This note was originally published at 8am on August 30, 2013 for Hedgeye subscribers.
“Neither a borrower or a lender be; For loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.”
-William Shakespeare, “Hamlet”
Shakespeare taught us many lessons in his writings. But the quote from Hamlet above is very apropos for those of us who are stock market operators. The lesson is simple: be careful with financial leverage.
Financial leverage is like the blue meth sold by Walter White and his colleagues in the acclaimed TV show Breaking Bad. It is both very addictive and hard to get off the streets. It can also make the sellers very rich in a short period of time.
In the last fifteen or so years, we’ve seen innumerable debt fueled bubbles. The Asian debt crisis, the stock market bubble of the early 2000s, the housing bubble, the sovereign debt crisis, and the list goes on. Shakespeare is correct: returns generated from borrowing dull our analytical focus.
In the spirit of another quote from Shakespeare, “brevity is the soul of wit”, let’s get directly to the global macro grind . . .
Next Wednesday, with all of Wall Street well rested and back from the Hamptons, we are going to update our emerging market outflows theme. Like most macro trends, emerging market outflows is unlikely to be a month or quarter long trend. With the dollar and interest rates being key supporting factors, this one also has legs.
In fact, my colleague Darius Dale looked at the last strong dollar period, from 1995 – 2001, and the MSCI Emerging Market Index CAGR’ed at -5.3% versus the SP500 at +15.8%. So, reasonably, if interest rates are just starting to turn, and the dollar is only in the early stages of a long term strengthening, then emerging markets can be expected to underperform for some time.
In the Chart of the Day, we’ve highlighted recent emerging market equity and bond outflows. As the chart shows, the last four months have been staggering for outflows and emerging market asset classes have performed commensurately. As they say, follow the flows (or at least the projected flows).
After the first big correction is when the “value” investors usually start to get interested in a stock or asset class. No doubt that guy from Franklin Templeton who originally cut his teeth marketing Snoopy is licking his chops right now on emerging markets. The problem is that cheap can get a lot cheaper.
Currently, on an EV/EBITDA basis emerging market equities are still trading at slight premium to the long run mean versus the MSCI World Index. In times of crisis, like in the 1998/1999 period, emerging markets trade at a multiple that are closer to the 30% of the rest of the world (versus north of 70% now). When the proverbial brown stuff hits the fan, emerging markets go no bid.
We will be sending out an update of our emerging market chart book later this morning (ping email@example.com if you don’t get it) and will also be hosting a call on Wednesday, September 4th at 11:30am eastern. Even if you aren’t invested in emerging markets, this will be an important call in helping to understand global asset allocation flows. Or as we like to call it: The Flow Show.
Speaking of flows, EPFR Global came out with some date this week that highlighted some of the key fund flows in the year-to-date. No surprise, emerging markets lead in outflows with almost $7.8 billion in outflows. On the positive is the United States, which has seen $83 billion in inflows, but in the category of sneaky positive is Europe, which has $9.4 billion of YTD inflows mostly over the past nine weeks.
Europe may only be bouncing on the bottom in terms of an economic recovery, but the money has to flow somewhere. Even more sneaky has been the improvement of sovereign yields in the European periphery, with both Italy and Spain both solidly at 4.5% or below (some of the best levels in years). If the sovereign debt issues in Europe are truly behind us, the flows into Europe will only continue.
It only helps the investment outlook in Europe to have more sane central bankers like Mark Carney, formerly head of the Bank of Canada, running things. In his first newspaper interview since taking over the Bank of England, Carney directly acknowledged the risks of low interest rates when he said:
“We have the responsibility to assess emerging vulnerabilities in the economy such as housing, make those assessments and recommend action. Interest rates are principally an instrument of monetary policy for achieving the inflation outcome and there are other tools that address risks."
Well said, Mr. Carney. Well said.
Speaking of central bankers, this long weekend will give us all some time to consider what might happen at the Fed next if either of the two front runners, Janet Yellen or Larry Summers, take over. Hawk or Dove? Shakespearean tragedy or comedy? To flow, or not to flow?
All joking aside, policy matters so this choice will be critical in contemplating asset allocation in coming years. As Shakespeare said about vision and strategy:
“See first that the design is wise and just; that ascertained, pursue it resolutely.”
As it relates to the leadership change at the Federal Reserve, we can only hope this is the path that is pursued.
Our immediate-term Macro Risk Ranges are now as follows:
UST 10yr Yield 2.70-2.93%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
TODAY’S S&P 500 SET-UP – September 13, 2013
As we look at today's setup for the S&P 500, the range is 37 points or 1.15% downside to 1664 and 1.04% upside to 1701.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.
Takeaway: EM debt and EM FX should continue to broadly decline while EM equity returns should become increasingly bifurcated at the country level.
When EM capital and currency markets were appropriately tanking into their late-JUN lows, making money on the short side of the emerging markets space was so easy even a bunch of former football and hockey players could do it. While never in search or need of validation for our research conclusions, we’d be lying if we said it wasn’t gratifying to see world-class investors such as Ray Dailio adopt what is essentially our #EmergingOutflows thesis.
As highlighted by our EM divergence monitor (full methodology below), just about any asset that had been previously perma-bull marketed to investors as an “emerging market” was down double digits on a trailing 1M, 3M and 6M basis at the JUN 24 low in the MSCI Emerging Market Index.
(prices and performance figures as of 6/24)
Flash forward to today, we’re seeing some pretty solid dead-cat bounces uniformly across the EM space on a WoW basis; in fact, the only primary or secondary asset class that isn’t up is Peruvian equities (down -0.1% WoW). Looking to performance across the 1-3 month time frame tells a different tale, however, in that the performance is decidedly less uniform.
In line with this market signal, we think it will become increasingly important for equity investors to become “country-pickers”.
It’s worth stressing that by “country-pickers”, we are not referring to the traditional “ABC country has great demographics and will be XYZ percent of global GDP by 2030” perma-bull marketing that is found in every emerging market fund prospectus on the planet.
Conversely, in a #StrongDollar, #RisingRates environment, we think the direction, supply and cost of global capital flows will increasingly determine the trend rates of growth, inflation, urbanization and reformation across the emerging market space – just as the USD and US interest rates did on the way down.
Specifically, we believe it to be flat-out intellectually dishonest to suggest that a pervasively weak dollar and cheap, excessive global capital haven’t perpetuated a golden era in EM economic and financial market conditions during the most recent EM “boom” cycle as it had done in the two previous cycles (late-70s to the early-80s and late-80s to the mid-90s).
Simply put, the absolute return strategy of gathering assets and aggressively “diversifying” into emerging markets is over and, quite frankly, it’s been over for a while now (FYI, EM equities peaked when the USD bottomed in 2011 – alongside other consensus carry trading strategies such as gold, commodities and EM currencies).
In light of this updated view, we thought it would be helpful to rehash where we think intermediate-to-long-term investors will be most rewarded for investing their hard-earned capital on the long and short side of emerging markets:
Below, we present our latest Hedgeye Macro Emerging Market Crisis Risk Index as some support for these selections. You’ll note that we didn’t just pick the absolute best vs. the absolute worst; other factors (such as accessibility and quantitative signals contributed to our thought process):
Please email us any time you’d like to receive our more nuanced thoughts on a specific country and/or its capital and currency markets. We’ve done all the analytical heavy-lifting and we continue to monitor for critical deltas and inflection points each day so it’s no trouble at all for us to assist you in that regard.
Have a great evening,
NOTES ON THE HEDGEYE MACRO EMERGING MARKET DIVERGENCE MONITOR:
To help clients get a better grasp of all the moving parts across EM capital and currency markets, we have created a dashboard to systematically monitor performance divergences with the intent on flagging developing, existing, and dissipating trends in the marketplace. The dashboard is specifically programmed to highlight divergences in EM primary and secondary asset classes that are in excess of  standard deviation relative to their respective sample means.
The dashboard is grouped into three distinct buckets (i.e. samples): Asset Classes, Regions and Countries. Realizing that we could and should do better than implementing an all-or-nothing strategy in emerging markets, this multi-tiered setup will allow us to spot the development and dissipation of said trends at the level most appropriate for any given investor.
Lastly, we thought it would be best to use actual ETFs, rather than the benchmark indices themselves to track said divergences because: A) the universe of liquid ETFs most likely accurately reflects the universe of broadly investable emerging market securities and asset classes; B) the ETFs are all both un-hedged and priced in US dollars, which means they automatically adjust for deltas in the currency markets; and C) ETFs have an underlying fund flow element to them that influences price trends – which is precisely what we’re trying to capture with our #EmergingOutflows thesis.
It’s also worth noting that whenever there was a collection of ETFs that represented a particular asset class, region and/or country, we selected the specific ETF in our sample based on a combo score of size (AUM) and liquidity (average daily trading volume).
Yesterday we hosted an expert conference call titled "Are Energy Drinks Harmful?" with Dr. Deborah Kennedy, a pediatric nutrition and expert on energy drinks. The call was very comprehensive and well received by our clients. If you missed the it, here are links to the podcast replay and presentation. We encourage you to take the time (one hour in length including a Q&A session) to listen to the call, and have included a summary of the call below.
Note: We will be putting out a subsequent post with our outlook on the energy drink space, in particular on Monster (MNST), and giving consideration to key take-aways from Dr. Kennedy’s presentation on the industry.
What are Energy Drinks?
How much Caffeine in Energy Drinks?
Dangers and What Experts are Saying
Dr. Kennedy Predictions
Q) What ingredient recommendations have been made or given to the energy drink makers from doctors and/or the FDA?
A) Nothing yet. A doctor can say whatever he or she wants but the manufacturers are not listening. Now some Senators are involved and they’re asking the energy drink manufacturers to playing nice and stop marketing to kids, but until the FDA comes down on limits to caffeine levels nothing will change.
Q) Do you foresee that the FDA could pass a standard for caffeine in drinks?
A) Yes, although technically it gets complicated because of molecular differences across caffeine types. So it will take awhile to get to any standard.
Q) With respect to the cross over between age regulations for energy drinks and coffee, would you promote that a 16 year old walking into a Starbucks can’t order a grande redeye coffee drink, or needs to show identification to purchase it?
A) For a teen there needs to be a warning label on anything over 100mg of caffeine. Similar to calorie counts on food menus, the consumers need to have information so that they can make a reasonable choice. The consumer should know which beverages are over 100mg of caffeine and could potentially cause toxicity. Not looking to card minors, rather given teens the ability to make their own choices.
Q) Would you like to see the energy drink makers come up with one size of energy drink with one level of caffeine?
A) I would like to see what happened to soda. Those companies are set to a certain standard so that you know exactly what you’re buying. So yes, I agree the same should be the standard for energy drinks.
Takeaway: In the note below, we debate the merits of the long-term bull case for China. We’re not impressed, but we’re not "not impressed" either.
[GOT] OUT OF THE WAY
My how fast things change in today’s policy-driven markets. A week ago, we were as bearish as anyone on China’s long-term economic outlook and both our top-down and bottom-up quantitative signals supported that view.
Fast forward one day from then to last Friday’s color on the Shanghai Free Trade Zone (FTZ) and the subsequent closing of the insider-dominated Shanghai Composite Index above its TREND line and, just like that, our choice to get out of the way on the short side is looking like an increasingly appropriate risk-managed decision (the index is up +5.4% WTD vs. a regional median delta of +2.6%).
Not to be all sales-y in a research note, but I personally think one of the main things that differentiates our Global Macro research product from the industry norm is the consistent demonstration of mental flexibility at potential inflection points like this (see: orchestrating a 180-degree turn to being bullish on US equities in DEC ’12 despite having US equity-bearish 4Q12 Macro Themes titled, “#EarningsSlowing and #KeynesianCliff).
Accordingly, Mr. Market doesn’t care that we’ve done months of bottom-up research on the structural headwinds facing China’s financial sector and its fixed assets investment-driven economy (most recently rehashed on slides 8, 62-72 and 77-78 in our AUG 30 EM chartbook). If it’s priced in, it’s priced in.
To that point, we turn to the latest Bloomberg Global Poll data (released today), which is based upon the responses from a random sample of 900 subscribers to the Bloomberg Professional Service (over 300k clients worldwide):
On balance, it’s clear the consensus attitude towards the Chinese economy and its financial markets has improved marginally QoQ. While it’s natural to want to be contrarian and fade this delta, we’d argue that after three straight years of slowing economic growth and three straight years of rancid-to-subpar equity market performance (-14.3% in 2010, -21.7% in 2011 and +3.2% in 2012), it’s more appropriate to extrapolate these results as positive on the margin.
MAKING THE TURN?
Looking at China objectively from here, we have to lend the appropriate amount of credence to Premier Li’s most recent guidance (key highlights from his commentary at the Davos Economic Forum):
As an aside, it’s good risk management practice to lend credence to anything that comes out of the “horse’s mouth” that is the Politburo Standing Committee (PSC); Chinese officials almost always do what they said they were going to do. From our JUN 26 Early Look titled, “Uncertain China”:
“We’ve become a broken record on this, but it’s critical to remember that China’s present day economic woes are actually a function of very deliberate macroprudential policies. While highly unlikely, at any given time, Chinese officials can reverse course and keep the credit bubble inflating longer than any of us short-sellers can remain solvent.”
We’re not going to make up a bunch of BS reasons why China’s economic reforms are going to specifically boost the Chinese economy; the whole, “reform ABC will contribute XYZ percentage points to GDP growth” is so sell-side/IMF. Rather, we’ll call it like we see it: no one outside of the PSC knows exactly what specific policies China will implement and at what pace.
All we really know at the current juncture is that the market clearly thinks the Shanghai FTZ and it’s “innovative tax policies” (per Premier Li… the latest rumors call for a -1,000bps corporate tax cut to 15%), interest rate and capital account liberalization and pro-foreign business reforms will be enough to help offset the structural liquidity headwinds to Chinese credit growth that are currently being predicated by deteriorating current account dynamics and a likely explosion of nonperforming assets (reported or evergreened) across the banking sector – at the margin at least!
At the end of the day, buying China here is akin to buying a tiny piece of a bombed-out stock in the thralls of its bull-bear debate. If it doesn’t work, you keep it on a tight leash and sell it; if it starts to work, you buy more and update the fundamental story as you go along.
NOT SO FAST!
All that being said, however, we are NOT telling you to run out and buy China here. Rather, we’re merely acknowledging the merits of what we view as the most credible intermediate-to-long term bull case (i.e. the rough opposite of our former bearish thesis).
Additionally, we continue to believe that SEP will mark the top in this latest cyclical uptrend in China’s monthly economic growth statistics (CLICK HERE for the analysis supporting this conclusion).
Inclusive of this short-cycle peak in Chinese economic growth, the Chinese economy as a whole looks poised to take a trip to Quad #3 on our GIP model in the fourth quarter amid a likely uptick in inflation after aggressive credit growth in the YTD (Total Social Financing is up +24.4% YoY through AUG).
All things being equal, that would make it difficult for Chinese stocks to perform well through the balance of the next few months – unless, of course, the insiders are looking through a sequential deterioration in corporate operating conditions in the fourth quarter to a long-term economic outlook that appears increasingly “less bad” on the margin.
Looking to the next potentially bearish catalyst, the insiders might eventually join us in looking towards NOV’s Third Plenary Session as a potential catalyst for the PSC to take down the country’s 2014 GDP growth target. As a refresher, the 2013 target is equal to +7.5% with a “floor” of +7%; will the 2014 target be revised lower to +7% with a “floor” of +6.5%?
We would not be surprised if that turned out to be the case; in fact, we expect them to keep walking Chinese growth expectations down the natural stair steps afforded by the law of large numbers – especially given their desire to rebalance the economy towards consumption in lieu of fixed assets investment and the aforementioned debt-induced headwinds to high growth rates from here.
Lastly, the Ministry of Housing and Urban-Rural Development (MOHURD) might blindside investors any month by tightening the screws on the Chinese property market(s) via additional curbs, more aggressive enforcement and/or an outright nationwide [punitive] property tax trial. Most recently, they were beginning to investigate local authorities on their potentially lax implementation of the existing nationwide curbs to housing transitions and mortgage lending.
One of the things we’ll monitor to determine whether or not it’s an appropriate time to buy or if more confirmation is needed is whether or not the insider-driven Shanghai Composite Index closes above its late-MAY highs; that lower-high came just before the JUN liquidity crunch and subsequent consensus debate about China’s financial sector risks (i.e. the same risks we called out in our Hedgeye Macro Emerging Market Crisis Risk Index back on APR 23).
Specifically, a close above that level would be akin to receiving a second quantitative “thumbs-up” in our playbook (the first being the recent TREND line breakout).
Best of luck out there risk managing the world’s second-largest economy!