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Response to Omega's Letter in Barron's on LINN Energy

We have transcribed Leon Cooperman’s letter to Barron’s (published 6/22/13) with respect to his views on LINN Energy.  We believe that there are several misleading statements and omissions of key information in the letter, and we offer our comments for the benefit of Mr. Cooperman and all others involved and interested.

 

CLICK HERE to link to the transcribed letter with our comments.

 

Kevin Kaiser

Senior Analyst

 


IS OUR BEARISH THESIS ON THE CHINESE FINANCIAL SYSTEM PRICED IN YET?

Takeaway: On an immediate-term basis, yes. On an intermediate-to-long-term basis, no. A crisis appears unlikely, but structural headwinds will remain.

SUMMARY BULLETS:

 

  • At any rate, the fact that the PBoC chose to disseminate this “quit whining” message to the broader public nearly one full week after it was first published is a reiteration of their conservative bent and an explicit affirmation of our call that the PBoC won’t be there to save the day this time.
  • This stance was no less backed up by the powers that be atop the Chinese communist party. Per Xinhua, the official state-run news agency: “It is not that there is no money, but the money has been put in the wrong place.”
  • All told, in the face of slowing deposit growth, the confluence of rising NPLs and/or the perpetual debt rollovers of SOE borrowers on top of balance sheets clogged with long-term assets that are held to maturity is something that will remain a sustainable headwind to the abundance of liquidity across the Chinese financial system.
  • From a deposit growth perspective, it’s not like Chinese households are going to save more, at the margins – especially in the context of the Communist Party’s economic rebalancing agenda. Structural headwinds to export growth (potential CNY overvaluation, sluggish growth in the EU and SAFE’s regulatory crackdown on “fexports”) will limit inflows of new capital into the Chinese economy as well.
  • As such, we expect credit growth to slow sharply from recent levels and remain sustainably slower for the foreseeable future. That will weigh on observed rates of economic growth and future growth expectations, which should reflexively perpetuate greater [unreported] NPL exposures.
  • Layer on NIM-compressing interest rate liberalization – which the PBoC recently affirmed they are forging ahead with – and you have one heck of a three-pronged bearish thesis for Chinese financials stocks, as outlined most recently in our 6/12 presentation.

 

The question from here, however, is: “Is all the bad news priced in?” While that’s always the hardest question for an in-the-money short-seller to answer, we’ll at least take a shot at answering it for the sake of maintaining our reputation for being both actionable and accountable with our research calls:

 

  • It is our opinion that the bad news is likely priced in on an immediate-term basis – i.e. don’t pile into the short today expecting another -5% down-day tomorrow/this week.
  • On a intermediate-to-long-term basis, however, there’s little-to-no chance that the end of Chinese financial repression and the commensurate unwinding of the country’s fixed assets investment bubble is priced in – especially if the Shanghai Composite takes out its DEC ’12 lows in the coming days and/or weeks.
  • Can the CHIX ETF go back to $8 (i.e. down another -25% from the current price)? Can CAT go back to $22.17? Can FCX go back to $8.40? Can copper go back to $1.25/lb.? Can the AUD/USD go back to $0.60? When we see consensus start to ask those kinds of questions, that’s when we’ll consider our bearish thesis on the Chinese financial system priced in. 
  • While it’s neither prudent nor analytically precise to make crisis calls like Barron’s did this weekend, we do think headwinds will remain across the Chinese financial system for the foreseeable future – at least until the PBoC meaningfully alters their stance (which is an obviously improbable scenario at the current juncture).

 

*** For the rigorous analyses backing our conclusions, please source the hyperlinked work listed at the conclusion of this note.***

 

SHORT-TERM HEADWINDS: NO EASING; NO LIQUIDITY

Down -529bps today, China’s benchmark Shanghai Composite Index took it on the chin largely due to the consensus realization of one of the core tenets to our bearish TREND & TAIL thesis on Chinese financials and property developers: the PBoC won’t be there to save the day this time.

 

One week ago, the PBoC sent out a note to commercial banks telling them that they will “continue to implement the prudent monetary policy while fine-tuning it at a proper time”. The statement continued: “Banks should allocate positions beforehand and keep abundant reserves. Prudence is needed in arranging asset portfolios and controlling liquidity risks arising from the credit binge.”

 

Essentially, the PBoC was firmly telling Chinese banking institutions to avoid channeling liquidity that could be better used for interbank lending and/or SME credit expansion, for example, into illiquid investment vehicles (such as WMP and Trust products), which is an activity that has been taking place with great frequency in recent quarters. In the context of the PBoC refusing to ease monetary policy in any meaningful way, credit misallocation has weighed heavily upon interbank liquidity ahead of (and likely through) dividend payout season:

 

  • China’s four major state banks owe roughly CNY250 billion in cash dividends for 2012, of which CNY146 billion will be distributed to A-share holders; and
  • Bank of China and China Construction Bank will pay out on 7/12, while ICBC and Agricultural Bank of China will pay out on 7/19 and 7/22, respectively.

 

At any rate, the fact that the PBoC chose to disseminate this “quit whining” message to the broader public nearly one full week after it was first published is a reiteration of their conservative bent and an explicit affirmation of our call. This stance was no less backed up by the powers that be atop the Chinese communist party. Per Xinhua, the official state-run news agency: “It is not that there is no money, but the money has been put in the wrong place.”

 

LONG-TERM HEADWINDS: SECULAR LIQUIDITY CONSTRAINTS (RISING NPLs/DEBT ROLLOVERS + SLOWING DEPOSIT GROWTH) AND NIM-COMPRESSION

By “wrong place” we assume they are referring to the country’s fixed assets investment bubble – where the long term credit instruments underpinning it having been increasingly funded by shorter-term liabilities in the form of WMP and Trust products. All told, in the face of slowing deposit growth, the confluence of rising NPLs and/or the perpetual debt rollovers of SOE borrowers on top of balance sheets clogged with long-term assets that are held to maturity is something that will remain a sustainable headwind to the abundance of liquidity across the Chinese financial system.

 

From a deposit growth perspective, it’s not like Chinese households are going to save more, at the margins – especially in the context of the Communist Party’s economic rebalancing agenda. Structural headwinds to export growth (potential CNY overvaluation, sluggish growth in the EU and SAFE’s regulatory crackdown on “fexports”) will limit inflows of new capital into the Chinese economy as well.

 

As such, we expect credit growth to slow sharply from recent levels and remain sustainably slower for the foreseeable future. That will weigh on observed rates of economic growth and future growth expectations, which should reflexively perpetuate greater [unreported] NPL exposures. Layer on NIM-compressing interest rate liberalization – which the PBoC recently affirmed they are forging ahead with – and you have one heck of a three-pronged bearish thesis for Chinese financials stocks, as outlined most recently in our 6/12 presentation.

 

IS ALL THE BAD NEWS PRICED IN?

The question from here, however, is: “Is all the bad news priced in?” While that’s always the hardest question for an in-the-money short-seller to answer, we’ll at least take a shot at answering it for the sake of maintaining our reputation for being both actionable and accountable with our research calls:

 

  • It is our opinion that the bad news is likely priced in on an immediate-term basis – i.e. don’t pile into the short today expecting another -5% down-day tomorrow/this week.
  • On a intermediate-to-long-term basis, however, there’s little-to-no chance that the end of Chinese financial repression and the commensurate unwinding of the country’s fixed assets investment bubble is priced in – especially if the Shanghai Composite takes out its DEC ’12 lows in the coming days and/or weeks.

 

Can the CHIX ETF go back to $8 (i.e. down another -25% from the current price)? Can CAT go back to $22.17? Can FCX go back to $8.40? Can copper go back to $1.25/lb.? Can the AUD/USD go back to $0.60? When we see consensus start to ask those kinds of questions, that’s when we’ll consider our bearish thesis on the Chinese financial system priced in.

 

IS OUR BEARISH THESIS ON THE CHINESE FINANCIAL SYSTEM PRICED IN YET? - 2

 

While it’s neither prudent nor analytically precise to make crisis calls like Barron’s did this weekend, we do think headwinds will remain across the Chinese financial system for the foreseeable future – at least until the PBoC meaningfully alters their stance (which is an obviously improbable scenario at the current juncture).

 

IS OUR BEARISH THESIS ON THE CHINESE FINANCIAL SYSTEM PRICED IN YET? - Barron s China Credit Crisis JUN  13

 

If you’re betting on systemically risky bank failures and a loud, disorderly bursting of China’s credit bubble, you will likely be sorely disappointed. As we have pointed out in our work, the Chinese sovereign has ample fiscal and foreign exchange firepower to meaningfully mollify that outcome. Moreover, the fact that much of our three-pronged bearish thesis is largely the result of policy directives suggests that the story can change at the drop of a favorable headline.

 

For now at least, investors should continue to expect a prolonged bleeding of Chinese financial sector fundamentals, as well as the long-term threat of destabilizing capital outflows from the Chinese economy. For the rigorous analyses backing our conclusions, please source the hyperlinked work below.

 

Darius Dale

Senior Analyst

 

  • THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED (6/19): There appears to be no end in sight for desert-like liquidity conditions across the Chinese financial system.
  • 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.

#EPIC

Takeaway: We’ve been warning investors about getting crushed in fixed income, commodities and emerging markets for months.

The epic move in bond yields continues. "Waterfall" anyone?

 

#EPIC - Niagara Falls

 

The horse has officially left the barn, folks. It’s barreling down the road. Fast. 10-year Treasuries have officially gone completely convex at this point, spiking to 2.64%, its highest level since August 2011. That’s over 100 basis points since early May.

 

If you were smoking the funny stuff and buying bonds when they broke through the 2.41 line on the Treasury curve, to me that would be the equivalent of buying US stocks in October 2008. You can make a serious mistake being too early there—you do not want to be too early. When you’re coming off a three-decade high, and it breaks its most important line, you do not get in the way. It’s common sense.

 

One quick observation on market reaction to this move: Beware talking heads. You’re not going to get good advice when bubbles begin popping, because people long bubbles don’t want to see them pop. For example, if you get a big bond manager on the tube right now, he’s going to be doing his best to get Bernanke to stop tapering and to devalue the dollar. It’s wrong on a number of levels and borderline un-American.

 

Meanwhile, myriad mediocre and myopic financial commentators following these market savants have their own conflicted intentions. Avoid their “advice” at all costs. Getting in line behind them isn’t entirely different than lemmings marching off a cliff. You almost never get good advice on what to do when you finally hear the “Pop!” sound.

 

#EPIC - 10water

 

Look, I’m not perfect. I’ll be the first to admit it. I make my fair share of mistakes. But one mistake I most definitely did not make is going over the “Waterfall” with consensus. Our clients know this. We’ve been warning investors about getting crushed in fixed income, commodities and emerging markets for months. Over and over again, until we were blue in the face. That’s the research call we made. It’s worked.

 

The waterfall is real—be careful out there. And don’t bother chasing the horse. It ain’t coming back. 

 

(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.)


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Consumption: Is Good, Good Enough?

Takeaway: Given the global macro alternatives, the answer is yes (but at a price).

This note was originally published June 21, 2013 at 13:26 in Macro

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.

 

Consumption: Is Good, Good Enough? - us

 

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: Is Good, Good Enough? - Consumption   GDP 2 

 

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

 

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

 

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

 

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

 

Consumption: 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 alternatives – 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 


European Banking Monitor: Sliding Into Summer

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 .

 

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European Financial CDS - The good news is, the systemic gauge of EU banking system risk, Euribor-OIS, remains benign. The bad news is, individual company swaps look awful. The table below speaks for itself, but we'd call attention to Sberbank of Russia (+44 bps WoW), RBS (+47 bps WoW), and the UK banks.

 

European Banking Monitor: Sliding Into Summer - rr. banks

 

Sovereign CDS – Sovereign swaps widened across the board last week. Italy, Spain and Portugal blew out by 24, 32 and 38 bps, respectively to 284, 284 and 409 bps. Meanwhile, Japan widened a further 5 bps to 86 bps, Germany widened 5 bps to 32 bps and the U.S. added 2 bps to 29 bps.

 

European Banking Monitor: Sliding Into Summer - rr. sov 1

 

European Banking Monitor: Sliding Into Summer - rr. sov 2

 

European Banking Monitor: Sliding Into Summer - rr. sov 3

 

Euribor-OIS Spread – The Euribor-OIS spread tightened by 1 bps to 12 bps. This is another token silver lining to the current maelstrom. European spreads are at least contained from a systemic standpoint. 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. 

 

European Banking Monitor: Sliding Into Summer - rr. euribor

 

ECB Liquidity Recourse to the Deposit Facility – Deposits were down another 12 billion Euros last week, signaling relative calm in the European financial system (relative vs. rest of world). 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.  

 

European Banking Monitor: Sliding Into Summer - rr. facility

 


Broken: SP500 Levels, Refreshed

Takeaway: For the 1st time since November 2012, the SP500 is bearish on both our TRADE and TREND durations.

POSITION: 5 LONGS, 6 SHORTS @Hedgeye

 

We’ve always thought this was about price, volume, and velocity. If #RatesRising were to break out at an accelerating rate, the rest of the market’s interconnected risk was going to start to shake. That’s happening now. And the SP500’s TREND line is broken.

 

The other big thing banging around in my head is did US Consumption #GrowthAccelerating peak sequentially in Q213? It’s been a heck of a run from the Q312 consumption lows. Anything can happen; especially if people lose enough money in bonds.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Intermediate-term TREND resistance = 1591
  2. Immediate-term TRADE support = 1566
  3. Long-term TAIL support = 1503

 

In other words, for the 1st time since November 2012, the SP500 is bearish on both our TRADE and TREND durations, and there’s no obvious intermediate-term support to 1503. That 1566 line is a loose one.

 

As always, we’ll remain market signal and data dependent (the signal generally front-runs the data).

KM

 

Keith R. McCullough
Chief Executive Officer

 

Broken: SP500 Levels, Refreshed - SPX


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