekly, and monthly P&L risk, and/or they don’t have a Giant Defense that has proactively prepared them to make these calls on the margin.


It’s what happens on the margin that matters to Macro Market Expectations most.


The reason why I pay such close attention to what Bernanke does is that he drives point #3 – Policy. If you get Fed Policy (hawkish or dovish on the margin) right, you’ll get the US Dollar right. If you get the US Dollar right, you tend to get most other things right.


Now plenty of people who are always taking offense to the Strong Dollar = Strong America point probably don’t agree with me on this either. Since we’ve been right on 26 of 27 long/short calls on the US Dollar since founding the firm in 2008, I’m not sure I care.


What I care about most is what Policy does to the Dollar - then what the purchasing power of that Dollar does to everything else that’s priced in Dollars. In the last 3 weeks, with the US Dollar down -3.2%, this is what Growth and Inflation Expectations have done:

  1. Inflation Expectations = Gold +7%, Copper +7%, and Oil +4%
  2. Growth Expectations = US Treasury Bonds (10yr) -5%, Yield Spread -6%

Again, a lot of people will take as much issue with me suggesting that falling US Bond Yields and a compressing Yield Curve (Yield Spread = 10-yr yields minus 2-year) represents Growth Slowing Expectations right here and now as they did in July, August, or November of 2011. This is the goal-line of the bull/bear US Equity debate.


This morning’s Global Macro Market signals only amplify my Growth Slowing point:

  1. Despite a stiff rally in US Equities on Friday, most other Asian and European equity markets didn’t agree
  2. Chinese stocks (Shanghai Composite) stopped going up at intermediate-term TREND resistance of 2342
  3. France, Spain, and Italy all backed off, hard, at their long-term TAIL lines of resistance (CAC = 3503)
  4. Dr. Copper said no thank you at its long-term TAIL of $3.98/lb resistance (down -1.1%)
  5. EUR/USD failed, again, at its intermediate-term TREND line of $1.34 resistance (down -0.5%)
  6. US Treasury Yield on the 10-year is down to 1.91% this morning and remains in a Bearish Formation

A Bearish Formation in US Growth Expectations (bond yields) is what made me bearish on US Growth in February of 2011 inasmuch as it is right here in February of 2012. Thankfully, unlike in January 2011, I caught most of the January 2012 up move in stocks.


Unlike most strategists in this game, I have no problem shifting from offense to defense – I usually slap on the Giant Defense when I see an inflection in the slope of Growth and Inflation Expectations. My process hasn’t changed. The game-time signals have.


My immediate-term support and resistance ranges for Gold, Oil (Brent), EUR/USD, Shanghai Composite, and the SP500 are now $1685-1726, $111.36-114.02, $1.29-1.32, 2269-2342, and 1321-1347, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


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Triangulating Asia

This Week's Topics:

  • China Is Not Going to Ease at These Prices
  • Is The Japanese Yen’s Underperformance a Canary in the Coal Mine?
  • Is It Time for India To Take a Breather?


China Is Not Going to Ease at These Prices

Earlier in the week, we received word from Chinese Premier Wen Jiabao that China would look to continue “fine-tuning” macroeconomic policy in 1Q12. Speaking at a council of corporate executives, Wen said:


“To cope with economic hardships this year, the government will offer support to the real economy… We have to make a proper judgment as early as possible when things happen and take quick action.”


From a policy perspective this statement pledges is more of the same – a little tinker here and there (via differentiated reserve requirements, altering capital requirements on SME loans, favorable tax policies, etc.) to acquiesce to growing domestic concerns regarding China’s intermediate-term growth outlook.


Unfortunately, that’s not enough to materially move the needle on Chinese growth. For us to factor in as probable a 2012 re-acceleration in Chinese economic growth, Chinese policymakers need to do two things: 1) lower interest rates and RRRs; and 2) ease curbs on the property sector, given the relative size of fixed asset investment as a driver of Chinese economic growth.


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Regarding the latter lever, Premier Wen’s comments last week were far less than supportive:


“China won’t waver on its real-estate curbs, which aim to bring home prices to a reasonable level... Although market mechanisms should play a fundamental role in the property market, the government will maintain restrictions to ensure fairness and stability.”


Regarding the first lever, rising domestic and global inflation expectations aren’t supportive of the PBOC easing Chinese monetary policy. Moreover, despite lower-highs over the past six months, headline CPI is still +50bps above the State Council’s +4% inflation target.


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A return to being comfortably under the target rests largely with the outlook for global food and energy prices, which are largely a function of the price level of the U.S. dollar, which itself is a function of U.S. monetary and fiscal policy. Any hint of Qe3 actually puts incremental tightening back on the table in China. For now, Chinese rate markets are simply pricing in less easing on the margin.


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All told, we think there is a fair amount of risk at current elevated prices across the higher-beta asset classes, given that the Chinese economic growth outlook is becoming re-subdued, on the margin, relative consensus expectations that are largely driven by a base case featuring interest rate/RRR cuts. The fact that Chinese equities failed to overtake their TREND line amid a YTD global equity melt-up is not a comforting signal.


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Moreover, while it is not in our style to speculate on commodities or another country’s equities/FX using the Chinese demand curve as a singular factor, the reality of it is that there are a great many investors who do – hence why we flag a consensus reevaluation of China’s intermediate-term growth outlook as a potential negative catalyst in the short term.


Is the Japanese Yen’s Underperformance a Canary in the Coal Mine?

The Japanese yen has been dramatically underperforming of late, falling -2.4% vs. the USD week/week. On a YTD basis, the currency is down -3.3% against the USD vs. a regional median of +2.5% – good for a (-580bps) negative divergence versus the region and the second largest decline in the world (Ghana’s new cedi is down -3.8% vs. the USD; we track 48 currencies and/or currency indices).


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While such large % changes are becoming increasingly more commonplace in the market for foreign currency exchange amid structurally higher global FX volatility, we can’t help but flag this outsized underperformance as a potential canary in the coal mine for what we see as heightening risks within the Japanese sovereign debt market.


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While the mere presence of heightening risk is no guarantee of a sovereign debt crisis, we’ve been vocal in calling out Japan’s MAR maturity spike as the potential grain of sand that could facilitate stress in the JGB market. So from a timing perspective, it doesn’t make sense for us to casually write off the yen’s underperformance as merely a function of decreased global risk aversion and higher expectations for U.S. interest rates.


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That said, however, we are cognizant that the aforementioned view could very much be the case after all – especially given that we aren’t a seeing similar degree of stress across the other Japanese asset classes over similar durations.


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Of course that could change, however; look no further than the outperformance of Japan’s 5yr sovereign CDS over the past three months (+10.7% vs. a regional median of -17.9%) as another potential canary in the coal mine. All told, we don’t view heightening risk of a Japanese sovereign debt crisis as something to downplay given the events in Europe over the past six months and we will keep our eyes and ears glued to our screens for any/all warning signs.


Is It Time for India To Take a Breather?

Earlier in the week, India posted a solid inflation report, with its benchmark WPI gauge slowing to a 26-month low of  +6.6% YoY in JAN (vs. +7.5% in DEC). This deceleration marks a cumulative -340bps decrease in India’s headline inflation rate since peaking in SEP from an intermediate-term perspective and, more importantly, puts the series well below the RBI’s forecast of +7% YoY inflation by the end of the fiscal year (MAR).


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The deceleration in Indian inflation and subsequent monetary easing speculation has been quite supportive of foreign inflows into Indian portfolio assets YTD: foreign ownership of Indian equities is up +4.8% YTD and foreign ownership of rupee-denominated fixed income is up +12.9% YTD.


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A growing outlook for growth-supportive monetary policy and earnings tailwinds via FX translation have fueled a melt-up in India’s benchmark SENSEX equity index, which is up +18.3% YTD – the best performance in the region over that duration and good for a +750bps positive divergence vs. the regional median gain.


Due to the dramatic uptick in inflows, India’s currency has had similar outperformance in the face of monetary easing speculation, gaining a regional-best +7.7% against the USD in the YTD – which compares to  a regional median gain of only +2.5%. More importantly, the rupee is outperforming global food and energy prices on a rolling 30-day basis, which we use to guide our expectations for sequential inflation readings on a real-time basis.

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Net-net-net, rupee-denominated assets are firing on all cylinders right now, which, again, is largely driven by the anticipation of a shift to growth-supportive monetary policy. In light of this, we’re flagging the risk that the RBI fails to deliver on consensus expectations for rate cuts in the short-to-intermediate term, given the bullish quantitative setup across global energy prices and lack of fiscal consolidation – which was highlighted by Governor Duvvuri Subbarao as a prerequisite to lowering rates as recently as this week.


While the fundamentals would suggest that India is not necessarily a top short idea, the risk of a short-to-intermediate-term correction in Indian assets is inflated, given that monetary easing might be farther out in duration than consensus hopes. We point to a developing trend of incrementally-less pricing in of monetary easing into Indian rate markets as supportive of this view.


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Fundamental Price Data

All % moves week-over-week unless otherwise specified.

    • Median: +1.5%
    • High: Japan +4.9%
    • Low: New Zealand -1.8%
    • Callout: Philippines +26.2% over the LTM vs. a regional median of -3.1%
  • FX (vs. USD):
    • Median: +0.1%
    • High: New Zealand dollar +0.7%
    • Low: Japanese yen -2.4%
    • Callout: Japanese yen -3.3% YTD vs. a regional median of +2.5%
    • High: Thailand +12bps
    • Low: Vietnam -38bps
    • Callout: Indonesia -88bps YTD
    • High: Indonesia +12bps
    • Low: Vietnam -47bps
    • Callout: China +11bps YTD
    • High: Philippines +9bps
    • Low: Vietnam -9bps
    • Callout: China (10yr-1yr) -26bps YTD
  • 5YR CDS:
    • Median: -0.1%
    • High: Japan +0.6%
    • Low: Australia -3.1%
    • Callout: Japan +19.7% over the last six months vs. a regional median of +1.6%
    • High: Australia +16bps
    • Low: Thailand -4bps
    • Callout: China +50bps YTD
    • High: China +181bps
    • Low: Vietnam -71bps
    • Callout: India +40bps YTD
  • CORRELATION RISK: The MSCI All-Country Asia Pacific Index is trading with a very slight positive correlation of +4% to the DXY on an three-week basis -- a large directional shift from -89% on a six-week basis. We would expect this correlation to intensify in the coming weeks, given the inflationary risks of further dollar-debauchery.

Darius Dale

Senior Analyst


The Economic Data calendar for the week of the 20th of February through the 24th 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.




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Chirp away...I deserve it!

In my earlier note on the hype around Nike's major media event next week, I noted that 'Melo plays for the NJ Nets.


Well guess what...he''s a Knick. 


The sad thing is that a) I lived in NY for 19 years, b) NJ for 10 years, and c) worked at Nike.


So there's my gift for you heading into the long weekend. Poke all the fun you want. I deserve 110% of it.


If you change the team name, however, the note's conclusion is the same. In fact, given his recent injury, there's even a greater chance that he shows up.


Maybe that's what happens being in an office filled with hockey guys.

Nike: For Beyond LinSanity

If you’ve heard that Nike is hosting an Analyst Meeting next week, that’s not entirely correct. The company is hosting a 2-day all-out media event in New York. If you have not been following Nike for a while, you should know that when Nike does a ‘media event’ it rivals the red carpet on Oscar night. No joke. The company invited the sell side to ‘participate’ (ie observe) Nike in its native habitat.


Make no mistake – people will be star-struck. This event is just days before the NBA all star game, and will likely feature athletes – and their respective products -- that will get people jacked up, to say the least.


While I can’t promise anything, in looking through NBA schedules, the Knicks will be local on the 21stad 22nd. LinSanity, anyone? Don’t forget Stoudamire either. The Nets will also be at Home, which gives us Carmello Anthony. The Heat has a bye on the 22nd, and why not have LeBron, Wade, and Bosch make a detour in NYC after they play Sacramento on the 21st? If you don't think that Nike had these schedules in mind when planning the event, then think again!


This won’t be all about basketball. Translation: I wouldn’t be surprised for people to be Tebow’d.


No, I don’t have any inside scoop as to who will be there. But this IS how the company thinks and operates. A product blitz with all the media and celebrity hype to support it. First class all the way. The average analyst out there (who will also have breakfast with CFO Don Blair) will be impressed.


NKE is still one of our top three long ideas.


In January, Y/Y CPI growth for Food at Home decreased by 70 basis points to 5.3% from 6.0% in December.  CPI for Food Away from Home gained 20 basis points to 3.1% from 2.9% in December. 


This is a trend that we are continuing to monitor closely.  2011 was a year where restaurant margins were impacted by inflation but, due to strong top line trends, rising food costs did not have as severe an impact on earnings as some were anticipating.  Management teams in the grocery space took significant levels of pricing during 2011 and we believe that this was a factor in helping restaurants attract customers.  Food Away from Home CPI was far more benign as restaurant companies prioritized traffic over margin.   Our view in 2012 is that, if the spread between these two CPI data points continues to narrow, the competitive benefit that the restaurant companies enjoyed in 2011 will shrink and any exposure to inflation will be felt more acutely on the bottom line. 


As JACK CFO Jerry Rebel said on a recent earnings call, management teams pay close attention to this data when thinking about pricing so we will continue to monitor these trends closely.


CPI – JAN FOOD AT HOME SLOWS AS AWAY FROM HOME PICKS UP - food at home vs food away from home cpi white



Howard Penney

Managing Director


Rory Green



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