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Early Look: Japan’s Battle of Diu

This note was originally published at 8am on January 10, 2013 for Hedgeye subscribers.

"He who ate the chick must also eat the rooster, or pay for it."

-Francisco de Almeida, first viceroy of the Portuguese State of India, circa 1508

 

Dom Francisco de Almeida (1450-1510) was a distinguished Portuguese solider and explorer. Also of noble background as a counselor to King John II of Portugal, he is widely credited with establishing Portuguese hegemony in the India Ocean – paving the way for nearly a century of Portuguese dominance in the Indian Ocean trade.

 

Before Almeida’s arrival as commander of Portugal’s fourth seaborne voyage to India, the Portuguese Empire had been struggling mightily to establish a stronghold in this globally omnipotent trading hub, failing to cultivate key trading relationships in addition to being denied a meaningful presence at key ports.

 

The first voyage was commanded by Vasco da Gama (1460-1524), who is credited with captaining the first ships to ever sail directly from Europe to India (1498), rounding the Cape of Good Hope into what was previously believed to be a landlocked Indian Ocean.

 

Beyond his discovery – which is arguably the most important geographic discovery in the history of globalization – his first voyage was a broad failure, losing roughly half his men and two of his four ships.

 

The second voyage of eight ships was commanded by Alvarez Cabral, which set sail for India’s port cities in 1500. After an inadvertent detour to the coast of Brazil, Cabral and his depleted crew finally docked in Calicut six months later.

 

Cabral’s brief stay in the region was highlighted by two violent skirmishes with established parties within the region, which perpetuated more largely unsuccessful trading exploits. He hastily retreated to Lisbon with just five men and one ship.

 

The third voyage was once again commanded by Vasco da Gama. Setting sail in 1502 with a 15-vessel fleet, da Gama’s primary objective was to uproot the Egyptian power preventing Portugal’s establishment of trading dominance in the region.

 

To some degree, da Gama found a fair amount of “success” – particularly in combat. His fleet is credited with burning alive 250 men, women and children on a ship, as well as slaughtering 800 fishermen in Calicut. Shortly after his ruthless exploits, he traveled to neighboring Cochin where he defied local wishes and set up a well-forfeited trading factory.

 

A costly tactical error would have cost the Portuguese all of their progress in India when Cochin was overran by Calicut forces, had it not been for the timely arrival of our “hero” Francisco de Almeida.

 

Under several years of the viceroy’s leadership, Portugal was able to make solid headway into Indian Ocean trade. His eventual victory over a joint fleet of Gujarat, Egyptian, Calicut, Ottoman, Venetian, and Ragusa forces in the Battle of Diu (1509) cemented Portugal’s dominance within the region and ultimately allowed the empire’s trading and transport strategies to flourish.

 

It is believed that had Almeida’s son Lourenco de Almeida not been murdered by a joint Gujarat-Egyptian fleet in the First Battle of Chaul, the decisive Portuguese victory mere months later at the Battle of Diu would have eluded the history books. The battle itself was pursued as a personal outlet for Almeida to avenge the death of his son, which is the origin of the highlighted quote above.

 

Motivated by the pain of a lost child, Almeida’s hasty foray into battle helped the Portuguese Empire finally overcome the headwinds to Portuguese dominance of the world’s most important trading route at the time.

 

If this colorful story of persistent failures preceding ultimate triumph reminds us of anything, it’s modern-day Japan. Plagued by persistent deflation (10YR average annual CPI = -0.2%) and nonexistent growth (10YR average annual nominal GDP growth = -0.7%), the Japanese economy has long been failing to establish itself as anything remotely resembling vibrant, dynamic or just plain healthy.

 

If Japan is the modern-day version of the Portuguese Empire – oft seeking, but not finding – then Japanese policymakers have undoubtedly been reincarnated versions of Vasco da Gama and Alvarez Cabral, multiplied many times over.

 

For over ten years now, Japanese policymakers have implemented a variety of “counter-structural” strategies (i.e. there’s absolutely nothing cyclical about Japan’s economic malaise) designed to overcome deflation and perpetuate nominal GDP growth: perpetual ZIRP, quantitative easing, comprehensive monetary easing, bloated sovereign deficits, etc.

 

All have failed to deliver the Japanese economy the inflation and nominal growth it has so desperately sought.

 

Enter recently-elected prime minster Shinzo Abe, who we think has a chance to be Japan’s modern-day version of Francisco de Almeida. Abe, head of the ruling Liberal Democratic Party (LDP), can indeed be said to be motivated by the “blood of a son”.

 

The LDP has long been the dominant political party in Japan. With the exception of a brief 11-month period between 1993 and 1994, the LDP was in power from 1995 through 2009, when it was flat-out dominated by rival Democratic Party of Japan (DPJ) in the AUG ’09 general election (308 to 119 seats).

 

On the strength of party leader Shinzo Abe’s pledge to proactively pursue a nominal growth target of +3% and an inflation target of +2%, the LDP was able to take back control of the Lower House to the tune of 294 seats vs. only  57 for the DPJ in the DEC ’12 general election.

 

Focused intently on the previous failures of Japanese policymakers (particularly the central bank) to deliver the goods, Abe has adopted a very open and aggressive anti-deflation stance in the media. His appointment of Taro Aso as Finance Minster is yet another signal that he is prepared to do what it takes to win Japan’s version of the Battle of Diu.

 

As outlined in our 12/26 note titled: “JAPAN TO LOOSEN FISCAL POLICY AS WELL”, the following is a list of the strategies we think Abe will purse to emulate Almeida’s success in the 1509 version of the battle – which the latter won by leading off with a massive naval bombardment that was followed up by the larger Portuguese ships pelting enemy vessels from afar with technically-advanced weaponry that was far superior to that of their opponents:

  • A +2-3% joint Diet-BOJ INFLATION target (likely at the JAN 21-22 BOJ board meeting);
  • A meaningful expansion of public expenditures and “large scale” stimulus package (additional details in the coming weeks);
  • A VAT hike delay (discussions to begin in late 2013);
  • The LDP wins a majority in the Upper House pending elections late-JUL/early-AUG, paving the way for a full-fledged assault on Japan’s public finances;
  • An erosion of BOJ independence, with the BOJ governorship and two deputy governorships eventually assumed by politicized puppets (late-MAR/early-APR); and
  • Experimental monetary POLICY – particularly a foreign asset purchase program (likely several weeks after the previous catalyst materializes).

All told, we are of the view that a true phase change in the Japanese economy is definitely underway. While some may still be viewing Abe through the same lens as previous Japanese policymakers, we think it will continue to pay to be short the Japanese yen with respect to the intermediate-term TREND and long-term TAIL.

 

And while we continue to view incremental monetary Policies To Inflate and expansionary fiscal POLICY as reflationary for Japanese equities and supportive of regional sentiment in the near term, we continue to flag material risk of Japanese currency and sovereign debt crises borne out of those same policies with respect to the long-term TAIL.

 

Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, EUR/USD, UST 10yr Yield, VIX, and the SP500 are now $1642-1671, $110.28-112.82, $80.26-80.81, $1.29-1.31, 1.84-1.96%, 13.34-16.03, and 1446-1491, respectively.

 

Darius Dale

Senior Analyst

 

Early Look: Japan’s Battle of Diu - Chart of the Day

 

Early Look: Japan’s Battle of Diu - Virtual Portfolio

 


What Keith's Reading

Note: Each morning, we will present up to five headlines that Hedgeye CEO Keith McCullough is reading. Please let us know what you think about the feature. Thank you.

 

-Female smoking death risk 'has soared'

 

-Japan posts record high trade deficit in 2012

 

-Gold Seen Extending Rally as Fed’s QE3 to Last Through 2014

 

-Spanish Jobless Rate Hits Record After Rajoy’s First Year

 

-Japan Expels Taiwan Boat From Disputed Area With Water Cannons


Retail: Negative Consumer Discretionary Datapoints

Takeaway: Industry sales decelerated for 2 weeks running, driven by weakness in discretionary categories. Does not bode well for department stores.

Here’s an interesting call out with some of today’s Retail Sector data. Specifically, sales decelerated for the second week in a row, and the underlying trends suggest that discount stores are holding steady while department stores continue to decelerate. It's probably too little and too soon to use that as a broad statement about the consumer, but on a day where Coach compounded its company-specific issues with statements about department store promotional activity, the data can definitely not be overlooked. It’s surprising that Macy’s actually traded up on these datapoints today. It remains one of our top short ideas.  

 

1)      The Johnson Redbook and ICSC Same Store Sales Indexes, which tracks 70 and 80 general merchandise and apparel retailers, respectively, are both decelerating on the margin.

Retail: Negative Consumer Discretionary Datapoints - eco1

 

2) Redbook’s breakout of Discount Stores versus Department Stores suggests that the more discretionary categories are lagging.

Retail: Negative Consumer Discretionary Datapoints - eco2

 

3) The spread between spending at Discount Stores versus Department stores remains on a general upswing…

Retail: Negative Consumer Discretionary Datapoints - eco3

 

4) …which on the whole is not a bullish statement about the consumer or the economy.

Retail: Negative Consumer Discretionary Datapoints - eco4


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.32%
  • SHORT SIGNALS 78.48%

IGT POWERS THROUGH GAME OPS HURDLES

“If you’re going through hell, keep going” – Sir Winston Churchill

 

 

It’s been a long, downward spiral for IGT and its gaming ops business – a five year peak to trough slide of 24% in revenues.  Ouch.  While we’re not sure that that road has turned north, IGT does seem to be making the best of the situation.  We could even go so far as to say that there is actually some definitive positives in the business.  Market share in gaming ops has held steady for 2 years and the continued trend of right-sizing capital expenditures has contributed to growing operating cash flow in the segment.

 

IGT’s gaming operations revenues have declined in 17 of the last 19 quarters and in the 2 that were positive, the YoY increase was less than 1%.   Gaming operations gross margin dollars have similarly seen declines in 15 of the last 20 quarters.   Given this backdrop, we are encouraged to see IGT investing less money to produce these lackluster results.  Gaming operations capital expenditures have seen 9 consecutive quarters of decline.  

 

IGT POWERS THROUGH GAME OPS HURDLES - IGT3

 

The bear may say that lower capex spending portends even worse results going forward.  However, based on our rigorous statistical analysis, we have found a surprisingly small and statistically insignificant relationship between gaming operations spend and revenues.  The fact is, IGT has been able to reduce the cost of maintaining its existing footprint.  Maintenance declines are driven by:

  • Game performance - The longer the games perform well, the lower the need is to refresh them
  • Cost of a refresh
    • It’s become a lot cheaper over the years to refresh titles (just a conversion kit and signage)
    • The ability to efficiently refurbish and deploy older boxes

 

The chart below illustrates that as a result of right-sizing their capital expenditures, IGT has been able to grow their cash flow from gaming operations and increase the productivity of their install base despite the pressure on revenues. 

 

IGT POWERS THROUGH GAME OPS HURDLES - IGT4

 

IGT’s gaming ops performance has been a focus of investors, especially the bears.  However, despite the strong headwinds, IGT has grown EPS YoY 6 out of the last 8 quarters, with 27% growth over the past 4 quarters.  For fiscal 2013, we’re projecting 26% growth.  The second leg of our positive thesis is IGT’s ability to generate strong cash flow and distribute that cash to shareholders.  As evidenced by the chart above, IGT has been very successful turning a declining top line business into a growing cash flow generator.  With the stock trading at just 11x, these factors should continue to move the stock higher as 2013 unfolds.

 

 


TRADE OF THE DAY: KMB

Today we shorted Kimberly Clark (KMB) at $87.25 a share at 10:50 AM EDT in our Real-Time Alerts. Hedgeye Consumer Staples Sector Head Rob Campagnino doesn't like Kimberly into the quarterly earnings print as we mentioned in a note yesterday. We're sticking with his call.

 

TRADE OF THE DAY: KMB - KMB


Will We See 6.5% Unemployment in 2013?

Takeaway: It won’t take extraordinary improvement in the factors that drive the unemployment rate to take it below 7% by year-end 2013

As global macro data continues to confirm that growth is stabilizing, we’ve been discussing the possibility of seeing a 6-handle in the unemployment rate in 2013.   With Bernanke offering an explicit employment target of 6.5% for a cessation in QE initiatives, a significant decline in unemployment over the NTM may augur higher yields as the bond market attempts to front-run a prospective Fed exit.  

 

With market expectations for rates likely to follow the slope in unemployment rather than the actual realization of a 6.5% unemployment rate, we attempted to put some math around how the principal variables driving the Unemployment rate would have to trend for Unemployment to breach the 7% threshold over the next twelve months.  Below we include a quick review of the variables driving the unemployment rate, the summary conclusions, and some other considerations as it relates to the go forward dynamics likely to directionally impact unemployment.   

 

Of course, Bernanke could effectively hold the exit timeline hostage by again changing the rules mid-game and attaching conditions that a the sub-6.5% unemployment rate be accompanied by a “normalized Labor Force Participation Rate” or a “sustained, negligible output gap”.  We’ve ignored this potentiality here as its largely unmodelable and because the bond market could well move ahead of the Federal Reserve realizing their growth forecast batting average isn’t going to improve from 0%.  

 

Note that rather than attempting to provide an explicit year-end or 7% unemployment target date, the broader goal of this risk management exercise is to frame up the variable dynamics and quantify the magnitude of change in the relevant unemployment rate drivers necessary to take unemployment below 7.0% and towards 6.5% over the NTM.  Certainly, any number of variable assumptions and scenario iterations can be contemplated.  If you’d like to observe the impact of your own growth and participation rate assumptions on the unemployment rate timeline you can link to the associated model here >> Unemployment Rate Variable Analysis_HEDGEYE

 

 

UNEMPLOYMENT 101 - THE VARIABLES:  Below is a summary review of the variables that drive the unemployment rate.  Here, we’ve broken them down into the Input and the Dependent variables based on how we model them.   

 

Independent/Input Variable Description:

  1. Civilian Non-institutional Population Growth (CNP): The CNP represents persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions, such as penal and mental facilities, and homes for the aged, and who are not on active duty in the Armed Forces.
  2. Employment Growth:  Growth in Employed workers as measured by the BLS Household (CPS) Survey.
  3. Labor Force Participation Rate (LFPR):  Represents the Civilian labor Force as a percentage of the Civilian Non-institutional Population.  Equal to the sum of employed & unemployed workers. 

 

Dependent Variables:

4. Total Labor Force:  The Civilian Labor force is a product of the Civilian Non-institutional Population & the labor force participation rate

5. Unemployed Workers:   The total number of unemployed workers is the difference between the Labor Force and total employed workers. 

 

Unemployment Rate = the number of unemployed workers as a % of the Total Labor Force (i.e. the sum of employed and unemployed workers)

 

So, assumptions need to be made for the growth in the Civilian Non-institutional Population (CNP),  growth in the number of Employed Workers and the Labor Force Participation Rate (LFPR).  The Total Labor Force and the Total Number of Unemployed become a function of the three input variables and the direction in the unemployment rate is determined by the participation rate and the delta between CNP growth and growth in the employed.    

 

 

The CONCLUSION:  Can we get 2 out of 3?

In the chart below we provide a timeline view of the 2013 Unemployment Rate under a selection of scenarios.  Obviously, any number of iterations can be envisaged with respect to growth rates and interaction between the principle drivers of the unemployment rate but, in general, 2 of the 3 variables need to trend positively with respect to the unemployment rate for a move to 7% and below to be a 2013 event.  

 

It’s notable that the NTM moves don’t have to be extraordinary for this to occur.  For example, scenarios in which Employment growth accelerates 30bps (2Y basis) on average in 2013 and CNP growth declines linearly to the historical average over the NTM or the Labor Force Participation rate continues to decline at the 3Y CAGR both result in a move to/below the 7% unemployment level in 4Q13. 

 

If, however, positive acceleration occurs in just a single variable while the other two flat-line or trend negatively, the timeline for <7.0% unemployment extends significantly.  For example, if employment accelerates 50bps (2Y basis) on average in 2013 while Labor force participation remains static at the current level and CNP growth holds at the current rate, the implied unemployment rate would reach a 2013 low of 7.3% in December. 

 

In terms of thinking about the directional trend in the relevant variables – with housing continuing to accelerate, the domestic jobs data continuing to trend positively and our #growthstabilzing theme extending itself, we could make a credible case for seeing a modest acceleration in employment growth.  Given that growth in the civilian non-institutional population generally tracks population growth in the 16YOA+ cohort over the longer term and that volatility in active duty military status should be more subdued going forward, the assumption that CNP growth decelerates towards population growth probably represents the baseline case. 

 

The Labor Force participation rate, and the structural and behavorial psychology dynamics underpinning it, remains the largest wildcard.   The consensus logic goes that in a typical recovery, economic growth and employment growth drive renewed worker interest in employment in a reflexive fashion.  Discouraged workers, who are not currently seeking employment and are not included in the Labor force totals, again begin to actively seek employment.  To the extent that growth in workers coming back to actively look for work outpaces actual employment gains, the unemployment rate is negatively impacted despite the improved economic conditions/outlook.  Here, the transient increase in the unemployment rate would belie a positive economic inflection.

 

The current situation is complicated by the fact  that despite the ongoing, albeit tepid employment recovery, the resurgence in job seeking, which typifies the back end of business cycle slowdowns, has yet to materialize and the LFPR continues to slide.  Whether this behavioral dynamic continues and to the extent that structural unemployment/length of unemployment is a contributing factor remains an unknown.    Also unknown is the extent to which protracted fiscal policy uncertainty (Health Law, Fiscal Cliff, Budget Control Act/Sequestration, etc) has dragged on employer hiring decisions.  Regardless of the outstanding questions, labor force participation will continue as the real wild-card variable to watch relative to its impact on the unemployment rate.

 

Will We See 6.5% Unemployment in 2013? - Unemployment Scenario Analysis

 

Will We See 6.5% Unemployment in 2013? - 16YOA Population Growth

 

Other Considerations:

  • Annual Benchmark Revision:  the Census Bureau applies an annual population control adjustment to the Civilian Non-institutional Population alongside the January release every year.  Historically, the magnitude of the January adjustment has ranged from tens to hundreds of thousands or even millions of individuals.  An outsized revision to the January 2013 data could shift the unemployment variable dynamics from their current trend.
  • Employment – Growth Connection:  The historical frequency distribution for Employment and growth suggests we’d need to see #growthstabilizing transition to growth accelerating for a concurrent acceleration in employment to manifest.  While employment growth could run ahead of economic growth at the onset of a recovery, historically, employment growth >2% is typically associated with real GDP growth north of 3%.  We show the historical relationship between real GDP Growth  and y/y employment growth as measured by the BLS’s Household Survey below. 
  • Energy/Commodity Inflation:  In our 1Q13 themes call we highlighted the top 3 risks to #growthstabilizing as 1. Rising Oil Prices 2. Japan & 3. Earnings Slowing.  As it relates to risk #1 - as of this morning, both Brent and WTIC have re-captured their respective long-term TAIL risk lines of $92.04 and $111.48 support.  A continued reflation in oil and commodity prices broadly represents a real time tax on consumers, an input cost related margin drag on business, and a material headwind to growth accelerating from here.  

 

Will We See 6.5% Unemployment in 2013? - Employmet vs GDP Growth

 

Will We See 6.5% Unemployment in 2013? - Employmet vs GDP Frequency Distribution

 

 

Christian B. Drake

Senior Analyst 

 


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

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