“The Italian people are tired of this corruption. Because we have too many people that steal, too many people that put the money in his pocket. We have 40% of people who don’t pay tax. Can you imagine? 40%. It’s unbelievable.”
Renzo Rosso is an Italian and founder of the Diesel jeans brand. He appeared in a 60 Minutes segment on Sunday titled “Saving Italy’s History Becomes Fashionable” that showed how he along with a number of other prominent Italian fashion houses (Tod’s, Fendi, Bulgari) were donating millions to repair and improve the country’s historical landmarks, from the Colosseum and the Spanish Steps in Rome to the 400 year old Rialto Bridge over the Grand Canal in Venice.
Why? Because the government is too broke to allocate funds to maintain the country’s historic treasures.
While the issues of deep corruption and oversized bureaucracy in Italy remain nothing new, it’s both telling and remarkable to see these individuals and companies take a stand (now), rather than pointing fingers or pushing the problem on to somebody else further down the road.
Back to the Global Macro Grind…
If only the Italian government could take a similar stand and unilaterally agree to reform itself… NOW.
As we’ve noted in previous work, Italy recently joined France as a standout in the camp of “Austerity Is Dead” in submitting 2015 budget plans that extend out its initial fiscal consolidation targets.
Specifically, Italian PM Matteo Renzi presented a budget last week that included cuts to labor taxes and personal income taxes worth €18 Billion, however some €11 Billion of it will be funded with extra borrowing that will raise the country’s deficit-to-GDP to 3% this year versus its previous target of 2.6% (with 2015 forecast as 2.9%).
And so for the first time in history, the European Commission may exercise its power to reject both Italy’s and France’s budgets and ask for new ones. A formal resolution is expected to come on October 29th.
What’s clear is that the 39 year old young-gun and reform-minded Renzi has inherited a challenged position and the country is looking for leadership to pull itself out of what will be three years of negative growth:
- He filled a power vacuum in February 2014 composed of splintered and diverse parties (that legacy continues and challenges reform)
- Italy has a record high youth unemployment rate at 43% (3rd highest in the Eurozone behind Spain and Greece at 50%+) and an aggregate unemployment rate of 12.3% vs Eurozone 11.5%
- Italy has put little dent in its record high debt of 133% (2nd highest to Greece’s in the Eurozone and 3rd highest of all countries in the developed world) vs Eurozone at 92% (that remains a persistent threat to raising debt/increasing interest rate costs)
Yet as we described in an Early Look note on 10/10 titled #EuropeSlowing – Austerity Is Dead? the main “rub” throughout the Eurozone is a leadership one.
On one hand, we have the ECB and European Commission pointing its finger at the member states to do more country-level reforms. On the other hand, we have member states (like Italy and France) saying they’ve already done a significant level of reform and collectively pointing the finger back at the ECB for not doing more to inflect the lack of growth and deflation they’re experiencing.
To fuel the fire, tack on the indecision created by the fiscally conservative Germans calling into question the potential negative consequences that could result for the ECB’s newest policy toolkit, including the TLTROs, ABS and covered bond buying programs. Just in the last few days we’ve heard whispers (because the information is private) that the ECB bought French, Italian, and Spanish covered bonds, ahead of ABS purchases and the second round of the TLTRO program that are slated to begin/issued in December.
We’ve been clear in our research, including in our Q4 Macro theme of #EuropeSlowing, that we do not see Draghi’s Drugs arresting the low levels of inflation in the Eurozone (CPI currently is at 0.3% Y/Y) nor producing sustainable economic growth (recent programs baked in and with record low interest rates).
As we show in The Chart of the Day below, not only do we think that Draghi’s inflation policies will not work, but we expect deflation to hit Italy (CPI at -0.1% Y/Y) and the other countries across the periphery harder, which should only further push out growth expectations and limit business and consumer confidence.
If Renzi’s Reform is to ever become a success, it will be counted in many years, not many months, and our opinion is that regaining competitiveness within the confines of the Eurozone structure is a sisyphean task.
Our bottom-up, qualitative analysis (e.g. our Growth/Inflation/Policy framework) indicates that the Eurozone is setting up to enter the ugly Quad4 in Q4 (equating to growth decelerates and inflation decelerates).
From an investment position we continue to recommend shorting Italian (EWI) and French (EWQ) equities (down -7.6% M/M and -8.1% M/M, respectively) and shorting the EUR/USD (FXE) (down -1.2% M/M).
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.09-2.24%
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TODAY’S S&P 500 SET-UP – October 22, 2014
As we look at today's setup for the S&P 500, the range is 117 points or 5.73% downside to 1830 and 0.29% upside to 1947.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 1.85 from 1.86
- VIX closed at 16.08 1 day percent change of -13.41%
MACRO DATA POINTS (Bloomberg Estimates):
- 7am: MBA Mortgage Applications, Oct. 17 (prior 5.6%)
- 8:30am: CPI m/m, Sept., est. 0.0% (prior -0.2%)
- 10:30am: DOE Energy Inventories
- 5pm: Reserve Bank of Australia’s Stevens speaks in Sydney
- Sec. of State John Kerry visits Berlin
- Senate, House out of session
- 10am: SEC holds open meeting on rules relating to credit risk retention by securitizers of asset-backed securities
- 3:30pm: Fed board holds open meeting to discuss final rulemaking requiring sponsors of securitization transactions to retain risk in those transactions
- U.S. ELECTION WRAP: Paul’s Prediction; Terror Ads; PAC Showdown
WHAT TO WATCH:
- Yahoo Pushes Back Against Activist Starboard as Sales Gain
- Daimler Sells Stake in Tesla as Powertrain Supply Deal Continues
- Dimon Says ‘Terrifying’ Cancer Hasn’t Changed His JPMorgan Plans
- J&J Sees 250,000 Ebola Vaccine Doses Ready for Trials in May
- Target CEO Eyes Holiday Turnaround With Free Shipping, Faux Fur
- Icahn Says EBay Should Pursue PayPal Sale Now in Spin Dual Track
- GT Advanced Allowed to Wind Down After Deal With Apple
- Apollo to Raise $2b-$3b From New Natural Resources Fund: Reuters
- Michigan Governor Signs Bill Securing Tesla Direct Sales Ban
- BOE Split on Key Rate as Majority Sees Heightened Euro-Area Risk
- Total CEO Will Contend With Production Slump as Pouyanne Tipped
- Heineken Revenue Misses Analyst Estimates as Europe Wanes
- Abbott Labs (ABT) 7:44am, $0.60 - Preview
- Amphenol (APH) 8am, $0.57
- Biogen Idec (BIIB) 6:45am, $3.49 - Preview
- Boeing (BA) 7:30am, $1.97 - Preview
- Boston Scientific (BSX) 7am, $0.20 - Preview
- Dow Chemical (DOW) 7am, $0.67 - Preview
- EMC (EMC) 6:53am, $0.46 - Preview
- FNB (FNB) 8:30am, $0.21
- General Dynamics (GD) 7am, $1.91 - Preview
- Gentex (GNTX) 8am, $0.47
- Hudson City Bancorp (HCBK) 8am, $0.06
- Ingersoll-Rand (IR) 7am, $1.03
- Interpublic Group (IPG) 7am, $0.21
- Lumber Liquidators (LL) 7am, $0.67
- New York Community Bancorp (NYCB) 7am, $0.26
- Norfolk Southern (NSC) 8am, $1.83 - Preview
- Northern Trust (NTRS) 7:30am, $0.87
- Northrop Grumman (NOC) 7am, $2.13 - Preview
- Owens Corning (OC) 7:28am, $0.48
- Polaris (PII) 6am, $2.02
- Popular (BPOP) 8am, $0.67
- Ryder System (R) 7:55am, $1.63
- SEI Investments (SEIC) 8:30am, $0.47
- Simon Property (SPG) 7am, $0.84 - Preview
- Stanley Black & Decker (SWK) 6am, $1.44
- Thermo Fisher Scientific (TMO) 6am, $1.69 - Preview
- Tupperware Brands (TUP) 7am, $0.91
- UniFirst (UNF) 8am, $1.31
- US Bancorp (USB) 7:15am, $0.78
- Xerox (XRX) 7am, $0.26
- A Schulman (SHLM) 4:10pm, $0.64
- Albemarle (ALB) 4:03pm, $1.02
- Angie’s List (ANGI) 4:02pm, ($0.07)
- AT&T (T) 4:01pm, $0.64 - Preview
- Brandywine Realty (BDN) 4:15pm, $0.02
- CA (CA) 4:05pm, $0.62
- Cheesecake Factory (CAKE) 4:15pm, $0.57
- Citrix Systems (CTXS) 4:05pm, $0.73
- Core Laboratories (CLB) 4:06pm, $1.52
- CoreLogic (CLGX) 4:10pm, $0.39
- Covanta Holding (CVA) 4:01pm, $0.21
- CR Bard (BCR) 4:05pm, $2.10
- Equifax (EFX) 4:15pm, $0.98
- Everest Re (RE) 4:05pm, $4.99
- Fortinet (FTNT) 4:15pm, $0.11
- Graco (GGG) 4:15pm, $0.95
- Lam Research (LRCX) 4:05pm, $0.93
- Leggett & Platt (LEG) 4:05pm, $0.49
- NXP Semiconductor (NXPI) 8pm, $1.31
- O’Reilly Automotive (ORLY) 6:30pm, $1.95
- Plexus (PLXS) 4pm, $0.78
- Polycom (PLCM) 4:05pm, $0.20
- Select Comfort (SCSS) 4:01pm, $0.40
- ServiceNow (NOW) 4:05pm, $0.01
- SLM (SLM) 5:15pm, $0.17
- Susquehanna (SUSQ) 4:30pm, $0.20
- Teradyne (TER) 5:01pm, $0.40
- Torchmark (TMK) 4:01pm, $1.02
- Tractor Supply (TSCO) 4:01pm, $0.50
- Varian Medical (VAR) 4:05pm, $1.21
- Weatherford (WFT) Aft-mkt, $0.33
- Yelp (YELP) 4:05pm, $0.03
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Gold Retreats From Six-Week High on Demand Outlook to Dollar
- Tin’s New Frontier Myanmar Threatens Indonesia: Southeast Asia
- Zinc Rises as Inventories at Two-Month Low Support Shortage Call
- India Eschewing Raw Sugar Output After Export Aid Withdrawn
- WTI Oil Climbs as U.S. Fuel Supply Seen Lower; Brent Advances
- China Sept. Nickel Ore Imports From Philippines 4.52 Mln Tons
- Steel Rebar Falls to 2-Week Low as China Supply Exceeds Demand
- European Gas Traders Boost Near-Term Buying to Cut Russian Need
- UD Group Plans to Apply for Membership on London Metal Exchange
- Cocoa Arrivals in Brazil’s Bahia Advance 3.5%, Hartmann Reports
- Rubber Rises to 6-Week High as Thai Efforts Offset China Concern
- Zinc Rises From 3-Month Low Before China PMI Data: LME Preview
- Truffle Boom Brings La Dolce Vita Amid Italy’s Economic Slump
- Nickel Surplus Was 4.7Kt in August in Second Month of Oversupply
The Hedgeye Macro Team
Takeaway: China’s 3Q/SEP economic data confirms our view that global growth is slowing and will likely continue to slow through at least year-end.
Contextualizing China’s 3Q GDP Print
This we know: Chinese economic data is, at best, massaged and, at worst, fabricated (as confirmed by Chinese Premier Li Keqiang years ago). In fact, we’d argue Chinese economic data is probably about as massaged as any pre-election Jobs Report is likely to be in the US!
Still, in the context of our process of focusing primarily on slopes, inflections and deltas when analyzing economic data, we are more than happy to compare any data point to the previous data point(s), so long as the data series itself is methodologically consistent.
In that light, it doesn’t matter to us if China’s “actual” real GDP growth is +7.3% YoY (NBS for 3Q14) or the +3.9% forecasted by the Conference Board’s 2020-2025 Chinese growth outlook. All we care about is any directional deviation from trend – which is what actually matters to investors, per the preponderance of Dr. Daniel Kahneman’s work in the field of behavioral economics (e.g. anchoring, prospect theory, etc.).
From that perspective, China’s 3Q14 real GDP growth rate of +7.3% is:
- The slowest rate of change since 1Q09;
- Is -1.1 standard deviations from its trailing 3Y average; and
- Is in the 5th percentile of readings on a trailing 10Y basis.
4Q Looks Dour as Well
From a forward-looking perspective, a marginally difficult base effect, slowing sequential momentum and seasonality are all supportive of continued trend-based slowing in the preponderance of China’s reported growth data here in 4Q – whatever underlying unit demand may be.
Diving deeper into the aforementioned point regarding slowing sequential momentum, our analysis of the data shows a Chinese economy continuing to lose steam without a meaningful enough change in either monetary or fiscal policy to support any semblance of a sustained inflection (i.e. 2-3 months or more).
- As of mid-OCT, the 2M moving average of the arithmetic mean of the YoY % change in monthly average iron ore, rebar and coal prices – our favorite real-time indicator for the slope of Chinese growth – continues to crash on a YoY basis and is decelerating versus its trailing 3M, 6M and 12M trends.
- As of SEP, China’s headline PMI data and each of its 10 sub-indices are decelerating versus their respective trailing 3M trends. China’s trade balance tells a similar tale; it too is decelerating both sequentially and versus its trailing 3M and 6M trends.
- As of SEP, various measures of “hot money” capital flows are decelerating both sequentially and versus their respective trailing 3M, 6M and 12M trends.
- The NBS’s Business Cycle Signal Index, Coincident Economic Indicator, Consumer Confidence Index and Leading Economic Indicator each decelerated sequentially in SEP.
- As of SEP, growth in retail sales has decelerated both sequentially and versus its trailing 3M, 6M and 12M trends. This is especially troubling considering the fact that household consumption has overtaken investment amid structural rebalancing efforts (“C” = 48.5% of GDP in the YTD vs. 41.5% for “I”).
- In the YTD through SEP, growth in fixed assets investment decelerated both sequentially and versus its trailing 3M, 6M and 12M trends.
- On the positive side of the ledger, growth in exports, FDI, imports, industrial production and total social financing has accelerated both sequentially (in SEP) and versus their respective trailing 3M trends.
Looking to the Chinese property market – which accounts for ~15% of Chinese GDP directly and materially affects some 40 industries – our analysis shows continues weakness there as well:
- As of SEP, growth in the availability of funding in the real estate sector decelerated both sequentially and versus its trailing 3M, 6M and 12M trends.
- As of SEP, growth in both the nominal value and square footage of property purchases decelerated sequentially and versus their respective trailing 3M, 6M and 12M trends.
- Contrast this with growth in both starts and completions having accelerated sequentially in SEP and versus their respective trailing 3M and 6M trends, and it’s easy to assume a dour outlook for Chinese property prices.
- Speaking of, growth in Chinese property prices across all tiers of cites decelerated both sequentially in AUG and versus their respective trailing 3M, 6M and 12M trends. Data from the China Real Estate Index System confirms a continued slowdown in SEP where average home prices across the 100 largest cities decelerated to +1.2% YoY from a gain of +3.2% in AUG. The -0.9% MoM decline recorded in SEP ‘14 is the steepest drop since the survey began back in 2010.
- All of this rhymes with the latest Real Estate Climate Index reading of 94.8 in AUG, which represented a deceleration from both a sequential perspective and versus its trailing 3M, 6M and 12M trends.
Again, it’s important to note that our daily analysis of official rhetoric via mainland press continues to suggest that no major stimulus initiatives are coming down the pike. Mortgage policy continues to ease, at the margins, but not in a material enough way to inflect the broader growth outlook; oversupply, rather than a lack of demand, is actually the key issue facing China’s housing market going forward.
For an even deeper dive into China’s Growth/Inflation/Policy outlook, please review our 9/30 note titled, “DEFCON 2.5: THE “CHINA OVERHANG” IS LIKELY TO CONTINUE”.
All told, the inclusion of today’s growth data and its associated policy rhetoric (the NBS actually talked up the 3Q GDP figure, saying it fell within their so-called “reasonable range”) is just more of the same as Chinese policymakers attempt to gradually walk the mainland economy “down the ledge” of overcapacity and systemic indebtedness, as opposed to allowing it to “fall off a cliff”.
It’s worth noting that our views on the Chinese economy and the policy that drives it haven’t changed all that much since we correctly forecasted the aforementioned approach over three years ago. As such, we continue to think that estimates of marginal Chinese demand should continue to decline for the foreseeable future.
With #ChinaSlowing (15% of marginal global demand in 2013), #JapanSlowing (5% of marginal global demand in 2013), #EuropeSlowing (18% of marginal global demand in 2013), and #USSlowing (17% of marginal global demand in 2013) all at once, what could possibly go wrong?
Associate: Macro Team
Brief Analysis: We removed EAT from our Investment Ideas list as a short on October 9th, 2014. We thought this was a prudent move given the current sales momentum we are seeing across the restaurant industry. To be clear, we wanted to get the 1QF15 release out of the way, and were mistaken in doing so. Brinker's comp sales outpaced both Knapp and Black Box by notable margins and surpassed consensus expectations, but weren't strong enough to drive enough leverage through the P&L. In addition, two-year average comps and traffic declined sequentially, suggesting that management is not doing enough to move the needle.
Brinker has prided itself over the past four years on methodically driving operating leverage in their business model, but we believe these days are abruptly coming to an end, even despite management's decision to maintain guidance for a 25-50 bps improvement in restaurant operating margin in FY15. We believe this will be difficult to achieve and think management is (almost solely) relying on cost of sales to moderate for this to happen.
Despite covering our short a couple of weeks ago, our short thesis has not changed. In fact, if anything, our conviction in it has strengthened. Unfortunately, we missed today's move, but we'd be looking to short the name once again into any strength. We think the margin story is played out here and management will be hard pressed to drive leverage moving forward. The street is banking on the FY16 free cash flow story to come through for them as capex begins to wind down. We suspect, however, that this will disappoint as management is forced to allocate additional dollars to reinvest in the business.
Comps: Brinker delivered system-wide comp growth of +2.4%. Chili's company-owned comps grew +2.6%, comprised of +1.8% of pricing, +0.7% of mix-shift and +0.1% of traffic. Traffic, while positive for the first time in the past seven quarters, saw its two-year average decline 30 bps sequentially to -1.7%. Total revenues of $711.018 million (+3.84% y/y) beat consensus estimates by 25 bps.
Margins: Cost of sales declined 28 bps y/y driven by favorable menu pricing, menu item changes, efficiency gains from new fryers and improved waste control. However, significant pressure from beef, cheese, avocados, and seafood resulted in significantly lower leverage than management had anticipated. Labor costs increased 18 bps y/y driven by higher bonuses and increased wage and payroll taxes, partially offset by lower health insurance expenses. Restaurant expenses increased 30 bps y/y driven by equipment charges associated with tabletop tablets and higher credit card fees. As a result, restaurant margins declined approximately 30 bps in the quarter. Management reaffirmed its guidance for a 25-50 bps improvement in this line in FY15.
Earnings: Adjusted EPS of $0.50 (+16.3% y/y) fell in-line with expectations.
What We Liked:
- Respectable system-wide comp growth of +2.4%
- Chili's comps outpaced Knapp and Black Box by 210 bps and 100 bps, respectively
- Reimage program is about 90% complete
- Installation of Kiosk tablets in all franchise restaurants will be completed next month
- Repurchased 1.1 million shares for $53.3 million in the quarter; repurchased another 712,000 shares for $37 million since then, bringing the outstanding share authorization down to $576 million
- Announced a 17% increase in quarterly dividend from $0.24 to $0.28
What We Didn't Like
- Two-year average traffic declined 30 bps sequentially to -1.7% at Chili's
- International franchise comps were down -0.5% driven by soft sales in Puerto Rico
- Menu innovation hasn't really moved the needle on traffic
- Restaurant level margins down despite a fairly strong comp
- Food costs will likely continue to present a challenge for management given their unpredictable nature
- Seemingly little to no leverage left on labor cost and other restaurant expenses lines
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