TODAY’S S&P 500 SET-UP – September 18, 2014
As we look at today's setup for the S&P 500, the range is 27 points or 1.08% downside to 1980 and 0.27% upside to 2007.
CREDIT/ECONOMIC MARKET LOOK:
MACRO DATA POINTS (Bloomberg Estimates):
WHAT TO WATCH:
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
The Hedgeye Macro Team
Takeaway: We recently added SBUX to our Best Ideas list as a short. We’ll be hosting a call today @11AM EST to review our thesis & field questions.
KEY TOPICS WILL INCLUDE:
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We have ‘liked’ FedEx shares since late 2012, gradually reducing our affinity as the shares have moved higher (although a bit too quickly). With today’s gains, we will move to ‘roughly indifferent’. Much of the undervaluation in the Express division has been recognized at this point – perhaps 2/3s, if it were possible to provide such allocations. Management caution on 2H FY15 and static guidance may point to a softer second half. We preferred FDX when the Express division looked like it was detracting from the market’s valuation of FDX shares. We would look to re-enter at more attractive prices and would not short/underweight FDX shares. We do expect FedEx to be reasonably successful with its profit improvement plan and may again be exiting too early.
Updated Sum of Parts
We have written a critique of this valuation methodology and recognize its flaws. However, we continue to find it a helpful framing when explaining our views on FDX. We present a comparison of the June 2013 SOTP table with the current one.
Sum of Parts in June 2013 – FedEx Express Implied Negative Valuation
(published here, odd formatting included)
Sum of Parts Following FY1Q 2015 Results – FedEx Express Implied $15 bil Valuation
FY 1Q 2015 Results
We will let others provide a detailed review of FDX’s quarter, but pull out some highlights below.
Express Segment Margin: The FedEx Express margin has made progress, but still has a way to go to reach those of UPS and Deutsche Post. We do not see a reason that FDX’s profit improvement plan (PIP) will not significantly close the gap between FDX and competitors. That said, we think a good portion of the margin improvement is already reflected in FDX shares.
It Isn’t Just Apple Product Launches: Call Q&A seemed to imply that the quarter was just an Apple launch phenomena. FedEx Express may wish it were more closely tied to iPhone launches, but the data suggest they are largely unrelated.
Far From Outlier Results: FY1Q 2015 was better better, but without easy comps or with unusually strong yields/volume growth.
Yields improved slightly, most likely because of less International Priority headwind.
Volumes also improved, consistent with broader airfreight data.
Ground Still Solid: Management again commented that it won’t be satisfied with less than high-teens margins.
Freight’s Highest Margin: The best quarter since the financial crisis for FedEx Freight.
Guidance: Management commented that the stronger FY1Q 15 was factored into guidance and implied a weaker back half relative to consensus. Guidance may just be conservative, but guidance has been fairly on target in the last couple of years.
FedEx Investment Negatives: When we presented FDX as a long in late 2012, we often heard its myriad investment negatives. Many of them were true negatives, but we felt there was adequate compensation for the risks. That offsetting compensation is less available at current prices. Negatives include:
Takeaway: Recent developments in the oil and gas space suggests the U.S. is closer to becoming an exporter
The Bureau of Labor Statistics (BLS) recently reported that the largest employment increases since the shale revolution commenced circa 2006 occurred in the four U.S. states which just so happened to have the heaviest amount of hydraulic fracturing: North Dakota, Louisiana, Oklahoma, and Texas.
Early estimates suggest that U.S. shale plays will add significant production capacity for years to come:
With hydraulic fracturing still a relatively new extraction method, we have come across a confusing and wide variation in estimates of two key factors:
Producers are developing more efficient and useful ways to induce hydraulic fracturing to improve the recovery process. At the end of the day, we expect the rapid evolution of this process to continue, and a constant refresh of those players improving marginal production costs faster than their peers will be key to picking the winners in an environment of low oil and gas prices. Until more research is completed on the possibilities of improving marginal production costs, we can conclude the following:
Available resources and marginal production costs aside for now, what other headwinds threaten the U.S. from fully capitalizing on the Shale Boom?
In this preliminary note on the topic, we’ll begin with recent developments to the current regulatory obstacles impeding our ability to become an exporter of oil and LNG. More extensive analyses surrounding the sustainability of the U.S. shale boom will follow in the coming weeks.
OIL: THE PRESSURE TO LIFT THE EXPORT BAN IS OFFICIALLY HERE
South Korea and other NATO allies have verbally challenged the U.S. ban on the back of our recent increase in domestic production capacity. Last week the EU’s commissioner for trade, Karel De Gucht, emphasized the need to free up more sources of oil and gas for a wider and more effective free-trade agreement to be instituted.
The Office of the U.S. Trade Representative and the NSC have held internal discussions with the Obama Administration on how to deal with a challenge from the international community. Washington was able to make a national security argument for implementing the ban back when it was importing most of its crude oil, but the added production from the Shale boom is challenging the credibility of that argument.
With added geopolitical tension globally this year, both Asian and European allies are pushing for diversified supply lines. Strengthening their argument, the U.S. just took China to the WTO earlier this year and won a case accusing Beijing of hoarding raw materials and precious metals. Under International Trade rules (General Agreement on Tariffs and Trade), the argument for upholding the restrictions on the exporting of U.S. fossil fuels may be too hypocritical to justify.
We expect a more publicized stance from Washington in Q4.
NATURAL GAS: LNG EXPORT TERMINAL APPROVAL PROCESS MODIFIED IN AUGUST, BUT DEVELOPING ADEQUATE INFRASTRUCTURE FOR INDIVIDUAL PROJECTS LAGS BY 2-3 YEARS.
In August a modification of federal law governing the LNG terminal approval process was implemented. The new rules essentially expedite the FINAL and LAST DOE approval process for those projects that uphold the requirements of NEPA (National Environmental Policy Act) and FERC (onshore)/MARAD (offshore). This will shorten the last step in fully-approving proposed projects:
The recently approved projects are not expected to be completed until 2017-18. As mentioned above, Sabine may be ready to export by the end of 2015. Stay tuned for additional research that we hope will help stay on top of the most important issues in the shale energy space.
As always, please reach out with comments, questions, or additional color on the most important issues that will make or break the potential of shale’s contribution to domestic production. Have a great night.
Takeaway: The slowdown in both growth and inflation domestically requires investors to adopt a particularly defensive asset allocation.
Quad #4 Confirmation
During the week ended August 15th, our Tactical Asset Class Rotation Model (TACRM) generated a “high-conviction SELL” signal for Commodities and it followed that up by generating a “low-conviction SELL” signal for FX during the week ended August 29th. In our model, concomitant USD appreciation and commodity deflation is a clean-cut leading indicator for reported disinflation and that’s what you’re seeing with this morning’s US CPI print, which slowed from +2% YoY in JUL to +1.7% in AUG.
For the quarter-to-date, headline CPI is now averaging +1.85% on a YoY basis, which is down from an average of +2.1% in the 2nd quarter. On the growth front, a handful of key indicators have negatively inflected in the 3rd quarter as well:
Debating the Bull Case
We don’t highlight these metrics to cherry pick bad data in support of our existing views. Rather, we think it’s important to highlight the risk of #GrowthSlowing given where consensus expectations for growth remain – i.e. out to lunch. Moreover, the lack of dispersion among forecasts remains a key risk; everyone and their mother is convinced a high-growth US economic expansion is here to stay – 63 months into an economic expansion nonetheless!
Indeed, there’s admittedly a lot of green remaining on our US Economic Indicator Summary table and even our Housing Compendium has a fair amount more green on it that it has had in recent months. The key takeaway for us calling that is out is to highlight our fair and balanced analysis of the data, as well as to show that we are well aware that #GrowthSlowing is not a foregone conclusion for the investment community at large. Indeed, many investors might review the following tables and interpret the trend in domestic economic growth as positive and we’d be remiss to dismiss such claims at face value.
That being said, we’re also well aware of the fact that few others, if any, model economies the way we do (i.e. with a predictive tracking algorithm that combines differential calculus with real-time market and high-frequency economic data), so we’re comfortable being alone in the domestic #GrowthSlowing camp. We prefer forecasting accuracy over the safety of anchoring and our GIP model has, in fact, been deadly accurate in predicting the 2nd derivative of both Real GDP and CPI over the years.
Speaking of the model, there simply isn’t enough sequential momentum in the high-frequency economic data for Real GDP to surmount extremely difficult compares in 2H14, which is a conclusion supported by a compendium of financial market indicators – especially falling interest rates, though our math continues to show that #GrowthSlowing and fears of deflation in the Eurozone have also played a major factor in that trend as well.
For the 3rd quarter in particular, we see Real GDP growth in a range of +1.6% YoY to +1.8% YoY. If it comes in exactly at the midpoint of that range, that would translate to +1.3% on a QoQ SAAR basis – i.e. less than half the rate of the Bloomberg consensus forecast of +3%. We get the advance estimate for 3Q14 GDP on October 30th.
Quad #4 = A Dovish Fed
With both economic growth and reported inflation slowing domestically, we are now in a markedly different economic environment than what we saw in the second quarter and we continue to expect a marginally dovish response from the Federal Reserve – particularly relative to near-consensus expectations of a tightening cycle commencing in 2H15.
In fact, we’d argue today’s FOMC statement was decidedly dovish:
The one hawkish takeaway that initially had the bond market spooked was that 14 FOMC members now see “policy firming” in 2015, which was up from 12 in JUN. Since 2015 growth and inflation data is a long ways away from being reported, however, we think such projections are, at best, useless. The only thing we actually know about 2015 is that the Fed will continue to be data dependent, and if the growth and inflation data continues to slow, there’s little chance of “policy firming” on par with their current expectations.
Adjust Your Asset Allocation Accordingly
From an asset allocation perspective, our GIP model would suggest Quad #4 requires a defensive allocation and we think few investors are prepared for that. If, however, you’ve been following our research, you undoubtedly are adequately prepared for Quad #4 (refer to our August 8th presentation titled, “Are You Prepared For Quad #4?” for more details).
In the table below, we show historical quarterly performance of various asset classes according to our GIP model quadrants. It’s worth noting that we anchor on history (i.e. historical performance), math and investor psychology in our tactical asset allocation process, rather than on feel and valuation. In fact, we’d argue valuation has little place in the tactical asset allocation process and, at best, should be reserved for the strategic asset allocation process – which is seldom the focus of our research.
While our team boasts an impressive number of Ivy League degrees, nowhere in our Yale or Princeton curriculum did we learn how to be smarter than the market or acquire enough hubris to think that we are. While stubbornly telling the market it’s wrong at valuing a security might work in the art of stock picking, it has little place in global macro investing, in our opinion.
Summary Investment Conclusions
As you can see, we think investors should be in bonds and defensive, bond-like equity exposure and out of both the domestic growth style factor(s) and inflation hedges.
On the long side we continue like:
And on the short side, we continue to like:
Please note that Quad #4 is not a good economic environment for REIT securities. Even though we’ve been recommending the Vanguard REIT ETF (VNQ) on the long side for several months as part of our slow-growth yield-chasing playbook, we now feel it is prudent for investors to cut or dramatically reduce their exposure to this asset class.
This is especially true if the weakness in commodities portends a Quad #4 setup for the fourth quarter as well. While that is not something we are currently forecasting given the ease of CPI compares in the 4th quarter, the probability of this occurrence is certainly rising according to TACRM:
Feel free to email us with any follow-up questions. Enjoy your respective afternoons!
Associate: Macro Team
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