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#Dislocation

Takeaway: All of the market dislocations -- Treasuries, commodities, etc. -- were percolating underneath the surface well before this frenzy.

(Editor's Note: This commentary was originally published on Thursday June 20. It was subsequently featured on Fortune. If you are an individual investor, and would like more information on how you can subscribe to Hedgeye's services, please click here.)

 

#Dislocation - st678

 

FORTUNE -- What an epic 48 hours it has been. Just. Total. Chaos.

 

We are officially going over the waterfall now. Boats are in midair. People are hanging on trees. Everybody is scrambling, trying to explain what they missed. Trying to make sense out of it all. Hat tip to Bernanke-sponsored bedlam with a big assist from our Central-Planning Fed Overlords.

 

The reality? Everything is playing out precisely how it should have played out.

 

If you're data-dependent, if you have a rigorous quantitative process backing the research (God forbid), this was a fairly straightforward call to make. U.S. growth has been accelerating as we have been saying all along (well ahead of consensus).

 

Here are the facts: U.S. economic data stabilized from December 2012 through March 2013. From April to June, growth accelerated. On June 18th the Russell 2000 hit an all-time high. On Wednesday, the Fed basically repeated all of this and outlined its view on tapering. Cue market mayhem.

 

All of these market dislocations were percolating underneath the surface of consensus well before this frenzy. When markets don't trust something, the forward curve of implied volatility starts to rise. When they really don't trust something, that volatility rises at a faster rate. It's called convexity.

 

In terms of implied volatility in everything that was already crashing (gold, Treasuries, emerging markets, etc), that concept has been pretty straightforward for going on for six months now. For U.S. equities, it's relatively new.

 

As consumption, employment, and housing growth accelerated in the last three months, stock market expectations went right squirrel. While it may seem strange, it does make sense. We have a Federal Reserve that is A) horrendous in terms of forecasting and B) compromised and conflicted in terms of timing its "communications." Bernanke made his legacy bed – now we all have to sleep in it.

 

This huge selloff we're witnessing in gold, Treasuries and emerging markets -- we are in the early innings of what could be a long-term macro trend.

 

Turning our attention to the rest of the world: What a disaster. Asia is a bloody mess. Go back to the tapes, we've been sounding the alarm here for a while now. Asian markets overnight were a debacle with the Nikkei "outperforming" its peers by only declining 1.7% (no, we still don't like Japan).

 

As for China -- just nasty. I don't know what else you would call it. Meanwhile, the Hang Seng is down 14.4% since the end of January. Now it's not as nasty as Brazil, or Russia, but it's pretty darn nasty. India is down 2.9%; Indonesia down 3.7%. Even though we like the Philippines, (it's an interesting micro story within the broader disaster which is Emerging Markets) we sold that as well. We realized the research there was going to be trumped by the risk management signal.

 

You can't be dogmatic in your stance. When the macro flows take over, get out of the way.

 

Europe? It doesn't look good, either. That's not new. Now if the DAX trend line at 8013 breaks, that would definitely be news. That is a critical line. Most trend lines in Europe are broken. The FTSE just broke its trend. So if the DAX breaks, there will not be one—not one—out of the 86 countries whose equity markets we follow that will have held its trend line, other than the U.S. stock market.

 

Investors are running out of places to put their money. So in a sense, the S&P 500 is the last of the Mohicans. Keep a close eye on the 1583 level on the S&P 500.

 

Now the question is at what point do growth expectations in equities get prices in? I don't know the answer to that. That's what we've been trying to convey recently. What we have been saying is No. 1: Don't buy fixed income and don't buy commodities or anything that we haven't liked for six months. No. 2: Take down your equity exposure. That's the risk management order of the day.

 

Ranting and raving about what has transpired these last six months is no longer my task. It's history. Right now you take a deep breath. You wait and you watch.

 

One of the first things we'll be buying is Financials (XLF). We like the Financials. Particularly with the yield spread at 211 basis points wide and climbing. That's a very bullish indicator for the group. Your buy list should have a lot of financial names on it. After that, we'll go to the old bailiwick which is consumption-oriented names in healthcare and consumer itself.

 

Keep an eye on that 1583 level on the S&P 500 (SPX). It's key. If that breaks, it's bye-bye to the Mohicans.


THE WEEK AHEAD

The Economic Data calendar for the week of the 24th of June through the 28th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.

 

THE WEEK AHEAD - WeekAhead


Trade of the Day: RSX

Takeaway: We re-shorted Russia (RSX) at 3:18 PM at $24.81.

We are re-shorting one of our favorite Emerging Markets that has explicit exposure to Brent Oil which is failing at TREND resistance this week: Russia. (Yes, we know Putin doesn't like being called an “emerging market.”) Tough.

 

Trade of the Day: RSX - RSX

 


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DRI COMPS FLATTER TO DECEIVE

We no longer see Darden as one of the most attractive longs in the space as soft traffic and confusing statements from the management team make it difficult to remain behind the stock. We are removing it from our Best Ideas list as of today. Given today's results and conference call, we can no longer defend the long case.

 

 

Conclusion

 

On today’s evidence, we believe that Darden’s shares have further to fall. We adopted a bullish stance on DRI in March having been bearish on the stock since July 2012. The bull case was comprised of two scenarios, either of which was sufficient, in March, to boost the stock considerably from the depressed levels it was trading at. The first was an improving economy, which implied accelerating Knapp Track comps that would most likely imply a sequential acceleration in Darden’s comps. The second was the possibility of an activist emerging to shake up management and take advantage of what we saw as a company whose equity was trading below the value of the sum of its parts. Following the earnings release and conference call today, we believe neither scenario is likely from here. The stock has appreciated handsomely since the lows of the year and we believe that management is entrenched in the company and the fundamental performance of the company suggests that further downward revisions of FY14 earnings are in play. While we have called out the deficit of leadership in Orlando, as well as the activist thesis that we see as attractive to those active in the space, it seems as though change will not be as forthcoming as we previously thought.

 

 

4QFY13 Recap

 

The primary takeaway from the quarter is that traffic trends at Olive Garden and Red Lobster remain soft and management seems to have little in its arsenal to rectify that situation. CEO Clarence Otis stated that traffic is the ultimate measure of brand health and blamed Darden’s weak comps on the macro economy, even offering a U.S. GDP growth estimate for 2013.

 

The company lowered FY14 EPS growth expectations and Blended “Big Three” same-restaurant sales guidance for the next four quarters.

 

DRI COMPS FLATTER TO DECEIVE - DRI 4Q13 Recap

 

 

Big Promises from the Top

 

Darden’s leadership deficit continues to grow. We were surprised to hear Clarence Otis tout the company’s positive traffic growth on CNBC this morning. While the company did register positive traffic, the traffic comparison was favorable and the two-year average trend at each of the “Big Three” concepts tells a distinctly different tale to what Otis was communicating. The sequential deceleration in two-year average trends in May, despite an easier compare, suggests that the underlying trend weakened into the end of the fiscal year.

 

DRI COMPS FLATTER TO DECEIVE - OG Traffic

 

DRI COMPS FLATTER TO DECEIVE - RL traffic

 

DRI COMPS FLATTER TO DECEIVE - LH Traffic

 

 

Capital Intensity a Key Point

 

While the capital intensity of Darden’s business model has been decreasing, what is more relevant for a restaurant company is the relationship between capex growth and EBITDA growth.  In this instance, we see, below, that Darden’s EBITDA growth is decelerating precipitously. Guiding to higher FY14 cash flow from operations on lower net income is raising the bar too high, in our view.

 

DRI COMPS FLATTER TO DECEIVE - dri capex ebitda

 

 

 

Howard Penney

Managing Director

 

Rory Green

Senior Analyst


The Only Good News This Week

Takeaway: What we do not want is for Ben Bernanke to back off what he said. We need him to taper.

The only good thing that’s happened this week from a global macro fundamental research perspective (which is different than the quantitative signaling perspective) is of course that the US Dollar has recaptured its trend line of support.

 

The Only Good News This Week - doll5

 

That line is 81.11. The corollary to that line for the Yen versus the Dollar is 96.18. Watch those lines very closely.

 

This is a good thing. It breaks down the oil price. And it keeps commodity deflation in play.

 

Obviously YTD the best place to be has been short commodities, long consumption. The CRB Index is down about 5.5% YTD versus the S&P 500 which is up about 12%.

 

By the way, what we’re having right now is a correction in equities, not a crash. What would provide additional support for just a correction instead of a crash would be #StrongDollar.

 

What we do not want is for Ben Bernanke to back off what he said. We need him to taper. The only thing that will keep the Dollar up is tapering.

 

Our Central-Planning Fed Overlords need to get out of these ridiculous programs and eliminate these ridiculous expectations that we’re going to have ridiculously low, zero percent interest rates for the rest of your life.

 

#NoMoreRidiculousness

 

 

(Editor's Note: This commentary comes from from Hedgeye CEO Keith McCullough's morning conference call. If you would like to learn more, please click here.)


Consumption Check - Is Good, Good Enough?

Conclusion:  Domestic Consumption should be 'okay' (not great) for 2Q13 with the low savings rate and historically low PCE inflation continuing to help offset ongoing, modest growth in wage inflation and disposable personal income.  Government furloughs beginning in July along with the potential for a further shift towards part-time/temp employment related to Obamacare hours worked thresholds is likely to constrain the upside in personal income in 3Q.   

 

-------------------------

 

The domestic Labor market, Housing and Confidence data all continue to accelerate – even the economic wet blanket that has been the March-May manufacturing data is showing some life with the latest Empire and Phili Fed reports.  Still, wage inflation remains subdued and real wage growth, while looking increasingly better, is still not exciting on an absolute basis and is benefitting, in large part, from abnormally lower inflation.

 

So, with the market remaining in FOMC myopia hangover mode, what’s the current read-through for consumption from the conflation of the above fundamental factors?      

 

Broadly speaking, the drivers of Consumption aren’t overly complicated.  In short, consumer spending growth is hostage to (the growth in) income, the marginal propensity to consume or save that income, and the net change in household credit. 

 

Asset reflation/appreciation and the wealth effect matter, but they are largely indirect impacts  - higher net worth doesn’t mystically transubstantiate itself into consumption – the incremental benefit to consumption has to come via a behavior shift such that households hold fewer non-housing related assets than they would otherwise have held.  Empirically, this manifests as a decline in the savings rate and/or an increase in debt levels.

 

Below we take a summary look at each of the primary consumption drivers:

 

 

Income and Savings:  Together, growth in disposable income and the change in the savings rate explain most of the change in nominal consumption growth.  Over the last 30 years, the multiple regression between PCE growth vs. Disposable Income growth and the change in the Savings rate produces an R^2 of 0.94.  Under the following assumptions, the regression equation suggests y/y real consumption growth of 2.6% for 2Q13.      

 

Assumptions:

  • Disposable Personal Income: In the estimate chart below we are assuming growth of 1.8% y/y – just north of reported April growth of 1.74% and inline with the recent trend average. 
  • Savings Rate:  assuming a static, sequential savings rate of 2.5%.  The personal savings rate dropped discretely in 1Q13 as households attempted to maintain consumption in the face of negative tax adjustments.  At 2.5%, we are already at the very low end of the normal LT range with a material boost to consumption stemming from a further drawdown in the savings rate unlikely.
  • Inflation:  The final inflation reading could be the acceleration/deceleration swing factor.  Excluding the 2008-09 recession trough, the latest April reading of 0.7% for PCE inflation represents a 60Y low.  In the scenario chart below we are assuming 1.0% PCE inflation for the quarter; above the 0.7% reported for April, but below the 1.24% reported in 1Q13.   

 

Consumption Check - Is Good, Good Enough? - Consumption   GDP 2 

 

Consumption Check - Is Good, Good Enough? - Real Earnings May 2013

 

Consumption Check - Is Good, Good Enough? - DPI vs Savings Rate

 

 

Sequestration:  The furloughing of ~ 750K federal employees will begin in July.  There are currently 2.75M federal employees, which represents 2.0% of the NFP workforce.  A continuation of current trends in Federal government employment growth alongside a 20% paycut for ~27% of the Federal workforce equates to a 7.2% decline in aggregate pre-tax income YoY.   Stated different, the collective impact of the furloughs and employment growth at the federal level should equate to a ~7% decline in income for 2% of the total workforce as we move through 3Q.

 

State & Local government employment growth went positive in May for the first time in 5 years.  Continued, positive job growth at the state/local level could serve as an offset to accelerating declines in federal employment and income growth.  Collectively, Federal, State, & Local government employment currently represents 16.1% of total payrolls.   Layering on an assumption of modest, but accelerating state & local gov’t employment growth to the furlough and employment related pressure at the Federal level, the net impact is ~1.2% negative aggregate income growth for 16% of the employment base.   

 

In short, negative income growth for 16% of the workforce will serve to constrain the potential for acceleration in personal disposable income growth, and aggregate consumption growth by extension, in 3Q13.

 

Consumption Check - Is Good, Good Enough? - Gov t Employee Income 

 

Household Balance Sheet:  The 2Q13 Fed Flow of Funds data reflected an acceleration in household net worth, largely on the back of accelerating home values and new highs in equities and other financial assets.  On a nominal basis, net wealth is 5.2% above the 2007 peak.  Adjusting for inflation and the growth in households, household net wealth remains ~7.6% below peak levels.   

 

Net-net, the household balance sheet recovery remains ongoing and should remain supportive of household capacity for credit expansion.  Further, the LTM appreciation in home values should be supportive of some measure of the wealth effect (+25-40bps net impact to GDP by our estimate).  While an expedited back-up in mortgage rates would be serve as a headwind to transaction volumes in the more immediate term, current affordability (even with the rate backup) and supply/demand dynamics coupled with the positive labor market trends and the giffen nature of housing, we continue to see further intermediate and longer-term upside for housing. 

 

Consumption Check - Is Good, Good Enough? - Household BS 3 Adj

 

Credit:  The latest Federal Reserve data reflects a $19B sequential decline in total household debt in 1Q13 with Y/Y growth in total debt recovering further towards the zero line.  The Fed’s 2Q13 Senior Loan officer survey showed bank credit standards continued to ease while business and consumer loan demand, particularly for real estate and auto loans, showed further sequential improvement. 

 

So, while broader credit trends are favorable and a positive change in the flow of net new household credit would provide an incremental tailwind to consumption growth, thus far, credit has had a muted to dampening impact on consumption as the larger deleveraging trend has continued to predominate.   Over the more immediate term, we’re not anticipating a change in credit to serve as a material driver of household consumption growth.

 

Consumption Check - Is Good, Good Enough? - Household Debt

 

Consumption Check - Is Good, Good Enough? - Household Debt to GDP

 

Consumption Check - Is Good, Good Enough? - HH Debt burden

 

Consumption Check - Is Good, Good Enough? - Senior loan Officer Survey Demand 2Q13

 

In sum, ‘okay’ is probably the right adjective in describing the outlook for consumption growth over the intermediate term.  Policy headwinds certainly exist but the labor market, housing, and confidence all continue to stream roll ahead alongside #StrongDollar upside for consumption. 

 

Given the global macro alternative’s – you don’t want to be long bonds, commodities, EU or EM debt, equity, or currencies, or anything Japan – is “okay” good enough to increase gross exposure to domestic equities with an eye towards easy comps and a diminishing fiscal drag in 2014? 

 

The answer is yes…but at a price.  As Keith highlighted in today’s S&P500 update note:  “For a few weeks I have been saying ‘get out of the way’ – and for the 1st time this year I am saying stay out of the way (for now).”

 

Enjoy the weekend,

 

Christian B. Drake

Senior Analyst 


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