March 19, 2014

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The Horror

Client Talking Points


It's mere scraps for the 2013 Nikkei bulls... The Nikkei up only +0.36% overnight (it's down over -11% year-to-date). The Yen remains strong versus US Dollar ahead of Fed Chair Janet Yellen’s first official Dollar Devaluation statement. Meanwhile, Japanese Government Bond yields are down to 0.60% on the 10-year as Japanese growth slows. Things could be better.



There's a horrifying setup ahead of the Fed's “qualitative rate guidance” (i.e., price fixing the long-end of the curve as inflation expectations rise). Sure, it may be good news for the stock market short term, but Burning Buck remains the single, biggest long term TAIL risk to the US economy. In other words?Watch out.


The only good economic news here is that options bets are way net long crude oil in the face of a TREND breakdown (+432,820 net long futures/options contracts). Oil needs to go a lot lower from here to become a consumption tax cut. But at least it's not going up. That's a start.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

Construction activity remains cyclically depressed, but has likely begun the long process of recovery.  A large multi-year rebound in construction should provide a tailwind to OC shares that the market appears to be underestimating.  Both residential and nonresidential construction in the U.S. would need to roughly double to reach post-war demographic norms.  As credit returns to the market and government funded construction begins to rebound, construction markets should make steady gains in coming years, quarterly weather aside, supporting OC’s revenue and capacity utilization. 


Darden is the world’s largest full service restaurant company. The company operates +2000 restaurants in the U.S. and Canada, including Olive Garden, Red Lobster, LongHorn and Capital Grille. Management has been under a firestorm of criticism for poor performance. Hedgeye's Howard Penney has been at the forefront of this activist movement since early 2013, when he first identified the potential for unleashing significant value creation for Darden shareholders. Less than a year later, it looks like Penney’s plan is coming to fruition. Penney (who thinks DRI is grossly mismanaged and in need of a major overhaul) believes activists will drive material change at Darden. This would obviously be extremely bullish for shareholders and could happen fairly soon driving shares materially higher.


We remain bullish on the British Pound versus the US Dollar, a position supported over the intermediate term TREND by prudent management of interest rate policy from Mark Carney at the BOE (oriented towards hiking rather than cutting as conditions improve) and the Bank maintaining its existing asset purchase program (QE). UK high frequency data continues to offer evidence of emergent strength in the economy, and in many cases the data is outperforming that of its western European peers, which should provide further strength to the currency. In short, we believe a strengthening UK economy coupled with the comparative hawkishness of the BOE (vs. Yellen et al.) will further perpetuate #StrongPound over the intermediate term.

Three for the Road


TREASURIES: 10yr 2.67% hasn't moved vs 24hrs ago - still pricing in US #GrowthSlowing  @KeithMcCullough


"Try not to become a man of success, but rather try to become a man of value." - Albert Einstein


A new £1 coin, billed by the Royal Mint as the "most secure coin in the world", is to be introduced in 2017. The move comes amid concerns about the 30-year old coin's vulnerability to counterfeiting, with an estimated 45 million forgeries in circulation. The Royal Mint, which believes 3% of existing £1 coins are fake, said the move would increase "public confidence" in the UK's currency and reduce costs for banks and other businesses. (BBC)

Voodoo Accounting + Face Tattoos

This note was originally published at 8am on March 05, 2014 for Hedgeye subscribers.

“Reality is wrong. Dreams are for real.”

-Tupac Shakur

My colleague and energy Sector head, Kevin Kaiser, approached me in the office the other day and told me that he had a disconcerting dream about me.  It turns out the dream itself wasn’t all that crazy, but was simply that I decided to get a Mike Tyson-esque face tattoo.  My takeaway was that Kaiser was probably just spending a little too much time on MLP accounting.


Incidentally we are still short Kinder Morgan (KMI) and Linn Energy (LINE) on our Best Ideas list.


In tribute to Kaiser’s dream, though, I’ve included as the Chart of the Day below an exhibit from his most recent note on LINE.  The exhibit shows the actual free cash flow from every quarter in 2013 as well as his projected 2014 free cash flow.  Admittedly, free cash flow might be a bit of a misnomer as cash flow is actually decidedly negative.


Voodoo Accounting + Face Tattoos - ironmike 

In fact, in 2013 free cash flow (defined as discretionary cash flow less cap-ex and contribution to JV) was negative $-374 million.  In 2014E, we are projecting free cash flow of negative $-132 million.  An astute analyst might actually note that at least the free cash flow deficit is improving, which is true if you believe LINE’s guidance.  The bigger issue, though, is one of distributions.


Based on current guidance, LINE will be paying right around $960 million in distribution in 2014E.  How does a company that has negative $-132 million in free cash flow pay almost $1 billion in distributions you might ask?  Well, in this instance, we can only assume that either they are going to issue massive amount of debt and new shares (they already have $9.1 billion in net debt), or as the famous American poet Tupac said in the quote above ...dreams are for real.


(Incidentally, you can rest assured that I won’t be getting a Mike Tyson face tattoo anytime soon!)

Back to the Global Macro Grind ...

Speaking of dreamland, President Putin proved yesterday that he may not actually be living in one based on his press conference to discuss Russia’s actions in Crimea.  We wrote in yesterday’s Early Look that Putin’s ambitions may not actually be as grandiose in the Ukraine as many in the manic media would have us believe.  In fact, it seems the key take away from the rambling press conference is that Putin has no intention to use force and is merely protecting legitimate Russian interests in the region.


The broader take away from this incident may actually be its impact on President Obama and, by default, the Democrats heading into the mid-term elections next fall.  As I wrote yesterday, we did a poll in which the results indicated pretty decisively that Putin would come out as the stronger leader and it seems this is certainly the case.  The New York Post (admittedly a Republican leaning newspaper) made an apt analogy between Obama and Jimmy Carter this morning in an op-ed in which they wrote:


“Vladimir Putin has taken the measure of Barack Obama. He’s found Jimmy Carter.


Like Jimmy Carter, who boasted he was free of any “inordinate fear of communism,” Obama began his term as president vowing to “reset” relations with Russia.


Like Jimmy Carter, who conveyed weakness when Iran took our embassy staff hostage, Obama confirmed his own weakness when he drew a red line in Syria and then backed down from enforcing it.


Like Jimmy Carter, who was rewarded by Leonid Brezhnev with a Soviet invasion of Afghanistan, Putin has returned Obama’s favor with a Russian invasion of Ukraine


And just like Carter, who responded with what his staff called “a strong public statement,” Obama responded with his own statement saying he is “deeply concerned” by Russia’s military movement in Ukraine.


As in the Carter era, Obama-era defenders of inaction suggest there is little they can now do to get Russia out of Crimea. They are likely right.”


Now whether Obama is truly a foreign policy comrade (for lack of a better word) of Jimmy Carter, or the NY Post is actually living in Republican dreamland, is certainly up for some debate.  But there can be no question that that is something that Republicans will push aggressively into the upcoming mid-terms, especially if the Russians remain in Crimea.


Even before the Ukrainian situation, President Obama’s approval rating was doing the Democrats no favors.   Since last summer, the last time his approval rating was higher than his disapproval rating, his rating has turned negative and decidedly so.  Based on the current Real Clear Politics poll aggregate, Obama’s disapproval rating is 52.7 for an almost 10 point spread versus his approval rating of 43.1.


In other news in the world of dreams, the Chinese this morning may be experiencing their first corporate bond default ever.  Specifically, Shanghai Chaoroi Solar announced it won’t be able to pay roughly $14.6 million in interest on a bond issue from two years ago.  It is likely too early to tell whether this is the canary in the Chinese debt coal mine, but one thing is for certain - the Chinese GDP target of 7.5% will be a mere dream if the $1.5 trillion Chinese corporate bond market starts to shake.


Conversely, the European economic recovery seems much less of a dream as PMI data accelerated to 32-month high 52.6 versus 51.6 prior. Additionally, European retail sales came in at a better than expected +1.3% year-over-year gain versus an expected decline of -0.4%.  When combined with the fact the periphery yields are now near all time lows, as evidenced by the Spanish 10-year yield ticking lower ahead of tomorrow’s auction, it may be time to do more than dream about the European revival.


Our immediate-term Risk Ranges are now as follows (our Top 12 macro ranges are in our Daily Trading Range product):


SPX 1848-1875

VIX 13.14-15.92 

USD 79.81-80.46 

Brent 108.05-111.85 

NatGas 3.79-5.09

Gold 1316-1351 


Keep your head up, stick on the ice and dream big,


Daryl G. Jones

Director of Research


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Wednesday, March 19

  • Galaxy Entertainment:  FY 2013 annual results, +1, Pin 705014
  • iGaming North America 2014 thru Friday, Planet Hollywood Las Vegas

Thursday, March 20

  • None       

Friday, March 21

  • None       

Monday, March 24

  • None       

Tuesday, March 25

  • CCL to report earnings pre-market, conf call at 10 a.m. EDT




MGM – established a marketing alliance with the United Auburn Indian’s Thunder Valley Casino in California. The agreement will give reciprocal benefits for each MGM’s and the United Auburn’s loyalty programs.

Takeaway: Companies claim there have been tangible benefits from these relationships. MGM has a similar agreement with PNK.  It hasn't really shown up in the numbers yet as gaming revenues have been under pressure nationwide.


MPEL – City of Dreams' House of Dancing Water theater will host the Asian Film Awards, known as the Oscars of Asia on March 27 and is promising "the most spectacular and grandest edition ever."   This will be the 8th edition of the Asian Film Awards which is organized by the Hong Kong International Film Festival Society. 

Takeaway:  Another example of a property trying to expand their marketing effort beyond gaming while also bringing positive media and public relations to their property.


CCL – is offering a new travel agent promotion, where the company is waiving its initial deposit requirement for group bookings, as well as offering an enhanced free cruise berth program, through April 30, 2014. Through the new promotion, no initial deposit will be required for group bookings on sailings departing between Nov. 1, 2014 and April 30, 2015 and CCL is offering travel agents one free cruise berth for every 10 full fare guests berthed, compared to the current policy of one free cruise berth for every 15 full fare guests berthed. 

Takeaway:  Could this be a new form of competition for agent bookings? 




Macau Smoking - the Macau Health Bureau has accepted the suggestion by the six casino operators that smoking zones in mass gaming halls be scrapped and replaced with smoking rooms without slot machines or gaming tables. The government has decided to apply the new arrangements first to the 14 casinos and slot machine parlors that failed two rounds of tests of the air quality in their smoking zones last year. The new arrangements would allow VIP gaming rooms to still have smoking zones where gamblers could continue playing

Takeaway: The smoking restrictions have clearly had little impact on Mass gaming revenues.  Protecting the VIPs ability to smoke is crucial.


South Florida Gaming – State of Florida regulators denied a request to move a non-profit, pari-mutuel permit associated with Gulfstream Park race track from Hallandale Beach (Broward County) to a downtown Miami (Dade County) location. The ruling effectively blocks Genting from starting a stand-alone casino as Genting sought to decouple the racing & pari-mutuel betting from the more profitable gambling, slot machine and poker play, which a Florida pari-mutuel permit allows. 

Takeaway:  Does the three strikes rule apply to casino development?   Maybe South Florida doesn't want commercial gaming after all.  


New York Panel Named – Governor Cuomo's appointments for the panel that will choose operators and locations for the state’s new casinos have been identified.  The appointees include: a former city comptroller William Thompson, Hofstra President Stuart Rabinowitz and gubernatorial adviser Paul Francis.

Takeaway:  I'm sure this will be an above board decision making process and the best bid will win regardless of political connections.


Suffolk County OTB – Suffolk Off-Track Betting Corp. has finalized a deal with a Buffalo-based gaming company to run a planned casino with 1,000 electronic slot machines, with the company providing up to $65 million in upfront financing and guaranteeing at least $58 million in revenue over the next decade. Delaware North Companies Gaming and Entertainment Inc. in November beat out seven other companies for the right to develop and manage Suffolk OTB's casino.  Seperately, Nassau OTB is negotiating on three or four locations for its 1,000 video slots, said president Joseph Cairo and he expects to determine a location within 30 to 60 days.

Takeaway:  Once Suffolk OTB opens, we will get a better view of Resorts World New York (Genting) player affinity as well as potential cannibalization from increased competition. 




PKF revised lodging forecast – The March 2014 edition of PKF Hospitality Research, LLC's "Hotel Horizons" forecasts the U.S. hotel industry occupancy rate will recover to pre-recession levels in 2014. With occupancy levels rising, hotel managers should be able to become more aggressive with their pricing. PKF-HR is forecasting ADR to increase by 4.9 percent in 2014 and another 5.7 percent in 2015.  Strong increases in lodging demand continue to support the supply growth that is occurring. PKF-HR is forecasting the number of accommodated room nights in the U.S. to increase by 2.6 percent in both 2014 and 2015. With demand growth outpacing supply, the national occupancy level will continue to increase through 2015. 

Takeaway:  Lodging is a later economic cycle investment theme and goes hand-in-hand with Hedgeye's macro policy themes. We remain constructive on the lodging names, particularly HOT, and would be buyers on weakness.


Venice Lifts Cruise Ship Ban – A government decree that took effect in January that banned all cruise ships from passing through the canals because of the risk of damage to the ancient channels. But the administrative court of Venice accepted an appeal by lobbyists, including the city's port, and suspended the ban because of ‘the absence of any practical alternative navigation routes’.  During 2013, more than 600 cruise ships bearing 1.7 million passengers visited the Venice harbor.



Hedgeye remains negative on consumer spending and believes in more inflation.  Following  a great call on rising housing prices, the Hedgeye Macro/Financials team is turning decidedly less positive. 

Takeaway:  We’ve found housing prices to be the single most significant factor in driving gaming revenues over the past 20 years in virtually all gaming markets across the US.


Summary Bullets:

  • Housing’s Pull:  Inflation in Owners Equivalent Rent/Shelter have almost single handedly buttressed headline inflation growth over the last year.
  • What if Housing Rolls?  The Fed faces a Sisyphean inflation battle if the slowdown in housing drives deceleration in Shelter price growth
  • Inflation Percolation:  Food & Energy Costs are taking a rising share of consumer wallet, but moderate inflationary pressures continue to hold in the largest part of the economy
  • Vicious Policy-Price Cycle: A material, policy driven acceleration in food and energy inflation only serves to slow inflation adjusted growth – particularly in a world of sub-trend credit and nominal wage growth.   
  • Fed Front Running:  Investor positioning into slowing growth and the expected, reactionary policy response has become largely Pavlovian & the dollar continues to breakdown and commodities breakout.



“If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”


In you're unaware, that perfectly imprecise line of questioning, asked as part of BLS’s monthly price survey process, drives the calculation of “owner’s equivalent rent” and singularly represents approximately one quarter of the index used to calculate CPI inflation in the United States.   


Calling out the sweeping subjectivity inherent in the domestic survey methodology is trivial at this point, but I still find it rather remarkable and worthy of a re-highlight every once in a while.   


What hasn’t been trivial is the impact of owner’s equivalent rent on the reported inflation figures. 




Owner’s equivalent rent (OER) carries a 23.9% weighting in the CPI index as of the latest reading while Shelter more broadly, which also includes insurance and housing fuels and utilities, carries a 32% weighting. 


What’s notable is that over the last year, the ongoing acceleration in OER and Shelter inflation has almost singularly buttressed headline inflation growth. 


The chart below shows YoY growth in CPI Shelter vs. CPI All Items ex-Shelter.   As can be seen, the divergence between the two measures has shown ongoing expansion over the last 3 quarters – a trend which extended itself in February with CPI Shelter flat sequentially at +2.6% YoY while YoY growth in CPI Ex-Shelter decelerated 60bps sequentially to just +0.5% YoY, its second lowest print since the end of the recession.






PADDLING UPSTREAM: DOMESTIC INFLATION - Owners Equivalent Rent Contribution



Shelter and OER inflation is generally pretty sticky but 100bp moves in the rate of change of growth over a 12 month period aren’t abnormal.   Housing activity has already begun to slow and home prices generally follow the slope of demand on a 12 to 18 month lag. 


While the relationship between growth in shelter inflation and growth in home prices isn’t overly tight (and we need to do more work on this), it’s probably more reasonable to expect a material slowdown in home price appreciation to drag on shelter inflation than not. 


In the chart/scenario analysis below, we show the trajectory for headline CPI growth over the next 10 months under a scenario of decelerating Shelter CPI growth. 


Specifically, we’ve assumed CPI All-items ex-Shelter continues to grow at its TTM average of +0.9% over the balance of 2014 while CPI Shelter decelerates 100bps ratably, from +2.6% to +1.6%, over that same period.    


Obviously, any number of scenario iterations can be envisaged, but under a scenario of modest deceleration in Shelter inflation, headline CPI growth would struggle to stay north of 1% over the remainder of 2014. 







Food & Energy costs have been the notable positive diverger, taking a greater share of consumer wallet YTD as protein and fuel cost have tracked back towards peak 2011 growth levels.   


However, pockets of inflation have been percolation eslewhere as well despite the broader disinflationary trend.   


CPI Services growth continues to hold above 2% and the growth trend looks similar even if you strip out the Shelter and Energy components of the Index.  On a YoY basis the slope of Services price growth is slowing, but it continues to accelerate on a 2Y basis. 


We’d argue that the 2Y comps generally offer a cleaner read on the Trend rate of improvement as outlier impacts and odd comp dynamics get smoothed, but the read through is somewhat equivocal here. 


The general takeaway is that the headline inflation figures modestly belie more moderate inflationary pressures in the largest part of the economy.







With the Fed rhetorically abandoning their 6.5% unemployment target, we’ve received the first tangible confirmation of what everyone already intuitively knew – namely, that  data dependence and forward guidance can’t credibly co-exist.   


With the fed broadening its “qualitative” focus across a broader swath of labor market data, talk of an inflation floor or other more inflation specific guidance is also likely to emerge as the Yellen transition matures. 


If rent inflation decelerates alongside the slowdown in housing, it will become increasingly harder for the Fed to achieve its stated inflation target.  To the extent they implement incremental easing to help combat another round of disinflation, it’s likely to perpetuate further speculative investment in hard commodities and other currency debasement and inflation hedge assets.   


Unfortunately, a material, policy driven acceleration in food and energy inflation only serves to slow inflation adjusted growth – particularly in a world of sub-trend credit and nominal wage growth.   




#InflationAccelerating:  Base effects alongside the combination of investors/$USD front-running a rhetorical shift in policy as the slope of domestic growth slows anchored our 1H14  #InflationAccelerating call. 


Investor positioning into slowing growth and the expected, reactionary policy response has become largely Pavlovian.     


With the dollar in bearish formation (Broken TRADE/TREND/TAIL) and back near 52-week lows, slow-growth equities leading (Utilities outperforming consumer by >900bps), and Gold and the CRB Index outperforming almost every other asset class  YTD at +13% and +8%, respectively, investors again appear to be (attempting) to front run the Fed.  







Christian B. Drake


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