Takeaway: Inflation is accelerating and we continue to think investors should proactively prepare their portfolios for this economic phase change.
This unlocked research note was originally published June 06, 2014 at 16:58 in Macro
“The Perils of Falling Inflation.” Like clockwork, that phrase was on the cover of the November 9th – 15th issue of The Economist right after headline CPI bottomed at +1% YoY in OCT ’13. Fast forward to today, domestic consumer price inflation – on the government’s conflicted and compromised metric – is running +100% higher at +2% YoY (APR ’14).
Inflation doubled, lol!
Ok, that’s probably not very funny – especially if you’re a consumer that is feeling the pinch of rising inflation. Growth in real incomes in America has slowed from its cycle-peak of +1.3% YoY in OCT ’13 to +0.3% YoY as of APR ’14.
As a late-20s working professional living in Manhattan, I can say honestly that just about everything I buy – from rent, to clothes, to food, even down to the occasional Bud Light – has gone up in price on a YoY basis at rates well north of +2%. Some things, like taxis and train tickets, are tracking up mid-to-high single digits from a YoY rate-of-change perspective. Obviously this is all specific to my consumption basket, but when I speak to people all across the country – be it the cab driver in San Francisco or the Midwestern woman on the plane ride next to me – all everyone wants to talk about these days is how expensive everything has gotten.
Again, anecdotal data is what it is, but I challenge you to find me someone who genuinely believes inflation is running at or below +2% or decelerating. Moving along, here are a few non-anecdotal data points that have hit my inbox in recent weeks (copy/pasted directly from StreetAccount):
Perhaps I’m not alone…
INTERMEDIATE-TERM TREND VIEW
Luckily you, unlike the vast majority of Americans, can do something about it. In line with our #InflationAccelerating macro theme (introduced in JAN ‘14), we continue to anticipate that reported inflation will accelerate throughout 2014. There are three primary reasons we hold this view:
One: Holding current prices flat, the US dollar on a trade-weighted basis will dip into negative YoY territory in 2Q14E and will remain negative through 3Q14E, only returning to marginally positive by 4Q14E. This is a sharp deterioration from the +3-4% trend we’ve seen since the start of 1Q13. That should provide a material shock to the rate of change in import price inflation, which, at -0.3% YoY, is currently accelerating off the lows of late-2013 (-1.8% YoY in NOV).
Two: We do not, however, think it’s prudent to hold current market prices flat. While most of Wall St. continues to anticipate higher rates amid tighter policy out of the Federal Reserve, we believe rising inflation will continue to slow consumption growth at the margins – which is ~70% of US GDP. That, coupled with the precipitous decline in both activity and price appreciation in the housing market, should eventually force the Fed to pare back their guidance on eventual monetary tightening. A cessation of their existing policy to taper is not out of the question by the third quarter. Commodities, which hold a -0.70 correlation to the USD (CRB Index vs. US Dollar Index; trailing 6M), should continue to grind higher. It’s worth noting that the CRB Index is up +9% YTD, besting the sub-6% return for the S&P 500.
Three: If none of our market-based forecasts come to fruition, we still have confidence in CPI accelerating over the intermediate term – if for no other reason than base effects. Without getting too geeked out on differential calculus, “simple” math would suggest that as comparative base rates decline sequentially – which they do throughout the balance of the year – the probability that the rate of change accelerates from the base rate (i.e. t₀) increases substantially.
LONG-TERM TAIL VIEW
In line with our #StructuralInflation macro theme (introduced in APR ’14), we continue to think structural inflationary pressures are building up across the US economy. While we cede the point that considerable slack remains in the labor market, we do not think investors are paying nearly enough attention to the following supply-side pressures that are likely to perpetuate cost-push inflation over the long term:
Buy TIPS. Protect yourself and/or your clients from a likely acceleration in CPI. Please note that we are not making a hysterical call for hyperinflation born out of serial money printing. That’s not our style. Rather, our style is to call it like it is: the US economy is likely to experience a run-of-the-mill pickup in reported inflation. A 3-handle on headline CPI – which remains a conflicted and compromised calculation – is probable over the intermediate term.
Inflation tripling, lol!
Have a great weekend. If you get hungry at the beach, grill an iPad!
Associate: Macro Team
TODAY’S S&P 500 SET-UP – June 11, 2014
As we look at today's setup for the S&P 500, the range is 24 points or 0.81% downside to 1935 and 0.42% upside to 1959.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
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Takeaway: If mgmt blows this shot at redemption, activists should have a field day. We’re all-in on a miss. Risk/reward starting to look really good.
Conclusion: The equity value destruction and erosion in sentiment since LULU’s ‘new CEO party’ in April served as a massive ‘show me’ invitation from Wall Street to LULU management. This is a superb brand that is backed by a sub-par company and lackluster management. A good quarter on Thursday might buy the CEO time before he has to actually articulate a growth plan. But a miss, from where we sit, should trigger more management changes. No change in how this company operates, will likely result in another new CEO six months down the road. For now, we’re actually positively biased on the print. If LULU misses, we’ll likely go all-in. Yes, there are competitive margin pressures. At $75 that was a problem – at $45, not so much. There’s $3.50 in earnings power, and a call option on getting acquired. A sell-off means higher likelihood of change in the C-Suite. The risk/reward here is starting to look really attractive.
To say that this is a critical quarter for Lululemon is an understatement. We wonder if management even knows. The Street is clearly betting against the company, as the stock is down 16% since the analyst meeting, and short interest (24% of the float) is nearly on par with levels (25%) that we saw last Spring when the ‘see thru’ Luon fiasco broke out. Laurent Potdevin has been CEO for a good six months, and although it’s too short a window for even a good manager to be a factor of change, it is certainly soon enough for the company to be articulating its go-forward growth plan. That was the biggest miss back at the analyst event. No strategy. If Potdevin didn’t get the message with how the stock has since reacted, then he shouldn’t be CEO. If he got the message and does not do anything about it, then he shouldn’t be CEO. Shareholders deserve better. It’s pretty simple, actually. Accountability 101.
So…we’ll see on June 12th whether or not Mr. Potdevin ‘gets it’. But the punchline, we think, is that this is one of those situations where, for the most part, ‘good is good, and bad will ultimately lead to good’. Our point is that the company either…
a) meets or beats the quarter, and buys itself more time before it has to show that it has a firm grasp on the long term growth strategy and the capital needed to achieve those plans. = Good Stock Event
b) meets or beats the quarter AND outlines crisp long term growth strategy. = Great Stock Event
c) Misses the quarter and outlines crisp strategy = Neutral Stock Event, depending on the size of the miss
d) Misses the quarter and still comes across as a deer in the headlights as it relates to Strategic Plan. Initial event will be very negative. The Board will have to answer to this – either because an activist says so, or the value destruction is so obvious. = Negative Stock Event leading to a potentially very positive event/change
We’re obviously getting a bit too cute with the outcomes here. But if we see an event that is negative enough for the stock to sell-off in spite of the 26mm shares held short, then we’ll likely go all-in on this one. The reality is that LULU is a great brand, is in a high-growth industry with global appeal and acceptance. Yes, there’s fierce competition and we think that margin expectations are way too high. At $75 that was a problem – at $45, not so much. The growth is there, and those kind of brands don’t come around too often. Even at a 19% EBIT margin (vs 24% last year) we get to $3.50 in earnings power with a call option on being acquired. The issue here is that it is a great brand backed by a sub-par company. That can be fixed.
What change? We still don’t think that the Board’s hiring process for Potdevin was anywhere near as rigorous as it should have been for a company the size of LULU. That said, we don’t think that his perceived failures to date are entirely his fault. He has extremely poor support in the C-Suite, particularly his CFO. In our opinion, John Currie was a great CFO when LULU was sub $500mm in sales 5-years ago. But he’s not the guy to be building a world class finance organization for a company that is $1.5bn in revenue that should have a plan to get to $5bn. It’s not his fault, per se, but the fact of the matter is that things like Finance, Strat Planning, and building the organizational depth of a world class company were never a priority at LULU. That’s common for many early cycle companies. But it needs to become a priority here. If Currie can’t do it, then Potdevin will be on the hook for things that are not within his skill set. Ultimately, LULU needs to turbocharge how it plans its business and match what is a limited capital budget to an unlimited number of growth opportunities. Potdevin has what is likely another six months to get this right. If not, we wouldn’t be surprised to see another new CEO.
Takeaway: Credit card loan growth appears to be quietly accelerating. COF remains one of our favorite names on the long side.
What Once Was Old ...
We haven't written about the Federal Reserve's G.19 consumer credit report in ages, and that's because there's been nothing to say. U.S. credit card loan balances have been muddling sideways at a 0-1% rate of growth for the last two and a half years. But in the last two months there's been an upturn, and suddenly it looks like it might be interesting.
One of our guiding principles is that we try and take note of inflection points in the rate of growth, i.e. the second derivative, since it's these second derivative changes that precipitate changes in the multiple.
Along those lines it's interesting to take a step back and consider whether the sleepy credit card space may have just entered such an inflection point.
On Friday afternoon of last week the Fed released its G.19 report for the month of April and it showed that US revolving consumer credit balances rose at a month-over-month annualized rate of +12.3%, the fastest rate of growth in, well, a really long time. In fact, you'd have to go back to the early/mid 1990s to revisit that rate of growth on a sustained basis. To be fair, we've followed the G.19 data for years and, speaking from experience, it's a very choppy and often-revised data series. We wouldn't get overly excited about it but for the fact that Capital One's numbers for the month of April also reflected a sharp upturn in the rate of growth in US credit card receivable balances.
We should know more on Monday next week when we get the May data from the various credit card companies.
In late January we issued a report arguing investors should get long Capital One following the 4Q earnings "blow-up". Our analysis showed that there was a quantifiable advantage to owning shares historically from the late January through mid-July timeframe. This owes largely to the fact that, like a clock, Capital One misses the 4Q numbers and beats the 1Q numbers every year. Our original intention was to exit the long trade ahead of reporting 2Q numbers, but now that growth is starting to show signs of life we may be interested in extending our duration. We'll know more on Monday.
On a separate note, we just couldn't resist the temptation to flag the unstoppable force that is student loan growth in this country. The chart below, also taken from the G.19 data, shows the amount of federally-backed student loans sitting on the books of the United States. Currently the figure stands at $775 billion, up $112 billion (+16.9%) in the last 12 months. For those wondering why there seems to be no recovery in the first time homebuyer market we offer the chart below as "Exhibit A".
Joshua Steiner, CFA
Jonathan Casteleyn, CFA
Last Friday we hosted a call with Diplomat-In-Residence at Yale, Charles Hill. A replay link is included below along with a brief summary:
Prior to his current position as professor of Grand Strategies, Charles Hill has held a number of posts including but not limited to the following:
On a high-level Professor Hill touched on four major geopolitical hotspots and painted a clear picture of a somewhat opaque interconnectedness between the four:
As a precursor to Professor Hill’s view of the current geopolitical reality, he described the differences in the current dynamic from the Cold War:
Throughout the Cold War, there were three main centers of influence:
Our current globalized society has now shifted into an entirely different but by no means antonymic world:
Russia: Russia has suffered an identity crisis after the desecration of traditional Russian values from years of communist experimentation during the cold war. Attempts to return to a more democratized society over the last decade have been largely unsuccessful. Putin has addressed this situation by combining communism with, more traditional, pre-communism values.
Putin’s intent is to take advantage of an apparent deterioration in the power of the nations that have sat atop of the current international system. The takeover of Crimea and involvement in Eastern Ukraine is a violation in and of itself, but the fact that Russia is infiltrating into eastern Ukraine in guerilla-like fashion confirms the speculation that he believes the current structural foundation, dominated by the West and EU, is highly vulnerable.
Syria: Russia has both supplied a helped strengthen Assad's regime in Syria. A Russian intelligence agenda has taken deliberate steps to obstruct those in opposition. With this direct involvement, Russia is gaining leverage in the Middle-East. The Arab Spring movement in 2011 was suppressed with deadly violence and terrorism. A more-traditional, Islamist movement into Syria led by Al-Queda influence has succeeded with brute force and terrorism. This radical camp is gaining steam in Iraq, Iran, Lebanon, and Syria. The militarism that has signified the Assad regime is being legitimized as the international community has been largely unsuccessful in intervening.
Iran: Iran has played the international scene perfectly by building nuclear capabilities while adhering to the minimal requirements of remaining a part of the U.N. The Iranian government has taken a revolutionary roll to help Assad remain in power and free itself of nuclear sanctions (November 2013). In a sense they are opposing the order of the structural foundation of today’s international law while still remaining a part of it.
China: China faces a severe identity crisis with the experimentation of communism and capitalism. Recent moves in the East and South China Sea prove that, like Russia, they believe the current structural foundation of a world policed by the United States and Western Europe is badly bruised. Other than the verbal disdain over Chinese strategy in the Senkaku Island dispute, Washington has been largely unresponsive to China’s direct violation of international law, especially as it pertains to the more recent moves (i.e. planting an oil rig in Vietnamese waters).
Conclusion: The global powers in charge of the international state system are being directly challenged, and if the current trend of structural deterioration continues, we will see a shift to a much different world. The flourishing globalized economy is going to be effected if this current system is uprooted. The maintenance of an international network dominated by computers has not been kept up, and the threat of an attack in this channel is ever-increasing.
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