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Complicating Life

“You should know that correcting your intuitions may complicate your life.”

-Daniel Kahneman

 

That’s just a great risk management quote from Chapter 18 of “Thinking, Fast and Slow” – Taming Your Intuitions. While the Storytelling about oil prices, what caused them, and what they mean to your portfolios can be creative, it can also complicate your life.

 

Complicating Life for the small some of us whose life will not change by prices at the pump is not what I mean. I’m talking about the most obvious of obvious of life’s complications – what’s in your wallet versus what you need to buy to feed your family.

 

While that may be the most intuitive statement of the year for the rest of the world’s consumer population, on Wall Street we are often numbed to believe that making the most obvious of obvious calls on markets and economies isn’t “smart” enough.

 

Back to the Global Macro Grind

 

One obvious call that we pounded on last week is that Global Consumption Growth has never not slowed with oil prices running north of $100/barrel. We’ll reiterate that very simple fact this morning. I couldn’t have repeated it enough in February of 2008.

 

Barron’s Mike Santoli did a nice job of bringing back those 2008 memories this weekend when he pointed out that the price of Brent Oil has not traded below $100/barrel for 269 days. Make that 270 days now. The longest streak (ever) prior to this was 110 days in 2008.

 

2008 and 2011 are the years that the willfully blind at both the Fed and Sell-Side groupthink-tanks would like to just forget. That’s why we like to remember them. When Growth Slowing happens every few years after the price of oil ramps, there’s something obvious Complicating Life for those of us who don’t hang our hats about being “dead” in the long-run.

 

To review the Dollar Debauchery, Oil Up trade last week:

  1. US Dollar Index was down -1.3% to $78.35
  2. Brent Oil price was up +4.9% to $125.47
  3. WTIC Oil price was up +6.4% to $109.77

And, of course, the headlines into the weekend were that Oil was rising because the “economic recovery” was picking up steam…

 

Then, a not so funny thing happened on the way to the pre-market US Futures forum this morning. Stocks fell down … because of “rising oil prices” … but, uh… oil prices this morning are falling…

 

Got Storytelling?

 

The sad fact of the matter is that many market participants need oil prices to rise to get paid. That’s just a sad fact for the country, not for absolute returns. At +25.2% and +21.8%, respectively, Russian and Venezuelan Equities are 2 of the Top 3 performing Stock Markets in the world for 2012 YTD. These are called Petro-Dollar markets – awesome, right?

 

It really is awesome if you are long Inflation Expectations Rising. The problem with that is 2 fold:

  1. That, ultimately, leads to Growth Expectations Slowing
  2. Most people on this earth are short inflation in their wallets

The other thing here Complicating Life is that our industry chases prices at tops and sells bottoms:

  1. CFTC data for last week shows bullish Commodity Options contracts up +7.3% week-over-week
  2. At 1.03 Million call options on commodity inflation, that’s the biggest number since the week of September 13, 2011
  3. From the CRB Index’s September 2011 high to its October 2011 low (292) we saw a -14% crash in commodities

Yes, Commodities Crashed. That was last year, remember?

 

Last year, post Qe2, expectations continued to build for a Stronger Dollar. So commodities crashed. Period. Commodities didn’t fall because growth expectations were slowing. US GDP Consumption Growth rose steadily as the price of oil fell with US GDP going from 0.36% in Q1 to +2.8% in Q4 of 2011.

 

I’m not saying it’s easy being a Macro man trying to navigate the whip-saw of Big Government Interventions. If I have written this 100 times I have said it 1,000 times over – cheap money Dollar Debauchery policies A) shorten economic cycles and B) amplify market volatility.

 

What I am saying is Ben Bernanke’s Policy To Inflate to 2014 is Complicating Life for the rest of the world’s consumption.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), Oil (WTIC), US Dollar Index, and the SP500 are now $1, $120.78-126.21, $105.44-110.66, $78.38-79.11, and 1, respectively.

 

Best of luck out there this week,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Complicating Life - Chart of the Day

 

Complicating Life - Virtual Portfolio


Mid-Tier Retail: That’s a Wrap

 

This week’s earnings provide the latest look at the state of mid-tier department store retail, which is playing out as we outlined back in Q3. The bottom-line here is that inventory growth continues to outpace sales, which is fueling a highly competitive pricing environment in the mid-tier (i.e. more promotional) further widening the bifurcation between the low-end and high-end retailers. Good for JWN, SKS, as well as discount and dollar store players TJX, ROST, DLTR; Bad for KSS, JCP, SHLD, M, HBI & GPS.

 

Here are a few considerations for this week’s key themes:

 

1) Inventory Growth: The trend of inventory growth outpacing sales continues to plague the mid-tier department stores as reflected in the chart below. Also worth noting are the three companies in this set that posted positive sales/inventory spreads: SHLD, JCP, and DDS. While a positive spread is a just that – positive on the margin, not all positive spreads are created equal, composition matters. In this regard, both SHLD and JCP achieved positive spreads by stripping inventories out faster than sales declined. This is considerably different in quality from TJX and DLTR which posted +11% and +13% sales growth respectively with inventories growing, but just at a slower rate.

 

Re WMT International… “Inventory management remains an area needing improvement” – Doug McMillon, CEO WMT Int’l

 

High inventory levels led to increased markdowns and clearance, and unseasonably warm weather impacted several categories” – Lou D’Ambrosio, CEO SHLD

 

I would expect inventory to be up at the end of the first quarter somewhere around 4% or so.” - Kevin Mansell, CEO KSS (compared to Q1 sales outlook for +3%)

 

 

2) Promotional Environment: The aforementioned factor is what continues to fuel the promotional fire currently ablaze in the mid-tier channel. With gas prices surging higher and discretionary wallets getting tighter, unloading excess inventory will weigh on margins through at least the 1H effecting not only those directly operating in the mid-tier, but also those selling into it (e.g. HBI).

 

Re Q4…“a highly promotional competitive environment” – Charles Holley, CFO WMT

 

We lost some of our leadership on the price element of our value equation; we didn't have enough consistent excitement in our merchandise content; and our sense is our marketing message did not cut through, especially in a highly promotional fourth quarter.” – Kevin Mansell, CEO KSS

 

“Our promotional cadence should have been more surgical, and cost actions could have been taken earlier.” – Lou D’Ambrosio, CEO SHLD

 

In terms of promotional activity, I think that we're always challenging our teams. Last year was not necessarily our best year on this front” – Glenn Murphy, CEO GPS

 

“competitive intensity reached an all-time high during the holiday season. Research indicates that across retail, two out of three holiday season purchases in gift giving categories were on some sort of promotion, and these promotional discounts were significant, ranging from 25% in some categories to more than 50% in others.” – Gregg Steinhafel, CEO TGT

 

 

3) High/Low End Bifurcation: Consistent with what we’ve seen since the 2H of F11, the high-end continues to outperform its more price sensitive peers. While high-end growth is starting to decelerate on the margin, the mid-tier is declining at a faster rate. We expect this reality to persist over the intermediate-term as discretionary spending remains constricted at the lower end. The other fact to consider here is that due to the excess inventory in the mid-tier channel, discounters like TJX, ROST and even dollar stores DLTR, etc. will continue to benefit from better product flow providing a traffic tailwind as evidenced by strong top-line results. .

 

 

Mid-Tier Retail: That’s a Wrap - mid tier market chart

 

Mid-Tier Retail: That’s a Wrap - MIdTier SvI

 

Mid-Tier Retail: That’s a Wrap - SIGMA

 

Casey Flavin

Director




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THE WEEK AHEAD

The Economic Data calendar for the week of the 27th of February through the 2nd of March 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

THE WEEK AHEAD - 2


Weekly European Monitor: Floating Ships in Shallow Waters

Positions in Europe: Short EUR/USD (FXE); Short France (EWQ)

 

Asset Class Performance:

  • Equities:  European equity performance fell largely in a band of -100 to +50bps week-over-week with some notable divergences. Top performers:Russia (RTSI) 4.4%; Romania 4.2%; Norway 1.7%. Bottom performers:Cyprus -19.3%; Greece -9.0%; Slovakia -1.8%; Poland -1.6%; Spain -1.5%; Portugal -1.0%. 
  • FX:  The EUR/USD is up 2.38% week-over-week.  Divergences:TRY/EUR -3.08%, ISK/EUR -3.05%, GBP/EUR -2.02%; PLN/EUR +0.46%. The RUB/EUR is up 6.10% YTD, one of the best performing major emerging market currencies against the EUR.
  • Fixed Income:  10YR sovereign yields were down week-over-week, with Portugal bucking the trend to the upside. Portuguese yields climbed 50bps to 12.77% w/w, while Spain’s 10YR saw the biggest decline at -21bps to 5.05%. Greece fell -14bps to 34.24% and Italy fell -9bps to 5.48%

Weekly European Monitor: Floating Ships in Shallow Waters  - 11. yields

 

 

In Review:


How hard can you scrape the hull of a ship before it tears? The Eurozone churned for another week and with the less-than-exuberant reaction to Tuesday’s news that Eurozone finance ministers forged a €130 billion rescue deal for Greece and terms on PSI to reduce the country's outstanding debt by €107 billion, it’s clear that few think this “deal” provides the nail to shore up Greece’s sovereign and banking imbalance and therein right the Greek economic ship. 

 

The main issue is that there are still so many question marks ahead, not unlike past weeks and months. One central issue concerns PSI. If not enough bondholders agree to the terms—and the agreement assumes 95% participation on a haircut of 53.5% of the principal value of the bonds with an average coupon of 2.63% for the first 8 years and then 3.65% for the balance of the 30 year maturity—a significant legal battle could be waged between parties.  And already in the weeds is discussion that the ECB, on its own and without judicial or parliamentary review, swapped its Greek debt for new Greek debt that is not subject to any collective action clauses (CACs). Obviously this “changing of the goalposts”, if substantiated, has severe negative implications on the success of participation and future issuance from other sovereigns.

 

Second, select Eurozone member parliaments still need to vote on the terms of the rescue fund and PSI package, with Germany’s vote coming on Monday, February 27. While it is expected to pass in Germany, it is not a guarantee, and more broadly the process to bring these measures to vote across countries simply runs final ratification closer to Greece’s €14.5 billion bond repayment coming due on March 20.

 

Announcements from the IMF this week also dampened sentiment, including a statement that the balance of risks in this "accident-prone" economic program is "mostly tilted to the downside, and “even a small shock could see the country's debt growing on an ever-increasing trajectory.”  Further, the downgrade from the European Commission of Eurozone GDP to -0.3% in 2012 versus a previous estimate of +0.5% muted the agreement talks. 

 

The bull camp however turns to the 2nd installment of the LTRO allotment of 36M paper that will be rolled out. We continue to caution that though this may help solve the liquidity crisis, it does little for underlying solvency issues at banks. Additionally, we’ve seen few indications that lending is picking up material. The chart below under “Charts of the Week” shows that these LTRO funds could simply be contributing to the elevated levels of the ECB’s overnight deposit facility.

 

Finally, another disturbing trend (however not new) is money deposits leaving southern Europe for Germany and points north. Bloomberg recently compiled this data and found that deposits in Greece, Spain and Italy shrank 28% from a peak in June 2009, as deposits climbed 10% since May 2010 (when Greece received its first bailout).

 

Below is a calendar of critical catalysts to be aware of:

 

This Weekend (2/25- 2/26):  G20 Finance Ministers Meeting in Mexico City. Decision on IMF loan of €500B is expected.

 

Wednesday (2/29):  2nd 36-Month LTRO Allotment.

Wednesday (2/29):  Eurogroup Meeting to sign the previously endorsed agreement between the 17 members on the Treaty for the European Stability Mechanism.

 

Thursday and Friday (3/1-3/2):  Signing of the Fiscal Compact by 17 Eurozone leaders together with the non-euro area leaders of countries willing to join. Further, the group will reassess the adequacy of resources under the EFSF and ESM rescue funds.

 

 

Call Outs:

  • The European Commission said it now expects the Eurozone economy to shrink by -0.3% in 2012, versus a previous forecast of +0.5% in November, with the region undergoing a "mild recession".
  • EU may give countries such as Spain softer deficit targets but there will be no let-up in the overall austerity drive as the continent struggles to draw a line under its two-year debt crisis.
  • Russia - Prime Minister Vladimir Putin will probably win Russia’s presidential election in the first round on March 4, according to the latest projection from the independent Levada Center.    Putin has the support of 66% of decided voters versus 15% for Communist Party leader Gennady Zyuganov, said Lev Gudkov, Levada Center’s director.

 

Portfolio Positions:

 

Short France (EWQ) – Keith opportunistically shorted France on 2/22 and again today (2/24) in the Hedgeye Virtual Portfolio as we got our price on a backdrop of weak fundamentals and data and an uncertain political climate that is trending towards a socialist candidate victory in the upcoming Presidential elections (in April) that could spell higher taxes and more spending.

 

French consumer confidence did climb for a second straight month in February one point to 82, according to a poll from the national statistics office Insee, however there are material signs that in 2012 France will be butting up against higher unemployment, a debt load of over 90% of GDP, stretched deficit targets, and uncertainty around cost saving measures (austerity) and associated revenues given the uncertainty of who will be leading the state in the weeks ahead: Sarkozy or his challenger, the socialist Francois Hollande.

 

While Hollande talks about fiscal consolidation, he’s indicated that he may undo Sarkozy’s rise in the pension age, has questioned the EU’s fiscal compact, is unclear on his position on Eurobonds, and may well be a bigger spender than saver of government money. Clearly there are many unanswered questions here, but we think the risk lies to the downside.

 

Returning to the data, this week showed that the number of people in France actively looking for work made its highest high since the Euro went into circulation, to 2,861,700 in January versus 2,848,300 in December. This should put upward pressure on last year’s 5.6% unemployment rate.  This week’s initial February PMI data also showed that Services underperformed expectations coming in at 50.3 (vs 52.0), which Manufacturing beat expectations at 50.2 (vs 49.0), as both run along the contraction/expansion line of 50.

 

Weekly European Monitor: Floating Ships in Shallow Waters  - 11. cac

 

 

Short EUR/USD (FXE) - Keith shorted the EUR/USD via the eft FXE on 2/23 and again today (2/24) in the Hedgeye Virtual Portfolio, after watching the pair rise from $1.30 earlier this week through $1.33 and then up to $1.34, the line in our quantitative model signaling overbought on the intermediate term TREND, prompting the decision to short.  We think that despite optimism around the Greek deal we see a long tail ahead to shore up Greek and Eurozone sovereign and banking imbalances.

 

Weekly European Monitor: Floating Ships in Shallow Waters  - 11. eurusd

 

 

CDS Risk Monitor:


On a week to date basis, CDS was largely down across European sovereigns (vs up last week), with Spain leading the charge on the downside -28bps to 370bps, followed by Italy (-25bps) to 391bps and Portugal (-19bps) to 1130 (see charts below).   

 

Weekly European Monitor: Floating Ships in Shallow Waters  - 11. cds a

 

Weekly European Monitor: Floating Ships in Shallow Waters  - 11. cds b


 

Charts of the Week:


Really?  In the chart below we show the secondary bond purchasing program of the ECB, known as the Securities Market Program (SMP). Last week the ECB did NO buying, and combining the last 4 weeks the Bank has only purchased €246 MILLION, versus €2.243 BILLION in the week ended 1/20 and 3.766 BILLION in the week ended 1/12, with the total facility at  €219.5B. We continue to wonder if the ECB is making up the numbers and not reporting their purchasing. Here we welcome your thoughts.


Weekly European Monitor: Floating Ships in Shallow Waters  - 11  smp

 

 

The ECB’s Overnight Deposit Facility remains elevated.  Thank you LTRO?

 

 Weekly European Monitor: Floating Ships in Shallow Waters  - 11. overnight ecb

 

 

The European Week Ahead:


Monday:  Jan. Eurozone Money Supply; Germany Bundestag will vote on new Greek Aid Package; Feb. UK Nationwide House Prices (Feb 27-29); Feb. Italy Business Confidence

 

Tuesday: Feb. Eurozone Consumer Confidence – Final, Business Climate Indicator, Economic, Industrial, and Services Confidence; Mar. Germany GfK Consumer Confidence Survey; Feb. Germany Consumer Price Index – Preliminary; Feb. Italy Reported Sales, GfK Consumer Confidence Survey

 

Wednesday:  Eurozone Second LTRO Allotment; Jan. Eurozone CPI; Feb. Germany Unemployment Change, Unemployment Rate; Jan. Germany Import Prices; Jan. UK Net Consumer Credit, Money Supply, Mortgage Approvals, Net Lending Sec. on Dwellings; Jan. France Consumer Spending

 

Thursday:  EU Leaders Meet in Brussels (Mar 1-2); Feb. Eurozone PMI Manufacturing – Final, CPI Estimate; Jan. Eurozone Unemployment Rate; Feb. Germany and France PMI Manufacturing – Final; Feb. UK, Russia, and Italy PMI Manufacturing; 4Q France Unemployment Rate; Feb. Italy CPI – Preliminary, Budget Balance; Jan. Italy Unemployment Rate - Preliminary

 

Friday:  Jan. Eurozone PPI; Jan. Germany Retail Sales; Feb. UK PMI Construction; 2011 Italy Deficit to GDP, Annual GDP

 

 

Extended Calendar Call-Outs:


27 February:  The German Bundestag plans to vote on the issue of Greece’s second bailout, including the embedded terms of the PSI.

 

25-26 February:  G20 Finance Ministers Meeting in Mexico City. Decision on IMF loan of €500B is expected.

 

29 February:  2nd 36-Month LTRO Allotment.

 

29 February:  Eurogroup Meeting to sign the previously endorsed agreement between the 17 members on the Treaty for the European Stability Mechanism.

 

1-2 March:  Signing of the Fiscal Compact by 17 Eurozone leaders together with the non-euro area leaders of countries willing to join. Further, the group will reassess the adequacy of resources under the EFSF and ESM rescue funds.

 

20 March: Greece’s €14.5 billion Bond Redemption due.

 

April:  French Elections (Round 1) begins to conclude in May.

 

April:  Greek Presidential Elections

 

30 June:  Deadline for EU Banks to meet €106 billion capital target/the 9% Tier 1 capital ratio.

 

1 July:  ESM to come into force.

 

 

Matthew Hedrick

Senior Analyst


Triangulating Asia

This Week’s Topics:

  • Lunar New Year Distortions or Simply a Weaker Outlook for Global Growth?
  • Entertaining Elections in Hong Kong and Australia
  • Are the Ratings Agencies Fearful of Downgrading Japan Further? 

Lunar New Year Distortions or Simply a Weaker Outlook for Global Growth?

As Asian equities, FX, and corporate credit climbed higher in the YTD, both investors and the legacy media have written off the region’s generally-nasty JAN economic growth data as merely a function of Lunar New Year calendar distortions – in full anticipation of a return to higher growth rates in FEB and beyond.

 

While we certainly agree that there has been a fair amount of distortion resulting from Lunar New Year (and the resulting week of holiday) being on JAN 23 (vs. FEB 3 last year), we don’t think it pays to overlook the string of sour data as a one-off – particularly given where the slope of regional inflation is likely headed with Brent prices > $120/bbl. Asia remains the world’s largest consumer of crude oil from a regional perspective, at just over 30% of total world demand.

 

A quick look at Asia’s JAN export data highlights the general trend of weakness we are referring to:

  • China: -0.5% YoY vs. +13.4% in DEC;
  • Japan: -9.3% YoY vs. -8% in DEC (en route to worst monthly trade deficit on record);
  • South Korea: -7% YoY vs. +10.8 in DEC;
  • Hong Kong: -8.6% YoY vs. +7.4% in DEC;
  • Singapore: -2.1% YoY vs. +9% in DEC;
  • Taiwan: -16.8% YoY vs. +0.6% in DEC;
  • Vietnam: -11.1% YoY vs. +25.4% in DEC;

We’ve created an aggregated index for Asian export growth which weights each country according to its share of regional exports; on this metric Asian export growth slowed to -4% YoY in JAN from +6.4% in DEC (generously holding Indonesian, Filipino, Thai, Malaysian, and Indian readings flat sequentially due to the lack of reporting at the time of publication).

 

Triangulating Asia - 1

 

Again, we don’t want to make too big a deal out of Asian growth data slowing in JAN because of the obvious effects of the Lunar New Year calendar shift, but it’s worth mentioning that the U.S. and E.U. combine for roughly a third of Asian export demand and 40-50% of intra-regional trade is meant for re-export outside the region, likely upping the U.S. and E.U. share of Asian trade to ~2/3rds. With the developed world accounting for 60-70% of Asian exports, a negative YoY JAN export growth reading for the region portends negatively, to some extent, for the slope of Western demand in over the intermediate-term.

 

That’s something to at least keep in the back of your mind as you ponder what the slope of global growth is likely to look like at these currently-elevated energy prices.

 

Entertaining Elections in Hong Kong and Australia

It’s very hard to spot a parliament that rivals the 112th U.S. Congress in being dysfunctional. That said, however, Australia has certainly thrown its hat into the competition in recent days.

 

Kevin Rudd, the country’s now-former foreign minister (he recently quit) seeks to challenge incumbent prime minster Julia Gillard as head of the Labor Party in a FEB 27 referendum (2nd one in 20 months), which Gillard called to determine once-and-for-all who will lead the party into next year’s general election. Currently her Labor Party is Australia’s least-popular ruling party in at least 27 years, capturing only 26% of a SEP primary vote and only 32% in a recent poll (vs. 46% for the rival Liberal-National coalition, who appears poised to challenge for ruling party status next year under the leadership of Tony Abbot).

 

Rudd, who enjoyed record popular support during his tenure as prime minister during 2007-10, has been known to ruffle quite a few feathers among his colleagues. So much so that key officials such as Treasurer Wayne Swan and Defense Minister Stephen Smith have publicly stated how difficult it was/would be to work under Rudd’s leadership again. To be fair, Rudd has launched a series of campaigns documenting his changed behavior and he does have the public support of some key members of the Labor Party, such as Immigration Minister Chris Bowen.

 

Looking ahead, while next Monday’s referendum will do little to change the intermediate-term slope of Aussie fiscal and regulatory policy, it may have an impact on the perception of the party among voters, as a less-than-decisive victory by either candidate broadcasts a signal of low intra-party confidence. From a longer-term perspective, the party may be forced to employ more populist policies ahead of the 2013 elections to make up ground vs. the Liberal-National Party. Adopting a history lesson from 1992, the Labor Party did come from behind to secure a victory in the general elections of MAR ’93 by collectively refocusing on the enemy rather than its own internal issues.

 

Turning to Hong Kong, the short-to-intermediate term implications of its upcoming election are far more serious in nature. The territory – which has never experienced universal suffrage under Britain nor Beijing’s leadership – is seeing its system of transferring the highest-ranking title of Chief Executive via the vote of a 1,200-member election committee (a collection of largely old-money shot-callers ranging from property tycoons to legislators to mainland representatives) challenged en masse by the 7,098,800 citizens who will remain on the outside looking in come election day on MAR 25 (as an aside, they’ll finally get to participate in 2017).

 

The widespread discontent with the process is largely being driven by the scandal surrounding one of Beijing’s approved candidates, Henry Tang Ying-yen, who, up until a week ago, was the front-runner to replace the incumbent Donald Tsang. Now, a discovery of his illegally-built, overly-lavish 2,200-sqaure-foot underground luxury chamber has completely cost him his ethos with Hong Kong’s populace.

 

In a recent poll, Tang Ying-yen received only 16% of the popular support vs. 63.9% for former gov’t advisor Leung Chun-ying, another Beijing-approved candidate. Moreover, 77.8% of respondents identified the scandal as having a negative impact on his integrity and the proportion of those who favor his withdrawal for the election increased to 66% from 51.3% last week. Still, Tang vows to proceed on, having already secured a pledge of support from 31.5% of the election committee members – most notably the votes of Li Ka-shing (H.K.’s wealthiest businessman), Thomas Kwok, and Lee Shau Kee, each of whom control one of Hong Kong’s four-largest property development companies.

 

All told, Tang’s confident bullheadedness and big-money support underscores a rift of rising socioeconomic inequality within the territory – a key issue as recently as last year when the Tsang’s gov’t was literally forced to respond to public demonstrations by broadly increasing cash handouts. Should he ultimately win the office, we think it could lead to widespread public discontent with Beijing’s heavy hand in Hong Kong politics, as well as a renewed public vigor against income disparity and wealthy elites. The policy ramifications of such an outcome are many and worthy of an additional note at some point in the future.

 

Are the Ratings Agencies Fearful of Downgrading Japan Further?

Over the past week, both Moody’s and Standard & Poor’s have both come out with public statements affirming Japan’s Aa3/AA- sovereign debt rating. While we don’t look to the ratings agencies to lead our interpretation of a particular sovereign’s credit risk, we have been vocal about their ability to spark a JGB sell-off in recent months – particularly due to their importance in determining capital bank capital requirements under Basel II standards.

 

For example, Japanese banks, which hold ¥4.7T in Japanese government debt on their balance sheets (through DEC ’11), would be on the hook for roughly $75 billion in capital raises should Japan get downgraded to single-A status. As recently as this week, Bank of Japan governor Masaaki Shirakawa said a +100bps increase in benchmark yields would cause a ¥3.5 trillion ($43.2B) loss on bank balance sheets at current holding levels. The estimate, which is up from a figure of ¥200B in OCT, highlights just how difficult it is to wrap one’s head around the implications of a loss of confidence in nearly 1 QUADRILLION yen (and counting) in Japanese government debt.

 

Triangulating Asia - 2

 

For now, Japanese banks – which are the largest holders of JGBs – remain seemingly unfazed by these projections, given that they simply have nowhere else to invest their excess liquidity into (¥165.7T as recently as JAN 31). Additionally, the returns on JGBs (+2.2% in ’11) far exceed what Japanese lenders can garner via traditional spread lending (average net interest margin at the nation’s three largest banks = 100bps). It remains a challenge to pinpoint the timing of when Japanese banks start to favor risk aversion vs. return seeking regarding this particular asset.

 

Triangulating Asia - 3

 

To that point, we’re not sure what exactly will trigger a crisis of confidence in this historically-bulletproof market. One avenue we’ll explore in greater detail on next Friday’s conference call (email our sales team if you don’t have the invite) is increased inflation expectations stemming from A) a dramatic rise in imports costs due to structurally-higher expenditures on crude oil as a result of lost nuclear power generation (+25.2% in 2011); and B) a dramatic uptick in Bank of Japan participation in financing the nation’s debt issuance.

 

It’s among the best-kept secrets in all of Global Macro that Japan, laden with Z.I.R.P. since ’99, has among the highest real interest rates in the developed world, proving a strong inflation-adjusted return for holders of Japanese sovereign debt. An erosion of this tailwind, particularly stemming from a rise in long-term inflation expectations, could force the Japanese state to pay a higher nominal price for capital to fund its largely-fixed operating budget (debt service and social security account for 53.5% of total expenditures in the FY12 budget).

 

Triangulating Asia - 4

 

Triangulating Asia - 5

 

Ironically, its Japanese politicians, including recently-elected Prime Minister Yoshihiko Noda, that are demanding that the BoJ adopt a more bold stance in its efforts to end deflation via increasing its underwriting government debt, among other alternatives. Earlier this month, the BoJ bowed to mounting political pressure by setting an inflation target of +1% “for the time being”. We applaud Shirakawa and his team for resisting calls to adopt a +2-3% target, given that such a level of inflation would likely erode demand for Japanese fixed-income assets to a dramatic extent – especially considering that Japan has averaged -0.2% YoY deflation over the last ten years!

 

Briefly turning our attention back to the ratings agencies, we are a bit puzzled by their decisions to not downgrade Japan, given that each of their criteria for a potential downgrade(s) have been or look to be met at some point over the long-term TAIL. For now, they remain comfortable with the status quo of slow-moving train wreck. Time will tell if the markets, again, force them to move just as they did in the U.S. MBS market and the European sovereign debt market. Getting front-run by three financial crises in five years would go a long way towards eroding what little credibility these organizations have left.

 

We’ll discuss their criteria in more detail on our conference call next Friday. For now, enjoy the weekend with your respective families.

 

Fundamental Price Data

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

  • EQUITIES:
    • Median: +0.8%
    • High: Vietnam +5%
    • Low: Indonesia -2.1%
    • Callout: Indonesia -2.5% over the last month vs. a regional median of +5.2%
  • FX (vs. USD):
    • Median: flat wk/wk
    • High: Thai baht +1.6%
    • Low: Japanese yen -1.8%
    • Callout: The Japanese yen is down -5.9% in the month of FEB ahead of a massive sovereign debt maturity spike in MAR ($705 billion needs to be rolled over)!
  • S/T SOVEREIGN DEBT (2YR YIELD):
    • High: Philippines +53bps
    • Low: Vietnam -16bps
    • Callout: China’s 1yr sovereign yield +35bps YTD as rising inflation expectations erode easing speculation
  • L/T SOVEREIGN DEBT (10YR YIELD):
    • High: Indonesia +21bps
    • Low: Vietnam -5bps
    • Callout: Australia +43bps YTD vs. India -36bps
  • SOVEREIGN YIELD SPREADS (10s-2s):
    • High: Thailand +14bps
    • Low: Philippines -48bps
    • Callout: China (10s-1s) spread has narrowed -25bps YTD
  • 5YR CDS:
    • Median: -1.5%
    • High: Australia +2.4% ahead of Monday’s referendum
    • Low: Malaysia -4.8%
    • Callout: Japan +8.1% over the last six months vs. a regional media of -8%
  • 1YR O/S INTEREST RATE SWAPS:
    • High: Indonesia +45bps
    • Low: Vietnam -30bps
    • Callout: China -7bps wk/wk
  • O/N INTERBANK RATES:
    • High: China +15bps
    • Low: Vietnam -67bps
    • Callout: India -50bps wk/wk
  • CORRELATION RISK: Asia, the world’s largest crude oil consumer, needs a  strong dollar to shield its economic growth from rising energy prices. The MSCI AC Asia Equity Index has developed an immediate-term -6% correlation to the U.S. Dollar Index, vs. -70% over the LTM. The receding of this once-high inverse correlation is a leading indicator for a positive correlation – which is exactly what we began to see around this time last year. The buck can only be burned to a point before it’s really, really bad for global growth.

Darius Dale

Senior Analyst


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