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THINKING LIKE A FED HEAD

Takeaway: A strong quantitative argument can be made for the FOMC board to remain on hold throughout the balance of 2013 and throughout 2014 as well.

This note was originally published September 23, 2013 at 18:01 in Macro

THINKING LIKE A FED HEAD - bb1

SUMMARY BULLETS:

  • A strong quantitative argument can be made for the FOMC board to remain on hold throughout the balance of 2013 and throughout 2014 as well. This debate is likely to become increasingly mainstream in the coming weeks and months and will have meaningful implications for the US dollar, US interest rates and global capital and currency markets at large.
  • Investors attempting to get inside of Bernanke's head and/or view the economy as the FOMC board does should arrive at the following three conclusions based on the most recent data:
    • Reported US economic growth is sluggish at best;
    • The labor market has cooled off substantially; and
    • Benign reported inflation will give policymakers ample headroom to continue easing even if the labor market starts to accelerate meaningfully.
  • Regarding the latter point, both St. Louis Fed President James Bullard and Chicago Fed President Chuck Evans (the both of whom are voting members on the FOMC board) have been calling out low inflation as their chief economic concern in recent weeks/months.
  • Our analysis suggests the US economy may have to sustainably record Real GDP growth in the +3% to +3.6% range in order to generate the kind of job creation necessary for the Unemployment Rate to breach the Fed’s 6.5% threshold over the intermediate term (holding flat other factors like the Labor Force Participation Rate).

 

Like most market participants, we were surprised by the Fed’s decision not to taper its asset purchase program last week.

 

In our view, both the pace and slope of economic growth has been solid enough to justify commencing a process of weaning the economy and its capital markets off of  large-scale asset purchases (LSAP).

 

The critical takeaway from the aforementioned statement is not the part about the pace and slope of economic growth; rather, the key element of that declaration was indeed the phrase, “in our view”.  

 

Specifically, “our view” of the pace and slope of economic growth is wholly shaped by leading and concurrent indicators, such as market prices, survey data (such as New Orders PMI readings) and our proprietary analysis of that data (e.g. modeling market prices with Keith’s quantitative risk management levels or something like tracking the YoY % change in Rolling NSA Jobless Claims).

 

Moreover, our process is designed to front-run inflection points in the market(s) and/or policy. Thus, an overt focus on concurrent-to-leading indicators is a prerequisite for any repeatable success in doing so.  

 

The Fed, on the other hand, primarily focuses on lagging economic indicators, like Unemployment, Core PCE and Real GDP. Their primary responsibility is to set monetary policy based on actual – not guesstimated – economic conditions. Thus, an overt focus on lagging indicators is appropriate for their task as it is defined.

 

While we’d certainly prefer they apply more modern-day analytical techniques (i.e. chaos theory, behavioral economics, etc.) to their policy-setting agenda, for the purposes of keeping this note tight, we will temporarily concede to the consensus view among the academic economist community that the Fed should be more measured (i.e. less dynamic) with respect to setting monetary policy.

 

All told, understanding this distinction between what market participants are focused on and what the FOMC board is focused on is critical to appropriately preparing your portfolio for the Fed’s next policy move and, more importantly, the timing therein.

 

Looking at the economy from the Fed’s perspective, it should not have come as a surprise to see them back away from tapering at last week’s FOMC meeting. If anything, their only fault was allowing tapering speculation to percolate throughout the global financial community in the first place!

 

  • In the 12M through 2Q13 (the latest reported figure), the US economy has grown only +1.6% on real basis; that rate of change represents a full standard deviation below the trailing 3Y trend.
  • In the QTD, Nonfarm Payrolls have averaged +136k MoM; that’s nearly one full standard deviation below the trailing 3Y trend (-0.9x) and down sharply from an average pace of +207.3k MoM in 1Q13.
  • In the 12M through JUL ’13 (the latest reported figure), underlying inflation – as measured by the Fed’s preferred measure of Core PCE – has tracked +1.2% YoY; that’s nearly one full standard deviation below the trailing 3Y trend (-0.9x).

 

Investors attempting to get inside of Bernanke's head and/or view the economy as the FOMC board does should arrive at the following three conclusions based on that sequence of data:

 

  1. Reported US economic growth is sluggish at best;
  2. The labor market has cooled off substantially;
  3. Benign reported inflation will give policymakers ample headroom to continue easing even if the labor market starts to accelerate meaningfully.

 

Regarding the latter point, both St. Louis Fed President James Bullard and Chicago Fed President Chuck Evans (the both of whom are voting members on the FOMC board) have been calling out low inflation as their chief economic concern in recent weeks/months.

 

THINKING LIKE A FED HEAD - dale1

 

Absent a dramatic near-term acceleration in core inflation – which is all but impossible given the neutering of consumer price indices in recent decades – the Fed is unlikely to find it appropriate to tighten monetary policy [via tapering… tapering is tightening, FYI] over the next few months.

 

Looking ahead to next year, one really has to see a dramatic acceleration of momentum in the labor market in order for the FOMC board to justify tapering LSAP – irrespective of whomever winds up in charge (no disrespect to Janet Yellen).

 

By our math which looks at the historical relationship between the deviation from trend in MoM Nonfarm Payrolls SA and deltas in the Unemployment Rate SA, the former series would have to average somewhere between +218.1k and +260k for five quarters in order for the latter series to reach the Fed’s 6.5% “target” (FYI, 6.5% is NOT a target for the initiation of tapering, as Bernanke has repeatedly stated in his recent commentary).

 

THINKING LIKE A FED HEAD - dale2

 

Regarding the study, please note that we purposefully decided to cap our study at a 10Y look-back; similar results hold over a trailing 30Y period as well, but we decided to front-run consensus pushback about how the labor market is structurally different today vs. 20Y or 30Y ago. We get it…

 

Moving along, it’s worth stressing that five quarters from now is the end of next year; not ironically, that is exactly when the FOMC board expects Unemployment Rate to hit that level.

 

Of course, maintaining the aforementioned pace of job creation for such an extended period of time would no doubt drag up the average and dampen any future deviations from trend. We understand that and would still expect to see continued improvement in the Unemployment Rate in spite of that – the purpose of this study is simply to gauge what level of economic performance we need to see in order to appropriately front-run the Fed from here.

 

Looking at the historical relationship between the deviation from trend in YoY Real GDP growth and the deviation from trend in MoM Nonfarm Payrolls SA, the former series would have to average somewhere between +3% and +3.6% produce readings in the latter series that are +1x to +2x standard deviations from the trailing 3Y trend. Using the most recent data set to reverse engineer those deviations produces the aforementioned range of +218.1k and +260k.

 

THINKING LIKE A FED HEAD - 2

 

Of course, the pace of job creation isn’t the only factor in determining deltas in the Unemployment Rate; rather, there other key indicators, such as the structurally challenged Labor Force Participation Rate, that are integral components of the calculus.

 

Still, for anyone looking to correlate economic growth to a pace of job creation that is appropriate for the FOMC board to authorize a reduction in its LSAP program, we’d advise anchoring on anything north of +3% YoY. That’s nearly a double from the latest reported rate.

 

We consider it noteworthy that the Fed’s full-year 2014 GDP growth projection is right in line with that rate, effectively confirming that their economic growth expectations are on track for a 6.5% Unemployment Rate target by EOY ’14.

 

Right now, our model can get as high as +2.7% for 2014E Real GDP growth, but that’s not an estimate we would advise lending any credence to at the current juncture. As mentioned our previous works, our predictive tracking algorithm is designed to capture deltas and inflection points on a rolling 1-2 quarter basis. It’s worth nothing that trying to predict anything much further out than that tends to negatively skew the balance between facts and assumptions in any economic model.

 

THINKING LIKE A FED HEAD - USA   ALTERNATIVE SCENARIO

 

Even if the economy can get up to and sustain a +3% rate of growth over the intermediate term, investors must continue to be cognizant of the fact that subdued core inflation will continue to keep the doves on the FOMC board uneasy about the mere thought of tapering – let alone hiking the Fed Funds Rate (which is what they likely intend to do when the Unemployment Rate reaches 6.5%, assuming both reported inflation and inflation expectations are in line with the committee’s +2% objective at that time).

 

Not surprisingly, those market participants closest to the pin-action are already starting to bake this scenario in. The implied probability of the Fed Funds Rate being 0.0% at the DEC ’14 FOMC meeting has increased from 7.7% in early SEP to 25.5% currently. Conversely, the implied probability of the Fed Funds Rate being hiked to 0.75% or 1% at the DEC ’14 meeting has dropped to 7.8% and 1.5%, respectively, from 23.2% and 10.4%, respectively, in early SEP.

 

THINKING LIKE A FED HEAD - 5

 

All told, a strong quantitative argument can be made for the FOMC board to remain on hold throughout the balance of 2013 and throughout 2014 as well. This debate is likely to become increasingly mainstream in the coming weeks and months and will have meaningful implications for the US dollar, US interest rates and global capital and currency markets at large.

 

Have a wonderful evening,

 

Darius Dale

Senior Analyst

 

THINKING LIKE A FED HEAD - 6


CHART OF THE DAY: CHINESE #GROWTHSTABILIZING

Takeaway: On the margin, key initiatives in the Shanghai FTZ reform package are positive for China’s structural economic outlook.

TAKEAWAY: On the margin, key initiatives in the Shanghai FTZ reform package are positive for China’s structural economic outlook.

 

Today, China announced general guidelines for economic and financial market reform within the Shanghai FTZ. On balance, the outline was met with mixed-to-slightly-disappointed reviews from the analyst and financial media community.

 

While regrettably and conspicuously devoid of specific rates, quotas and other metrics that would allow analysts to quantitatively extrapolate the zone’s impact upon the broader Chinese economy, the guidelines were indeed full of key initiatives that we continue to think are positive for China’s TAIL-duration growth outlook via an infusion of capital and liquidity into the nation’s increasingly cash-strapped financial sector.

 

  • Key positives:
    • 18 service sectors will be granted access to private and foreign capital, with financial services being the most important as it relates to Chinese economic growth.
    • “On the condition of effective oversight”, China will allow Chinese banks in the zone to conduct offshore business – essentially allowing them to provide banking services to foreign depositors.
    • “China will push for a full-scale opening of the financial services sector to eligible private capital and foreign financial institutions.” Essentially, this will allow foreign-funded financial institutions to set up banks and team up with private Chinese banks to form joint ventures. Both initiatives will undoubtedly be supportive of increasing the supply of credit to China’s SMEs, which tend to be significantly more productive than their SOE counterparts.
    • Foreign-funded mutual funds will be granted access to operate in China via the Shanghai FTZ. With the securitization of financial assets also being promoted, the presence of foreign-funded mutual funds helps address the elephant in the room surrounding China’s still-developing ABS market (i.e. “who’s going to hit the bid on the bulk of China’s pending ABS sales?”), given that Chinese banks themselves will inevitably find it difficult to broadly offload assets unto one another.
    • While not specific to banking, another pro-growth reform initiative is the implementation of favorable tax policies that seek to boost investment and trade. An example of this is the Chinese government’s plan to make imported capital equipment exempt from taxes within the FTZ.
  • Key negatives:
    • Aside from the fact that it was light on specifics, the fact that the zone “aims to get up to international standards of convenient investment and trade, as well as full capital account conversion in 2-3 years” is disappointing. Why such a long delay? It’s not like this is China’s first rodeo with special economic zones (think: Deng Xiaoping’s Shenzhen success story).
    • Moreover, “creating conditions” to “test” capital account conversion, interest rate liberalization and cross-border use of the CNY is not the same as “proceeding with” any/all of those reforms right off the bat.

 

All told, while not necessarily a game-changer for the broader Chinese economy, we stand counter to the consensus interpretation that today’s announcement of the specific reforms earmarked for the Shanghai FTZ amounts to little more than a policy non-event.

 

Rather, we continue to believe Chinese officials are embarking  on a grand-strategy to [methodically] import foreign capital to offset the structural liquidity headwinds weighing on the country’s financial sector and its economic growth potential.

 

That, on the margin, is positive for China’s structural economic outlook (CLICK HERE for more details).

 

Have a great weekend,

 

Darius Dale

Senior Analyst

 

CHART OF THE DAY: CHINESE #GROWTHSTABILIZING - 1



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JCP Flash Call Invite. Today at 1pm EDT.

Takeaway: Please join us for a flash call on JCP today at 1:00pm. We'll take an in-depth look at why we'd play the other side of the JCP = zero call.

Please join us for a flash call on J.C. Penney (JCP) today, September 27th at 1:00pm EDT. The call will take an in-depth look at JCP and why we would play the other side of the 'going to zero' trade.

 

 

CALL DETAILS

  • Toll Free Number:
  • Direct Dial Number:
  • Conference Code: 798797#
  • Materials: CLICK HERE (slides will download one hour prior to the start of the call)

 

 

We'll Take The Other Side of The 'Going To Zero'  Trade

This is not for the faint of heart, as earnings are non-existent, there's a lame duck CEO, no square footage growth, and the average American probably could care less if JCP exists or not.  But everything has a price - even JCP. 

 

Almost All of Its Problems Are Fixable

Apparel retail might not be the best business in the world, but it is one that allows you to shake the etch-a-sketch clean every 13 weeks.  Our work shows that JCP's problems have been largely due to pricing, lack of promotions, and the omission of product that the consumer had otherwise grown to rely upon.

 

There's a Steep Gross Margin Opportunity

Johnson took away $2.5bn in revenue at a 48% GM, and substituted with less than $1bn of 33% GM product. There's over 500bp in GM recovery right there.

 

This Equity Offering Solved More Problems Than It Caused

As tight as cash seemed to be, JCP did not need this deal now. It was poorly managed/telegraphed. But the reality is that liquidity is no longer a near-term risk.  This makes the 'going to zero' call really tough to play for. It also takes risk of factoring companies limiting goods  out of the equation.  Lastly, it accelerates the quality and quantity  of CEO candidates.

 

Another Way To Play the JCP Recovery is to Short KSS

Our work suggests that KSS stole $800mm from JCP, and there's nothing permanent about that share shift. JCP is gunning for the business, and whether it succeeds or not, it will hurt KSS while it tries.

 

 

CONTACT 

Please email for further details (please note that email will be the best way contact the team).


NKE: Adidas Hates These Guys

Takeaway: Nike is making ailing US retailers as well as its global competitors (aka Adidas) look downright silly.

This note was originally published September 26, 2013 at 20:28 in Retail

What’s there to say about Nike’s quarter? We’re surrounded left and right by weakness in US retail, and yet Nike comes out and prints a quarter of Champions.

 

NKE: Adidas Hates These Guys - nike

 

NKE printed top line growth of 8%, and an acceleration in futures to +10%, with a nice balance of 7% growth in units, and 3% increase in price. We saw +120bp improvement in gross margins, which was far ahead of our above-consensus estimate – as pricing initiatives are being met with very little resistance, and raw materials costs are coming in below plan. SG&A was flat for the quarter, which is largely due to comparisons against event spending vs last year. But still, the growth algorithm is inarguable…sales +8%, gross profit +11%, and EBIT +40%. EPS came in at $0.86, well ahead of our estimate of $0.82 and the Street at $0.78. Inventory looked great as well, growing 6% -- below the rate of sales for the 5th quarter in a row.

 

You might say that Nike naturally sidesteps the US retail malaise due to the fact that it is a global company. But then why did Adidas – its closest global competitor that has a nearly identical scope, reach and mix outside of the United States – put out an announcement on September 20 taking down expectations for the quarter and the year due to weak sales globally, particularly Russia (which Nike highlighted as a strength this quarter), and golf (this was also weak for Nike, to be fair). This juxtaposition simply highlights how well Nike is managed relative to its peers.

 

We’re taking up our estimate to $3.25 for the year (20% EPS growth). We think that Nike is being conservative with its expectation for only 50bps of improvement in gross margins for the year, and although we’ll start to see more normalized levels of SG&A spending, the reality is that a high-single-digit growth rate in sales with 100bp+ in gross margin improvement is nothing to shake a stick at. Mid-high teens EPS growth on top of 25% ROIC makes Nike every bit worthy of its 20 forward multiple (and then some). Nike’s still a core holding any way we cut it.

 

We’ll return with a more thorough deep dive after Nike’s analyst meeting in two weeks. 


A Close Eye on Oil & Bonds

Client Talking Points

OIL

Brent is down -0.5% this morning and testing our long-term TAIL risk line of $108.57 support for the secondtime this week. There’s potential for a big breakdown here if the US Dollar can find a way to fight off Ben Bernanke. Down Oil is obviously a good thing for US consumers and economic growth.

RUSSIA

Make no mistake: Vladimir Putin does not like the Petro Dollar being under pressure. Neither does the Russian stock market. It is down -1.4% this morning leading the losers. It is down at -2.8% year-to-date for the RTSI. You can bet your ruble that I’d like to see more of that.

UST 10YR

The 10-year Treasury yield is still hanging out there in no man’s land at 2.62%. Our TREND support is the line that matters most at 2.55%. The immediate-term TRADE resistance is 2.74% now. Next week's U.S. employment report should be a rather decisive factor in determining where it goes next. We are watching bonds and Ben Bernanke very closely.

Asset Allocation

CASH 49% US EQUITIES 16%
INTL EQUITIES 20% COMMODITIES 0%
FIXED INCOME 0% INTL CURRENCIES 15%

Top Long Ideas

Company Ticker Sector Duration
WWW

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.

HCA

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.

TROW

Financials sector senior analyst Jonathan Casteleyn continues to carry T. Rowe Price as his highest-conviction long call, based on the long-range reallocation out of bonds with investors continuing to move into stocks.  T Rowe is one of the fastest growing equity asset managers and has consistently had the best performing stock funds over the past ten years.

Three for the Road

TWEET OF THE DAY

@KeithMcCullough So much hate against you! You must be doing something right!!! @1ens

QUOTE OF THE DAY

He who lives by the crystal ball will eat shattered glass.
- Ray Dalio

STAT OF THE DAY

A shutdown of the U.S. government would reduce Q4 economic growth by as much as 1.4 percentage points depending on its length, economists say, as government workers from park rangers to telephone receptionists are furloughed. (Bloomberg)


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