Our experience is that consumer staples generally lag a "risk on" market such as we have seen since January 1st. This has not been the case to start 2013 - staples have outperformed the broader market (+6.5% including agricultural services and protein, +5.5% core staples vs. the S&P +5.4%) since January 1st. Admittedly, the world doesn't change when the calendar rolls over, but let's run with it.
Outside of the agricultural service names and protein - likely investors getting positioned for the new crop year, which is consistent with our views - the best performing sectors have been household and personal care (+7.5%, 2.4% of which came from PG's performance on Friday) and packaged food (+6.4% to start the year). We are a bit surprised by packaged food's performance - a highly defensive sector. Part of it may be that people are looking at 2012 laggards and part of it may be investors looking at the possibility of lower input costs (again, consistent with our initiation call back in December).
Also somewhat surprisingly, investors have broken the pattern of the last two years and not put risk on within the staples sector to start the year. Generally, we see higher beta names outperform lower beta within consumer staples when the calendar turns. That has not been the case thus far in 2013.
This year to date performance, accomplished absent any significant upward EPS revisions, has left the valuation of the consumer staples sector somewhat stretched versus recent history.
The consumer staples sector performance has been somewhat confounding for another reason - the sector has become increasingly sensitive to changes in yields on government securities in recent years, a theme we discussed at length on our initiation.
In fact, the spread between the yield on the 10 year and the yield of the XLP has decreased 44 bps (from -139 to -95 bps) in just a few weeks. This represents a combination of the price performance of the XLP and the fact that yields have crept higher.
We are left with the relative out-performance of the sector in the face of two potential headwinds - a "risk on" market and a relatively less attractive yield profile. So, we went searching for an answer and tested a few possibilities.
Our first though was short covering. Short covering has been a powerful theme to start the year - just ask the shorts in NFLX. We looked at the short interest ratio for individual stocks as of December 31st and the associated absolute performance to start the year. No dice - R2 of 0.0052.
Next, we looked at names that lagged in 2012, anticipating investors positioning for some regression to the mean in the sector. Again, no luck, as you can see below.
We then asked the question "what if investors simply don't believe this move up in the market?" In that case, the go to move would be to try and participate in as safe a way as possible, with limited downside should the economy stall or negative news flow surrounding the debt ceiling debate increase in intensity. The consumer staples sector makes sense in that context. In fact, we have heard some investors suggest that they were waiting for a better entry point, anticipating broad weakness as the debt ceiling debate looms.
We examined this possibility by looking at the performance of the XLP versus the performance of the Citi Economic Surprise Index (an index that purports to measure the gap between expectations and reality with respect to multiple economic data points). When the index is rising, data is better than expectations, and consumer staples generally lag. When the index is falling (as it is currently), the XLP tends to perform well as expectations are not being met by the reported data. Imperfect, indeed, but directionally and intuitively compelling.
Where does that leave us? A quick summary:
Very good performance to start the year across consumer staples
If this move up in the market is "real", and to the extent that more investors start to believe that, money should flow from staples. Alternatively, if those investors that are on the sideline are correct, staples will decline, albeit not as significantly as the broader market. So, it follows that we are getting more cautious across the sector. Our preferred shorts remain TAP, KMB, PM and either GIS or CPB in packaged food. We are sticking with our preferred longs:
One more thought - for those investors that can, options are broadly inexpensive and stock replacement strategies might make sense particularly as we are getting more and more cautious on the group given the dynamics outlined in this note. Finally, the upcoming earnings season will be revealing in terms of business momentum and the likely direction of EPS revisions. We prefer to pick our spots (like we did with PG) where we either see risk or opportunity in single stock ideas.
Have a good week,
HEDGEYE RISK MANAGEMENT, LLC
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Takeaway: Global CPI readings should trend higher in the short-term, but to low absolute levels before resuming their current disinflationary trend.
At Hedgeye, we have developed a proprietary modeling process that allows us to front-run both consensus estimates of and the actual reported growth and inflation readings of any country, region or economic bloc (such as the world, on a GDP-weighted basis). In the note below, we walk through what this rigorous analytical process is signaling to us right now.
STEP #1: QUANTITATIVE SIGNAL(S)
Unlike many researchers who impose their theses and theories upon the market – usually the “smartest guys in the room” types – our research process remains grounded in uncertainty. We use a proven, three-factor quantitative overlay to consistently guide us to the most appropriate places to “fish”.
Right now, those signals are suggesting the US Dollar Index is poised to continue making a series of higher-lows over the intermediate-to-long term. That view is underpinned by our uber-bullish bias on US housing, our street-leading expectations for US employment growth and our call for a currency crisis in Japan.
We have been vocal about our call for the domestic housing market and the yen in recent weeks/months, as culminated in our 1Q13 Macro Themes of #HousingsHammer and #Quadrill-yen. Our updated thoughts on the domestic labor market can be found in the notes below:
Moving along, we anticipate that the confluence of the domestic factors highlighted above will result in the FX market pulling forward its expectations of the culmination of QE (which, on the margin, would likely be functionally equivalent to a rate hike).
That’s explicitly bullish for America’s currency and bearish for commodities and international inflation hedges – which are broadly priced in and settled in US dollars internationally.
At least for now, domestic interest rates are confirming this view:
STEP #2: GIP MODEL
Now that we know where to look from a quantitative perspective, we turn to our predictive tracking algorithms to guide us to hard numbers on the economic data front. With respect to Bloomberg’s GDP-weighted world CPI YoY index specifically, our algorithm backtests with an r² of 0.76 on the median estimate.
For background, the model is purposefully designed to produce a high, mid and low estimate and we use the respective market-based quantitative signals to guide our expectations to the higher or lower of the two economic data risk ranges.
Applying the same algorithm to a particular country, region or economic bloc’s GDP growth figures allows us to triangulate the associated sequential deltas and monetary/fiscal policy implications on our GIP chart. Currently, the world is entering Quad #2 on this analysis (i.e. Growth Accelerates as Inflation Accelerates).
Taking a broader perspective of what the model is signaling to us, we can rest assured that any near-term pickup in reported inflation across the world (again, generally speaking) will be both transient and to absolute levels that we would consider not threatening to economic growth.
As the chart above highlights, our model has been better than bad at calling for major inflection points and trends in global inflation readings for the past 4-5 years, so we feel comfortable with its summary outputs in the absence of disconfirming evidence.
STEP #3 THE SEARCH FOR CONFIRMING OR DISCONFIRMING EVIDENCE
It would be intellectually lazy to rest our call on the confluence of quantitative signals and the output of our modeling of economic data. Rather, the appropriate exercise – which is what we spend all day doing when not publishing research or engaging with clients – is to constantly vet confirming or disconfirming evidence.
With respect to commodities specifically – which we think holds a slightly leading relationship with reported CPI readings globally (varies by country based on index weights) – we are coming up with some particularly muted YoY gains when you streamline current prices throughout the year, which is in and of itself a generous assumption.
In fact, the current estimate of a JUN ’13 peak of +10% is well off the peak YoY growth rates of we saw in the summer of 2008 (+45.4%) and the summer of 2011 (+37.2%).
Our Global Macro team continues to hold the view that commodities – particularly food and energy price inflation/deflation - have become the largest contributors to the direction and magnitude of global inflation readings in the post-crisis era of muted/nonexistent labor and income growth across the key developed markets. Slack capacity utilization also remains a headwind for the economic growth-driven inflation policymakers have been desperately searching for across much of the developed world.
You can see the obvious aforementioned relationship in the following chart of median YoY CPI readings of the US, Eurozone and China overlaid with our commodity price sample:
Net-net-net, it’s really tough to get to anything more than +3% inflation in the world’s three largest economies on a median basis by mid-summer without some meaningful degree of commodity price inflation from here – which is precisely what we do not expect to happen. If anything, further weakness across key commodity markets should augment our call for lower-highs in global reported inflation readings throughout the year.
Looking to the previous chart, we don't find it at all ironic that the universal view of "price stability" across developed central banks anchors on +2% YoY CPI when considering that the same +2% happens to align with neither inflation nor deflation in international commodity markets. The deep simplicity of chaos theory strikes again...
On the disconfirming evidence side, both Oil and the EUR are outliers here; each looks good quantitatively at the current juncture and both stand completely counter to our call for strength in the DXY and weakness across the commodity complex (energy prices are a key driver) over the intermediate term.
While it’s rather difficult for us to endorse a rock-solid fundamental call on either asset class at the current juncture, we think our non-consensus fundamental thesis regarding the USD and international commodities prices will ultimately prevail. For now, however, both crude oil and the EUR remain the two largest financial market-based risks to this view.
All told, our models, signals and the data all suggest global inflation readings should trend higher in the short-term, but to low absolute levels relative to their prior peaks. As such, the current disinflationary trend across the world economy is very much intact.
Have a wonderful weekend,
We have a bullish bias on Germany within Europe. This week we received three pieces of data from Germany that we think are worth calling out:
Germany is leading the charge in the Eurozone according to its PMI readings. Services are comfortably above the 50 line dividing expansion (above) and contraction (below). Here we caution that the numbers could be ahead of themselves as the underlying economic climate of the region is still working off a sluggish base. While Germany can lead in economic performance, the German economy cannot materially inflect without underlying improvement from the region given its dependence on its neighbors as export buyers. To this end, French PMIs looked abysmal for the region’s second largest economy. France’s Manufacturing slowed to 42.9 in JAN vs 44.6 DEC and Services fell to 43.6 in JAN (exp. 45.5) vs 45.2 DEC. The Eurozone PMI Composite figure gained to 48.2 in JAN vs 47.2 DEC but still stands in contraction.
The huge bounce in the 6-month forward looking economic ZEW sentiment survey month-over-month (a three-year high) may be overdone and we caution against slower, and even lower, numbers from this survey as we move further into 2013. Interestingly, we also saw a huge bounce in the Eurozone survey, 31.2 JAN vs 7.6 DEC.
The IFO survey confirmed the move in the ZEW earlier in the week, which gave investors more powder to be optimistic. Consensus estimates for German GDP in 2013 are in a range of +0.5% to 0.7%. If this is as good as it gets for the Eurozone’s largest economy, it’s not that great, which could limit the run in these high-frequency surveys.