TODAY’S S&P 500 SET-UP – November 3, 2014
As we look at today's setup for the S&P 500, the range is 56 points or 2.53% downside to 1967 and 0.25% upside to 2023.
CREDIT/ECONOMIC MARKET LOOK:
- YIELD CURVE: 1.83 from 1.84
- VIX closed at 14.03 1 day percent change of -3.37%
MACRO DATA POINTS (Bloomberg Estimates):
- 9:30am: Fed’s Evans speaks in Chicago
- 9:45am: Markit US Mfg PMI, Oct, final, est. 56.2 (prior 56.2)
- 10am: ISM Manufacturing, Oct., est. 56.2 (prior 56.6)
- 10am: Construction Spending, Sept., est. 0.7% (prior -0.8%)
- 11am: U.S. to announce plans for auction of 4W bills
- 11:30am: U.S. to sell $24b 3M bills, $30b 6M bills
- 12:40pm: Fed’s Fisher speaks in New York
- President Obama meets with Fed Chair Janet Yellen to discuss long-term outlook for U.S. economy, global recovery
- Senate, House out of session
- FSOC holds meeting on MetLife’s objection to proposed designation as “systemically important” financial firm
- 9am: NATO Supreme Allied Commander, Europe, and Commander of U.S. European Command Air Force Gen. Philip Breedlove holds media briefing
- 10am: Supreme Court hears arguments in case involving designation of “Israel” as place of birth for U.S. citizens born in Jerusalem
- 10:30am: CFTC reviews rules to make sure they don’t have unintended consequences for non-financial cos.
- 2pm: Greece’s energy minister, Yiannis Maniatis, speaks at the Center for Strategic and International Studies on energy trends in the eastern Mediterranean region
- Washington Week Ahead
- U.S. ELECTION WRAP: The Magic Senate Number; Googling ‘Nunn’
WHAT TO WATCH:
- Publicis to Buy Sapient for $3.7b to Extend Digital Reach
- Diageo Gets Full Control of Don Julio in Swap for Bushmills
- Gold Extends Decline Toward 4-Year Low as Silver Tumbles
- MetLife to Appear Before FSOC to Appeal Prelim. SIFI Designation
- Altice Offers Oi $8.8b for Portugal Telecom Assets
- NY Doctor With Ebola Now in ‘Stable’ Condition at Bellevue
- Omega Healthcare to Acquire Aviv REIT in $1.65B Deal
- Net Neutrality Groups Praise Using FCC Phone Rules on Web
- Verizon, AT&T Cut Mobile Prices While Boosting Data Allotments
- American Realty Capital Said to Face Accounting Errors Probe
- Einhorn’s Greenlight Rose 2.2% in Oct. as Volatility Surged
- Final Election Push: GOP Has the Edge; Will It Be Enough?
- Billionaire Malone Got Double Tax Break in Liberty Inversion
- Virgin Spacecraft’s Rocket Motor Intact After Breakup: NTSB
- Gyllenhaal’s ‘Nightcrawler’ Movie Creeps to Tie With ‘Ouija’
- Herbalife to Pay $15m to End ‘Pyramid Scheme’ Lawsuit
- Obama Ends Midterm Campaigning With Eye on Governors’ Races
- Auto Sales Preview: Oct. SAAR May Be 16.4m
- Affiliated Managers (AMG) 7:30am, $2.71
- Allete (ALE) 8:30am, $0.72
- Arena Pharmaceuticals (ARNA) 6:45am, ($0.12)
- Church & Dwight (CHD) 7am, $0.82
- CNA Financial (CNA) 6am, $0.78
- Enbridge Energy Partners (EEP) 8am, $0.26
- Kosmos Energy (KOS) 7am, ($0.02)
- Loews (L) 6am, $0.68
- Sysco (SYY) 8am, $0.51
- Acxiom (ACXM) 4:05pm, $0.17
- Agrium (AGU CN) 6:13pm, $0.50
- Alleghany (Y) 4:07pm, $7.66
- American Intl Group (AIG) 4:03pm, $1.09
- Community Health Systems (CYH) 4:30pm, $0.76 - Preview
- Corrections of America (CXW) 4:15pm, $0.47
- Covance (CVD) 4pm, $0.98
- Detour Gold (DGC CN) 5:35pm, ($0.10)
- Frontier Communications (FTR) 4:01pm, $0.04
- Herbalife (HLF) 4:30pm, $1.51
- Lannett (LCI) 4:04pm, $0.92
- MannKind (MNKD) 4pm, ($0.02)
- Marathon Oil (MRO) Aft-mkt, $0.59
- MDU Resources (MDU) 5:30pm, $0.44
- Mindray Medical (MR) 5pm, $0.46
- Neurocrine Biosciences (NBIX) 4:02pm, ($0.21)
- Protective Life (PL) 4:14pm, $1.22
- Regency Centers (REG) 4:05pm, $0.18
- RetailMeNot (SALE) 4:01pm, $0.13
- Rock-Tenn Co (RKT) 5pm, $1.06
- Rosetta Resources (ROSE) 5:15pm, $0.74
- Ruckus Wireless (RKUS) 4:05pm, $0.11
- Sprint (S) 4pm, ($0.06)
- Stone Energy (SGY) 4:03pm, $0.07
- Tenet Healthcare (THC) 4:15pm, $0.09
- Veresen (VSN CN) 5pm, $0.02
- Vornado Realty Trust (VNO) Aft-mkt, $0.43
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- Gold Extends Decline Toward Lowest Since 2010 as Silver Drops
- Gold Wagers Drop as $1.3 Billion Pulled From Funds: Commodities
- Brent Crude Trades Near 4-Day Low as China Manufacturing Slows
- Palm Enters Bull Market as Soybeans Rally, Biofuels Drive Demand
- Nickel Drops as Chinese Manufacturing Growth Misses Estimates
- Hedge Funds Cut Bullish Oil Bets as Global Glut Expands: Energy
- ICE Brent Money Managers Net-Longs Rose to 54,715 Last Week
- White Sugar Falls for Third Day on Ample Supply; Cocoa Declines
- Natural Gas Rises for Fifth Day as Cold Forecast for U.S. East
- Lehman Antidote Hits Nordic Power Exchange With Another Problem
- Steel Rebar Falls on Signs of China Slowdown, Iron Ore Price
- Hurricane Vance in Pacific Will Weaken From Tonight, NHC Says
- Tomato Demand Spurs Record California Crop as Drought Worsens
- Zimbabwe Needs to Clarify its Black Ownership Laws, IMF Says
- Corn Drops With Soybeans as U.S. Weather Seen Boosting Harvest
The Hedgeye Macro Team
This note was originally published at 8am on October 20, 2014 for Hedgeye subscribers.
“We will have to send soldiers into this party seeing red.”
World War II #history rarely accuses British Army General Bernard Montgomery of having a confidence problem. He was often decisive and ruthless. In the end, he was also a winner.
On the eve of landing on the beaches of Normandy, Monty’s bravado reminded Churchill’s Chief of Staff (Lieutenant Hastings Ismay) of the eve of Agincourt (as depicted in Henry V):
“He which hath no stomach to this fight – let him depart.” (The Guns At Last Light, pg 11)
Back to the Global Macro Grind…
Seeing red, in single-factor price momentum terms, is not what everyone saw on Friday’s US stock market bounce. That’s because not everyone looks at risk on a multi-factor, multi-duration basis. But that doesn’t mean it ceases to exist.
Actually, the Russell 2000 was down on Friday, so even in single-factor terms, many saw red. Don’t forget that even though the Russell was up for the 1st week in 7, over 60% of stocks in the Russell 2000 are currently crashing (-20% from their 12-month highs).
Back to the multi-factor thing, we highly suggest you consider Mr. Macro’s market message on a baseline 3-factor basis – PRICE, VOLUME, and VOLATILITY. In those terms, this is what we saw on Friday’s “bounce”:
- PRICE – both the SPX and Russell failed at all 3 core levels of @Hedgeye resistance (TRADE, TREND, TAIL)
- VOLUME – Total US Equity Market Volume was -11% and -4% vs. its 1 and 3 month averages, respectively
- VOLATILITY – VIX was down on the day but +3.5% and +60.3% for the week and YTD, respectively
Price momentum is an easy concept for people to understand (it goes up or down – look at the chart, bro!). That’s why many still use what I affectionately refer to as Moving Monkeys (50 and 200 day) in order to contextualize price. Unfortunately, that is not a risk management process.
The direction of price obviously matters, but so does multi-factor context. Here’s what I mean by that:
- BULLISH – Price Up, Volume Up, Volatility Down
- BEARISH – Price Down, Volume Up, Volatility Up
Within the context of a bearish intermediate-term TREND @Hedgeye, Price UP, Volume DOWN, and trending (implied) Volatility UP is bearish too.
Setting aside our research view of US #GrowthSlowing, to get bullish and “buy-the-damn-dip” in US Equity beta, what I would need to see is the SP500 close above my immediate-term TRADE line of 1949 on accelerating VOLUME and a break-down in the VIX below my TRADE line of 15.03.
Those of you paying attention to my immediate-term risk ranges will note that these levels aren’t in the area code of today’s ranges. And, to a degree, that’s the point. If I look beyond 1-3 days in duration (to 3 weeks), I’m seeing a heightening probability of more red.
Across asset classes (multi-factor), here are the other big #Quad4 deflationary forces at work across multiple-durations (TRADE and TREND):
- European Equity deflation of -0.9% last week (-2.9% YTD EuroStoxx600) is bearish TRADE and TREND
- Emerging Market Equity deflation of -1.9% last week (-3.2% YTD MSCI) is bearish TRADE and TREND
- CRB Index deflation of -1.1% last week (-2.7% YTD) is bearish TRADE and TREND
- Oil (WTI) deflation of -3.3% last week (-11.1% YTD) is bearish TRADE and TREND
- Energy Equity (XLE) deflation of -1.1% last week (-6.6% YTD) is bearish TRADE and TREND
Then, of course, you have trivial risk signals like:
- US 10yr Treasury Yield crashing (-27% YTD) to 2.19% (bearish TRADE, TREND, and TAIL)
- US Treasury Yield Spread crashing (-31% YTD) to +182bps wide (10yr minus 2yr)
- And Credit Spreads starting to move off of their all-time lows as equity and commodity volatilities breakout
“So”, yes, I do see more red pending in US, European, and Emerging Market Equities in the coming weeks and months. And, no, I don’t think last week’s immediate-term capitulation was the bottom.
But consensus does! Here’s the updated net positioning of hedge funds in non-commercial CFTC futures/options terms:
- SP500 (Index + E-mini) got longer by +5,537 contracts to a net LONG position of +54,153 last week
- 10yr Treasury Bond saw shorts get -6,976 contracts shorter last week to a net SHORT position of -58,930
- Crude Oil bulls only gave up -14,225 contracts last week, keeping the net LONG position at +285,500 contracts!
In other words, consensus got longer of the US stock market, shorter of the Long Bond, and not nearly less-long enough of a crashing Oil price.
I know that some are frustrated out there with their performance. I can assure you that I’ve been there and had to deal with that. But there comes a time where you have to choose between being consensus and not seeing any more red in your P&L.
Our Immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.09-2.28%
WTI Oil 79.96-84.58
Best of luck out there this week,
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Takeaway: YUM could easily be the next Restaurant company to face the scrutiny of an activists. We see 32-53% upside under such a scenario.
We are adding YUM to the Hedgeye Best Ideas list as a long.
Vulnerable to Activism
Both Wall Street and the media have been focused on McDonald’s as the next target of activism in the restaurant space. While it certainly could be, we believe the often overlooked Yum! Brands is the more sensible target. Unlike McDonald’s, YUM’s multiple brands and new operating structure can, and should, be altered in a way to create significant shareholder value.
For the better part of the past two years, management has been asked about a potential spinoff of the China business. Spinning out this business would be the first step in a series of potential transactions that would simplify the structure and improve the operating performance of the company. In fact, we find it likely that a group of influential shareholders begin to push the board in that direction.
We’ve been saying for years that multi-concept restaurant companies are structurally flawed, putting them at a distinct disadvantage to their nimble counterparts. If you recall, YUM initially got off to a rocky start as a public company, but has benefitted greatly over the last decade as growth in the China business has largely overshadowed inefficiencies and other underperforming brands. For this reason, YUM has never been lumped into the category of inefficient multi-branded restaurant companies.
Times are a changing for YUM. The company’s growth driver, China, has been under pressure and the overall performance of the enterprise has suffered, while the stock has underperformed the S&P 500 for the past three years. Underperformance is the kiss of death and typically the starting point for most activist white papers.
But mere underperformance is only the tip of the iceberg. There have been a series of transactions in the restaurant space that highlight how vulnerable YUM is to more progressive thinking. The balance sheet is underleveraged and there is ample liquidity in the marketplace to fund the type of restructuring we believe would benefit all constituents.
Activist investors have been an ambitious bunch lately, amassing war chests to support their cause. In the last two years, we’ve seen the community shift from buying up 5-10% stakes in smaller companies to buying smaller stakes in larger targets and working together to effect change. Recent examples of this include Icahn’s Apple campaign, ValueAct Capital Management’s sub-1% stake in Microsoft, Elliott Management Corp’s $1 billion investment in EMC and Jana Partners’ $1 billion investment in Apache Corp, which is approximately the same market cap as YUM.
In this day and age, YUM’s $31 billion in equity value is now in the sweet spot of the activist pool.
We’re not going to wait for an activist to come knocking; rather we’re going to lay out the activist thesis for you in an upcoming presentation. It will focus on the following key points:
- The new global reporting structure of the company allows for a clean split of the business units into multiple asset-lite business models.
- Creating a Pan-Asian KFC business listed on the Hong Kong exchange and headed by a Chinese national would limit the pressure being placed on the business by the Chinese government. A Hong Kong-listed company would go a long way in restoring consumer faith in the KFC brand in China.
- The BKW/THI deal highlight’s YUM’s underleveraged balance sheet.
- More shareholder friendly thinking would lead the board to take advantage of the liquidity in the marketplace and increase the leverage of the company to pay a special dividend or repurchase stock.
- There is significant liquidity in the franchisee community to refranchise more stores and structure the company as an asset-lite business.
- Cut excess G&A spend.
- Global asset-lite restaurant companies are trading at a 30% premium to YUM on an EV/EBITDA basis.
Importantly, YUM is already amidst a significant transition. David Novak, the charismatic CEO the company, is stepping down at the end of the year. Mr. Novak has been an incredible CEO and is the backbone of this company. With that being said, it will be extremely difficult to replace him.
The company announced last May that Greg Creed, the CEO of Taco Bell, will take on this daunting challenge as the next CEO of Yum! Brands. At the time, we believed the selection of Mr. Creed as CEO was a strange, although not illogical choice. It’s not that we don’t think Mr. Creed will make a good CEO, but rather that we expected Sam Su, the CEO of YUM China, to replace Mr. Novak. That would've, however, required Mr. Su move to the U.S., which is something we believe he didn’t want to do. Potentially for good reason; he is needed in China more now than ever before.
This leads us to believe that the leadership team, under a new operating structure, is already in place. YUM currently has several viable, and competent, CEO’s within the organization. When considering a potential split of the company, the two most important divisions (Yum! Brands China, Taco Bell) have management team’s that would ensure a smooth transition.
- Sam Su as CEO of the Pan-Asian KFC business
- Greg Creed as CEO of Taco Bell
We will work around these assumptions in our forthcoming black book on the company. With such strong assets, an opportunity for value creation is readily apparent to most investors. As a standalone business, we believe each of YUM’s brands would trade at a premium to where the conglomerate is trading today.
Under the scenario we will layout in our upcoming presentation, we believe the stock could trade between $95-110, representing approximately 32-53% upside from current levels.
Takeaway: Current Investing Ideas: EDV, GLD, MUB, RH, TLT and XLP.
Below are Hedgeye analysts’ latest updates on our six current high-conviction long investing ideas and CEO Keith McCullough’s updated levels for each.
At the end we also feature two pieces of content from our research team, including a note revealing insight on what next week's midterm elections could mean for defense stocks.
Trade :: Trend :: Tail Process - These are three durations over which we analyze investment ideas and themes. Hedgeye has created a process as a way of characterizing our investment ideas and their risk profiles, to fit the investing strategies and preferences of our subscribers.
- "Trade" is a duration of 3 weeks or less
- "Trend" is a duration of 3 months or more
- "Tail" is a duration of 3 years or less
CARTOON OF THE WEEK
U.S. consumer spending fell 0.2% in September, according to a government report released Friday. It’s yet another sign of the weak U.S. consumer.
TLT | EDV | XLP | MUB
THE MONEY TEAM: TLT, EDV, MUB & XLP
The Money Team is a masterfully engineered marketing scheme/branding group consisting of ringleader Floyd “Money” Mayweather, 50 Cent, Justin Bieber, Lil’ Wayne and Warren Buffett. Yes, that Warren Buffett.
With respect to our Macro Team’s bullish bias TLT, EDV, MUB and XLP, these positions have held up masterfully in the context of a barrage of universal bullishness over the past ~10 trading days. Specifically, these positions continue to evade even the toughest “punches” from the same investor consensus that has been negative on long duration fixed income all year – much like the great “Money” Mayweather himself.
Also like Floyd, they have been throwing counterpunches of their own – in the form of this week’s slowing economic data, none more important than the Q3 GDP print:
- Headline: 3.5% QoQ SAAR from 4.6% prior
- YoY: 2.3% from 2.6% prior
- Consumption: 1.8% QoQ SAAR from 2.5% prior
- Investment: 1% QoQ SAAR from 19% prior
- Net Exports: 7.8% QoQ SAAR from 11.1% prior
- Gross Domestic Purchases: 2.1% QoQ SAAR from 4.8% prior
- Real Final Sales to Gross Domestic Purchasers: 2.7% QoQ SAAR from 3.4% prior
In fact, one could argue that the lone bright spot in the Q3 GDP report was “G” – a.k.a. pre-election government spending, which accelerated to 4.6% QoQ SAAR from 1.7% prior and contributed 24% (83bps) of the 350bps headline figure.
Our multi-cycle backtest data shows that the rate-of-change of the rate-of-change (i.e. 2nd derivative) in real GDP has been the primary determinant of the direction of bond yields in the U.S. And since our models continue to call for slowing (and falling inflation) over the intermediate term, we continue to think rates are likely to test/make new lows over that duration.
As such, defensively positioned investors should continue to outperform their counterparts as we inch closer to year-end.
Remember November 2007?
Of course you do…
A stronger dollar is not good for the commodities complex. Nor is A Yen bazooka because commodities, priced in U.S. dollars, get cheaper. We’ve been bearish on the commodities space since we entered a QUAD#4 set-up half-way through the year. Consequently, gold has move inversely, which is what we expect:
1-month correlation: -.79
3-month correlation: -.95
6-month correlation: -.84
1 -year correlation: -.58
To be clear on gold we’re wrestling with two conflicting factors and on the strong USD set-up is winning the battle right now.
- For one, our idea about gold’s interaction with Fed policy and the dollar may still manifest because our model is signaling that consensus expectations for growth remain too high and that growth and inflation are decelerating in the United States.
- In the meantime the relative currency debasement from the BOJ and ECB since we added Gold to investing ideas at the end of May has strengthened the dollar and hurt the price of gold.
With Yen-finity, and the final step of fed tapering from the Federal Reserve ending this week, gold took a big hit, and we would not buy it right here in real-time alerts. Gold failed at its first attempt to move back above its intermediate-term TREND line, and we will wait and watch for follow-through over the next week to see if Yen-finity can move the YEN to a level against the USD that can hold.
With the strong negative correlations inherent in a QUAD#4 deflationary set-up and a breakout in the VIX, our risk ranges in big macro widen out (the absolute price movements needed to generate overbought and oversold signals are larger). Therefore the chance of gold testing its $1231 intermediate-term TREND line again is greater in an environment of higher volatility. Stay tuned for direction.
One of the most powerful growth algorithms in the consumer space. We think that by 2018 the company will earn $11 per share.
Common perception is that RH is building a bunch of palaces and hoping that people will show up to shop. We think about it the other way around…they are creating assortments of product across multiple categories in the home space, and are subsequently taking a massive piece of a category where they only have 2-3% share. Yes, bigger stores are a part of this, which is critical to support the kind of product extensions we’ll see from RH.
Currently, the Legacy 9,000 sq. ft. stores only house 10% of the SKUs and run at about $10mm per store. The 25,000 Design Galleries highlight closer to 30% of the product, and they average a ‘per foot productivity’ rate that is 2x the existing core.
People often ask us about why RH has the right to expand into new categories of Home. People asked that same question about Ralph Lauren in the 1980s when he expanded beyond neckties and polo shirts. This remains our favorite name in retail.
* * * * * * * * * *
ADDITIONAL RESEARCH CONTENT BELOW
Midterm Elections and Defense Stocks
Editor’s Note: We thought we’d do something special this week, and take you behind the scenes of Hedgeye’s research team. Below, Jay Van Sciver, our Industrials sector head, answers a question about defense stocks and next week’s midterm elections.
With the US Government spending more on defense in the third quarter and it looking like the Republicans will probably get a Senate majority, how do defense stocks look for investment now?
This is a big question and each contractor can have its pluses and minuses, particularly smaller ones. That said, here is a broad answer:
The question relates to the blip up on the right of the chart below. In the grand scheme, when defense spending declines, it tends to decline for about a decade. Defense cuts tend to be a bit reflexive, just as buildups are. We built down during conflicts, like the first Iraq war, too. Judging by history, we still have a long period of declining real defense spending ahead of us.
Procurement, which impacts contractors, tends to be even more cyclical. Cuts in defense spending can also take a while to filter through to contractor reports. The blip up is partly driven by the urge to commit funds before the government fiscal year-end at the end of 3Q (use it, or lose it), which is bigger because of the last budget deal.
As for whether to buy defense stocks, my answer is “No!” They group has been bid up on the expectation that dividend increases (it’s an interest rate sensitive group) will follow better cash flow from changes in the way the government reimburses pension costs.
While positive, accelerated pension payments do not change the value of contractors all that much because the government has owed them reimbursement – it was just behind in the payments. DoD is just paying faster now.
What also changed, we think, is that the Overseas Contingency Operations (OCO) funding has been used to protect defense budgets from steeper cuts. In a sense, this could be view as a misdirection of what are supposed to be funds for active engagements toward base spending. Regardless, the OCO funds are exempt from sequestration and are a fantastic political tool to keep spending up AND look tough on deficits.
These two factors have pushed valuations beyond historical norms during a builddown, which is pretty exceptional. We show Relative EV/Sales for NOC below, since P/Es are often hard to use for cyclicals (many contractors had very low earnings/losses in first half of 1990s).
As for Republicans, it seems that there are isolationist/deficit hawks in the party that tend to split its traditional support of big defense. Neither party seems to want to flinch on the grand deficit reduction bargain. Washington is a funny place, but midterms do not look very impactful. Bigger changes may come after 2016.
The group lacks a good downside catalyst at the moment, but we are certainly looking for one!
(Click on the title to unlock this content)
Here's our Retail sector team's take on athletic retailer Under Armour from the day when the company reported its third quarter earnings.
Takeaway: Consensus equity bulls won the day thanks to Japan, but, in the end (likely sooner rather than later), we all lose.
“The Death of Active Management” Just Accelerated
Q: What happens when stocks go up every day, across sectors, style factors and countries?
A: Volatility collapses and variance (i.e. return dispersion) disappears.
Q: What happens when there’s a globally coordinated Central Plan to inflate asset prices – effectively crushing volatility and variance in the process?
A: Asset prices inflate on thinner and thinner volume as investors increase their allocations to passive index exposure in lieu of active management, at the margins.
Q: What happens when there’s a globally coordinated beta chase facilitated through the rise of relatively liquid investment vehicles like ETFs?
A: Asset prices surge higher, forcing active managers to take on leverage and/or liquidity risk in order to keep pace – effectively calling into question the very need for active management in the first place.
We’re not trying to be trite about this. We won’t mince words either.
In that spirit of being frank, anyone who thinks the pension fund industry, retail investors and/or sovereign wealth funds aren’t seriously reconsidering how much they are willing to pay “2&20” or even 60-75bps (for a mutual fund) for exposure to a subpar return profile is smoking peyote.
In fact, the latest data would seem to suggest they are shunning active management at an accelerated pace across the globe: http://www.efinancialnews.com/story/2014-10-29/two-major-pension-funds-railpen-bt-pension-scheme-join-hedge-fund-pullback.
Obviously, we are in the business of servicing active managers so we do not approve of the risk central planners are imposing upon our livelihoods any more than you do. We are all in this [sinking] boat together…
Back to Japan… What a Freaking Disaster
At ~7pm on Friday evening (assuming anyone is even at their desks still “actively” managing risk), you probably don’t need me to rehash what happened in Japan overnight.
In short, the BoJ surprised investors by expanding its QQE program to an annual target of ¥80T (up from ¥60-70T prior) – just hours before the $1.2T Government Pension Investment Fund of Japan (GPIF) announced widely telegraphed changes to its target asset allocations:
- JGBs: 35% from a target of 60% prior
- Foreign Debt Securities: 15% from a target of 12% prior
- Japanese Equities: 25% from a target of 12% prior (NOTE: GPIF already has 17% of its assets in Japanese stocks, so the delta is less incremental than widely assumed)
- International Equities: 25% from a target of 12% prior
It’s hard contextualize how out-of-left-field this contested move by BoJ Governor Haruhiko Kuroda truly was (5-4 vote, to be exact). Our proprietary monetary policy and currency war models – which are far and away the most robust tools on the Street – suggested Japan had a fair amount of hay to bale in order to justify incremental easing – something Kuroda himself even agreed with us on just days ago!
Alas, as our early-2013 profile of the man clearly outlined, Haruhiko Kuroda has always been an outspoken proponent of “shock and awe” monetary easing. With the JPY down -2.8% vs. the USD and the Nikkei up +4.8% on the day, it’s clear to say he achieved his targeted shock value.
Interestingly, GPIF has to divest itself of ~¥30T in JGBs – the exact amount of the BoJ is targeting for its increased purchases. It’s also worth noting that the BoJ’s plan to now target ¥8-12T in JGB purchases per month is roughly in line w/ the Finance Ministry’s ~¥10 of net issuance per month. The BoJ is already the largest single owner of JGBs, at about 21% of the float.
Let’s follow the bouncing ball here…
Debt monetization = currency debasement:
Currency debasement = rising inflationary pressures; it’s worth noting that mineral fuels account for only 34% of Japanese imports (w/ crude oil accounting for roughly half of that total):
Rising inflationary pressures = an eventual rise inflation that threatens to slow Japanese consumption growth even further than it already has:
All told, yet another recession in Japan is not out of the band of probable outcomes over the intermediate term in the context of the recent loss of sequential economic momentum across a variety of key indicators:
Lots of red developing in the left-most columns of that table indeed.
We’ve Never Been in the Japanese Hyperinflation Camp, But the Risk Is Indeed Rising
To top that all off, the consumption tax is scheduled to get hiked by another +200bps on April 1st, 2015 and both Finance Minister Taro Aso and BoJ Governor would like things to proceed as planned.
The upside risk (to the economy) is that Shinzo Abe caves into rising political pressure stemming from a recent pullback(s) in public support for his cabinet and pushes out the fiscal tightening to some distant year.
In most cases, a lack of fiscal sobriety in Japan is a non-event. But now with such a large investor exiting the JGB market, on the margin, (and others sure to follow) and with Japan careening towards becoming a net capital importer, Abe backing away from his plan to halve the primary balance deficit by FY15 risks a loss of faith in the sustainability of the JGB #Bubble.
Who's at risk of having to blow out of their JGB exposures?:
- Banks, which are over-allocated due to persistent surplus deposits: 35.5% of the float
- Insurers: 19.3% of the float
- Public Pensions: 6.4% of the float
- Pension Funds: 3.4% of the float
- Foreigners: 8.5% of the float
- Households: 2% of the float
This we now know for sure: the more sellers of JGBs that emerge, the more the BoJ is likely to step up its role as a provider of liquidity in that market.
That risks triggering a pseudo-hyperinflationary spiral in the Japanese yen and, as it relates to the sustainability of the Japanese economy and everything we discussed above regarding active management, this chart all but confirms our fears:
Ladies and gentlemen, we are now fast approaching the other side of our then-bullish [contrarian] thesis on Japanese equities we introduced roughly two years ago.
Investment Conclusion: Remain Short of Japanese Equities and Long of the Japanese Yen… For Now
We’re inclined to maintain our short bias on the DXJ and our long bias on the FXY for now. We think recent moves are exaggerated in both directions in the context of a highly likely dearth of incremental Policies to Inflate over at least the next few months.
That being said, however, we are actively looking for a rise in cross-asset volatility as an opportunity to exit this position in the coming weeks. In short, we are now wrong on this trade and are seeking to minimize the damage by not covering high (DXJ) and selling low (FXY).
Have a great weekend,
Associate: Macro Team
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