“Russia is a riddle wrapped in a mystery inside an enigma.”
In college, I wrote my senior essay on constitutionalism in post-Soviet Russia. It was a great topic for an Ivy League kid and I had the privilege of being advised on the paper by General William Odom, a former head of the National Security Council under Ronald Reagan, and expert on Soviet affairs. Despite my heroic efforts at primary research, the conclusion could have been shorter than a tweet.
Simply put, the rule of law was going to take time, perhaps generations, to take hold in Russia. Unlike the United States and many Western nations, the history of Russia, even before Communism, was one of rule “by law” and not rule “of law”. So, in effect, any new Constitution would simply be viewed by the people as an apparatus by which they were ruled, rather than a document that freed them.
Then, as now, it is impossible to analyze Russian action solely from the lens of the West. Actions which may same outrageous to the West may actually be very subdued to the Kremlin.
A quick review of any major Western media source is that there are two schools of thoughts in analyzing the current situation. The first is that Putin is clearly violating the sovereignty of the Ukraine and will pay for it, likely economically. The second is that Obama has largely been incompetent in dealing with Russia and is in a box because Putin has become his partner, of sorts, on Iran and Syria.
Stepping back though, it is worth viewing this from the Russian perspective. For starters, Crimea, which is and has been recognized as a sovereign part of the Ukraine by Russia, is also the home to Russia’s Black Sea Fleet and will be until 2042 under an agreement between the two countries. It is also a region that is almost 60% Russian speaking and ethnic Russian. So, clearly, the Kremlin has vested interests in the Crimean peninsula.
Meanwhile, in overthrowing President Yanukovych, the Ukrainians overthrew a Russian ally who had been moving further away from the Europe and closer to Russian, including taking a recent $15 billion loan from Russia. The current leadership in the Ukraine also does have some far right-wing elements. Specifically, one of the three main leaders of the protest and the new deputy Prime Minister of the Ukraine, Oleh Tyahnybok, is the leader of the far-right ultranationalist Svoboda party that was allied with the Nazis in World War II. (Tyahnybok has at times blamed the Ukraine’s problems on the “Jewish-Russian” mafia running the country.)
Back to the Global Macro Grind...
Clearly, from a Western perspective neither of the above factors, strategic interests in Crimea or extreme nationalists in the new Ukrainian government, justifies an invasion into sovereign Ukraine. Hence, the West is in uproar and among other things is threatening to pull out of the Sochi G-8 conference this summer and implement economic sanctions. For his part, Putin has towed the line closely in Crimea; there have been no shots fired and little violence. As well, so far, the Russians have not made a move into the mainland of Ukraine.
On some level, Putin also likely respects history. Similar to Afghanistan, Crimea has been a thorn in Russia’s side historically. Russia also fought a war in the Crimea, against a British, French and Ottoman coalition, in the middle of the 19th century. This war was an unmitigated disaster for the Russian Empire, then led by Nicholas I. Not only did Nicholas I not live to see the end of the war, but his successor Alexander II signed the Treaty of Paris and initiated the biggest liberalization campaign in the history of Russia.
Despite the fervor that was brewing on political TV this weekend, the perception based on a poll we took yesterday is that the situation in the Ukraine is actually favoring Putin vis-à-vis President Obama. In fact, 78% of the respondents to our poll said Putin will come out stronger. Napoleon famously said:
“Never interrupt your enemy when he is making a mistake.”
Of course, it begs the question: who is making the mistake?
In all likelihood, the most significant reason that Russia is unlikely to escalate is an economic one. Even as the Russian stock market is rallying this morning (perhaps an indication that the worst is behind us?), Russian asset prices have been decimated. In the Chart of the Day, we show this with a chart of the Russian ruble, which is literally hitting all-time lows. Despite the Russian central bank aggressively raising interest rates by 150 basis points, the ruble continues to be better for sale. Internally, a weak ruble is the worst economic outcome for Putin as it has the potential to drive inflation up dramatically.
Externally, the most significant “river card” Russia has to play is its natural resources that much of Western Europe is dependent on. Last year, Russia shipped 133 billion cubic meters of gas to Europe, including 40 billion to Germany, which was more than 1/3 of Germany’s supply. Ultimately, Russia has become very economically integrated with the West and it is likely this integration that leads to resolution before escalation in the Ukraine.
This all of course reminds me of the following joke:
A Ukrainian immigrant goes to the Department of Motor Vehicles to apply for a driver's license.
He has to take an eye test. The clerk shows him a card with the letters:
C Z W I X N O S T A C Z
"Can you read this?" the clerk asks.
“Read it?" the Ukrainian replies, "Heck, I know the guy!"
Our immediate-term Risk Ranges are now as follows (our Top 12 macro ranges are in our Daily Trading Range product):
UST 10yr Yield 2.59-2.73%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
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TODAY’S S&P 500 SET-UP – March 4, 2014
As we look at today's setup for the S&P 500, the range is 35 points or 1.07% downside to 1826 and 0.83% upside to 1861.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 2.33 from 2.30
- VIX closed at 16 1 day percent change of 14.29%
MACRO DATA POINTS (Bloomberg Estimates):
- 7:45am: ICSC weekly sales
- 8:55am: Johnson/Redbook weekly sales
- 9:45am: ISM New York, Feb. (prior 64.4)
- 10am: IBD/TIPP Economic Optimism, March, est 45.3 (pr 44.9)
- 4:15pm: Fed’s Lacker speaks in New York
- 4:30pm: API weekly oil inventories
- NOTE: Weather may lead to delays, postponements
- President Obama formally submits budget request for FY2015
- Texas kicks off primary season, including Senate vote
- 8:45am: Federation of American Hospitals holds public policy conf., with Senate Finance Cmte Chairman Ron Wyden, House Budget Cmte Chai Paul Ryan, CMS Administrator Marilyn Tavenner
- 11am: House Ways and Means Chairman Dave Camp attends briefing on tax code changes hosted by Institute for Policy Innovation
- 3:30pm: Energy Dept holds FY 2015 budget briefing
WHAT TO WATCH:
- Russia stays in Ukraine, says intervention is legitimate
- Putin scheduled to speak on Ukraine
- Secretary Kerry due to arrive in Kiev today
- Ukraine crisis seen building support for U.S. natgas export
- BOE seeks derivs pact to prevent repeat of Lehman cascade
- Dish gains Web rights to Disney TV shows in multiyear pact
- President Obama formally submits budget request for FY2015
- Pentagon seeks weapons spending $25b less than planned
- Senate banking committee hearing on Fed nominees postponed
- JPMorgan pays $400m to settle Syncora mortgage-bond suits
- Jeep debuting at Geneva auto show is test for Fiat Chrysler
- Rock-Tenn to buy Simpson Tacoma paper mill for $343m
- Patton Boggs hires advisers, says not cutting jobs: WSJ
- Bridgepoint said to seek up to $5.5b for European buyouts
- Alexion’s $569k drug draws data demand from U.K. cost agency
- Glencore CEO sees no roadblock in talks for $5b mine sale
- Facebook said in talks to buy Titan Aerospace: TechCrunch
- Los Angeles poised to restrict $1.5b e-cigarette industry
- Human traders squeezed in Europe as fees dwindle, Tabb says
- ABM Industries (ABM) 5pm, $0.25
- AutoZone (AZO) 7am, $5.56
- Bank of Nova Scotia (BNS CN) 6am, $1.34 - Preview
- Bob Evans Farms/DE (BOBE) 4:02pm, $0.53
- EW Scripps Co (SSP) 7:30am, $0.13
- Insys Therapeutics (INSY) 7am, $0.55
- Smith & Wesson Holding (SWHC) 4:05pm, $0.29
- Veeva Systems (VEEV) 4:02pm, $0.06
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Commodities Slide From Six-Month High as Ukraine Concern Recedes
- Gold Drops From Four-Month High After Russia Military Drill Ends
- Grain Boom Busting Canada Farmers on Clogged Rails: Commodities
- WTI Falls From Four-Month High With Brent as Ukraine Risk Ebbs
- Gold Bulls Run for $1,400 as Ukraine Turmoil Spurs Haven Demand
- Wheat Drops After Surging Most Since 2012 as Russian Drill Ends
- Copper Rises From Three-Month Low on Signs Ukraine Tension Eased
- Ukraine Grain Growers See Threat to Planting as Troops Mobilize
- Iron Ore Cost Curve Shows 98% of World Output Profitable at $118
- Ukraine Crisis Seen Building Support for U.S. Natural Gas Export
- Europe Gas Storage Seen Enough for 45-Day Ukraine Supply Cut
- WTI May Fall to $95 in 2015 as Supply Pace Remains Buoyant
- Platinum Strike Union Softens Pay Demands at Biggest Mines
- Demon Oil Back in Colombian Rebels’ Crosshairs: Chart of the Day
The Hedgeye Macro Team
This note was originally published at 8am on February 18, 2014 for Hedgeye subscribers.
“Most successful pundits are selected for being opinionated, because it’s interesting, and the penalties for incorrect predictions are negligible. You can make predictions and a year later people won’t remember them.”
Last night I gave the keynote presentation at the Trader’s Expo at the Marriot Marquis in Times Square. Prior to giving the speech, I walked around the conference floor and heard a lot of stories of trading systems that would generate ten bagger returns, some that had triple digit positive performance last year, and so on. Clearly, the exhibitors needed to grab people’s attention in order to engage in a sales discussion.
Frankly, compared to some of the presentations, I’m guessing my presentation on the U.S. economy was a tad boring. In my presentation, I gave a quick update on our Q1 Themes and the view that economic growth in the U.S. may be slower than consensus expectations in 2014. Rightfully so, my prognostication, if you want to call it that, raised some questions.
The first question related to the cover of Barron’s this weekend which heralded the potential return of 4% growth in an article titled, “Why the Economy Could Grow by 4%”. The article was, in effect, an interview with a group called Applied Global Macro Research (AGMR), and to be fair they sounded like thoughtful guys, who are clearly an outlier with a 4% growth projection for the U.S. economy.
The question poised to me related to how the Hedgeye view differed from the view on the cover of Barron’s. My response was simple: housing. The economists from AGMR expect housing to be a massive tailwind. In the long run, we get their thesis, but in the short run we see headwinds to housing and this more tepid view on the U.S. economy may, sadly, keep us off the cover of Barron’s this year.
Back to the Global Macro Grind . . .
Speaking of housing, I wanted to touch on a few points that make us incrementally more cautious:
- Mortgage Purchase Applications - This point is highlighted in the Chart of the Day, but at a reading of 171.5 in the MBA purchase index, we are now -22% below the May 2013 peak. Mortgage applications are a direct leading indicator of home purchases and this implies that home purchase are likely to fall a commensurate amount from the peak;
- Pending Home Sales – We view housing as a giffen good and our demand driven model was fairly accurate in modeling the acceleration in housing activity. Alongside the decline in purchase apps, pending home sales are down ~9% year-over-year, which is decidedly negative for forward home price appreciation if price continues to follow the slope of demand;
- Home Price Deceleration - Corelogic home price data show that after last year’s parabolic rise, home price growth has now decelerated for 3 consecutive months; and
- Qualified Mortgages - The new “QM” (Qualified Mortgage) rules that went into effect in January tighten standards and increase culpability for both lenders and servicers. Tighter lending standards will be a drag on aggregate housing activity on the margin – particularly for 1st time home buyers and others with irregular incomes. First time home buyers are ~35% of the market.
In the long run, the housing recovery likely does have legs given the nature of the massive over build and then years of inventory drawdown, but in the short run the headwinds noted above will be important to monitor. The caveat to any view of housing, either negative or positive, is that interest rates will be the biggest driver and if interest rates head meaningfully lower from here (hard to believe that will happen if the taper is in) then our cautious view on housing would likely become more positive.
Speaking of becoming more positive, and I’m not saying we are just yet, but Merrill’s Global Fund Manager Survey came out this weekend and had some interesting contrarian data points. First, cash levels have risen from 4.5% to 4.8%, the highest since July 2012. Second, emerging markets and global energy allocations are at record lows, while global bank allocations are at record highs. Finally, global staples allocations are at the lowest levels since September 2003 (ahead of CAGNY).
It is difficult to put too much credence in a set of data we didn’t create or collect ourselves, but it is certainly worth noting the extremes in the Merrill survey. Much easier to discern is the market based indicators of inflation, which continue to percolate. An extreme example of commodity based inflation domestically is natural gas, which is up almost 30% for the year-to-date.
Less extreme is the pervasive use of natural gas in the domestic U.S. economy. According to the Energy Information Administration, there is almost 25 million MMcf used domestically on an annual basis. If my math is correct that is an almost ~$125 billion input cost into the U.S. economy every year, which is split broadly between heating, residential use and industrial use.
The bottom line is that if one of the key commodity input costs into the U.S. economy is up almost 30% in the year-to-date that, my friends, is inflationary. Although perhaps not quite as bad to the economy, even worse is that a coffee addict like myself has to endure Arabica coffee bean prices up 10% this morning!
Our immediate-term Risk Ranges are now:
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
THE HEDGEYE EDGE
Brief background: Brent Oil is a major trading classification of crude oil and is a benchmark for oil traders globally. Brent is sourced from the North Sea, where it was originally produced in a Shell oilfield named after the Brent Goose (at one time Shell Oil had a policy of naming all of its fields after birds). Brent is classified as sweet crude and contains approximately 0.37% sulphur, but is not as sweet at West Texas Intermediate (WTI).
Historically, Brent has traded at plus or minus $3 versus WTI. Since 2010, that spread has expanded dramatically and Brent has traded at more than a $10 premium to WTI. This widening of the spread between Brent and WTI is attributed to an increase in oil production in North America which has led to a surplus of oil in Cushing, Oklahoma.
Our long thesis for Brent is based on three key factors: expected decline of the U.S. dollar, tightening global oil supply and demand, and a break out in our quant models.
In the past decade, the U.S. dollar has had a consistently negative correlation to those global commodities that are priced in U.S. dollars. Intuitively, this makes sense because as the dollar, or any currency for that matter, is devalued it can buy less of any fixed price physical asset, such as a commodity, that is priced in that currency.
Our interpretation of Chairperson Yellen’s most recent monetary policy comments last week is that the Federal Reserve is likely to continue to debauch the dollar and generate commodity inflation.
Specifically while speaking to the Senate on Thursday, Yellen outlined that the Fed will continue with accommodative policy and in fact halt tapering, making it incrementally dovish, if conditions warrant. On Friday, real GDP for Q4 2013 was revised lower by 80 basis points to 2.4%, which only strengthens Yellen’s dovish case.
On the supply front, the IEA recently indicated that global supplies slid by 290,000 barrels in January. In as much as oil is highly inversely correlated to the U.S. dollar, its price is also driven by supply and demand. Domestically, as stated above, oil production has been accelerating, but the story is very different globally.
On the demand side, primarily due to accelerating economic growth in Europe, the International Energy Administration (IEA) recently raised its global daily demand expectations by 125,000 barrels a day.
As a result of this accelerating demand and declining supply, commercial stocks in OECD countries are at a six year low and saw their steepest quarterly decline in Q4 2013 since 1999. Clearly, the global market for oil is tight and likely to get tighter through 2014 as OECD economic growth maintains its trajectory.
We added Brent Crude Oil (Brent) via the etf BNO to Investing Ideas on February 27th.
INTERMEDIATE TERM (TREND) (the next 3 months or more)
As a result of the dynamics outlined above, Brent Oil broke out above our TREND (three months or more) line of $108.02. Currently, on the same duration, the correlation between the U.S. dollar and Brent is -0.75, so highly inversely correlated.
LONG-TERM (TAIL) (the next 3 years or less)
In our analysis, a tight supply and demand story combined with a dovish Fed make future prices gains in Brent likely. As a result of this accelerating demand and declining supply, commercial stocks in OECD countries are at a six year low and the global market for oil is likely to get tighter through 2014.
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