Don’t Fight the Fed… In Brazil?

Conclusion: All told, we continue to view Brazil’s intermediate term economic outlook as supportive for Brazilian equities over that duration and, while the recent spate of Big Government Intervention has cast a dark cloud of regulatory uncertainty over Brazilian assets and introduced new risks to Brazil’s economy over the long term, our analysis suggests concerns here are vastly overblown – creating a fair amount of asymmetry between what’s being priced in relative to Brazil’s fundamental outlook.


Virtual Portfolio Position: Long Brazilian equities (EWZ).


While we pride ourselves on the highly differentiated nature of our Global Macro research, one certainly does not require a three-factor quant model borne out of the principles of chaos theory to know that this isn’t good:


Don’t Fight the Fed… In Brazil? - 1


Per the MSCI index in the chart above, Brazilian Financials stocks have retraced roughly 90% of their gains from their SEP ’11 trough in just over two months – largely on the strength of the central government’s plan drive down interest rates throughout the Brazilian economy, which will ultimately put a great deal of pressure on the profitability Brazil’s domestic banking sector.


Per President Rousseff: “[Brazil] will only be competitive when interest rates fall to global levels.” Per Nelson Barbosa, her Secretary for Macroeconomic Policy at the Ministry of Finance, last week’s changes to the 150-year-old savings account minimum return mandate (“poupanca” was reduced to 70% of SELIC rate when it falls < 8.5% vs. 7.3% per annum previously) will leave room for the benchmark SELIC rate to be cut to “as low as it needs to go”. According to the MOF spokespeople, lower interest rates will reduce pressure on debtors across all sectors, which, in turn, will drive down default rates – which have trended up over the last ~18 months and now rest at 5.7% across the entire banking system – and ultimately allow banks to maintain reasonable profit growth by accelerating underwriting into a healthier, more robust economy.


Don’t Fight the Fed… In Brazil? - 2


It’s clear that Rousseff and Co. are making a enormously “levered” bet on the Brazilian and its ability to repay debt in a lower interest rate environment. If they are right, Brazilian economic growth could accelerate to new heights over the long term, putting Brazil on par with some of its faster-growing “BRIC” competitors.


On the flip side, their politicized reforms could ultimately backfire and spur higher rates of inflation as credit and consumption growth expand faster than growth rates of productive capacity and/or the real continues to make a series of lower-highs over the long term as Brazil’s global real interest rate advantage (2nd highest globally) is eroded on top of global investors increasingly shunning Brazilian assets due to accelerating political interference (see: Value CEO ouster, IOF tax hikes and now this state-directed crusade to lower interest rates). Recent USD-debt issuance trends and Bovespa net flows data help elucidate the ill-effect the latest round of capital controls and Big Government Intervention have had on Brazil’s foreign investment inflows:


Don’t Fight the Fed… In Brazil? - 3


Don’t Fight the Fed… In Brazil? - 4


A banking crisis is also a heightened tail risk in any downside economic scenario over the long term if heightened liquidity temporarily masks an erosion of credit quality across the industry (i.e. systematic “adverse selection”).


As usual, time will reveal all truths. Right now, however, our task as Global Macro risk managers is to figure out what’s priced in and make a call on the more probable of the aforementioned scenarios from here.



Alluding to the chart above, it wouldn’t be a stretch to suggest that a secular narrowing of Net Interest Margins (NIMs) is in store for Brazilian banks as the government forces the industry to lower lending rates (likely affecting private banks via increased competition from state banks). Average interest rates on Brazilian loans were 37.3% per the latest report (MAR) – good for a 2,830bps cushion above the SELIC.


Don’t Fight the Fed… In Brazil? - 5


Looking at NIMs from a more traditional perspective, Brazilian banks in aggregate enjoy an average NIM of 2,800bps (MAR). Interestingly, this ratio has stayed largely flat over the past 10+ years, despite the SELIC rate being cut by nearly two-thirds over this time period. Also interesting, when analyzing NIM by sector (though not necessarily how it’s done in actuality), the spread between consumer lending and deposit rates has trended down over time roughly in line with the fall in the SELIC; a similar spread has trended UP over time in corporate credit operations.


Don’t Fight the Fed… In Brazil? - 6


Looking at inflation, both Brazil’s 2015 Breakeven Inflation Rate and L/T sovereign debt yields have actually trended down over the last two months – suggesting that long-term inflation expectations in the Brazilian fixed income market are not currently being exacerbated by the aforementioned drive to lower interest rates. This is a noteworthy signal, given that roughly 20yrs ago, the Brazilian economy was experiencing severe hyperinflation, which itself was buoyed by rapid credit expansion (YoY growth north of +4,000%!).


Don’t Fight the Fed… In Brazil? - 7


Don’t Fight the Fed… In Brazil? - 8


It could be argued, however, that the Brazilian central bank has become completely politicized, and any policy response to inflation will be both muted and delayed – thus suppressing the signaling ability of the Brazilian interest rate curve. While we stand counter to this view, investors would be keen to keep an eye on real asset prices in the Brazilian economy. Housing inflation accelerated dramatically to +12-13% per year during Brazil’s 2002-03 inflation scare (CPI peaked at +17.2% YoY in MAY ’03), which was largely predicated by a -47% fall/devaluation of the BRL vs. the USD during the global EM scare and ahead of the Lula presidency.


Don’t Fight the Fed… In Brazil? - 9


To many in Brazil, these events and the hyperinflation saga of the 1990’s are not far enough in the past to escape the cognitive anchoring that naturally occurs with Big Government Intervention targeting lower rates of both interest and foreign exchange – of which current market expectations over the NTM are for -100bps and -5.4% (via 1yr OIS and 12mo USD/BRL forward rates). We continue to view the market sentiment here as both extreme and asymmetric, given where our predictive tracking algorithms suggest the slopes of Brazilian economic growth and inflation are headed over the intermediate term. Refer to our MAY 3 note titled, “What the Heck Is Going On In Brazil?” for more details regarding this topic and our bull thesis on Brazil from here.


Per the latest central bank minutes: “… even considering that the activity recovery has occurred more slowly than anticipated, the Committee believes that, given the cumulative and lagged effects of policy actions implemented so far [i.e. 350bps of rate cuts], any movement of additional monetary easing should be conducted with parsimony.” Brazilian FX and interest rate markets are pricing in far more easing than suggested by the central bank’s guidance – an event that could lead to, at a bare minimum, a floor in the BRL/USD cross in short-to-intermediate term. We walk through precisely how this event would be supportive of Brazilian equities (via a positive inflection in earnings growth) in the aforementioned note.



We’ve already alluded to the more negative of the two scenarios laid about above, which leaves the positive scenario as the one in which we view as more probable over the long term. We are currently long (and wrong) Brazilian stocks in our Virtual Portfolio as a way to play what we view as a highly probable positive inflection point in Brazil’s economic fundamentals over the intermediate term. Thus, we are aware that our positioning might cause some clients to question whether or not we’re viewing the recent spate of policy maneuvers out of Brazil with an Optimistic Bias.


While we wouldn’t refute that as being a risk, our analytical integrity will always trump any Virtual Portfolio trade or research call we make; Brazil here is no exception and we’ll happily book the loss if it becomes clear to us that the government has no plan to combat the key risks we’ve highlighted above. For now, we are comfortable giving Brazilian policymakers the benefit of the doubt, given that they have shown us they can go both ways on both the fiscal and monetary policy front, depending on what the Brazilian economy has required, since Rousseff and her team took over the reins.


Taking a “glass half full” approach to the recent events, it’s clear to us that Brazil has an enormous opportunity to grow its economy by easing liquidity conditions, though this gain is likely to come at the expense of Brazil’s relatively high Return On Equity (ROE) across the banking sector. Still, one man’s trash is another man’s treasure; despite having a consumer debt service burden that is twice that of the US, Brazil’s aggregate consumer indebtedness and mortgage burden are a fifth and a fourth of their US equivalent ratios, respectively. While no doubt an apples-to-oranges comparison, we accept the US as an easily-digestible proxy of what Brazil could become given this hyper focus on improving domestic financial conditions and international competitiveness.


Don’t Fight the Fed… In Brazil? - 10


Don’t Fight the Fed… In Brazil? - 11


Credit growth – particularly in the consumer sector where growth has slowed by over one-third since peaking in FEB ’11 – could be poised to rebound in the coming quarters amid incessant urging from the central government and increased public/private competition among Brazilian banks. We’d be remiss to ignore the fact that during the Global Financial Crisis the Bovespa Index bottomed in OCT ’08 – well ahead of other global equity markets – as rapid [state-urged] credit expansion helped mitigate the effects of the Great Recession upon the Brazilian economy.


Don’t Fight the Fed… In Brazil? - 12


As an aside, Brazil has developed a tendency to cyclically trough well ahead of other global equity markets during the recent Global Macro summertime selloffs (OCT ’08, MAY ’10 and early AUG ’11).


Ironically, one area where the government’s recent drive to lower interest rates is potentially being dramatically mispriced is on the currency front. Our analysis shows the BRL/USD cross to be positively correlated with a narrowing of the Brazilian central government budget deficit – which would be a natural byproduct of a lower interest rate environment (assuming Rousseff and Mantega maintain their pledge to be fiscally hawkish). Brazil, which has enjoyed a persistent primary surplus of around +3-4% of GDP over the last 10+ years, has posted fairly wide budget deficits ranging from (2%)-(6%) of GDP over that same duration.  This is a direct function of Brazil’s elevated interest expense burden, which has ranged from +5-9% of GDP over the last 10+ years.


Don’t Fight the Fed… In Brazil? - 13


Don’t Fight the Fed… In Brazil? - 14


Net-net, any move toward fiscal tightening will help offset any inflationary pressures being introduced by this pending acceleration in liquidity throughout the economy.



All told, we continue to view Brazil’s intermediate term economic outlook as supportive for Brazilian equities over that duration and, while the recent spate of Big Government Intervention has cast a dark cloud of regulatory uncertainty over Brazilian assets and introduced new risks to Brazil’s economy over the long term, our analysis suggests concerns here are vastly overblown – creating a fair amount of asymmetry between what’s being priced in relative to Brazil’s fundamental outlook.


Have a great weekend,


Darius Dale

Senior Analyst


The Economic Data calendar for the week of the 14th of May through the 18th 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.



Weekly European Monitor: Moving the Goalposts, Again!

European Positions Update: Short Italy (EWI)


Asset Class Performance:

  • Equities:  The STOXX Europe 600 closed down -0.4% week-over-week vs -2.4% last week. Bottom performers: Cyprus -15.4%; Greece -11.3%; Ukraine -9.8%; Romania -6.4%; UK -3.3%; Hungary -2.9%; Ireland -2.9%; Denmark -2.6%.  Top performers:  Spain +1.7%; Netherlands +1.4%; Slovakia +1.0%; Italy +90bps; Finland +80bps.  
  • FX:  The EUR/USD is down -1.15% week-over-week vs -1.23% last week.  W/W Divergences: PLN/EUR -1.11%, HUF/EUR -0.96%, SEK/EUR -0.74%, CZK/EUR -0.32%; CHF/EUR +0.02%, DKK/EUR +0.05%, NOK/EUR +0.19%, GBP/EUR +0.74%
  • Fixed Income:  Greece’s 10YR government bond yield saw the biggest gain of +396bps to 24.53% week-over-week. Spain gained +28bps to 5.98% and Portugal rose +13bps to 10.96%.

Weekly European Monitor: Moving the Goalposts, Again! - 11. YIELDS



In Review:

It was yet again another week in which Europe dominated the headlines, with Greece and Spain taking most of the attention. In the mix this week the Bank of England kept its interest rate and asset purchasing program on hold, as expected, and the European Commission revised down its growth targets for much of the periphery, while boosting Germany’s (more below under Call Outs). However, it was also a week in which Russia’s Vladimir Putin and Dmitry Medvedev were confirmed, switching roles to become President and Prime Minister, respectively. For those of you that missed it, Putin put on a show in an inauguration day hockey game. Here’s a link to the video: Vlady, who recently learned how to skate, propelled his team to a 3-2 victory with two assists and the game winner (surprised?).


As Keith has mentioned, the Russian stock market is down -16.6% since March 14th (when most Global Equity markets topped for the year) and is a good example of why the USD Correlation Risk matters so much – Russia is a Petro Dollar market, so with the USD up for the 8th consecutive day (and the Petro snapping his $113.87 Brent line), this is not good.



A Greek Tragedy


This week saw each of the three main Greek parties (New Democracy, Syriza, and Pasok) try to form a coalition with each another, only to come up short each time. There’s new hope from some that Pasok leader Evangelos Venizelos can put together a unity government given a shift in stance on the part of Democratic Left leader Fotis Kouvelis, who has broken ranks with Syriza, which it had backed earlier in the week. (Syriza is thoroughly against the mandates of austerity, and may be the most divisive partner in a coalition build).


As uncertainties of the prospects for a coalition persist, the calling of another general election seems a very probable event, which could come as soon as June 10th or June 17th. Here it’s important to note that despite the unknown on the future shape of the Greek government, what’s key is the strong voice from the Greek people to stay with the EUR currency and in the Eurozone. So despite all the noise from headlines discussing a Greek exit from the Eurozone (example: a Bloomberg Global Poll recorded a 50% chance Greece exits the Eurozone this year), we do not see this as a probable event for Greece in 2012. We expect the future Greek government to play ball with Brussels (and Troika for its bailouts), with more concessions likely to come from Brussels (and consent from the Germans swinging the largest bat), as Eurocrats are determined to save the existing Union. Greece will likely moderate its austerity push in favor of growth strategies (at least rhetorically), but really to appease a population pushing back at the consolidation of government spending. We think the most relevant quote of the week expressing this view came from Germany’s Finance Minister Wolfgang Schaeuble:


“If Greece decides not to stay in the Eurozone, we cannot force Greece. They will decide whether to stay in the euro zone or not.”



Spain’s Shifting Pain

After Wednesday’s announcement that Bankia, the banking group with the most real estate on its books in Spain, was nationalized, today the Spanish government rolled out a number of provisions for banks, all of which are not easily digestible in the first gulp. While the measures show directional progress, the future findings of assets as risk (which are highly tied to real estate prices that we think could have another -30% leg down) could well be considerably larger than the €184 billion of assets which the Bank of Spain terms “problematic.”


The main points, according to Economy Minister Luis de Guindos’ speech today, include:

  • Spain will force banks to increase provisions against real estate loans by about €30 billion ($38 billion)
  • Spain will hire two auditors to value Spanish lenders’ assets
  • Banks will have to raise provisions on real estate loans that are still performing to 30% from 7% on average and the government will provide funds for those that need support
  • The state will inject less than €15 billion into struggling banks, and the funds won’t add to the budget deficit, according to Luis de Guindos
  • The government will also force all banks to move foreclosed real estate assets off their balance sheets into independently managed companies so they can be sold
  • Spain will boost provisioning on still-good land assets to 52% from the 7% level set for all types of real estate risk in February
  • Spain will raise the coverage level on loans linked to unfinished buildings to 29% and to 14% for finished homes and it will raise coverage for real estate assets to 45%
    • De Guindos said banks will have a month from today to say how they will meet the provisioning requirements, which come on top of the €53.8 billion of charges and capital ordered by the government in the previous cleanup effort in February
    • The state will step in through its bank rescue fund, known as FROB, to buy shares or contingent convertible bonds of banks that struggle to meet the requirements. Under the program, which Luis de Guindos said will be profitable for the government, banks that borrow will have to pay 10% interest and repay the aid within five years


In other news, the European Commission today estimated that Spain will have a budget deficit of 6.4% of GDP in 2012 and 6.3% in 2013 versus Spain’s pledge to bring its budget deficit down to 5.3% this year from 8.5% in 2011. It has also said that it will hit the EU-mandated 3% deficit target in 2013. The Commission also now expects Spain's economy to contract 1.8% this year versus its February estimate of a 1% contraction. While the Spanish government expects the economy will grow in 2013, the Commission forecast that it would still contract by another 0.3%.


The key point here to mention is the changing goal posts that the European Commission will have to make for Spain’s deficit consolidation, a case which may be mimicked across the periphery. All in, our point is that an additional bailout for Spain seems highly probable over the next months as we underweight the ability of the Spanish government to internally clean up its banks, create jobs for the some 24.4% unemployed (52% for youths), reduce its deficit, and grow the economy.



Call Outs:

European Commission:  forecasts 2012 Eurozone GDP to fall by -0.3% (unchanged from prior estimate) and return to growth of 1.0% in 2013. The report said Greek GDP should decline -4.7% this year and may stay unchanged in 2013; Italy will fall -1.4% this year and Portugal should contract -3.3% before both return to growth next year. It sees Spain’s economy shrinking by -1.8% this year and -0.3% in 2013. The report also Germany should grow at 0.7% this year and raised its out to1.7% next year; that France could miss its deficit target in 2013; and the Eurozone unemployment rate will probably average 11% this year, up from 10.2% in 2011.


Eurozone:  Eurogroup head Jean-Claude Juncker talking to broadcaster ZDF made it clear to French president-elect Francois Hollande that fiscal compact could not be renegotiated. However, he added that the while the treaty cannot be reopened, it is possible to add growth measures, something that is already under discussion.


France:  Fitch Ratings says that it will not comment on France’s AAA rating before 2013.


Germany: SEB Asset Management will liquidate its €6 Billion ImmoInvest portfolio, the largest German property mutual fund to be dissolved after failing to meet investor withdrawals. Several real-estate mutual funds, including funds owned by Credit Suisse Group AG and UBS AG, face deadlines this year to reopen or liquidate, according to Germany’s financial trade group, Bundesverband Investment and Asset Management.


IMF may limit lending to Europe: The Dow Jones, citing people familiar with the situation, reported that the IMF is drafting plans to protect it from potential lending losses, including proposals that could limit the size of loans to Eurozone countries. The article said that the proposals are being developed as the political turnover in Europe and growing austerity backlash has triggered concerns about another flare-up of the sovereign debt crisis. It added that another safeguard under consideration is the sequencing of procuring IMF funds, meaning that if Europe's recent $200B contribution is used for Eurozone loans before other countries' contributions, then Europe bears the risk if something goes wrong.


More than 50% predict euro exit: Bloomberg, citing its own global poll, reported that 57% of the 1,253 investors, analysts and traders surveyed said at least one country would exit the euro by year-end, up from 11% in January 2011. It added that 80% expected more trouble for Europe's bond markets. Highlighting contagion concerns, the article also pointed out that 47% said Spain is likely to default, the most since the survey started measuring this possibility in June 2010 and almost double the level from four months ago.


China's sovereign wealth fund says it has stopped buying European debt:  Bloomberg cited comments from China Investment Corp. President Gao Xiqing, who said that the sovereign wealth fund has stopped buying European government debt given the economic crisis on the continent. However, he added that the fund still has people looking for opportunities in Europe.


CDS Risk Monitor:


Week-over-week CDS was up across the main countries we track.  Portugal saw the largest gain in CDS w/w, +66bps to 1075bps, followed by Spain +39bps to 514bps, Ireland +28bps to 593bps, and Italy +19bps to 456bps.   


Weekly European Monitor: Moving the Goalposts, Again! - 11. CDS REAL A


Weekly European Monitor: Moving the Goalposts, Again! - 11. CDS A


Data Dump:

Eurozone Sentix Investor Confidence -24.5 MAY vs -14.7 APR


Germany CPI 2.2% APR Y/Y Final (UNCH)

Germany Exports 0.9% MAR M/M (exp -0.5%) vs 1.5% FEB

Germany Imports 1.2% MAR M/M (exp. 1.0%) vs 3.6% FEB

Germany Current Acct 19.8B EUR MAR (exp.18B) vs 11.7B EUR FEB

Germany Trade Balance 17.4B EUR MAR (exp. 14.3B) vs 14.9B EUR FEB

Germany Factory Orders -1.3% MAR Y/Y (exp. -2.8%) vs -6.0% FEB  [2.2% MAR M/M (exp. 0.5%) vs 0.6% FEB]

Germany Industrial Production 1.6% MAR Y/Y (exp. -1.2%) vs 0.0% FEB


Spain Industrial Output -10.4% MAR Y/Y vs -3.2% FEB   [workday adjusted y/y worse than expected (-7.5% versus estimate -5.3%) ]

Spain House Transactions -22.7% MAR Y/Y vs -31.8% FEB

Spain CPI 2.0% APR Y/Y Final (UNCH)

Italy Industrial Production NSA -5.9% MAR Y/Y vs -3.3% FEB


Greece CPI 1.5% APR Y/Y (exp. 1.3%) vs 1.4% MAR

Greece Industrial Production -8.5% MAR Y/Y vs -8.3% FEB

Greece Unemployment Rate 21.7% FEB vs 21.8% JAN


France Bank of France Business Sentiment 95 APR (exp. 95) vs 95 MAR

France Industrial Production -0.9% MAR Y/Y (exp. -1.3%) vs -1.4% FEB

France Manufacturing Production -0.3% MAR Y/Y (exp. -2.8%) vs -3.2% FEB


UK Industrial Production -2.6% MAR Y/Y (exp. -2.6%) vs -2.3% FEB

UK Manufacturing Production -0.9% MAR Y/Y (exp. -1.3%) vs -1.5% FEB

UK PPI Input -1.5% APR M/M (exp -0.9%) vs 1.7% MAR  [1.2% APR Y/Y (exp. 2.1%) vs 5.6% MAR]

UK PPI Output 0.7% APR M/M (exp. 0.4%) vs 0.6% MAR   [3.3% APR Y/Y (exp. 2.9%) vs 3.7% MAR]


Switzerland Unemployment Rate  3.1% APR vs 3.0% MAR

Switzerland CPI -1.1% APR Y/Y vs -1.0% MAR


Netherlands CPI 2.8% APR Y/Y (exp. 2.7%) vs 2.9% MAR

Netherlands Industrial Production 0.7% MAR Y/Y vs -2.7% FEB


Sweden Industrial Production -6.5% MAR Y/Y (exp. -2.6%) vs -7.1% FEB

Sweden CPI 1.3% APR Y/Y (exp. 1.4%) vs 1.5% MAR

Norway CPI 0.3% APR Y/Y (exp. 0.5%) vs 0.8% MAR

Norway Producer Prices Incl. Oil 2.5% APR Y/Y vs 6.6% MAR

Norway Industrial Production 2.4% MAR Y/Y vs 3.1% FEB

Finland Industrial Production -5.7% MAR Y/Y (exp. -2.2%) vs -3.3% FEB


Ireland CPI 1.9% APR Y/Y (exp. 2.3%) vs 2.2% MAR

Ireland Consumer Confidence 62.5 APR vs 60.6 MAR

Portugal Industrial Sales -1.3% MAR Y/Y vs 1.1% FEB

Portugal CPI 2.9% APR Y/Y vs 3.1% MAR


Hungary Industrial Production 0.6% MAR Prelim Y/Y vs -3.5% FEB

Hungary CPI 5.7% APR Y/Y vs 5.5% MAR

Czech Republic Retail Sales -0.3% MAR (exp. 0.2%) vs 1.6% FEB

Turkey Industrial Production 2.5% MAR Y/Y vs 1.6% FEB

Romania CPI 1.8% APR Y/Y vs 2.4% MAR

Latvia Unemployment Rate 12.9% APR vs 11.7% MAR


Interest Rate Decisions:

(5/9) Poland Base Rate HIKED 25bps to 4.75%

(5/10) BOE Interest Rate Announcement UNCH 0.50% (expected)

(5/10) BOE Asset Purchase Target UNCH 325B GBP (expected)

(5/10) Norwegian Deposit Rate Announcement UNCH 1.50% (expected)



The European Week Ahead:

Monday: Mar. Eurozone Industrial Production; Apr. Germany Wholesale Price Index; Mar. France Current Account; Apr. Italy CPI - Final


Tuesday: 1Q Eurozone GDP – Advance; May Germany Zew Survey Current Situation and Economic Sentiment; 1Q Germany GDP – Preliminary; Mar. UK Trade Balance; Apr. France CPI; 1Q France GDP – Preliminary, Non-Farm Payrolls and Wages – Preliminary; 1Q Greece GDP - Preliminary


Wednesday: Apr. Eurozone 25 New Car Registrations, CPI; Mar. Eurozone Trade Balance; BoE Inflation Report; Apr. UK Claimant Count Rate, Jobless Claims Change; Mar. UK Average Weekly Earnings, ILO Unemployment; 1Q Italy GDP - Preliminary; Mar. Italy Trade Balance


Thursday: 1Q Spain GDP - Final


Friday: G8 Leaders Meet Near Washington (May 18-19); Apr. Germany Producer Prices; Mar. Spain Trade Balance; Mar. Italy Industrial Orders



Matthew Hedrick

Senior Analyst

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Emulation is not going to get it done in the domestic QSR burger category for the same reason it did not work for Linens ‘n’ Things in retail.  A thesis has been put forward over the last few days that the QSR burger industry is not a zero sum game.  In this industry it is difficult to neatly delineate boundaries of competition or addressable markets but we are of the view that, if not a zero sum game, the niche of the burger industry that Burger King inhabits could possibly be shrinking.  Recent commentary from Wendy’s CEO Emil Brolick supports this view.




Given the rapid growth of “better burger” category, or fast casual in general, it is easy to make blanket statements about the QSR industry because such proclamations are difficult to refute in the absence of definitive market share data.  Justice Holdings took advantage of this in framing its narrative describing Burger King’s growth prospect, touting the strong expansion of the QSR industry over recent years.  QSR is becoming more varied, however, both in terms of price point and product offerings.  McDonald’s, Wendy’s, Burger King, and Taco Bell occupy a certain sector of the QSR industry; we think that the growth in that sector is stagnant and only differentiated concepts can achieve the level of growth that would justify the $16 per share price tag that is being attached to Burger King’s IPO.  Just looking at the products Burger King is currently offering versus the McDonald’s menu highlights how little in the way of differentiation Burger King is bringing to the table.  An article published last month by Advertising Age titled “Nothing Exciting About Burger King’s Menu Expansion” outlines this issue comprehensively.  Discussing the “folly of emulation”, the author writes, “What was Linens ‘n’ Things’ strategy? Emulate the leader with similar stores and similar marketing strategies”.  Burger King – a follower – emulating McDonald’s – a leader – is equally unwise.





There is a reason why McDonald’s has recently bought up billboards and radio air time in markets where Wendy’s tested breakfast; the competition in the segment of the market where those companies operate is fierce because of the difficult macro environment, growing ranks of competitors, and a consumer that demands not only a great product but a great overall experience too.  We see it as highly unlikely that all four of the aforementioned QSR concepts are going to see positive same-store sales over the next few years absent a dramatic turnaround in the macro environment.  We believe that in this small group, someone is winning and someone is losing.  For that reason, making life difficult for your competitors – as McDonald’s does – is a winning strategy.  Along the same lines, trying to emulate a better-positioned industry leader – as Burger King is doing – is unlikely to be effective. 


This cut-throat environment is going to hamper the efforts of Wendy’s and Burger King to convince investors that their respective turnaround stories are in place.  That’s bad news for two chains that need to attract billions of dollars in capital to restore severely depleted asset bases.   Taco Bell’s slogan, “Think Outside the Bun”, underscores how much they compete with the burger companies.  Both Yum Brands and McDonald’s have tremendous ammunition to spend.  Both Taco Bell and McDonald’s have shown a willingness to lead with price and value to attract customers from other chains.  McDonald’s has benefitted from the mismanagement of Wendy’s and Burger King and has recently squared up to Dunkin’ Donuts in its core geography of New England in a bid to steal some breakfast market share.  Companies are hyper-competitive in their pursuit of consumers at the moment.  Our view is that Burger King and, to a lesser extent Wendy’s, are facing a difficult battle to regain their prior statuses in the industry.





Clearly our contention here is that a rising tide is not going to lift all boats in the domestic QSR burger industry.  Burger King and Wendy’s are the two names that we would be most concerned about from an operational perspective over the next two-to-three years.  Specifically, we think same-store sales growth could be weak at those concepts.  This is suboptimal given that top line growth is needed to inspire confidence among investors, lenders and franchisees if the turnaround is not to turn into a protracted siege that can do long term damage to the brands.


Of course, given that “activist” investors are deeply involved with both Wendy’s and Burger King, adds another element to their stories.  Weak operational performance may not lead to stock price weakness.  Taking Burger King first, we believe that the $16 is a price tag that should give investors pause when considering an investment in the company.  The implied valuation multiple, on an EV/EBIT basis, is 17x which makes Burger King the most expensive of the four companies (MCD, YUM, WEN, BKC).  Our “Too Big To Fix” thesis contends that the issues at Burger King may be much more substantial than people realize. 


Moving on to Wendy’s, the company is trading at a 26% discount to Burger King but at a 12% premium to McDonald’s.  We think that represents a mispricing of the company’s fundamental outlook but investors’ expectations of Nelson Peltz’s possible next move.  Given the sideways move in the stock over the past 3.5 years and the vast amount of capital needed to fix the asset base ($3.5 billion), it would not surprise us if Mr. Peltz was becoming a little anxious about Wendy’s future.  Perhaps the changes that need to be brought around would be better implemented in the context of a public company, away from investor and analyst scrutiny?  It would not be shocking if, in the not-too-distant future, we woke up to a rumor that Trian is shopping the company.  The possibility of that happens, we believe, is helping to maintain that premium to McDonald’s which otherwise doesn’t seem to have any grounding in a fundamental comparison of the two companies.


Wendy’s CEO Emil Brolick’s recent comment on his company’s category was insightful: “we were hopeful that our February promotion of Dave's Hot 'N Juicy would help us regain our momentum, but unusually intense competitive couponing and discounting negatively impacted our sales growth.”  This corroborates our view that the burger industry is, effectively, a zero sum game. 



Howard Penney

Managing Director


Rory Green







Selling Opportunity: SP500 Levels, Refreshed

POSITION: Long Healthcare (XLV), Short Industrials (XLI)


Same fundamental research thesis – Growth Slowing and Deflating The Inflation.


From a price, that will be good for US and Global Consumption Growth, but that (like all good sustainable things in life) will take some time.


Across our core risk management durations, here are the lines that matter most: 

  1. Intermediate-term TREND resistance = 1368
  2. Immediate-term TRADE support = 1338
  3. Long-term TAIL support = 1281 

In other words, your new immediate-term risk range = 1. Sell on green on the way up to 1368, and buy on the way down to 1338 – but be mindful that the gravity associated with 1281’s mean reversion risk is very much new and in play over the intermediate-term; particularly with the Financials (XLF) being the lead relative performance gainer in the market YTD – plenty to give back there.


Enjoy your weekend,




Keith R. McCullough
Chief Executive Officer


Selling Opportunity: SP500 Levels, Refreshed - SPX

Deep Dive into JP Morgan



TRADE (3 Weeks or Less)

JP Morgan is being punished by the market following the announcement of $2B in trading losses out of the CIO’s office.  The real loss, however, is the impairment to industry credibility just as the Volcker rule is being finalized by Congress and the regulators.  The apparent weakness of controls at the firm is a problematic indicator, particularly in the current regulatory environment. Additionally, the imminent downgrade of many large financials, likely including JPM, by Moody’s will add  further short-term pressure.


TREND (3 Months or More)

JP Morgan is likely to suffer as we approach implementation of the Volcker rule on July 21st.  While  CEO Dimon was clear in his view that the trade in question was not proprietary (and thus permissible under Volcker), optics of the trade are working against him.  A loss of $2B over the course of six weeks certainly gets regulators’ attention.  With the trade now public, the loss is likely to grow in the coming weeks. 


TAIL (3 Years or Less)

Over the long term, we expect the impact from Volcker will be less severe than the market fears.  Former Citi Chairman & CEO John Reed recently noted that banking lobbyists in favor of a weaker Volcker rule outnumber and outspend consumer lobbyists by 25 to 1. We expect significant downside in the stock on both regulatory fears and macro data over the course of the next several months – but this downside could ultimately present an attractive entry point. 






Deep Dive into JP Morgan  - JPM Levels 051112






Risk will ramp back up throughout the summer months, as seasonal factors drive optical weakness in economic data.  We expect this will provoke greater concern in the U.S. about Europe and other external negative factors, as the defense of “de-coupling” vanishes. Spain is the likely vector for contagion fears in 2012, just as Greece was in 2011.  The global moneycenter banks and large broker-dealers (JPM, BAC, C, GS, MS) are most exposed.  Until yesterday, the market was indicating that MS and C were perceived as the greatest risks among this group. This week, JPM has lost some of its “fortress” credibility, increasing the risk that they will be viewed more punitively.  






Deep Dive into JP Morgan  - Screen Shot 2012 05 11 at 10.39.48 AM

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