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#ASIANCONTAGION PREVIEW

Takeaway: China’s secular slowdown will weigh on global growth and serve as an outsized drag on the regional economy.

SUMMARY BULLETS:

 

  • All told, we continue to think the Chinese banking sector will represent a material, long-term drag on Chinese economic growth as funding for incremental fixed assets investment dries up at the margins. Additionally, the Politburo’s economic rebalancing agenda and a pending acceleration in anti-pollution regulation will also eat away at Chinese growth at the margins.
  • As such, the confluence of these headwinds will remain a sustainable drag on the growth rates of the regional and global economies, though we do think the US is best-positioned to cope with this headwind.  
  •  In this scenario, the USD remains a ball-under-water trade from a TAIL perspective. Will Germany favor an increasingly weak EUR as China downshifts its growth rates (which, BTW, is the best case scenario; key tail risks remain)? Are investors bearish enough on Gold? Are speculators positioned for a secular decline in the energy markets? Are FX market participants bearish enough on the JPY?

On Monday, July 15 at 11am EDT, we will be hosting our highly-anticipated Quarterly Macro Themes conference call. To the extent you can join us, the dial-in details are below. If you can’t make the scheduled time, we’ll be sure to circulate the replay information after the call.

 

  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 317583#
  • Materials: CLICK HERE (Slides will download one hour prior to the start of the call)

 

Today, we thought we’d kick things off with a sneak peek at one of our Q3 themes: #AsianContagion. To summarize the theme into a few digestible nuggets, we think:

 

  1. China’s secular slowdown will have an outsized negative impact on regional economic growth;
  2. RisingRates and #StrongDollar should continue to perpetuate #EmergingOutflows across the developing Asia region; and
  3. A likely resurgence of positive sentiment surrounding the Abenomics agenda and continued yen weakness should help Japanese equities continue to outperform the region.

 

Specifically regarding point #1:

 

At the US-China Strategic and Economic Dialogue yesterday and Washington D.C., China’s Finance Minster Lou Jiwei said that Chinese GDP growth might come in slightly below-target this year and that growth as low as +6.5% YoY may be tolerable in the future. If there is a caveat to his dour remarks, he did express confidence in achieving the existing +7% growth target (most recently affirmed by Premier Li in MAY), which is down from the official +7.5% as laid out in the 12th Five-Year Plan.

 

Lou continued: “I want to emphasize that the structural economic adjustment is a painful process. It won’t be possible to enjoy a comfortable life and a rapid growth rate with the structural adjustment. The slowdown is necessary to achieve a structural transition.”

 

With China’s Q1 real GDP growth coming in at +7.7% YoY, it doesn’t take a rocket scientist to figure out that Chinese growth is going to slow from here if +7% is in play on a full-year basis. Recent trends across China’s monthly economic indicators, including today’s JUN credit data (growth in total social financing slowed to a 14M low; M2 growth slowed to a 6M low) suggests a flat-to-slightly-down 2Q GDP print when it is released Sunday night; perhaps the “pain” will be back-end loaded as credit expansion continues to dry up.

 

Regarding China’s 2Q13 GDP specifically, consensus is at +7.5% YoY, which has trended down from an estimate of +8.2% at the start of the 2nd quarter. Another sharp immediate-term relief rally in Chinese equities from bombed-out lows could occur Monday if the numbers are doctored up to come in ahead of bombed-out consensus expectations.

 

Looking out further, however, this latest bit of economic guidance out of the Chinese officialdom all but confirms our TAIL duration expectations for the Chinese economy – the same expectations we’ve held for the past 12-18 months. The fact that the sell-side and western financial media outlets are overly focused on the hazy nature of the 2013 GDP growth target (is it +7% or +7.5%?) reminds us that consensus doesn’t quite comprehend the secular nature of China’s downshifting economy.

 

Either that or consensus is paid to simply ignore the elephant in the room; we know for a fact that companies like CAT and FCX sure are!

 

Like Lou Jiwei, we also want to emphasize that structural economic adjustment will be a painful process – and not just for China:

 

  • At this  point, it’s trivial to say that the Chinese economy matters to Asia, but it’s worth noting China 37.7% share of regional GDP has more than doubled over the past 10 years;
  • Exports to China account for nearly 6% of regional GDP, a ratio that has also more than doubled over the past 10 years;
  • As a contribution to global GDP growth (trailing 10 years), China 19.3% share has nearly doubled over the past 10 years; and
  • Excluding the US, exports to China account for roughly 2.5% of global GDP, a ratio that has also more than doubled over the past 10 years… the US’s ratio is much smaller at 0.7%.

 

#ASIANCONTAGION PREVIEW - 1

 

#ASIANCONTAGION PREVIEW - 2

 

#ASIANCONTAGION PREVIEW - 3

 

All told, we continue to think the Chinese banking sector will represent a material, long-term drag on Chinese economic growth as funding for incremental fixed assets investment dries up at the margins. Additionally, the Politburo’s economic rebalancing agenda and a pending acceleration in anti-pollution regulation will also eat away at Chinese growth at the margins.

 

As such, the confluence of these headwinds will remain a sustainable drag on the growth rates of the regional and global economies, though we do think the US is best-positioned to cope with this headwind.  

 

In this scenario, the USD remains a ball-under-water trade from a TAIL perspective. Will Germany favor an increasingly weak EUR as China downshifts its growth rates (which, BTW, is the best case scenario; key tail risks remain)? Are investors bearish enough on Gold? Are speculators positioned for a secular decline in the energy markets? Are FX market participants bearish enough on the JPY?

 

Just a few noteworthy TAIL-duration risk management questions to start pondering late on a summer Friday…

 

Have a great weekend; we look forward to having you join us on the call Monday.

 

Darius Dale

Senior Analyst


THE WEEK AHEAD

The Economic Data calendar for the week of the 15th of July through the 19th 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 - week


Shorting the MLPs: BBEP and ROYT

Takeaway: Time to sell your upstream MLP? That time started long ago.

Hedgeye senior Energy sector analyst Kevin Kaiser expands his work in upstream MLPs, a group he considers ripe for shorting.  In Tuesday’s institutional call he laid out the short case for Breitburn Energy Partners (BBEP), an upstream MLP, and Pacific Coast Oil Trust (ROYT), an oil royalty trust.

 

You have probably heard the screeching around Kaiser’s work on LINN Energy, a battle that has been raging in the pages of Barron’s and on television, as well as across the Twittersphere. 

 

In June the SEC put pressure on LINN to be more transparent in their accounting and followed up last week with an SEC inquiry – an announcement that dropped the price of LINN’s publicly traded units and won Kaiser some instant converts in the investing world.

 

Shorting the MLPs: BBEP and ROYT - d77

BBEP


Kaiser put out a full note on BBEP a week ago.  A few key takeaways were highlighted in Tuesday’s call:

 

The General Partner of BBEP no longer has any direct economic interest in the MLP after the LP acquired the GP stake in 2008.  Most GPs retain only a small ownership of around 2%, which counts as “skin in the game,” if only just.  Zero is about as skinless as you can get – while still drawing management fees.

 

Kaiser’s calculations clash with BBEP’s.  His evaluation of operating fields the MLP acquired just a month ago indicates BBEP paid $770 million for properties worth not more than $690 million.

 

This becomes more complicated, because BBEP funded the acquisition completely through bank borrowings.  In order to obtain the financing, BBEP had its banks amend the loan covenants, allowing the company to take on more indebtedness.  Kaiser estimates BBEP will have to do an equity raise before the end of the third quarter, or risk breaching their new debt ratio limits.  Kaiser believes this will result in around 12% dilution to current unit holders.

 

Another key number affecting Distributable Cash Flow (DCF – the money out of which you get paid as a unitholder) is “maintenance capex,” the amount of money an oil and gas producer has to pay each year just to maintain the same level of production.

 

BBEP never provides a full and clear accounting of their DCF.  They mention numbers and project distributions on their conference calls, but they don’t publish a breakdown of DCF.  This means you either have to take their word for it – which most investors apparently do – or do your own work.  Which Kaiser did.

 

BBEP also doesn’t publish a clear definition of what they consider maintenance capex, and Kaiser says their working definition appears to differ from conference call to conference call.  For this year, BBEP management estimates a requirement of $88 million maintenance capex.  Kaiser’s calculation is a whopping $228 million, based on its Depreciation, Depletion & Amortization rate (the standard method of accounting for exploration and development of new oil and gas reserves).

 

All in, Kaiser figures NAV for BBEP is around $7 per unit, or less than half today’s price in the marketplace.  The NAV is, at any given moment, the most realistic measure of the expectation of all future payouts the trust should be able to deliver – thus, while NAV may not be the price of an MLP, it is the best proxy for the actual value.  Enthusiastic write-ups from major Wall Street firms notwithstanding, Kaiser says no investor should ever pay above NAV for an MLP, a mistake investors routinely make, especially in the early years of the trust’s trading history when most of the in-ground assets remain and the trust’s finances are still pretty straightforward. 

 

ROYT


Cutting to the chase, Kaiser calculates the NAV of ROYT at around $9 at current commodity prices, or about half its current market price.

 

ROYT is a royalty trust, a tax-advantaged entity that has ownership rights to in-ground oil and gas.  Like an MLP, a royalty trust benefits from the sales of those deposits, and like an MLP, it distributes the lion’s share of those cash flows to unit holders.  Like MLPs, many royalty trusts pay high dividends – the current yield on ROYT is over 10%.  Unlike MLPs, the trusts do not acquire additional operating properties to bolster future payments.  When the assets conveyed to the trust are depleted, the trust simply ceases to exist.  As with the MLPs that have recently come under Kaiser’s lens, royalty trusts may also take advantage of financial engineering to make sure they meet dividend payments,

 

Affiliates of BBEP brought ROYT public last year, taking advantage of a pricing anomaly in domestic oil that has since started fading from the markets – though apparently not from enthusiastic analyst valuations for ROYT.

 

ROYT’s home fields in California produce a grade of crude oil that generally trades anywhere from $5 to $12 a barrel below the NYMEX WTI benchmark.  Starting in mid-2011, the price lines crossed, and California crude traded at a premium through the end of last year.  Prices have since started declining, and look to revert to their historical relationship some time next year – which is coincidentally also when ROYT’s hedge on its oil and gas properties will roll off.  This combination could produce a double-whammy for ROYT unitholders. 

 

Kaiser says no one should pay a penny above a concretely demonstrable NAV for ROYT.  In particular, a conservative NAV calculation must be based on a realistic projection of oil prices, which Kaiser says ROYT’s current price is definitely not.  With the units trading at about a 100% premium to what Kaiser calls a reasonable NAV, that spells S-E-L-L.

 

Conclusion: Up the Stream Without a Paddle?


Kaiser believes the whole high-yield oil and gas sector is vulnerable, in particular the eleven publicly-traded upstream MLPs, whose distributions come from cash flows from oil and gas producing operations.

 

Kaiser sees the group as largely characterized by aggressive or irregular accounting and heavy dependence on non-GAAP measures in order to arrive at the reported free cash flow numbers they need to justify their distributions.  Opaque accounting and reporting practices are often promoted in an atmosphere of poor corporate governance, with little effort made to mask interlocking ownerships and nested interests. 

 

So far, both the IRS and the SEC have permitted the loose and idiosyncratic accounting and reporting that characterizes these entities.  Many of these companies have gone through the initial production stages of their properties and now face low organic growth prospects.  Since they must keep making payments in order to satisfy unitholders, there is clear incentive to raise cash By Any Means Necessary.  This can result in MLPs routinely paying out distributions well in excess of actual cash flows generated by their business.

 

Kaiser notes that the royalty trusts as a group are down about 40% from last year.  This has the perverse effect of making them look more attractive, because the distributions work out in many cases to near-double digit yields, based on price.  The great majority of unitholders are individual investors who buy only on basis of quoted yield.  Kaiser says this is the absolute worst way to value these vehicles.

 

For one thing, the payments are largely not derived from actual oil or gas production – indeed, in some cases they may not be based at all on actual production, but on a combination of accounting offsets, and the distribution of proceeds from capital raises.

 

The recent SEC inquiry into LINN’s accounting practices may be the tip of a fast-melting iceberg.  We believe market transparency is a good thing – though we also recognize that forcing it at this time will hurt large numbers of individual investors, a consideration that may temper the SEC’s zeal to force more disclosure too soon.

 

These companies’ market prices are generally well protected because there’s a powerful narrative around them, coupled with the knee-jerk reaction of Short Sellers = Very Bad Guys.  It is significant to note that major brokerage firms came out with upbeat BUY recommendations on LINN immediately after the stock dropped on news of the SEC inquiry.  We read a couple of reports from household name firms, looking in vain for a set of calculations that might call Kaiser’s thesis into question.  In fact, these reports simply said “this is still a great stock to buy” and contained no factual analysis – the most informative numbers were the page numbers.

 

If the SEC is looking at possible manipulation of the markets, maybe they should start by asking why major brokerage firms, whose retail brokers have sold these MLP to so many of their customers over the years, should be touting these stocks without even addressing arguments about their viability. 


There have been some cheap shots at Hedgeye over Kaiser’s work, and at Kaiser personally.  There has been lots of indignation expressed – by managements of these companies, by shareholders, and by the brokerage community.  But so far no one has produced a scrap of analytical work tackling Kaiser’s analysis head on.

 

Time to sell your upstream MLP?  That time started long ago.  The clock’s ticking.


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MARKET EYES CHINA GDP PRINT

Takeaway: Structural economic adjustment is a painful process.

Recent trends across China’s monthly economic indicators, including today’s June credit data, suggests a flat-to-slightly-down 2Q GDP print Sunday night. Consensus is at 7.5%, which has trended down from an estimate of 8.2% at the start of the 2nd quarter.

 

MARKET EYES CHINA GDP PRINT - Expectations Management

 

Another sharp immediate-term relief rally from oversold lows could occur Monday if the numbers are doctored up to come in ahead of bombed-out consensus expectations.

 

Looking out further, however, Finance Minster Lou Jiwei’s commentary yesterday afternoon all but confirms our TREND and TAIL duration expectations for the Chinese economy. The fact that the sell-side and Western financial media outlets are overly focused on the 2013 GDP growth target (is it 7% or 7.5%?) reminds us that consensus doesn’t understand the secular nature of China’s downshifting economy.

 

Like Lou Jiwei, we also want to emphasize that structural economic adjustment is a painful process.


Q3 2013 Macro Themes Conference Call

Q3 2013 Macro Themes Conference Call - 3Q13themesdialb

 

Hedgeye's Macro Team, led by CEO Keith McCullough and DOR Daryl Jones, is hosting its highly anticipated Quarterly Macro Themes conference call with a presentation and a live Q&A session for participants. The presentation highlights the THREE MOST IMPORTANT MACRO TRENDS that our team has identified for the quarter, analyzing potential impacts across multiple scenarios and identifying investment opportunities. The Q3 2013 Macro Themes Call will be held Monday, July 15th at 11:00am EDT.              

 

 

Q3 THEMES INCLUDES:

  1. #RatesRising: The 30Y bull cycle in bonds is over.  We'll discuss the cross-asset class implications of the reversal and how to be positioned for the ongoing deflation of Bernanke's last (and largest) bubble.  
  2. #DebtDeflation:With total outstanding debt equal to three times equity, we give caution to the impact of debt deflating and offer investment vehicles to play this theme.
  3. #AsianContagion: China sneezes and the rest of Asia catches the flu. #RisingRates and #StrongDollar continue to perpetuate #EmergingOutflows across the developing Asia region while a likely resurgence of positive sentiment surrounding the Abenomics agenda and continued yen weakness should help Japanese equities continue to outperform the region.  

 

 CALL DETAILS 

  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 317583#
  • Materials: CLICK HERE (Slides will download one hour prior to the start of the call)

 

CONTACT

Please email if you have any questions. 

 

 


Morning Reads on Our Radar Screen

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

Keith McCullough – CEO

30yrs old, giving up $77M > NJ Devils star Kovalchuk announces retirement (via ESPN)

China Can Endure Growth Slowdown to 6.5%, Finance Chief Says (via Bloomberg)

Treasury Secretary says China to hand audit work to SEC (via Reuters)

Egypt prepares for rival Ramadan protests (via BBC)

 

Morning Reads on Our Radar Screen - asia

 

Daryl Jones – Macro

China GDP To Hit 6.7% (via Zero Hedge)

ETF Simplicity Betrayed by Volatility in Market Selloff (via Bloomberg)

 

Tom Tobin – Healthcare

Affordable Care Act insurance unaffordable for college students (via WorldMag.com)

The Affordable Care Act: The key to opening up ‘job lock’ (via The Bay State Banner)

 

Josh Steiner & Jonathan Casteleyn – Financials

JPMorgan Profit Rises 31% on Trading, Beats Estimates (via Bloomberg)

 

Matt Hedrick – Macro

European Parliament demands spending increase (via The Telegraph

                    

Todd Jordan – Gaming

Cash declaration idea ‘not targeting’ gaming: Tam (via Macau Business Daily)


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