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This morning we co-hosted a conference call with our Industrials Team, lead by Managing Director Jay Van Sciver, featuring Carl Walter, co-author of Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise (2012). On the call, Carl dove deeply into the complexion of and outlook for the Chinese financial system – specifically its key risks, most misunderstood features and the outlook for reform(s).


To listen to a reply of the aforementioned call, please click CLICK HERE. To download the associated presentation, please click CLICK HERE.


The replay podcast is about 50 minutes in its entirely (~25 mins of prepared remarks and ~25 mins of Q&A); if you care on China, it’s worth every minute of your time. If, however, you enjoy a more passing interest on the subject(s), please enjoy the following collection of what we thought were some of the more critical, candid and/or colorful quotes from our expert, Carl Walter:


  • RE: provincial and municipal governments“Really, you’re looking at a huge country that’s much like Europe… you have the Germanys, you have the Frances, you have the Greeces and you have the Portugals. You have places that work and places that don’t work.”
  • RE: why banks are so integral to the Chinese financial system“Banks are the pillar of the system because they have all of the deposits. The Big 5 Banks hold over 60% of all deposits.”
  • RE: corporate bond market“People seem to think the corporate bond market is being developed to take pressure off of the banks… I’ve never read such shallow and meaningless stuff in my life… The guys that own the bonds are the banks. They are the only ones that have the money to lend.”
  • RE: bonds vs. loans tradeoff“Banks have lent long and have run up to various liquidity measures. On a net-net basis, you can lend less than if you [underwrite] a bond.” … “You can see there is a [consistent] 3% or so differential between [yields on] loans and bonds.” … “Why are you creating a bond market where 75% of the issuers are the same as your borrowers?... What does a bond market really mean when there are no real third party interests?”
  • RE: banks being the source of the problem“Bank lending is no longer the solution for China, which is why you have all this discussion about changing business models.”
  • RE: Too Big To Fail“The banks really are just too big to fail and I truly doubt that any of them will be allowed to fail… When Lehman Bros. was allowed to fail here or, rather, was put into bankruptcy, the Chinese were completely taken aback because they couldn’t understand how the US gov’t would let one of its blue-chip banks go under unless it the gov’t really didn’t have the capacity to support it. In my point of view, [a major bank failure] would never happen in China because it would truly mean that the gov’t doesn’t have the capacity to support it.”
  • RE: contextualizing shadow banking“The huge bulk of [lending over the last 3-4yrs] has not been the shadow banking market. It’s been the banks.” … “WMPs have grown to be about 13% of deposits and pose a real risk to the credibility of the banks.”
  • RE: NPL estimates“[Chinese banks] certainly are hiding NPLs. The biggest way to hide them has been to extend maturities. But there are problem loans there and sooner or later they are going to have to come out or the banks are not going to be able to continue to lend… [For comparison] in 1997, 25% of total loans were bad… [Applying 20% to today’s post credit bubble loan portfolio yields about CNY6 trillion.]… CNY6 trillion is a conservative figure. You’re going to see a lot more capital raising on behalf of the banks.”
  • RE: why China can’t use FX reserves as fiscal firepower“Foreign reserves can’t really save China’s banks.” … “The capital [i.e. US Treasuries] is sitting in New York in a subaccount at the Fed under the PBOC. The capital is in New York. The bank is operating in China. It doesn’t really have any capital. So what happened was that they did five-year currency swaps and swapped them into RMB with the shareholder, Central Huijin… Those swaps were done over a period of three years and were done in such a way that they would not cause any kind of pip in inflation. If you’re going to use foreign exchange reserves – of which China has a load – you can’t really bring them back into the country to use them. You’ve already created RMB when you got them. If you bring them back into the country, you’re going to create a similar amount of RMB all over again and you’re going to create an inflationary situation.”
  • RE: national debt“If you add local government debt plus estimated NPLs [to a “narrow” calculation that includes the MOF, Policy Banks, Ministry of Railways and Bank Subordinated Debt] you get to 97% [sovereign debt/GDP].”
  • RE: broad-based financial reform“How do you reform interest rates – which are now fixed by the PBOC – when you have banks that are frozen in time with long-term loans with fixed interest rates and a big chunk of their corporate bond portfolio – which also long-term and has fixed interest rates? How are you going to reform your interest rates when it’s going to require a tremendous recapitalization of the banks? And you can’t hide it, because these banks are all listed in Hong Kong.” … “If you really want to reform this market, you’re going to dismantle everything that’s made it work so far. And you’re going to dismantle the levers of control the government and the Party has. I can’t imagine real serious reform.”
  • RE: CNY and capital account liberalization“How are you going to liberalize the RMB?... How are you going to reform [China’s financial system] by opening up the RMB markets? What would be the first thing that happened? People say that the RMB will appreciate. My comment is there’ll be a vast swooshing sound as people take their money out of the country.”
  • RE: interest rate reform triggering a massive bank recapitalization requirement“The real cost of capital is nowhere near 3% in China… As soon as you [liberalize deposit rates and] put on a more realistic cost of capital, you’re going to lose money on the banks’ bond portfolios – which are 25-30% of their balance sheets. And similarly, you’ll lose money on their loan portfolios as well.”
  • RE: previous financial sector reforms“Between the Asian Financial Crisis to 2005, there was a real serious effort to restructure the Chinese banks… My view of it is that the new leadership came in and didn’t have an appreciation for what was accomplished and stopped it. Serious people [in China] don’t want financial reform because they would not be the beneficiaries of reform – for example, the big SOEs.”
  • RE: NPL evergreening“Rolling this stuff forward so they can buy time to decide what to do is the typical bureaucratic way of dealing with this [NPL] problem. That will only make the problem worse.”
  • RE: social unrest“Unless GDP picks up in the next 3-5 years, there’s a possibility of some real social problems there [in China].”
  • RE: sustained slowdown in fixed assets investment “[Fixed assets investment] has to come down [as a percentage of GDP] because I don’t think the banks can continue to support this stuff. If you look at total social financing growth, we’re talking about [incremental] lending that’s over 30% of GDP the last four years… If a big chunk of [bank] assets are nonperforming and another big chunk of [bank] assets are long term and if [bank] deposits aren’t growing, then how are [Chinese banks] going to make new loans? You’ve got to have new liquidity.  And the export sector, the WTO is what provided all this new liquidity. If you look at any of these charts – look at household savings – all of these things take off like rockets. [Look at] foreign reserves… [Look at] foreign direct investment. All of these things took off like rockets. The amount of liquidity injected into that system was unbelievable and that’s what allowed the banks to make all these loans. And now that liquidity is not being created.”
  • RE: key players in the reform process“I thought Hu Jintao and Wen Jiabao were the most useless people I’ve ever seen in my life. The new [President], Xi Jinping, impresses me. The new Premier [Li Keqiang] is not impressive. He’s a bureaucrat and if you’re a bureaucrat, you’re not going to achieve anything in that environment.”


As always, we’re available for follow-up discussions; simply email us a to connect.


Enjoy your evening,


Darius Dale

Senior Analyst



Carl Walter joined Stanford's Walter H. Shorenstein Asia-Pacific Research Center (Shorenstein APARC) during the winter and spring terms of the 2012-13 academic year after a career in banking spent largely in China. Walter has contributed articles to publications including Caijing, the Wall Street Journal and the China Quarterly. He is also the co-author of Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise (2012) and Privatizing China: Inside China's Stock Markets (2005).


Walter lived and worked in Beijing from 1991 to 2011, first as an investment banker involved in the earliest SOE restructurings and overseas public listings, then as chief operation officer of China's first joint venture investment bank, China International Capital Corporation. Over the last ten years he was JPMorgan's China chief operating officer as well as chief executive officer of its China banking subsidiary.


Walter holds a PhD in political science from Stanford University, a certificate of advanced study from Peking University and a BA in Russian Studies from Princeton University.


Today we bought Restoration Hardware (RH) at $37.60 a share at 10:28 AM EDT in our Real-Time Alerts. Nice pullback (on no volume) to immediate-term TRADE support here for Hedgeye Retail Sector Head Brian McGough to hit the buy button on. Shorts are going to keep getting squeezed here is our call. Fundamentals are solid.



ECB to Cut?

On Thursday the ECB convenes to discuss an interest rate cut. This is a highly anticipated meeting, with 43 of 70 Bloomberg economists estimating a 25bps cut to the main refinancing rate (to 0.50%), 26 of 70 on HOLD, and 1 of 70 forecasting a 50bps cut. The last major inflection point in ECB policy came in the September 2012 meeting in which Draghi announced the OMT facility. Since then our call has been for no change in rates. 


ECB to Cut? - vv. rates


We’ve been calling for an interest rate cut in 2H 2013 but think the probability of a 25bps cut has gone up in recent weeks and it may come as soon as this Thursday. In the Early Look today Keith noted that the EuroStoxx600 outperformance last week, closing +3.7%, is one indication of increased expectations around a cut. That said, we’re less optimistic that a cut will be an outright panacea to the real economy that shows (among other factors) lending activity clogged (chart below), even if fundamentals are beginning to show a bottoming process.  


ECB to Cut? - vv. loans


We continue to expect the ECB to move in a reactive fashion and therefore to save its powder until economic conditions get noticeably worse.  Assessing where we’re at on the front shows a mixed picture:


Of the positive signs (= no rate cut): Cyprus is rear view; Slovakia is out of sights (for now at least); Italy formed a coalition government (confidence vote pending); the European Commission (alongside the key Eurocrats) remain dovish and positioned to extend deficit targets (in Spain, France, Portugal, to name a few) and lessen the bite of austerity; there’s an improved risk picture, with 10YR sovereign yields across the periphery at some of their lowest levels in years (Italy hit 3.94%, this morning!), and bond issuance YTD has largely been priced at lower yields.  Equities continue to reflect weekly headline risk, but here again we see continued support behind Draghi’s OMT to prevent an exit of any countries and stabilize the EUR. 


Of the negative signs (= rate cut): high frequency data continues to show that the bottom may not in fact be in. For example, Eurozone confidence figures out today were all down versus consensus and last month’s print. Political and sovereign risk remains high in Spain, Portugal, and Italy given the tenuous popular support for governments and the impact of Austerity’s Bite.


ECB to Cut? - vv. eurozone confidence




If the ECB cuts the main interest rate, we believe that’s bad for the EUR, good for the USD, and bad for commodities, which is in turn good for the consumer.


Our critical quantitative lines on the EUR/USD are outlined in the chart below. Beyond immediate term TRADE support of $1.29 we do not see any meaningful support until around $1.22.


 ECB to Cut? - vv. eur levels


The most recent weekly CFTC data is somewhat stale (from 4/23) but shows that April has largely been a less bearish month for the cross.  


ECB to Cut? - vv. cftc


Without a crystal ball we will be waiting and watching for market price signals into Thursday.


Have a great week!


Matthew Hedrick

Senior Analyst

Early Look

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Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.

USD: Still Plenty To Like

The US dollar has been in bullish formation for the past three months, as displayed in the chart below. The PowerShares DB US Dollar Index Bullish ETF (UUP) is up +2.8% over the last three months due to significant appreciation in the value of the dollar. In turn, commodities have taken a hit across the board, which has become quite evident in gold, oil and agricultural commodities like corn. 


The strong dollar is a catalyst for a stronger America. A boost in consumption will help drive economic growth in the United States and that's accomplished through lower gas prices and cheaper groceries. The dollar might be down today but it will continue to rise over the coming months and that's something investors and consumers can get excited about.


USD: Still Plenty To Like - UUP TODAY


This note was originally published April 26, 2013 at 10:39 in Restaurants

Starbucks (SBUX) is the best-run company that we follow and the long-term TAIL seems unlimited. The company’s geographical reach and size is highly impressive. Even more impressive is the performance of the Americas business, given its size and maturity.


We maintain a positive view of Starbucks as an effective way to play improving US consumption.  While sell-side analysts this morning are correct that the global macro outlook is challenging, it is important to know where SBUX has its exposure.  The U.S. is what will drive beats and misses in the near term, despite much unit growth being focused in China/Asia-Pacific. ~88% of company stores and ~85% of licensed stores within the "Americas" division are located in the United States.


SBUX: STILL TOP DOG - yum mcd sbux opinc



The Good


Last night, Starbucks reported global same-store sales growth of 6% (13th consecutive quarter above 5%).  Same-stores sales in the Americas division grew 6% (including 5% traffic). Total revenue growth of 11% produced a 1.8% increase in operating margin and a 20% increase in earnings per share (EPS). 



  • Revenues + 10% year-over-year
  • SRS two-year comp sequentially declined 1%
  • Operating Income +22%
  • Operating Margin +2.2% to 21.1% (highest 2Q ever)

SBUX: STILL TOP DOG - sbux americas pod1




  • Revenues unchanged, operating margin unchanged
  • -2% second quarter of fiscal year 2013 comps implies 2-year  comps negative
  • Emphasis is on improving profitability by refranchising (“sold to you!”)
  • Applying Americas “learnings” not trumping macro

SBUX: STILL TOP DOG - sbux emea pod1




  • Revenues grew 22%
  • Comps at +8% came in light vs consensus
  • Operating margin down -7.1% on investment spending on China growth

SBUX: STILL TOP DOG - sbux cap pod1



The Less-Good: Expectations, Food


The only slight negative stemming from what was, overall, a bullish conference call was management reigning in expectations for 2H13, but upping the official guidance. During the call management guided for third quarter fiscal year 2013 EPS of $0.50-0.53 and fourth quarter fiscal year 2013 EPS of $0.54-0.57, versus consensus of $0.54 and $0.57, respectively. The coffee cost tailwinds should continue well into fiscal year 2015 now, offsetting continued investments in growth-related initiatives. 


Food remains Starbucks’ Achilles’ heel.  The acquisition of La Boulange is a long way from being branded a “success”.  As of yesterday, there were 439 stores carrying La Boulange products, including all stores in the San Francisco Bay Area.  The company is planning a rollout of La Boulange pastries in the Pacific Northwest including Seattle in June, then will expand to cities including Los Angeles and Chicago, followed later in the year by New York and Boston. The company is on track to have La Boulange products in all of our U.S. company operated stores by the end of 2014.

Booking Gains: SP500 Levels, Refreshed

Takeaway: We'll continue to risk manage the range, booking gains on the way up to 1,603.

Positions: 12 longs, 7 shorts @hedgeye


In our real-time alerts product, the last ten booked positions have been gains. Certainly, that is better than bad and has been in-line with our market call this year that with #GrowthStabilizing equities in the U.S. should outperform.  Increasingly, our view is that stabilizing growth is morphing into accelerating growth domestically.


Admittedly, the Dallas Fed Manufacturing Index coming in this morning at -15.6 versus +5.0 expected was a soft reading and certainly a data point to consider.  That said, and more important to our thesis was pending home sales, which were up +1.5% versus +0.7% expected and saw a sequential acceleration from -0.4% in the prior month.


As we saw in last week’s GDP report, consumption was up +3.2% last quarter and is the key factor driving U.S. GDP recovery.  In fact, consumer spending contributed +2.24% of the total growth of GDP last quarter.  To the extent that housing demand remains strong and inventory continues to tighten, this will be positive for home prices, the consumer balance sheet and discretionary consumption.


This morning we have made three key changes in our Real-Time Alerts:

1)      Sold Budwesier (BUD)

2)      Covered Gold Miners (GDX)

3)      Bought Restoration Hardware (RH)


Currently, as outlined in the chart below, the TRADE range for the SP500 has immediate term support and resistance at 1567 and 1,603, respectively.  We'll continue to risk manage the range, booking gains as we move towards the high end. 


Daryl G. Jones

Director of Research


Booking Gains: SP500 Levels, Refreshed - SPX

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