#CommodityDeflation. It's bad news for commodity linked equity markets. Brazil has been the poster child of this and what we call #EmergingOutflows here at Hedgeye. The Bovespa was down -2.1% yesterday and continues to crash. It's down -22.2% year-to-date.
On a related note, the only country that’s worse off year-to-date than Brazil? Yet another mining tape. You guessed it. (Or not.) It's Peru which has gotten whacked -25% year-to-date.
It sounds ominous doesn’t it? In this final installment of Hedgeye’s Q3 Macro Themes, CEO Keith McCullough warns investors of both the bullish and bearish implications of what’s going on in Asia. Keith weighs in on what to buy, what to sell, and how to avoid getting steamrolled in what has become an increasingly precarious global macro environment.
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Takeaway: Without China to fuel the engine, Asia's economic racecar looks to be in for a long pit stop.
(Editor's note: This article was originally posted on Fortune.)
By Moshe Silver, Hedgeye
FORTUNE -- Right now, Japan's equity markets are being buoyed by the same "Print-And-Spend" policy that the Federal Reserve used to pay off Wall Street, emanating from the same ivory tower that paid untold trillions in bonuses to America's failed bankers. Meanwhile, a motley crew of high-level economists including Ben Bernanke's Princeton colleague Paul Krugman continue to exhort the Japanese to "Print! Print! Print!" their way to prosperity. As if printing more dollars and yens was some restorative, magical monetary panacea to cure a nation's economic ills.
One of Krugman's areas of expertise is, of course, the "liquidity trap." This is when bond yields sink so low, the market treats them like cash. He has written that Japan's "lost decade," the 10 (or 20, depending on who you ask) years following the collapse of Japan's real estate bubble, was an extended liquidity trap. Like cockroaches dosed for generations with insecticides, in a liquidity trap the markets become immune to further cash injections. In Keynesian economics, the central bank's job is to manage interest rates by adding or withdrawing liquidity -- buying or selling bonds in the open market. Thus, in the liquidity trap government policy is incapable of stimulating economic growth.
Krugman has argued that Japan's government hasn't thrown enough cash into the system. With the Abe government firmly in place after last month's elections, Krugman and his Keynesian buds have a ringside seat at a real live social experiment: Will Abe-nomics, with its tsunami of banknotes, bail out Japan, or will the economy continue to lag?
Mind you, not everyone thinks Japan is lagging. Some observers point out that most Japanese kept their jobs during the "lost decades," and that measured by standard of living, foreign trade, and the strength of the currency, Japan's decades weren't "lost" at all. This must also be seen through the lens of cultural values and expectations: The Japanese value stability of employment more than the ability to climb the corporate ladder.
Anyway, for the time being Shinzo Abe, the well-liked -- and re-elected -- Prime Minister, is printing Yen for all he's worth, and Japan's stock market is inflating like a giant balloon at the Macy's Thanksgiving Day Parade. Abe's winning the election could provide the political stability for much-needed economic reforms, but for now he's mirroring America's experiment in putting free money in bankers' pockets. This policy should work well for their equity markets -- until it doesn't.
But don't look anywhere else in Asia for comfort. The rest of Asia's policymakers are well and truly out of ammo as Asian economic growth has been nearly cut in half since 2010.
And if you weren't worried about China, now would be a good time to start.
China has been the main driver of growth in the region, accounting for nearly 38% of all Asian GDP last year. Now the Chinese government is acknowledging that growth is in a downturn, publicly forecasting growth in the 7% range -- well below the double digits of only three years ago.
China's fixed capital formation grew like Topsy during the expansion years. But many of these were empty make-work projects designed only to inflate GDP, leaving the country awash in unused airports, unfinished roads and office buildings -- and in bank loans for these projects with no revenues.
China's banks are a loudly ticking time bomb. Their assets are bloated to an estimated 270% of GDP. A huge percentage of those "assets" are already in creditor limbo, having secured roads and bridges and tunnels and airports to Nowhere. China's banks face a potential crisis as investment in major fixed asset projects declines amid eroding liquidity throughout the financial system.
Rising rates should hit China's markets too, pushing Asian rates higher. This will clobber the region's capital-intensive economies, many of which expanded capacity specifically to serve Chinese demand. Rising rates -- globally, but especially in the "safe haven" U.S. Treasury market -- coupled with a strong Dollar, should punish overvalued Asian currencies, sparking inflation, but in the context of economic decline. This spells economic trouble and the potential for social unrest.
Hedgeye Senior analyst and keen-eyed Asia watcher Darius Dale says Chinese policy makers are starting to appear less concerned about a possible domestic asset price bubble. This could give them more flexibility in some kind of easy-money policy aimed at domestic stimulus. Any such policy move is likely to be slow to be implemented and much slower to take effect.
Dale cautions that massive debt rollovers generally slow economic growth by sucking liquidity out of the financial system, "diverting incremental credit from productive enterprises." Perhaps more crucial is the impact on a fragile economy, which can hamper the creation of a stable economic base by diverting liquidity away from marginally productive business, or from temporarily unproductive ones that are merely trying to weather the economic storm.
Finally, any debt rollover China's leaders may contemplate will almost surely not be offset by a significant increase in private savings. Without China to fuel the engine, Asia's economic racecar looks to be in for a long pit stop.
Moshe Silver is a Managing Director at Hedgeye Risk Management and author of Fixing a Broken Wall Street.
Conclusion: Credit trends continue to strengthen as employment, loan demand, and credit availability all continue to improve, household financial obligation ratio’s remain troughed, and household net worth makes new nominal highs. Employment, credit and confidence are key macro factor ingredients for perpetuating a positive, self-reinforcing economic upswing, and trends across all three metrics remain positive.
According to the latest Fed data, total U.S credit market debt totals ~$57T dollars. The total Monetary Base (currency + reserves) meanwhile sits at ~$3.2T. So, at present, there is ~17.8X more obligations to pay dollars than there are actual dollars - Fancy that, Credit Matters.
Generally, credit is pro-cyclical with banks loosening standards and extending credit in response to rising demand and improved credit risk. The reason for the pro-cyclicality is rather straightforward - Household capacity for credit increases as incomes rise alongside positive employment growth and as net wealth rises alongside the rise in real and financial assets that typically accompanies an expansionary economic phase.
Thus, cash flows to service debt and the collateral values backing the debt both support incremental capacity for credit and serve to drive an upswing in the credit cycle, which can serve to jumpstart and/or amplify the economic cycle.
The Fed’s release of its 3Q13 Senior Loan Officer Survey this morning reflects further strengthening in both Loan Demand and Credit Availability. A review of the 3Q13 Loan Officer Survey data below along with a quick tour of household debt and balance sheet trends.
3Q13 Senior Loan Officer Survey: Rising Demand, Loan Spreads & Credit Standard Easing Steady
- Stronger Demand for Prime, Nontraditional, and Subprime Residential real estate loans
- Stronger Demand for Auto and Consumer loans excluding Credit Cards and Autos.
- Stronger Demand for Commercial Real Estate loans
- Stronger Demand for C&I loans from both large & Small Firms. Notably, the net percentage of bank reporting stronger demand for C&I loans from small firms went jumped from 7.7% in 2Q13 to 24.3% in 3Q13.
- Lower Standards on Auto loans
- The net percentage of banks reporting easing credit standards remained positive but cooled (modestly) sequentially across C&I, Commercial Real Estate Loans, and Credit Card Loans.
CREDIT FLOW: The idea of the Credit Impulse, popularized by Biggs, Meyer & Pick (2010), centers on the idea that it’s the flow, not the stock, of credit that matters relative to economic growth. The implication is that if the change in net new credit is positive, credit can still support demand even if the nominal stock of total debt is still declining, and vice versa.
The first chart below illustrates the Credit Impulse (Household and Non-Financial Corporate Debt, Flow of Funds data) vs. the Y/Y change in consumer and business demand (represented by the y/y change for the Consumption and Investment components of GDP) along with the Y/Y change in total household and Non-financial corporate debt. As can be seen, the trend in private sector demand growth tracks the credit impulse closely and leads the positive inflection in y/y debt growth.
The second chart shows the Credit impulse vs. the ‘Banks Willingness to Lend’ measure from the Senior Loan Officer Survey. Again, the Trend relationship is strong and with Willingness to Lend accelerating in 3Q13 the read through for credit catalyzed private consumption remains favorable
We’ll get the updated Flow of Funds data from the Fed on Sept 25th.
Household Debt-to-GDP & Debt Service: Household Debt/GDP continues to fall as nominal debt declines alongside ongoing, albeit modest, GDP growth. At 77.4%, we’re currently 16.9% off peak 2009 Debt/GDP levels and have nearly retraced back to (1) trend. Financial obligation ratio’s remain just north of trough levels due to the combination of organic deleveraging, low interest rates, and nominal earnings growth.
Debt Growth vs. Income Growth: Debt growth in excess of income growth is (obviously) unsustainable with a long-term credit cycle ultimately ending with a 2008 style deleveraging. In the wake of the financial crisis and through to the present, income growth has run at a positive spread to debt growth.
Debt growth has already inflected and given positive mortgage, auto, and consumer loan trends YTD is likely to turn positive when 2Q13 is officially reported. The closing of the delta between income and debt growth represent the upside to credit driven consumption.
Household Net Wealth: Household net wealth is +5.2% above the prior 2007 peak on a nominal basis, -4.2% on a inflation adjusted basis, and -7.6% when adjusted for both inflation and the number of households. Reported net wealth should continue to recover/advance alongside strong, ongoing home price growth and higher equity market highs. Asset/Collateral inflation and a strengthening in the household balance sheet will support capacity for incremental credit and should serve to drive some measure of wealth effect spending.
Christian B. Drake
Takeaway: RL is making all the right investments, and the TAIL story is a winner. But where the consensus numbers come out near-term is critical.
We were negative on RL coming out of the print in May – not because we did not like what the company was doing – quite the opposite, actually. RL was investing in IT systems, stepping up its Retail and e-commerce investments on a global scale, and preparing to take in the Chaps license from Warnaco. But these initiatives cost money, and the outward capital flow unfortunately precedes turning on the revenue spigot by at least 9-12 months. Simply put, there’s almost no way that returns can turn up when this is happening, and valuation multiples don’t expand when returns are going down. Given that RL’s multiple was sitting near peak, it made sense to us to wait to get involved until the market to freaked out over sloppy results.
The financial results played out as we thought, but the reality is that if you asked us a couple of days ago if we’d see a sell-off this quarter, we’d have said ‘probably not’. Don’t get us wrong, the quarter itself was poor, with 4% sales growth de-levering to an 11% decline in EBIT. Comps came in down -1%, and inventory growth outstripped sales growth by a factor of 2x. Again, not return-enhancing metrics – consistent with our concern last quarter. But that said, we think that expectations were set appropriately headed into this print. 2Q guidance of lsd growth and margins down 300-350bp vs last year seemed to be the big culprit, as they suggest EPS in the range of $2.25-$2.20 vs the consensus at $2.57. The question, therefore, is likely whether that is the real number, or if it is a sandbag.
Our sense is that financial reality is somewhere in between guidance and current estimates. We’re coming out at $2.31 for 2Q, and where the consensus lands will be critical as it relates to our near-term take on the stock. We’ll watch that in the coming days, and will be back accordingly.
Long-term, we continue to like RL in that the actions that the company is taking today should propel RL’s top line over $10bn within 3-years, push EBIT margin into the 17-18% range, and take RNOA from 24% today to 35% as asset turns increase on top of a higher margin business. Those characteristics are tough to find. But the catch, once again, is that our estimates are hovering right on top of the Street’s for the next three years (based on last night’s consensus numbers – see table below). That’s rare for us and RL. We’re usually far above. That tells us that the Street finally has it right, or we’re missing something. Either way, we don’t have the conviction to jump in at current levels – at least not while it is still in the early half of its ‘investing year’.
Ralph Lauren Investment Summary
RL Profitability Roadmap: Solid Outlook Over Our TAIL (3-Year) Duration
HERE'S OUR NOTE AFTER RL'S 4Q RESULTS
RL: The Market Is Not Recognizing The Risk
Takeaway: Stocks don't go up when sales slow, costs increase, capex goes up materially and the stock is at 20x EPS. A textbook 'investing year.
Conclusion: We like what RL is doing, but the near-term financial implications will not be pretty and EBIT growth trajectory and RNOA will suffer. Even though this impact will likely be temporary, investors will need to wait until near the end of this calendar year until the risk profile improves. Until then, valuation matters.
We're surprised that RL was not down more on its 4Q print. Yes, the company overdelivered -- in typical RL fashion. But there are enough factors that are changing negatively on the margin that we think will make RL a good candidate for multiple compression in the sloppy quarters that lie ahead in the upcoming fiscal year.
We like this company as much as we ever have. It continually reinvests in its intellectual property to elevate the retail experience and gain share -- something that has worked for RL without fail.
Case in point…we kept a little scorecard of all the times that retailers and brands mentioned the words 'omni-channel' in press releases and earnings calls this earnings season. We stopped count at 100, and no, it did not take us long to get there. This has officially become the biggest cliché buzzword since 'supply chain' made it on to the scene 15 years ago. We swear that half of the execs talking about omni-channel don't even know what it means (if there even is a universally-understood definition). They're just following the cool kids.
Ralph is one of the cool kids. It did not discuss 'omni-channel' once on its call or press release. Why? The reality is that it has been implementing a true omni-channel strategy for much of the past five-years…at a time when no one knew what it even was. Now RL is implementing retail and e-commerce models that others will be trying to implement in another five years. Simply put, we think that RL will continue to be a winner.
But this is one of those years where the negatives to the story are likely to outweigh the positives. Specifically…
- FX will be a meaningful headwind in FY14 -- especially given RL's significant exposure to Japan. Check out the Yen's move over the past six weeks. Not good. FX is a $75mm hit to EBIT for the year.
- RL's Global SAP implementation, Korean e-commerce rollout, acceleration of retail rollout -- including NY flagship. There's another $75mm hit to EBIT this year.
- Capex is going from $276mm last year to up to $450mm in FY14 -- that's one of the biggest capex increases we're seeing out of anyone in retail.
In fairness to RL, it has proven to be an exceptional steward of capital in the past, and we have no reason to think that will change this year. But the reality is that the $150mm in extra costs puts RL in a hole for 13% EBIT growth. This would be ok if we could justify solid double-digit top line growth as an offset -- but the reality is that we cannot (even if partially due to FX). So we've got slowing sales, eroding margins, and a step-up in capex. Any way we cut it, we can't justify the combination of these factors leading to any form of multiple expansion.
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