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SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES?

Takeaway: Both our quantitative signals and fundamental research support buying China here. This stance is in stark contrast to our previous view.

INTRODUCTION

Last week, we put out a note titled “REITERATING OUR RESEARCH VIEW ON CHINA” in which the conclusion read: “Recent economic data supports renewed optimism across Chinese capital markets, but we don’t think improvement in the former is sustainable.” While we weren’t wrong on the stocks per se (fortuitously, we never developed enough conviction in our fundamental view to recommend shorting China), that was still the wrong call to make.

 

Specifically, our latest analysis of the many puts and takes throughout the Chinese policymaking spectrum leads us to believe the current acceleration in growth is sustainable for at least one more quarter (the jury is still out for 4Q14E).

 

That being said, we weren’t necessarily wrong to believe that the “mini stimulus” efforts out of Beijing in recent months would result in a marginal-at-best boost to growth. What we missed, however, is that Beijing’s spate of efforts would send a shockwave throughout the various layers of Chinese policymaking.

 

In particular, a rash of expansionary fiscal policy at the local government level would suggest that there is significantly more stimulus hitting the Chinese economy than meets the eye at the current juncture. This is in stark contrast to the headline guidance out of the State Council and PBoC, which continues to downplay the likelihood of a major shift in monetary or fiscal policy.

 

Essentially, what Chinese policymakers are doing is stimulating growth behind the scenes while protecting their credibility in light of the 2009-10 four trillion CNY stimulus package that more-or-less got them in the current mess to begin with.

 

POLICY: BULLISH

Again, there are a lot of moving parts here, so we’ll do our best to summarize the many stimulus efforts introduced throughout the Chinese economy of late:

 

  • Early-APR: the State Council pledges to accelerate railway construction and investment in public housing
  • Late-MAY: the State Council gives the go-ahead to launch targeted RRR cuts to enhance financial support to the “real economy”
  • JUN 9: the PBoC announces a -50bps RRR cut for banks that focus on lending to the agriculture sector and SMEs, as well as for those engaged in various forms of consumer finance (e.g. automobile financing)
  • JUN 10: Premier Li pledges to “intensify fine-tuning” and make [additional] “targeted changes” in policy
  • JUN 12: following up on his recent pledge, Premier Li announces that the government will boost public investment in the Yangtze River Basin, while lowering tax rates for some utility companies
  • JUN 12: Huang Min, head of the fixed-asset investment department at the National Development and Reform Commission (NDRC) reiterates the public sector’s commitment to investing in Chinese infrastructure, while also soliciting private investment (63% of all FAI in 2013) for 80 major projects
  • JUN 30: the China Banking Association (CBA) “affirms” that the PBoC will continue with “slight loosening” of monetary policy throughout the year
  • JUN 30: the China Banking Regulatory Commission (CBRC) made some changes to its loan-to-deposit calculus in a move to free up incremental capital for traditional credit expansion
  • JUL 4: the China Securities Regulatory Commission (CSRC) announces that it will approve 100 IPOs through DEC at about ~20 per month – a move that effectively forces the PBoC to maintain relaxed liquidity conditions, as IPO gluts tend to freeze up capital across the Chinese banking system
  • Mid-JUN: Premier Li convenes eight provincial governors and majors in Beijing to discuss the current economic situation, concluding that “downward pressure [on the economy] is still considerable… we should not ignore the challenges and risks” “I took his remarks as criticism,” said Heilongjiang Governor Lu Hao
  • JUN 25 though mid-JUL: the State Council sends a total of eight inspection groups to 27 ministerial departments and 16 provinces and municipalities… determining whether or not local governments did a good job of stabilizing growth was among the top priorities for the inspectors… Yang Chuantang, head of the inspection group, subsequently states that, “Local governments should step up pro-growth efforts and strive to accomplish this year’s target and lay a solid foundation for years to come.”
  • JUL-to-date: in responding to Premier Li’s call to action, the Hebei province rolled out a series of preferential policies, including increased land supply, streamlined approval procedures and tax cuts, to support a variety of strategic emerging industries… the Heilongjiang province implemented similar measures to support its service sector

 

If you analyze any one of these measures in isolation, you’ll likely end up where we were prior to today: not all that impressed with China’s stimulus efforts. Analyzing them in conjunction, however, leads one to believe that there are indeed meaningful stimulus efforts being implemented across China’s state-run economy.

 

It’s worth remembering that mainland China has 32 provincial-level administrative units: 23 provinces, four municipalities (Beijing, Tianjin, Shanghai, Chongqing) and five autonomous regions (Guangxi, Inner Mongolia, Tibet, Ningxia, Xinjiang). In extrapolating the stimulus efforts of Hebei and Heilongjiang throughout the entire country, it’s easy to arrive at the aforementioned conclusion.

 

Is this trend of “mini stimulus(es) = major stimulus” sustainable enough to chase?

 

For now the answer is, “yes”. Real GDP growth was tracking at +7.4% YoY (i.e. only ~10bps south of the official target) when the bulk of these measures were rolled out, so perhaps policymakers want to see a meaningful acceleration in growth before they pull back on the stimulus reins. Moreover, CPI tracking well south of their official +3.5% YoY target in the YTD would seem to suggest they have plenty of scope to do so.

 

SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES? - CPI

 

That being said, annualized currency weakness and easier policy should support a marginal acceleration in inflation from here.

 

SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES? - FX

 

SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES? - CHINA

 

But perhaps the real reason Chinese policymakers were content to ease monetary and fiscal policy of late was to shore up the country’s crashing property market.

 

Along those lines, many local governments have taken matters into their own hands by easing home purchase restrictions (27 of 46 cities did so yesterday). Moreover, last week’s statement out of the Ministry of Housing and Urban-Rural Development (MOHURD) would seem to suggest that such easing in property markets at the local level have the official blessing of Beijing as well.

 

This is a major positive given the dour nature of China’s property market trends. New home prices fell in 55 of the monitored 70 cities last month – the most since JAN ‘11 when the government changed the way it compiles the statistics. This data point followed earlier data which showed a continued sharp deterioration in property price trends nationwide:

 

  • JUN E-House Home Price Index (288 cities): 5.3% YoY from 5.8% prior
    • Prices of new homes in 288 cities fell -0.1% MoM in JUN, the third sequential decline in a row
  • JUN China Real Estate System Index (CREIS) Home Price Index (100 cities): 6.5% YoY from 7.8% prior
    • Average prices in the 100 biggest cities fell -0.5% MoM, the second consecutive sequential decline

 

Such targeted easing measures have indeed stabilized China’s property market – albeit at brutal levels of new investment (i.e. land areas purchased and housing starts), demand (i.e. value and volume of building sales) and confidence (i.e. CREIS Real Estate Climate Index). Supply growth (i.e. housing completions) continues unabated, but that should slow in the coming months with decelerating units under construction and contracting levels of new investment.

 

SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES? - CHINA Property Market Monitor

 

Lastly, there are two more things to note as far as sustainability is concerned:

 

  1. Land sales account for nearly 60% of local government fiscal revenue, which means China’s local governments will likely need to dramatically accelerate the pace of [now-contracting] land sales to keep pace with all their spending
  2. China’s labor market remains in contraction territory from a PMI perspective; the latest reading of 48.6 compares to a TTM average of 48.7 and is supportive of the view that Chinese policymakers may need to “do more” to ensure their labor targets are being met

 

QUANT: BULLISH

In our investment framework, which anchors heavily differential calculus and prospect theory, going from “absolutely horrendous” to merely “really bad” is bullish insomuch as going from “bad” to “good” is. This is especially true when the quantitative signals support it – which they now do for China in both of our proprietary risk management models.

 

Looking to Keith’s factoring of price, volume and volatility, the Shanghai Composite Index has now undergone a bearish-to-bullish TREND reversal and is threatening to do the same on a long-term TAIL basis as well:

 

SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES? - 5

 

Looking to our TACRM system, I’ve had the “great pleasure” of being told that “Old China” exposures (i.e. the CHIX and CHXX) were “BUYS” every day since JUL 3rd. Base metals, which remain overexposed to China from a marginal demand perspective, have been signaling “BUY” as well in recent weeks.

 

SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES? - TACRM Heat Map

 

In spite of these signals, however, I chose to anchor on my existing fundamental research view on China, which obviously did not rhyme with what the market was signaling. Classic rookie mistake. Now, we are content to let the market dictate our interpretation of China’s macro fundamentals.

 

***CLICK HERE to learn more about TACRM’s world-class signaling capabilities***

 

GROWTH/INFLATION/POLICY TRENDS: BULLISH

Having spent my entire analytical career at Hedgeye, I have not yet had the opportunity to develop some of the more traditional skills in the sell side research toolkit, such as storytelling about “feel” and “valuation”. Instead, we’re confined to storytelling about slopes, deltas and inflections in the data – which is exactly what the following table attempts to supplement:

 

SHOULD YOU CHASE THE RALLY IN CHINESE EQUITIES? - CHINA High Frequency GIP Data Monitor

 

The key takeaways to highlight from this table are:

 

  • The positive % deviations from the 3M, 6M and 12M trends in the preponderance of China’s PMI data
  • The two latest (i.e. JUL) data points show flat-to-mid-single-digit improvement relative to their 3M and 6M trends
  • Specifically, the JUL flash Manufacturing PMI data came in at an 18M-high, with the New Orders, New Export Orders, Backlogs of Work, and Quantity of Purchases sub-indices all showing sequential accelerations
  • Chinese credit growth is accelerating markedly (the JUN Total Social Financing figure was the fast rate for any JUN since 2009) without capital inflows, which are now a net negative and well shy of its 3M, 6M and 12M trends
  • Growth in sovereign fiscal expenditures is accelerating materially relative to its 3M, 6M and 12M trends
  • The sovereign budget balance has now swung squarely into deficit territory, and should generally remain there given that Chinese deficit spending tends to be back-half loaded
  • While the rate of liquidity provision has come in of late, the PBoC is still pumping over 100B CNY into the Chinese banking system each month, which is in stark contrast to the 6M and 12M trends of net liquidity withdrawals
  • The aforementioned policy shift has materially tamed forward-looking expectations for Chinese money market rates, while the recently heavy IPO calendar has applied some upward pressure to near-term rates… we expect the PBoC to take note of this phenomenon and react accordingly

 

Indeed, Chinese economic growth has stabilized on a slew of monetary and fiscal easing measures and certain segments of the Chinese economy (e.g. trade data and credit formation… the latter of which is supported by BoP stabilization) are showing marked improvement on a trending basis.

 

CONCLUSION: BULLISH

All told, both our quantitative signals and fundamental research support buying China here. This stance is in stark contrast to our previous view, which concluded that investors would do better to stay out of China altogether.

 

While we’re certainly not making the case that China has turned the corner from a long-term TAIL perspective, we do see considerable upside to Chinese equities – specifically “Old China” exposures – with respect to the intermediate-term TREND. Because of the casino-like nature of the high-beta Chinese equity market, Chinese “investors” tend to extrapolate recent trends and “over-discount” in both directions.

 

As such, we think international equity investors should advantage of this phenomenon on the long side of Chinese equities; long-only fund managers should appropriately overweight China. Ping us with any follow-up questions.

 

Have a great evening,

 

DD

 

Darius Dale

Associate: Macro Team


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HSY – Beware C-Store and Commodity Headwinds in 2H

Hershey reported Q2 results that were largely in line with consensus -- $1,578.4M of sales rose 4.6% Y/Y (excluding FX), a sequential improvement vs 2.4% in Q1, but the company signaled weaker in-store activity and will likely face increasing commodity cost pressure in 2H.  EPS of $0.76 rose 5.6%, albeit off the easier comp of the year.  

 

HSY cited weakness in the quarter from the C-store channel on a continued challenged macro environment that’s impacting consumer spending and higher levels of in-store competition.

 

The stock is trading down -2% intraday on the release and is down over 14% since its ytd high in late February. The market’s discount has come alongside the company’s strategy of volume driven sales. This strategy changed last week when the company issued an 8% price increase across all of its products, citing increased commodity costs, in particular from dairy costs (note: Mars raised pricing ~ 7%). 

 

Commodity cost pressure remain square on our radar. In the quarter, the company saw a 230bp decline in GM – and for the remainder of the year expects these costs to be a headwind to GM on the year, falling hardest in Q3.  Below we show longer term charts of milk and cocoa, each up 15% and 13%, respectively ytd, that should also pressure results.

HSY – Beware C-Store and Commodity Headwinds in 2H - z. milk

HSY – Beware C-Store and Commodity Headwinds in 2H - 2. hsy

 

The company stressed its 2H plan for increased innovation (beyond what was previously planned) to make up for weakness seen in the quarter, but we think there’s a threat to the business in the back half of the year as many of the issues cited in the quarter continue to play out: weak macro environment; commodity cost inflation; impact of a price hike on demand; and increased shelf space competition.  Any hiccups with advertising and promotion to reach the consumer will also be a negative drag. 

 

Further, and as we show below, comps get more difficult on the top and bottom lines as we move out over the next 2-3 quarters.

HSY – Beware C-Store and Commodity Headwinds in 2H - 3. hsy

HSY – Beware C-Store and Commodity Headwinds in 2H - 4 hsy

 

We’re cognizant that HSY is entering the holiday-rich second half of the year in the U.S. that could help to make up for underlying weaknesses. However, the business is also experience weakness internationally. In the quarter, international sales were up 7%, however China slowed sequentially and Mexico sales were down -5% Y/Y due to FX headwinds. Taken together, there are winds blowing against the company across all of its regions.

 

We are not currently involve in HSY in our Real Time Alerts portfolio, but our quantitative levels below suggest a bearish TRADE and TREND outlook on the stock. 

 

HSY – Beware C-Store and Commodity Headwinds in 2H - 5. hsy

 

Howard Penney

Managing Director

 

Matt Hedrick

Associate

 

Fred Masotta

Analyst


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Cartoon of the Day: Inflation Shark

Takeaway: Real Americans are about to get eaten.

Cartoon of the Day: Inflation Shark - Inflation shark cartoon 07.24.2014


Initial Jobless Claims: How Low Can You Go?

Takeaway: The U.S. labor market continues to improve steadily.

Editor's note: This is an excerpt from a research report issued earlier today by Hedgeye's Financials team. For more information on how you can subscribe to Hedgeye click here.

 

Crisis: Risk & Opportunity


Last week, we flagged how the strength in claims represents both risk and opportunity. The opportunity lies in the fact that historically claims tracked at sub-330k for 24 months in the mid-to-late 1980s, 45 months in the mid-to-late 1990s, and 31 months in the 2005-2007 period. Currently, claims have been running at sub-330k for 6 months (though if you count from the initial drop in mid-2013 then we're closer to ~12 months). In other words, history would suggest (the last 3 cycles at any rate) there could be another 18-39 months of track left before claims begin to rise.

 

The risk lies in the fact that major market downturns follow sub-330k claims periods. And, importantly, there's no guarantee the last 3 cycles will reasonably represent the blueprint for this cycle. We often work in close conjunction with our Macro Team on the labor and housing markets. The chart below, illustrating the dynamic, comes from Christian Drake on the Macro Team.

 

Initial Jobless Claims: How Low Can You Go? - drake jobs

 

The Data

Prior to revision, initial jobless claims fell 18k to 284k from 302k WoW, as the prior week's number was revised up by 1k to 303k.

 

The headline (unrevised) number shows claims were lower by 19k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims fell -7.25k WoW to 302k.

 

The 4-week rolling average of NSA claims, which we consider a more accurate representation of the underlying labor market trend, was -12.2% lower YoY, which is a sequential improvement versus the previous week's YoY change of -11.1%

 

Initial Jobless Claims: How Low Can You Go? - nsa jobs

 


HOT Q2 2014 CONF CALL NOTES

Suspect capital allocation policy and and lower than expected 3Q guidance cools HOT. RevPAR acceleration from here unlikely so near term catalysts must be asset sales and more aggressive share appreciation.

 

CONFERENCE CALL

 

Prepared Remarks:

Performance

  • Co owned hotel margins +87 bps
  • First time into four years without a global economic wobble
  • North America - record occupancy
  • Corporate Profitability high & Confidence = 2008
  • RevPAR during Q2 2014
    • US
      • Slower in North 4.4%, Chicago flat, WDC <3%, NYC 5%, Boston & Baltimore up double digits,
      • Hawaii flat - weak yen, higher airfares, higher Japanese sales tax.  
      • Better in South & Southwest 9% 
    • Latin America +5%, Mexico +13%, Brazil +25% (Germany stayed at Sheraton Rio), Chile demand struggles.   LA ex Brazil +1%, expect low end of RevPAR range if not lower.
    • Europe:  modest recovery to continue; RevPAR 2%.  Greece +25%, UK slow, France soft, Germany tough comps.  Ukraine & Russia - if events don't escalate, expect improved European outlook.
    • Africa/ME -1%:   Dubai down, Qatar +17%, Saudi flat, Egypt -20%, Nigeria down more than 20%.
    • South Africa +6%
    • China +11%, skewed by Sheraton Macau.  Ex Sheraton +7%, demand better and increased occupancy +550 bps.  Shanghai double digit revpar.  West & Central China 4%.  Sheraton Macau tailwind will taper.
    • Indonesia +19%   Thailand -12% due to coup but calm returning and business slow to recover.  India down more than 4%, hoping for needed economic change and development.
    • Asia ex China expect growth in the low single digits.
    • Maintain RevPAR outlook
  • Management fees:  in 3Q, difficult comps but YoY growth remains very strong. Ex this fee, growth would be 12%.
  • During 2Q opened 19 hotels, 3,800 rooms.  2H14 openings > 1H14 openings.
  • SVO: better tour flows, better pricing, higher closing ratios. Focused on high returns in Orlando, Mexico, Hawaii and St. John.
  • June 6th, closed final unit at St. Regis Bal Harbour. 
  • SG&A: up 16% but lapped $7m in CT State Tax incentives.  In 3Q benefit of $3-$4m in new tax incentives.

Outline to Capital Allocation

  • Impossible to have a Balance Sheet which pleases all shareholders
  • Leverage: stay investment grade in wake of major economic downturn.  Conduct a Monte Carlo scenario for how business would operate during a major economic downturn. $500m in off shore cash. Leveraged allowed to 2.5x but less than 3x. Today about $750 million of add'l capacity to get to 2.5x.  Maintain target leverage.
  • Dividends: regular dividends based on payout ratio of 50%, but 35% to 50% on a future basis. 
  • Stock buybacks: offset annual dilution of stock based comp of $85 million in 2014; expect to compete $614 million in 2014.
  • Opportunities:  Step up pace of repurchase activity or special dividends (asset sales).

Transaction Markets:

  • Optimistic HOT will announce significant transactions in 2H14 and early 2015.

Other

  • CFO search progressing with Korn Ferry. 

 

Q&A:

  • Portfolio Sales $1 billion transaction in market or greater value on single asset basis?
    • Geographic:  not a consistent set that appeals to a single buyer, finding better/greater prices via individual asset sales.
  • US RevPAR: Luxury lagging, broader acceleration?
    • Early in recovery, significant and higher growth rates in upscale, upper upscale and luxury, but now percolating down to lower segments.
  • RevPAR trends and performance through cycle?
    • Continue to build rate so additive, performance of international segments outperforming, so not sure HOT will underperform. 
  • Share repurchase?
    • $85 million at least to offset dilution (baseline) but as HOT gets to asset light and sell $2.5 billion in sales, they will generate cash and then evaluate repurchases vs. special dividends
  • Given capital model - only able to buy back $750 million shares versus some estimates of $2b to $3b?
    • Need to take into consideration rating agency definitions, but $750m is NOT the maximum.
  • Opportunities to grow/add brands - especially in 3/4 star segments?
    • Aloft today is what W Hotels was 10 years ago...and present opportunity to grow select service hotels.
    • Four Points continues to draft off Sheraton
    • Element small but growing, tremendous growth potential
    • Difficult/challenging to launch and build De Novo
  • Group pace:
    • Bookings in 2Q. Good for in the year, for the year, but slower for 2015 but still mid-single digits range is on par with historical booking trends.
  • Share based compensation - why leave out of adjusted ebitda?
    • Better transparency to client and better measure of core business.
  • CFO search, characteristics, & timing?
    • Strong CFO, with seat at the C-Table, great mind, not afraid to have an opinion/discuss strategy and financing functions.  Have a number of interested and exciting candidates.  Will announce when they have "a name".
  • REIT Spin off of assets
    • Most North America REIT trading at discount to NAV, REIT would require add'l G&A, too many US lodging REITs trading with too few assets in their portfolio and shareholders not benefiting
  • Summarize from Q1 call to today, how did capital strategy and thinking change?
    • Had an approach to leverage limits and targeted debt levels, today more clarity on calculation.

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