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THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING

Takeaway: Chinese policymakers appear to be embarking on a clever strategy to offset internal headwinds to growth with foreign capital.

SUMMARY BULLETS:

 

  • Chinese policymakers appear to be embarking on a clever strategy to offset internal headwinds to growth with foreign capital.
  • If executed properly, China’s structural economic outlook – one that we continue to think has many headwinds – will be much improved, on the margin.
  • Near-term risks remain, however, including an additional round of property market tightening and a potential negative revision to China’s 2014 GDP growth target at the 18th CPC Central Committee's 3rd Plenary Session come NOV.
  • Of course, one of, neither of or both of the aforementioned risks may materialize. We have no edge beyond stating that both are likely more probable than consensus may realize. This is the primary reason we are not outright bullish on China at the current juncture in spite of the developing intermediate-to-long-term bull case we have expanded upon in this note.
  • One of the things we’ll monitor to determine whether or not it’s an appropriate time to A) buy China outright or B) trade it with a bullish bias 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.

 

PLEASE NOTE: The discussion below is a direct continuation of an analysis we presented in our SEP 12 research note titled, “DEBATING THE BULL CASE FOR CHINA”. To the extent you have not reviewed that piece, we encourage you to do so prior to examining the analysis below, as it will help elucidate the conclusions we continue to make. In the event you may have missed it come through, please email us for a copy of that note or to set up a call to discuss China more broadly.

 

This morning we received what we interpreted as positive news with respect to China’s TAIL-duration economic outlook.

 

Specifically, interest rates will be fully liberalized within the Shanghai Free Trade Zone and there’ll be no restrictions on raising capital – either from domestic or foreign banks – for companies operating inside the zone.

 

While still very much in the realm of conjecture, this piece of information is positive, on the margin, for the following two reasons:

 

  1. Interest rate liberalization will allow China’s liquidity-starved banks to compete for the acquisition of foreign deposits. This, of course, assumes some degree of capital account conversion.
    • In a closed setting such as the Shanghai FTZ, the risk of a systemic unwind of the shadow banking system can be offset by continuing to restrict the broader Chinese public's access to liberalized deposit rates or international markets – effectively maintaining their incentive to speculate in the property market and/or in WMP and Trust Products.
    • More deposits = more liquidity and more liquidity = faster credit growth, at the margins. This is a direct offset to what we believe to be the most convincing secular bear case for Chinese economic growth (i.e. sustainably slower credit growth born out of rising NPLs and waning liquidity from the current account).
  2. The unrestricted ability of Chinese firms – particularly credit-starved SMEs – to raise capital in the Shanghai FTZ is also supportive of faster credit growth, at the margins. This, of course, assumes an ample supply of foreign capital.

 

On that last point, we think the powers that be up in Beijing are no dummies when it comes to making China an increasingly attractive destination for foreign capital.

 

Not unlike the migration of foreign capital from the imperiled South America to the then-attractive Asian Tigers in the early-to-mid 90s, China appears to be inclined to promote itself as a bastion of economic and financial stability amid rising risk of EM crises in places India, Indonesia, Turkey and Brazil.

 

Perhaps that’s why the PBoC has been inclined to mark up the CNY over the LTM (+3% YoY and +1.8% YTD).

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - 1

 

Amid that process, the CNY has hit an all-time high on a REER basis, imposing systemic risk to China’s export economy and its razor-thin margins. Moreover, they have done so in the face of some fairly obvious international headwinds to export growth.

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - 2

 

No doubt, Chinese officials appear keen to sacrifice what little liquidity they are likely to receive from the current account over the long term for what may turn out to be a far deeper and more sustainable source of liquidity in the form of foreign portfolio and direct investment flows.

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - 3

 

Furthermore, they appear willing to entice said capital flows with the allure of FX appreciation and higher real interest rates within the Shanghai FTZ (in addition to favorable corporate tax policies). Importantly, their strategy appears to be increasingly effective at improving foreign investor sentiment towards China, on the margin.

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - 4

 

All told, if Chinese policymakers are, in fact, pursuing the growth strategy we have outlined above, then it would behoove us to have a bullish bias on the Chinese economy, its currency and under-owned stock market (less than 20% of Chinese households’ financial assets are allocated to equities vs. 33.7%% in the US).

 

In the face of the bear case getting “less bad” at the margins, easy comps and GDP seasonality support a sanguine 1H14 outlook for Chinese economic growth.

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - CHINA

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - 6

 

We can’t forget that China’s most recent real GDP growth rate of +7.5% was over a full standard deviation (-1.1x) below the trailing 3Y mean. The balance of risks imply some degree of mean reversion born out of a combination of marginal retracement and continued pressure on the average itself. Net-net, the likelihood of a downside economic surprise(s) in China is declining, at the margins, and should be rather muted on an absolute basis in 2014.

 

On the bearish front, the two most probable catalysts that would increase the likelihood of a downside economic surprise(s) over the intermediate term are:

 

  1. An additional round of property market tightening. To recap the recent developments, MOHURD has been investigating local authorities on their potentially lax implementation of the existing nationwide curbs to housing transitions and mortgage lending. Additionally, the latest statistics indicate serious froth in the property market at its most basis levels:
    • Municipal residential land sales (to property developers) are up +26% YTD through AUG;
    • The average price per square meter has increased +43% over that same period, bringing total land sale proceeds for municipalities to 816.5B CNY YTD (+80% YoY);
    • The average starting price at residential land auctions has increased +16% in the YTD and final sale prices have exceeded initial asking prices by +25% on average in the YTD;
    • In MAY ’11, the land ministry required all municipalities to report land sales when the final sale price was +50% higher than the starting auction price… there were 115 such transactions in 2Q13 vs. only 50 in 1Q13 and the average premium on those transactions was +142%!
  2. A negative revision to China’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 don’t know, but it is likely that we will have to wait until NOV’s Third Plenary Session to find out.

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - 7

 

Of course, one of, neither of or both of the aforementioned risks may materialize. We have no edge beyond stating that both are likely more probable than consensus may realize. This is the primary reason we are not outright bullish on China at the current juncture in spite of the developing intermediate-to-long-term bull case we have expanded upon in this note.

 

One of the things we’ll monitor to determine whether or not it’s an appropriate time to A) buy China outright or B) trade it with a bullish bias 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).

 

THE DEVELOPING BULL CASE FOR CHINA: PROGRESSING - China SHCOMP

 

Specifically, a close above that level would be akin to receiving a second quantitative “thumbs-up” (i.e. no more lower-highs) in our playbook (the first being the recent TREND line breakout).

 

Darius Dale

Senior Analyst


QE: Visualizing the Markets Vote

The Fed kept its level of asset purchasing unchanged because it was worried about the level/trajectory of growth and inflation. 

 

Ironically, but not surprisingly, the effect, from a market perspective, has been the opposite of that intended. 

 

Inflation expectations have rolled over, slow growth exposure has outperformed and pro-growth leverage has been marked lower alongside treasury yields, the yield spread and the dollar.    

 

No particularly groundbreaking analysis here, just a quick visual illustrating the market vote on the Feds decision. 

 

Perhaps the Pavlovian response to stimulus policy has officially faded and consensus is coming around to the point we’ve been harping on all year:  #StrongDollar + #RatesRising both reflects and helps perpetuate sustainable real growth, and vice versa.  The graphic below, unfortunately, reflects the “vice versa”. 

 

To Growth,

- Hedgeye Macro

 

QE: Visualizing the Markets Vote -  Un Love Triange 2


JCP: WE'LL TAKE THE OTHER SIDE

Takeaway: Not particularly a high-quality 'feel good' call, but everything has a price. We'll take the other side of today's JCP sell-off.

Editor's note: What follows below is a brief, complimentary excerpt from a report just issued by Hedgeye Retail Sector Head Brian McGough. It comes on the heels of J.C. Penney's shares' precipitous plunge to 13-year lows. To learn more about how to subscribe to McGough's  "Hedgeye Retail Pro" research please click here.  

 

JCP: WE'LL TAKE THE OTHER SIDE - jcp

Bottom Line 

We’re buyers of J.C. Penney (JCP) on today’s sell-off. Let’s be clear about what kind of call this is, because it’s definitely not for the faint of heart.

 

We still know nothing about the long-term strategy or upcoming management transition, and are still living with the balance sheet baggage from the past two years.

 

This is a company with no square footage growth, where the average consumer could care less if it exists or not. (Sounds great, huh?).  But everything has a price.  And at $10, way too much credence is being given to the ‘terminal’ call.

 

We can say a lot of bad things about JCP, but we definitely don’t think it is terminal and our recent work suggests that much of the business lost is definitely recoverable.

 

As it relates to liquidity, we think that the only reason why the company would act now is to ensure that it has the best pool of CEO candidates possible (questions around liquidity would otherwise weed out the best candidates).


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JCP: We'll Take the Other Side of Today's Sell-Off

Takeaway: Not particularly a high-quality 'feel good' call, but everything has a price. We'll take the other side of today's JCP sell-off.

Conclusion: We’re buyers of JCP on today’s sell-off. Let’s be clear about what kind of call this is, because it’s definitely not for the faint of heart. We still know nothing about the long-term strategy or upcoming management transition, and are still living with the balance sheet baggage from the past two years. This is a company with no square footage growth, where the average consumer could care less if it exists or not. (Sounds great, huh?).  But everything has a price.  And at $10, way too much credence is being given to the ‘terminal’ call. We can say a lot of bad things about JCP, but we definitely don’t think it is terminal and our recent work suggests that much of the business lost is definitely recoverable. As it relates to liquidity, we think that the only reason why the company would act now is to ensure that it has the best pool of CEO candidates possible (questions around liquidity would otherwise weed out the best candidates).

 

1) Some Consumer Insights From Our Recent Survey Work

  • Our recent survey work of JCP’s customers suggests that they left (or are spending less) for reasons that are fixable. Such as a) poor pricing, and b) lack of sales/promotions…

JCP: We'll Take the Other Side of Today's Sell-Off - chart1
  

  • Consumers noted, on the whole, that they will return to JCP if these items are fixed.

JCP: We'll Take the Other Side of Today's Sell-Off - chart2

  • Another big negative… elimination of exclusive brands like Arizona, St. John’s Bay, etc…

JCP: We'll Take the Other Side of Today's Sell-Off - chart3

 

  • Consumers went to KSS and M more than any other retailers. We think KSS (which got about 19% of JCP’s business lost) will be particularly easy to target for customer re-acquisition. We’re talking about $800mm.

JCP: We'll Take the Other Side of Today's Sell-Off - chart4

 

2) Gross Margin: Don’t underestimate the GM opportunity here. Johnson took away $2.5bn in revenue at 48% GM%, and substituted it it with under $1bn of revenue at 33% GM%. That’s a 500bp opportunity right there.

 

JCP Historical Gross Margin Change

JCP: We'll Take the Other Side of Today's Sell-Off - chart5

JCP: We'll Take the Other Side of Today's Sell-Off - chart6

 

3) Liquidity: Our analysis (below) suggests that JCP’s liquidity will definitely be tight – starting in about 6 quarters – but will not crimp its ability to self-finance its recovery. The company has in excess of $1bn of sources to monetize before tapping capital markets (which is not included in the analysis below).   Here’s a catch: They’re searching for a CEO. Having a cash-filled balance sheet broadens the pool of candidates. As such, they might tap markets simply to get the right talent on Board.
JCP: We'll Take the Other Side of Today's Sell-Off - chart7

 

4) Re today’s price movement: Five things combined to create the massive sell-off you see today.

  • A research firm came out today saying JCP 3Q sales are weak and that the company won’t comp in 4Q
  • JCP in court today for MSO/M case – something that absolutely no longer matters.
  • CEO Ullman is having a meeting with a broker today
  • GS Hi Yield analyst out last night saying that equity is worthless
  • Zerohedge glomming on to the fact that GS profited from the JCP secured term loan that it issued (and currently holds) in April, and now it is trying to make money on the other end while it pushes for JCP to file.

 


McCullough: Bernanke Channels Nero

Takeaway: This is the first 2013 US stock market “correction” that I will not be buying because of Ben Bernanke.

Editor's note: Forbes published an opinion piece written by Hedgeye CEO Keith McCullough earlier this morning. The following is an excerpt. Please click on the link at the conclusion to continue reading.

 

McCullough: Bernanke Channels Nero - im1

 

Central planners have been clipping coins and devaluing the The People’s hard-earned currency for at least two thousand years.  The Roman Emperor Nero of course devalued the Roman currency for the first time in the Empire’s history.

 

...If you don’t understand the history of un-elected politicians devaluing currencies, you have some reading to do. Most people who aren’t paid not to “get” it understand this now. Self-education is the best long-term path to avoid becoming a lemming.

 

Look, I’m not that smart. Most people who have seen my SAT scores would agree. But I work hard and I recognize that Mr. Market is a very smart cookie. What I tend to get on a lag, is what Mr. Market is telling me to get. Unlike our Fed Chief, I don’t wake up every morning trying to bend economic gravity.

 

Ben Bernanke believes he can “smooth” gravity, economic cycles, etc. He’s basically telling the entire bond, currency, and stock markets that they are all wrong. So let’s stop, rewind the tapes and go to the score – what have markets done since Bernanke decided not to taper?

 

Click here to continue reading on Forbes.

 

McCullough: Bernanke Channels Nero - im2

(Image courtesy of the Bureau of Labor Statistics)

 


BOOK REVIEW: ANTIFRAGILE

Takeaway: Buy the book. A must read.

I’ve had many of you ask me for my thoughts on Nassim Taleb’s latest risk management book, Antifragile. So, in the spirit of the main criticism I’d give the book (it’s repetitive), here are some brief notes (< 1000 words = Top 50 highlights):

 

Summary Thoughts

  1. He doesn’t like academic/unaccountable government policy. Neither do I.
  2. He likes the recent work of Dan Kahnemann (Thinking, Fast and Slow). So do I.
  3. He’s transitioning from market practitioner to philosopher. I wouldn’t do that.

Bottom line: Buy the book. A must read as we continue to narrow the gap between Chaos Theory and Behavioral Finance.

 

BOOK REVIEW: ANTIFRAGILE - antif

 

Content Highlights

 

  1. “I’d rather be dumb and antifragile than extremely smart and fragile” (pg 4) Wall St “smart” is changing
  2. “anything that has more upside than downside from random events is antifragile; the reverse is fragile (pg 5)
  3. “This is the tragedy of modernity… those trying to help are often hurting us the most (pg 5) #agreed
  4. I.A.N.D (International Association of Name Droppers)” (pg 6) #funny
  5. “academics with too much power and no real downside and/or accountability” (pg 6) #yep
  6. “Less is more and usually more effective”, cites Steve Jobs  (pg 11); good advice, #practice it
  7. “only practitioners (or people who do things) tend to spontaneously get to the point” (pg 13)
  8. “Table 1: The Central Triad (3 Types of Exposures” (pgs 24-27) very #thoughtful/concise on Behavioral Econ
  9. “We are all… similarly handicapped, unable to recognize the same idea…” (pg 39) good pt on #context #bias
  10. “Abundance is harder for us to handle than scarcity” (pg 42)
  11. Equilibrium, Not Again” (pg 60) solid complexity theory (Stuart Kaufman) reference vs #Keynesian
  12. “Leopards… are not instructed by personal trainers on the “proper form” to lift a deer up a tree” (pg 73) #true
  13. “you learn from the errors of others…” (pg 73),  #important lessons, especially on Wall St
  14. National Entrepreneur Day” (pg 79) #Obama, please read
  15. “what is made to fly will not do well on the ground… volatility comes from volare, “to fly” in Latin” (pg 81)
  16. “Nature loves small errors… humans don’t.” (pg 85) #evolve
  17. “those experiencing a brand of variations called chaos can be stabilized by adding randomness to them” (pg 103)
  18. “For a theory is a very dangerous thing to have… Theories are superfragile.” (pg 116) #awesome quotes
  19. “Men feel good less intensely than bad.” (pg 155) good quote by Livy in the context of #Seneca’s thoughts
  20. Seneca’s Barbell” (pg 161) #important pg to read related to your #Cash position and #Drawdown risk
  21. “An agent does not move except out of intention for an end.” (pg 169) #quote from St Thomas Aquina
  22. Convex Tinkering” (pg 182) makes an #excellent risk mgt pt on asymmetry with a picture
  23. “Life is long Gamma” (pg 184) would love to hear the anti-free market #answer to that
  24. “Risk taking ain’t gambling, and optionality ain’t lottery tickets” (pg 185) this ain’t Kansas, and I ain’t Toto
  25. “Few want to jeopardize their jobs and reputation for the sake of change” (pg 192) #truth
  26. “Evolution does not rely on narratives, humans do” (pg 207) #money quote
  27. Table 4: “The difference between teleological and optionality” (pg 214) good thinkers framework
  28. Chapter 15 = “History Written by the Losers” #rant
  29. “The difference between humans and animals lies in the ability to collaborate” (pg 233), bingo #collaboratio
  30. “Nokia … began as a paper mill” (pg 235), #re-learn, find a way to win
  31. “Trial and error is freedom.” (pg 246) #RiskMgt101
  32. “You are taking the joy of ignorance out of out of the things we don’t understand” (pg 253) Fat Tony to Socrates
  33. “What is not intelligible to me is not necessarily unintelligent” (pg 256) #Nietzsche
  34. “It would be like prostitutes listening to technical commentary by nuns” (pg 264) Bernanke, comments?
  35. “Smile! A better way to understand convexity and concavity” (pg 272) #pics summarize hundreds of pages
  36. “Squeezes are exacerbated by size” (pg 279) think #HedgeFundBubble, Short Interest, etc.
  37. “If you have favorable asymmetries, or positive convexity… in the long run you will do reasonably well” (pg 300)
  38. “Innovation is saying no to 1,000 things.” (pg 305) quotes Steve #Jobs again
  39. “we are moving into the far more uneven distribution of 99/1 across many things that used to be 80/20” (pg 306)
  40. “absence of literary culture is actually a marker of future blindness” (pg 314) on some #techies vs the classics
  41. Medicine, Convexity, and Opacity” (pg 337), you can skip this chapter unless you like to rip on doctors
  42. “mention of the fragilista journalists Friedman or Krugman can lead to explosive bouts of anger” (pg 362) #lol
  43. Chapter 23 = “Skin In The Game” (pg 375) 1st three pages and Table 7 of this chapter #excellent
  44. “a person is only as respectable … as the downside he is willing to face for the sake of others” (pg 376) #skin
  45. “you can’t feel insulted by a dog” (pg 380) #woof
  46. “in traditional societies even those who fail have a higher status than those who are not exposed” (pg 383)
  47. “Isn’t this unethical?” (pg 413) crushes Princeton’s Alan #Blinder for his conflicts of interest as an academic
  48. “Everything gains or losses from volatility. Fragility is what loses from volatility and uncertainty” (pg 421) #conclusion
  49. “Prometheus is long disorder; Epimetheus is short disorder” (pg 422) #conclusion
  50. “living things are long volatility. The best way to verify that you are alive is by checking if you like variations” (pg 423)

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