“Let those flatter, who fear.”
Two years prior to penning his first draft of the Declaration of Independence in 1776, Thomas Jefferson wrote his first significant thought piece. That’s where the aforementioned quote comes from – it was called The Summary View (1774).
In addition to his comment about the British old-boy culture of backslapping, he went on to add that “it is not an American art. To give praise which is not due might be well from the venal, but would ill beseech those who are asserting the rights of human nature…” (Thomas Jefferson: The Art of Power, pg 74)
Less government, more economic freedom, and a strong currency – there is no praise to give those who fear these founding American principles. As corrupt Russians whine about getting taxed in Cyprus, think that through. What scares Putin should flatter us.
Back to the Global Macro Grind…
To fear, or not to fear – remains your risk management question. Clearly, living in fear of the US Equity Futures indicated down 20 handles was no way to live yesterday; buying on red was.
To review the lower-highs (see Chart of The Day) of Front-Month Fear (US Equity Volatility, VIX):
- December 28th, 2012: people freak-out on New Year’s Eve on a Congress concern; VIX down -41% since
- February 25th, 2013: 1-day freak-out over an Italian Election; VIX down -30% since
- March 18th, 2013: 1-hour freak-out over taxing money launderers in Cyprus; VIX down -11% from the open
In other words, from a Behavioral perspective, the stock market’s implied fear is:
A) Coming on lower-quality “crisis” story-telling
B) Becoming more and more short lived
No, I will not navel gaze with Old Media sources who make-up crisis stories in order to sell ad space. Instead, I will call them to account; especially if they are the same people who have missed this entire 4 month rally. It’s un-becoming.
There will be a time to fear the market’s internal signals. And while I am probably blind to them again this morning, there is nothing I can do about that. I go with my process, not the inevitable and humbling force that will be the market eventually going against me.
To review: there are 2 big parts to our process – the Research View and the Risk Management Signals. In terms of the Research View, the fulcrum point of our bull case since December has been #StrongDollar. It got stronger, again, yesterday – and:
- That makes this the 6th week in the last 7 of an up US Dollar Index, $82.79 last
- Commodities (CRB Index) have been down for 6 of the last 7 weeks, in kind
- Commodity Deflation keeps A) the Fed on hold and B) a Consumption Tax Cut in play
Good getting better in terms of US Consumption is good for a Q113 (vs Q412) sequential US GDP acceleration and, at the same time, the wealth effect on the two big things that matter (your house price and stock market portfolio) going up, at the same time.
What could go wrong? Well, that’s easy - the things that have been going right (US employment and housing). #HousingsHammer remains one of our Q113 Global Macro Themes, and we’ll be very interested to see this week’s US Housing data (Housing Starts come out today; Existing Home Sales/Inventory on Thursday). Jobless Claims on Thursday is important too.
All the while, the Global Macro Risk Management Signals continue to tick:
- Japan’s Nikkei held TRADE and TREND support and led Asian Equities higher last night, closing +2%
- China’s Shanghai Composite held TREND support (2206) and rallied +0.8%, making another higher-low
- South Korea’s KOSPI recovered TREND support (1975) after dipping below it on Cyprus fears (for a day)
- Germany’s DAX continues to hold a Bullish Formation (Russian mob footing bailout bills is good for Merkel)
- Russia’s RTSI stock market index continues to break down (bearish TREND), down -12% since topping in JAN
- Brazil’s Bovespa remains bearish TREND as well (Commodity Stock markets are not like Consumption ones)
- Gold failed at its 1st major line of resistance (TRADE = $1605, TREND $1659, TAIL $1681)
- Treasury Yield (UST 10yr) held TRADE support (1.91%) and long-term TAIL risk support of 1.84% remains intact
- Japanese Yen (vs USD) failed at TRADE resistance (93.65) and remains in a Bearish Formation
- US Equity Volatility (VIX) failed at 14.46 TRADE resistance and remains in a Bearish Formation
Net, net, net – what all this means is that chariots of Cypriot fire haven’t changed the view we’ve held since December. In fact, they’ve improved it. Don’t forget that money leaving Europe and Japan goes somewhere. US currency and equity finally has the flows.
Will we get run-over by a legitimate market fear? For sure – I just don’t know when (so let me know, if you know!). In the meantime, we want to be long of growth (Asian and US Stocks) and short of fear (Gold, Treasuries, Yen). It’s been a flattering position.
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, Russell2000, and the SP500 are now $1, $107.74-109.93, $82.14-83.13, 93.65-97.10, 1.93-2.02%, 10.77-14.46, 941-958, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Takeaway: We think that the Q is in good shape, but if there are any fireworks we’re confident enough in our thesis to support the name.
Conclusion: Our analysis suggests that Nike’s quarter is in good shape. But let’s face it, Nike always manages to light off a firework or two. If that happens to be case on Thursday, we’re confident enough in our underlying thesis that we’d support any weakness.
Nike remains one of our favorite names right now. We think its fiscal third quarter to be released on Thursday after the close will be another datapoint to support our view that it is gaining share and returns are rising – and there aren’t many other names that are doing both of those two things right now.
Will the quarter be a blowout? Not exactly. We’re modeling $0.72 vs the Street at $0.67. Nice upside -- but not huge. We’re about in line with the Street on the top line at about 11%, but we’re 50bp higher on the gross margin line. We think that’s fair given the easing product costs flowing through the P&L as well as 2Q ending with the most favorable inventory position in nine quarters.
Futures: As it relates to futures, bears are calling me with the expected ‘futures are decelerating’ concerns. The company is going against a 22% North American futures number in this quarter, and +18% globally. It doesn’t take a genius to figure out that this is a ridiculously tough quarter to comp. On a 2-year run rate, a 7% North American or 5% Global futures number suggests an even underlying trend. We think Nike comes in 2-3 points above those levels. On a go-forward basis, keep in mind that after this quarter, we started to see China drop off precipitously. Beginning next quarter, we expect any slowdown in growth in North America to be offset by a rebound in China and an uptick in Western Europe (NKE is about to anniversary the latest downturn there, and FL recently noted a stabilization in Europe).
Sentiment is Flat-Out Bad: Lastly, we need to acknowledge sentiment and valuation. We agree that the stock isn’t cheap at 17x earnings. But let’s not forget that sentiment on Nike remains quite bad. Our sentiment monitor, which is based on both sell-side recommendations, short interest and insider trading activity, suggests that Nike is more hated today than almost any time over the past 10-years.
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Takeaway: Even if this blow-up proves to be a 1-off, the reality is that it calls into question the sustainability of high-20s mgn on a 30x pe stock.
Conclusion: LULU's blunder has near-term financial implications, but the bigger question is whether high 20s margins are sustainable. We know that costs are going up, but now with such a major process breakdown that threatens one of its most important products it will surely call into question whether the real margin level is high 20s, 25%, 20%, 15%? The reality is that we simply don’t know. Regardless, this kind of uncertainty does not help with the stock trading at 30x earnings.
There’s one key question that we think should be asked about LULU’s ‘wardrobe malfunction’ announcement, and it has nothing to do with the impact on comps, the quarter, or the year.
The question is whether or not this issue is worth the $1.5 billion in market cap that the company collectively lost today (when the news leaked) and in after hours trading. We think that the answer is ‘Yes’.
We don’t understand how could this company possibly have had such a breakdown in its procurement process that 17% of the most important product (women’s bottoms) became compromised in quality to the extent that it could not be sold.
Some people on the Street will come out and defend this as LULU making a great move to do what it needs to in order to protect its brand image. Yes, that’s a fair argument. But it’s irrelevant in the context of how big of a mistake this was.
This is a company that has huge top line growth opportunity as it expands its reach globally. But margins are already in the high 20s, and we already know that costs are heading up to support more expensive growth. On top of that we’ve got proof of a hole in the company’s process that will hurt financially near-term.
Could this be a one-off 1-timer? Yes, it could, and we hope it is. But ‘hope’ is not an investment process. This will call into question how far LULU’s margins could potentially fall to preclude issues like this from happening again before finding a new baseline that will support future growth.
Is the real margin level 26%, 25%, 20%, 15%? If it's at the higher end, then the stock is probably a buy on this sell-off. But the harsh reality is that we simply don’t know. Regardless, this kind of uncertainty does not help with the stock trading at 30x earnings.
What’s a RIN and what does it matter to corn prices and ethanol producers?
A RIN is a Renewable Identification Number – a unique serial number that is attached to each gallon of renewable fuel produced. Each year, petroleum refiners are required to submit RINs to the EPA to prove that the required amount of renewable fuel (ethanol) has been blended into the gasoline the company has produced.
During any given year, some refiners use more renewable fuel than the mandate requires - those refiners are permitted to sell the excess RINs. This process insures, in theory, that the industry (collectively) will satisfy the Renewable Fuel Standard (RFS) quota as required by the Environmental Protection Agency. We have seen estimates of anywhere between 1.9 to 2.0 billion gallons worth of RINs carried over from 2012 to 2013 (we are going to come back to that number in just a bit).
A secondary market for RINs has emerged, and while not the most efficient market in the world (it is somewhat opaque and there is counterparty risk related to fraudulent RINs, among other things) it is a market and it has been telling us some interesting things in recent weeks - RIN prices have been melting up.
Due to the shortage of corn, a number of ethanol plants have been shuttered across the U.S. – this despite the fact that the RFS mandate increased from 13.2 billion gallons of ethanol in 2012 to 13.8 billion in 2013.
As it currently stands, under Federal regulations ethanol can be blended into gasoline and sold at levels of up to 10% (“E10”). Higher blending levels are possible (“E15” and “E85”) but require specially designed vehicles, so higher blends are consumed in very limited volumes. Gasoline consumption in the United States has been declining, but is currently about 130 billion gallons per year.
At a 10% blend rate, current gasoline consumption levels demand approximately 13.0 billion gallons of ethanol (note that, as previously mentioned, the RFS mandate of 13.8 billion gallons is already above projected demand – the “blend wall”). Not all of the demand for ethanol is demand for corn based ethanol – approximately 750 million gallons will come from sugar-based ethanol (imported).
Where does that leave us?
The bottom line is that the demand for ethanol from gasoline consumption at the 10% blend rate less imported ethanol will be below the RFS mandate to the point where the excess RINs that were carried over from 2012 to 2013 will be nearly exhausted by end of year as companies purchase those RINs to be in compliance with the blending mandate. To add insult to possible injury, the 2014 mandate is 14.4 billion gallons of ethanol blended.
Absent a rapid move to E15 (15% blend) – an initiative pushed through by the ethanol lobby, in our view – it would appear that something has to give. E15 is getting pushback because of potential damage to automobiles and the fuel infrastructure, so it would seem a move in that direction is unlikely. The EPA has beaten down all legal challenges to the RFS, but it would seem it may be left with little choice but to relax the mandate.
If the mandate isn’t relaxed, it represents a negative for consumers, as gasoline prices will likely increase regardless of the price of crude oil. The lack of ethanol will drive the price of RINS higher as blenders seek to satisfy the RFS, thereby increasing gas prices at the pump. In fact, there is some thought that speculation and manipulation may be driving RIN prices, in part in an effort to force the EPA’s hand.
If the mandate is relaxed, we suspect that corn prices and corn acreage will drop, to the detriment of farm level economics. Ethanol margins should improve, to the benefit of producers (ADM, for example). Fertilizer stocks are the names that are heavily levered to corn production and farm level economics, and were a significant beneficiary of the “ethanol pivot” – the continuing increases in the ethanol mandate over time. A relaxed mandate might be a “reverse pivot”, if you will.
This is a complex issue, with multiple moving parts, but one the bears continued scrutiny as we move through the year.
Call with questions,
HEDGEYE RISK MANAGEMENT, LLC
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.
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%.
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.
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.
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!
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.
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.
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.
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