Bullish on the Union Jack

This note was originally published August 16, 2013 at 09:45 in Macro

  • Bullish position on the UK (etf: EWU) and Germany (EWG) remains.
  • Eurozone fundamentals inching higher; investor sentiment improving on weak comps. On a relative basis the Eurozone is well below its historical growth average and churning only modestly higher as deep structural imbalances and the lack of credit drag on growth.
  • We underline the significance of Eurocrat and ECB resolve to lend support to the region and markets (at all costs), which, along with marginally better data, should continue to support Eurozone capital market performance.

Bullish on the Union Jack - uk7 

UK’s Island Economics

In support of our fundamental bullish call on the UK economy since our June 11th European update presentation titled “Where Does Europe Go From Here”, yesterday the UK printed a strong Retail Sales figure of 3.0% in July year-over-year (exp. 2.4%) vs 1.9% JUN.


The print and the down move in the FTSE100 yesterday prompted us to add the UK via the etf EWU to our real-time portfolio positions on the long side.


Bullish on the Union Jack - hed1


Bullish on the Union Jack - z. uk retail and IP


Our outlook on the UK is data and price dependent and hasn’t changed: we expect to see outperformance from the UK economy versus many of its European peers due to its decision to issue austerity earlier in the fiscal consolidation cycle. We are now seeing stronger signs of improved consumer sentiment, and expect PMI readings to maintain their level above the 50 line (expansion) into year-end. Beyond retail sales, industrial production and housing figures have improved year-to-date, and while wage volatility and sticky stagflation persist, we view reductions in the saving rate as another indicator of improved sentiment.  Further, we’re bullish on the changing of the guard at the BOE to Mark Carney – while it’s up for argument on just how effective tying monetary policy to the unemployment rate is, we like the Bank’s move towards a more transparent state to better manage and guide expectations.


Bullish on the Union Jack - z. uk cpi


Bullish on the Union Jack - z. uk house prices


Bullish on the Union Jack - z. uk savings rate



Eurozone Inching Higher


The big news this week was a better-than-expected first print of Q2 GDP out of the Eurozone, a follow-on to improving fundamental data out of the Eurozone in recent weeks.


The Eurozone’s +0.3% Q2 GDP rise marked the end of an 18 month recession (cheer!), and the figure beat our expectations for only modest improvement over Q1 (consensus was at +0.2%), especially in a quarter that was hampered by bad weather (including serious flooding throughout central Europe), continued misdirection in economic leadership from France’s Hollande (France has the second largest economy behind Germany in the Eurozone), and continued political strife in Italy, Spain, and Portugal.


Bullish on the Union Jack - z. eurozone gdp


Clearly the data is looking better.  Germany and France also beat Q2 GDP expectations. Germany reported growth of +0.7% Q/Q (+10bps above expectations) versus 0.0% in Q1 and France rose +0.5% Q/Q (+30bps above expectations) vs -0.2% in Q1. Add to this performance PMI figures that have improved across the region over the last 3-5 months (reaching over the 50 line in the last 1-2 readings) and improvement in sentiment readings across the core and periphery.


Bullish on the Union Jack - z. pmis


Risk Spreads are dropping to new lows. Also, 10YR Spanish and Italian bonds are trading at their tightest spreads over comparable German paper in more than two years at ~252bps and 235bps, respectively.


Bullish on the Union Jack - z. 10 spreads



Not All Is Rosy

What’s our read?  While there’s optimism to be had on improving data, GDP was still down -0.7% year-over-year in Q2 and we expect a very slow churn higher in Eurozone GDP in the balance of 2013. Certainly GDP will remain well below the pre-crisis average of 2.1% (since 2000) as the region hits the reset button on standards of spending and lending as budgets are readjusted at the government and household levels.  We maintain our call for 2013 GDP between -0.8% and -0.6% year-over-year.

Beyond struggling to reset spending and lifestyles habits, here are some significant hurdles that we expect will continue to weigh on Eurozone GDP:

  • The slim availability of credit, in particular to the small and medium sized businesses, the core drivers of growth and employment (see chart below on ECB Loans to Non-Financial Corporations and Households as proxy—at or near all-time lows)
  • Diminished credit quality of banks, especially across the periphery, as they report increasing non-performing loans
  • Further bank write-downs of non-performing assets
  • Labor market reforms slow to enact or institute at all
  • A protracted unemployment overhang, especially youth unemployment across the periphery, that will limit consumer spending and confidence
  •  Political uncertainty, in Italy, Spain, and Portugal, to weigh on budget reforms and confidence

Bullish on the Union Jack - z. ecb lending


To throw out a couple anecdotes from the media stories we’ve recently come across that paint a still subdued outlook, we include:

  • The WSJ reported that auto sales in Europe are so bad that less than half the factories in the region operate at the minimum 75% of capacity needed to break even. It said that those operating below that level are mostly located in Italy, France, and Spain whose economies have been hit by the crisis. The article noted that governments in Western Europe are worried about seeing more workers join the ranks of the unemployed and that unions are aggressively protecting jobs, while the courts have also been sympathetic. The paper said that because of this, auto makers are losing billions of euros a year by retaining workers and factories they no longer need.
  • A poll by ING-DiBa AG and the University of Hohenheim shows that only 17% of Germans believe that the worst of the Eurozone crisis is over, while 91% think that the crisis will still go on for a long time. Only 10% of Germans believe that politicians are being honest with citizens regarding Eurozone issues.


Concluding Thoughts


Our call remains that into Q4 we expect European PMIs to hover around the 50 line (ups and downs) but not to show a material breakout given the very weak structural issues that we do not see inflecting materially over the intermediate term, including weak credit conditions, high unemployment, alongside political uncertainty at the country level – Italy, Spain, and France in particular.  We continue to be fundamentally bullish on German and the UK equities, so should we see any outperformance from PMIs, we think it could come from these two countries.


As it relates to the capital markets, we think a much larger force versus marginal improvement in fundamental data is the political resolve of the Eurocrats and Draghi to lend fund if needed (back-pocket OMT ready) and prevent any country from leaving the Eurozone, which we think can continue to stabilize and push markets higher. Already we’re seeing domestic and international investors become increasingly confident in Draghi’s heavy hand and buying distressed asset, for example housing in Spain and bank debt across the periphery, as the EU banking system slowly continues to heal.      


Enjoy the weekend!


Matthew Hedrick

Senior Analyst

Morning Reads on Our Radar Screen

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

Keith McCullough – CEO

Alpha Hunter James Rickards on Gold and the U.S. Dollar (via All About Alpha)

Sales of U.S. Existing Homes Rise to Highest Since 2009 (via Bloomberg)

Indian stocks plunge 11% in a month (via CNNMoney)

Syria conflict: 'Chemical attacks' kill hundreds (via BBC)


Morning Reads on Our Radar Screen - bullbear


Daryl Jones – Macro

Abandoned Dogs Roam Detroit in Packs as Humans Dwindle (via Bloomberg)


Jonathan Casteleyn – Financials

Goldman’s Options Error Shows Peril Persists After Knight (JC note: A $100 MM loss has a small impact on $GS - would be just $0.71 per share on a tangible book value of $140 per share  via Bloomberg)

Bond Trading Hampered as Buyers Retreat to Crowded Exits (JC note: Bond market illiquidity is a huge risk for fixed income investors - we highlighted it in our rollout via Bloomberg)


Brian McGough – Retail

PetSmart 2Q profit tops Street, lifts outlook (BM note: PETM maintains its streak of being the only retailer to never comp down -- ever. 'Ever' is a long time. If you know of others, let me know. via AP)


Matt Hedrick – Macro

Europe Prepares for More Greek Aid as German Election Approaches (via Bloomberg)


Client Talking Points


At the recent US Dollar lows in June ($79.11 is the long-term TAIL risk line of support), the Yen tested 94 vs USD and the S&P 500 was probing 1575. A lot changed in a hurry come the beginning of July, and the USD strengthening off those higher all-time-lows was a big driver of that. Bottom line here right now is the USD needs to hold $79.11 to keep buying US Equity corrections. We continue to keep a close eye on this.


One of my key weekly looks on sentiment is probing its June lows all of a sudden too (that’s actually bullish). This morning’s Bull/Bear Spread is +2170; that’s down -34% from when it peaked at +3310 in the first week of August as the S&P 500 and Russell made all-time highs. Bulls have dropped to a shockingly low level of 43.3%. Professional market top calling? It is still in vogue


Got #AsianContagion? It’s officially a race to the bottom for the Rupee (India) vs the Rupiah (Indonesia). Growth continues to slow as currency-adjusted inflation accelerates in these countries. What's the message here? Don’t buy those equity markets. Don't do it. India was down -1.9% overnight. It is now down -11.8% since July 23 and -6.7% year-to-date.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.


Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016.


Health Care sector head Tom Tobin has identified a number of tailwinds in the near and longer term that act as tailwinds to the hospital industry, and HCA in particular. This includes: Utilization, Maternity Trends as well as Pent-Up Demand and Acuity. The demographic shift towards more health care – driven by a gradually improving economy, improving employment trends, and accelerating new household formation and births – is a meaningful Macro factor and likely to lead to improving revenue and volume trends moving forward.  Near-term market mayhem should not hamper this  trend, even if it means slightly higher borrowing costs for hospitals down the road.

Three for the Road


Seeing clients in CA yesterday, biggest risk discussion centered on whether USD can hold its June lows vs Yen @KeithMcCullough


"Courage is fear holding on a minute longer."

- General George Patton 


Crash or correction? The S&P 500 and Russell 2000 both closed -3.3% from their all-time highs yesterday, while the Nasdaq closed -2.1% from its year-to-date high.

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Thinking Time

“Before I went to jail, I was active in politics as a member of South Africa’s leading organization – and I was generally busy from 7 A.M. to midnight. I never had time to sit and think.”

-Nelson Mandela


Former South African Prime Minister Nelson Mandela had more time to sit and think then most of us will ever get.   He served 27 years in prison, first on Robben Island, and later in Pollsmoor Prison and Victor Verster Prison after being convicted of sabotage and conspiracy to overthrow the South African government.


I’ve recently been reading Mandela’s biography and after reading about how he spent his nights in a damp concrete cell of 8 feet by 7 feet and his days breaking rocks into gravel, I’m not sure I would wish this type of “thinking time” on my worst enemy.  But, thinking time is important for all us, and I will be taking some thinking time myself as my first two week vacation of the last decade looms in the next couple of weeks.


In a book we have cited many times, “Thinking, Fast and Slow”, Nobel laureate Daniel Kahneman describes two modes of thought.  The first is System 1, which is fast, instinctive, and emotional.  The second is System 2 and is slower, more deliberative, and more logical.  The main purpose of his book is to describe the dichotomy between these two kinds of thought.


To illustrate how the two different systems work, answer this before you go on:


A hockey stick and puck cost $1.10 together.


If the stick costs $1.00 more than the puck, what does the puck cost?


If you are like most people, even the highly numerical, it is likely that the price of $0.10 popped into your head.  The correct answer of course is that stick cost $1.05 and the puck cost $0.05, so thus the stick cost $1.00 more than the puck.


In a day and age when we are inundated with more stimuli and decision making opportunities than ever before, it is becoming even more critical to take some Thinking Time to maintain the deep logic of System 2. The fact of the matter is, the self-induced dopamine loops of constant texting, tweeting, googling and emailing diminish our performance. (Well, at least that’s how I’m justifying my vacation to my colleagues :) ) 


Back to the global macro grind . . .


I’m going to take this concept of short term versus long term thinking and apply it to the current battleground stock of the day, J.C. Penney (JCP).  Recently Pershing Square’s Bill Ackman all but admitted defeated in his attempt to turn around the retailer as he resigned from the board of JCP and received permission for Pershing Square to sell the more than 15% of the stock it owns. This is short term capitulation.


At the same time, a number of other hedge funds have been taking sizeable positions at the stock has declined, including Kyle Bass, Soros Fund Management and Perry Capital.   Bass, as reported by Bloomberg is actually buying the debt.  These are long term investment positions.


Before I dig into the stock a little more, I wanted to let you know that our Retail Sectorhead Brian McGough will be doing a deep dive on the stock on August 27th at 1pm. (Ping for details.)  As many of you know, Brian was in early in recommending investors short and/or sell the stock when Ackman got involved.  He then tried to call the turn around and added the stock to our Best Ideas list, but ultimately removed the name at about the current price level on March 14th as there was little evidence of a turnaround and his view was that JCP was dead money (which it was).


The Chart of the Day today is a chart of JCP credit default swaps that shows that while a bankruptcy isn’t a foregone conclusion, there is certainly risk as investors are willing to pay a meaningful premium to insure JCP debt.  Interestingly, while JCP debt has declined versus its peer group over the last couple years, it is not yet at extreme levels.


As examples, per Bloomberg and Forbes, the J.C. Penney 5.65% notes due 2020, yesterday traded up two points, at 73.5.  While the long-tenor 6.375% bonds due 2036 traded up half a point, at 69.5, for a net gain of 3.5 points week over week.  In the loan market, J.C. Penney’s covenant-lite term loan due 2018 (L+500, 1% LIBOR floor) were slightly firmer, recently quoted at 96.5/97. As a reference, the $2.25 billion loan was issued at 99.5 in May.


As McGough noted yesterday, “the fact that JCP hit the liquidity levels it guided toward at quarter-end is notable. Add on the fact that capex next year is guided to be down as far as $300mm, and the liquidity picture looks less pressured. We’d argue that these two factors are the sole reasons why the stock was up today. Why?

Let’s stress test the model. We quarter-ized our model for the next three years using the following assumptions a) JCP reaches 2012 sales per square foot levels in 2015, with a gradual comp lift throughout, b) the company generates 37% gross margins – a level we think there is no structural reason it can’t hit again relatively quickly (we know we'll get pushback on that -- but will happily entertain the debate), EBIT margins don’t turn positive until 2016, c) capex increases by $50mm each year, d) working capital patterns are similar to what we saw before 2012.

In tracking the cumulative liquidity for the next three years, there are two periods where it definitely gets dicey for JCP (the worst is 3Q15 -- in two years) – close enough such that it will likely need to find some asset sales that are not already tied to the GS secured debt offering. But even without assuming a miraculous turn at the company, we don’t get to a big liquidity event.”


So, if there is no major liquidity event for the next three years, there is decent runway for the company to turnaround and the shorter term debt, at the very least, looks reasonably safe.  But what do you think?


Next Thursday at 1pm, we’ll introduce some new information and dig into more of our thoughts.  If the turnaround actually happens, based on historical margin levels, JCP equity is a really cheap option at these levels.


Our immediate-term Risk Ranges are now:


UST10yr 2.71-2.94%


Nikkei 13,6

USD 80.80-81.94

Brent 108.78-110.32

Gold 1


Keep your head up and stick on the ice,


Daryl G. Jones



Thinking Time - JCP COD


Thinking Time - vp 821

August 21, 2013

August 21, 2013 - dtr



August 21, 2013 - 10yr

August 21, 2013 - spx

August 21, 2013 - nik

August 21, 2013 - dax

August 21, 2013 - dxy

August 21, 2013 - euro

August 21, 2013 - oil



August 21, 2013 - VIX

August 21, 2013 - yen

August 21, 2013 - natgas
August 21, 2013 - gold

August 21, 2013 - copper

Early Look

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