Today we shorted the iShares MSCI Emerging Markets Index ETF (EEM) at $41.59 a share at 10:02 AM EDT in our Real-Time Alerts. #EmergingOutflows is one of our Top 3 Global Macro Themes for Q213, so we'll put this position on in conjunction with that.



VIDEO: Positive Notes


Hedgeye Director of Research Daryl Jones appeared on CNBC’s Closing Bell this afternoon to discuss the US stock market and earnings season. Jones noted that with lower volatility and the Federal Reserve taking a more subdued approach to market participation, the climate for US stocks is undoubtedly bullish. As more companies report in the S&P 500, chances are that the majority of earnings will come in at or above expectations.


You can watch the full clip of Daryl discussing the markets in the clip posted above. Skip ahead to 1:15 to go straight to Daryl. 


HOUSING: The Inflection Point

This morning's housing data was existing home sales, which came in at 4.92 million for the month of March. That's a 0.6% decline month-over-month (March vs February), which came in below consensus expectations. In general, the housing market is encountering seasonal headwinds which has lowered investor confidence in housing. Hedgeye Financials Sector Head Josh Steiner explains the current paradox plaguing the housing market:


"On the one hand, low inventory precipitates rising prices, while on the other hand low inventory marginally constrains volume growth. All things equal, low inventory helps the housing market far more than it hurts."


HOUSING: The Inflection Point - housingc1


Our expectation is that over time, both volume and inventory will rise. As mortgage demand increases and more homes come out of being "underwater," the market will continue to placate investors. We remain bullish on housing and think that any near-term hurdles will be overcome.


HOUSING: The Inflection Point - housingc2


HOUSING: The Inflection Point - housingc3


HOUSING: The Inflection Point - housingc4


HOUSING: The Inflection Point - housingc5

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China Catches Its Breath

Takeaway: China’s new environmental policies might actually fix one of the world’s worst air pollution problems.

How Do You Say “Parts Per Million” In Chinese? – China’s New Environmental Policies

This week Hedgeye Risk Management hosted a conference call with Dr. Melanie Hart, head of the China Energy and Climate Policy program at the Center for American Progress.  Dr. Hart is a recognized expert on Chinese technology and regulatory matters and a Mandarin speaker who resides part time in China.


China is prominent on the world economic radar for a large number of reasons.  1.4 billion reasons, to be exact.  A lot of people who consume lots of everything.  When China’s economy strengthens, much of the rest of the world benefits.  A major policy shift affecting Chinese manufacturing and transportation would have a global impact.  Dr. Hart says we are witnessing that shift right now as new regulations issued in 2012 will dramatically change Chinese industry as they are implemented on a schedule set to run through 2015.


The Problem

China’s official environmental policy used to consist of trying to convince the world that things were going well.  The global public relations blitz surrounding the 2008 summer Olympics in Beijing highlighted “Blue Sky Days,” a metric the government continued to track through most of 2011 as they kept telling their citizens “the air is getting better, the air is getting better.” 


But the air wasn’t getting better, the air wasn’t getting better.  In the face of the official “Blue Sky” count, ordinary Chinese were blogging photographs of distinctly Nasty Sky Days.  While official figures counted most of the year as being “Blue Sky Days,” bloggers tracked fewer than 100 acceptable days a year.


The US embassy in Beijing installed an air quality monitor in 2009 to test for “PM 2.5 particulates” within the embassy compound.  PM 2.5 measures “Particulate Matter,” which can be made up of a nearly infinite range of substances, chemicals and gases – in a heavily industrialized region, most of them are either bad for you, very bad for you, or really seriously extremely bad for you.  Says the EPA:


Particle pollution includes “inhalable coarse particles,” with diameters larger than 2.5 micrometers, and “fine particles,” with diameters that are 2.5 micrometers and smaller.  How small is 2.5 micrometers?  Think about a single hair from your head.  The average human hair is about 70 micrometers in diameter – making it 30 times larger than the largest fine particle.


China Catches Its Breath - humanhair



Take a look at the graphic and decide how much of this you want your family breathing in every day.  All right, then.  Neither do the Chinese.

Beijing residents figured out how to access the Twitter feed on the air quality monitor at the US embassy.  Ordinary citizens started re-blogging embassy Twitter messages to places where others could read them.  By 2011 a crisis erupted: here was proof that the authorities’ “Blue Sky” statistics were false.  The embassy readings indicated “extremely hazardous” levels of PM 2.5 particles and other pollutants.


So the Chinese government did something few Western observers would have anticipated: they acknowledged that air quality was dangerous and committed to new policies to aggressively clean up the environment.


Dr. Hart says this was a simple political reality driven by the average middle-class Chinese urban resident – a group comprising over 300 million people – a sizeable constituency even in a country where “One Citizen, One Vote” is considered a quaint notion.  Most of them are not English speakers and get their information primarily from the state-run media.  But they are well aware of the environmental situation and are sophisticated about monitoring air pollution levels.  They are plugged into blog networks and other sources of news about the environment.  They all know exactly what “PM 2.5” means and use the term routinely in their conversation.


The Party Takes The Clean Air Pledge

Once they acknowledged that there was a problem, Dr. Hart says the Party swung into action, to tremendous effect.


Starting in early 2012, Beijing started publishing accurate air quality readings, urging citizens to monitor the government’s progress.  In early 2012 the Ministry of Environmental Protection rolled out new air quality standards and a set of directives covering residential areas.  Under a formal 5-Year Plan, emission targets are set for 2015, and again for 2020.


The 2012 national standards for coal plants set emissions control standards comparable to, or better than those in the US and the EU.  New plants must be 100% in compliance, while existing plants have only until the end of the initial five-year stage, in 2015.  This may strike us as odd here in America where the worst polluters can get a court order allowing them to continue to run their plants, or simply violate federal rules and pay a fine much smaller than the profits they earn from their improper behavior.  Something to be said for central planning?


This unprecedented plan is focused on residential centers.  Dr. Hart says the Party recognizes they can’t clamp down on all emissions nationwide without disrupting economic growth, so they developed a 12-year plan covering 13 broad regions and 117 cities, with urban pollution reduction targets of up to 10%.  Each city must develop its own plan for emissions reduction and in the next phase, cities and regions will be linked to ensure air quality improvement along broad geographical corridors. 


Beijing itself has all but completely eliminated coal consumption, replacing it with natural gas.  Five remaining coal plants are all marked for closure and Beijing will soon be the world’s largest all-gas powered city.  The city has also imposed rigid vehicle restrictions, making it exceedingly difficult to get a new vehicle permit, and permitting drivers to go out only every second day, using odd / even license plate numbers. 


The central government is absolutely serious about this, says Dr. Hart, but they want the cooperation of the citizenry.  The government acknowledges this is a problem that took many years to develop, and which will therefore take time to clean up.  At last November’s Party congress, outgoing general secretary Hu Jinao coined the expression “ecological civilization,” an expression that has taken root as a key political concept.  Dr. Hart says this is a highly significant development, signaling a deep commitment at the highest levels of government, one that is being brought forward under the current general secretary Xi Jinping.   


Steps this year include a reassignment of high Party officials to key regulatory posts where they will have the authority to implement change.  The national electricity regulator has been moved under the authority of the national reform commission, for example, and there are rumors that the once-powerful monopoly will be broken up into more manageable units. 


What Will Change Look Like?

Apart from citizens enjoying an increasing number of Blue Sky Days, Dr. Hart says big changes will start to become apparent in 2014 as the 2015 deadline for full implementation approaches.  New regulations have been issued at the rate of one every month since February of 2012, and numerous industrial facilities have already been relocated or shut down.  A big push to complete the retooling should carry through 2014.


The message from the central government to the cadres is clear: “You can not mess this up.”  Implementation will be tracked at the local level, and meeting environmental targets will be the key to promotion through the party ranks.  In Chinese political culture, promotion within the Party hierarchy is the ultimate bottom line.


In terms of its economic impact, this has already led to consolidation in heavy industry.  Cities have made conscious policy changes to force small operators out of business, since larger facilities have greater economies of scale and are better equipped to adopt increased environmental controls.


Some industry has moved to Myanmar, a country with which China has a long commercial relationship, giving rise to concerns that Chine is merely shifting their pollution to Someone Else’s Back Yard.  Among the policy initiatives at the central government level are new rules that will require stiff pollution controls to be in place in all Chinese-owned facilities, even outside the national borders.


The government is installing monitoring equipment across the country that report air quality levels directly to Beijing.  Air quality is hard to certify and easy to fake.  And as the local cadres see their path to either advancement or ignominy dependent on improving local air quality, there is high incentive to lie.  Cameras on central government monitors have already caught local officials tampering with the devices, and the government is pursuing companies that keep shifting production just out of range of the monitoring posts. 


A significant international development is seen in complaints lodged by the Japanese, who say Chinese pollution is blowing across the open water and flowing into Japan.  The Chinese government, answering only to the political pressure from its own citizens, has basically told the Japanese, “if you buy us new technology, we’ll be happy to use it.”  This will bear watching over the next year or so as there may be increasing political pressure from China’s neighbors as the five-year plan advances and major polluters find themselves scrambling to meet a looming 2015 deadline.


Finally, a major wild card will be China’s domestic natural gas industry.  China has been watching the US shale gas business with great interest – observers estimate that China has substantially larger shale gas reserves than the US.  There are high hopes for a natural gas boom as the nation moves away from coal power – but there are a number of potential problems.


China’s shale gas deposits are much more difficult to access than those in the US, and their chemical makeup is harsher.  The highly corrosive output damages drilling equipment and will make refining more costly.  China also lacks an extensive pipeline infrastructure and has significantly less water resources for the fracking process.


Yet, with all these challenges, China’s leadership is dedicated to building a successful natural gas business and has put key experts in positions of authority to do everything possible to make this succeed.



Dr. Hart says the government will “absolutely not back away” from their air quality goals. 


First, the Party does not accept defeat.  The existence of a written five-year plan is a major commitment – indeed, an unshakeable one.  Having set the mechanism in place for ordinary citizens to monitor air quality, there will be no return to “Blue Sky Days.”


Secondly, Chinese are used to a High-Low society where the wealthy buy things the average citizen can’t afford.  European designer clothes and shoes.  Million-dollar luxury apartments.  Imported food and wine.  Bottled mineral water.  But clean air…?  There are some things money can’t buy.


It may prove difficult to attain all targets exactly on the projected schedule, and Dr. Hart says the next significant update should come from this autumn’s Party plenum.  She will be watching closely for any significant policy updates which could signal the level of success they are having in overcoming barriers along the path.


Average table revenues slowed dramatically this past week, averaging only HK$775MM per day, still up 1% YoY.  Our full-month projection for April is now for GGR of HK$25.5-26.5 billion, which represents YoY growth of +5-9%, down from our previous estimate of +11-15%.  We heard that hold may have been low this past week.


In terms of market share, MPEL and Sands China continue to track above recent trend.  Despite the softness this past week, we remain positive on MPEL, given its likely strong Q1 earnings report, continued market share gains, and relatively low valuation. 






Friday’s earnings release from McDonald’s confirms our thesis that the magnitude of acceleration in same-restaurant sales that the Street is expecting in 2013 is unlikely to materialize. 


History Repeating Itself?


Knowing that, in late 2003, the aggressive push for positive comparable sales growth via promotion of the dollar menu did not fix the underlying problems of the business, it seems clear that the current value message is merely a stop-gap measure for the recent slide in comparable sales growth. 2014 earnings estimates may be under threat if management is slow to respond to changes in the marketplace and unwilling to correct past mistakes.  Part of a sustainable improvement in McDonald’s top line growth will be achieved through driving efficiency in the stores.  Of late, sales initiatives seem to be adding to the complexity of the menu and dragging on store-level efficiency.


Addressing these issues will require investment and time and will also likely negatively impact operating margins and EPS over the near-term.  The chart below implies that there is a disconnect between earnings expectations and the stock price. Taking the long-term perspective on same-restaurant sales into account, it seems unlikely that the earnings multiple can continue to expand from here.


MCD THESIS INTACT - mcd px vs eps





The last earnings call offered little in terms of incremental initiatives that the company is  implementing to improve upon the 1Q13 global same-store sales number of -1%.  The “three global priorities” of optimizing the menu, modernizing the customer experience, and broadening accessibility to “Brand McDonald’s” around the world comprise a message that is stale and, lately, ineffectual.



United States


1Q13 same-store sales declined -1.2% and operating income declined -3% but management stated that improved trends over the balance of the year will be driven by:

  1. Premium McWraps: with April same store sales still negative, the impact may not be sufficient
  2. Egg White Delight: according to GrubGrade 55% of consumer surveyed are NOT excited to try this product
  3. Blueberry Pomegranate Smoothies (imported from Canada)

MCD THESIS INTACT - mcd us sss





In 1Q13, same store sales were down 1.1 % and operating income was up 1% (in constant currencies).  The countries that were weak in 2012 (Germany and France) continue to remain soft in 2013.  The two countries that were strong in 2012 (U.K. and Russia) outperformed 1Q13, but their trends are slowing.  Further complicating the problem, the decline in inflation in Russia is limiting the company’s pricing power.  Importantly, the U.K. and Russia represent over half of the Europe division’s company-operated margin dollars.  


Like the USA, Europe is also focused on value, but at the same time trying to feature premium products and promotions that try to get the consumer to trade-up and increase the average check. This strategy is not well suited for the current challenging consumer environment throughout most of Europe.


MCD THESIS INTACT - mcd europe sss





While comparable sales were down 3.3 % for the quarter, operating income increased 2 % in constant currencies. Management’s comments highlighted the following:

  1. Continued emphasis on our value platforms
  2. Accelerating growth at breakfast (this requires changing consumer behavior)
  3. Enhancing service and convenience initiatives

In Australia (like Europe), management is trying to balance value initiatives with promotional activities that encourage trade-up. Japan's performance for the quarter was negatively impacted by the difficult economy and management is still trying to evaluate and adjust its plans to complement existing value initiatives. China saw same-store sales of -4.6 % in 1Q13 partly due to the residual effects of consumer sensitivity around the supply chain issue and the recent bird flu is also slowing a potential recovery.


MCD THESIS INTACT - mcd apmea sss



Global Margin Pressure


Margin pressure will likely persist in 2013. In 1Q13 margins declined around the world for McDonald’s and there is no end in sight.  The company specifically said they are in a market share battle and they intend to win, which suggests further margin pressure even if sales improve in 2H13.  As we have said before, we do not see a sales recovery for MCD in 2H13.



Howard Penney

Managing Director


Rory Green

Senior Analyst



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