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THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED

Takeaway: There appears to be no end in sight for desert-like liquidity conditions across the Chinese financial system.

SUMMARY BULLETS:

 

  • There appears to be no end in sight for desert-like liquidity conditions across the Chinese financial system. For example, the benchmark weighted-average seven day repo rate jumped +143bps DoD to close at 8.07%, which is the highest close since the rate hit 8.1% in JAN ’12. On a monthly average basis of 6.21%, China’s benchmark seven-day repo rate is at all-time highs (data going back to JAN ’04).
  • What we find interesting about Premier Li’s latest commentary is that Chinese officials aren’t responding to the dire monetary conditions with a rapid reach for the monetary stimulus gun, but rather with a calculated, conservative approach that favors ridding the system of its excesses, rather than perpetuating them. This is new as it relates to how China has handled such liquidity constraints over the past several years and has clearly caught consensus investors and corporations (i.e. those that blindly clamor for Chinese stimulus in a Pavlovian manner) offsides.
  • At any rate, all of the recent negative developments across the Chinese financial system are very much in line with our recent work on the Chinese economy, including our 61-slide presentation on Chinese financial system risks (among other topics). In the event you missed that come through, we’ve included a hyperlinked compendium of that work at the conclusion of this note.
  • Specifically, we think recent [bubbly] trends in the Chinese property market will keep the PBOC on the sidelines with respect to the intermediate term. Additionally, we think a delayed recognition of NPL exposures will continue to effectively tighten/keep tight liquidity conditions across the Chinese financial system as incremental credit is increasingly allocated to servicing existing liabilities, rather than generating economic output that ultimately allows for the retirement of debt. That will ultimately equate to sustainably slower GDP growth, which will, in turn, exacerbate the problem in a reflexive manner.
  • All told, no change to our dour outlook for the Chinese financial system and the equity values that underpin it. We reiterate our bearish bias on Chinese banks and property developers (CHIX is the ETF we are using to #TimeStamp the position) and our structural bearish thesis for emerging markets broadly. The recent developments in China are clearly not positive for sentiment among EM investors; nor are they supportive of EM economic fundamentals, particularly given that so much of EM growth was perpetuated by China’s fixed asset investment bubble – which we clearly view as in the process of popping.

 

There appears to be no end in sight for desert-like liquidity conditions across the Chinese financial system. The benchmark weighted-average seven day repo rate jumped +143bps DoD to close at 8.07%, which is the highest close since the rate hit 8.1% in JAN ’12. On a monthly average basis of 6.21%, China’s benchmark seven-day repo rate is at all-time highs (data going back to JAN ’04).

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 1

 

More signs of stress:

 

  • The overnight repo rate jumped +203bps to close at 7.58%, while overnight Shibor increased +206bps to close at 7.66%. On a monthly average basis, those rates are up +339bps and +348bps, respectively. On a quarterly average basis, those rates are up +114bps and +115bps, respectively.
  • Looking to O/N Shibor specifically, it’s interesting (and dangerous) to see that the monthly average of 6.40% is a full 40bps above the PBOC’s benchmark 1Y lending rate. Assuming SOE borrowers have been taking advantage of the 30% reduction in the lending rate floor, the JUN-to-date average for overnight interbank deposits is a whopping +220bps above what Chinese banks are likely to have been extending 1Y credit at! Obviously, negative carry is neither a safe nor sustainable environment for any bank to operate in.
  • The 1Y on-shore interest rate swap (i.e. the fixed cost needed to receive the benchmark seven-day repo rate) increased +50bps DoD to 4.49%, which is a full 149bps premium to the PBOC benchmark 1Y household deposit rate and good for the highest close of all-time (data going back to APR ’06). On a period-average basis, the 1Y swap rate is up +30bps MoM and +12bps QoQ, respectively.

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 6

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 2

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 3

 

With stress like this across the Chinese financial system, it’s no surprise to see that the Ministry of Finance’s auction of of 30B yuan ($4.9B) of 10Y paper closed with a bid-to-cover ratio of 1.43x, which was the lowest since AUG ’12.

 

Perhaps more important than the aforementioned signals we continue to receive from Chinese money markets was the commentary we received from Primer Li overnight, suggesting that, “China should further support the development of real economy by improving the use of money stock on the market.”

 

He followed up by saying, “Although the amount of capital invested into the real economy remains considerable, the marginal effect of money supply in economic growth becomes small. From January to May, the volume of social financing had reached CNY 9.11 trillion, a year-on-year increase of CNY 3.12 trillion, but China’s economic growth was still on a downward trend. This is mainly due to the oversized debts and inefficient use of capital in the real economy.”

 

What we find interesting about this is the fact that Chinese officials aren’t responding to the dire monetary conditions with a rapid reach for the monetary stimulus gun, but rather with a calculated, conservative approach that favors ridding the system of its excesses, rather than perpetuating them. This is new as it relates to how China has handled such liquidity constraints over the past several years and has clearly caught consensus investors and corporations (i.e. those that blindly clamor for Chinese stimulus in a Pavlovian manner) offsides.

 

Per the state-run China Securities Journal (a media outlet for the CSRC), “[China] cannot use as fast money supply growth as in the past, or even faster, to promote economic growth. This means that authorities must control the pace of money supply growth.”

 

At any rate, all of the recent negative developments across the Chinese financial system are very much in line with our recent work on the Chinese economy, including our 61-slide presentation on Chinese financial system risks (among other topics). In the event you missed that come through, we’ve included a hyperlinked compendium of that work at the conclusion of this note.

 

Specifically, we think recent [bubbly] trends in the Chinese property market will keep the PBOC on the sidelines with respect to the intermediate term. Additionally, we think a delayed recognition of NPL exposures will continue to effectively tighten/keep tight liquidity conditions across the Chinese financial system as incremental credit is increasingly allocated to servicing existing liabilities, rather than generating economic output that ultimately allows for the retirement of debt. That will ultimately equate to sustainably slower GDP growth, which will, in turn, exacerbate the problem in a reflexive manner.

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 7

 

You’re already seeing our bearish cyclical [and structural] thesis on Chinese economic  growth confirmed by both domestic and international commodity markets, the latter of which China remains the key player in from an incremental demand perspective.

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 4

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 8

 

THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED - 5

 

All told, no change to our dour outlook for the Chinese financial system and the equity values that underpin it. We reiterate our bearish bias on Chinese banks and property developers (CHIX is the ETF we are using to #TimeStamp the position) and our structural bearish thesis for emerging markets broadly. The recent developments in China are clearly not positive for sentiment among EM investors; nor are they supportive of EM economic fundamentals, particularly given that so much of EM growth was perpetuated by China’s fixed asset investment bubble – which we clearly view as in the process of popping.

 

Darius Dale

Senior Analyst

 

  • REPLAY PODCAST AND SLIDES: ARE YOU SHORT CHINA [AND OTHER EMERGING MARKETS] YET? (6/12): We think the outlook for Chinese credit growth is structurally impaired. Moreover, we anticipate that growth in non-performing loans will accelerate sustainably over the long term. Lastly, we believe that net interest margins across the Chinese banking industry face immense regulatory headwinds that may ultimately have dire consequences for China’s fixed assets investment bubble. At a bare minimum, investors should steer clear of these obvious value traps over the intermediate-to-long term. Moreover, we continue to believe assets linked to Chinese industrial demand will remain under pressure for the foreseeable future.
  • IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? (6/10): Recent policy developments call attention to the systemic risks facing China’s banking system. Additionally, MAY growth data came in soft.
  • IS A RATE HIKE(S) COMING DOWN THE PIKE IN CHINA? (6/4): No change to our dour view of China’s TREND-duration growth outlook or the pending bifurcation of FAI and consumption growth.
  • IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? (5/17): We do not think the recent strength in the Chinese equity market is sustainable, as China’s 2H13 growth outlook appears dicey at best.
  • WHY IS CHINA GOOSING ITS EXPORT FIGURES AND HOW MUCH LONGER WILL IT CONTINUE? (5/8): Chinese firms are goosing exports to drive incremental liquidity into the banking system – a phenomenon that appears set to slow from here.
  • TWO CHINAS? (5/1): Financial system headwinds continue to outweigh consumption tailwinds within the Chinese economy.
  • REPLAY: Will China Break? (4/30): The Party’s use of state owned banks to drive economic growth through fixed asset investment has left the financial system loaded with bad assets.  The bad assets mirror bad investments in the real economy.  They also can limit the ability of Chinese banks to make new loans.  Following the financial crisis, the Chinese government pushed too hard on the FAI growth lever, building infrastructure projects “for the next 10 years.” It has also left the banking sector choked with bad debts that may limit future lending.  Those factors should slow Chinese FAI growth and slower Chinese FAI growth should be negative for commodity prices and resource-related profits, all else equal.
  • CAN CHINA AVOID FINANCIAL CRISIS? (4/26): The risk of a Chinese financial crisis is heightened to the extent that financial sector reforms are not appropriately managed.
  • REPLAY: EMERGING MARKET CRISES (4/23): We currently see a pervasive level of risk across the emerging market space at the country level and have quantified which countries are most vulnerable. China is particularly vulnerable to experiencing a financial crisis.
  • IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? (3/28): Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.

Big Day for Fed Overlords

Takeaway: If we get some tapering and that equates to Strong USD, we’re going to do more of what we’ve been doing successfully for the last 6 months.

Today of course is a big day for Ben Bernanke and his fellow Central-Planning Overlords at the Fed. Everyone is fixated on their comments, the media will be all excited, etc. You know the drill.

 

Big Day for Fed Overlords - bbo8

 

What do you do from here?

 

If you know what Bernanke’s going to say, you know more than me. Because I have no idea what he’s going to say. I do know what I think he should say, and I do know what I think he should do. But that’s an entirely different matter.

 

Last week, the whispers and leaks were indicating that Bernanke would push out the tapering; this week’s rumor is that he has the tapering back on. Now, if the Fed made a decision based solely from an economic fundamental (e.g. housing, consumption and employment growth) perspective, they of course should have already started tapering.

 

The reality here is that tapering would be good.

 

For the record, there’s a good reason why I’ve taken down my gross exposure to equities. I have no idea what’s going to happen this afternoon and what this guy is going to say. That’s just the simple fact of the matter. So I have to be in a position where I’m able to react to that, and I will.

 

You know what I’m going to do? If he tapers, and the US Dollar strengthens, you’re going to see me out there buying stocks. Of course, some people are saying, “Tapering scares me! We need the Fed to hold our hand!” Come on. Get off the pot already. Seriously. It’s been five years of this scaring the hell out of people, worrying about everything under the sun.

 

People are really regressive out there. I want to be progressive. I want to be invested.

 

Bottom line is if we get some tapering and that equates to #StrongDollar, we’re going to be doing more of what we’ve been doing successfully here at Hedgeye for the last six months. That of course is being bullish on U.S. equities and bearish on all the things I’ve already outlined like gold, Treasuries and commodities.

 

More to be revealed. 

 

(Editor's Note: This was an excerpt from Hedgeye CEO Keith McCullough's morning conference call. If you would like additional information please click here.)


THE JACK OPTION: PART II

We continue to believe that the long-term potential of JACK is underappreciated, particularly with respect to the future growth of Qdoba.  The company’s recent announcement to restructure enhances this view.

 

Looking Back

On May 8, 2012, we published our SOTP analysis describing Qdoba as the “Jack Option” and suggesting significant upside.  Since that time, Qdoba’s performance has stagnated while Jack in the Box has performed quite well.  The recent Qdoba announcement included a strategic review of store-level market performance, geared toward correcting growth related issues and setting the stage for stronger performance moving forward.  We have seen similar initiatives before, where concepts have successfully shrunk to a core base of stores, establishing new platforms and leading to significant value creation.

 

Sometimes Less Is More

The announcement included the planned closure of 67, or 21% of, Qdoba company-owned stores by the end of FY13.  The vast majority of these stores are cash flow or EBITDA negative and only represent 13% of Qdoba brand company sales.  Yesterday, JACK disclosed the following estimates of the pro forma impact the closures would have had on Q2 fiscal year-to-date results:

  1. 500bps increase in Qdoba restaurant operating margin
  2. $4.5mm increase in EBITDA
  3. $7mm increase in operating profit
  4. $750,000 decrease in G&A

Updated Development Plans

The strategic decision to close these unprofitable stores represents a meaningful positive for the stock and the overall operating performance of the enterprise.  Management also reiterated its FY13 development plans and suggested that there will be approximately 12% unit growth at company and franchised stores in FY14.  We believe these recent actions, coupled with the analysis of consumer insights and a new brand positioning, should allow for continued improvement in Qdoba’s performance.

 

Potential Upside In The Stock

In our view, the company’s aggressive move to restructure Qdoba is likely to improve the brand’s profitability and should provide investors with the confidence to assign the brand a growth multiple.  In the past we have described Qdoba as a call option for shareholders given the concept’s long-term growth potential.  Due to this renewed growth profile, we see approximately 30% potential upside in the stock over the next 2-3 years from current levels.

 

 

 

Howard Penney

Managing Director

 

Rory Green

Senior Analyst


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#BULLISH BUILDER CONFIDENCE

Takeaway: Builder confidence has historically trended to 65-78 after crossing positively through 50, making today's reading of 52 noteworthy.

This note was originally published June 17, 2013 at 12:42 in Financials

#BULLISH BUILDER CONFIDENCE  - hous5

Reflexivity

Typically we pay little attention to the builder confidence survey, but given the recent underperformance in the builder complex we thought it was worth some further consideration. Looking at the history of the series, which unfortunately only dates back to 1985, there have been four prior episodes of builder confidence crossing above 50 and then moving on steadily to 65-70. In the first chart below we illustrate this tendency. The four prior peaks were 65 in June, 1986, 71 in November, 1993, 78 in December, 1998 and 72 in June, 2005. We find it interesting that builder confidence tends to autocorrelate (i.e. move in the same, self-reinforcing direction for long periods of time), just as home prices and housing demand do.

 

#BULLISH BUILDER CONFIDENCE  - nahb peaks large

 

If we assume that builder confidence continues to trend higher, toward its prior peaks in the 65-78 range, what are the implications for construction activity? The chart below shows the historical relationship between builder confidence and construction activity. There are several takeaways from this chart. The x-axis shows the HMI (builder confidence) reading, while the y-axis is the concurrent level of single family housing starts in thousands of units annualized. Over the history of the series (1985-Present), we've seen a 16k change in SF starts for every one point change in the HMI index. Interestingly, based on today's builder confidence reading of 52, the fair value for SF starts is 1.137 million vs. the current reading of 610k, or 87% above where it is today. If we assume that confidence rises to 65, then SF starts should reach 1.35 million and if we assume 78, we get 1.56 million. 

 

#BULLISH BUILDER CONFIDENCE  - mr

 

Bear in mind, this is single family starts. Historically, as the chart below shows, single family starts have averaged 72% of total starts from 1960-present. The most recent reading was identical at 72%, but if we take the average of the last six months, single family starts have been averaging 67% of total starts. If we divide the above figures by the long-term average of 72%, it translates to high side estimates for total starts of 1.58 million (today's HMI of 52), 1.875 million (HMI 65), and 2.17 million (HMI 78). These rates of construction are generally consistent with the levels we would expect to see given the current rates of new household formation we're seeing coupled with the historical relationship between household formation and housing construction.

 

#BULLISH BUILDER CONFIDENCE  - starts to total

 

It's also worth noting that the recovery in builder confidence remains more parabolic than linear, i.e. supportive of our conclusion that the housing recovery continues to show signs of acceleration. It doesn't hurt that mortgage rates have also backed off their recent highs, ticking down to 3.94% from their recent highs of 4.16%. As the chart below shows, the second order measure of trajectory remains much stronger (0.92) than the first order (0.76).

 

#BULLISH BUILDER CONFIDENCE  - parab

 

Conclusion 

Housing's momentum has been one of the three central tenets of our bullish stance on Financials, alongside the labor market recovery and the Fed's asset purchase program. Today's signs of ongoing recovery, and even acceleration, are a welcome sign suggesting that our bullish intermediate to long term view on the Financials remains on track. However, in the short-run, we remain cautious for several reasons including the predictable deceleration in seasonally-adjusted labor data, elevated uncertainty around the Fed's willingness to continue its asset purchase program, and steadily deteriorating conditions in the credit markets.

 

 

The two charts below look at the long-term as well as the short-term relationship between builder confidence and builder activity levels. 

 

#BULLISH BUILDER CONFIDENCE  - lt

 

#BULLISH BUILDER CONFIDENCE  - st

 

Joshua Steiner, CFA

203-562-6500

jsteiner@hedgeye.com

 

Jonathan Casteleyn, CFA, CMT

203-562-6500

jcasteleyn@hedgeye.com

 


Morning Reads on Our Radar Screen

Takeaway: A quick look at stories on Hedgeye's radar screen this morning.

Daryl Jones – Macro

Inflation at 53-Year Low Gives Bernanke Time to Press on With QE (via Bloomberg)

 

Morning Reads on Our Radar Screen - radar

 

Keith McCullough – CEO

Brazil sends national security force to quell protests (via BBC)

China Billionaire Invests $1.6 Billion in London Land, Boats (KM note: #EmergingOutflows out of China …  via Bloomberg)


Josh Steiner – Financials

Mortgage-Bond Auction Failures Reach Most in 2013 as Prices Drop (via Bloomberg)


Howard Penney - Resturants

Red Robin Garden Burger Ad Under Fire For Dissing Vegetarians (via Huffington Post)

McDonald's Worker Says She Was Required to Receive Pay on Fee-Laden Debit Card (via ABC News)


Matt Hedrick – Macro

Doctors Call for Halt to Energy Drink Ads to U.S. Youths (via Bloomberg)


"I Got Nowhere Else to Go!"

Client Talking Points

YEN

Keeping a close eye on currencies remains key. Yen vs USD is failing at our 96.17 intermediate-term TREND line of support this morning. This comes after the propaganda of down currency, up exports (Japan reported +10% exports for May, but their 3rd worst monthly trade deficit ever) was being cheered on by Japanese bureaucrats. The #WeimarNikkei gained +1.8%, but failed to close above 13,641 TREND resistance again.

CHINA

#GrowthSlowing in most things Chinese continues... Meanwhile, the rest of Asia (ex-Japan) traded very poorly again overnight. Over in Hong Kong, the Hang Seng led the losers, down another -1.1%. It is now down -5.1% year-to-date. It's bearish TRADE and TREND for most Asian Equity markets now, including Singapore, KOSPI, and BSE Sensex. Be alert here.

RUT

All the while the Russell 2000 quietly (volume was -15% yesterday vs my TREND duration average) clocked a new all-time closing high yesterday of 999. Yes, all-time is a long time. The continuing flows to US Equities (and out of everything Treasuries, Gold, Sovereign Debt, etc) make sense to me. A lot of sense. The world is running out of places to flow capital. That's bullish for US stocks.

Asset Allocation

CASH 53% US EQUITIES 17%
INTL EQUITIES 15% COMMODITIES 0%
FIXED INCOME 0% INTL CURRENCIES 15%

Top Long Ideas

Company Ticker Sector Duration
NSM

Financials sector head Josh Steiner is the Street’s head bull on residential mortgage originator/servicer Nationstar, projecting $9 in earnings for the company in 2014.  This is well above the company’s own guidance range, which tops out at around $7.50. NSM had a successful start to the year as it won servicing bids on substantial mortgage portfolios.  They also reported significant increases in their profit margins on those portfolios, and double-digit increases in their own originations.  Housing prices are ramping significantly higher, as Steiner predicted, as demand continues to exceed supply in both new and existing homes.  Steiner says this quality mortgage company could ride the crest of a sustained wave of sector improvement.

MPEL

Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016.  

WWW

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.

Three for the Road

TWEET OF THE DAY

Marty Feldstein on @SquawkCNBC : I think the Fed made a mistake in doing as much as it has ... it's created a bubble in the long-term bond

@beckyquickcnbc

QUOTE OF THE DAY

Be wary of the arrogant intellectual who comments from the stands without having played on the field.

-Ray Dalio

STAT OF THE DAY

The IRS is about to pay $70 million in employee bonuses despite an Obama administration directive to cancel discretionary bonuses because of automatic spending cuts enacted this year.


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