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Wandering Trends

This note was originally published at 8am on June 06, 2013 for Hedgeye subscribers.

“One main factor in the upward trend of animal life has been the power of wandering.”

-Alfred North Whitehead

 

Rather than get all googly eyed about modern day central planners who are long of social science dogma and short of math, I tend to wander backwards when looking for direction. History is my contextual guide, and so are her credible sources.

 

Whitehead was one of the British math guys (1861-1947) who wandered outside of academia’s box. He co-authored Principia Mathematica with one of the world’s premier strategists (Bertrand Russell) and was an early adopter of what we now call Chaos Theory.

 

From considering the metaphysical global macro market to the process you have developed to absorb it, what is that you do when markets go against you? What do we do when immediate-term TRADEs wander from the intermediate-term TRENDs? Bull or bear? Personally, I am ok with being called an animal.

 

Back to the Global Macro Grind

 

I had a very bad day yesterday. Yes, for those of us who timestamp every move we make, they do happen. But what, precisely, was happening? Was my first move to do more of what wasn’t working? Or was it a better decision to wait and watch?

 

The good news about today is that Mr Market gives us direct feedback on however we answered those questions. Right or wrong, we are tasked with always questioning the behavioral side of our decision making process. #evolve

 

To put yesterday’s -1.38% drop (SP500) in context, it was the 5th worst day for US stocks in 2013:

  1. February 28, 2013 = -1.83%
  2. April 15, 2013 = -2.30%
  3. April 17, 2013 = -1.43%
  4. May 31, 2013 = -1.43% 

When I was a younger man trading on simple moving averages and voodoo technical charting systems that my bosses would push down on me, one-factor price moves could really throw me for an emotional loop.

 

Now I use a baseline 3-factor model that includes PRICE/VOLUME/VOLATILITY parameters and predictive tracking algorithms. And it’s that last little critter (VOLATILITY) that helps me sometimes front-run the proactively predictable behavior of machines.

 

What all 5 of the worst US stock market down days have in common is front-month US Equity volatility (VIX) seeing a very short-term capitulation to lower TREND duration highs. Here’s that history of VIX closing prices:

  1. February 25, 2013 = 18.99
  2. April 15, 2013 = 17.27
  3. April 18, 2013 = 17.56
  4. May 31, 2013 = 16.30

And yesterday, the VIX closed +7.6% on the day at 17.50.

 

So, what say you Mr Mucker, TRADE or TREND? That’s easy:

  1. SP500 = bearish TRADE; bullish TREND
  2. VIX = bullish TRADE; bearish TREND 

For those of you who are new to reading my rants, in our model TRADEs are 3 weeks or less and TRENDs are 3 months or more. I built the model this way so that I don’t let my emotions allow me to wander too far away from fundamental research trends.

 

Freaking out and selling at every higher-low within a bullish TREND is called losing money. And since that would violate Rule #1 in our risk management process, we don’t want to be like that.

 

Why is the intermediate-term TREND for US stocks bullish and for fear bearish? I think the fundamental research answer to this quantitatively prefaced question is crystal clear – what everyone lives in fear of (#GrowthSlowing) is now #GrowthAccelerating.

 

Darius Dale will show you this in our Chart of The Day (6 month TREND duration charts)

  1. US Equity Volatility is still crashing (-23% from its Johnny Boehner sequestration fear-mongering high in December 2012)
  2. US Equities (SPY) continue to make a series of higher-lows on selloffs as the VIX makes lower-highs

If the VIX can’t close above 18.99 and the SP500 can’t snap my TREND support line of 1577, what I’ll be doing from here is doing more of what we have been doing for the past 6 months (buying the damn dips in US Consumption and shorting almost everything Commodities).

 

No, that doesn’t mean I bought all the way down yesterday. It actually meant I did a whole lot of nothing. The SP500’s TRADE line broke, so why hurry when I can either buy lower or buy on another TRADE breakout above 1624 SPX when my convictions are confirmed?

 

Of all the bubbles Bernanke has helped perpetuate, one of the biggest is fear. The fear of change (rates rising) in this market is pervasive. But don’t wander too far from the TREND here my friends. Shorting fear and buying growth has been right; stay with it until the mathematical signals collide with the fundamentals. If they change, we will.

 

Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1361-1419, $100.24-104.42, $82.21-83.32, 98.71-103.02, 2.01-2.23%, 15.31-17.91, and 1601-1624, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Wandering Trends - Chart of the Day

Wandering Trends - Virtual Portfolio


THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP – June 20, 2013


As we look at today's setup for the S&P 500, the range is 45 points or 1.10% downside to 1611 and 1.66% upside to 1656.               

                                                                                                                

SECTOR PERFORMANCE


THE HEDGEYE DAILY OUTLOOK - 1

 

THE HEDGEYE DAILY OUTLOOK - 2

 

EQUITY SENTIMENT:


THE HEDGEYE DAILY OUTLOOK - 10


CREDIT/ECONOMIC MARKET LOOK:

  • YIELD CURVE: 2.09 from 2.05
  • VIX closed at 16.64 1 day percent change of 0.18%

MACRO DATA POINTS (Bloomberg Estimates):

  • 8:30am: Initial Jobless Claims, June 15, est. 340k (prior 334k)
  • 8:30am: Continuing Claims, June 8, est. 2.958m (prior 2.973m)
  • 8:58am: Markit US PMI Preliminary, June
  • 9:45am: Bloomberg Economic Expectations, June (prior -1)
  • 9:45am: Bloomberg Consumer Comfort, June 16
  • 10am: Philadelphia Fed Factory Index, June, est. -2 (prior -5.2)
  • 10am: Existing Home Sales, May, est. 5m (prior 4.97m)
  • 10am: Leading Indicators, May, est. 0.2% (prior 0.6%)
  • 10am: Freddie Mac mortgage rates
  • 10:30am: EIA natural-gas storage change
  • 11am: Fed to purchase $2.75b-$3.5b notes in 2020-2023 sector
  • 1pm: U.S. to sell $7b 30Y TIPS in reopening

GOVERNMENT:

    • 8:55am: Inter-American Development Bank President Luis Alberto Moreno delivers keynote remarks at Woodrow Wilson Center event on Latin America, Asia relations
    • 9:30am: House Ways and Means Cmte health panel holds hearing on 2013 Medicare Trustees Report
    • 10:30am: Senate Appropriations Cmte marks up several FY2014 spending bills, including the Agriculture, Rural Development, FDA and Related Agencies Appropriations Bill

WHAT TO WATCH

  • European stocks sink as Bernanke outlines paring of stimulus
  • Goldman Sachs drops Ebix deal as U.S. prosecutors open probe
  • Facebook said to plan unveiling Instagram video sharing
  • Microsoft reverses stance on trading games for Xbox One
  • Men’s Wearhouse founder said ousted amid clash with CEO
  • Ford’s Mulally calls Japan currency manipulator
  • Ford CEO opens $300m China plant as sales surge
  • Fiat judge seen leaving Marchionne in lurch over Chrysler
  • Boeing, Airbus tighten jet-order grip as upstarts falter
  • AirAsia orders $8.6b CFM engines to power A320 planes
  • Airbus explores A380 superjumbo refresher to help sales
  • “Candy Crush Saga” maker said to enlist bankers for IPO
  • Ex-AMD worker seeks probation in insider case on aid to U.S.
  • IEA says U.S. natgas production to accelerate next year
  • Credit Suisse, Baer seen facing delay in U.S. tax deal
  • Five U.K. banks must raise $21.2b total in capital, BOE says
  • Stratasys to acquire 3-D printer rival MakerBot for $403m
  • China manufacturing contraction deepens amid cash pinch
  • Tata wins over IBM, Dell in India as solar cheaper than grid 

EARNINGS:

    • Pier 1 Imports (PIR) 6am, $0.19
    • IHS (IHS) 6am, $1.05
    • Rite Aid (RAD) 7am, $0.09
    • Kroger (KR) 8:30am, $0.88 - Preview
    • Oracle (ORCL) 4:01pm, $0.87
    • TIBCO Software (TIBX) 4:05pm, $0.19

COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)

  • Gold Tumbles to 2 1/2-Year Low as Bear Market Extends After Fed
  • SocGen’s Haigh Sees Gold Lower After Calling Rout: Commodities
  • Commodities From Gold to Oil Slump on Fed Outlook, China Crunch
  • Copper Reaches Seven-Week Low on Fed Concern and China Slowdown
  • WTI Crude Drops a Second Day on Chinese Slowdown, Fed Easing
  • Socgen’s Bhar Sees Silver Sliding to $10-$15 ‘Quite Quickly’
  • Corn Exports From India Seen Climbing to Record on Bigger Crop
  • Gold Imports by India Seen Tumbling 40% This Month From May
  • Gold ‘Bubble’ Is Fit to Burst as Funds Unwound: Chart of the Day
  • Glencore to BP Widen Fuel Oil Price Gap in Spree: Energy Markets
  • Rebar Falls for First Day in Six on Steel Output, China Data
  • LNG Market Will Be Tight Through 2014 on Asia Demand, IEA Says
  • Russia’s Oil Champion Shunned as Putin Weighs Share Sale: Energy
  • SPDR Gold Assets Drop Below 1,000 Tons as $30 Billion Erased

THE HEDGEYE DAILY OUTLOOK - 5

 

CURRENCIES


THE HEDGEYE DAILY OUTLOOK - 6

 

GLOBAL PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - 3

 

THE HEDGEYE DAILY OUTLOOK - 4

 

EUROPEAN MARKETS


THE HEDGEYE DAILY OUTLOOK - 7

 

ASIAN MARKETS


THE HEDGEYE DAILY OUTLOOK - 8

 

MIDDLE EAST


THE HEDGEYE DAILY OUTLOOK - 9

 

 

The Hedgeye Macro Team

 

 

 

 

 

 

 

 

 

 


FDX: Can FDX Earn $8.00/share in FY 2014?

Summary

 

We’ll let others summarize the FDX quarter and will instead focus on the development of key value drivers.  For us, the one factor that matters most is the Express margin.  FDX needed to “show” Express margin progress and the company delivered.  That should be a positive set-up heading into the core of the FDX’s restructuring in FY14 and FY15.  We see further evidence in the quarter that FDX will execute on its plan to improve Express margins, likely taking the share price significantly higher.  We will also be looking for the 10-Q, which should be out tomorrow.

 

Express Operating Margin Strong:  FedEx Express is not dead yet.  Instead, it is improving margins and growing total volume (IP+IE, Domestic).  Capacity reductions, a younger fleet and, perhaps most importantly, the use of commercial lift for International Economy volume drove the highest quarterly segment margin since the tight market of FY4Q 2010.  Importantly, the margin gain was from what some pejoratively refer to as “self-help”, not a strong Express environment.  Management's tone when discussing International Economy (IE) vs. International Priority (IP) seemed clearer and more positive than it had previously.  

 

FDX: Can FDX Earn $8.00/share in FY 2014? - k1

 

 

Why Did Express Margins Expand Now? This is the first quarter we expected to see any benefit Express restructuring because this is the first quarter since the restructuring is in place (see “Clock Starts Now”). The early results are encouraging and there should be more to come.

 

$8.00 In FY14 EPS? Given the strong FY4Q 2013 Express margin and the further improvements expected in FY14, a 6% Express margin for next year is not unrealistic.   FedEx Ground reported strong growth and margins, putting >$2 billion in operating income within reach.  Assuming another decent year for Freight, it is not a big stretch to model FY2014 adjusted EPS at just under $8.00/share. 

 

Why was guidance so weak?  It seems pretty obvious that management sandbagged guidance, refusing even to elaborate on it in Q&A.  Even though management claimed that they did not play the conservative guidance game, we do not precisely believe them.  In a long-term restructuring, it is much more attractive to progressively raise guidance than to cut/raise/cut/raise the way a true 50/50 guidance expectation could force them to.  Besides, the guided EPS growth barely accounts for the improved pension expense next year, let alone the profit improvement demonstrated in the quarter and expected in the restructuring. 

 

Capacity & Capital Spending:  Some may have been disappointed by the higher than expected capital spending number.  Our opinion is that the faster FDX gets rid of old aircraft, the better. If they were adding capacity to grab market share, we would worry.  Instead, the capital spending is being directed at replacing high cost, out of date aircraft.  In the international express market, International Economy should increasingly be handled through the asset light FedEx Trade Networks (FTN). 

“We are not buying any airplane capacity for growth. The airplanes that we are buying are for replacement. We're replacing the 727s and, as Alan mentioned, the last one flies Friday, with 757s, ditto  the A310s. The 767s start coming in, in September and those are very high  ROIC activities with the existing volumes. It's not growth at all, and the  777s are replacing the MD-11s over the next 10 years and I think we've got 18 more of them on order over the 10 years. So, there is no capital in  airplanes. We're not putting capital in the business for growth. We're simply replacing the assets that we have.” – Fredrick W. Smith

 

Express Margin Gains May Slow From Here:  FedEx Express finally moved to fix the capacity/international mix issue this quarter with a sizeable initial benefit.  That pace of margin expansion may be difficult to duplicate and we expect more of a lumpy/seasonal grind higher from here.  The moving of the Investors and Lenders meeting out a year may suggest that there is less incremental news coming and more focus on delivering what the company has already outlined. 

“I'd say the one thing that we're a bit disappointed on, we probably should have moved a bit faster on some of our capacity because we thought that the mix would be a little bit different than it ended up, but it's like Ground and Express, we're happy to get either one and we just have to manage properly within those segment demands from the customers.” – Fredrick W. Smith

 

Significant Upside:  Although we do not usually like sum of the parts valuations for a number of reasons, the one below helps illustrates the kind of much upside available if FDX is able to execute on its plan to expand margins.  We continue to believe that FDX represents one of the best longer-term opportunities in the Industrials sector.

 

FDX: Can FDX Earn $8.00/share in FY 2014? - k2


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REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS

Takeaway: We reiterate our long-term research conclusions for Japanese policy and its expected impact(s) upon various financial markets.

SUMMARY BULLETS:

 

  • On the heels of a clearly sanguine,  moderately hawkish FOMC presser today, the USD/JPY spot rate is now trading back above its TREND line of 96.17. Whether or not it holds there is a different story, but, assuming it is confirmed on a closing price basis, it would appear to us that the recent correction in that currency cross is over. If not, there’s no support to the TAIL line of 89.19.
  • With BOJ Governor Kuroda’s uneventful commentary overnight highlighting the very obvious fact that the BOJ could tighten or ease monetary policy depending on economic conditions and that the BOJ expects market volatility to subside over time, we are not inclined to deviate from the risk management conclusions we outlined in our latest note on Japan titled, “JAPAN STRATEGY UPDATE: IS THE ABENOMICS TRADE OVER?” (6/13).

 

All told, we reiterate our long-term research conclusions for Japanese monetary and fiscal policy, which are three-fold:

 

  1. While enthusiasm for the Abenomics agenda may come and go in the immediate-term, we believe investors are greatly underestimating the long-term impact of imposing – and ultimately working towards – a +2% inflation target and +3% nominal GDP growth target in Japan.
  2. No country in the history of the recorded universe has ever devalued its way to sustainable economic prosperity. While Japan’s case is fundamentally different than most – given entrenched deflation – we are inclined to side with the odds of history by suggesting that Japan’s Policies To Inflate will, if anything, result in inflation, not real GDP growth.
  3. The confluence of #1 and #2 will [continue to] prove decidedly negative for both the Japanese yen and the JGB market. In the context of intermittent spikes in bond market volatility, the risk-adjusted outlook for Japanese stocks appears a lot less rosy than one would assume given the reflationary tailwind of currency debasement. The caveat here is that this headwind can be offset – at least in part – by fiscal reforms (corporate tax cuts, labor market deregulation, etc.). This, of course, assumes that the Abe Cabinet will pursue these opportunities post July’s Upper House elections.

 

USD/JPY TREND BREAKOUT?

On the heels of a clearly sanguine,  moderately hawkish FOMC presser today, the USD/JPY spot rate is now trading back above its TREND line of 96.17. Whether or not it holds there is a different story, but, assuming it is confirmed on a closing price basis, it would appear to us that the recent correction in that currency cross is over. If not, there’s no support to the TAIL line of 89.19.

 

REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS - 1

 

REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS - 2

 

With BOJ Governor Kuroda’s uneventful commentary overnight highlighting the very obvious fact that the BOJ could tighten or ease monetary policy depending on economic conditions and that the BOJ expects market volatility to subside over time, we are not inclined to deviate from the risk management conclusions we outlined in our latest note on Japan titled, “JAPAN STRATEGY UPDATE: IS THE ABENOMICS TRADE OVER?” (6/13). To recap that game plan:

 

  • “To the extent you have been short the yen or playing the Abenomics Trade in ancillary vehicles, it may prove prudent to sell/reduce your exposure upon confirmation (i.e. give it time to breathe) of a breakdown through the TREND line [on the USD/JPY spot rate].”
  • “The long-term TAIL line of support is down at [89.19]; that would be a good level to put the position back on/increase your exposure (as would a breakout back above the TREND line).”
  • “As one of our core research views, we remain the bears on the Japanese yen with respect to the long-term TAIL. We’re merely attempting to manage the immediate-to-potentially-intermediate-term risk of the position.”

 

INFLATION IS NOT [EXPORT] GROWTH

Elsewhere in Japan, export growth accelerated in MAY to +10.1% YoY from +3.8% prior. Hooray Abenomics? Not quite – Japan’s trade deficit widened to the fifth largest monthly reading ever on a seasonally-adjusted basis.

 

REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS - 3

 

REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS - 4

 

Clearly Japan hasn’t experienced the export reflation/import substitution effect mainstream economists have been calling for amid yen debauchery.

 

Regarding the impact of yen devaluation on Japan’s BOP dynamics:

 

  • Commodities accounted for 49.1% of Japanese imports in 2012, up from 45% in 2010 (i.e. the last full year w/ nuclear power).  Imports of energy have increased to 34.1% of the total from 28.6% over that time frame. Incremental imports of commodities accounted for 94% of Japan’s trade balance deterioration in 2011 and 43% in 2012.
  • It will be interesting to see whether or not the weaker yen (down -17% YoY) starts to sustainably inflate exports, which re-price on a far greater lag than imports due to: A) preexisting FX hedges and B) the length of time between export orders, manufacturing production and actual shipments – which, of course, varies by industry. We have our doubts, especially given that 18.1% of Japanese exports go to China (largely in the form of capital equipment); we continue to have a very negative outlook for Chinese fixed assets investment – particularly with respect to the long-term TAIL duration.
  • Additionally, Japan also continues to experience tailwinds on the import front. While the weak JPY does indeed augment USD strength (which has been a headwind for commodity prices), the downside beta for the yen has outpaced the downside beta for commodity prices, meaning that the recent declines we’ve seen across the commodity complex have not been translated into import savings for Japan. In fact the opposite has occurred, as evidenced by the chart below which showcases the CRB Index priced in yen.

 

REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS - 5

 

REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS - 6

 

REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS - 7

 

CONCLUSIONS

All told, we reiterate our long-term research conclusions for Japanese monetary and fiscal policy, which are three-fold:

 

  1. While enthusiasm for the Abenomics agenda may come and go in the immediate-term, we believe investors are greatly underestimating the long-term impact of imposing – and ultimately working towards – a +2% inflation target and +3% nominal GDP growth target in Japan.
  2. No country in the history of the recorded universe has ever devalued its way to sustainable economic prosperity. While Japan’s case is fundamentally different than most – given entrenched deflation – we are inclined to side with the odds of history by suggesting that Japan’s Policies To Inflate will, if anything, result in inflation, not real GDP growth.
  3. The confluence of #1 and #2 will [continue to] prove decidedly negative for both the Japanese yen and the JGB market. In the context of intermittent spikes in bond market volatility, the risk-adjusted outlook for Japanese stocks appears a lot less rosy than one would assume given the reflationary tailwind of currency debasement. The caveat here is that this headwind can be offset – at least in part – by fiscal reforms (corporate tax cuts, labor market deregulation, etc.). This, of course, assumes that the Abe Cabinet will pursue these opportunities post July’s Upper House elections.

 

Best of luck out there continuing to navigate these immediate-term risks within the constructs of our/your intermediate-term and long-term views.

 

Darius Dale

Senior Analyst


Trade of the Day: NSM

Takeaway: We bought back Nationstar (NSM) at 2:11 PM at 42.41.

Hedgeye Financial Sector Head Josh Steiner buying back one of his Best Ideas on red here. Financials (XLF) remain my favorite sector with bond yields rising. #GrowthAccelerating.

 

Trade of the Day: NSM - NSM


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.

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