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EYE ON THE IMF

The IMF released its updated “World Economic Outlook Update” today, with revised global projections for 2009 and 2010. In it, IMF Chief Economist Olivier Blanchard states bluntly, “we now expect the global economy to come to a virtual halt.” While our macro view is not as bearish as Blanchard’s holistically, we questions if some estimates are padded, in particular India.

A few main call-outs from the Report: World growth is projected to fall to 0.5% in 2009, the lowest rate since WWII, a downward revision of about 1.7% from the November 2008 WEO update, with a gradual recovery projected in 2010 to 3%. Advanced economies are expected to suffer the deepest recession with a 2% contraction this year. Inflation is expected to fall to 0.25% in 2009 from 3.5 % in 2008, before edging up to 0.75% in 2010. Emerging and developing economies are expected to slow from 6.25% in 2008 to 3.25% in 2009, with inflation in these countries expected to decline from 9.5% in 2008 to 5.75% in 2009 and 5% in 2010.

We took special note of the projections for India: at 5.1% the IMF projection for growth is well below the 6.5 - 7% that the ministry of Industry has been hyping in the press, but still strikes us as very optimistic. We re-shorted the Indian equity market via IFN today and continue to think that growth could slow more than many expect there.

The graph below taken from IMF data presents country specific, commodity, and import/export forecasts for 2009 juxtaposed with predictions from their last report in November.

Matthew Hedrick
Analyst

Andrew Barber
Director

US HOUSING - BULLISH BOTTOM FORMING

Earlier this week we learned that this month’s existing home sales came in +6.5% higher than last month’s number (see Keith McCullough’s post titled US Housing: Bullish Bottom Forming? - 1/26/09), and more importantly, inventories declined significantly. The supply of homes came down to 9.3 months, down significantly from the peak and the 11.2 months recorded in November 2008.

The second positive data point came yesterday. It was reported that the S&P/Case-Shiller 20-city index fell 18.2% year-over-year, the biggest drop since it began 2001. Less attention was paid to the fact that the October decline was 18.1%. Yes, it was the worst month on record, but the rate of deceleration continues to slow. On the margin, this is a positive. As we noted in our MEGA note, we believe that as we reach the spring, we will have reached the peak in declining home prices. Home prices will continue to decline but at a much lesser rate.

The bears point to the fact that home values will continue to decline contributing to what’s already been the biggest destruction of American household wealth in many generations. Consequently, the decline in home prices makes banks even more reluctant to offer mortgages. We know all this!

How many times have you heard everything has its price? Clearly, the decline in home prices is now leading buyers back into the market. At the same time, we are seeing a zero percent Fed funds rate, and an Obama administration focused on getting banks to lend to those seeking new lows in 30-year mortgage rates. The combination of significantly lower home prices and lower mortgage rates will have a positive impact on the US real estate market in 2009!


US HOUSING - BULLISH BOTTOM FORMING PART II

Earlier this week we learned that this month’s existing home sales came in +6.5% higher than last month’s number (see post US Housing: Bullish Bottom Forming? - 1/26/09), and more importantly, inventories declined significantly. The supply of homes came down to 9.3 months, down significantly from the peak and the 11.2 months recorded in November 2008.

The second positive data point came yesterday. It was reported that the S&P/Case-Shiller 20-city index fell 18.2% year-over-year, the biggest drop since it began 2001. Less attention was paid to the fact that the October decline was 18.1%. Yes, it was the worst month on record, but the rate of deceleration continues to slow. On the margin, this is a positive. As we noted in our MEGA note, we believe that as we reach the spring, we will have reached the peak in declining home prices. Home prices will continue to decline but at a much lesser rate.

The bears point to the fact that home values will continue to decline contributing to what’s already been the biggest destruction of American household wealth in many generations. Consequently, the decline in home prices makes banks even more reluctant to offer mortgages. We know all this!

How many times have you heard everything has its price? Clearly, the decline in home prices is now leading buyers back into the market. At the same time, we are seeing a zero percent Fed funds rate, and an Obama administration focused on getting banks to lend to those seeking new lows in 30-year mortgage rates. The combination of significantly lower home prices and lower mortgage rates will have a positive impact on the US real estate market in 2009!

Howard Penney
Managing Director

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MCD - DECELERATING

MCD’s U.S. same-store sales growth remained surprisingly strong throughout 2008 despite the tough economic environment. The company states that half of this comparable sales growth has been driven by traffic with the remainder coming from increases in average check. The growth in average check in 2008 was driven solely by MCD’s 3%-4% price increase, which was partially offset by negative mix contribution in each quarter. Please refer to the charts below, which assume 50% of MCD’s quarterly U.S. comparable sales growth is driven by traffic and 3.5% pricing for each quarter in 2008. One obvious explanation for MCD’s negative mix in the U.S. is that customers are trading down to the Dollar Menu, which has also helped to support traffic growth. Management has said, however, that the Dollar Menu has remained within its historical range of 13%-14% of sales.

Instead, management commented on this negative mix issue on its 3Q08 earnings call, saying, “I wouldn’t call it negative mix. The problem with an average check is you have a lot of different transactions in there. So our breakfast business, as we have said, in the U.S. continues to grow faster than the rest of the day and breakfast is a lower average check but a higher margin transaction. The same way with drinks. We were strong in our drink promotions through the summer, as we have talked about. Coffee is up more than 30% and a lot of those end up being transactions that are during off-peaks which are also smaller average checks, or they are only individual versus family purchases.”

When asked earlier this week about its pricing plans for 2009, management said in reference to Europe that MCD will most likely not be taking the level of pricing in the first half of the year that it normally would because “you’ve got to consider how the consumer is feeling and during these times the consumer is looking for deals and we want to make sure that we’re out there.” Although the company did not make any specific comments about pricing in the U.S., I believe the same line of thinking must hold for the U.S. as consumers are under increased pressure. I do not think the company will reduce its pricing but it may be become more difficult going forward to maintain its 3%-4% price increases. In 2008, MCD relied on these price increases to offset its negative mix and support same-store sales growth.

Also hurting average check in 2009 will be the increased contribution from specialty coffee sales. I continue to believe that MCD is launching its specialty coffee platform at exactly the wrong time (with people cutting back on these more discretionary purchases) and that it will not provide the expected sales lift. The bulls on MCD continue to believe that the company will be able to flawlessly execute on the launch of this new beverage platform, but specialty beverages are just that for MCD; a new platform. The company is not maintaining its strict focus on its core products, and I think these beverages will add complexity to a system that in the recent past has consistently improved its operations. That being said, increased coffee sales have resulted in lower average checks in the past so I would expect any incremental off-peak specialty coffee sales to put further pressure on average check growth.

Going forward, MCD’s ability to maintain its same-store sales momentum in the U.S. may be at risk as it becomes more difficult for the company to raise prices and as its average check is hurt by increased Dollar Menu, breakfast and coffee sales. Although increased breakfast and beverage sales would be good for margins, investors have become accustomed to consistently superior same-store sales results. Additionally, it should not go unnoticed that some of MCD’s biggest competitors, Wendy’s and Sonic in particular, are increasingly focused on their value offerings, and based on its recent success, MCD has the most to lose should these companies experience improved traffic growth. Remember, the restaurant industry is a zero sum game!

EYE ON THE YIELD CURVE

With issues of historic size for 2 & 5 year paper driving yields higher on the short end and market anticipation of a “bad bank”, the curve is starting to show declining steepness -a data point that could be negative on the margin if the trend were to continue.

With a spread of over 170 basis between the twos and tens it would be premature to call this out as a sea change but it is worth taking note of and we will keep it in our line of sight.


Andrew Barber
Director

EYE ON LEVERAGE: ULTRASHORT

We have recently fielded several questions about ETF structures with enhanced leverage features.

The matter of ultrashort ETFs pricing has been a hot topic of conversation for the past two or three months as investors who purchased and held them realized returns that diverged significantly from the results they had anticipated. The common issue that many investors encountered was a misunderstanding of the actual mechanics of the products.

Ultrashort ETFs, such as TBT -the ProShares Long-Term Lehman Bond Index product that is used for the charts below, replicate a short position that is recalibrated daily rather than a static leveraged position in the underlying (which would not be possible to duplicate in this type of structure mathematically). As such, investors that have purchased the shares and held them have often been very disappointed as illustrated by the first chart below which illustrates the divergence in returns realized by a long term holder of the ETF vs. a static short in the underlying index. The increasing number of shareholders holding the ETF over multiple trading sessions has increased with volume since inception (see "OVERHANG" in the second chart on the first illustration panel).

The confusion over these structures has been compounded by the existence of active options for many, which has led some retail investors that regularly engage in buy-write strategies to buy ultrashort ETFs and sell call options against the position without fully understanding what they were buying and selling.

For intraday traders who are utilizing the ETF as it was intended, the returns have come in with a very close correlation to a leveraged short intra-day position in the underlying, as illustrated in the second illustration panel below. Since the trading-leverage drought started last year the ultrashort class of ETF has become a magnet for hedge funds employing short term strategies who have found leverage to be difficult to extract from their prime brokers.

Ultimately, it seems unlikely that an ETF will be introduced that can truly approximate the economic exposure of a static 2-to-1 leveraged short position given the inherent credit exposure assumed by the issuer of any such product in the event that the underlying investment declined by an amount greater than the value of the actual ETF. As such I would expect that sophisticated speculators looking for multi session exposures will probably prefer futures and options markets whenever available.


Andrew Barber
Director

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