“And so he urged his countrymen: No more.”
-Hampton Sides (Blood and Thunder)
That’s what the head of the Navajo warriors, Manuelito, said to his people before ultimately succumbing to General Sherman’s troops. Maybe we’re going down versus the Fed’s Bailout Beggars too, but it won’t be without one heck of a fight.
Last week ended with a Draghi bagging the Jackson Hole meeting and Ben Bernanke doing nothing that resembled what he was allegedly going to do only 2 weeks prior. Rumor versus reality is a widening spread.
“What is the truth (Ray Dalio)?” Stocks continue to make lower-highs as bonds continue to make higher-lows. I urge all of you to join me in calling for No More of what has not worked. Otherwise, you’ll have $130-150 Oil and 1970s stagflation all over again.
Back to the Global Macro Grind…
Both US and Global Equities were down again last week (2 consecutive down weeks for the SP500, 1 month lows for Asia). Both Treasury Bonds and Commodities were up. The latter perpetuates #GrowthSlowing expectations in the former.
But no worries. Everyone who drives to work, eats food, and sends their kids to school this week understands the very basic P&L problem associated with cost of living rising as nominal wages are falling:
- American median incomes = down -5% since 2009
- US Dollar = down -5% since January 20, 2009
- Oil (WTIC) = +150% since January 20, 2009
Almost everyone, that is…
Mostly everyone else understands the concept of long-term lower-highs (stocks) and higher-lows (bonds) as well. Here’s what’s happened in the last 2 weeks as we setup for risk managing September:
- US Stocks (SP500) = down -0.85% (from 1418) to 1406 on Friday
- European Stocks (Eurostoxx600) = down -1.8% (from 272) to 267 this morning
- Chinese Stocks (Shanghai Comp) = down -3.5% (from 2118) to 2043 this morning
All the while:
- US Equity Volatility (VIX) = up +30% from its YTD closing low (2wks ago)
- Commodities (CRB Index) = up +1.9% (from 303) to 309 this morning
- US Treasury Yields (10yr) = down -14% (from 1.81%) to 1.55% this morning
So, who on God’s good earth profits from this economic model? If you bought bonds, volatility, and commodities 2 weeks ago, you did. But what % is that of the global population? Did higher prices in those 3 things perpetuate economic growth, or slow it?
If you bought Gold 2 weeks ago (we didn’t because we didn’t think Bernanke would go to Qe4 – and he didn’t), that’s up +4.8%. Great trade! But what does that mean? It means that the purchasing power of US Dollars continues to be debauched.
Are institutional investors long Gold? You bet your Madoff they are – and with headlines dominating your every day like this: “Gold, Near 5mth High, Seen Gaining on Prospects for More Stimulus” (Bloomberg), why shouldn’t they be?
Weekly CFTC data implies Gold buyers ramped bets on Bernanke right back up to where they were before they started falling in March (+19% wk-over-wk to almost 132,000 contracts).
Those are called expectations. Instead of jobs and economic growth, that’s what Bernanke really stimulates and, in doing so, perpetuates the US growth slow-down via commodity inflation.
This is why our Global Macro Model continues to nail #GrowthSlowing calls at these shortened economic cycle turns well ahead of consensus. Our models adjust, real-time, for Dollar Debauchery and Oil Inflation.
How long can inflation of market prices be masked as “economic growth”? Not for long. Each and every one of these Qe experiments gives markets shorter-term pops and more volatile reversals.
So, if you bought Gold (or Commodities) at the month-end markup of February 2012, or if you bought it there at lower-highs on Friday, the probability just went straight up (like the asset price did) that they will now come down again.
That’s called Deflating The Inflation. And while Bernanke wants you to believe that you’ll have no more of that (maybe ever), I’ll repeat what we all can’t afford any more of – policies to inflate asset prices that, in turn, slow growth.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, 10yr UST Yield, and the SP500 are now $1, $113.69-116.57, $81.11-81.91, $1.24-1.26, 1.55-1.64%, and 1, respectively.
Best of luck out there this week,
Keith R. McCullough
Chief Executive Officer
This note was originally published at 8am on August 20, 2012 for Hedgeye subscribers.
“This is a serious problem, although it is not as dramatic as sort of an epidemic.”
Author Ian Fleming created James Bond, code named 007, in 1953 and subsequently featured him in twelve novels and two short story collections. Bond was an intelligence officer in the Secret Intelligence Service and a Royal Naval Reserve Commander. Fleming based this fictional character on many of the intelligence officers and commandos he met during World War II. Interestingly, the name James Bond came from American ornithologist James Bond, a Caribbean bird expert and author of the definitive field guide Birds of the West Indies. (Don’t worry, I haven’t read it either.)
Over the course of the Fleming’s twelve novels and the twenty-two James Bond movies (the highest grossing series ever at $4.9 billion), Bond utilizes his astute intelligence gathering capabilities, combined with various gadgets, including an exploding attaché case, to save the world from a myriad of threats. If Bond were a research analyst studying today’s markets, the U.S. bond markets may be considered an emerging epidemic in his analytical purview.
Even if not an epidemic, bond issuance levels this year have been staggering. Firstly, in the municipal bond market in the United States, as of May, issuance is up 70% compared to the same period in 2011. Secondly, in the U.S. corporate bond market issuance is up 5% year-over-year, but has seen a serious acceleration in the last few months with investment grade issuance up 54% and high yield up 30% in July 2012. Finally, according to Lipper Research, bond ETFs have seen the eighteenth consecutive month of net inflows.
So, is there is a bond epidemic / bubble? Given the stance of the global central banks to keep interest rates at artificially low levels, it is likely not an epidemic that is going to end in the short term. In fact, we are actually aggressively allocated to U.S. government bonds as we think equities are at an extreme and growth is continuing to slow. Certainly though, James Bond, the research analyst, would be gathering his intelligence and watching and waiting for an opportunity to sell the high yield bond market.
As we show in the Chart of the Day below, which we have aptly named, From the Central Banks with Love, the high yield market is at a generational low in yield. Obviously when studying a corporate bond, there are a number of factors to analyze in determining whether it is overvalued or undervalued. Certainly, the overall interest rate environment is critical, but ultimately the prospects of the company are the drivers of a junk bond’s value, especially given the bond’s inferior position in the capital structure. Therefore, given that yields in the junk bond market are literally at generational lows, it implies that default risk is also close to an all-time low. Personally, I’d need a few James Bond-esque martinis before I’d believe that last point to be an accurate assessment of default risk.
Speaking of bonds, Der Spiegel reported this weekend that the ECB may set a specific threshold to cap periphery bond yields at its meeting in September. The immediate reaction in the European sovereign debt markets is, not surprisingly, positive as credit default swaps are trading tighter across the board. As well, the Spanish 10-year is back down to 6.19%. Even if positive in the short term, broad intervention in a large market speaks to another epidemic, the epidemic of government intervention in the free markets. Random intervention by governments does not build confidence in the markets. And confidence is what is sorely missing in the European debt markets.
In the latest sign that global growth is slowing, the Shanghai Composite hit a fresh three and a half year low this morning. The Chinese equity markets may not always garner headlines in the U.S. financial media, but nonetheless China remains the engine for global growth and as China goes so goes marginal global growth. Thursday will give us some important insights on Chinese and global growth as flash PMIs are reported for China, Europe and the United States.
Keith is back in Thunder Bay this week taking some time off with his family ahead of what is going to be a busy next few months at Hedgeye, so we will be highlighting some of the key calls from our broader research team this week. This will be kicked off this morning with our Financials Sector Head Josh Steiner and our Retail Sector Brian McGough leading our morning client call at 830 a.m. Email firstname.lastname@example.org if you like to ask them any questions, or get access to the call.
Although we are currently not short it in the Virtual Portfolio, one of McGough’s favorite short ideas has been J.C. Penney. We’ve been consistently short JCP for the past fifteen months and will likely look to re-short when we see our level. McGough had the following to say after JCP’s recent earnings announcement:
“We won't bother with the full financial review. Comps down -22%, dot.com down 33% and a ($0.67) loss pretty much sums that up.
But that's the past. We invest for the future. One thing that matters in investing for the future is believing in who is running the ship. We initially figured that Johnson's Apple halo would have lasted 18-24 months. But about 5-minutes into his commentary today, his credibility stood up, ran out the door, and got hit by a bus.
Last quarter, his level of arrogance around communicating the message was bothersome. He spoke to the Street like we were toddlers, or at least retail novices. He glossed over the bad, and played up whatever positive statistic he could find. A JV mistake for a new CEO.”
As it relates to CEO Ron Johnson at J.C. Penney, or really any CEO of a large public company, perhaps Ian Fleming said it best when he wrote:
“Once is happenstance. Twice is coincidence. Three times is enemy action.”
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, 10yr UST Yield, and the SP500 are now $1601-1624, $110.89-115.21, $82.20-82.89, $1.22-1.24, 1.72-1.87%, and 1406-1419, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
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Takeaway: Despite sovereign yields moderating, growth remains constrained and austerity’s tail is not fully priced in across Europe.
Positions in Europe: Short EUR/USD (FXE)
Asset Class Performance:
- Equities: The STOXX Europe 600 closed down -0.7% week-over-week vs -1.8% last week. Bottom performers: Ukraine -5.2%; Russia (RTSI) -2.9%; Sweden -1.4%; Switzerland -1.4%; UK -1.1%; Finland -1.0%. Top performers: Portugal +2.5%; Spain +1.5%; Italy +1.5%; Hungary +0.7%.[Other: France -0.6%; Germany 0.0%; Greece +0.4%].
- FX: The EUR/USD is up +0.56% week-over-week. W/W Divergences: RUB/EUR -2.14%; HUF/EUR -1.90%; PLN/EUR -1.85%; TRY/EUR -1.69%; GBP/EUR -0.15%; DKK/EUR -0.04%; NOK/EUR -0.01%; CHF/EUR +0.01%.
- Fixed Income: The 10YR yield for sovereigns across the region were mostly higher this week. Spain saw the largest increase, +28bps to 6.70%, followed by France’s +14bps move to 2.19%. Italy rose +8bps to 5.79bps and Germany was up +4bps to 1.39%. Greece bucked the trend, falling -54bps to 23.43%.
- Sovereign CDS: Sovereign CDS followed yields, up slightly across the periphery this week. On a week-over-week basis Spain rose the most, up +18bps to 511bps, followed by Italy +14bps to 463bps. France, Germany, the UK, and Ireland were mostly flat on the week. Portugal showed a negative inflection of -13bps to 669bps.
This week in Europe produced a ton of noise: it started off with Draghi announcing that he would not attend Jackson Hole and increased speculation that the ECB is considering informal, flexible yield targets on short-term peripheral sovereign debt and concluded with Bundesbank President Jens Weidmann reiterating his opposition to ECB purchases of peripheral debt and his possible resignation. In short, we see the success of targeting yields as highly doubtful. Interesting, Chancellor Merkel remains in a tight spot supporting Weidmann while understanding that she must play ball with her fellow Eurocrats and inevitably grant more bailouts and support concessions to prevent the exit of Greece and limit risk premiums across the periphery.
Keep in mind that the market is wrestling with two immediate catalysts: 1. The results of the Governing Council meeting of the ECB this coming Thursday (9/6), and 2. The decision of the German Constitutional Court on 9/12.
We think it’s unlikely that we’ll get definitive color on secondary peripheral buying at the ECB’s meeting and expect rates to be on hold until we get at least another month of data and after there’s clarity from the German Constitutional Court’s decision on the constitutionality of the ESM and Fiscal Compact; currently it looks probable that it will pass.
While sovereign yields and CDS spreads were marginally higher on a week over week basis, they remain (at least for the moment) under levels seen earlier this summer -- as recently as late July -- when Italy and Spain’s 10YR were trading north of the 6% and 7% levels, effectively the market’s freak-out level. It’s unclear whether this is a function of indecision ahead of the ECB and German Court decisions or a new-found confidence that Eurocrats will continue to throw the kitchen sink at their problems despite our view that Eurocrats have no clue on how to craft a long term path towards a united, growing Europe.
Interestingly, new issuance from Italy and Spain this week was issued at lower yields than previous auctions for similar maturities, a bullish signal. But is it sustainable? We think not so long as growth remains constrained and austerity’s tail is not fully priced in. Recent fundamental data, as we show below for this week under the section Data Dump, remains awful to challenged.
Auction Results (highlights):
Italy sold €4.0B 10YR bonds with an average yield of 5.82% vs prior 5.96%, (bid to cover 1.42 vs prior 1.29; target €3.0-4.0B).
Italy sold €9.0B 6M bills with an average yield of 1.585% vs previous 2.454% on July 27 (bid-to-cover 1.69 times vs previous 1.61).
Spain sold 3M bills at 0.946%, down from the 2.434% at the last auction in July (bid-to-cover improved to 3.4x from 2.9x).
Spain sold 6M bills at 2.026% vs 3.691% last month (bid-to-cover fell to 2.2x from 3.0x in July).
Germany - German government economic adviser Lars Feld (one of Germany's five "wise men") said that a breakup of the Euro would cut up to 10% off the German economy. He added that even just a Greek exit would present significant risks.
China - Premier Wen told visiting Merkel that Spain, Italy, and Greece must take “comprehensive measures” to prevent crisis from worsening. Wen did say China is willing to invest in the European Bond Market, though on the condition of a full evaluation of risk, and said that the key to solving the crisis is to strike a balance between fiscal tightening and economic stimulus.
Netherlands - The Political backdrop in the Netherlands ahead of the 12-Sept elections: opinion surveys show that the anti-austerity Socialist Party could garner between a fifth and a quarter of the seats in parliament, beating out the pro-business Liberal Party. This could put Socialist party and its leader, Emile Roemer, in a position to form a coalition. However, forming a coalition will not be easy, as an alliance with its two natural allies, Labor and Green, would be unlikely to secure enough seats to form a government. This could spell coalition building problems over austerity plans agreed under the government in April and derail the budget targets for 2013 set by the European Commission. The Socialists also want a referendum on the new fiscal compact.
Germany - Der Spiegel reported that German Chancellor Merkel wants an EU convention to draft a new treaty for deeper Eurozone integration. The magazine said that Merkel hopes that an EU leaders' summit in December can produce a firm date for the start of the convention on a new treaty.
Spain - ECB data showed that deposits in Spanish banking institutions fell 4.7% M/M in July. However, a Bank of Spain official told Dow Jones that the number was impacted by the fact that Spanish companies typically pay taxes in July, while households tend to spend more in the summer months as they go on holiday.
Spain - ECB data showed that Spanish banks cut their government bond holdings by €7.58B to €247.2B in July, the largest monthly drop since August of last year.
Italy - Prime Minister Monti said in an interview with the Italian business daily Il sole-24 Ore that while he may seek support from the Eurozone bailout mechanism to help lower borrowing costs, he does not want Italy to be subjected to "some sort of intrusive special administration like has happened with the countries that needed aid to balance their accounts". He added that Italy is "not in that situation".
Spanish - Deposit outflows for July was €74B (2x the previous month and equal to 7% GDP).
Portugal - According to a government source, troika is considering relaxing Portugal's 2012 budget deficit target from 4.5% of GDP to slightly above 5%. The paper said that the concession is in exchange for the improvement that Portugal has shown with its external deficit, which came in below 2% in the first half of the year, below the annual 2.5% target.
Spain - Moody's expected to downgrade Spain to junk in September. Moody's put Spain on negative review in June, giving itself three months to decide whether or not to cut the sovereign debt rating to junk.
Our immediate term TRADE range for the cross is $1.23 to $1.26. In the second chart below we look at CFTC data for net contracts of Euro non-commercial positions. Interestingly, since a high in short positions in the Euro on 6/5/12 (-213.060 contracts), investors have been less bearish (and covering), moving to 41% less bearish contracts (-125.817) as of 8/21. On a 1M basis, contracts moved to 20% less bearish; 3M = 35% less bearish; and 6M = 8% less bearish.
In yet another week Europe showed very weak fundamental data across most of the board. In highlight, Eurozone confidence figures broadly declined in August versus July, a similar trend that was seen with German (IFO) confidence declining for four straight months, as inflation moved higher in the Eurozone (+2.6% in August) and remained sticky and high in Italy, at 3.5%.
Eurozone Business Climate -1.21 AUG (exp. -1.30) vs -1.27 JUL
Eurozone Consumer Confidence (Final) -24.6 AUG (inline) vs -21.5 JUL
Eurozone Economic Confidence 86.1 AUG (exp. 87.5) vs 87.9 JUL
Eurozone Industrial Confidence -15.3 AUG (exp. -15.5) vs -15.1 JUL
Eurozone Services Confidence -10.8 AUG (exp. -9.0) vs -8.5 JUL
Eurozone M3 3.8% JUL Y/Y (exp. 3.2%) vs 3.1% JUN
Eurozone CPI 2.6% AUG (exp. 2.5%) vs 2.4% JUL
Eurozone Unemployment Rate 11.3% JUL vs 11.3% JUN (revised from 11.2%)
Germany Unemployment Change +9K AUG (exp. +7K) vs +9K JUL
Germany Unemployment Rate 6.8% AUG vs 6.8% JUL
Germany IFO Business Climate 102.3 AUG (exp. 102.7) vs 103.2 JUL
Germany IFO Current Assessment 111.2 AUG (exp. 110.8) vs 111.5 JUL
Germany IFO Expectations 94.2 AUG (exp. 95) vs 95.5 JUL
Germany Import Price Index 0.7% JUL M/M (exp. 0.9%) vs -1.5% JUN [1.2% JUL Y/Y (exp. 1.4%) vs 1.3% JUN]
Germany GfK Consumer Confidence 5.9 SEPT vs 5.8 AUG
Germany CPI Preliminary 2.2% AUG Y/Y (exp. 2.0%) vs 1.9% JUL
Germany Retail Sales -1.0% JUL Y/Y (exp. 0.1%) vs 3.7% JUN
France Own Company Production Outlook -6 AUG vs -9 JUL
France Production Outlook -44 AUG vs -44 JUL
France Business Confidence 90 AUG vs 89 JUL
UK M4 Money Supply -4.6% JUL Y/Y vs -5.2% JUN
UK Nationwide House Prices -0.7% AUG Y/Y (exp. -2.2%) vs -2.6% JUL
Italy Business Confidence 87.2 AUG (exp. 86.8) vs 87.1 JUL
Italy Hourly Wages 1.5% JUL Y/Y vs 1.5% JUN
Italy Retail Sales -0.5% JUN Y/Y vs -1.7% MAY
Italy Consumer Confidence 86 AUG vs 86.5 JUL
Italy Unemployment Rate 10.7% JUL Prelim. vs 10.7% JUN
Italy CPI 3.5% AUG Prelim Y/Y vs 3.6% JUL
Italy PPI 2.4% JUL Y/Y vs 2.2% JUN
Spain CPI Preliminary 2.7% AUG Y/Y (exp. 2.3%) vs 2.2% JUL
Spain final Q2 GDP -0.4% Q/Q (exp. -0.4%) and UNCH vs preliminary [-1.3% Y/Y (exp. -1.0%) and -1.0% preliminary]
Spain Mortgages on Houses -25.2% JUN Y/Y vs -30.5% MAY
Spain Retail Sales -6.9% JUL Y/Y vs -4.4% JUN
Portugal Consumer Confidence -49.2 AUG vs -50.4 JUL
Portugal Economic Climate -4.0 AUG vs -4.4 JUL
Portugal Industrial Production -0.2% JUL Y/Y vs -4.6% JUN
Portugal Retail Sales -7.9% JUL Y/Y vs -5.4% JUN
Ireland Property Prices -13.6% JUL vs -14.4% JUN
Austria PPI 0.2% JUL Y/Y vs 0.3% JUN
Belgium CPI 2.86% AUG Y/Y vs 2.32% JUL
Switzerland KOF Swiss Leading Indicator 1.57 AUG vs 1.41 JUL
Sweden Household Lending 4.4% JUL Y/Y vs 4.6% MAY
Sweden PPI -1.1% JUL Y/Y (exp. -0.6%) vs 0.2% JUN
Sweden Consumer Confidence 5.4 AUG vs 5.6 JUL
Sweden Manufacturing Confidence -9 AUG vs -3 JUL
Sweden Economic Tendency 97.1 AUG vs 95.4 JUL
Netherlands Producer Confidence -4.6 AUG vs -5.2 JUL
Netherlands Consumer Spending -0.6% JUN Y/Y (exp. -1.7%) vs -1.6% MAY
Belgium Unemployment Rate 7.2% JUL vs 7.2% JUN
Denmark Q2 GDP Preliminary -0.5% Q/Q vs 0.3% in Q1 [-0.9% Y/Y vs 0.3% in Q1]
Norway Unemployment Rate 2.6% AUG vs 2.7% JUL
Finland Business Confidence -7 AUG vs -5 JUL
Finland Consumer Confidence 0.5 AUG vs 0.1 JUL
Ireland Consumer Confidence 70 AUG vs 67.7 JUL
Ireland Retail Sales Volume -1.5% JUL Y/Y vs -6.0% JUN
Greece Retail Sales -9.6% JUN Y/Y vs -9.2% MAY
Poland Q2 GDP 0.4% Q/Q (exp. 0.5%) vs 0.6% in Q1 [2.4% Y/Y (exp. 2.9%) vs 3.5% in Q1]
Hungary Unemployment Rate 10.5% JUL vs 10.9% JUN
Hungary Producer Prices 6.2% JUL Y/Y vs 6.9% JUN
Slovakia Consumer Confidence -25.9 AUG vs -23.0 JUL
Slovakia Industrial Confidence -4.7 AUG vs -6.7 JUL
Slovakia PPI 3.6% JUL Y/Y vs 4.0% JUN
Turkey Tourist Arrivals -0.6% JUL Y/Y vs 2.7% JUN
Interest Rate Decisions:
(8/28) Hungary Base Rate Announcement CUT 25bps to 6.75%
(8/29) Norway Deposit Rates UNCH at 1.50%
The Week Ahead:
Monday: Aug. Eurozone, Germany and France PMI Manufacturing – Final; Aug. UK PMI Manufacturing; Spain and Greece Manufacturing PMI; Aug. Italy PMI Manufacturing, New Car Registrations, and Budget Balance
Tuesday: Jul. Eurozone PPI; Aug. UK PMI Construction, BRC Shop Price Index; Aug. Spain Unemployment
Wednesday: Aug. Eurozone PMI Composite and Services - Final; Jul. Eurozone Retail Sales; Aug. Germany PMI Services – Final; Aug. UK. PMI Services, Official Reserves; Aug. France PMI Services – Final; Spain Services PMI; Aug. Italy PMI Services
Thursday: Governing Council meeting of the ECB in Frankfurt; ECB Announces Interest Rates; 2Q Eurozone Household Consumption Expenditures, Gross Fixed Capital Formation, Government Expenditures, GDP – Preliminary; Jul. Germany Factory Orders; BoE Announces Rates; BoE Asset Purchase Target; Aug. UK New Car Registrations; 2Q France Unemployment Rate; Jun. Greece Unemployment
Friday: Aug. Germany Wholesale Price Index (Sept. 7-12); Jul. Germany Exports, Imports, Current Account, Trade Balance, Industrial Production; 2Q Germany Labor Costs Workday and Season 1Q Labor Costs to be published the day as 2Q; Aug. UK BoE/GfK Inflation Next 12 Months, PPI Input and Output
Takeaway: Revised EPA NCPs are minimal and may be challenged. Looking like a failure risk can make $NAV a failure risk. Owning $PCAR a way to benefit.
Best Outcome on Non-Conformance Penalties, Outlook Still Pretty Grim
Still Expect NAV to Lose Market Share, Generate Losses. Paccar a Potential Winner.
Surprisingly Small Changes: Navistar avoided retroactive fines, outright bans and prohibitively high fines. The new maximum penalty is $3,775, increasing “several hundred dollars per engine each year for later model years.” The EPA release can be found at http://www.epa.gov/otaq/regs/hd-hwy/ncp/420f12049.pdf.
Breathing Room: Navistar can continue to sell its existing 13L engine at this penalty level for quite some time. That may give NAV additional time to integrate the 15L engine from Cummins, which we expect to take longer than the company’s current January 2013 forecast. It may allow Navistar to delay the new 13L engine and develop a more practical solution. The revised NCPs help to ease selling risks in CARB states in the near-term.
Expect Challenges: Competitors may not see this as an adequate penalty and the court may well agree. The advantages of noncompliance probably exceed the increased (straight-line) cost addition of $400-$800 per year.
Navistar a Potential Zero (Reflexive Risk): That Navistar looks like it could end up in distress increases the probability that Navistar WILL end up in distress. Customers need a strong corporation providing warranties, service and replacement parts for years to come. Residual value guarantees and off balance sheet commitments could add to the concerns should the resale market falter. Customers depend heavily on their trucks and do not want supplier risk. Once confidence is lost, it will probably require an outside buyer like VW or Hino to get it back. The CDS chart below shows how confidence in NAV is trending. Looking like a failure risk could make Navistar a failure risk.
Products Matter: Navistar does not have a successful product strategy, in our view. There are already concerns regarding the reliability of the current 13L MaxxForce engine. The 15L from Cummins looks like the most promising answer, but 15L engines represent less than half of the class 8 market and it isn’t obvious that they can get it out by January 2013. At least initially, we expect NAV’s EGR cum SCR 13L engine to be uncompetitive.
Navistar Losses: Heavy discounting has allowed the company to maintain market share amid product uncertainty. Losses could accelerate as the company runs out of emissions credits and NCPs increase. We expect NAV to lose market share as its financial situation looks more acute and the company struggles to deliver compliant products.
Market Share Losses: Even if NAV is purchased by a stronger company, International is likely to shed market share in 2H 2012/2013. Navistar cannot maintain heavy discounting indefinitely.
PCAR and Volatility, Not NAV: Navistar is most likely not going to resolve these problems as an independent company, in our view. The brand and dealer network are valuable assets and Navistar could get bought, though probably not at a price above $40/share. That makes shorting very risky. However, the company may well be purchased in distress or even bankruptcy, if this drags on. That makes long positions a tough bet. We would keep an eye on implied volatility, though, and consider January straddles if they get cheap, with the Cummins 15L, a potential acquisition and market share losses as catalysts. Better, the best way to play problems at Navistar is to be long PCAR, in our view, a company likely to benefit from Navistar’s market share losses.
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