Conclusion: In the note below, we attempt to quantify and contextualize Chinese economic growth scenarios over both the intermediate and long term. Needless to say, a structural downshift in rates of Chinese economic growth is not at all out of the band of probable outcomes over the long term and this has major implications for a great many corporations and investor portfolios worldwide.
In the near-manic construct that has become financial analysis, it helps to have a little context. Specifically, we think it’s worth reminding that Chinese growth has been slowing for the larger part of the past two years and the consensus freak-out you’re seeing/hearing about Chinese economic growth is largely overdone. We do, however, agree with the Chinese equity market and the price of copper that the -280bps (-23.5%) slowdown in China’s YoY Real GDP growth rate from the 1Q10 cyclical peak remains a headwind to global growth.
For reference, if the U.S. had slowed by a comparable amount from its 2010 cycle peak, our domestic Real GDP growth would be only +0.7% YoY (down from the latest reading of +1.6% YoY).
Speaking of the market, Chinese equities, which are down for the second straight year and have fallen -27.3% since the start of 2010, have been discounting this deceleration in growth for quite some time now. Given, we don’t think it pays to use today’s GDP print as an opportunity to jump on the “Chinese GDP is getting halved bandwagon” (which is expected to happen within the next year by 12% of the respondents in the latest Bloomberg Global Poll of Investors).
That said, however, we continue to believe that bottoms are processes – not points – and China is no different than anything else in the price discovery matrix. In our opinion, valuation remains no catalyst here until inflection points in each of our three core factors (growth, inflation, and monetary/fiscal policy) are within reach. The rub, as always, will be in determining what is within reach (catalysts becoming supportive) vs. what is priced in (consensus sentiment presenting an asymmetric opportunity).
Quantitatively speaking, our models are currently pointing to a 1Q12 bottom in Chinese real economic growth in the mid-to-high 8% range (pending more data, of course). That doesn’t seem so bad from current levels, but it’s an enormous delta from the pre-crisis peak quarterly growth rate of +14% YoY registered in 1Q07 (down nearly -40%, to be exact).
Keeping that in perspective, we argue that consensus has been having a “big boy talk” with China pertaining to the sustainability of its current economic growth model of investing in what are widely rumored to be largely unproductive property assets and transportation infrastructure. Fixed asset investment now accounts for 69.3% of Chinese nominal GDP – up +2,870bps/+70.1% from the 40.6% ratio recorded just eight years ago! As of 2010, gross domestic capital formation contributed nearly half of all of China’s economic growth (48.6%) – 1,360bps higher than India, which we’d argue is a comparable country in both size and economic development. Additionally, at nearly half of GDP, modern-day China is more levered to gross domestic capital formation as a means of economic growth more so than Malaysia, Thailand, Indonesia, South Korea, and Hong Kong were in the years leading up to the 1997-98 Asian Financial crisis.
Given the long-term headwinds facing both China’s property market and banking sector (which we have quantified in recent notes; email us for copies), it’s likely that the peak in these ratios is in the rear-view or within reach.
Whether China will be able to gracefully rebalance its economy towards a more consumer-driven growth model in the process – as outlined in the current 5yr plan which calls for only +7% economic growth rates – will go a long way towards determining the slope of global economic growth over the long-term TAIL – particularly given the debt, deleveraging, demographics, property market, and structural unemployment headwinds facing the U.S. and parts of the E.U. Obviously this has major implications for a great many corporations and investor portfolios worldwide.
Indeed, that is a TAIL risk worth pondering for any long-term investor. As the law of large numbers reminds us, as China continues to grow larger (now the world’s second-largest single-nation economy), a structural downshift in rates of Chinese economic growth is not at all out of the band of probable outcomes over the long term.
Positions in Europe: Short EUR-USD (FXE)
France’s credit rating is going to get downgraded – now the question is when, and what becomes of the EFSF? The three main ratings agencies (Moody’s, S&P, and Fitch) are classic lagging indicators, however Moody’s announcement to downgrade France’s AAA credit outlook from stable to negative is having significant follow-through market implications. In the charts below we show the spread between German bunds and 10YR French bond yields, which is hitting an all-time wide (since the Euro was introduced) of 110bps today. Additionally, French CDS is trending up and to the right (currently at 193bps) and the French 10YR bond yield has gained 57bps in October alone.
The rise in yields and risk increases France’s debt servicing costs at a juncture in which its outstanding sovereign debt is elevated and its banks look to require more funding. On the French sovereign side, €122 Billion in debt (Principal and Interest) is due into year-end and €259 Billion will be due in 2012 on a €1.9 Trillion economy. That compares to year-end maturing debt figures of €64 Billion in Germany (on a €2.5 Trillion economy) and Italy at €68B on a €1.6 Trillion economy.
On the banking side, the European Banking Authority is considering increasing the core Tier 1 capital ratio level to 9% in a third round of tests (from 5%). If this is the case, Credit Suisse estimates that France’s four largest banks will need to raise €43 Billion, or 2.2% of France’s GDP. If state recapitalization was mandated this would likely push France’s 2011 estimated Debt as a % of GDP to 88.4% from 86.2%, and add to that the upward pressures from the government’s guarantees of Dexia’s losses. As Reinhart and Rogoff outline in their book “This Time is Different” a 90% level of debt (as a % of GDP) is prohibitive to economic expansion. In our work in conjunction with our Financials Team we’ve also shown the exposure risks of European banks to the PIIGS. As it relates to French banks, we’ve noted in particular BNP Paribas’ massive Core Tier 1 capital exposure to sovereign debt and commercial loans of 194%.
Politically, Sarkozy continues to lose support, as high unemployment, at 9.2%, or 22.8% among youth, create dissent and the country remains more hostage to domestic demand (unlike Germany) to grow.
Should a ratings agency cut France’s credit rating, which we think is highly probably—although we wouldn’t rule out Eurocrat measures to prevent such a move (through influence) or to act to create its own ratings agency—it would throw a wrench into the EFSF, 20% of the collateral for which France is on the hook for, the second largest contributor behind Germany at 27%. Essentially, the EFSF would be back at square one with the likely outcome that the ECB would be forced to take on a big role to bailout/provide the bazooka for Europe.
Europe’s sovereign and banking crisis seems to live one day at a time. However, we hope you can get ahead of the risk that France’s credit rating deteriorates from here.
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McCarran Airport posted a 9% increase in traffic.
Assuming normal slot and table hold percentages, we are projecting a 6-8% year over year increase in total Strip gaming revenue in September. The big driver should be table drop which could be up 20% over last year. Hold percentages in September of 2010 were slightly higher than normal on both tables and slots so that is somewhat of an inhibiting factor. However, given the weak numbers of July and August, high single-digit growth in September should be favorably received. We would note that hold percentages can swing wildly from month to month, particularly on the tables – especially Baccarat. However, volumes should show a nice uptick.
Here are our September Strip projections:
Domino’s reported 3Q earnings this morning and confirmed what we already knew: its focus on technology and the consumer experience has helped the company take share from competitors.
DPZ reported 3Q11 earnings this morning that beat expectations on the top and bottom line. EPS came in at $0.35 vs expectations of $0.33. Same-store sales came in at 3.0%, 4.2%, 2.6% and 8.1% for Domestic, Company, Franchise, and International restaurants, respectively. Each print was ahead of expectations.
Technology was a key theme of the call. The increased consumer “mobility” is changing how consumers connect with restaurants. A key difference is emerging between companies that can put technology to work and drive incremental transactions and those that can’t. SBUX is another example of a company successfully leveraging technology to drive sales.
Below are our Top Ten Takeaways from the quarter and management’s commentary during the earnings call:
- Domino’s is changing the business. Digital sales – mobile and online ordering – are now approaching 30% of total sales. This number grabbed our attention and, we believe, lies at the core of DPZ’s market-share story. The ordering experience being that much better than before, together with the improved pizza launched in ’10, is helping the company “comp the comps” despite extremely difficult double-digit compares. In Asia, in particular Japan and Korea, the percentage of digital orders is pushing 50%. Within the US, 1.5% of sales in the quarter came off the iPhone app alone.
- The company’s top-line is as healthy as any in the industry; the top-line compares on a year-over-year basis were extremely difficult and the company posted strong a strong acceleration in company same-store sales two-year average trends (first chart below).
- The comp growth and margin expansion bodes well for the stock (second chart below).
- The company’s margin expansion in the face of elevated cheese costs was impressive; the company’s price of cheese per pound in the quarter was $2.08, up 36% year-over-year and 24% quarter-over-quarter. By the end of the third quarter, the price had come down to $1.79 and the company expects similar levels for the remainder of the year. The company reiterated its expectation that its overall market basket for 2011 will be between 4.5% and 6% above 2010 levels.
- Refranchising has helped the company avoid margin headwinds from increased costs. Consolidated operating margin actually expanded by 36 basis points year-over-year to 27.5% as a result of a change in the mix of revenues due to fewer company-owned stores and increased franchise revenues and also an increase in company-owned store operating margin.
- Company-owned operating margin increased 2.6% year-over-year because of labor efficiencies and lower insurance expenses offset by cheese and meat inflation (third chart below).
- The company intends for the “$7.99 for two” price point to become a permanent addition to the menu. Even at that low price, management says that the company and franchisees are happy with the impact on the bottom line.
- The company is going to continue to buy back shares as a means to return value to shareholders.
- While the international business is now approximately equal to the domestic business in size, the population of the US versus the countries that constitute the international markets is only 5%. Management maintains that there is huge runway for growth in international markets.
- Sell-side sentiment on the name is not bullish. There is room for upgrades and, as is typical, when bullishness reaches peak levels it will be a signal to consider becoming cautious (fourth chart below).
POSITIONS: Long Utilities (XLU), Long Consumer Discretionary (XLY)
Yesterday I wrote a note titled “Bearish TREND.” Today its Bullish TRADE – 2 different durations, 2 different risk management views. Less and less people I talk to can afford not to be Duration Agnostic.
Here are the lines that matter:
- TAIL = 1266
- TREND = 1235
- TRADE = 1194
So this morning’s test of 1194 holding (on very ratty pre-market news) is bullish in the immediate-term. And if that’s too immediate-term for some, I guess that’s too bad. With the VIX having a 3-handle, volatility requires us to tighten up our durations and risk management callouts.
Another bullish rotational factor I see today is the US Dollar holding its bid as US Equities rally. Strong Dollar = Strong America. If we Deflate The Inflation, the biggest factor in US GDP growth (consumption) can recover.
That’s why I bought Consumer Discretionary (XLY) this morning when it was red. Our analysts like TGT, EAT, and MAR as ways to play this theme.
Keith R. McCullough
Chief Executive Officer