“Affairs are easier of entrance than exit; and it is but common prudence to see our way out before we venture in.”
Yesterday morning I was in the Canadian ski town of Banff, Alberta and today I found myself in Park City, Utah. Since this is my first trip to Park City, I must admit it is a very picturesque town. In fact, the beauty here almost offsets the fact the beers and cocktails are all watered down. Almost being the key word. But enough beating around the bush, today I’m going to jump right into it.
Yesterday morning in the Early Look I noted that violating the debt ceiling was imminent. Coincidentally or not, later in the day yesterday Treasury Secretary Geithner issued a press release stating that the statutory debt limit would be violated by December 31st but that the Treasury department could take extraordinary measures to extend the ceiling by an additional $200 billion. In the press release, it was also noted that:
1.) The extraordinary measures can create approximately $200B in headroom under the debt limit; and
2.) Under normal circumstances, that amount of headroom would last approximately two months. However, given the significant uncertainty that now exists with regard to unresolved tax and spending policies for 2013, it is not possible to predict the effective duration of these measures.
To summarize: while there may be two more months of flexibility, the uncertain policy environment makes it difficult to project. So, just as he is preparing to exit stage door left, Geithner sticks the markets with more uncertainty.
Managing through the fiscal and monetary crises that is looming over the next couple of months would actually require some discipline and willpower. Unfortunately, both of those attributes are currently in short supply in the hallowed halls of Congress. Yesterday, I referenced the book “Willpower” by Roy Baumeister and John Tierney. The authors actually provide some advice as to how to build willpower. They write:
“Religious people are less likely than others to develop unhealthy habits, like getting drunk, engaging in risky sex, taking illicit drugs, and smoking cigarettes. They’re more likely to wear seat belts, visit a dentist, and take vitamins … And they have better self-control, as McCullough and his colleague at the University of Miami, Brian Willoughby, recently concluded after analyzing hundreds of studies of religion and self control over eight decades.”
There you have it, a key way to build will power it to become religious. Sadly absent a mass baptism, I think it is unlikely that Congress gets fiscal religion in the coming weeks.
Speaking of getting monetary religion, or lack thereof, probably the most noteworthy move in global macro markets over the last month has been the utter collapse of the Japanese Yen. Shorting the Yen was actually our top Macro idea in our Best Ideas Call back on November 15th. The flip side of this trade has been an inflation of Japanese equities. The Nikkei 225 is now up 9% for the month of December and 22% for 2012. On one hand, an inflating stock market benefits those that own Japanese equities, but the longer term issue is that this flagrant printing of money actually leads to a loss of confidence in the Japanese currency with the second derivative being a loss of confidence in Japanese government debt.
The more looming concern in Japan may actually be the yet to be implemented fiscal policy of the new administration. As Darius Dale wrote yesterday in a macro note intraday:
“Abe and Aso will craft a “large-scale” supplementary budget for the FY12 year (likely > ¥10 trillion), as well as a FY13 federal budget. Regarding the latter, the previously-imposed ¥71 trillion spending cap for FY13 was recently disregarded by the LDP, suggesting Abe is poised to take public expenditures to new heights. In short, we think Japan’s pending fiscal and monetary POLICY mix risks igniting a backup in JGB yields that could threaten Japan’s fiscal sustainability, potentially triggering a European-style sovereign debt crisis.”
Now, clearly shorting Japanese government bonds has been called the “Widow Maker” trade for a reason. The reason being it has been an utter failure of a trade, but Japanese yields and CDS are starting to back up as the Japanese appear to be on the verge of entering a new era of indulgent Keynesian policy.
The truly scary fact about Japan is that almost 50% of the public budget is financed by debt issuance. Further, almost a quarter of the annual budget is actually used for debt service. Astoundingly this is occurring at a time when Japan’s weighted average cost of debt is as low as it has ever been. Clearly, any sustained back up in rates would be catastrophic for a country that already has a debt-to-GDP of 229%.
In positive news, yesterday we had more confirmation of the emerging housing market recovery in the United States. On a year-over-year basis, the Case-Shiller national home price index was up 4.3% in October, up from a 3.0% increase in September. On one hand, this is no surprise since Case-Shiller reflects Corelogic data on a lag. Regardless, as our Financials Sector Head Josh Steiner has been noting, the market, media and Main Street focus on Case-Shiller and the nature of the housing market recovery is that good news will feed on itself.
Could the housing recovering reach escape velocity in 2013? It is likely too early to tell, but our models continue to suggest home price recovery will come sooner than the consensus expects.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, and the SP500 are now $1, $108.95-111.58, $3.51-3.61, $79.06-79.92, $1.31-1.33, 1.70-1.85%, and 1, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
This note was originally published at 8am on December 13, 2012 for Hedgeye subscribers.
“Socialism would make our society comparable to that of the white ant.”
After the market close last night I was excited to crack open the biggest brick in my reading pile – The Last Lion: Defender of The Realm (1940-1965). This puppy is 1182 pages long; could take awhile – so prepare for plenty from the Old Man on 10 Downing St.
Comparing Britain’s rise and fall from global economic (and currency) power of the early 20th century is very appropriate when considering what the United States of America is doing under Bush/Obama in the 21st. Churchill has always resonated with me, not because I am like him, but because he wasn’t liked by the burgeoning British #PoliticalClass.
“Churchill had a natural sympathy for simple people because he himself took a simple view of what was required… That was no doubt why the man-in-the-street loved him and the intellectuals did not… For that reason, Churchill had “dislike and contempt”, of a kind that transcended politics.” (Preamble, page 6)
Back to the Global Macro Grind…
Reading the preamble to Churchill after watching the gong show that became Ben Bernanke’s rock-star presser yesterday may very well have done the unthinkable to me last night – it made me think.
How conflicted, constrained, and compromised are we in America at this point to even consider some of the un-qualified spew that comes out of an un-elected and un-accountable professor who is literally making it up at this point on the fly?
Educating yourself to contextualize this moment in economic history is one thing – having common sense is entirely another. Bernanke admitted yesterday that his entire policy framework is based on forecasts that you should have no confidence in.
Finally, I think global markets actually took his word for it on that.
To review Bernanke’s 2012 experimentations (actually he called them “innovations” yesterday, and smirked):
1. January 25th, 2012 – right when Global Growth was accelerating (I was as bullish as anyone in the world on the prospects for US and Global Consumption growth on JAN24), he arbitrarily decided to move his 0% interest rate Policy To Inflate out to 2014 from 2013. Stocks and Commodities ripped for the next month, then topped.
2. September 13th, 2012 – after whispering sweet bailout promises to whoever got the memo (other than me) from Jackson Hole, Bernanke pushes his 0% interest rate Policy To Inflate out to 2015 and beyond. Stocks and Commodities continued to rip for another day, then topped.
3. December 12th, 2012 – whoever was front-running the Fed’s latest “innovation” (knowing he’d move to “targeting” an unemployment rate that you may not see until 2017-2020) didn’t even stick around for the full press conference. Stocks and Commodities topped, intraday!
After perpetuating all-time highs in Housing, Education, Oil, Gold, and Food prices (2006-2012), he pushed out 0% rates 3x in 10 months, from 2013 to 2017 and beyond. Each time, the market rallied less (for less time) on less volume. Atta boy Ben!
And people wonder why the commodity/stock market casino of front-running whatever Bernanke makes up next doesn’t reflect the underlying fundamentals of A) the economy and/or B) corporate revenue/earnings growth? Wonder no more. His explanation of what he is doing and why yesterday was so scary that even Gold wouldn’t keep going up.
And boom! Gold and Silver fall another -1.2% to 2.4%, respectively, this morning. To me at least, it’s like watching White Ants marching over their own expectations cliff. If you’re really long this stuff (say, for example, you own 21% of the Gold ETF), what, precisely, is your next catalyst? 2050?
As Churchill said, “Never, ever, give up!” And I won’t in contextualizing the moment markets are in within the lessons of history learned. Gold has been up (year-over-year) for 12 consecutive years. One might assume that the market has sufficiently discounted:
- Japan cutting to zero (and now setting the Yen on fire)
- USA cutting to zero (and then re-defining zero)
- Europe readying itself to create the fiscal/debt union to accomplish Japanese/American Style Zero
Zero. Think about what zero means. If the risk-free rate is zero, going forward it’s going to be increasingly difficult to beat zero.
I think most people who run money get that. And if you’re being honest with yourself (all you have to do is look at the balances in your equity market accounts versus where they were in December 2007 to get the point), you’d be happy to get back to zero (break-even). Like the Nikkei post its real-estate/asset 1980s price bubble, the SP500 keeps making lower long-term highs.
As I’ve written multiple times since stocks bottomed at higher-lows in November, there will be a great economic opportunity born out of food and energy price deflation if we allow Bernanke’s Bubbles (Commodities) to pop.
Deflating The Inflation Expectations out there will definitely take time – but at this point you don’t even have to have faith. You don’t have to believe the Keynesian intellectuals who are failing all-over themselves anymore either.
Just be a simpleton, like me. Think mean reversion, gravity, and White Ants.
Our immediate-term Risk Ranges for Gold, Oil (Brent), Copper, US Dollar, EUR/USD, UST 10yr Yield, Shanghai Composite, and the SP500 are now $1684-1719, $105.43-109.65, $3.61-3.71, $1.29-1.31, 1.66-1.72%, 2035-2095, and 1419-1432, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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Last week, during our initiation on the Consumer Staples sector, we suggested that some investors have been involved in the sector in an effort to chase yield, given that lack of yield in other investment vehicles. In this note, we expand our original analysis of the XLP to include the Utility sector (XLU), another sector whose constituents enjoy stable and consistent cash flows and pay out a significant portion of those cash flows to investors in the form of dividends. As one would suspect, the XLU has seen some of the same anomalous behavior relative to history that we pointed out
regarding the XLP. In fact, the recent correlation of the price of the XLU and the 10 year yield is higher (r2 = 0.5485) that that of XLP versus the 10 year (r2=0.4836). Both sectors correlation to the yield of the 10 year is a relatively new phenomenon (since 2009) and represents a break with historical trends.
Unsurprisingly, the difference between the yield of the XLU and the yield of the XLP has been remarkably consistent since the beginning of 2009, with an average of 1.42% (the XLU has the greater yield) with a standard deviation of 0.22% - very stable. The yield spreads of each sector versus the yield of the 10 year are stable in relationship to each other as well – this makes sense intuitively as investors wouldn’t likely see a need to shift between the XLP and the XLU, but rather to simply look at the yield of each index in relation to the yield of the 10 year.
With regard to the price of each index, we were hoping for some predictive ability in terms of price movements, but were disappointed. Peaks and troughs for the two sectors occurred simultaneously or with inconsistent leadership by sector. Intuitively, the XLU, with the higher yield, should have been more sensitive to changes in the 10 year – this turned out not to be the case.
What was the case (again, unsurprisingly), was that the price movements for the two sectors were highly correlated (r2 =0.9259), lending significant support to our view that both sectors have seen significant inflows as investors search for yield in a yield-less world. At the same time, we have seen the multiple of the consumer staples sector creep upward. We believe that this increases the risk for fundamental investors in the staples sector, to the extent that fund flows are being dictated by circumstances unrelated to business fundamentals - it would not surprise us at all that at a point when investors should start to see improvement in the underlying business as the broader economy recovers, money flows out of the sector as rates creep upward. This will likely be in addition to any sector allocation strategies that might favor more recovery-oriented sectors.
In summary, our analysis shows that the XLU does indeed display the same anomalies with respect to investors chasing yield the past several years as does the XLP, and this phenomenon increases the risk for fundamental investors in both sectors.
HEDGEYE RISK MANAGEMENT, LLC
Today we covered our short position in Core Labs (CLB) at $108.69 a share at 3:27 PM EDT in our Real-Time Alerts. We originally shorted Core Labs on December 19 at $108.87 a share at 3:41 PM EDT. We believe the stock is oversold at the moment so we covered on red, booking a modest gain. We remain bearish on the TREND duration for CLB.
Takeaway: Japan’s fiscal POLICY outlook augurs bearishly for the yen over the intermediate term.
- Between now and the JAN 22nd BOJ meeting and from then until the APR ’13 replacements of the BOJ governorship and two deputy-governorships, Japan’s fiscal POLICY outlook will take center stage in our TREND/TAIL call for a demonstrably weaker yen.
- Ahead of the APR 1st fiscal new year, Abe and Aso will craft a “large-scale” supplementary budget for the FY12 year (likely > ¥10 trillion), as well as a FY13 federal budget. Regarding the latter, the previously-imposed ¥71 trillion spending cap for FY13 was recently disregarded by the LDP, suggesting Abe is poised to take public expenditures to new heights. In short, we think Japan’s pending fiscal and monetary POLICY mix risks igniting a backup in JGB yields that could threaten Japan’s fiscal sustainability, potentially triggering a European-style sovereign debt crisis.
- Regarding the yen specifically, sell-side consensus and Japanese exporters do not yet agree with our call for sustained yen weakness over the intermediate-to-long term. Sell-side consensus expects the currency to strengthen to ¥83 per USD by the end of 1Q13 and Japan’s large manufacturers expect it to average ¥78.73 per USD in the fiscal half year through the end of MAR ’13 (up from the current average of ¥81 in the fiscal-half-year-to-date).
- To the extent the latter party joins the “party” we could see another meaningful leg down in the yen over the next few months, as commercial traders remain positioned long of the JPY to the tune of two standard deviations relative to the trailing 52-week average.
While we were away, Japan’s parliament approved Shinzo Abe as the nation’s seventh prime minster throughout the past six years, returning him to a post he abandoned in 2007. Coming in hot, Abe was quick to name Taro Aso as his minister of finance – Japan’s sixth finance chief throughout the past three years. With political turnover like that, it’s no wonder Japan is struggling mightily to get its fiscal house in order.
Aso, a former prime minster in his own right in the 12 months through SEP ’09, will also serve as deputy prime minster and financial services minister in Abe’s cabinet. This give the LDP a strong 1-2 spending punch atop Japanese leadership, as both Abe and Aso are champions of Keynesian-style, countercyclically-expansionary fiscal POLICY.
During his brief stint as prime minster, Aso introduced three extra budgets worth about ¥20 TRILLION, abandoned a pledge to balance the budget by March 2012 and distributed a ¥12,000 per-person cash handout. A supporter of the “by any means necessary” fiscal POLICY that has plagued the Japanese sovereign balance sheet for much of the past ~20 years, Aso has developed a reputation for signing off on seemingly wasteful stimulus initiatives (such as authorizing ¥12.4 BILLION in 2009 for the cleanup of fishing gear).
It should be noted that Abe, Aso and their underlings will be hard at work on crafting a “large scale” supplementary budget for the FY12 year (ending in MAR ’13), as well as a FY13 budget that takes Japanese public expenditures to new heights. The party has already abandoned the previously-imposed ¥71 trillion spending cap for the upcoming fiscal year (starting in APR ’13); following through with that pledge would grow Japan’s primary public expenditures by roughly +4% YoY in nominal terms.
Importantly, doing that in a time of economic calamity as Japan currently is in (second recession in the last two years; third in the last four) would likely impose a greater reliance on sovereign debt issuance to fund public expenditures. We consider it crucial that Japan is poised to surpass the 50% mark with regards to the sovereign’s bond dependency ratio in the upcoming fiscal year – i.e. over half of public expenditures will be funded via debt issuance, as opposed to more traditional revenue sources such as tax and fee collection.
Indeed, historical trends for the growth of sovereign debt service and total tax & fee revenue suggest long-term holders of JGB’s should be very leery of the Abe/Aso duo. Extrapolating CAGRs from the previous five years suggests Japan’s sovereign debt service is poised to completely consume all traditional revenues in 15 years – i.e. the “point of no return” or the sovereign “endgame”, so to speak. There are a myriad of reasons why 15 years is a really aggressive assumption (i.e. the point of intersection is likely much further into the future), but it is a fun theoretical exercise nonetheless.
What is not theoretical is the fact that both Japan’s sovereign debt service (currently 24.3% of total public expenditures) and interest expense (currently 44.7% of total debt service) continue to grow in nominal terms – despite the sovereign’s weighted average cost of capital plunging to new lows in recent years (1-1.2% by our estimates, down from 2% ten years ago and 5.8% twenty years ago).
To the extent Abe makes good on his promise for +3% nominal GROWTH and +2% consumer price INFLATION or if his POLICY mix induces a stagflationary concoction of said “monetary math” (i.e. +1% GROWTH and +4% INFLATION), a demonstrable backup across the JGB yield curve could make the aforementioned theoretical exercise a lot closer to reality than what we think is currently implied by a sovereign CDS quote of 81bps. It should be duly noted that the trailing 10-year averages for Japan’s nominal GDP growth and CPI are -0.7% and -0.2%, respectively.
This is why we continue to express caution regarding Japan’s pending monetary and fiscal POLICY mix – specifically in that a backup in JGB yields could threaten Japan’s fiscal sustainability, potentially triggering a European-style sovereign debt crisis. Fear not, however. Our interpretation of market chatter suggests Abe fundamentally believes Japan can avert a meaningful jump in bond yields a long as the central bank is committed to unlimited financing of the sovereign; per the latest data (3Q12), BOJ holdings of JGBs increased to the highest on record (¥104.9 TRILLION or 11.1% of all sovereign debt).
To the extent investors start to anticipate anything meaningfully in the direction of a 1930’s-style debt monetization scheme over the long-term TAIL, it could be “look out below” with respect to the market PRICE of the Japanese yen and the market PRICE(s) of Japanese sovereign debt. We wouldn’t want to be holding the bag on Japanese equities in that scenario, which is exactly why we continue to anticipate reflation in the months ahead, but refuse to endorse the trade explicitly.
On the monetary POLICY front, the latest developments suggest that the LDP will consider revising the BOJ’s mandate if the board fails to double its INFLATION target at the JAN ’13 meeting. Abe also suggested that he plans to nominate a BOJ governor that favors the policies of his party and explicitly stated that it was vital for Japan to resist the strengthening of the yen which he sees as a likely result of other countries weakening their currencies.
Be careful what you wish for Misters Abe and Aso; you just might receive it. On that note, the JPY has fallen for six consecutive weeks vs. the USD as is now at multi-year lows of ~¥85.61 per USD. In the spirit of keeping score, Japan’s currency has plunged -9.4% vs. the USD since we outlined our TREND-duration bearish thesis on 9/27; that compares to regional median gain of +0.2%.
From a sentiment perspective, sell-side consensus and Japanese exporters do not yet agree with our call for sustained yen weakness over the intermediate-to-long term. Sell-side consensus expects the currency to strengthen to ¥83 per USD by the end of 1Q13 and Japan’s large manufacturers expect it to average ¥78.73 per USD in the fiscal half year through the end of MAR ’13 (up from the current average of ¥81 in the fiscal-half-year-to-date). To the extent the latter party joins the “party” we could see another meaningful leg down in the yen over the next few months, as commercial traders remain positioned long of the JPY to the tune of two standard deviations relative to the trailing 52-week average.
Lastly, to review the POLICY and PRICE catalysts embedded in our bearish thesis on the Japanese yen, we view each one of the following risks as probable over the next 12-18 months:
- A +2-3% joint Diet-BOJ INFLATION target (JAN ’13?);
- A meaningful expansion of public expenditures and “large scale” stimulus package (1Q13?);
- A VAT hike delay (2H13?);
- The LDP wins a majority in the Upper House pending elections (JUL or AUG?);
- An erosion of BOJ independence, with the BOJ governorship and two deputy governorships eventually assumed by LDP puppets (1H13?);
- Experimental monetary POLICY – particularly a foreign asset purchase program (1H13?); and
- The UST 2Y-JGB 2Y yield spread widens in any meaningful way (2013?).
Stay tuned; if the market is telling us anything, it’s that this train is just getting started.
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