This note was originally published July 25, 2012 at 15:56 in Macro
CONCLUSION: We continue to expect that global economic growth will be skewed to the downside over the intermediate term – both relative to current readings and also relative to currently-elevated expectations. Moreover, we would view the inflationary impact of any incremental LSAP program out of the Federal Reserve as a negative shock to reported growth figures globally – particularly when considering how weak the world economy is currently.
THEMES AT PLAY: Growth Slowing’s Slope, Deflating the Inflation [of Bernanke’s Bubbles], and King Dollar via The Last War: Fed Fighting.
If you’ve been following our highly-differentiated Global Macro research process over the last four years, you’ll know that we rarely anchor on company forecasts for guidance on economic growth. At best, we use them to vet our internal analysis of said trends. The logic behind applying such a limited weight to corporate executive guidance in our process is primarily three-fold:
- Like traditional sell-side economists, corporate executives carry a persistent optimistic bias, which typically leaves them reacting to – rather than preparing for – economic downturns;
- Like traditional sell-side economists, corporate executives tend to streamline current trends into perpetuity when forecasting, often limiting their ability to appropriately risk manage any increase in the probability of exogenous events; and
- Ironically, both entities (sell-side economists and corporate executives) rely on each other’s work in true circular reference nature when developing their own “independent” forecasts.
As previously mentioned, we do occasionally find opportunities to vet our existing conclusions with company results and/or guidance. In this example, we focus on Caterpillar Inc. (CAT), which just reported a positive 11.31% surprise in 2Q EPS ($2.54 vs. $2.28). CEO Doug Oberhelman was particularly pleased with the results (all-time highs in revenues ($17.374B) and profits ($2.54/share)), as indicated in the press release:
- Reaction to Quarter: “I am very pleased with Caterpillar's record-breaking performance in the second quarter.”
- Operating Guidance: “We have narrowed the outlook range for sales and revenues and raised the outlook for profit. The sales and revenues outlook range for 2012 is now $68 to $70 billion with profit of about $9.60 per share at the middle of the sales and revenues outlook range. The previous outlook for sales and revenues was a range of $68 to $72 billion with profit of about $9.50 per share at the middle of the sales and revenues outlook range.”
- Economic Guidance: "While we're expecting a record year in 2012, we understand the world is facing economic challenges, and if it becomes necessary, we are prepared to act quickly as we did in late 2008 and 2009. While we're prepared, the good news is, this doesn't feel like 2008. Interest rates are low, central banks are prepared to inject more liquidity if needed, and housing is coming off lows, not a peak, and seems to be improving… While we will not hesitate to act if we need to, we believe that actions needed for better world economic growth for the future have already begun… I am cautiously optimistic about the world economy in 2013, very positive on the long-term prospects for global growth and excited about the role Caterpillar will play in making that growth happen.”
We on the Hedgeye Macro Team “feel” far less optimistic about their quarter (top line growth slowed; margins compressed) and the slope of global growth over the intermediate-term TREND. As the table below shows (sourced from our 3Q12 Macro Themes slide deck; email us for an updated copy), we remain well below consensus growth estimates for a number of key countries and economic blocs globally.
Jumping back to CAT specifically, we offer the following analysis from our new Industrials ace, Jay Van Sciver, who recently launched coverage of that sector for Hedgeye with his hyper-contrarian bearish thesis on the airlines industry. To the extent you’d like to see more of his work and/or connect with Jay live, please email firstname.lastname@example.org.
- “Despite the move up in CAT today, which we view as short covering driven, weak backlog trends support recent underperformance in the shares.
- Backlogs declined for first time since 3Q 2009, as the company drew down backlogs in today’s “beat.”
- As shown below, months of backlog are highly correlated with CAT’s relative performance.
- Implied orders (estimated as change in backlogs plus revenue) declined 3.0% y-o-y after posting 12.2% growth y-o-y in 1Q2012. That is a significant deceleration.
- Something has to give: orders will need to rebound, production will have to be cut, or backlogs will be drawn down. The current macro data does not suggest a near-term order rebound to us.
- CAT has been one of the primary beneficiaries of what we view as unsustainably high levels of resource capital investment. Slowing activity in China is a risk to mining capital spending.
- Though CAT has an excellent competitive position and a strong franchise, we believe that the shares are overvalued from a cyclically adjusted perspective.
- While the months of backlog is still relatively high, historically that has presented an exit opportunity.
- Implied orders rates now trail revenue, as indicated by backlog declines.”
In looking at their results from my coverage purview (Asia and Latin America), we highlight a couple key negative comments on China that may be flying under the radar to some extent:
- “Construction sales declined in the Asia/Pacific region, where a large decrease in China more than offset increases in other Asia/Pacific countries.”
- “The Chinese government has accelerated policy easing, with its second consecutive interest rate cut in July 2012. Infrastructure spending is running behind the government's target, and we expect the government will introduce supplemental investment programs.”
- “Sales in China were also weak during the second quarter of 2012 and were well below the second quarter of 2011, which was a strong quarter for sales in China.”
- “As we began 2012, our expectations for sales in China were higher, and we built substantial new machine inventory in the first quarter to support what is usually a seasonally strong quarter. First-quarter sales were lower than expected, and we ended the first quarter with higher inventory in China. We developed and are executing a plan for an orderly reduction of China inventory that includes lower production, merchandising programs to improve sales and the export of machines from China to other parts of the world.”
- “We remain very positive on long-term industry growth in China and our strategy to grow our business there. Our plans for the remainder of 2012 reflect an orderly ramp down of production that considers our entire supply chain in China. Given the current low rate of sales and the production ramp down, it will likely take the rest of 2012 to reduce inventory to appropriate levels.”
We highlight the following red flags:
- The large YoY decrease in sales to China “more than offset increases in other Asia/Pacific countries”, suggesting to us that A) demand for industrial machinery in China is outright contracting and B) China, being the economic behemoth that it has become is large enough to offset sales growth from the broader region;
- They, like many sell-side prognosticators (that may or may not service CAT from a banking/advisory perspective), expect China to “introduce supplemental investment programs” (i.e. fiscal stimulus and/or a state-directed lending program). We remain on the other side of this view with respect to the TRADE and TREND durations (see compendium on China below);
- Despite “remain[ing] very positive on long-term industry growth in China” they plan an “orderly ramp down of production” with respect to their “entire supply chain in China” though year-end in hopes of repackaging that product and delivering it to other parts of the world. It remains to be seen if the region can accelerate their demand for industrial equipment with Chinese growth continuing to slow. Given China’s growing role in the industrial supply chain as an end-consumer of raw materials, we’ll take the other side of that bet…
All told, CAT’s results and guidance on China rhymes directly with what we’ve been saying for months now. Moreover, CAT is not the first major industrial company to come out and talk down their Chinese growth expectations in recent weeks:
Sany Heavy Industry Co., China’s biggest maker of excavators, lowered its sales forecast for the equipment as slowing economic growth and government curbs on property market sap demand. Excavator sales may increase 10 percent this year, slower than a previous target of 40 percent, Vice Chairman Xiang Wenbo said in a July 11 interview in Changsha, Hunan province, where the company is based. Sany will still outperform the industry, which may see a fall in demand, he said.
-JUL 13 via Bloomberg Professional
We continue to see signs of slowing growth in Fixed Investment in China (46.2% of Chinese GDP), which being exposed by the accelerated decline in rebar prices, as indicated in the chart below.
Moreover, we can’t stress enough our counter-consensus stance on the outlook for Chinese policy, in that we believe the State Council is no hurry to introduce a meaningful fiscal stimulus package or a large-scale state-directed lending spree over the intermediate term. In fact, we wouldn’t be surprised if they were inclined to tighten the screws on the property market further (pending a potential second-consecutive monthly acceleration in property prices here in JUL). Refer to the following notes for our extended thoughts on the Chinese economy at this critical juncture:
- CHINA’S INCREMENTAL GROWTH SLOWDOWN CONFIRMED (MAY 23): While Deflating the Inflation remains a bullish catalyst for the Chinese economy, the lag between this event and the turn in both the reported growth data and growth expectations may have just increased. As such, we are of the view that waiting and watching for clarity is the best strategy in the immediate term for China.
- As an aside, China’s Shanghai Composite Index remains in a Bearish Formation and is down -9.6% since we put out this initial bearish piece on the Chinese economy in this latest cycle. That is far and away the largest decline throughout the region over that duration and is vastly underperforming the regional median gain of +0.5% (same duration).
- CHINA’S RATE CUT IS LIKELY A BAD SIGN OF WHAT LIES AHEAD (JUN 7): We don’t see the early innings of this Chinese rate cut cycle as a signal to get bullish on China’s economy or equity market at the current juncture. Moreover, we do not find it prudent for investors to increase their asset allocation exposure to commodities here.
- CHINESE GROWTH: STICKING TO THE CENTRAL PLAN (JUL 13): We maintain conviction in our view that Chinese economic growth is not poised to meaningfully inflect over the intermediate term. Furthermore, we can’t stress how much the late-year transition in leadership or the growing official realization that the 2008-09 stimulus package and central plan (i.e. state-directed lending) contributed heavily to a rapid and potentially unhealthy expansion in credit (+96.6% since the end of 2008) may slow Chinese policymakers’ fiscal/regulatory response [if any] to an incremental deterioration in economic growth. Remember, Chinese banks have yet to see a material deterioration in credit quality (the industry-wide NPL ratio is at a measly 0.9%), so it’s not unreasonable to believe that Chinese policymakers could be saving their “bullets” for a potentially more worthy cause than a purposefully-engineered slowdown in Real GDP growth to +10bps above their official 2012 “target” of +7.5% (announced in MAR).
- PONDERING CHINESE GROWTH PART II (JUL 17): Contrary to consensus speculation, we are of the view that Chinese policymakers are likely not readying a stimulus package to be announced and administered over the intermediate term that would be substantial enough to meaningfully inflect the slope of Chinese economic growth. As such, it would be prudent to fade any incremental Chinese stimulus rallies for the time being.
Taking a 30,000 foot view of our active macro themes, a bevy of key economic and financial market data points across the globe have brought forth renewed concerns about the slope of global growth. A few of the more noteworthy recent callouts include:
- The US Treasury 10s-2s spread, a historically reliable leading indicator for the slope of US economic growth, has narrowed in recent weeks to 119bps wide – the tightest spread since JAN ’08!
- Chinese, Japanese, Hong Kong, Thai, and Vietnamese Export growth figures each slowed in JUN (to +11.3% YoY, -2.3% YoY, -4.8% YoY, -2.5% YoY and +15.2% YoY, respectively).
- In the Eurozone, the composite Manufacturing PMI ticked down in JUN to 44.1 from 45.1 (a 3yr-low) and the composite ZEW Economic Expectations Index dropped to -22.3 (the lowest since JAN).
We could continue listing data points, but the point isn’t to belabor what has already been reported; rather, we continue to expect that global economic growth will be skewed to the downside over the intermediate term – both relative to current readings and also relative to currently-elevated expectations.
Moreover, we would view the inflationary impact of any incremental LSAP program out of the Federal Reserve as a negative shock to reported growth figures globally – particularly when considering how weak the world economy is currently. Catalysts on this front include:
- AUG 1: Federal Reserve FOMC Rate Decision;
- AUG 23-25: The annual central bankers confab in Jackson Hole; and/or
- SEP 13: Federal Reserve FOMC Rate Decision.
We conclude this piece with how we started this note – highlighting CAT’s cheery guidance, which anchors heavily on aggressive exceptions that the world’s central planners can and will “save the day” in the near term. Coincidentally, their current outlook in on this topic rhymes a great deal with their mid-2008 outlook – the last time they were forecasting record full-year Revenues and EPS while accelerating CapEx on hopeful expectations of incremental Polices to Inflate:
- 2Q12 Press Release: “Brazil started easing monetary policy with lower interest rates in late 2011, and we are now seeing improvement in our business there. China has started taking action, and we expect that further monetary easing and investment initiatives in China should help economic growth in late 2012 and 2013… It will likely take some time for the Eurozone to fix its problems, but we expect that monetary easing by the European Central Bank, a commitment to resolve debt issues and more focus on economic growth should help stabilize the situation and lead to better prospects in the future… Eventually, we expect the U.S. Federal Reserve will resume expanding its balance sheet…”
- 2Q08 Press Release: “Eventually central banks [in developed countries] will return to cutting interest rates… Many developing countries are experiencing increased inflation, and some have tightened economic policies. However, most counties have moved cautiously, and policies remain expansive. We expect strength growth in construction to continue… Strong sales outside North America are being driven by solid economic growth in the developing world, continued investment in infrastructure throughout much of the world and commodity prices for metals, minerals and energy levels that encourage our customers to invest.”
The moral of this story is rather simple: don’t get caught offsides by buying into corporate hope.