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THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN

Takeaway: We are once again short the yen and remain bearish on the JPY in light of Japan’s deteriorating cyclical and structural GIP outlooks.

SUMMARY BULLETS:

 

  • We continue to hold a bearish bias on the JPY vs. the USD as we anticipate a series of economic and political catalysts that we think will drive the Bank of Japan to ease monetary POLICY like it never has before with respect to the intermediate-term TREND.
  • With respect to the long-term TAIL duration, at the present moment we think Japan faces material risk of a currency crisis (as loosely defined by a peak-to-trough move of -20% vs. the USD). During that decline, we would expect to see some reflation among Japanese equities as the exporters and industrials reap the obvious benefits of an FX tailwind. We think that beta risk is to be eventually faded however, as the JGB market may start to aggressively price in the confluence of rising inflation expectations and capital flight.
  • Ultimately, we continue to view these steps as the most probable functional mechanisms for a Japanese sovereign debt crisis, though we believe that remains an improbable risk for now.

 

Yesterday, a very astute client of ours pinged us with a question on the morning call asking about tail risk within the Japanese sovereign debt market in light of yesterday’s bombed-out SEP current account data, which, like Japan’s SEP trade balance, narrowed to an all-time low on a monthly basis:

 

THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN - 1

 

Our answer was that the client was 100% correct to callout the awful current account data point, as Japan’s significant loss of international competitiveness due to secular yen appreciation (JPY up over +50% vs. the USD over the last 10yrs) will remain a headwind to Japanese GROWTH over the intermediate term – especially in light of the erosion of export demand stemming from the geopolitical dispute with China. That is but one more domino among a series of economic and political catalysts that we think will drive the Bank of Japan to ease monetary POLICY like it never has before – literally, as a foreign asset purchase program remain a critical tail risk for the JPY. In support of our view that the BOJ is poised to accelerate its balance sheet expansion in a potentially unprecedented way over the intermediate term are the latest trends in implied volatility in the JGB futures market, which recently dropped to the lowest since 2002 (1.27%).

 

Regarding the BOJ, in its latest meeting (OCT 31), the BOJ announced its first back-to-back monthly stimulus expansion since 2003, increasing its revolving Asset Purchase Program by ¥11 trillion to ¥66 trillion and introducing an “unlimited” credit program for Japanese banks. We doubt Japanese banks will respond to this easing of liquidity conditions with a commensurate expansion of their balance sheets. Net interest margins at Japanese banks are at decade-plus lows (~140bps) as the average interest rate on new loans continues to track the 10yr nominal JGB yield lower.

 

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We continue to view these latest easing measures as mere precursors to the real fireworks, likely beginning around mid-2013, shortly after current BOJ governor Masaaki Shirakawa steps down from his post; he’ll likely be replaced by an incrementally dovish puppet of whichever party controls the Diet – more on this later. For now, Japan is likely to continue edging towards recession as companies like Sharp, Panasonic and Toshiba continue to scramble for ways to cut costs amid material profit erosion. To say corporate credit risk in Japan has undergone a demonstrably negative phase change with the JPY consistently trading just shy of post-war highs would be an understatement.

 

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Leading and concurrent indicators in Japan continue to support our bleak cyclical expectations for Japanese GROWTH – expectations that continue to be driven lower by de facto protectionism emanating from the Senkaku/Diaoyu Islands dispute, which has weighed on both Japanese exports and industrial production in recent months. The latest developments on that front is that Japan is now seeking to revise its military cooperation pact with the US amid fears of China’s increasing military presence in the region (especially after Hu’s incredibly hawkish foreign policy speech yesterday).

 

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Meanwhile the Japanese bond market – with the 5yr breakeven rate at/near all-time highs and the yield premium to take on additional duration risk widening – continues to support our hawkish structural expectations for Japanese INFLATION:

 

THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN - 8

 

THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN - 9

 

Interestingly, we continue to point to Shirakawa’s term expiration as one of the key catalysts for an acceleration of monetary easing by the BOJ, as the Milton Friedman-trained economist has been somewhat of a human dam, shielding the the BOJ board at the margins from the bi-partisan will [to inflate] of Japan’s two dominant political parties – the DPJ and LDP.

 

The primary reason we have been so focused on Japan’s looming government shutdown is that the LDP was previously using a brinksmanship tactic on the outstanding deficit financing bill (covering ~40% of FY12 expenditures), only agreeing to negotiate in exchange for a promise of early elections – likely sometime before year-end. The LDP, which would be likely to regain control of Diet as it has been heavily favored in the latest polls vs. the DPJ, has been outspoken in favor of hiking the BOJ’s long-term inflation target +200bps to +3% (and with it, the pace and scope of BOJ balance sheet expansion).

 

Turning back to Japan’s debt ceiling showdown, we’ve received some directionally positive news on this front this week. Japan’s three main parties (the DPJ, LDP and New Komeito Party) agreed to approve the deficit financing legislation in the Lower House on NOV 15 after the previous impasse slowed public expenditures enough to begin causing increasing disruptions in funding at the regional and local levels. LDP chief Shinzo Abe even gave his blessing to the local media, though promising to forge ahead with his party’s demands:

 

“It might be called a sunshine policy, but we will continue to press our demands… We are allowing Mr. Noda a chance to keep his end of the promise.”

 

In addition to recent weakness across Global Macro markets, this latest news has been very positive for the JPY with respect to the TRADE duration, giving us a new opportunity to re-short a favorite TREND and TAIL thesis within the FX market. Our quantitative risk management levels on the CurrencyShares Japanese Yen Trust etf “FXY” are included in the chart below. Do not, however, disrespect what the former of the previous two catalysts could do as it relates to further JPY strength from here (email us for more details) and we would look to re-short the FXY at TREND resistance if it manages to recapture its TRADE line.

 

THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN - 10

 

All that being said, we were never of the view that Japanese government would actually shutdown; nor did we expect a near-term Japanese sovereign default (a view supported by the continued tightening of Japanese sovereign CDS). Instead we fully anticipated a deal being struck with early parliamentary elections being the ultimate outcome. We still believe this is the base case scenario, though chatter from senior officials within the DPJ suggest a that the current redistricting process may delay dissolution of the Diet even further. Still, Noda is out recently affirming his AUG promise to call elections in the “near term” (by law, they must be called by AUG ’13) and we think Noda might just be trying to buy himself and the DPJ a bit more time to potentially regain some lost momentum in the polls.

 

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Regardless of the actual timing of the election (DEC or early 2013), a potential recession is unlikely to sit well with the Japanese populace and we would expect the LDP to maintain its advantage among Japanese voters over the intermediate term – making them Japan’s “new” ruling party (they were in power for over a generation before the DPJ won in 2009). As we mentioned before, that event would be overtly bearish for the JPY – a currency that is already struggling with gaggle of cyclical headwinds.

 

With respect to the long-term TAIL duration, at the present moment we think Japan faces material risk of a currency crisis (as loosely defined by a peak-to-trough move of -20% vs. the USD). During that decline, we would expect to see some reflation among Japanese equities as the exporters and industrials reap the obvious benefits of an FX tailwind. We think that beta risk is to be eventually faded however, as the JGB market may start to aggressively price in the confluence of rising inflation expectations and capital flight.

 

Ultimately, we continue to view these steps as the most probable functional mechanisms for a Japanese sovereign debt crisis and, as we highlighted on our MAR 2 presentation titled, “JAPAN’S DEBT, DEFICIT AND DEMOGRAPHIC RECKONING”, mere storytelling about Japan’s fiscal imbalances simply will not suffice to nail the timing of the “Widowmaker Trade”. It will pay to focus on the specific catalysts going forward, as well as any other globally interconnected risks that may impact marginal demand for the JPY and JGBs (such as US monetary and fiscal POLICY).

 

For those of you looking to establish a position here or generally interested in understanding the foreign exchange and global financial market risk embedded in our thesis, we encourage you to review the notes below. As always, we are available to dialogue further; simply email us and we’ll set up a call.

 

Darius Dale

Senior Analyst

 

  • 10/26: IDEA ALERT: RE-SHORTING THE YEN, OUR FAVORITE CURRENCY SHORT ACROSS ASIA
    • We see downside risk in the JPY relative to the USD across our TRADE, TREND and TAIL durations, driven largely by our expectations for the BOJ to dramatically accelerate their monetary easing measures amid heightening political pressure, a rapidly-deteriorating domestic GROWTH outlook and a potential upward revision(s) to their long-term inflation target over the intermediate term.
  • 9/27: IDEA ALERT: SHORTING THE YEN AS SINO-JAPANESE TENSIONS ESCALATE
    • We are now short the Japanese yen (via the CurrencyShares Japanese Yen Trust etf “FXY”) in our Real-Time Positions product as a way to communicate our bearish TRADE and TREND thesis on the JPY relative to the USD.
    • The key catalyst in support of our bearish bias is a likely acceleration of the BOJ’s balance sheet expansion, which may include a potential implementation of a foreign asset purchase program as Japan’s economic outlook deteriorates on the margin due to slowing commerce with China and recent yen strength.
    • From a TAIL duration perspective, any sustained weakness in the yen risks Japanese banks and asset managers clearing out of the JGB market en masse in search of higher yields abroad (which they couldn’t do previously due to structural yen appreciation), as well as imposing the threat of structurally higher rates of inflation – a risk the JGB market hasn’t had to price in for over a decade.
  • 9/19: ARE CHINA AND JAPAN HEADING FOR WAR?
    • While we view the threat of military intervention as highly improbable, we do think the heightened tension over the Senkaku (Japan)/Diaoyu (China) islands risks facilitating a string of international protectionism – which is already poised to accelerate due to recent political promises out of the Obama and Romney camps.
    • Such protectionism would have dire economic effects globally, with Japanese industrial production and US/EU consumption getting hurt the most – the former due to lower Chinese demand; the latter due to higher import price inflation.
    • Retaliatory measures, while not an acute risk, could beget broader financial market and economic contagion globally. This is a meaningful TAIL risk, given the recent rhetoric and maneuvers of international policymakers.
  •  8/28: THE RAMIFICATIONS OF JAPAN’S LOOMING GOVERNMENT SHUTDOWN
    • The political calendar poses a great deal of risk to the Japanese economy, JGBs and Japanese financial institutions over the next ~2 months.
    • The ramifications of a potential/actual Japanese government shutdown are three-fold: a potential sovereign default; a potential sovereign credit rating downgrade(s); and an associated $75-80 billion capital call across the Japanese banking system in the event JGBs are downgraded to single-A level by Moody’s and/or Standard and Poor’s, where the outlook is already “negative”.
  •  7/27: ARE JAPANESE GOVERNMENT BONDS POISED TO MAKE SOME NOISE?
    • By authorizing BOJ purchases of foreign currency assets, Japanese policymakers risk materially elevating the risk of sustained yen depreciation and inflation within the JGB market.
    • Though we have yet to receive anything concrete on the policy front, we will be paying close attention to the next two BOJ monetary policy board meetings for signs of official movement in this direction. 
    • We are now short the Japanese yen (via the CurrencyShares Japanese Yen Trust etf “FXY”) in our Real-Time Positions product as a way to communicate our bearish TRADE and TREND thesis on the JPY relative to the USD.
    • The key catalyst in support of our bearish bias is a likely acceleration of the BOJ’s balance sheet expansion, which may include a potential implementation of a foreign asset purchase program as Japan’s economic outlook deteriorates on the margin due to slowing commerce with China and recent yen strength.
    • From a TAIL duration perspective, any sustained weakness in the yen risks Japanese banks and asset managers clearing out of the JGB market en masse in search of higher yields abroad (which they couldn’t do previously due to structural yen appreciation), as well as imposing the threat of structurally higher rates of inflation – a risk the JGB market hasn’t had to price in for over a decade.
  • 3/30: DIGGING DEEPER INTO JAPANESE SOVEREIGN DEBT RISK
    • Is there a historical tipping point for a sovereign interest expense burden as it relates to default and/or financial crises?
    • How large of a risk to Japanese banks are their holdings of JGBs?
    • What are the assumptions the government is making regarding Japan’s fiscal outlook? How do Japan’s fiscal metrics look under various economic scenarios?
    • What’s the composition of Japan’s current account? Can the income balance sustain the current account surplus even in the absence of a reflating trade balance?
    • What’s the risk that the ~95% never sells and how much damage could the ~5% do if they become a heavy seller?
    • What sorts of labor market reforms could Japan undertake to boost economic output and lower the financial burden?
    • What are the best ways to play your thesis?
    • What’s the timing of the VAT hike discussions, given its importance as a catalyst for a ratings downgrade(s)?

Crude Oil Differentials

For October/November, water-borne light, sweet crudes (Brent, LLS, ANS) continue to trend higher against WTI, and regional crudes (Bakken, Midland, Syncrude, WCS) have traded away from WTI since mid-September. Wide differentials could persist in 4Q12, but we expect them to tighten across the board in 2013.

 

Crude Oil Differentials  - CRUDEoiltypes


JCP: War Pending in the Mall

Takeaway: Owning this name means waiting for the new stores to outweigh the old stores in quantity. Let’s hope the balance sheet lets it get there.

What Everyone Will Say: Results severely missed expectations. Comps down 26%, Internet sales down 37%, and margins off by -1237bps. Adjusted earnings showed a loss of $0.93. Management seems to have a very good sense as to where things went wrong, but not necessarily a good strategy to fix things anytime soon. The video of the new store concept looked great, and shows a transformed JC Penney into jcp, but it will take time to rollout en masse until newco outweighs the size of JC Penney.


What We Say: We did not like the stock the day Johnson started, and we don’t like it today. In fairness, this weakness was worse than even our model by a factor of 2x. We expected better, but are not surprised. Here’s are our low/highlights…

  1. We liked the fact that Johnson was more humble compared to a flat-out arrogant 2Q conference call (when he said he is missing Analysts targets, not His, just 2 quarters after spoonfeeding the Street).
  2. But unfortunately, it took the form of RJ going through his ‘Learnings’, which were really nothing more than realizations of factors that he should have known about this business before he took the job.
  3. The biggest Learning was ‘pricing’ in that when he offered lower prices, consumers responded in both traffic and conversion. When they held firm with a higher price, both metrics suffered. Sounds basic enough, huh?  unfortunately, it took a year to understand.
  4. If we were locked in a dark room and could see only one statistic about a company’s performance (aside from the stock price) it would be e-commerce sales. The simple fact that .com was down by 37% -- a sequential erosion – is just sad. One part of e-commerce is being operationally sound to handle consumer demand through a different, and more profitable, channel. But another is actually having consumers that care about the content in the first place. JCP has done a great job in driving consumers away, and it is going to take more than free haircuts to get people back shopping. It is going to take repeated positive experiences – which will take years to play out over a base of 1,100 stores.
  5. Johnson noted again how ‘this is a Journey’. We don’t want a Journey. We want a business that will take share profitably, and return capital to shareholders at a greater rate than other retailers.

JCP: War Pending in the Mall - JCP remodels

 

6.  Cash flow from operations for the year is -$655mm, JCP’s net debt to equity is sitting at historical highs of 0.67x, and we’re staring down the face of a FASB-mandated accounting change to capitalize operating leases that could inflate JCP’s balance sheet further to a point where borrowing capital to fund its transformation could become very difficult. Ultimately, JCP is likely to charge ahead, but would have to sell assets in order to do so. It’s already made the easy sales. Future ones are going to be less favorable economically.

7.  On that note, RJ stepped into dangerous waters when he started to call JCP a specialty store yet compare it to mall owners Simon, GGP, Macerich and Taubman. That was odd, to say the least. He followed up later to a question about specialty store productivity (which is $300-$400/square foot). He admitted then that jcp will be a specialty store, but with department store productivity.

 

The punchline here is that the call has not changed from last summer. Johnson is operating on a 7 (now 6) year duration. That’s when he gets paid. Wall Street largely cannot wait that long. Until then (and possibly after) we still are not sure that JCP will ever see an earnings number over $2.00. Trying to gage earnings this year is a Hail Mary. And either way you come up with a negative number. P/E valuation is meaningless. But with it its current debt burden and lack of cash, we’re looking at an EBITDA multiple near 10x. That’s just flat-out bad. At some point, this stock will look interesting as the shops gain traction, but that will be a long time from now, and until then we can point to nothing that should make it go up from $20. We think that JCP will create a massive headache for companies such as Macy’s, Gap, and Kohl’s as it takes up its product mix. The rationale is that regardless of JCP’s success, 100% of the product is being sold through. It just depends on the price, and therefore gross margin.

 

 


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WEN CARDIAC ARREST

Takeaway: Looming risks facing the Wendy's system make the stock unattractive to us on the long side.

We’ve outlined our concerns about Wendy’s cash flow, given the years of intensive capex required to fix the system, since the analyst day back in January when the price tag of the turnaround ($3.7 billion) was brought to light.

 

 

Thoughts on the Quarter

 

We expect fixing the Wendy’s system to take another two years.  Years of deferred capex has turned the company’s store base from an asset into a brand liability.  It has taken CEO Emil Brolick the better part of a year to get the upgrade cycle going.  As things stand, the vast majority of the initiative remains to be done.  The company is working frantically to reimage stores in order to produce data and assure the investment and franchisee communities of the initiative’s viability. 

 

The desire to demonstrate results is a positive but, on the other hand, it also implies an accelerating pace of spending and an increasing risk of earnings misses.  Yesterday’s earnings announcement was mixed, at best, as operational metrics came in light besides same-restaurant sales.  This company, by any conventional measure, is not producing free cash flow and likely will not for the next two years.

 

The comps during 3Q have vindicated management’s recent introduction of new menu items to increase consumer appeal.  However, Brolick has emphasized the long-term importance of the asset base upgrade for gaining full credit from consumers for the upgraded menu.  Where same-restaurant sales are in the fourth quarter is the key question for investors as the company laps the introduction of the Dave’s Hot ‘N’ Juicy Cheeseburger in October 2011.  It is a strong possibility that comps are negative in 4Q with consensus expecting +1%.

 

WEN CARDIAC ARREST - wendy s earnings recap

 

 

Nothing Better To Do With Cash?

 

The biggest concern from the earnings release, for us, was the doubling of the dividend and a new $100 million share repurchase program.  The board seems to be throwing money at the stock in order to support the share price which has been flat-lining for five years now.  An owner of the stock yesterday was happy to learn that the dividend was going higher but the truth is that the company does – or should – have a better use for its cash. 

 

WEN CARDIAC ARREST - wen cardiac arrest

 

 

Near-Term Uncertainty for Franchisees

 

Management announced a franchisee incentive program to get the larger, better-financed franchisees on board with the reimage program.  As an observer, it’s difficult to know how the impact of these initiatives will play out over the near- and intermediate-term.  As management has alluded to, the transformation of the Wendy’s brand will involve substantial turnover among the franchisee base.  The journey from “mom and pop” franchisees to “mega” franchisees will, we believe, have a positive impact on the long-term health of the Wendy’s system.  It is worth bearing in mind, however, that these transitions rarely occur without a hitch. 

 

There are other factors, on the macro and micro level that are adding to franchisee blood pressure.  On the macro side, Obamacare, commodity prices, and the fiscal cliff and its myriad possible consequences from a tax and economic perspective are weighing on the minds of operators.  On the micro level, there has been some discontent among smaller franchisees at the level of investment required of them to partake in this (largely unproven) reimage initiative. 

 

While we believe management can allay the micro-level concerns, the macro issues are unknown but could be especially meaningful for a company, like Wendy's, that is in transition. Our industry contacts continue to state that the implementation of Obamacare will be a negative for the restaurant industry.  Franchisee communities which operate on thin margins, like Wendy’s, are particularly vulnerable. 

 

 

The Latent Risks of the Franchised Business Model


In June, we held a conference call with John Hamburger of the Restaurant Finance Monitor and discussed the general perception of franchised companies as stable cash flow generators and the premium multiple that investors award the stock of such companies.  Shares of BKW, DIN, DNKN, MCD, WEN, YUM & DPZ are some of the most richly valued in the restaurant space. 

 

It makes intuitive sense to award a higher multiple to the shares of franchised companies but an important caveat is the prospective health of the constituent franchisees.  Yesterday, Wendy’s stated that the impact of the healthcare overhaul will be “less than” (read: “around”) $25,000 per store.  Assuming the company-franchise mix of ownership remains as it is, we calculate that Wendy’s could be facing a $0.10 hit to earnings per share.   Given the company and franchisees’ need to reinvest in the business, it is important to look at the impact on franchisee cash flow.  The impact of this new cost may amount to as much as 18-20% of store level cash flow for a ten-unit franchisee. 

 

WEN CARDIAC ARREST - obamacare unit econ impact

 

 

The looming impact of this, and other risks, is adding a real sense of urgency to the Wendy’s reimage initiative.  For those taking a shorter-term view of the stock, accelerating spending during such an uncertain time implies a higher risk of earnings disappointments.   

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 


Manheim Index Under Pressure?

The Manheim Index of Used Car Values rose in October by 1% on a month-over-month basis, an improvement but is still trending negative on a year-over-year basis. As of November 1, new vehicle inventory levels have been below 60 days (on a 12-month rolling basis) for the longest period ever. Low inventory in new auto sales means there’s a strong market there, putting pressure on used car sales.

 

Manheim Index Under Pressure?  - Manheim Index vs SPX normal

 

Why do used car sales matter? Because the Manheim Index historically correlates closely to the S&P 500 and financials (XLF). Pressure on the used car market could be a harbinger for things to come in the broader market.

 

Manheim Index Under Pressure?  - Manheim Index vs XLF normal

 

Manheim Index Under Pressure?  - Manheim Vs SPX normal


TUMI: How Low Can You Go?

Tumi Holdings (TUMI) looks weak right now and with the broader market selling off, it’s tempting to jump in and buy it. It’s important to note that TUMI just fell below its critical level of support at the TREND duration; we don’t see any support until the $17 level, so if you’re able to put temptation aside, you can likely snap up TUMI at a much lower price.

 

TUMI: How Low Can You Go?  - tumi


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