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Com-pounding Implications in the UK

Last Thursday BOE Governor Mervyn King said that “markets determine the level of exchange rate, not us” in response to the Pound’s strong move lower.


Below we provide a refresher on the economic and political developments that have in fact influenced Sterling’s -7.2% slide against the USD year-to-date, performance second worse only to the Japanese Yen (-9.0%) among its G10 brethren.


We suggest that the BOE’s dovish set-up on monetary easing should encourage the Pound Sterling lower, which should put increased downward pressure on the economy as it can’t export its way out of its malaise given its high import dependency. Also, further stoking of inflation through dovish monetary policy should only erode the purchasing power of an already deflated populous.



Lackluster Performance

Britain, like its European neighbors, is struggling with the question of Austerity versus Stimulus. Those mostly on the left (including Labour) suggest that austerity is self defeating, and that by cutting and/or reducing spending during a period of weak demand, it is encouraging economic malaise. Conversely, those to the right (including the Tories under PM Cameron and his Chancellor of the Exchequer George Osborne) suggest that cuts in taxes and spending will revive the private sector (and hiring) and improve the credit rating and therefore lessen the debt and deficit levels and help encourage foreign investment into the country.


We remain in the camp that supports prudent levels of fiscal austerity with directed spending to support job creation. We think, however, that the biggest problem ailing the country right now is the lack of support for a strong Pound from the country’s ruling elite, especially following Moody’s decision on February 22nd to downgrade the UK’s Credit rating one notch to Aa1 from Aaa. In our mind, Mervyn King’s dovish stance on monetary stimulus suggests to us additional downside in the GBP/USD, protracted slower growth, and higher inflation across the island economy over the near to intermediate term.



Under the Hood

While we don’t think Moody’s rate cut is devastating for the credit market, and have suggested in the past that AA is the new AAA, the cut compounds an already perfect storm of fundamental drags hampering the economy, with the threat of rising bond yields only one of them. Here’s what we see:


Weak GDP: A starting place to assess the UK is its GDP. Final Q4 GDP came in lower than consensus expectations on a Q/Q basis at -0.3% versus expectations of -0.1% and at 0.0% Y/Y versus expectations of +0.2%.  Of note is that 63% of UK GDP is private household spending. As we’ll show below, we think the policy and rhetoric of key government figures, taken with the fundamental drivers of the economy, is choking off economic confidence, and therefore consumer confidence, which should extend the stagnation period or prolong the period until a sustainable economic recovery gains traction.  We are below consensus expectations for 2013 of 0.90%.


Com-pounding Implications in the UK - vv. gdp


Dumpy Data: From Retail Sales to industrial production, the breadth of recent macro data is headed in the wrong direction.  The rollover in economic activity supports the idea that politicians are mismanaging the calculus between austerity and stimulus and driving a decidedly un-virtuous cycle.  


Com-pounding Implications in the UK - vv. retail sales vs industrial prod


The Fallacy of an Export Recovery: This export camp claims that a fall in the Pound makes British exports cheaper for foreign buyers. While this may be true at face value, a historical look at the current account balance (which is currently in deficit at -3.5% of GDP), shows little correlation between declines in the Sterling and improvements in the trade balance, in fact next to zero (or an r^2 over the past 3 years of 0.174 and 0.038 back to 1971).  Further, the export camp leaves out the fact that a weak sterling reduces purchasing power. For an economy 63% levered to consumer spending that buys half of its goods and services from abroad, including that it is a net importer of energy, a weak GBP is a HUGE economic tax, not a benefit. 


Com-pounding Implications in the UK - vv. trade deficit


Inflation Rising: CPI is currently at 2.7% Y/Y and pushing higher. We expect higher import prices through a weaker currency and increased pressure due to elevated and sticky energy costs. This will all put pressure on the BOE overshooting its 2% target rate. The bank has publically said inflation will stay above the target for the next two years.  As we show in the chart, CPI is running a full 1.4% above wage increases. Now that’s another tax!


Com-pounding Implications in the UK - vv. cpi


Yields and Deficit/Debt Scares: Is AA the new AAA?  …Well maybe. Interestingly, the sovereign bond yields for the USA and France haven’t moved meaningfully (higher) in the wake of a downgrade. We think that given continued uncertainty and slow to contracting growth profiles across the Eurozone, the UK too may not see a meaningful jump in credit spreads.  (Fitch and Standard & Poor’s have Britain on “negative watch”).  That said, the government is seen struggling to reduce the deficit, which is currently at 7.8% (as Labour calls for more spending), with an elevated debt level at 89% of GDP.  Should attention move away from the Eurozone mess, the UK could be in for a real shift of sentiment away from its safe haven status. This could have additional downside risk for the currency.   


Com-pounding Implications in the UK - vv. debt vs deficit as


Savings is the Inverse of Confidence: In the chart below we show another way to represent falling confidence and that’s through the savings rate.  The pullback in spending rhymes with increased savings.  We’ll leave it to the politicians to see if they can turn around this tide.


Com-pounding Implications in the UK - vv. savings


Politically Dovish: 3 of the 9 Monetary Policy Committee members, including Governor Mervyn King, have voted for more quantitative easing, as of the last minutes, which should put upward pressure on yields and weaken the Pound. With the 10yr around 2% we could see foreign investors shun the low yield in an environment of currency debasement.


For context, for months David Miles was the lone wolf calling for looser policy. In January King and Paul Fisher joined him, which could tip the balance in favor of increasing the Bank’s current target of £375B. However, the tipping of this balance could once again be disrupted by Mark Carney replacing King in July.  We’ll have to wait and watch to see how he comes out of the box. 


Sterling Weak: It’s not the Yen, but a close second for the 2nd worst performer YTD versus the USD of the 10 major currencies.  Below we outline our key levels.


Com-pounding Implications in the UK - vv. gbp usd



Matthew Hedrick

Senior Analyst






Looking Closely at LULU

Takeaway: Lululemon (LULU) reports earnings later this week. Here's a key indicator to watch when the company reports.

Lululemon (LULU) is set to report earnings this Thursday. The consensus is looking for a decline in the company’s same store sales over the next five quarters, which is probably accurate. But notice how on a two-year basis the expected trend hardly budges. This is the usual "extend the trend" mentality of comp modeling for the consensus.


Margin compares get easy for LULU starting this quarter, but at the same time it is comping against its biggest store growth performance in years, and is starting to invest incremental capital overseas to continue its growth curve. This is a great company with a lot of runway, but growth is getting more expensive. 


Looking Closely at LULU - Lulu Lemon



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Why are Retailers Spending?

Takeaway: Planned capex spending is higher for many retailers. Here's why they're spending and what it means.

Retail Sector Head Brian McGough's research shows that planned capex spending is expected be up 30% across the industry as you'll see from the chart below. Note that many companies that are on the lower end of the spending spectrum were big capex spenders in 2012.


Why are Retailers Spending? - Retail Capex


McGough says capital spending comes just at a time when margins across the industry are the highest they have been in five years.  McGough says this is not bullish for the sector: a haphazard approach to capital spending will drive down Return On Capital figures in the coming quarters and retailers will be under pressure to either drive margins still higher, or to show a major ramp-up in sales growth.


McGough says this is not a strategy of smart managers plowing profits back into their businesses, while managing investor expectations.  “Retailers deploy capital when they can,” says McGough.  “Not when they should.”


“Peak” profit margins are, by definition, unsustainable, and McGough sees this capital spending as a knee-jerk reaction, not a strategic allocation of resources.  Wall Street analysts will now assume these peak margins are a “new normal.” 


But Return on Capital will be substantially down in coming quarters.  First, because “peak” is just that: the point before the decline.  Second, because spending one-third more capital makes the denominator one-third larger, which results in a much smaller final number.  Look for retailers to start reporting lower Return On Capital in coming quarters, causing analysts to go negative on some of today’s star players.


Stock Report: Melco Crown (MPEL)

Stock Report: Melco Crown (MPEL) - HE II MPEL 3 30 13


Melco Crown has quintupled in the last 2 ½ years since we began recommending it at $4.  However, the upside has been driven mostly by higher earnings than expected and not as much by multiple expansion.  We’re still higher than the Street on earnings but we believe that MPEL is finally ripe for some serious multiple expansion.


Here are some reasons why we believe the stock, even though it’s trading at its 52-wk high, can move higher:  1) We believe Macau should have a great year in 2013, with MPEL maintaining/gaining share.  Current Q1 2013 and FY 2013 estimates for MPEL remain too low. 2) With one of the best locations in Cotai, MPEL’s JV, Macau Studio City, is scheduled to open in 2015.  We believe a 20-30% ROI is not unreasonable. 3) Free cash flow (before project capex) is well over $1 billion and net debt is roughly zero 4) Given that MPEL is not yet considered to be an investable stock by most long only investors, there is opportunity to build a bigger base of investors which should boost the multiple.


On a forward EV/EBITDA basis, MPEL only trades at 8x 2014 EV/EBITDA after excluding Macau Studio City construction costs.  The other US listed Macau operators currently trade between 9x and 14x.  What’s the right multiple?  We think a 11-12x multiple is sufficient for now, which implies a $30 stock with upside from there as investors begin to look forward to the opening of Macau Studio City. 


INTERMEDIATE TERM (the next 3 months or more)

Q1 earnings should be a good one.  The Street continues to underestimate MPEL’s potential and we’ve above for both Q1 and 2013.


LONG-TERM (the next 3 years or less)

Macau is poised to grow considerably with latent demand and better transportation infrastructure.  MPEL will capitalize on the market growth but also maintains a deep bench of new unit growth.  In addition to a Filipino project, Macau Studio City should be a gem in 2015, considering its prized location on Cotai.  It is situated close to the Lotus Bridge and to the upcoming Light Rapid Transit station.  We believe the stock is becoming more attractive to long only investors as management continues to prove itself, the company continues to grow same store EBITDA, and new growth projects move into the forefront.


Stock Report: Melco Crown (MPEL) - HE II MPEL chart 3 30 13

Perspective on Cyprus

We think the market’s reaction to Cyrus’ bailout is overdone and that these ‘crisis’ conditions will be short lived.


A quick update on the latest development is that parliament has delayed a scheduled vote today on the proposed bailout, namely on the levying of a one-time tax of 9.9% on Cypriot bank deposits of more than €100K and a tax of 6.75% on smaller deposits, until tomorrow.


Internally there’s much pushback on the scheme as the country’s banking system is tied with political and banking corruption that allows a home for Russian money laundering. It is therefore playing out on the streets that “oligarchs” banking in Cyprus should pay disproportionately more versus average deposit holders, if the latter should play at all. 


Externally, the move to tax deposit holders for bailout packages (versus for example sovereign bond holders) sets a dangerous precedent that throws fear across Eurozone deposit holders. We expect Eurocrats to rhetorically smooth over the deposit levy and signal that Cyprus is a unique and extreme case given the inner workings of its corrupt banking system.


Note that today is a holiday in Cyprus and there’s talk that a bank holiday will be extended at least to Wednesday to prevent capital flight as the terms around a €10B bailout are voted on this week. This morning the WSJ cited an official that said the new proposal will allow depositors with less than €100K to be taxed at 3%, savers with €100K-€500K taxed at 10%, and those with over €500K taxed at 15%. While we cannot know the accuracy of this citation, it appears likely that the government will tax higher deposits at a higher rate to go after large Russian deposit holders. Depending on the crafting of the levy it would also seem probable that temporary restrictive measure may have to be put in place to prevent the flight of deposits to other countries.


Here are some take-aways to consider as the media runs hard with this story.

  • It has been clear for many months that Cyprus would need external assistance to repair the country’s finances, a country with a banking system some eight times larger than the economy.
  • Had a flat €17B bailout package been crafted, we would not have expected such a negative market move. We think the market will move past this development as terms around the deposit levy are likely mitigated for smaller deposit holders and the EU PR machine assures Pan-Europe that its deposits would not be considered for future bailouts.
  • While Chancellor Merkel was hoping to delay the bailout until after her election in September, this deal is a political win for her. Why?
  • Having Cyprus cover a portion of the bailout (~€5.8B) and a loan reduced to €10B  instead of an estimated €17B looks good for Merkel’s constituency as Germany is writing the biggest portion of the bailout checks. Further, a bailout of Cyprus now allows the issue to be swept under the rug well before German elections in September.
  • Even with an economy the size of less than one half a percent of the 17 nation Eurozone, Eurocrats are incentivized to throw money at the problem to limit fall out.  The experience of Greece  and Portugal in particular shows that even puny economies can impact economic sentiment. Eurocrats’ biggest incentive remains their own jobs -- they'll continue to squash any fears of contagion with bailout band-aids.
  • Cyprus represents, to many, a huge flaw in the Eurozone system – allowing countries like Cyprus to enter the Eurozone in the first place. Again we expect the play from them to be throwing good money at bad, with initial attempts of setting forth banking reforms to limit corruption.
  • Russian President Vladimir Putin has criticized the levy saying that the decision, should it be made, would be unfair, unprofessional and dangerous. Maybe Putin has some money in Cyprus too??  It is estimated that Russia has ~  €60B of total exposure to Cyprus on a ~€24B economy. So there’s a real fear of Russians pulling their money and the negative windfall it would have on the banking system and economy. This further suggests that restrictive measure will have to be placed on deposits to prevent flight.

While we think the market will move past Cyprus over the short term, this event along with the Italian elections provide good ammo to put pressure on the EUR/USD.


Nothing like another good crisis to stir up the markets!


Perspective on Cyprus - zz. eurusd


Matthew Hedrick
Senior Analyst


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

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