“I get no respect. The way my luck is running, if I was a politician I would be honest.”
I’ve been handed the Early Look pen this morning and thought starting with Dangerfield’s humor was in order. After all, I cover Europe for the macro team and there’s nothing funny about what’s going on in the region. Frankly stated, we don’t see a “bazooka” in Europe over the intermediate term as Eurocrats remain politically divided and in a slow and reactive mode to address sovereign and banking imbalances, slapping band-aids on peripheral woes at every corner, but failing to craft a real “path” forward.
Unfortunately, now the stakes are much higher as Italy is Too Big to Bail. For reference, Italy’s total sovereign debt alone is €1.9 Trillion with €372 Billion in debt coming due in the next 12 months versus the combined EFSF and ESM bailout facilities worth around €700-800 Billion. To boot, markets continued to shake this week on statements from Italian PM and technocrat-in-Chief Mario Monti that Italy may want to tap the Eurozone bailout mechanism to help lower its borrowing costs (the 10YR is currently at 5.99%); that he has no plans to seek another term when elections are called next spring; and on Moody’s downgrade of the Italian sovereign yesterday to Baa2 from A3. And if the political state wasn’t fractured enough, rumors also flew of a Berlusconi comeback. Can you say Bunga Bunga increased risk premium Party!
Interestingly enough, much hangs on the Eurozone’s ability to craft a fiscal union (compact) alongside its monetary union. It is firmer ground on this step that we think is critical before real action can be delivered on such proposed plans as: a banking authority; pan-European deposit insurance; European Redemption Fund; European Financial Transaction Tax; and Eurobonds.
That said, we see the passage of a fiscal compact many months to years out, if ever, as countries will be slow to give up their sovereignty to Brussels/Frankfurt. Further, we’d expect the aforementioned facilities to receive approval after much foot-dragging and politicking as the ECB is likely to be wary of extending its balance sheet as a backstop for the programs while strong fiscal nations like Germany will likely balk at signing off on lower creditworthiness in exchange for the region’s risk (Eurobonds).
However, as these programs stew, the most pressing issue right now is that the European Stability Mechanism (ESM), originally targeted to be operational by July 1 with firepower of €600 Billion, is in limbo given that Germany’s Constitutional Court passed on making a decision on it this week; already German Finance Minister Wolfgang Schaeuble warned that a ruling (in conjunction with the fiscal compact) could be pushed to this Fall!
We mention this indecision on the ESM and fiscal compact from the Germans for a number of reasons:
- A lack of decision on Germany’s commitment will broadly breed further indecision across capital markets until the court makes a decision.
- Spain’s €100 Billion bailout is dependent on the loans from the EFSF and ESM, and further clarity on the firepower of both facilities is essential because A.) they were not originally crafted with a specific mandate for bank bailouts; and B.) lending first through the sovereign (at least as they were originally intended), before sovereigns can then loan to banks, will simply pile on more sovereign debt and perpetuate the cycle of more sovereign and banking imbalances across the weaker states.
- We believe Germany is still carrying the biggest policy stick in Europe (despite a stronger “socialist” French-Italian handshake developing) and how Merkel and her courts rule will have great impact on how Germany may or may not choose to underpin a future fiscal union.
In the Balance
If the political landscape and potential direction of the Eurozone sounds convoluted, it is! We return to our fundamental view that neither bailouts nor encouraging more borrowing through cheaper money is the solution to Europe's problem of over-indebtedness. That said, we fully realize that when assessing Europe one must recognize that what Eurocrats “should” do (from an economic policy perspective) may be very different from what they “will” do.
Given the runway on a ruling from the German Court and the fact that there are no planned Summits (i.e. catalysts) around which markets could rally over the intermediate term, we expect Crumble Cake Europe to continue to trade on headline risk, and the EUR/USD cross to remain a relative loser until more decisive action is taken from Eurocrats. As we show in the chart below, the cross broke our intermediate term TREND Line of $1.22 this week and is nearing 2010 lows, back when Greece received its first bailout in May.
Should Europe play out as we expect – continued slower growth beyond consensus and Eurocrats socializing weaker members and changing the goalposts along the way– we fear that the next two years across the Eurozone could look a lot like the last two years – short of a default from Italy or more expedient action on such measures as Eurobonds.
I suppose I misspoke at the beginning of this missive when I said there was nothing humorous in Europe. Yesterday, Italy's national statistics office threatened to stop issuing data on the economy, saying that it has been crippled by government spending cuts aimed at reducing national debt.
Whether or not Italy has an agency to report its economic data reminds me of the old philosophical question: “If a tree falls in a forest and no one is around to hear it, does it make a sound?” Unfortunately for the Eurozone, the whole is only as strong as its weakest parts and everyone is forced to listen!
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, and the SP500 are now $1, $96.76-103.01, $82.81-84.06, $1.20-1.23, and 1, respectively.
Have a great weekend!
This note was originally published at 8am on June 29, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“… part of the Game is the anticipation of how the other players will behave.”
-George Goodman, The Money Game
It’s both fascinating and frightening that central planners will be emboldened by the market’s reaction to their latest plan. Europe is fixed again, and everything is back to being fine until people report their month and quarter end. The duration on that trade = 3 days.
Price Stability Update: At 230PM EST yesterday, the SP500 was tanking, down -1.3% on the day to 1314. An hour and a half later, it was +1.1% higher at 1329. This morning it’s trading up another 16 handles higher than that. This is really starting to rhyme with 2008.
This is one of the many reasons why I am in 94% Cash this morning (up from 91% yesterday and down from 100% last week). Part of The Game is understanding that there are times when the game becomes so volatile and arbitrary that it’s best to get out of the way.
Back to the Global Macro Grind…
If I haven’t been crystal clear on this since March, let me write it one more time – I am bearish on growth. Doing more of what has not worked is only going to slow economic growth further. Central planners do not get that; markets do.
Yesterday’s rip into the close and this morning’s melt-up in the US equity futures only amplifies my greatest fear about markets that are trading purely on the anticipation of the next Big Government Intervention catalysts – government itself.
If you disagree with me, that’s fine. If you think governments do a good job creating jobs, innovation, and confidence, you’re probably thinking they are going to do a great job running our stock markets too.
That’s the long-term TAIL risk. All long-term investors need to acknowledge this and raise Cash on all rallies to lower-no-volume-highs. Since the March top, you’ve had (and, evidently, will continue to have) plenty of opportunities to get out.
Enough about the long-term implications of this market gong show. Since not many people are allowed to invest or manage risk on that long-term duration anymore, here’s how the immediate-term TRADE setup looks for US Equities:
- SP500 closing > 1320 keeps it bullish TRADE (1320 support); bearish TREND (1365 resistance)
- Russell2000 closing > 764 keeps it bullish TRADE (764 support); bearish TREND (795 resistance)
- US Equity VIX closing < 21.15 keeps it bearish TRADE (21.15 resistance); bullish TREND (18.22 support)
In other words, I’ll cover/buy at 1320 and short/sell at 1365, and let these government people deal with themselves everywhere in between. If 1320 snaps like it did intraday yesterday again, I’ll be recommending prayer.
In Europe, all 3 of our risk management durations (TRADE, TREND, and TAIL) were signaling bearish up until the minute of this morning’s European market open. Now, all immediate-term TRADE lines that were resistance become support:
- EuroStoxx50 > 2169 makes it bullish TRADE (2169 support); bearish TREND (2316 resistance)
- Germany’s DAX > 6251 makes it bullish TRADE (6251 support); bearish TREND (6669 resistance)
- Spain’s IBEX > 6698 makes it bullish TRADE (6698 support); bearish TREND (7289 resistance)
All the while, the Euro (versus the USD) is having one of its biggest short squeeze days of what was an awful Q2. Trading +1.1% this morning to $1.25, it would have to close > $1.26 to recapture its immediate-term TRADE line of support. So watch that closely.
Again, get the EUR/USD right, and you get a lot of other things right. US Dollar down hard this morning is also why everything from the price of Copper (+2.2%) to almost anything that ticks in US Equities is up. Enjoy your 4th of July tax hike at the pump.
Just don’t confuse government sponsored immediate-term TRADEs with long-term economic prosperity. It’s perverse, but what these people are doing is managing their short-term political career risk for the sake of short-term market pops, to lower highs.
Each lower-high in stock and commodity markets is met with lower and lower market volume. That’s Part of The Game. When The People no longer trust it, they just get out of the way too.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, Germany’s DAX, Spain’s IBEX, and the SP500 are now $1537-1586, $88.36-96.89, $82.19-83.08, $1.24-1.26, 6251-6438, 6698-6913, and 1320-1342, respectively.
Best of luck out there today and enjoy your weekend,
Keith R. McCullough
Chief Executive Officer
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Yesterday, we announced that we will be doing a conference call on Thursday, July 19th at 11am EST titled "DRI: Too Big To Perform?" Shortly after notifying clients of this, Darden announced a dilutive acquisition of Yard House USA, Inc., which in our view will only complicate the issues the company is experiencing.
The acquisition highlights one of the issues that may be causing the recent underperformance and may represent, at least in part, an example of a company growing when perhaps focusing on the core business might better drive shareholder value. Time will tell, but we were surprised by some of the initial details.
- Acquiring Yard House USA, Inc. for $585 million in cash ($555 million after tax savings)
- Yard House offers American cuisine and has grown to 39 restaurants in 13 states since its launch in 1996. AUV’s are $8.4 million. Implied price paid is $15 million per store or 1.8x sales
- FY13 EPS outlook revised to account for transaction-related impact of $0.03-0.05
- FY13 Sales growth expected to be 9-10% versus 6-7% prior guidance
- Share repurchases now expected to be $50 million in FY13 versus $200-250 million prior guidance
We expect the company to add leverage to the balance sheet (and stop buying back stock) to finance the acquisition which appears to be at a growth premium of roughly 17x and 13x 2012 EV/EBITDA and 2013 EV/EBITDA, respectively.
“Too Big to Perform” is a turn of phrase that our CEO, Keith McCullough, loves to use to describe the mega-banks that make up the Old Wall. We think Darden is in danger of falling into that same category within the restaurant space. While the company generates ample cash flow (to make expensive acquisitions like the Yard House), the reasons to own this stock, in our view, are increasingly moving away from fundamentals such as market share and toward a blinkered perspective on "hitting numbers" and the “growth” mantra of senior management.
The acquisition of the Yard House only amplifies the issues we see the company is facing over the next three years. Yard House may be one of the country’s best positioned casual-dining concepts; its upscale position with consumers highlights one of the competitive disadvantages Olive Garden and Red Lobster are currently burdened with. The guest counts data at Darden’s two largest brands tell a sad story; both chains require extensive changes to begin the process of growing again.
Our conference call next Thursday will address all of this in greater detail. Topics include, but are not limited to;
- Management (and executive compensation) is laser-focused on growth. We think that is a problem when the company's two largest brands are struggling to gain any sustained traction with consumers
- Blind dedication to a "rate of growth" target independent of a changing operating environment can be a fatal mistake. Growth can mask issues, particularly of the transient variety, but the issues at Olive Garden and Red Lobster are long-standing and require significant attention.
- Inconsistency in the company's rationale behind its top-line strategy at Olive Garden. We are not deducing a clear message from the company regarding its ability to stop the sustained traffic losses at Olive Garden.
- Massive CapEx demands. The company is facing a prolonged period of investment into its largest chain. Getting this effort started in earnest is taking more time than many were expecting.
- The margin gap between Darden and some competitors offers clues as to how management could seek to bring about sustainable positive momentum in their largest business.
Conclusion: Our industrials team has highlighted some key inflections in Chinese rebar pricing, real defense spending and reinvestment by mining companies.
As many of you know, Jay Van Sciver recently joined Hedgeye as our Industrials Sector Head and launched a few weeks ago with his first key call being a negative view of the U.S. Airline Industry. This call is obviously particularly timely with Goldman’s bearish initiation on the Airlines today.
As part of their research product mix, our industrials team is publishing a daily “Industrials Indicator” note that synthesizes and emphasizes the key data points and events in the global industrials sector. We thought a number of their recent call outs were also particularly relevant to the global macro space, so we have highlighted them below. (If you’d like to trial our industrial team’s work and/or speak to Jay email .)
1. Chinese Rebar Prices – For those that aren’t aware, rebar is reinforcement steel that is used in concrete and masonry structures. Rebar is a critical component of any large scale construction projects – like highway bridges, parking garages, and so on. Demand in 2012 has been anemic for rebar in China, which is reflected in the declining prices that are reflected in the chart below.
China produces 50% of the world’s steel, so to the extent we can consider rebar a decent proxy for steel demand in China, and we believe we can, this is somewhat ominous for the global steel market as China may look to increase steel exports in order to stabilize prices. As well, the rebar price data is negative for iron ore, as China is the world’s largest importer of iron ore, which is the key steel input.
On a much higher level of course, steel and iron ore demand by China is a reflection of economic activity in China. As economic activity softens, naturally demand for these products will soften and lead to price declines, as we are seeing the rebar market.
2.The Mining Investment Cycle – Caterpillar (CAT) is probably the best proxy for the mining investment cycle since the start of the Millennium. Over that time period, CAT has seen a stock price increase of 393% versus mere 16.9% for the SP500. So, the mining boom has been good for CAT and its peers. The question of course is how sustainable is this cycle going forward.
In the chart below, our industrials team looks at the capital expenditures of large miners versus their depreciation and amortization. A company’s cap-ex should not greatly exceed the company’s depreciation and amortization unless growth is expected. As the chart outlines, this was the case for much of the 1990s. This isn’t totally surprising in commodity type industries where reinvestment occurs at the marginal cost. So, in theory, increased capital investment leads to higher production, lower prices, and decreased capital investment in the future.
Conversely, in the last ten years capital expenditures in the global mining sector have dramatically outpaced D&A expenditures, and on an accelerating basis. In fact, in 2011 cap-ex exceeded D&A by an astounding $50 billion across the sector. Clearly, commodity prices are in some form of an easy money-induced bubble, albeit increased demand from emerging growth economies is also a factor supporting the story underpinning market prices, but as our industrials team wrote:
“Mature, cyclical industries (mining is among the most mature) do not support high levels of growth investment in the long-run.”
3. Real Defense Spending – The U.S.’s federal budgetary issues are really no surprise to anyone that does macro research or focuses on the U.S. Treasury market (or actually reads a newspaper). Currently, the United States has ~104% debt-to-GDP, is running a deficit-to-GDP of ~9%, and ~40% of all deficit spending comes from borrowing. To narrow the budget, spending needs to decline, with defense spending being a major focus.
In the chart below, we highlight real defense spending going back to 1962. Two key points jump out from the chart. First, defense is a highly cyclical industry. There are periods of high real spending, typically during wars, and then spending declines following the war or with a change in administration. Secondly, defense spending on a real basis is at an almost all time high in the United States. Given the real level of spending and massive budgetary issues in the United States, it is difficult to envision a scenario in which the defense industry sees broad top line growth. In fact, future years of declining top line are more likely. In effect, it is an industry in which the “value trap” risk is alive and well – i.e. cheap stocks getting cheaper.
Daryl G. Jones
Director of Research
CONCLUSION: Our analysis of recent trends across a handful of key growth economies (using China, South Korea and Brazil as proxies in this note; there are many others) lends credence to our view that growth across Asia and Latin America continue to slow. More importantly, we are of the view that economic trends across each region will continue to deteriorate over the intermediate term – a conclusion strongly supported by our quantitative risk management models.
Q: What do Chinese equities, Korean equities and Brazilian equities all have in common?
A: Bearish Formations; cheap gets cheaper when growth is slowing.
With the latest reported growth generally slowing in each of those economies – on both a high-frequency and low-frequency basis – it’s fair to say that the recent rate cut cycles we’ve seen across China (-50bps), Korea (-25bps) and Brazil (-450bps) are merely indications that policymakers in each country are cognizant of the aforementioned trends and risks to growth globally (Europe; 112th Congress).
Chinese growth – slowing:
South Korean growth – slowing:
Brazilian growth – slowing:
We highlight the following statements from policymakers from each country as supportive of our view that the negative trend in global economic growth has not turned the corner:
“Stabilizing economic growth is not only a pressing priority for China now, it is also a long-term arduous task.”
-Chinese Premier Wen Jiabao (JUL 11, 2012)
“The South Korean economy is growing less than expected and growth will be less than potential for a considerable time.”
-JUL 12, 2012 Bank of Korea Monetary Policy Statement
“The recovery of Brazil’s economy has been slower than anticipated… The world economy will have an impact that is either neutral or disinflationary on Brazilian consumer prices.”
-JUL 11, 2012 Central Bank of Brazil Monetary Policy Statement
As an aside, the Bank of Korea’s rate cut was a surprise to us as well as the market (KOSPI closed down -2.2% on the day; KRW/USD -0.9%). We titled our JUN 28 note: “WAIT ON SOUTH KOREA” as a coherent message that it wasn’t the right time to increase one’s exposure to the KOSPI Index. Judging by the market response since then (including today’s sell-off), that appears to have been a prescient call. More importantly, the “wait” has been extended in our view, as this new monetary easing cycle takes the relatively strong KRW story – a key component of our formerly-bullish, TREND-duration fundamental bias – off of the table for now.
Looking ahead, the next major catalysts on the growth front out of each country are as follows:
- TONIGHT: Chinese 2Q12 Real GDP, JUN Industrial Production, JUN Fixed Assets Investment and JUN Retail Sales data will be realized. Consensus expectations for China’s 2Q Real GDP growth have come in from +8.3% at the start of MAY to +7.7%, creating ample room for headline upside surprise risk. We are inclined to fade any/all associated rallies that do not eclipse TRADE resistance on the Shanghai Composite. Chinese policymakers have been guiding towards a negative slope of domestic economic growth since 1Q10; listen to them.
- JUL 31: JUL Manufacturing PMI
- AUG 2: JUL Services PMI
- JUL 25: 2Q12 Real GDP
- JUL 29: AUG Business Sentiment Survey (Manufacturing and Services)
- JUL 31: JUL Manufacturing PMI
- AUG 1: JUN Industrial Production, JUN Trade Data and JUL Manufacturing PMI
- AUG 3: JUL Services PMI
- AUG 16: JUN Retail Sales
- AUG 31: 2Q12 Real GDP; We’ve been calling for a bottom here and will look to confirm if there’s anything in the number that will cause us to revise down our 2H12 outlook for Brazilian economic growth.
All told, our analysis of recent trends across a handful of key growth economies (using China, South Korea and Brazil as proxies in this note; there are many others) lends credence to our view that growth across Asia and Latin America continue to slow. More importantly, we are of the view that economic trends across each region will continue to deteriorate over the intermediate term – a conclusion strongly supported by our quantitative risk management models.
Anecdotally speaking, in a 30-minute call earlier this morning with one of our sharper clients on the international equity investment front, neither he nor I could come up with a solid bull case for any of the major-to-mid-major economies across Asia or Latin America – the consensus “engines of global growth” per the overwhelming majority of sell-side economists and corporate CFOs. Either we’ve become contrarian indicators or the GROWTH/INFLATION/POLICY dynamics simply aren’t there to support an incremental investment(s) in either region at the current juncture. You know where we stand on that.
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