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THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP – April 24, 2013


As we look at today's setup for the S&P 500, the range is 46 points or 1.38% downside to 1557 and 1.53% upside to 1603. 

                                                                                                                              

SECTOR PERFORMANCE


THE HEDGEYE DAILY OUTLOOK - one

 

THE HEDGEYE DAILY OUTLOOK - 2A

 

EQUITY SENTIMENT:


THE HEDGEYE DAILY OUTLOOK - ten


CREDIT/ECONOMIC MARKET LOOK:

  • YIELD CURVE: 1.49 from 1.48
  • VIX closed at 13.48 1 day percent change of -6.32%

MACRO DATA POINTS (Bloomberg Estimates):

  • 7am: MBA Mortgage Applications, April 19 (prior 4.8%)
  • 8:30am: Durable Goods Orders, March, est. -3% (prior 5.6%)
  • 8:30am: Durables Ex-Trans, March, est. 0.5% (prior -0.7%)
  • 8:30am: Cap Goods Orders Nondef Ex Air, March est. 0.3%
  • 8:30am: Cap Goods Shipments Nondef Ex Air, March, est. 1%
  • 10:30am: DOE Energy Inventories
  • 11am: Fed to buy $1.25b-$1.75b notes in 2036-2043 sector
  • 1pm: U.S. to sell $35b 5Y notes

GOVERNMENT:

    • VP Joe Biden attends service for MIT police officer killed during Boston Marathon bomber manhunt
    • 9am: NTSB concludes meeting on how Boeing, FAA approved the 787’s lithium-ion batteries
    • 10am: House Transportation, Infrastructure Cmte hearing on freight transportation system
    • 10am: Full cmte markup of H.R. 807, which would require gov. to prioritize obligations on debt held by public in event the debt limit is reached
    • 10am: House Natural Resources Cmte marks up H.R. 3, “Northern Route Approval Act,” to approve construction, operation, maintenance of Keystone XL pipeline
    • 10am: House Fin. Svcs panel hearing on Sallie Mae wind-down as government-sponsored enterprise
    • 10:30am: Joint Economic Cmte hearing on long-term unemployment
    • 12:30pm: Sen. Sherrod Brown, D-Ohio, Sen. David Vitter, R-La., to disclose details of their “too big to fail” banking measure, including “exact” capital requirements
    • 2pm: House Oversight and Government Reform Cmte hearing on Fisker Automotive’s DoE loan, witnesses incl. founder Henrik Fisker

WHAT TO WATCH

  • Apple to return $55b more to investors as growth slows
  • Apple says to have new products in the fall, in all 2014
  • Boeing faces 2nd day of Dreamliner U.S. safety investigation
  • United sends first 787 for installation of new battery system
  • Too-big-to-fail bill due today faces opposition in Senate
  • Patriot Coal wins court permission to probe Peabody spinoff
  • Anadarko seeks dismissal of investor suit over 2010 gulf spill
  • BMC said to get separate bids from KKR, Bain buyout groups
  • Dell approves retention bonuses for execs amid buyout talks
  • Clearwire sets May 21 date for vote on Sprint’s takeover offer
  • Toyota outsells GM for 5th quarter amid yen-led recovery
  • Billabong extends talks with Sycamore for A$287m bid
  • FedEx shuts out UPS to win $10.5b in Postal Service work
  • ZTE signs patent-licensing deal w/Microsoft over smartphones
  • Payday loan restrictions said considered by 3 U.S. agencies

EARNINGS:

    • Ashland (ASH) 6am, $1.54
    • Carlisles (CSL) 6am, $0.84
    • Thermo Fisher Scientific (TMO) 6am, $1.29
    • Whirlpool (WHR) 6am, $1.90
    • WR Grace (GRA) 6am, $0.80
    • WellPoint (WLP) 6am, $2.38
    • Evercore Partners (EVR) 6am, $0.45
    • Cenovus Energy (CVE CN) 6am, C$0.46 - Preview
    • Praxair (PX) 6:05am, $1.39
    • Prosperity Bancshares (PB) 6:05am, $0.84
    • Timken (TKR) 6:30am, $0.80
    • MarketAxess Holdings (MKTX) 6:30am, $0.37
    • Wyndham Worldwide (WYN) 6:30am, $0.67
    • Eli Lilly (LLY) 6:30am, $1.05 - Preview
    • Barrick Gold (ABX CN) 6:31am, $0.86 - Preview
    • Procter & Gamble (PG) 6:58am, $0.96 - Preview
    • Meritage Homes (MTH) 7am, $0.25
    • Northrop Grumman (NOC) 7am, $1.73 - Preview
    • Omnicare (OCR) 7am, $0.87
    • Valley National Bancorp (VLY) 7am, $0.18
    • Lorillard (LO) 7am, $0.64 - Preview
    • Tupperware Brands (TUP) 7am, $1.13
    • Asbury Automotive (ABG) 7am, $0.67
    • Teledyne Technologies (TDY) 7am, $0.97
    • EMC/MA (EMC) 7am, $0.40
    • Ford Motor (F) 7am, $0.37 - Preview
    • Motorola Solutions (MSI) 7am, $0.67
    • Sprint Nextel (S) 7am, $(0.34) - Preview
    • Metro (MRU CN) 7am, C$1.01
    • Rockwell Automation (ROK) 7am, $1.29
    • NASDAQ OMX Group (NDAQ) 7am, $0.62
    • General Dynamics (GD) 7am, $1.50 - Preview
    • Lumber Liquidators Holdings (LL) 7am, $0.42
    • Corning (GLW) 7:10am, $0.24
    • RPC (RES) 7:15am, $0.25
    • Rollins (ROL) 7:15am, $0.16
    • Owens Corning (OC) 7:28am, $0.19
    • Hess (HES) 7:30am, $1.59 - Preview
    • T Rowe Price (TROW) 7:30am, $0.89
    • Waste Management (WM) 7:30am, $0.41
    • Lithia Motors (LAD) 7:30am, $0.71
    • Silicon Laboratories (SLAB) 7:30am, $0.55
    • BankUnited (BKU) 7:30am, $0.45
    • Boeing (BA) 7:30am, $1.49 - Preview
    • Southern (SO) 7:30am, $0.50
    • Canadian Pacific Railway (CP CN) 7:30am, C$1.22
    • Allegheny Technologies (ATI) 7:30am, $0.12
    • Sherritt International (S CN) 7:46am, C$0.05
    • Iconix Brand (ICON) 8am, $0.52
    • Silgan Holdings (SLGN) 8am, $0.47
    • Wabtec (WAB) 8am, $1.41
    • Dr Pepper Snapple (DPS) 8am, $0.46
    • New York Community Bancorp (NYCB) 8am, $0.26
    • SUPERVALU (SVU) 8am, $0.11
    • Prologis (PLD) 8am, $0.40
    • Medicines (MDCO) 8am, $(0.27)
    • TC Pipelines (TCP) 8am, $0.64
    • Mine Safety Appliances (MSA) 8:30am, $0.63
    • SEI Investments (SEIC) 8:30am, $0.34
    • AVX (AVX) 8:30am, $0.15
    • Avery Dennison (AVY) 8:30am, $0.58
    • USG (USG) 8:30am, $0.08
    • OSI Systems (OSIS) 8:30am, $0.74
    • NuStar Energy (NS) 8:55am, $0.43
    • Cullen/Frost Bankers (CFR) 9am, $0.96
    • NuStar GP Holdings (NSH) 9:05am, $0.38
    • Toromont Industries (TIH CN) 11:15am, C$0.25
    • Euronet Worldwide (EEFT) Bef-mkt, $0.37
    • Stryker (SYK) 4pm, $1.01
    • QUALCOMM (QCOM) 4pm, $1.17
    • Sterling Financial (STSA) 4pm, $0.35
    • Open Text (OTC CN) 4pm, $1.30
    • Texas Capital Bancshares (TCBI) 4pm, $0.83
    • Crocs (CROX) 4pm, $0.34
    • Coherent (COHR) 4pm, $0.84
    • Interface (TILE) 4pm, $0.14
    • ARRIS Group (ARRS) 4pm, $0.24
    • Knight Transportation (KNX) 4pm, $0.18
    • Whiting Petroleum (WLL) 4pm, $0.91
    • Varian Medical Systems (VAR) 4pm, $1.02
    • Cliffs Natural Resources (CLF) 4:01pm, $0.33
    • LSI (LSI) 4:01pm, $0.12
    • On Assignment (ASGN) 4:01pm, $0.18
    • Bally Technologies (BYI) 4:01pm, $0.85
    • Tractor Supply (TSCO) 4:01pm, $0.62
    • Crown Castle International (CCI) 4:01pm, $0.04
    • Montpelier Re Holdings (MRH) 4:01pm, $0.90
    • Akamai Technologies (AKAM) 4:01pm, $0.46
    • Equinix (EQIX) 4:01pm, $0.76
    • Stericycle (SRCL) 4:02pm, $0.88
    • Service International (SCI) 4:03pm, $0.22
    • CNO Financial (CNO) 4:03pm, $0.20
    • Lender Processing Services (LPS) 4:03pm, $0.65
    • Zynga (ZNGA) 4:03pm, $(0.04)
    • Morningstar (MORN) 4:03pm, $0.58
    • Glimcher Realty Trust (GRT) 4:04pm, $0.14
    • Citrix Systems (CTXS) 4:05pm, $0.63
    • F5 Networks (FFIV) 4:05pm, $1.06
    • Cadence Design Systems (CDNS) 4:05pm, $0.20
    • Flowserve (FLS) 4:05pm, $1.95
    • Fair Isaac (FICO) 4:05pm, $0.63
    • Jarden (JAH) 4:05pm, $0.23
    • Waste Connections (WCN) 4:05pm, $0.33
    • Clearwater Paper (CLW) 4:05pm, $0.52
    • Fusion-io (FIO) 4:05pm, $(0.07)
    • Angie’s List (ANGI) 4:05pm, $(0.17)
    • PetroLogistics (PDH) 4:05pm, $0.68
    • ServiceNow (NOW) 4:06pm, $(0.03)
    • Aflac (AFL) 4:07pm, $1.62
    • Tyler Technologies (TYL) 4:07pm, $0.30
    • Equifax (EFX) 4:09pm, $0.87
    • Symetra Financial (SYA) 4:10pm, $0.34
    • Cheesecake Factory (CAKE) 4:15pm, $0.42
    • Ryland Group (RYL) 4:15pm, $0.28 - Preview
    • Western Digital (WDC) 4:15pm, $1.77
    • CoreLogic (CLGX) 4:15pm, $0.37
    • Brandywine Realty Trust (BDN) 4:15pm, $0.34
    • Lam Research (LRCX) 4:15pm, $0.37
    • Selective Insurance (SIGI) 4:15pm, $0.38
    • CoStar Group (CSGP) 4:15pm, $0.44
    • Oil States International (OIS) 4:15pm, $1.82
    • Aspen Insurance Holdings (AHL) 4:15pm, $1.10
    • Assurant (AIZ) 4:15pm, $1.55
    • Raymond James Financial (RJF) 4:19pm, $0.78
    • Xilinx (XLNX) 4:20pm, $0.45
    • Churchill Downs (CHDN) 4:30pm, $0.11
    • Graco (GGG) 4:30pm, $0.73
    • Susquehanna Bancshares (SUSQ) 4:30pm, $0.23
    • MKS Instruments (MKSI) 4:30pm, $0.03
    • Duke Realty (DRE) 4:37pm, $0.26
    • PTC (PMTC) 4:58pm, $0.36
    • Mullen Group (MTL CN) 5pm, C$0.50
    • Hill-Rom Holdings (HRC) 5pm, $0.50
    • EverBank Financial (EVER) 5pm, $0.29
    • NewMarket (NEU) 5:01pm, $4.82
    • TAL International (TAL) 5:01pm, $1.05
    • Capstead Mortgage (CMO) 5:15pm, $0.32
    • Terex (TEX) 5:27pm, $0.28
    • Lundin Mining (LUN CN) 5:35pm, $0.09
    • Teradyne (TER) 6pm, $0.03
    • Kirby (KEX) 6pm, $0.91
    • Cabot Oil & Gas (COG) 6:02pm, $0.24
    • O’Reilly Automotive (ORLY) 6:30pm, $1.35
    • Methanex (MX CN) Aft-mkt, $0.73

COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)

  • Gold ETPs Head for Record Monthly Drop as $20 Billion Wiped Out
  • Mysterious Lake Threatens Ethiopian Sugar Ambitions: Commodities
  • WTI Crude Climbs to One-Week High on ECB Rate Cut Speculation
  • Gold Resumes Climb as Physical Purchases Temper Drop in Holdings
  • Copper Rises as Commodities Advance Amid Stimulus Speculation
  • Corn Drops for Third Day as Drier U.S. Weather May Speed Sowing
  • Arabica Coffee Rebounds as Prices Fell Too Far; Sugar Advances
  • Lead Premium in Europe Said to Extend Drop on Battery Slump
  • Rebar Jumps Most in Five Weeks After Drop Spurs Investor Demand
  • Barrick Profit Tops Estimates as Costs Rise Less Than Expected
  • Kansas-Wheat Premium to Chicago Grain May Jump: Chart of the Day
  • Rubber Climbs to One-Week High as Weakening Yen Boosts Appeal
  • Midwest Diesel Gains as Farmers Sow Record Crop: Energy Markets
  • Record Carbon Plunge Means Pain for Europe’s Utilities: Energy
  • Mint Runs Out of Smallest American Eagle Gold Coin on Sales

THE HEDGEYE DAILY OUTLOOK - five

 

CURRENCIES


THE HEDGEYE DAILY OUTLOOK - six

 

GLOBAL PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - three

 

THE HEDGEYE DAILY OUTLOOK - four

 

EUROPEAN MARKETS


THE HEDGEYE DAILY OUTLOOK - seven

 

ASIAN MARKETS


THE HEDGEYE DAILY OUTLOOK - eight

 

MIDDLE EAST


THE HEDGEYE DAILY OUTLOOK - nine

 

 

The Hedgeye Macro Team

 

 

 

 

 

 

 

 

 

 


HBI: Sorry, But It’s Not A Staple

Takeaway: This might not be a short, but the reasons against buying this stock stack up very quickly the way we see it.

Conclusion: This stock had so much going its way over the past year to enhance its multiple. While we can't point to any specific catalysts that would make the stock go down, we think that nearly every multiple-enhancer is in the final stretch. We can think of very few reasons to own this stock today. 

 

DETAILS 

We think HBI is a ‘do nothing’ stock here (and that's being generous). Yes, we give the company a golf clap for taking up EBIT by 8x vs last year despite a decline in its top line, and by doing more to de-risk its balance sheet than most companies we’ve seen in a while.

 

But on the flip side, we simply have a tough time getting too excited about most parts of this story. Management keeps touting this company as a Consumer Staple. Sorry to say, but Staples a) usually don’t have sales down 2.8% in a given quarter, b) find a way to grow International sales at a rate greater than the US core (they were down 5% in dollars and +1% in local currency), and c) don’t face a +740bp change in gross margins due to a (favorable) swing in commodity prices.

 

We’re not trying to be punitive in our description of this company, but as it relates to valuing the stock, we can’t call it a Staple. Is 14-15x earnings and 9x EBITDA an egregious multiple for a company like this? As long as the current earnings trajectory sustains itself we think it’s fair – and we think that guidance for this year is probably doable. That's the sole factor that prevents us from shorting it.

 

But we can’t argue for multiple expansion for the following reasons.

a)      Sales were down 2.8% in 1Q, and to hit the company’s guidance we need to see sales growth accelerate to a low-single digit rate throughout the remainder of the year. A couple of points in growth is hardly heroic, and sales have picked up in recent weeks – as such we have no reason to think they’ll miss. But banking on a sales acceleration and multiple acceleration is not where we want to be.

 

b)      Same goes for the gross margin. There was 840bp improvement in 1Q – and only 100bp was driven by the company’s own ‘innovate to elevate’ initiative. The other 740bp was sheer commodity cost recovery. Those benefits are completely recovered within the next two quarters. Then we’re back to a gross margin that is 100% based on company pricing, innovation and efficiency initiatives. Again, we’ll be more generous with multiple expansion when we’re just entering the positive side of a potential gross margin recovery. Here, we’re nearing the end.

 

c)       Similarly, SG&A is up by $30-$40mm this year due to higher media spend – which alone accounts for about 3-4% growth in aggregate SG&A. That’s a big number for a company that considers it a victory when it grows its top line by 3%. Don’t get us wrong, we usually like when companies invest in their brands – it’s one of the more ‘Staple-like’ things that HBI is doing. It’s also one of the things that gives us a bit of confidence that we probably see sales tick up a couple of percent in the back half. But unfortunately, spend comes first and revenue comes second. It’s how the world works. And that reality rarely enhances multiples.

 

d)      Lastly, we have yet to meet a single HBI owner who has not had ‘delevering the balance sheet and improved use of cash’ as one of the top two reasons for owning the stock.  HBI has a) paid down 30% of its debt over the past year, b) just initiated a dividend, and c) has set expectations for the added pay-down of its $250mm 8% (expensive) senior notes in 4Q13. Our point here is that anticipation of all of this has helped the multiple, but it’s highly unlikely that we’ll see anything related to the balance sheet that get people incrementally more positive over the next year.

 

So…the punchline is that we can’t necessarily point to a catalyst to make this stock go down. But we think that valuation is relatively full, we need to bank on sales accelerating while commodity benefits are waning and media spend is headed higher, and there are no more positive surprises related to the balance sheet to sweeten the deal. Short interest has been lower only once – back in May of 2010 – but the difference is that today, there’s absolutely no shortage of insider sales.

 

It’s tough for us to find reasons to buy this stock today.

 

HBI: Hedgeye Sentiment Monitor -- Insiders Selling Strength

HBI: Sorry, But It’s Not A Staple - hbi sentiment

 

HBI SIGMA: Still In Sweet Spot, But Getting Worse On The Margin

HBI: Sorry, But It’s Not A Staple - hbi sigma

 


TRADE OF THE DAY: FDX

Today we sold our position in FedEx (FDX) at $92.99 a share at 1:49 PM EDT in our Real-Time Alerts. We originally bought FedEx at $91.93 a share at 3:29 PM EDT on 4/18/13 and #timestamped it. We'll book our buck and continue to risk manage the FDX range within our bullish long-term TAIL view.

 

TRADE OF THE DAY: FDX - FDX


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

VIDEO: Apples To Earnings

 

Hedgeye CEO Keith McCullough appeared on CNBC Fast Money this evening to discuss the earnings report that every investor is focused on: Apple (AAPL). The company reported Q2 earnings that beat expectations and raised their quarterly dividend, but is it still a stock worth buying? Keith says that the stock remains a momentum stock. Keith won't trade the stock until it recovers and holds his line of support at $426 a share. 

 

Skip ahead to 5:15 in the video for Keith's take on Apple and what he thinks of the stock post-earnings report.

 


BYI YOUTUBE

In preparation for BYI's F3Q 2013 earnings release tomorrow, we’ve put together the recent pertinent forward looking company commentary.

 

 

BYI YOUTUBE - FFF

 

POST FQ2 CONFERENCE CALL COMMENTS

  • "With respect to games operations…  NASCAR is one of the most anticipated games and that should be coming out in the next few months. The Hot Shot Dual Wheel… is an internal brand. We recently introduced a WAP game with a dual wheel, a big cabinet. That has just hit the floors, very small sample size, not statistically significant, but very, very good start… Pawn Stars on the premium segment, we know the reports have been very good from casinos. So overall we feel very good about our product momentum."
  • "Our market share in WAP is probably about 10% now, give or take around that and that applies to the premium segment as well. So both in the WAP and premium segment we have tremendous opportunities for growth."
  • "Our game development capacity has gone up a lot. So there is a good set of WAP and premium titles that are being worked on now that will hit the market at a steady rate. And also we've become much better at handling brands and licenses, and when you do a good job with games like GREASE and Michael Jackson, what tends to happen is the next set of negotiations tend to become easier.
  • In the June, July, August timeframe we have a whole lot of new titles that come from these diverse studios and third-party partners."
  • [GREASE AND MJ] "Both of them beat that target of 750 very comfortably; so both of them did very well."
  • "In Canada VLT we were awarded two separate contracts for about 2,200 units. About half of those were sold in the first half of fiscal 2013, probably finish up the rest of that in the second half of the fiscal 2013." 
  • "Within Illinois, we have contracts in place for 4,000 units. We've sold, a little under 600 so far through December, probably take about two years to complete those with the bars and taverns getting licensed throughout the state. I think the market overall is probably about 15,000 to 18,000 VLTs, assuming that Chicago does not opt in."
  • "So Italy is not going to be a major needle-mover for us in the near term, but it's a very good market for us to be in the long-term. So that's an investment we are making for our long-term, because that's a significant market that we are committed to."
  • "The replacement cycle continues to improve; albeit at a measured pace, probably about 55,000 units replaced in calendar 2012. I think most people in your shoes think that it probably goes to about 60,000 in calendar 2013, which make sense to us."
  • "The other opportunity for us in game equipment margins is conversion kits as we build out a bigger presence of the newer cabinets, the video versions that should give us an opportunity longer term to sell more conversion kits into that footprint."
  • "As we continue to generate significant free cash flow, the best use beyond some of the smaller tuck-in acquisitions that Ramesh talked about earlier is to buyback our stock and return capital to shareholders and we've been doing that for about 21 quarters now and don't expect any significant changes in that strategy."

YOUTUBE FROM FQ2 CONFERENCE CALL

  • "Maintenance revenues for the quarter were a record…. as we continue to grow the number of units connected to our systems and the average maintenance revenue per connection. Sequentially, recent conversions of Class II systems to traditional SDS systems, which reduced our centrally-determined system unit count in Gaming Operations, drove additional maintenance revenue growth."
  • "We had approximately $126 million available under our current board-authorized share repurchase plan."
  • "Even with G2E expenses in both quarters, which approximated $2 million, we were able to increase our operating margins to 24% versus 20% in the prior year"
  • "We will be launching two additional titles, Hot Shot Progressive and NASCAR on the Cash Connection link during the coming months."
  • "We expect Tiki Magic, the much anticipated follow-up title to the very successful Cash Wizard theme to launch later this quarter."
  • "During the quarter, we announced an agreement to provide 650 VLTs to WCLC Canada and expect to begin shipping the initial tranche during the March quarter."
  • "International Games sales have been a disappointment once again… We have multiple product development initiatives currently underway focused on these international markets… We remain confident such efforts will pay off with improved International Games sales in the future."
  • "On the Systems front, we expect fiscal 2013 to be our best year ever with increasingly visible backlog strength for the quarters ahead."
  • "Our Cloud-based Mobile platform offering a non-wagering portfolio of content and services continues its strong momentum and has now grown to more six million users. Thanks to the measurable return on investment these mobile applications are generating for our customers, we are seeing significant growth both in new customer acquisitions, which has grown by more than 50% year-over-year to over 75% now and in the delivery of new applications and features for existing customers."
  • "For the quarter… we had some unusual SG&A expenses to the tune of about $2.9 million."
  • "With respect to the Atlantic Lottery… somewhere around 1,200 to 1,300 of those shipped, so the remainder of those will likely come into this fiscal year."



Exploring Emerging Markets

Takeaway: The dollar is surging, commodity prices are tumbling. Is Emerging Market investing a one-trick pony whose time has come and gone?

Submerging Markets: A Hedgeye Exclusive Presentation

Hedgeye Senior Analyst Darius Dale presented an exhaustive report in an institutional conference call today.  “Emerging Market Crises: Identifying, Contextualizing and Navigating Key Risks in the Next Cycle” drew an enthusiastic response from our global investor client base, many of whom run “long-only” mutual funds, investment vehicles that are contractually required to always be fully invested, owning a portfolio of stocks drawn from pre-determined market or geographical sectors.  These long-only investors are often among the first to suffer when there is uncertainty in the marketplace.  Put yourself in the position of a long-only manager when volatility rocks the boat, all you can do is hold on for dear life and hope the storm passes.  In times like these, Hedgeye’s Macro work becomes critical to plotting a course through turbulent waters.

 

Emerging Markets – What Are The Risks?

Perhaps the overarching risk in EM investing is the shift in attitude that leads investors, first to chase investments they would normally shun, then to suddenly shun investments they recently adored.  Markets reflect mass perceptions, and when the mass of investors fear a further decline in formerly-stable markets – as occurred in the US markets in the depths of the financial crisis – they seek refuge in hopeful markets.  This may not appear highly intellectual or disciplined – in fact, it’s not.  But it is the way many investors behave.  “Many” investors becomes a statistic, and a string of statistics establishes a trend.  Before you know it, the “smart” money identifies the trend and hops on the bandwagon.  

 

In short, much of what we have seen in major global moves in asset prices and stock markets has been the result of waves of panic sweeping across large swathes of the investment community.

 

For this you got an Ivy League MBA?

There’s a critical point to keep in mind when assessing risks in global markets.  There are huge pockets of vulnerability across the EM space, but exposure to the possibility of a crisis does not guarantee that there will be a crisis.  As a 2010 IMF report on emerging market crises states, “Crises require some triggering event.”  What we shall call “Dale’s Corollary” is the critical observation that Crises tend to start when investors apply developed market rigor to analyzing emerging markets.


It’s impossible to put too much emphasis on this point.  “Hot Money” is driven by the hunt for yield.  In global terms this translates into investors seeking opportunity in foreign markets – what’s known as Private Capital Flows.

 

As interest rates on US Treasuries declined, and as investment returns dropped across the developed world in the aftermath of the financial crisis, portfolio managers and investment analysts gladly applied different standards to analyzing the Emerging Economies, leading to a global arc of cross-border investment driven by a perception of strong commodity demand.  The stark message here is that – as Hedgeye’s Macro team has been saying – maybe it was all just the Dollar all along.  As Hedgeye CEO Keith McCullough frequently observes: “If you get the Dollar right, you’ll get a lot of other things right.”  Dale’s analysis indicates the notion of global commodity demand may be a fantasy.  The twin sibling of the chimera of perpetually-increasing house prices that drove the US economy up, up, up… over the tippy-top and into Mr. Greenspan’s executive toilet. 

 

Four Pillars of EM Wisdom

Dale’s presentation targets a complex set of risks in emerging markets and points to drivers of EM vulnerability.  

 

For starters, EM stock markets are largely tied to local commodities, and Dale measures levels of beta market volatility associated with this commodity exposure.  Continued unwinding of the global commodity bubble could be a very powerful tail wagging such dogs as Russia (70% volatility exposure to commodity prices), and Brazil (43%).

 

Dale then presents the “Hedgeye Macro Emerging Market Crisis Risk Index,” constructed on four “Pillars,” each measuring ten key economic indicators, including: 

  • Pillar I: External Sector – Currency exposure, including exchange rate and foreign currency reserves on hand; the costs of foreign trade, including commodities exposure; and the costs of short-term debt.  
  • Pillar II: Fiscal Policy – Sovereign debt; tax policy.
  • Pillar III: Financial Sector – Bank capital adequacy; cash and cash equivalents in the marketplace; real rates of interest; stock market.
  • Pillar IV: Political and Regulatory Risk – Ease of doing business; enforceability of contracts; unemployment; measures of inequality.

Taking previous EM crises as a guide, Dale’s work applied this rigorous analysis to 29 EM countries, as represented primarily in the 21-nation MSCI Emerging Markets Index.  Ranking these nations from lowest to highest risk, Dale found different Pillars, unsurprisingly, had different weights.  

 

A House of BRICS

We’ll use the BRICS (Brazil, Russia, India, China and South Africa) to demonstrate how Dale’s complex analysis presents these risks.  It looks like the third Little Piggy may finally be out of luck – not because the wolf is any stronger, but Dale has found a design flaw in the BRICS.  Dale’s Pillars measure risk across the 29-nation sample, with countries ranked by how many standard deviations they fall either above or below the average for those metrics.  

 

In Pillar I, Balance of Payments and Currency Risk, the high-risk BRICS countries are South Africa, Brazil and Russia, while India and China fall well below the mean.  

 

Pillar II, Fiscal Sustainability Risk, sees Russia and China as rather safe, with South Africa only marginally safer than the average.  India and Brazil, however, ranked as the third and second most risky on this metric, only topped by Egypt.

Pillar III, Financial Crisis Risk, ranks Brazil and Russia at below average risk, but the More Risk side of the chart features India and South Africa, and is topped by China, which comes out a whopping two standard deviations above the norm of the 29-nation sample.

 

Pillar IV, Political and Regulatory Risk, is led by India (1.8 standard deviations above average), followed by South Africa and Brazil, while Russia and China are relatively lower risk on those metrics.

 

Finally, three of the BRICS nations are among the top 4 for Aggregate Risk: India is highest aggregate risk, while South Africa and Brazil are at third and fourth places – the second slot is occupied by Egypt, which we think says rather a lot about The Company You Keep.  Dale singles out India, Brazil and South Africa as “outliers,” meaning they are “more than averagely more than average” risky.

 

But wait – there’s more!

 

The Elephant In The Emerging Room

China.

 

Need we say more?  All right, then we will.

 

China occupies a dominant position in the global marketplace – and in most investors’ minds.  Dale devoted an entire second half of his presentation to the question “Will China Blow?”  (Spoiler alert: the answer is “We have no idea, but we have some important observations that can tell you what to watch for.”)

 

“China sticks out like a sore thumb on the Hedgeye Emerging Market Financial Crisis Index,” says Dale.  And, while we remind you that Vulnerability does not mean a crisis is certain, it’s one heck of a wake-up call.

 

How often have you heard stock market pundits enthusiastic about the bottomless well of Chinese demand?  “There’s over a billion of ‘em!” they would chortle.  “That’s a lot of cell phones! (TV sets, automobiles, athletic shoes, personal care products… or whatever it is you’re touting…)”

 

Says Dale’s analysis, “Oops…!” 

 

A number of factors point to a dramatic shrinking of Chinese demand:

  • Financial repression has left little-to-no place for Chinese savers to put their money.
  • Artificially low prices of basic inputs such as water, gas and labor have allowed state-sponsored enterprises to fuel systematic over-investment – despite being much less profitable than private businesses.
  • Over-investment creates excess capacity throughout the economy, leading to potential maturity mismatches and nonperforming loans – on and off bank balance sheets
  • … China’s expansion of credit is greater than any expansion in any “bubble” economy in recent decades.  By a lot.

Chinese savers have no place to get what used to be a normal rate of return on their hard-earned money (sounds like your money market account, doesn’t it?) and have taken to investing in risky off-book trusts and wealth management products structured by Chinese banks.  These vehicles operate like blind pools, investing deposits in high-yield projects.  China’s own minister of finance has publicly called these trusts “Ponzi Schemes.”

 

Other potentially massive risks include regional funding shortfalls.  Local governments are not allowed to issue their own debt, and so they rely on land sales to plug funding gaps.  Some of these sales are of disputed property, which may lead to social unrest as China’s social activist bloggers continue to gain traction.

 

What’s The Endgame?

Dale says China has implemented – or announced – a number of key reforms.  Among those either in the works or on the launch pad:

  • Bank deposit reform, including interest rate liberalization and some form of deposit insurance
  • Deepening of financial markets, including increased supervision, better central bank intervention policies, and financial crisis policy
  • Currency policy, including a looser exchange rate trading range and more flexibility on dealing across China’s borders
  • Capital account policy, allowing freedom of investment to attract portfolio flows, but also to permit Chinese to invest offshore.

Conclusion: Read My Lips

China’s financial and political system is, in the words of one senior official, “unbalanced, unstable, uncoordinated, and unsustainable.”  But Dale reminds us, this situation will only turn into a full-blown crisis if there is a triggering event.  Dale says China’s economic policies are well suited to address the myriad problems facing the nation.

 

So, can they do it?  

 

China has accomplished most of the easier reforms.  The bad news is, that still leaves the hard ones.  Dale points to historical precedents, and to recent analysis by the IMF, that indicate China can thread this needle, but he cautions this situation is so complex there is no way to predict the final outcome. 

 

Still, Dale says policies adopted by the Party all point to the right solutions – if they can be implemented both effectively, and on time.  Says Dale, “Chinese officials almost always do what they say.”  That should make for a refreshing change while we bite our nails waiting for the next financial crisis.  

 

For more on Darius Dale’s work on China – and more on Hedgeye’s Macro coverage – please go to  www.hedgeye.com.


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