Weekly European Monitor: Chatter

No Current Positions in Europe


Asset Class Performance:

  • Equities:  The EuroStoxx50 closed down -1.9% week-over-week vs -3.2% last week. Bottom performers: Russia (MICEX) -4.6%; Finland -3.5%; Italy -3.5%; Sweden -3.5%; France -3.3%. Top performers:  Greece 1.0%; Portugal 70bps; Slovakia 10bps.  
  • FX:  The EUR/USD is up +0.52% week-over-week.  W/W Divergences: SEK/EUR +1.26%, NOK/EUR +0.59%, GBP/EUR +0.29%, CHF/EUR +0.09%; RUB/EUR -0.77%, CZK/EUR -0.75%, ISK/EUR -0.74%.
  • Fixed Income:  Greek 10YR yields gained +100 bps to 21.04% week-over-week after a rise of +192bps last week.  10YR Portuguese yields dropped the most, -126bps to 11.40%, while most other countries we track were broadly flat.

Weekly European Monitor: Chatter - 11. yields



Call Outs:

Germany - Chancellor Merkel’s party won a regional ballot in the western state of Saarland, the first electoral test of her crisis-fighting policy since she persuaded European leaders into a pact to limit budget deficits. [Federal elections due in 2013].


Greece - In comments to privately-owned television station Antenna, Greek Government spokesman Pantelis Kapsis confirmed three possible dates on which the country is widely expected to hold national elections: April 29, May 6, or May 13 ("It will be one of these three Sundays," he said).


Ireland - The Government said a referendum on the EU’s new fiscal treaty will be held on May 31. Formally starting a campaign to persuade voters to back the compact or risk exclusion from access to future bailout funds.


UK - The economy shrinks more than previously estimated (Q4 GDP Q/Q -0.3% vs -0.2 estimate).


UK - Is in talks to sell as much as a third of its RBS stake to Abu Dhabi.


In Review:

Book ends. The week started with increased fears that Spain is the next domino to fall after Italy’s PM Mario Monti responded in a Q&A session at a conference that “it doesn’t take much to recreate risks of contagion.” While he praised Spain’s efforts to loosen work regulations, he advised Spain to focus on cutting the national budget, saying it “hasn’t paid enough attention to its public accounts.” Meanwhile, the market waited around for today’s decision (and seemingly liked it as European equities shot up 1%), on the structure of a combined ESM and EFSF bailout facilities and Spanish PM Rajoy’s 2012 Budget announcement.


The unnerving part remains days like today when equities (and EUR/USD) are rising despite underlying imbalances that are far from corrected, understood, or revealing an improving trend. After all, there is to be no increase in the combined size of the bailout fund, ESM (€500B) + EFSF (€240B existing) + €50-60B of addition loans, and it’s laughable to think that Spain will reach its deficit target of 5.3% of GDP this year versus 8.5%, along with the issue of Portugal requiring (another) bailout. Are we really out of the clear on the sovereign and banking sides because of two rounds of LTRO?


In between the events we continue to just hear a lot of “chatter” (including Monti back pedaling his statement on Spain this week) from leading Eurocrats and commentators that demonstrated: 1. How little Eurocrats understand about the severity of the region’s sovereign imbalances, 2.) the extent to which Eurocrats are saving face for their own job security, 3.) how uncertain Eurocrats are on future policy measures to shore up fiscal risks, reset expectations, sustain a union, and 4.) a combination of all of the above.


Here are some notable comments this week:

  • Draghi sees signs of stabilization in economic activity and bank lending
  • Draghi says Ireland and Portugal programs are on track, Spain showing progress “to some extent”
  • Merkel says that it would be a huge political mistake if Greece was allowed to leave the Euro
  • IMF sees improvements in global outlook but severe downside risks remain (Deputy MD Shinoha)
  • Mario Monti says Eurozone crisis is almost over, Italy has helped stop crisis from getting worse
    • Risk of a Spanish debt restructuring is higher now than it's been since the beginning of the crisis, said Citigroup Inc. chief economist William Buiter

What comes out in the wash is an unwillingness to turn the dial on years of fiscal excess. This “New Reality”, or “New Normal”, as PIMCO’s Gross has called it, is not fun, sexy, or easy. It means real pain for real people (see strikes and riots on the streets in Spain this week), and there’s no alternative?  Spending your way out of a crisis doesn’t work. After all, it was this spending over the last decade that got these nations into the fiscal gutter. Sky-high unemployment rates across the PIIGS nations won’t recede over night. Countries like Portugal and Greece, for example, must figure out ways to increase competitiveness and grow their economies. As an example, over the last 10 years, Portugal’s GDP has averaged an annual -0.5%!  What’s clear is that if the Eurozone project is going to work in the long run, we’re likely to see it at the hand of subsidization of the weak countries by the strong, and an acceptance of The New Normal standard of living and consuming (or at least uneven wealth across countries). However, a persistent headwind for Eurocrats will be managing this union around the underlying challenges of one common currency and one monetary policy, which we think is inherently flawed. 


From the “Data Dump” below we want to point out that March fundamentals continue to be challenged. The five Eurozone confidence surveys all ticked down month-over-month, following on weak March Services and Manufacturing PMI numbers for the Eurozone, an unemployment rate of 10.7%, and CPI holding steady above the 2% target.



CDS Risk Monitor:


CDS fell -143bps to 1,074bps in Portugal on a w/w basis after a -94bps move last week, to lead decliners. Ireland fell -47bps to 570bps.  Like sovereign yields, we did not see large moves on a week-over-week basis for the countries we track.  Italy led gainers at +13bps to 397bps. 


Weekly European Monitor: Chatter - 11. cds   a


Weekly European Monitor: Chatter - 11. cds   b


Data Dump:

Eurozone Business Climate -0.30 MAR (exp. -0.16) vs -0.16 FEB

Eurozone Consumer Confidence -19.1 MAR (exp. -19.0) vs -19 FEB

Eurozone Economic Confidence 94.4 MAR (exp. 94.5) vs 94.5 FEB

Eurozone Industrial Confidence -7.2 MAR (exp. -5.8) vs -5.7 FEB

Eurozone Services Confidence -0.3 MAR (exp. -0.8) vs -0.9 FEB

Eurozone M3 2.8% FEB Y/Y (exp. 2.4%) vs 2.5% JAN   [3M AVG = 2.3% FEB Y/Y vs 2.0% JAN]

Eurozone CPI Estimate 2.6% MAR Y/Y (exp. 2.5%) vs 2.7% FEB


Germany GfK Consumer Confidence 5.9 APR (exp. 6) vs 6 MAR

Germany IFO Business Climate 109.8 MAR (exp. 109.6) vs 109.7

Germany IFO Current Assessment 117.4 MAR (exp. 117) vs 117.4 FEB

Germany IFO Expectations 102.7 MAR (exp. 102.6) vs 102.4 FEB

Germany Import Price Index 1% FEB M/M (exp. 0.9%) vs 1.3% JAN   

Germany CPI 2.3% MAR Prelim Y/Y (exp. 2.3%) vs 2.5% FEB   

Germany Unemployment Rate 6.7% MAR (20yr low) (exp. 6.8%) vs 6.8% FEB

Germany Unemployment Chg -18K MAR (to 2.84 million) vs -3K FEB

Germany Retail Sales 1.7% FEB Y/Y (exp. 0.1%) vs 1.7% JAN   [-1.1% FEB M/M (exp 1.1%) vs -1.2%]


France Consumer Confidence Indicator 87 MAR (exp. 82) vs 82 FEB

France Q4 GDP Final 0.2% Q/Q = UNCH vs prev. est   [1.3% Y/Y = down 10bps vs prev. est.]

France Producer Prices 4.3% FEB Y/Y (exp. 4%) vs 4.3% JAN  


Italy Consumer Confidence 96.8 MAR (exp. 93.5) vs 94.4 FEB

Italy PPI 3.2% FEB Y/Y (exp. 3.3%) vs 3.5% JAN   [0.4% FEB M/M vs 0.8%]

Italy CPI 3.8% MAR Prelim Y/Y (exp. 3.3%) vs 3.4% FEB

Italy Hourly Wages 1.4% FEB Y/Y vs 1.4% JAN


UK Q4 GDP Final -0.3% Q/Q = down -10bps vs prev. est.  

UK Total Business Investment 1.6% in Q4 Y/Y vs 6.6% in Q3

UK Nationwide House Prices -1.0% MAR M/M (exp. 0.2%) vs 0.4% FEB   [-0.9% MAR Y/Y (inline) vs 0.9% FEB]

UK M4 Money Supply -3.4% FEB Y/Y vs -1.8% JAN

UK Mortgage Approvals 49K FEB (exp. 57.2K) vs 57.9K


Spain Housing Permits -25% JAN Y/Y vs -27.9% DEC

Spain Mortgages on Houses -41.3% JAN Y/Y vs -37.2% DEC

Spain CPI 1.8% MAR Prelim. Y/Y (inline) vs 1.9% FEB

Spain Retail Sales -3.4% FEB Y/Y vs -4.6% JAN


Switzerland UBS Consumption Indicator 0.87 FEB vs 0.93 JAN

Switzerland KOF Swiss Leading Indicator 0.08 MAR vs -0.11 FEB


Sweden Retail Sales 3.4% FEB Y/Y (exp. 1.6%) vs 1.6% JAN

Sweden Household Lending 5% FEB Y/Y (exp. 5%) vs 5.1% JAN

Sweden PPI 0.5% FEB Y/Y (exp. 0.3%) vs 0.1% JAN

Sweden Consumer Confidence 0 MAR (exp. -2.1) vs -3.2 FEB

Sweden Manufacturing Confidence 1 MAR (exp. -11%) vs -13 FEB

Sweden Economic Tendency Survey 101.8 MAR (exp. 94) vs 93.4 FEB


Ireland Property Prices M/M -2.2% FEB vs -1.9% JAN   [-17.8% FEB Y/Y vs -17.4% JAN]

Norway Unemployment Rate 2.6% MAR vs 2.7% FEB

Finland Business Confidence -4 MAR (exp. -2) vs -2 FEB

Finland Consumer Confidence 8 MAR (exp. 10) vs 8.3 FEB

Belgium CPI 3.37% MAR Y/Y vs 3.66% FEB


Portugal Consumer Confidence -54.5 MAR vs -55.8 FEB

Portugal Economic Climate Indicator -4.8 MAR vs -4.9 FEB

Portugal Industrial Production -6,8% FEB Y/Y vs -5.4% JAN

Portugal Retail Sales -8.9% FEB Y/Y vs -7.8% JAN


Hungary Unemployment Rate 11.6% FEB vs 11.1% JAN

Slovakia Consumer Confidence -32.3 MAR vs -32.5 FEB

Slovakia Industrial Confidence 3 MAR vs -1.3 FEB

Lithuania Consumer Confidence -21 MAR vs -23 FEB


Interest Rate Decisions:

(3/27) Turkey Benchmark Repo Rate UNCH at 5.75%

(3/27) Hungary Base Rate UNCH at 7.00%

(3/29) Romania Interest Rate CUT 25bps to 5.25%

(3/29) Czech Repo Rate UNCH at 0.75%



The European Week Ahead:

Friday/Saturday: Eurozone Financial Ministers and Central Bankers will meet in Copenhagen to discuss strengthening the region's firewall


Sunday: Mar. UK Lloyds Business Barometer, Hometrack Housing Survey


Monday: Mar. Eurozone, Germany, and France PMI Manufacturing - Final; Feb. Eurozone Unemployment Rate; Mar. UK, Italy, and Greece PMI Manufacturing; 4Q UK BoE Housing Equity Withdrawal; 4Q Italy Unemployment Rate, Budget Balance; Feb. Italy Unemployment Rate - Preliminary       


Tuesday: Feb. Eurozone PPI; Mar. UK PMI Construction, BRC Shop Price Index; Mar. Spain Unemployment MoM


Wednesday: ECB Policy Meeting/Announces Interest Rates; Mar. Eurozone PMI Composite and Services - Final; Feb. Eurozone Retail Sales; Mar. Germany and France PMI Services - Final; Feb. Germany Factory Orders; Mar. UK, Italy, and Spain PMI Services; Mar. UK Official Reserves; 4Q Italy Deficit to GDP


Thursday: Feb. Germany Industrial Production; BoE Announces Rates; Apr. UK BoE Asset Purchase Target; Mar. UK NIESR GDP Estimate; Feb. UK Industrial and Manufacturing Production


Friday: Feb. France Central Government Balance, Trade Balance



Extended Calendar Call-Outs:

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


29 April, 6 or, 13 May:  Potential 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

FCX: Shorting Global Growth

This morning Keith added a short position in Freeport-McMoRan (FCX) in the Hedgeye Virtual Portfolio at $37.54.


We like FCX on the short side right now because it plays off two of our key macro calls – Global Growth Slowing and Bullish US Dollar.


FCX is the world’s second-largest copper miner.  Every $0.10/lb change in the price of copper equates to +/- $380MM in annual EBITDA for FCX (on a base of $8.9B in annual EBITDA).  We think that demand for copper, as well its price, will decline alongside the slowdown in global growth.  On our quantitative model, copper is broken from an immediate-term TRADE perspective with resistance at $3.85/lb.  Shares of FCX and the spot price of copper have between a +0.50 and +0.65 correlation on every duration between three months and three years.


While FCX is the beneficiary of a stronger USD on its income statement due to foreign currency translation, a break-out in the USD is a net negative for FCX, as the prices of copper and gold are strongly inversely correlated to the dollar.  Over the past year, copper and gold have had inverse correlations with the USD of -0.70 and 0-.79, respectively.


The macro back drop is negative, and FCX’s 2012 fundamentals do not look better.  Contrary to popular opinion, FCX is not “cheap” at 4X EV/2012 consensus EBITDA.  Notwithstanding the fact that consensus EBITDA is wrong if copper prices go down, we project that FCX will put up negative top line growth in 2012 versus +9% in 2011, and gross margins are contracting rapidly, down 2200 bps YoY to 36% in 4Q11.  A super-cyclical like FCX gets a lower multiple when the top line is slowing and margins are contracting (see Charts 1 and 2 below).


FCX: Shorting Global Growth - 1


FCX: Shorting Global Growth - 2


FXC screens well as a short on our sentiment model.  The sell-side is bullish with 21 buys, 4 holds, and 0 sells despite negative revenue and earnings estimates over the last six months (top line revised 9% lower, EPS revised 21% lower).  And with only 2% short interest, there is little risk of this being a consensus idea or the stock squeezing higher.


Per our Macro Team’s quantitative model, FXC is bearish on the TRADE and TREND durations with resistance at $39.68 and $42.04, respectively.


FCX: Shorting Global Growth - FCX


Kevin Kaiser


Digging Deeper Into Japanese Sovereign Debt Risk

Last week, Daryl Jones and I took our team’s 100-page slide deck regarding the risks associated with Japanese sovereign debt on the road to meet with clients in Boston and New York. Per usual, the discussions were both lively and educational for both parties. Specifically, there were a number of thoughtful follow-up questions that we’ve researched further:

  • Is there a historical tipping point for a sovereign interest expense burden as it relates to default and/or financial crises?
  • How large of a risk to Japanese banks are their holdings of JGBs?
  • What are the assumptions the government is making regarding Japan’s fiscal outlook? How do Japan’s fiscal metrics look under various economic scenarios?
  • What’s the composition of Japan’s current account? Can the income balance sustain the current account surplus even in the absence of a reflating trade balance?
  • What’s the risk that the ~95% never sells and how much damage could the ~5% do if they become a heavy seller?
  • What sorts of labor market reforms could Japan undertake to boost economic output and lower the financial burden?
  • What are the best ways to play your thesis?
  • What’s the timing of the VAT hike discussions, given its importance as a catalyst for a ratings downgrade(s)?

Q: Is there a historical tipping point for a sovereign interest expense burden as it relates to default and/or financial crises?

In our search, we found a surprising lack of focus on interest payments in the academic study of sovereign debt crises. In fact, most studies focused primarily on the aggregate debt burden as well as inflation/deflation of consumer and asset prices amid dramatic currency fluctuations.


That said, however, we were able to find a keen study out of Global Financial Data that uses two centuries of data across twelve countries to determine which groups ultimately bear the cost of sovereign debt. Specifically regarding interest expense, the paper read:


“The interest coverage cost is more important to sparking a financial crisis than the debt/GDP ratio… if the interest coverage [i.e. interest expense/GDP] rises above 5%, this can spark a financial crisis if it appears the level will remain above that level and will continue to rise.”


Adopting this framework, we’ve used a combination of OECD and IMF data to plot sovereign interest coverage cost (per GFD’s definition) across time for a handful of key economies. On this metric, Japan is at a safe “2.6%” (data through 2009):


Digging Deeper Into Japanese Sovereign Debt Risk - 1


That said, however, Japan’s interest coverage cost appears to have bottomed out in this range – meaning that despite bombed-out nominal yields, Japan’s interest burden is poised to grow alongside the stock of sovereign debt for the foreseeable future. The following scenario analysis from the Peterson Institute agrees with our conclusion:


Digging Deeper Into Japanese Sovereign Debt Risk - 2


Q: How large of a risk to Japanese banks are their holdings of JGBs?

Japanese banks, which hold roughly 25% of their assets in JGBs and are the largest owners of Japanese sovereign debt, are very much at risk should Japan succumb to our Sovereign Debt Dichotomy thesis. In the slide deck, we’ve focused slides 59-61 on the risk of further sovereign downgrades as it relates to JGBs going from a 0% risk-weighted asset (RWA) to a 20% RWA at the single-A level; a roughly $70-80B capital hole would need to be filled across the banking system.


Digging Deeper Into Japanese Sovereign Debt Risk - 3


Digging Deeper Into Japanese Sovereign Debt Risk - 4


Digging Deeper Into Japanese Sovereign Debt Risk - 5


Looking at their vulnerability from an interest rate risk perspective, a recent BOJ statement claimed that if interest rates backed up +100bps across all maturities, Japanese banks would experience a ¥3.5 trillion (~$43B) loss on their balance sheets. Taking that a step further, a DEC ’11 IMF working paper suggested that the total value of interest rate risk on Japanese bank balance sheets in the aforementioned +100bps scenario corresponds to ~10% of major banks’ tier 1 capital and over 30% of regional banks’ tier one capital:


Digging Deeper Into Japanese Sovereign Debt Risk - 7


Lastly, from a duration perspective, the average maturity of major banks’ JGB holdings has declined from over 3yrs in the early-00’s to roughly 2.5yrs. Regional banks have seen the average maturity of their JGB holdings increase to nearly 4yrs from a trough of ~2.75yrs in FY07. As the chart below highlights, Japanese banks have sought to become increasingly exposed to duration risk amid ever-falling nominal interest rates; the central banker’s dare to chase yield is alive and well in Japan:


Digging Deeper Into Japanese Sovereign Debt Risk - 8


Q: What are the assumptions the government is making regarding Japan’s fiscal outlook? How do Japan’s fiscal metrics look under various economic scenarios?

Per the latest Economic and Fiscal Projections for Medium to Long Term Analysis report out of Japan’s Cabinet Office (AUG ’11), Japan targets mid-to-upper +1% nominal GDP growth on average from FY11 to FY20 in their baseline (“Prudent”) scenario. In their aggressive (“Growth Strategy”) scenario, nominal GDP is expected to average roughly +3% over that same duration.


Both of their growth scenarios appear aggressive to us, given Japan’s trailing 10yr average nominal GDP growth rate of -0.7%, which we use in one of our scenario analyses (along with the 10yr trends in real GDP growth and Japan’s GDP deflator). In the other, we “split-the-difference” between Japan’s trend-line economic statistics and those of the ultra-aggressive Cabinet Office’s “Growth Strategy” scenario. Lastly, in both our scenarios, we generously hold spending flat (relative to their projections), only subtracting out the lost revenues that would accompany lower nominal GDP.


Before we compare our scenario analyses with the Japan’s official outlook(s), below is a list of key assumptions the Cabinet Office makes regarding the long-term outlook for Japanese fiscal and regulatory policy:

  • Assumes a steady state with regards to Japan’s energy situation (no restarting of the nuclear plants from an energy supply perspective; no new energy investment from a demand perspective);
  • Assumes a similar expenditure pattern to the post-quake response to the Great Hanshin-Awaji  Earthquake, extending temporary fiscal research measures for 5yrs in one scenario and 10yrs in the other (to be generous, we run our scenario analyses off their 5yr scenario); and
  • Assumes the consumption tax rate (central and local) will be raised in stages to 10% by FY15 and assumes that +20bps of new expenditure will be added with every +100bps increase in the consumption tax rate.

The tables and charts below highlight the divergence between our view of where Japan’s fiscal metrics are headed over the next four years vs. Japan’s official baseline and aggressive outlooks. Even giving Japan the benefit of the doubt on growth (i.e. looking to our “Split-the-Difference” scenario), Japan’s debt/GDP and deficit/GDP metrics will be +930bps and +130bps higher, respectively, than the Cabinet Office’s “Prudent” growth scenario. Obviously, this spread widens when taking into account Japan’s historic economic performance and contrasting that scenario with the pollyannaish assumptions embedded in their “Growth Strategy” scenario.


Digging Deeper Into Japanese Sovereign Debt Risk - 9


Digging Deeper Into Japanese Sovereign Debt Risk - 10


Digging Deeper Into Japanese Sovereign Debt Risk - 11


Q: What’s the composition of Japan’s current account? Can the income balance sustain the current account surplus even in the absence of a reflating trade balance?

Over the years, as Japan’s persistent current account surpluses have relentlessly buoyed the country’s net foreign assets position. From a capital account perspective, the Japanese private sector has increasingly acquired offshore assets to supplement investment income, as well as to take advantage of cost savings by increasing production abroad. The latter phenomenon has been a boon to Japan’s income balance, as those earnings get repatriated over time.


Digging Deeper Into Japanese Sovereign Debt Risk - 13


In theory, as long as Japan maintains a current account surplus and net foreign assets continue to increase, the country’s income balance will remain in surplus. In light of this, you’d have to see a fairly dramatic trade deficit to north of ¥14-16 trillion to swing Japan’s current account into deficit territory (holding flat recent trends in the income balance). While a rising energy import bill that is predicated on a lower domestic production of nuclear energy going forward (currently, almost all reactors are idle) acts as a governor on Japan’s net exports, it is unlikely that Japan will experience a dramatic-enough loss of productivity and/or a measured-enough increase in consumption to post consistent, elevated trade deficits.


Digging Deeper Into Japanese Sovereign Debt Risk - 14


From a longer-term perspective, however, we borrow the following table from Japan’s Ministry of Finance Fiscal 1984 White Paper on Trade (courtesy of NLI Research) to highlight where Japan is in terms of its balance of payment cycle with respect to its stage of economic development. If Japan’s 2011 BOP data was any indication (could be an aberration given the Great East Japan Earthquake & Tsunami and generational levels of flooding in Thailand), the country is entering the 2nd stage of being a net creditor nation. If that is the case, we could be a generation or two away from Japan becoming a net debtor nation again, of course, following persistent current account deficits.


Digging Deeper Into Japanese Sovereign Debt Risk - 15


While 30 to 60 years is a long time horizon to make a call on sovereign debt risk, we turn our attention to risks associated with Japan’s current account over the next 3-5yrs. Japan, which has experienced a secular decline in domestic investment during its post-bubble era, may be unable to meaningfully kick-start economic growth that is commensurate with its ageing population absent a pickup in investment (investment leads future consumption growth).


That is a dangerous request, and puts Japan in a catch-22: increase investments relative to savings and erode the current account or maintain the current account surplus and idly watch as infrastructure and capital equipment deteriorate. To the latter point, Japanese corporations have dramatically neglected fixed investment over the past ten years, which suggests to us that such a cycle might be closer than one would tend to expect – especially if Japan is going to even sniff its Cabinet Office’s aggressive growth assumptions (see above).


Digging Deeper Into Japanese Sovereign Debt Risk - 16


Digging Deeper Into Japanese Sovereign Debt Risk - 17


All told, Japan’s current account surplus, while likely be structurally lower going forward amid structural headwinds to the trade deficit due to declining productivity and higher energy imports, is not really at risk of shifting into consistent deficits anytime soon. That said, however, the days of persistent 3-4% (of GDP) surpluses may indeed be over and a structural downshift to the 1-2% (of GDP) does seem likely.


Q: What’s the risk that the ~95% never sells and how much damage could the ~5% do if they become a heavy seller?

On paper, there is little incentive for the Japanese sovereign to ever pursue a default given that the vast majority of its debt burden is financed with domestic capital (93.7% to be exact). The is largely due to the secular deleveraging we’ve seen out of the Japanese private sector, given that their persistent financial surpluses have been more-or-less circulated throughout the banking system and ultimately parked in JGBs.


A chart of this relationship between Japan’s total private sector net financial position vs. the central government’s net financial position highlights this inverse relationship perfectly. To the extent that Japanese households and private nonfinancial corporates continue to build cash on the margin, faster or in-line with the pace of sovereign debt growth, it can be reasonably argued that there won’t be internal pressure on JGB prices from a supply/demand perspective (absent specific catalysts like a credit downgrade, etc.).


Digging Deeper Into Japanese Sovereign Debt Risk - 18


Turning to the ~5%, an interesting analysis out of the IMF in conjunction with the Japan Securities Dealers Association and Japanese Ministry of Finance shows that foreign investors in JGBs perhaps pose slightly more risk than meets the naked eye.


As the chart below highlights, while foreign investors’ share of transactions in the JGB secondary cash market is commensurate with their share of ownership, their share of transactions in the JGB futures market is substantially higher, controlling roughly one-third of all outstanding contracts. Moreover, while down from its 2007 peak, turnover in the JGB futures market is roughly three-quarters that of the JGB cash market, meaning that one-sided selling by foreigners does indeed pose a fair amount of risk to Japanese brokerages. It’s no surprise to us to see Nomura 5yr CDS just above the Lehman Line of 300bps wide (currently at 301bps).


Digging Deeper Into Japanese Sovereign Debt Risk - 19


Q: What sorts of labor market reforms could Japan undertake to boost economic output and lower the financial burden?

Shifting gears, we focused a fair amount of one of our discussions on what Japan could do from a regulatory perspective to increase its growth potential and lower its debt burden. Specifically, labor market reform(s) dominated the general flow of that discourse.


It’s certainly true that Japan has one of the world’s most rigid and inefficient labor markets known to man, largely stemming from a focus on lifetime employment contracts. This has resulted in unabated growth in non-benefited, non-regular employees. There are, however, other areas of concern as well, including a relatively low level of female participation in the Japanese labor force – despite Japanese women being more educated than their domestic male and OECD female counterparts with 14.3 years of schooling by their mid-20s.


Digging Deeper Into Japanese Sovereign Debt Risk - 20


Potential avenues for reform include:

  • Adopting a more flexible system of employment in order to mitigate barriers to labor force re-entry from a full-time job seeker perspective;
  • A government led shift to encourage female participation in the labor force, partially by upping social expenditures on child support;
  • Broadly encouraging immigration by providing favorable tax treatment and  making it easier for foreigners to obtain work visas and permanent residency (Japan’s working-age population is on course to drop by roughly -40% by 2050); and
  • Expanding government assistance programs designed to re-train and re-locate job seekers.

All told, while there is, in fact, much Japan can do from a reform perspective to improve its long-term economic outlook, we must be cognizant of the fact that even if such reforms were implemented today, we are unlikely to see any material results for perhaps at least a decade or more! Dramatically altering long-held social dynamics is a long-term process that requires a great deal of patience.


Q: What are the best ways to play your thesis?

From a longer-term perspective, we continue to see asymmetric risk in the Japanese yen vs. peer currencies – particularly against the USD. That said, however, we don’t want to be short the yen at every price, as short-term interest rate spreadscontinue to be the driving force behind short-to-intermediate term fluctuations in various JPY exchange rates. In fact, even us long-term yen bears would not be surprised to see yen strength over the intermediate term, given our outlook for global growth over that duration.


Other potential ways to play the thesis that were discussed in our meetings included:

  • Hedging for volatility in the JPY and JGB markets;
  • Shorting the equity of internally-facing Japanese consumer names vs. being long the equity of outward facing exporters; and
  • Going long of Japanese sovereign and bank CDS – particularly on those banks that are not as strongly capitalized.

These are just a few ideas that we thought had the highest probability of working over the intermediate-to-long term. As always, not all positions will work and certainly not from every price!


Looking at the yen’s monetary policy fundamentals from a long-term TAIL perspective, we expect the mounting political pressure emanating from the Diet upon the BOJ to dovetail into a reasonably-aggressive expansion of the central bank’s balance sheet as it seeks to achieve its recently-adopted +1% inflation target.  Moreover, this is likely to come during a time when both the Fed and the ECB are exhibiting slowing growth of their balance sheets – widening a critical spread to the detriment of JPY exchange rates.


Digging Deeper Into Japanese Sovereign Debt Risk - 6


Looking at the latest developments, it appears BNP Paribas SA economist Ryutaro Kono – a known hawk – will be rejected for appointment to the BOJ’s nine member monetary policy board. Two spots open up on APR 5 and the replacements for Seiji Nakamura and  Hidetoshi Kamezaki are still unknown, leaving the bank to potentially head into its APR 9-10 meeting understaffed. While it is not yet confirmed who will replace the departed board members, it is increasingly likely in our opinion that they will be quite dovish and openly committed to implementing measures designed to combat deflation. We hold  this belief due to the widespread, multi-partisan rejection of Kono by members of the Diet due to his hawkish lean (central bank board members need to be approved by both houses).


Looking ahead to next year, when the marginally hawkish Masaaki Shirakawa’s term as BOJ Governor ends in APR ’13, we would anticipate his replacement to also be a fairly dramatic step in the dovish direction. Coupled with Japan’s structurally-impaired growth outlook, waning productivity, eroding current account dynamics, and bloated fiscal position, we see asymmetric downside risk in the Japanese yen vs. peer currencies over the long-term TAIL.


Q: What’s the timing of the VAT hike discussions, given its importance as a catalyst for a ratings downgrade(s)?

The latest news out of the Diet shows that the DPJ has recently agreed upon a watered-down version of the VAT hike bill, which now only calls for implementation if economic conditions are favorable at the time of execution. The bill has yet to be submitted to the broader parliament for deliberation, so there remains no clear date to hang on the calendar from a catalyst perspective.


Looking ahead, the LDP, led by Sadakazu Tanigaki continues to oppose ratifying this piece of legislation at the current juncture, demanding a dissolution of the Diet prior to any cooperation on the bill in an attempt to regain political power. He was on NHK television as recently as MAR 2 highlighting this view.


It remains the case that both parties support raising the consumption tax; that really isn’t the issue from a credit rating perspective. What’s at stake here is Japan exhibiting further political ineptitude that is becoming an increasing factor in the sovereign rating calculus. Japan moving on to its 7thprime minister in 5-6 years amid chronic infighting that puts individual political desires ahead of the long-term health of the economy would very likely be a credit-negative event.


Still unable to pass the FY12 budget law, which begins APR 1, the Diet has resorted to drafting a stopgap budget of ¥3.6 trillion (~$43B) to cover the minimum costs of operation for the first six days of APR (the budget automatically becomes law then because it was approved by the DPJ-controlled lower house 30 days ago). If their progress (or lack thereof) on the FY12 budget is any indication, we might be in for some fireworks regarding the consumption tax debate.


Stay tuned; there’s nothing like a little political drama to keep things interesting!


Darius Dale

Senior Analyst

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.46%
  • SHORT SIGNALS 78.35%

Asymmetric Downside?: TIP Trade Update

Conclusion: Treasury Inflation Protection looks overvalued here, especially given the asymmetry associated with the long side of the USD. In fact, TIPS appear to have asymmetric downside risk, absent further monetary easing out of the Federal Reserve.


Position: Short the iShares Barclays TIPS Bond Fund (TIP).


This morning, Keith shorted the iShares Barclays TIPS Bond Fund in our Virtual Portfolio on the expectation that the demand for Treasury Inflation Protected Securities will wane in the coming months as the leading indicators for the slope of inflation (input costs in the form of energy, food, and raw materials prices) continue to make lower highs, consistent with our 1Q12 theme of Deflating the Inflation II.


As you recall, we took a brief respite from that theme immediately following Bernanke’s JAN 25thpledge to extend ZIRP to 2014, which we viewed as a headwind to our bullish view on King Dollar – the most notable of many factors driving commodity prices, in our opinion. Following a few weeks of taking the Fed’s queue and being bullish on assets correlated to inflation, we are now view the topping process in the Inflation Trade as a leading indicator for disinflation and, thus, are inclined to short TIPS.


Already broken from a TRADE-duration perspective, the TIP etf is flirting with a TREND-duration breakdown per our quantitative risk management model:


Asymmetric Downside?: TIP Trade Update - 1


We’ve made this point in previous notes, but absent a commensurate pickup in employment growth and wage inflation, accelerating input costs do little more than slow growth on a lag. While it can be nice to watch “risky assets” (equities, commodities, HY credit) all trade higher in unison and tell stories about accelerating demand/economic growth,  the reality of the situation remains is that we have a central bank that remains committed to perpetuating inflation due to a classical economic theory that views that as a prerequisite for employment growth.


Looking forward, however, the chart of the U.S. Dollar Index is telling us that from an intermediate-term TREND (bullish) and long-term TAIL (bullish) perspective, the current state of monetary policy backing the U.S.’s currency will come under increasing scrutiny and relegate Bernanke and Co. into an increasingly smaller box or, potentially, out of their roles altogether. Either way, further USD strength will have a negative effect on global commodity prices and assets that are highly correlated with inflation. The CRB Index (a basket of 19 commodities including crude oil) is breaking down and its quantitative setup inversely mirrors that of the DXY’s:


Asymmetric Downside?: TIP Trade Update - 2


Asymmetric Downside?: TIP Trade Update - 3


All told, Treasury Inflation Protection looks overvalued here, especially given the asymmetry associated with the long side of the USD. In fact, TIPS appear to have asymmetric downside risk, absent further monetary easing out of the Federal Reserve – which, in our view, poses a dramatic risk to U.S. growth, given that we’re already in the midst of an oil price shock!


Darius Dale

Senior Analyst











THE HBM: DNKN, COSI, BWLD - subsector





DNKN: Dunkin’ Brands announced an upsizing and pricing of its secondary offering.  The secondary offering will be priced at $29.50.  We do not think it is any coincidence that the company made this announcement the day after announcing a partnership – the largest of its kind so far in 2012 – with Jerry Jones and Troy Aikman to open 50 Dallas/Fort Worth restaurants.  


COSI: Cosi reported a $0.04 EPS loss in 4Q along with same store sales of 2.6%.  With one week remaining in 1Q12, system-wide comparable sales increased by almost 5%.




PEET: Peet’s has been performing well over the last month but declined 4.8% on accelerating volume yesterday.





BWLD: Buffalo Wild Wings was initiated Neutral at Morgan Stanley.




DIN: DineEquity underperformed its peers yesterday.





Howard Penney

Managing Director


Rory Green




Not terrible but more evidence of a more competitive junket environment.



The data is in.  With the enhanced disclosure from MPEL, we can confirm that while the sky isn’t falling, junket commissions did tick up in the 2H11.  This is on top of a sharp increase in receivables – see our note this morning “MACAU: HIGHER RECEIVABLES”.  On a positive note, commissions barely budged on a YoY basis.  


The charts below show the composition by company of all-in commissions among the straight junket commission, the rebate that goes back to the player, and non-gaming giveaways.  The first analyzes the dynamics on a revenue share basis, the second as a percentage of rolling chip.  


Main takeaways: 

  • The gap between the lowest all-in commission rate and the highest commission narrowed considerably in 2011 to 4.3% from 6.7% in 2010 on a % of win basis and to 15bps from 18bps on a % of RC basis.  The compression was largely driven by junket commissions
  • Excluding comped non-gaming amenities (rooms/F&B), Wynn remains the least aggressive.  However, on a YoY basis Wynn’s rebate and junket commission (as a % win) increased 5% and 1%, respectively, from 1H to 2H2011.  
  • We were surprised to discover that MPEL actually had the lowest all-in commission rate on both a RC and % of win basis in 2H12.  Despite offering the largest junket commission, MPEL has consistently had the lowest comps on non-gaming amenities.  MPEL also offered one of the lower rebate rates, which is surprising given the relatively large direct premium play business at City of Dreams.

Other observations:

  • Rebate rates increased YoY and in the 2H of 2011 vs. the 1H
    • The average rebate rate for the year and 2H was 32.4% (as a % of win) or 95bps (2011)/96bps (2H11) (as a % of RC)  
    • Wynn had the lowest rebate rate in 2011 at 30.6%/90bps
    • MPEL had the lowest rebate rate in 2H11 at 30.0%/91bps
  • Junket commission increased YoY and in the 2H of 2011 vs. the 1H
    • The average junket commission increased 4% YoY (on a % win and RC basis) to 8.2%/24bps in 2011
    • In 2H11, the average junket commission was 8.4%/25bps
    • Wynn continued to offer the lowest commission rate in 2011 and 2H11
      • 2H11: 7.2%/22bps
      • 2011: 7.2%/20bps
    • MPEL continued to offer the highest commission rate in 2011 and 2H11
      • 2H11: 9.3%/29bps
      • 2011: 8.9%/26bps
  • Comped non-gaming amenities decreased YoY and but increased in the second half of 2011
    • The average non-gaming comps fell to 9% on a % of win basis to 4.2% in 2011 from 4.5% in 2010 and 5.5% in 2009
    • The YoY drop on a % of RC basis was 8% from 13bps in 2010 to 12bps in 2011 
    • In 2H11 the average non-gaming comps increased 8% and 11% on a % win and % RC basis, respectively, to 4.3%/13bps from 4.0%/12bps in 1H11
    • MPEL continued to offer the lowest comps in 2011 and 2H11
      • 2H11: 2.7%/8bps
      • 2011: 2.6%/8bps
    • LVS continued to offer the highest comps in 2011 and 2H11 which is not surprising given that they have the largest % of their revenue base coming from non-gaming amenities.  Comps as a % of win and RC have been steadily declining from 2008 to 2011.
      • 2H11: 6.3%/17bps
      • 2011: 5.8%/17bps
  • The all-in commission rate was flatish YoY but increased in the 2H of the year compared to the 1H to 46.5%/1.41bps
    • On a % of win basis, LVS paid the highest all-in rate at 49.4% in 2H11 and 46.9% in 2011.
    • On a % of RC basis, MGM was the biggest spender at an all-in rate of 1.41% in 2H11 and 1.4% in 2011.







get free cartoon of the day!

Start receiving Hedgeye's Cartoon of the Day, an exclusive and humourous take on the market and the economy, delivered every morning to your inbox

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.