Chinese Chicken

“Chickity China the Chinese Chicken. You have a drumstick and your brain stops tickin’.”

-Barenaked Ladies (1998)


Thank goodness the A-Shares are closed today.


Ok, perhaps that is quite a bit dramatic, but we’re certainly not thrilled by the fact that the Shanghai Composite Index is down -3.8% since our Macro Team pitched Chinese equities on the long side in our 2/27 Best Ideas Presentation (underperforming the regional median equity market gain of +1.3% by 507bps).


The lesser analyst in me would’ve begun the note pointing to the SHCOMP’s +6.8% delta since 12/10 (when we originally introduced the idea), calling for the index to continue making higher-highs and higher-lows over the intermediate term.


While that remains our base case scenario – for now at least – we would be remiss to ignore what we have learned from Dr. Daniel Kahneman’s work in the then-groundbreaking field of prospect theory – specifically in that economic agents A) assign an asymmetrically greater absolute value of utility to losses then they do to gains and B) multiple gains and/or losses are accumulated to create an overall feeling about a series of transactions that extends from the most recent, not original, reference point.


Applying prospect theory to our bullish bias on China, the absolute value of the negative utility associated with the -3.8% delta since 2/27 is likely in excess of the positive utility associated with the +11% delta from 12/10 to 2/27. Loosely applying the above quote from our Canadian friends up north (which itself hardly makes sense even in the context of the song it is sourced from), it would be fair to say that the Chinese stock market has indeed indulged in a rather infamous “drumstick”.


Cutting to the chase, it was our view that Chinese authorities would delay any tightening of monetary policy and/or macroprudential regulation until well after the country’s economic recovery had been firmly entrenched – creating cover for at least 3-6 additional months of potential upside for a traditionally high-beta market. With the introduction of the early-MAR propriety curbs, the late-MAR clamp-down on wealth management products (WMPs) and the dramatic acceleration in official recognition of systemic risks in the financial sector, however, it has become quite clear to us that the aforementioned view was dead wrong.


No doubt these measures will have some negative impact on Chinese economic activity, which we still see as accelerating over the intermediate term. But as prospect theory would have, the negative delta from our original, fairly-subdued expectations for a Chinese economic rebound to our updated view of an even more muted acceleration likely registers the entire sequence as a negative utility event.


In broader terms, it’s bad when your bull case gets less bullish, at the margin. Moreover, to the extent that the bull case was consensus across the investment community, the initial delta from “positive” to “less-positive” in any fundamental thesis is often the first cue for experienced short-sellers to enter a particular market.


Is China a short?


While we don’t believe it is (at least not yet; as evidenced by Keith’s buy signal on the CAF yesterday afternoon), we would be downright slipshod to not thoroughly debate the merits of the bear case, which we did in our 3/28 note titled “IS CHINA CAREENING TOWARDS FINANCIAL CRISIS?”. To recap a few highlights:

  • Last week China Daily reported that the China's banking regulator has urged banks to pay close attention to the credit risks in key industries affected by the economic downturn and hit by overcapacity woes. Zhang Ping, Chairman of the National Development and Reform Commission recently said that the industrial sectors suffering most from overcapacity include steel, cement, electrolytic aluminum, plate glass and coal coke sectors, each of which is operating at 70-75% of total capacity. Analysts estimate the outstanding loan portfolio of those industries may amount to around 30T-40T yuan ($4.83T-$6.44T or 22.6-30.2% of total banking system assets at the end of JAN). Per the PBOC, outstanding loans to the property sector were 12.1T yuan at EOY ’12.
  • In addition to these on-balance sheet risks, China has roughly 15T yuan of off-balance sheet credit (28.8% of GDP) in the form of commercial bills, trust financing, entrusted loans, etc. that has increasingly been allocated to riskier borrowers in recent years (per various agencies, including the IMF) – many of whom which have outsized exposure to property prices, such as property developers and local gov’t financing vehicles (LGFVs). The latter entity has 636.8B yuan in bonds outstanding as of EOY ’12 (+148% YoY) and 9.3T yuan of loans outstanding (17.9% of GDP) – 20% of which are “funding projects which are largely not profitable and thus are vulnerable to [repayment] risk,” per PBOC Governor Zhou Xiaochuan.
  • The next round of interest rate liberalization should promote better real returns and improved access to credit for Chinese households and SMEs, respectively, and that may perpetuate an unwind of off-balance sheet lending activities, which, according to most sources, have been largely capitalized with the surplus savings of China’s private sector that are seeking higher real yields via Trust Products and WMPs, where average annualized yields are 37% higher than the PBOC’s benchmark 1Y household deposit rate of 3%. To the extent there are any weak hands in the WMP or trust financing sectors, a lack of new inflows, at the margins, would expose the “ponzi-scheme” nature of some products (per the words of the Xiao Gang, Chairman of the Bank of China) – specifically those that rely on short-term funds in order to invest in illiquid fixed assets and fund distributions largely with new net inflows.
  • Ultimately, the most recent WMP regulations should translate into slower (and potentially even negative) growth in the supply of credit within the shadow banking channel and to the extent any existing liabilities facing repayment risk aren’t able to be rolled over, we will start to see default rates accelerate across China’s shadow banking sector. Any spillover effects across key industries – particularly in the oversupplied construction and construction materials sectors – could adversely impact Chinese bank NPL ratios (currently at 0.95%) on a lag.

In spite of all this, we continue to hold a reasonably high degree of conviction in our bull case on China, as a core driver of the thesis (i.e. Strong Dollar) is, in fact, the same bull case for US equities we have held since late 2012 that consensus has largely ignored and/or fought all year. To sum it up in a few bullets:

  • As expected, early MAR growth data is supportive of the Chinese economy resuming its trend of broad economic acceleration (the official Manufacturing PMI accelerated to 50.9 from 50.1 and the official Non-Manufacturing PMI accelerated to 55.6 from 54.5).
  • A sequential slowing in China’s MAR CPI and PPI figures (due out 4/8) is highly probable from the Lunar New Year jump in FEB. Moreover, continued gains in the CNY (at a ~19yr high) should weigh on inflation expectations over the intermediate-to-long term as China reorients its economy, though rebalancing certainly won’t happen overnight. Amid rebalancing, the country’s import model should change (less commodities; more consumer goods), ultimately increasing the impact of currency fluctuations upon consumer prices.
  • Lastly, continued USD strength should continue weighing on the prices of internationally-traded commodities, which should ultimately allow the pace of economic activity to creep higher in China on a lag. China’s heavy industry benefits from energy and raw material deflation via margin expansion and potentially increased production, at the margins, in a backdrop of subdued credit expansion. Additionally, Chinese consumers benefit from food and energy deflation by freeing up share of wallet for more discretionary goods and services.

All told, being long of China is certainly a non-consensus position at the current juncture. In spite of fairly recent gains, the fundamental backdrop for the Chinese stock market is as convoluted as it has been in quite some time. As such, we are sticking to our process and deferring to the quant on this one.


Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/JPY, UST 10yr Yield, VIX and the SP500 are now 1, 106.26-109.11, 82.55-83.46, 93.07-96.11, 1.81-1.93%, 12.31-14.54 and 1, respectively.


Keep your head on a swivel,


Darius Dale

Senior Analyst


Chinese Chicken - Chart of the Day


Chinese Chicken - Virtual Portfolio


TODAY’S S&P 500 SET-UP – April 4, 2013

As we look at today's setup for the S&P 500, the range is 30 points or 0.49% downside to 1546 and 1.44% upside to 1576.       










  • YIELD CURVE: 1.58 from 1.58
  • VIX closed at 14.21 1 day percent change of 11.19%

MACRO DATA POINTS (Bloomberg Estimates):

  • 7am: BoE interest rate announcement
  • 7:30am: Challenger Job Cuts Y/y, March (prior 7.0%)
  • 7:30am: RBC Consumer Outlook Index, April (prior 47.1)
  • 7:45am: ECB interest rate announcement
  • 8:30am: ECB’s Draghi holds news conference on interest rates
  • 8:30am: Init Jobless Claims, Mar 30, est. 353k (prior 357k)
  • 9:45am: Bloomberg Consumer Comfort, March 31 (prior -34.4)
  • 10:30am: Fed’s Bernanke speaks on economy
  • 10:30am: EIA natural-gas storage change
  • 11am: Fed to buy $1.25b-$1.75b in 2036-2043 sector
  • 12:30pm: Fed’s George speaks in El Reno, Okla.
  • 5pm: Fed’s Yellen speaks in Washington


    • Carlyle Group Managing Director David Rubenstein, Bloomberg CEO Dan Doctoroff, 32 Advisors CEO Robert Wolf, Asst. to the Pres. Michael Froman among panelists at Export-Import Bank annual conf., 8:45am
    • Fed Vice Chair Janet Yellen, AOL CEO Tim Armstrong speak at Society of American Business Editors and Writers conf.
    • CSIS hosts forum on financial reform in China, with Dep. Asst Treasury Sec Robert Dohner, IMF’s Markus Rodlauer, Institute of Intl Finance MD Timothy Adams, 2pm
    • SEC holds closed meeting on injunctive actions, administrative and enforcement proceedings, 3:45pm
    • Treasury, IRS discuss proposed regulations on implementation of additional Medicare tax, 10am
    • U.S.-China Economic and Security Review Commission holds hearing on political, and economic drivers of China’s maritime disputes in east, south China seas, 9am


  • Facebook said to plan Android phone push to boost ad sales
  • BOJ doubles monthly bond purchases to meet inflation target in 2 yrs
  • Lululemon chief product officer to leave; reaffirms 1Q view
  • Primary dealers are losing influence in U.S.
  • British Airways parent IAG to buy 18 extra Boeing 787 Dreamliners
  • Cerberus said to tap Goldman, JPMorgan, BofA for property IPO
  • GM board calls emergency meeting at Germany’s Opel: Bild
  • Deutsche Bank said to be probed over hidden losses in crisis
  • Vodafone restates results in change to accounting for ventures
  • Euro-area March services output shrinks more than estimated
  • ECB, BoE to leave benchmark rates unchanged today, according to est.
  • North Korea warns U.S. it approved ‘lighter’ nuclear attack
  • Chinese Army on ‘high alert’ over North Korea: DPA
  • New bird flu strain kills third person in China as cases spread


    • International Speedway (ISCA) 7am, $0.36
    • RPM International (RPM) 7:30am, $0.06
    • WD-40 (WDFC) 4pm, $0.56


  • Gold Slumps Toward Bear Market as Investors Reduce ETP Holdings
  • Iron Ore Bear Market Looms as Supply Swamps Demand: Commodities
  • Brent Rises After Closing at Four-Month Low; WTI Little Changed
  • Barclays Oil-Research Head Horsnell Said to Leave After 10 Years
  • Copper Reaches Eight-Month Low as Services Contraction Worsens
  • Sugar Climbs on Speculation of More Ethanol Demand; Coffee Gains
  • Soybeans Drop on Concern Bird Flu in China May Limit Feed Use
  • ETF Securities Says Investors Move from Gold to Cyclical Assets
  • Macquarie Says China Bonded Copper Stocks Fell 100,000t in Q1
  • Shenzhen Is First in China With June Start for Emissions Trading
  • Norway’s Oil Future Seen With Ice-Free Arctic’s Barrels: Energy
  • New Bird Flu Kills Third Person in China as Cases Rise to 10
  • Copper Heading Toward June Low of $7,219.50: Technical Analysis
  • Drought-Hit Coffee Area in Vietnam Forecast to Receive Rains






















The Hedgeye Macro Team











FNP: Debt Free FNP?

Takeaway: The potential sale of Lucky is a new and positive change. FNP would only be doing this if the price was a steep premium = a debt free FNP.

This note was originally published April 03, 2013 at 11:45 in Retail


One of the usual ‘Juicy Coture is on the block’ stories just hit the tape regarding FNP, but the unusual component is that it had Lucky Brand attached to it as well.


While the market wants to see a sale of Juicy, we’d probably rather see FNP hang on to it for another quarter or two as we think that it’s in the process of bottoming, after which it will likely command a higher price.


Lucky, however, has better momentum right now around its product line than it has had in years as FNP parlays best practices learned from Kate over to Lucky (handbag line, brand extentions, etc..,).


Our best estimate is that Juicy will attract somewhere in the neighborhood of $200mm-$250mm (about 0.4x-0.5x sales). But for the company to let Lucky go at a point when momentum is building, we think that it would only do so at a premium valuation. 7x EBITDA implies around $150mm, which we think is the minimum Lucky would sell for.


We can speculate all day about the precise multiples that these two would sell for, but the truth is that only people involved in the transaction (which we’re not) should know. But what we can safely point out is that is that FNP ended the year with $325mm in net debt, and even if our estimates are high by 20%, the net proceeds of a deal would leave FNP debt free.


The company has already gone from being a debt-laden, low margin, low asset turning portfolio of bad brands to being one of the best growth stories in retail. Adding a debt-free element with the sale of its lowest-margin and lowest RNOA divisions only makes the story that much more attractive.


FNP has been our favorite name, and its still one of our top three. Despite the run, if you have a 12-month time horizon we'd resist the temptation to peel away today in the high teens. 


FNP: Debt Free FNP? - fnp1

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Housing: Boosting Outdoor Power Equipment

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Goldpocalypse Now

Gold (GLD) is currently down $12.70 (-0.95%) to $1559/oz after a massive sell off that saw GLD drop -3.27% over the last seven days.This comes on the heels of Hedgeye CEO Keith McCullough mentioning that the sell-side would be turning bearish on gold this week as the wave of downgrades begin to emerge from analysts' desks. Things will continue to get worse for the precious metal as the US dollar continues to appreciate in value and as large institutional asset managers (mutual funds and hedge funds) sell off their positions.


Goldpocalypse Now - GLD

ECB on Hold; EUR Pressured; Slovenia Scares

Takeaway: We expect no change on Thursday from the ECB in interest rates as the data is “accommodative”. EUR/USD continued downside support alongside Italian election uncertainty, Cyprus, and new Slovenian scares. 


Real-time Positions in Europe: Short SPDR Euro Stoxx50 (FEZ)

ECB on Hold

On Thursday the ECB’s governing council convenes. We expect no change to the main interest rates. Our rate position is largely in agreement with consensus -- 46 of 48 economists polled by Bloomberg expect no change. We don’t rule out a rate cut in 2013, but aren’t calling for one tomorrow.


This position is grounded in recent data that is supportive of an “accommodative” hands off approach from Draghi – CPI came down over recent months and is resting at 1.7% Y/Y in MAR, below the ECB’s 2.0% targeted level. PMIs across the region continue to look dim, but across the core were revised up in MAR versus initial estimates.  While the Eurozone unemployment rate has ticked up to all-time highs of 12%, Draghi will offload this concern to the labor market reforms needed at the country level.  Also, the aggregate unemployment rate has historically been higher than in the U.S. and is tame compared to peripheral figures. 


While we think that investor sentiment is lower on the region currently due to concerns over Italy, Cyprus, and now possibly Slovenia (more below) – as compared to the optimism in the back half of 2012 following the announcement of Draghi’s OMT –– we expect Draghi to keep his policy powder stowed on Thursday until there is a more meaningful flair-up in risk or greater change to the underlying data that the bank tracks. We believe the bank is also waiting and watching to see the outcome of the political scene in Italy.


ECB on Hold; EUR Pressured; Slovenia Scares - vv. interest rates


EUR/USD Levels

Broadly we think the uncertainty around the next Italian government, the tail of Cyprus, recent scares over Slovenia (more below), and the ECB interest rate stance on hold will put downside pressure on the EUR/USD. We’re no closer since the Italian election of late February in determining if a coalition can be formed as both Pier Luigi Bersani’s center-left and Beppe Grillo’s Five Star Movement refuse to accept a coalition.   


Our critical quantitative lines on the EUR/USD are outline in the chart below. We do not see any meaningful support until around $1.22.


ECB on Hold; EUR Pressured; Slovenia Scares - vv. eur usd new


The most recent weekly CFTC data (from 3/26) shows a continued net bearish positioning in the EUR/USD.


ECB on Hold; EUR Pressured; Slovenia Scares - vv. CFTC



Slovenia Joins the Mixer

Interestingly, the financial risks associated with Slovenia have received more attention this week. Take a look at the charts of the 8YR Yield on Slovenian debt, which began its hockey stick move on 3/15 to top out near 7% on 3/27, and 5yr CDS that jumped up since 3/22, but still remains below associated Greek freak-out levels last summer.


ECB on Hold; EUR Pressured; Slovenia Scares - vv. slovenia


If we have a Slovenian moment it will be very similar to Cyprus – a blip on the radar in terms of shaking the Eurozone apart – and we would not expect a similar deposit levy to be issued. Slovenia is much too close to the heart of Europe, it has different banking issues than Cyprus, and we believe the levy in Cyprus was largely a misstep on the part of the Eurocrats anyways.


To provide a bit of context on Slovenia, the country has been in the cross hairs (so to say) regarding its fiscal state for over a year, with the government at times saying either that it doesn’t need a bailout, or if it did, would not ask for external help.  But who can you trust these days?  Certainly not the Slovenian government.


The government actually fell in FEB 2013 over then PM Janex Jansa receiving slush funds, and on 3/14 was replaced by a coalition government led by the center left. 


It’s a rather small country (population of 2MM), with little great industry to speak of versus say its near neighbors the Austrians, Hungarians, or Slovaks.  Its banks, much like most countries in the region, are stuck with a bunch of bad loans (many construction related), with estimates to the tune of €7 Billion.


Here are a few economic facts:

  • GDP ~ €35 Bill (or 0.3% of Eurozone) vs Cyprus of €20B
  • GDP was down -2.3% in 2012
  • Debt as a % of GDP = 53.2% (as of 2012)
  • Deficit as % of GDP = -6.4% (as of 2011) vs -5.7 in 2010
  • CPI = 2% Y/Y
  • Industrial Production -1.8% (trending lower for last 15M)
  • Unemployment Rate at 13.6% JAN

We’ll continue to monitor and dig in on Slovenia as the market turns. In any case, our bottom line is that should there be a need for a bailout, the Eurocrats will again jump at the opportunity to throw good money at bad and sweep Slovenia, like Cyprus, under the rug. 


Matthew Hedrick
Senior Analyst


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