We’re going back to the playbook - buying Consumption, shorting Commodities. You can express this macro long-term TAIL view in many different ways. Hedgeye Industrials Sector Head Jay Van Sciver remains bullish on FedEx's margin opportunity.
Takeaway: We bought FedEx (FDX) at 9:48am this morning at $97.84.
Takeaway: The ABI fell out of bed in April, signaling contraction for the first time in eight months.
The Architectural Billings Index (ABI) fell out of bed in April, signaling contraction for the first time in eight months. The index is supposed to lead non-residential construction activity by 9-12 months. The index suggests that, while non-residential construction activity may continue to strengthen through 2013, it may soften around year-end/early 2014. The weaker ABI is a potentially negative data point for a number of non-residential construction exposed companies/industries, such as TEX, MTW, URI, Steel & E&Cs. Given the significant optimism around the non-residential construction rebound, it is a noteworthy reversal.
Takeaway: Jim gave us his updated perspective on global markets. We like his process, we disagree on a couple of key conclusions.
We hosted a conference call with Jim Rickards back on 8/29/2012 where he outlined his bull case for the Euro. On 5/21/2013 we had a follow up call with Jim to get his updated perspective on global markets, policy implications, and the current manifestations of the currency war.
A replay of the call and the presentation materials can be accessed via the following links:
Replay: CLICK HERE
Materials: CLICK HERE
Below we review the key themes of the call, highlight some of the notable callouts and provide some discussion around points where Hedgeye and Jim are in disagreement.
THE SETUP: Below we highlight the key themes of the call (paraphrased and extended where appropriate to provide context).
Inflation vs. Deflation and Dynamic vs. Static
A snapshot view of the economy and the, thus far, “well-tamed” inflation readings belie entropy building under the hood as the inflationary (policy) and deflationary tug of war plays out under the surface. “Nothing happens on the fault line of two tectonic plates most of the time until it does” – the inflation-deflationary dynamics represent the interplay of a complex system with the potential for a decidedly unexpected and non-linear outcome.
The goal of monetary policy in a deleveraging period is to stimulate inflation and drive positive nominal growth in an attempt to offset the deflationary forces inherent to a debt deflation scenario. Achieving positive, nominal growth is critical because debt is nominal, so nominal growth is required to ease the real debt burden and because of negative real interest rates, the goal of financial repression and the policy supported yield chase, requires that nominal interest rates (inflation) be positive.
The FED’s Sisyphean Fight
Monetary policy remains a blunt instrument. The Fed, through policy initiatives and open market operations, can effectively control the base money supply. What it can’t control is private sector demand for credit or banks willingness to lend. While the Fed can print as much money as it wants in hopes of moderating both an acute shock and a protracted deleveraging, if that money simply sits at the Fed as excess bank reserves, it can’t work to drive credit creation, money turnover (M1 Velocity) or end demand growth
So, what we’ve observed over the last 5 years is a continual rise in base money and a continued collapse in velocity as Fed printing has proved ineffectual in the face of declining consumer and investment demand and a lack of risk appetite from lenders.
Velocity: A Socio-psychological phenomenon
In a deleveraging, and when interest rates are already at their lower bound, increasing the money supply is not an effective enticement for consumers to spend, re-lever or accelerate economic activity broadly. The Fed has two primary approaches to attempt to bend the velocity curve:
Nominal vs Real Growth: The Fed needs 4% inflation
As stated above, the Fed needs nominal growth to help ease the real debt burden and avoid a painful, debt deflation.
If deflationary forces overcome inflationary policy efforts you could have a situation in which Real growth accelerates. This would occur simply if deflation is greater than the drop on nominal growth (i.e. -1 Nominal growth less -4 Inflation = +3 Real Growth).
In this situation, positive real growth is realized but with broader negative economic consequences;
We Are In A Depression
“We are in a depression that won’t end until a host of policy changes occur.”
Complexity Theory: If the Fed gets the inflation they are looking for, can they actually handle it?
The fed continues to use equilibrium models when they should be using non-equilibrium and complexity based models. In effect, they believe they can use a thermostat to control the temperature of the economy. In actuality, the economy/inflation functions more like a nuclear reactor in that once a threshold is breached, the system goes critical and is no longer amenable to conventional “dial it up, dial it down” policy initiatives.
In effect, inflation becomes non-linear and is more likely to go from 2% to 4% then straight to 8-10%. In large part, this occurs because of a behavioral/psychological shift occurs in the collective consumer/business psyche and once the velocity curve is bent, its hard to bend it back the other way in short order.
To review the critical components and characteristics of complex systems:
Commonalities of Complex Systems: All 4 factors apply to capital markets
Characteristics of Complex Systems:
Q: If deflation gets some traction, do big moves have to occur in JGB’s or Treasury yields?
A: The prevalence of deflation would cause a big rally in treasuries. “I could see the 10Y going to 80bps” similar to yields we’ve seen in Japan. “We are Japan, we’re just 7 years in while Japan is 20Y in”. Monetary Policy may be able to get us out from here, but they need to bend the velocity curve.
Q: How do you view the Behavioral component as it relates to the market/policy currently?
A: If velocity does turn, it will go to 1,2,3..then go straight to 7,8,9 which is exactly what happened in the 70’s. Velocity increasing is a psychological phenomenon and you can’t bend it back once it gets some mojo - thats what makes it an exponential phenomenon
Q: How does the Fed navigate from here?
A: There will be trades as we move along. The dollar will rally but then they will come back in with messaging and a reminder that they will dial it up to get inflation and dollar devaluation. They clearly want the wealth effect - 50% of the wealth of the American people is in housing and stocks.
The problem is if they are too successful, you get an asset bubble and the bubble could pop. This would destroy confidence and kill velocity – exactly the factors policy was attempting to cultivate. So, how do you inflation the bubble without popping it?...you deflate it every once in a while, and you do this via communication – hint that a ‘taper’ is being considered and let equities correct a bit. It is all communications management. “This is just lying, propaganda, money illusion”…”they are just trying to lie to us & head-fake us”
Q: How would you have handled the crisis if you had been chairman of the Fed?
A: I would have acted similarly in 2008/2009 in the early stage in providing liquidity. But I would have let the banks fail & nationalized them by executive order.
Gold: Keep 10% of investible assets in gold. Gold wins either way - Fed gets the inflation they want & gold goes up or deflation wins out & you want gold in a deflationary environment (for example, gold went up 75% during Depression) as the treasury bids up gold as a way of causing generalized inflation (ie if gold goes up, silver goes up, oil goes up, etc).
Yen: Keep shorting the Yen. “Yen is not done declining, its going to go to the 110 to 120 level”.
Sterling: When Yen hits 110, rotate out of short yen/long gold to short sterling/long gold.
Euro: Long Euro/Short USD
Europe: Only Economy I’m really bullish on is Europe. Very Virtuous cycle present there:
“We are in a Depression that won’t end until policy changes”
“China is completely unsustainable. Probably headed for a collapse in 2014, maybe 2015 at the latest”
“Yen is not done declining, its going to go to the 110 to 120 level”.
“Private Equity is completely out of ideas”
Rickards vs. HEDGEYE: We very much like Jim’s process and his contextualization of current macro dynamics. We disagree with some of the conclusions.
Process: Jim has an attractive analytic framework for processing information and contextualizing market and policy events (he’s also uniquely adept at articulating the complex in a straightforward & tractable manner). A dynamic, complexity based model with a behavioral overlay is the right approach and parallels our own.
Deflation: We understand the need for nominal growth in a debt deflation scenario. However, we think there is a fair probability price deflations play out in a more nuanced fashion – essentially, more of what has been occurring over the last year. Targeted and rotating asset class deflations – commodities (currently), treasuries (likely next), etc – are economically manageable and present trade-able opportunities. Inflation/Deflation need not be a completely binary, On/Off or all-or-nothing type dynamic here.
Inflation/Growth: Jim used 5% nominal growth as his bogey, with a base assumption that we only get ~1% real growth. If we do, in fact, get a continuation in domestic #GrowthAccelerating then the inflation component necessary for hitting that 5% nominal target comes down. Here, the magnitude and need for negative real rates is reduced as is the level of ongoing easing initiatives. With employment, housing and confidence accelerating and $USD dollar strength and credit trends supportive, we think key pieces are in place for driving a positive reflexive economic cycle in the immediate/intermediate term.
$USD: Citing falling labor costs, inflow of foreign capital, upside to efficiency, and positive labor force demographics, Jim indicated he likes both the Euro currency and the setup for the European economy relative to that of the USA. While we wouldn’t necessarily take issue with that reasoning we think it holds the potential for significant duration mismatch.
Being inefficient (efficiency upside) and having significant, secular unemployment (labor force upside) may indeed be opportunities, but ‘if’, the magnitude of, and the timeline over which that upside may be realized is highly uncertain. Here, our disagreement may be principally a function of duration. At present, we continue to like U.S. consumption related exposure and select European exposure on the long side (ie. Germany,at a price) while holding a negative view of EU country exposure broadly.
Gold: Jim continues to like gold and thinks it wins under both inflationary or deflationary scenario’s. Here again the difference of investment opinion may be duration based. We have been bearish on gold since November and continue to see further upside for the $USD and further downside for gold over the intermediate term as the domestic macro data improves and monetary policy leans incrementally hawkish on both an absolute and relative basis.
We always enjoy the opportunity to host Mr. Rickards. We are fans of his process and the conversations are open and constructive. We occasionally differ in our interpretation of the data and investment conclusions, but that's what makes a market. We looking forward to catching up with Jim again.
Christian B. Drake
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Takeaway: Domestic and international headwinds are weighing on Mexican capital markets and that’s not something that we see reversing anytime soon.
Two weekends ago, National Action Party (PAN) Chairman Gustavo Madero decided against his party’s wishes to remove 45-year-old former Finance Minister Ernesto Cordero from his post as PAN Senate leader (24 of the PAN's 38 senators signed a letter in support of Cordero). The internal struggle atop the PAN, one of Mexico’s three main political parties, has accentuated the divide between PAN lawmakers willing to work with the ruling Institutional Revolutionary Party (PRI) and those who believe the party must mount a robust opposition to the galvanizing Pena Nieto in order to mitigate the risk becoming irrelevant (i.e. Cordero and the 24 senators that openly support him).
The key issue with this is that President Pena Nieto's PRI, which remains short of a majority in Mexican Congress, needs support from the conservative PAN to advance his economic reform agenda, which includes re-working the Mexican Constitution to overhaul state oil behemoth Pemex and to broaden the tax base. It would be hard to argue that President Nieto’s reform agenda has not been the primary driver of positive sentiment among international investors surrounding Mexico’s economic outlook in the YTD, so to the extent this creates a sustained rift within the PAN, you could see incremental selling pressure upon Mexican capital markets.
All that being said, some solace should be taken in the fact that Madero has openly stated that removing Cordero was merely an attempt to improve relationship between PAN party leaders and senators, insinuating that the move was unrelated to differences about party’s future in the “Pact For Mexico” alliance (i.e. the tri-party political vehicle responsible for streamlining economic reforms). At any rate, it’s tough to see how much of the reform agenda is permanently derailed by this act until the political dust settles, which, last month, included allegations of corruption upon PRI officials at the state level.
With no trustworthy way of modeling intraparty and interparty political risk, we have deferred to our quantitative risk management signals, which have confirmed a TRADE & TREND breakdown in the Mexican equity market. Specifically, we have interpreted that to mean there is a high probability of more political consternation ahead.
Since early last week, the Mexican political scene has been relatively quiet with no major developments regarding the now-shaky Pact For Mexico and President Nieto’s economic reform agenda. What has weighed on Mexican capital markets in recent days has been rising investor expectations that the Federal Reserve’s QE program is poised to be pared back at some point over the intermediate term.
Mexico, due to its proximity and economic integration with the US (as opposed to a recessionary Europe and structurally slower China; the US accounts for 80% of Mexican exports) has been a darling for yield-chasing capital during the Ben S. Bernanke financial repression era. As such, we’re really starting to see Mexican capital markets break down in recent weeks amid the recent backing up of global interest rates. Through yesterday’s close:
Net-net, Mexican capital markets are getting hammered from both sides – domestically and internationally – and that’s not something that we see reversing anytime soon – at least until President Nieto’s reform agenda gets firmly back on track. Using the yield on the 10Y US Treasury as a proxy for financial repression in the US, it’s no surprise to see that Mexican 10Y yields have a +0.85 positive correlation to their American counterparts on a trailing 3Y basis.
With super-sovereign yields backing up globally now (review our detailed thoughts HERE, HERE, HERE and HERE), it’s no surprise to see one of the favorite yield chasing plays of US and Japanese investors throughout recent years is getting tattooed. Moreover, with everything we now know about EM crises cycles (CLICK HERE for our 120+ page presentation), it’s getting a lot easier to spot these risks in real-time and reallocate assets before it’s too late.
We’ve obviously been the bulls on domestic equities and USD exposure in the YTD, but for those of you who must remain invested in emerging markets, we continue to like consumption-oriented markets like the Philippines, India and Indonesia in lieu of commodity/inflation oriented markets such as Russia, Brazil, South Africa and Peru. If you’re looking to play our thesis in the FX market, we continue to warn of material downside across the currencies of Latin American and African commodity producing nations.
Best of luck navigating these globally-interconnected risks.
Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor". If you'd like to receive the work of the Financials team or request a trial please email .
European Financial CDS - Though unremarkable, European financial swaps were broadly wider last week with a median increase of 8 bps. Barclays (+13 bps), Deutsche Bank (+10 bps) and UBS (+8 bps) showed the largest deterioration, while DNB of Norway, Investor AB of Sweden and Danske Bank of Denmark were all tighter.
Sovereign CDS – Sovereign swaps were mixed last week with Italy and Spain widening by 15 and 8 bps, respectively, while Germany and France tightened by 2 and 4 bps. Meanwhile, Japan widened 7 bps to 72 bps. The U.S. was unchanged at 30 bps, one basis point narrower than Germany.
Euribor-OIS Spread – The Euribor-OIS spread tightened by 1 bps to 13 bps. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk.
ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB. Taken in conjunction with excess reserves, the ECB deposit facility measures excess liquidity in the Euro banking system. An increase in this metric shows that banks are borrowing from the ECB. In other words, the deposit facility measures one element of the ECB response to the crisis.
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