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ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET?

Takeaway: Our LONG “New China” vs. SHORT “Old China” theme is working and should continue to deliver alpha over the intermediate term.

CONCLUSIONS:

 

  1. We continue to see evidence that confirms our view that China’s credit-fueled fixed-assets investment bubble is firmly in the process of popping. Furthermore, this unwind will remain a growing headwind to Chinese GDP growth for the foreseeable future (CLICK HERE for more details).
  2. Such confirming evidence underpins our long-held view that China’s growth potential and its demand curve for certain resources (namely commodities) is structurally impaired – thus necessitating a commensurate shift in the way investors should seek to allocate capital to China plays.
  3. As such, we see value in being exposed to our LONG “New China” (i.e. growth in the consumer and services sectors + broad deregulation) vs. SHORT “Old China” (i.e. the concomitant bubbles in credit and fixed assets investment + anti-pollution regulation) theme. For equity investors, this equates to being exposed to Chinese technology and consumer staples names on the LONG side and exposed to Chinese financials and industrials names on the SHORT side. We also see value in being exposed to foreign companies with “New China” exposure on the LONG side.
  4. Switching gears, we continue to think Chinese economic growth will go from slowing to stabilizing to accelerating throughout 1H14; we lack conviction in our (or any) 2H14 outlook for Chinese growth amid policy uncertainty on the economic reform front (more details below).
  5. Make no mistake, however, if China can’t “comp” ridiculously easy growth compares with clear signs of #GrowthAccelerating in 1H14, we think Chinese real GDP growth has downside to the mid-to-low 6% range by year’s end. That would represent a material delta vs. current consensus estimates of +7.4% YoY real GDP growth in 4Q14 and would obviously have broad negative implications for a variety of asset classes (particularly emerging market assets and commodities).

 

Today, China released its DEC credit data. Headline total social financing figures were solid sequentially, but all was far from well underneath the hood:

 

  • DEC Total Social Financing:flat at +1.23T CNY MoM
    • New CNY Loans:+482.5 CNY MoM vs. +624.6B prior
      • Ratio: 39.2% of the total in DEC vs. 50.7% in NOV; 51.4% in 2013 vs. 52% prior
    • Non-Traditional Credit (TSF less CNY and FX Bank Loans, Net New Corporate Bond Issuance and New Equity Capital Raised): +553.5 CNY MoM vs. +377.9 prior
      • Ratio: 45% of the total in DEC vs. 30.6% in NOV; 29.9% of the total in 2013 vs. 23% of the total in 2012
    • Total Social Financing: +9.7% YoY in 2013 vs. +22.9% YoY in 2012 vs. -8.5% in 2011
    • New Loans: +8.4% YoY in 2013 vs. +9.8% YoY in 2012 vs. -6% in 2011
    • Non-Traditional Credit: +42.8% YoY in 2013 vs. +43.2% YoY in 2012 vs. -29.7% in 2011

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Nominal TSF Q

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Nominal TSF Y

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - TSF YoY Q

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - TSF YoY Y

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - TSF Ratio Q

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - TSF Ratio Y

 

The demonstrable ramp in non-traditional (a.k.a. “shadow”) financing speaks volumes to our long-held view that perpetually rising NPLs have clogged traditional credit channels in China – forcing both corporations and lenders to find creative (and often convoluted) ways to maintain financial lubrication throughout the economy.

 

While this creativity has offset some of the downward pressure on Chinese economic growth over the past 2-3Y, it has dramatically increased system-wide financial risks and has effectively tightened monetary conditions by giving less creditworthy borrowers and institutions a seat at the table (side note: SOE and government borrowers are the only entities in China with access to cheap capital via bank loans; everyone else must scramble to find capital from whatever source at whatever cost they can find).

 

As a result, we’ve seen a demonstrable rip in borrowing costs all throughout the Chinese economy that has weighed on economic growth amid what we believe to be rising quantities of traditional financing that are coming due without the necessary cash flows to retire the debt – essentially financing debt rollovers at the expense of net new credit growth (see: “Key Problem Loan Areas” chart below). Consider the following data points:

 

  • Almost 22% of the 17.89 trillion CNY ($2.96 trillion) of local government financing vehicle debt outstanding comes due in 2014. Local government debt overdue at the end of June was 1.15 trillion CNY, or 10.6% of borrowings, according to National Audit Office data… Meanwhile, the rate on AA-rated five-year notes  jumped +146bps in the past year to a record 8.3%; that compares to a TTM rise of +104bps to 5.2% for Bloomberg’s EM USD Corporate Bond Index. Most local government financing vehicles are rated AA in China. (sources: China Daily, StreetAccount and Bloomberg News)
  • Liabilities at non-financial companies may rise to more than 150 percent of gross domestic product in 2014, raising default risks, according to Haitong Securities Co. The ratio of 139 percent at the end of 2012 was already the highest among the world’s 10 biggest economies, according to the most recent data. That compares with 108 percent in France, 103 percent in Japan and 78 percent in the U.S., figures from the Bank for International Settlements and the World Bank show. (source: Bloomberg news)
  • China Cinda Asset Management, one of the nation's four state-owned bad-loan managers, raised $2.4B in Hong Kong's biggest IPO in a year as it prepares to take on more distressed assets. The IPO will help Cinda to profit from a new round of non-performing loans following a $6.5 trillion lending spree since the end of 2008. Non-performing loans at Chinese banks increased for an eighth consecutive quarter in Q3 to 563.6B CNY ($93B), extending the longest streak in at least nine years. (source: StreetAccount)

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Shadow Banking

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Rates

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Key Problem Loan Areas             

 

Perhaps most importantly, it is our view that the aforementioned phenomenon will remain a structural headwind to Chinese GDP growth. The good news is that, for whatever reason – be it policy guidance or the pervasive extrapolation of recent trends – consensus is now squarely in our camp with respect to structurally depressed expectations for Chinese GDP growth.

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - GDP Growth

 

As such, we continue to believe that investors should not be looking to passively allocate assets to China as a play on elevated rates of economic growth – especially if expectations for the second derivative of GDP are set to remain in negative territory on a structural basis. Rather, we continue to call for investors to #GetActive with their China exposure.

 

One of the ways we think investors should be actively managing their China exposure is by being LONG “New China” plays and SHORT “Old China” plays. For equity investors, this equates to being exposed to Chinese technology and consumer staples names on the LONG side and exposed to Chinese financials and industrials names on the SHORT side. It’s worth noting that on an equal-weighted basis this strategy is up +2,039bps since we introduced it on 12/4/14. This is obviously net of transaction costs and we are fully aware these aren’t investable indices; still, we think the takeaway is clear.

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Long New China vs. Short Old China

 

Another way investors can play our LONG “New China” vs. SHORT “Old China” theme is by being LONG foreign companies with material exposure to the growth of the Chinese consumer and service sectors. The following table is a screen of US, German, UK and Japanese equities (i.e. the four developed markets we like on the long side of equities here) above $10B in market cap that attribute > 33% of their sales to China. Obviously not all companies break out their revenues by geographic segment, but this is a good starting place for those that do. QUALCOMM Inc. looks very interesting from a valuation perspective and, to a lesser extent, so does Murata Manufacturing Co. Ltd.

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Equity Screen

 

Thus far, the focus of this note has been from a strategic asset allocation perspective. In adopting a more tactical purview, we continue to think Chinese economic growth is slowing and we think it is likely to continue to slow for the next 1-2M.

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Market Based Leading Indicators

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - PMI Manufacturing

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - PMI Services

 

From there, Chinese growth should stabilize and then accelerate throughout the balance of 1H14. A favorable base effect, easing money market conditions and seasonality are all supportive of an acceleration in Chinese GDP growth in 1H14.

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - GDP Comps

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - Money Markets Monitor

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - GDP Seasonality

 

ARE YOU LONG “NEW CHINA” AND SHORT “OLD CHINA” YET? - CHINA

 

It’s tough to have a strong view beyond that given the continued lack of clarity on the economic reform implementation front – though the latest signs are indeed positive. Specifically, Shanghai FTZ capital account reform is likely to come as soon as 1Q14, per the latest official commentary (click HERE, HERE and HERE for detailed explanations on why that is the most important catalyst for a positive upside surprise with respect to Chinese GDP growth over the intermediate-term TREND and long-term TAIL).

 

Make no mistake, however, if China can’t “comp” ridiculously easy growth compares with clear signs of #GrowthAccelerating in 1H14, we think Chinese real GDP growth has downside to the mid-to-low 6% range by year’s end. That would represent a material delta vs. current consensus estimates of +7.4% YoY real GDP growth in 4Q14 and would obviously have broad negative implications for a variety of asset classes (particularly emerging market assets and commodities).

 

The analytical table is now set; best of luck risk managing your China exposure(s) from here. Feel free to ping us with follow up questions.

 

Have a great evening,

 

DD

 

Darius Dale

Associate: Macro Team


A Notorius Nikkei/Yen Correlation

Takeaway: Correlation matters.

We've been banging the Japanese gong a lot lately. For good reason.

 

Take a look at the -0.97 long-term TAIL correlation trending between the Yen and the Nikkei.

 

Pretty remarkable.

 

A Notorius Nikkei/Yen Correlation - If You don t know

 

The Yen had its first down day of consequence versus the US Dollar yesterday. Guess what happened?

 

Of course. The Nikkei jumped +2.5%.

 

Correlation matters.

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Questions for Kinder Morgan (Edition 2)

The Kinder Morgan complex (KMI, KMP, and EPB) is scheduled to release 4Q13 results at 4:05pm EST TODAY, closely followed by its quarterly conference call at 4:30pm EST.  Here are some questions that we hope the management team will address:


1.  What are KM's long-term distribution/dividend growth targets for KMP, EPB, and KMI?


2.  Why not amend KMP’s Partnership Agreement to include sustaining/replacement CapEx for E&P, coal royalty, G&P, and shipping businesses?  This seems appropriate given that these businesses were not in KMP when the Partnership Agreement was put in place, and it will protect the LPs from dilution.


3.  Is KMP seeing cost creep on the growth CapEx side?  KMP’s 2014 growth CapEx guidance of $3.6 billion was higher than we were expecting.  What is this attributable to?


4.  With respect to the recently acquired Jones Act tankers, how will KMP account for sustaining CapEx on those assets?  Will there be a replacement CapEx reserve to reflect the fact that the tankers will one day need to be replaced?  Why or why not?

 

5.  Discuss KM's appetite for additional shipping acquisitions/investments.


6.  In KMP’s Natural Gas segment, how much CapEx was spent on midstream (gathering and processing) in 4Q13?


7.  Over the long-term, how much capital would KMP need to spend on an annual basis to keep gathering throughput and NGL production flat (including CPNO)?


8.  Given the cost cuts (O&M expenses and maintenance CapEx) on the major El Paso systems since the acquisition, do you expect that those savings will be passed on to the consumer via rate reductions at EPNG and TGP?  When are those pipelines up for rate cases?

 

9.  Discuss contract renewal risk on KMP’s major natural gas transmission systems.


10.  How does KMP define "capacity" in its E&P operations?


11.  How much CapEx does KMP need to spend in its E&P operations in 2014 to “keep production flat” with the 2013 exit rate?


12.  How is the St. John's Dome project (CO2) going?  How much capital has been put into the project to date?  Discuss the well results.


13.  Discuss KM's intentions with respect to investing in “coal / other natural resources.”  How much capital will be dedicated to this effort?  What has been done so far?

 

14.  More importantly, how will KM define sustaining CapEx for this business?  Will there be a replacement reserve to reflect the fact that these will be depleting assets? 

 

Kevin Kaiser

Managing Director

 

 

 



Stay the Course: Long LO, Short PM

The year has kicked off with big news this week that Suntory is buying BEAM for $16B. Not to mention Constellation Brands (STZ) up on a rope – already +15% YTD on strong earnings results.

 

We would like to take a moment to briefly reiterate that we are sticking with two of our highest conviction Consumer Staples investment ideas from last quarter (originally published on 11/29/13).

 

Long Lorillard (LO) and Short Philip Morris (PM).

 

From a sector perspective and based on our quantitative levels, Consumer Staples is trading bearish TRADE and bullish TREND. This implies a favorable outlook over the intermediate term, based on the current price level.  XLP was up 23% in 2013, and as the chart shows, has traded largely sideways over much of the past 2 months.

 

Stay the Course: Long LO, Short PM - z. xlp

 

We think valuation is still stretched for the group at 18.9x, or 2 standard deviations above the 5 year historical average. But we remain committed to bringing you alpha-generating investment ideas on the long and short sides this year. 

 

Stay the Course: Long LO, Short PM - z. staples PE

 

Lorillard (LO)we are staying long with the dominant player in menthol. The stock was up 32% last year and its FY 2014 P/E of 13.8x trades at a slight discount to its peers average of 14.3x. We believe its advantaged portfolio and growth strategy should continue to drive the stock higher this quarter.

 

Some key points:  

  • Outperformance based on an advantaged cigarette portfolio and leading share in the e-cig category.
  • Continued strong demand for its full-flavored offerings and dominant share of menthol (~85% of its portfolio). Both are contributing to volume outperformance versus the industry (in the last quarter LO’s vol. +3.5% versus industry’s avg. -4%).
  • Growth in menthol supported by positive demographic shifts to the menthol category:
    • According to 2012 data from the National Survey on Drug Use and Health (NSDUH), over the last decade, the number of adult African-American menthol smokers has increased at a 2% CAGR, and at a 7% CAGR for Hispanics.  As of 2012, this equates to 84% of African-American smokers smoke menthol; the figure for primary menthol smokers among Hispanics is 47%.
    • Over the last decade, the adult African-American smoking population has increased at a 0.4% CAGR, whereas the adult Hispanic smoking population has increased at a 0.3% CAGR. We expect these trends to continue which should support the outperformance of LO’s menthol portfolio.
  • We’re bullish on Lorillard’s rollout of “Newport Gold” – a non-menthol compliment to “Red.”
  • We expect the FDA to punt on banning menthol cigarettes over the intermediate term given the lack of definitive and recognized studies that menthol is more harmful than non-menthol cigarettes. We also believe that the EU Parliament’s decision to ban menthol does not provide a useful guide to FDA policy given the sheer market size difference (Menthol = 31% of the U.S. cigarette market vs. 1-2% in Europe).
  • E-cigs: Lorillard was the first Big Tobacco company to market with the acquisition of “Blu” branded e-cigs in April 2012 for $135MM.
  • Despite only representing 4.9% of the portfolio, in Q3 Blu saw strong sales growth of 11% quarter-over-quarter (+350% year-over-year) to $63MM.
  • LO CEO Murray Kessler’s e-cig strategy appears to forgo short-term profits for long term gains: he sold e-cigs at break-even in the quarter and was able to boost Blu’s market share to 49% from 40% in the previous quarter. We expect similar trends as LO attempts to capture brand loyalty. Over time, we do think that e-cigs can be margin-enhancing to the combined cigarette category.
  • The company became an international e-cig dealer through its purchase of UK-based SKYCIG in October 2013 for £30MM in cash, plus an additional £30MM to be paid in 2016 based on the achievement of certain financial benchmarks.
  • SKYCIG is a three year old company with ~ 300,000 users in the UK (there exists around ~ 10MM smokers in the country) that also happens to have nearly identical branding to Blu.
  • LO is comfortably trading above our intermediate term quantitative TREND level of support of $48.12.

Stay the Course: Long LO, Short PM - z. lo

 

Stay the Course: Long LO, Short PM - z.price diverg 

 

 

Philip Morris (PM) The company continues to be plagued by a series of material headwinds.

 

To wit: a weak macro environment, challenging FX, excise tax hikes, and volume declines in key geographies. These ought to challenge earnings while the top line is running against a more difficult comp in Q4 and Q1.

 

Some key points:

  • FX: in NOV 2013 the company updated its guidance which reflected a $0.40 2014 EPS FX headwind -- we think this estimate undershoots the weakness in its basket of currencies, in particular those of the emerging market. As an example, over the past 3 month against the USD the Indonesian Rupiah is down -10.8%, the Turkish Lira is down -10.1% and the Yen is down -6.6%!
  • Volume: we expect volume to be impacted by a combination of continued weakness in the macro of core geographies (including the EU that the company expects to be down -7% to -8% in 2014) and an increase in excise taxes in key profit centers. France has been a negative outlier and we continue to believe that the tax policy of President Francois Hollande will impair consumer confidence. We expect Philip Morris has taken much of its pricing and will struggle to stem volume declines.
  • Excise tax: into year-end Turkey announced a tax increase that should equate to hike in retail prices of 6-9%. This in on top of recent hikes in key geographies like Russia (volume impact est. -9% to -11%) and the Philippines (volume impact could be larger than Russia), which should also encourage an uptick in illicit trade.
  • Push to Non-Combustible: we applaud the company’s push in Q4 2013 to accelerate its offerings of non-combustible harm-reduction products, however the initiatives come at a hefty price that we believe will influence the stock on downside over the near-term:
    • The company announced plans in late NOV to accelerate the launch of a non-combustible harm-reduction product to mid-2014 versus previous guidance of 2016/7 at an incremental price tag of $100MM (note: it’s unclear on the form of this product – but suggestive of a category under the e-cig umbrella)
    • In December the company announced that it is acquiring a 20% interest in Russian Megapolis Group for $750M. Longer-term, we believe this is positive for the company (Russia is the world’s second largest market behind China and Megapolis handles 70% of Russia’s cigarette volumes through its distribution agreements).
    • The company announced in late DEC a strategic partnership with Altria (MO) in which MO will make its e-cigs (currently under the MarkTen brand in the U.S.) exclusively available to PM for sale outside the U.S.  Conversely, PM will make available two of its harm-reduction products exclusively available to MO for sale in the U.S. We see this as a win for both parties, especially for MO given PM’s geographic sales stretch and to catch up to LO’s e-cig lead in the U.S. market.
    • The company announced last Friday that it will invest up to €500MM in a reduced-risk product manufacturing facility in Italy, to be operation in 2016 with capacity of 30B units.
  • Taken together, we see 2014 setting up to be a year of investment and 1H results to drag in concert with this investment and the continuation of broader headwinds of FX, excise hikes, and a challenged macro, alongside more difficult top line comparisons for Q4 and Q1.
  • Quantitatively, PM is trading below our intermediate term TREND line of resistance, implying a bearish intermediate term set-up from its current price level.

Stay the Course: Long LO, Short PM - z. pm

 

Matthew Hedrick

Associate


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