“The human mind does not deal well with non-events.”
When you are me, analytical life can get lonely. Every single major Growth Slowing call I have made since 2007 has been met with doubt, denial, and disdain. But growth still slowed.
Whether I’m out for a run, on a plane, or in the shower, I’m constantly trying to re-think better ways to communicate our process. What is it that we do? How do we model our assumptions? What are the risk management signals?
Ultimately, I’ve come to the conclusion that I can always do better, but I can’t make it any more simple than stating it each and every day before it occurs. I’ll call this Risk Managing Non-Events.
Back to the Global Macro Grind…
What is a Non-Event? You can ask Dan Kahneman for his definition – mine is that Non-Events are constantly occurring and tipping the slopes and probabilities of events becoming obvious.
Got tipping points? Consider the following Growth Slowing Signals in our globally interconnected Macro Model from the last month:
- Basic Materials Stocks (XLB) stopped going up on February 3rd, 2011 (now down -3.1% from YTD top)
- India’s Stock Market (INP) stopped going up on February 21st, 2011 (now down -6.8% from YTD top)
- Small Cap Stocks (IWM) stopped going up on February 23rd, 2011 (now down -3.1% from YTD top)
Those are obviously just leading indicators from big, liquid, stock markets. All the while, Copper, 10-year US Treasury yields, and Global Yield Spreads continued to flag what they started flagging immediately after the Ben Bernanke’s January 25thPolicy To Inflate to 2014 – Growth Expectations started falling as Inflation Expectations started spiking.
Overlay immediate-term leading indicators (real-time market prices, yields, and spreads) with our long-term Fundamental Research View that:
A) Debt (when crossing 90% of GDP) structurally impairs long-term growth (Reinhart & Rogoff data supports this view)
B) Inflation, from a certain time/price level, slows real (inflation adjusted) growth
All the while, have a Keynesian economist promise you that they can centrally plan just the right amount of “inflation” for just the right amount of employment and economic growth.
And you have yourself an “event” (versus consensus expectations) in the making…
Non-events are the proverbial grains of sand falling on the pyramid of risk that is our globally interconnected Macro Model. One by one, price by price, data point by data point, they fall onto the sand-pile of expectations.
Then, one day… week… or month, they become “events.”
If the deep simplicity of Chaos Theory is this obvious, how do we almighty chosen ones from the Ivy League routinely get this wrong?
“A general limitation of the human mind is its imperfect ability to reconstruct past states of knowledge, or beliefs, that have changed.” –Daniel Kahneman (Thinking, Fast and Slow – page 202)
That’s why we have to humble ourselves and Embrace Uncertainty. The idea that going to Yale immunizes my mind from being human under pressure is as ridiculous as Bernanke not seeing inflation at $120 oil.
There may have been a day in this business, without internet connections or Twitter, that you could have legitimately had an information edge on a company and its implied valuation. A lot has changed since then. Today, my 4-year old son can pull up cash flow multiples with two clicks on Yahoo finance (provided that I give him the ticker!).
Risk Managing Non-Events is the next frontier of finance. Yes, it’s a lot harder to do than proclaiming our mystery of faith on the “right” earnings “multiple” for the SP500. That’s why we do it every morning. Risk never sleeps.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1, $121.12-123.98, $79.03-79.74, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Yesterday's press release confirms that PVH is indeed taking back the license for the ck Calvin Klein European apparel and accessories retail business from Warnaco in 2013 as originally announced last week. This may appear insignificant relative to the overall size of these businesses, but that’s not the case when you run through the numbers. In fact, this deal could provide a nice kicker to PVH earnings growth 3-4 years out to the tune of $8 in value added to PVH and $1 lost for WRC, which we don’t think the Street is focused on. As a result, this move is bullish for PVH and bearish for WRC over the near-term, though over the long-term we think this move is bullish for both.
This scenario is hardly new in retail, only the names and faces are different. WRC misses its minimum growth targets on the CK bridge line and underperforms. Then it loses the business because the licensee feels they can do better. Think JNY losing Lauren, Ralph, Polo Jeans and LIZ losing DKNY. Management teams always talk about the 'safety' of certain licensing agreements, but when a licensee is under pressure it will always invest in brands it owns, not licenses. We’ve seen this movie before. But here are some things to consider in this case:
- For starters, the CK ‘bridge’ brand accounts for ~$100mm in revenues at breakeven for WRC including what is approximately a 7% royalty. That equates to ~4% of WRC’s total sales for 2011, which the company expects to largely replace with its CK Jeans business at higher margin. Take a look at the table below to see how this line stacks up to other CK licenses WRC operates for reference.
- Assuming a normalized profitability in the LSD range, the loss of this license could be sized at roughly $1 in value (which presumably is already in the stock).
- The bottom-line is that this deal won’t have much of an impact on WRC losing a breakeven business and if anything will be net positive as the company removes the distraction and focuses on investing in its own content.
- In addition to filling these stores with CK Jeans, WRC is likely to get more aggressive in growing its CK underwear line at retail, product it owns and doesn’t license and which accounts for ~50% of EBIT.
- At the aforementioned royalty rate of 7%, this business currently generates roughly $7mm in EBIT for PVH equating to ~$0.07 in EPS or 1% of PVH’s earnings. Bringing the line in-house should nearly double that out of the gate.
- PVH highlights the opportunity to grow this CK line to a $500mm business over the next 5-7 years, but it’s important to note that we shouldn’t think of this growth in a straight line. Typically, when licenses are bought back in, the business are grown far more aggressively in the early years. Recall when RL brought the Lauren and Ralph licenses back in from JNY back in 2003.
- So, let’s assume that when PVH brings this business back in-house in 2013 that it can get it close to $300mm by 2015 at 20% margin. That would equate to $0.60 in EPS. If we assume 25% margins, more in-line to the rest of PVH’s CK brand profitability, we’re looking at $0.75 in incremental EPS. With EPS over $9 in earnings power in 2015, that would take the CK ‘bridge’ line from 1% to accounting for nearly 8-10% of PVH’s earnings 3-4 years out, or about $10 in stock value at a 13x multiple. That equates to ~$8 in present value. A meaningful contribution to an $85 stock.we'd argue that this is probably not on the stock.
Like its doing with its Hilfiger licenses, if PVH decides to get more aggressive in taking control over its own content and driving growth at its CK business, it will have investors thinking about $10 in earnings power 4-5 years out providing further upside. Investors that missed the strategic importance and magnitude of this when RL first started buying in its licenses are likely to consider this as PVH embarks down this same path.
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The Hedgeye Election Indicator (HEI), a proprietary metric that uses real-time market and economic data to determine the probability of President Obama’s reelection chances, debuts today with a 116.9 reading, which equates to 58.4% chance that President Obama would win the US Presidential election if it were held today.
Hedgeye Risk Management, one of the leading independents research firms on Wall Street, developed the HEI over the past year to understand the relationship between key market and economic data and the US Presidential Election. We will release the HEI every Tuesday at 7 a.m. ET, beginning today all the way until election day Tuesday November 6.
After rigorous back testing, Hedgeye has determined that there are a short list of real time market-based indicators, for example, like the relative strength of the US Dollar versus a basket of selected international currencies, that move ahead of President Obama’s position in conventional polls or other measures of sentiment. Based on our analysis, market prices will adjust in real-time ahead of economic conditions, which will ultimately shape voters’ perception of the Obama Presidency, the Republican candidates and influence the probability of an Obama reelection.
The model assumes that the Presidential election would be held today against any Republican candidate. Our model is indifferent toward who the Republican candidate is as the sentiment for Obama and for any Republican opponent is imputed in the market prices that determine the HEI. The Hedgeye Election Indicator is based on a scale of 0 – 200, with 100 equating to a 50% probability that President Obama would win or lose if the election were held today.
Topics discussed this week:
- China’s 2012 Policy Targets Bode Incrementally Poorly for Global Growth
- Will IN-flation Become a Problem In Japan?
- Policy Ping-Pong Sets Indian Equities Up For A Sustainable Breakout Or Breakdown
China’s 2012 Policy Targets Bode Incrementally Poorly for Global Growth
In a presentation to the National People’s Congress today, China’s Premier Wen Jiabao unveiled a bevy of key targets regarding China’s intermediate-term growth/inflation/policy dynamics. To summarize them briefly (per the National Development and Reform Commission), China will target:
- Real GDP growth of +7.5% YoY in 2012, down from +8% in 2011 – a target that had been in place since 2005
- CPI of +4% YoY in 2012, unchanged from 2011
- M2 Money Supply growth of +14% in 2012, down from an actual growth rate of +14.7% in 2011
- Fixed Asset Investment growth of +16% in 2012, down from an actual growth rate of +25% in 2011
- A Central Government Deficit of 1.5% of GDP, down from a target of 2% in 2011
- Budget composition:
- Expenditures +14.1% YoY to CNY12.43 trillion
- Social Security and Employment Spending +22% YoY
- Education Spending +16% YoY
- General Housing-related Expenditures +23% YoY
- Spending on Low-Income Housing and Housing Subsides +25% YoY
- Agriculture, Forestry and Water Conservation Expenditures +14.8% YoY
- Expenditures +14.1% YoY to CNY12.43 trillion
- Tax Receipts (ex a CNY270 billion transfer from the Stabilization Fund) +9.5% YoY to CNY11.63 trillion
- Income Tax Receipts -6.4% YoY (the number of tax-exempt citizens increased by ~60 million after the gov’t raised the minimum monthly income threshold)
- Local Government Land Sale Receipts -18.6% YoY
- Local governments will continue see fiscal pressure from declining land sale values and volumes, but the PBOC’s recent decision to relax lending curbs to local government financing vehicles will offset/delay a potential liquidity crunch facing the CNY10.7 trillion of debt outstanding (70% due by 2015).
The first thing we’d point out to investors is that China’s economic targets have been interpreted rather loosely by the real economy in the past. For example, Chinese GDP growth has exceeded the State Council’s +8% target every year since 2005 by an average of 294bps. Moreover, Chinese CPI came in at 5.42% last year, a full 142bps above the target.
That said, however, China’s setup as a State-directed economy and it’s historically air-tight model of State Capitalism do lend credence to our long-held belief that it’s very important to take Chinese bureaucrats’ words at face value – much more so than most other sovereign entities. In light of this, we think it’s very important to focus on what Wen’s speech entails for China’s long-term economic outlook.
During his prepared remarks, Wen stated: “[China] needs to shift to a more sustainable and efficient economic model and achieve higher-quality development over a longer period of time.” We interpret this comment as supportive of our view that the long-term outlook for Chinese economic growth is structurally lower. For more details regarding the fundamental reasoning behind this view, please refer to our OCT 18 note titled: “Putting China Into Perspective”.
The Shanghai Composite Index’s quantitative setup (demonstrably broken from a TAIL perspective) suggests to us that our view is not yet consensus on the buy side.
Additionally, what bodes poorly (on the margin vs. expectations) for the intermediate-term slope of Chinese economic growth is the continued emphasis on slowing asset price appreciation in China’s property market. Given that fixed asset investment is slightly less than half of Chinese GDP, the explicit target for FAI – which calls for slowing – and the implicit target that is maintaining real estate curbs combine to suggest a slower, but more sustainable outlook for Chinese GDP growth in 2012.
All told, we think China’s economic policy will continue to force investors to lower their expectations for Chinese real GDP growth over the long-term TAIL. Equally as important, the composition of Chinese growth is likely to [finally] shift, on the margin, towards more household consumption and less FAI, manufacturing and exports. This is likely to slow Chinese demand for industrial commodities and energy stockpiles over the long term.
Will IN-flation Become a Problem In Japan?
Japan’s benchmark equity index, the Nikkei 225, is up +10.2% since the start of FEB (vs. a regional median gain of only +4.3%) on the strength of an earnings tailwind that is yen depreciation (USD/JPY down -6.4% over that duration vs. a regional median gain of +0.1%). For now, at least, Japanese equities are thoroughly enjoying their own version of the Inflation Trade.
We covered our EWJ short on FEB 27 for a -2.87% loss in our Virtual Portfolio, bowing to the short-term upside risk that is rising inflation expectations within Japan that have accelerated on the margin alongside the yen’s fairly rapid decline – especially given the FX translation tailwind afforded to the 48.2% of the Nikkei 225 Index that is Japanese Industrial and Tech stocks.
From a longer-term perspective, what will rising inflation expectations mean to Japan’s low-yielding (nominal) sovereign debt market? As mentioned on our conference call last Friday, we think the JGB market will eventually become hostage to a marked acceleration in long-term inflation expectations. While the timing of this is hard to pinpoint at the current juncture, the latest developments suggest Japanese policymakers are likely to continue playing right into our view.
Of divine coincidence, Japan’s 5yr Breakeven Rate turned positive (+1bps) for the first time ever on the day of our conference call (securities in existence since JUN ’09) and closed at the same level today.
Again, we think the onset of long-term expectations for IN-flation (rather than DE-flation) in Japan bode poorly for the long end of the JGB curve. Again, while the timing is certainly hard to gauge at the current juncture, we’d be remiss not to signal this happening in real time, on the margin, within Japan’s equity and currency markets.
Going back to our point regarding Japanese policymakers playing right into our view, Prime Minister Yoshihiko Noda, whose approval rating hit an all-time low of 26.4% in FEB, said over the weekend that he remains optimistic that the DPJ and LDP can come to an understanding over his party’s proposal to hike the nation’s 5% VAT – a bill opposed by 40% of the public and which caused 9 former-DPJ lawmakers to defect from the ruling party in opposition.
Contrary to Noda’s [apparently groundless] optimism, LDP head Sadakazu Tanigaki reiterated his party’s long-held demand for Noda to call a snap election on top of meaningful spending cuts in exchange for acquiescing to the DPJ’s proposal. It remains to be seen whether Noda is willing to risk his party’s control over the lower house of the Diet and his own short-lived premiership (185 days) in exchange for pushing through a much-needed piece of austerity legislation. In doing so, Noda would risk becoming Japan’s seventh prime minister in just over five years!
Net-net, should the VAT not be raised according to Noda’s timeline, we expect the market to expect the Bank of Japan to be called upon to finance increasing shares of Japan’s sovereign debt issuance – particularly given their newfound +1% inflation target. Additionally, the DPJ is due to appoint two members to the BoJ’s nine-member board in APR ’12 and current governor Masaaki Shirakawa’s term is due in APR ’13. All three appointees are expected by us to be openly committed to increasing (to +2-3%) and achieving the bank’s inflation target by any means necessary – a view supported by accelerating political pressure emanating from lawmakers upon the central bank.
If this path is pursued, at risk is a loss of fiscal and monetary policy discipline that may end up stoking just what Japanese bureaucrats seek so desperately – inflation. Of course, Japanese policymakers will hold the view that they can appropriately dial back the necessary levers when the time comes, but we expect the JGB market to take the other side of this politicized view (i.e. “of course politicians will tell the market that they have all the answers – it’s their job!”).
Refer to slides 84-94 from our recent presentation on Japan for more details.
Policy Ping-Pong Sets Indian Equities Up For A Sustainable Breakout Or Breakdown
Indian equities (benchmark SENSEX Index), which have backed off hard from when/where we said they would, are now stuck between the proverbial “rock and a hard place”. The setup makes for a proactively predictable trading range and allows us to appropriately handicap the scenario analyses that are most likely to take place over the intermediate-term TREND.
Quickly delving into the past, Indian assets are generally outperforming the region on a YTD basis on the strength of capital flows that are largely predicated on the expectation that monetary policy will be incrementally eased to support growth:
- SENSEX: +12.3%
- INR/USD: +6.6%
- 10yr Sovereign Yield: -35bps
- Foreign Equity Investment: +7.4%
- Foreign Debt Investment: +20.2%
We’ve actually seen those foreign portfolio inflows accelerate in recent weeks despite what we feel are ominous signals from India’s interest rate and currency markets. To be specific, 1yr O/S Interest Rate Swaps and 1yr Sovereign Yields continue to price in incrementally less monetary easing (a trend in place for much of the year-to-date) and the rupee is now underperforming both food and energy prices on a 1mo basis (a leading indicator for sequential inflation) to the tune of -367bps and -1,073bps, respectively.
Looking forward from a TREND perspective, we expect the Reserve Bank of India to incrementally ease monetary policy at its MAR 15 meeting to help alleviate a liquidity shortage within the banking system. In FEB, Indian financial institutions borrowed an average of 1.4 trillion rupees from the RBI per day – the most since MAY ’10. And as recently as last Thursday, they borrowed a record 1.92 trillion rupees – more than three times the suggested maximum of 600 billion – from the central bank to circumvent a lack of funding. Per RBI Deputy Governor Subir Gokarn: “The RBI does not want the liquidity shortage to persist; [thus, we are] looking at ways to mitigate pressure on system.”
The liquidity shortage has served to tighten domestic monetary conditions, with O/N Interbank Rates continuing to trend higher in the YTD and commercial credit growth slowing incrementally. Interestingly, the dramatic slowing of India’s benchmark inflation readings to +6.6% in JAN has served to push India’s real sovereign yields to 2yr-plus highs. It is unlikely that the RBI will sit on its hands in the face of these hawkish trends in domestic monetary conditions.
With India’s Real GDP growth slowing to a near three-year low of +6.1% YoY in 4Q11 and both Manufacturing and Services PMI readings ticking down in FEB (to 56.6 and 56.5, respectively), we think the pressure is incrementally on the RBI to lower interest rates and/or RRRs to support growth at its upcoming meeting (MAR 15).
For now, fiscal policy remains a headwind to Indian growth from an inflation perspective, and the RBI has expressed continued reluctance in easing monetary policy with such loose fiscal policy providing domestic inflationary pressures. Recall this was an issue that we correctly positioned clients ahead of via our FEB ’11 note titled: “India: Missing Where It Matters Most”.
From a near-term catalyst perspective, the budget for the upcoming fiscal year (staring APR 1) will be unveiled on MAR 16. Should the government adopt realistic economic growth/revenue targets and truly commit itself to reigning in public spending and narrowing the budget deficit, we expect to see market expectations of monetary easing accelerate, given that this remains the RBI’s stated largest headwind to further easing.
If, however, we see continued fiscal laxity, a TRADE and TREND breakdown on the SENSEX becomes an increasingly probable outcome – especially in light of the current international inflationary pressures we touched on above. Moreover, the ruling Congress party’s lackluster performance in the omnipotent Uttar Pradesh election (projected to win 38-55 of 403 seats per the latest polls) is a leading indicator for more partisan gridlock and continued lower-highs in the nation’s Investment growth.
Fundamental Price Data
All % moves week-over-week unless otherwise specified.
- Median: +1.3%
- High: Vietnam +6.7%
- Low: India -0.5%
- Callout: Vietnam +30.1% YTD on “Viet-TARP” speculation vs. a regional median of +12.3%
- FX (vs. USD):
- Median: -0.1%
- High: Korean won +0.8%
- Low: Japanese yen -1%
- Callout: Japanese yen -5.6% YTD vs. a regional median of +2.7%
- S/T SOVEREIGN DEBT (2YR YIELD):
- High: India +11bps
- Low: Vietnam -28bps
- Callout: Vietnam -94bps YTD
- L/T SOVEREIGN DEBT (10YR YIELD):
- High: Philippines +9bps
- Low: Vietnam -59bps
- Callout: Australia +37bps YTD
- SOVEREIGN YIELD SPREADS (10s-2s):
- High: Philippines +13bps
- Low: Vietnam -31bps
- Callout: India (10s-1s) -12bps wk/wk
- 5YR CDS:
- Median: -5%
- High: China flat wk/wk
- Low: Japan -6.5%
- Callout: Japan +7% over the last six months vs. a regional median of -8.2%
- 1YR O/S INTEREST RATE SWAPS:
- High: Korea +5bps
- Low: Indonesia -45bps
- Callout: India +40bps YTD
- O/N INTERBANK RATES:
- High: Australia +1bps
- Low: China -57bps
- Callout: India -25bps wk/wk
- CORRELATION RISK: Indian equity investors generally like our Strong Dollar = Deflating of the Inflation view, given the positive correlation of the SENSEX to the DXY on a 15-day, 90-day, 120-day, and 3yr duration (+0.25, +0.32, +0.26, and +0.31, respectively).
No current positions in Europe
Final February Services PMI figures for select Eurozone countries were released today. As the table and chart below show, there was a notable contraction in the month-over-month figures. In our work we’ve warned about recent unfounded optimism in Europe.
First, our most immediate concern is that the Private Sector Involvement (PSI) deal to haircut Greek debt holders does not receive sufficient participation (especially since the ECB was exempt from taking a loss on about €50 billion of Greek bonds it exchanged for new, longer maturity securities), which will invalidate the debt reduction schedules agreed upon by Troika, the European commission, and individual country parliaments, which will leave the market back to square one on the Greek mess.
Second, not only may we see additional downside revisions to sovereign debt and deficit levels (last week Spain announced that its 2011 budget deficit reached 8.5% of GDP versus the original target of 6.0%), but due to austerity there may well be a longer tail of slow growth than the Street is forecasting.
Finally, we keep front and center that Eurocrats will fight for their own job security in supporting the broken union of uneven countries at all costs.
Keith has selectively traded around European positions in the Hedgeye Virtual Portfolio based on our price sensitive macro model, however we continue to reiterate that we largely do not want to be involved in the risk imbedded in indecision of the next Eurocrat action.
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