CONCLUSION: We continue to warn of material long-term risks to prices in Hong Kong's property market, potentially exposing the territory’s banks to a non-performing loan crisis.
On MAR 25, despite not yet enjoying the privilege of universal suffrage, the people of Hong Kong “elected” its new Chief Executive Leung Chun-ying through a combination of polling and widespread popular discontent with the wealthy elite’s preferred candidate Heny Tang Ying-yen. His supporters in the 1,200-member election committee were eventually outdone by the demands of Hong Kong’s seven million-plus citizens – many of whom had become outright dismayed with the territory’s widening socioeconomic inequality and rising consumer price inflation (particularly in what has become the world’s least-affordable housing market per Demographia at 12x the median salary per the Economist).
Enter Chun-ying (or “CY” as he is popularly referred to). As a member of the pan-Establishment camp (i.e. pro-Beijing), CY campaigned on a populist approach and was often seen rallying support in the city-state’s poorest districts. The statement: “I will be willing to upset the status quo and bring about change,” is indicative of his platform. Upon election back in MAR, he pledged to adequately address the territory’s structural wealth gap as part of his agenda to prepare the nation for universal suffrage in 2017 – making him Hong Kong’s first Chief Executive at risk of being denied a second term as a result of popular mandate. We think that risk will impose great pressure upon him to fulfill his populist agenda over the next five years.
One area where CY could enact great change is in Hong Kong’s property market, where prices have increased +88.2% off of the NOV ’08 lows to an all-time high in the latest reported period (MAY ’12). For reference, the last time Hong Kong property prices were around this level was in late ’97; in the 5-6 years following, prices plunged nearly -70% to a APR ’03 index bottom. Capital outflows predicated by the Asian Financial Crisis, the Russian and Argentinean defaults, the Dot-Com Bubble bursting, and a Chinese banking crisis all contributed to destabilizing forces then. Will the Sovereign Debt Dichotomy play a destabilizing role now? That’s certainly a tough question to answer at the current juncture; nonetheless, it is one that must be debated.
Already, Hong Kong officials have targeted the nation’s property market with regulations designed to remove what appears to be a heavy speculative bid. The latest measures include introducing a special stamp duty (SSD) on housing transactions, forcing borrowers to disclose more information about their mortgage history (potentially forcing some borrowers into lower LTV buckets), and raising minimum down payments and deposits for foreign buyers (mainland Chinese account for 14% of all residential sales) to 50% and an additional 10%, respectively, for dwellings costing HK$10M or more.
If the aforementioned measures are deemed insufficient by the incoming administration – as they have been particularly ineffective at containing prices – CY could impose further measures, potentially opting to speed up the development of subsidized housing and increasing land supply at new home development auctions – the decline of which has limited incremental supply in recent years an been a supportive factor for speculative gains.
A sustained regulatory effort to cool house price appreciation in Hong Kong could potentially lead to a dramatic reversal of that market’s latest melt-up. Whether Hong Kong property prices are officially in bubble territory or not is beyond any point we’d ever try to make; rather we prefer to focus on the risks associated with any policy-sponsored regression to the mean. Per the IMF, commercial and residential mortgages accounted for 22.6% of assets at Hong Kong banks at 15.8% and 6.8%, respectively (DEC ’11). Loans to and equity/debt securities of Hong Kong property developers surely account for additional shares of Hong Kong bank assets – increasing the industry’s aggregate exposure to a potential NPL shock over the long-term TAIL.
Below are a few statistics to highlight the imbalances within Hong Kong’s property market – imbalances that may contribute sustainable inertia once prices start to decline:
At the current prices of 6,288 HK$/sq.ft., a family earning the median income (HK$21k/MO) in Hong Kong can only afford to buy 3.3 square feet of housing per month – down from 5.4 at year-end 2008 and 6.7 in 2000.
Despite property prices nearly doubling in just under four years, the aggregate loan-to-value (LTV) ratio of mortgages in Hong Kong has dropped only -3,600bps to 57.9% – suggesting that the rapid price gains of recent years were supported primarily by a dramatic increase in borrower leverage (+37.8% since year-end 2008).
The previous cyclical bottom in Hong Kong property prices roughly coincided with the announcements of QE1 and China’s major economic stimulus package (CNY4 trillion), as well as the Fed Funds Rate being lowered to the zero-bound. All three massive injections of liquidity served to ignite speculation in Hong Kong’s low-supply property market due to the territory’s tight linkages with both economies (increasingly wealthy Chinese buyers; the Hong Kong dollar’s ~30yr-old peg to the USD essentially binds Hong Kong interest rates to those in the US).Given these linkages, a harder-than-expected landing in the Chinese economy or a lack of further injections of liquidity out of the Federal Reserve could remove the speculative bid and/or prompt outright selling in Hong Kong’s property market.
All told, we continue to warn of material long-term risks to prices in Hong Kong's property market, potentially exposing the territory’s banks to a NPL crisis – something we dug into as early as MAY ’11 in a then-bearish cyclical piece on Hong Kong equities. With a persistent budget surplus and low debt-to-GDP by international standards, the Hong Kong sovereign certainly has the fiscal space to offset any potential domestic banking crisis. That said, however, counting on international policymakers being proactive – rather than reactive – relies on some fairly aggressive assumptions, especially given all that we have learned from watching the US/EU political gong show(s) over the past 4-5 years.
Turing to the scoreboard, the aforementioned cyclical thesis has played out in spades, with Hong Kong’s economic growth – largely a byproduct of the global trade flows – slowed, consecutively, from +7.8% YoY in 1Q11 to +0.4% YoY in 1Q12. Moreover, Hong Kong’s benchmark Hang Seng Index is down -17.6% since last MAY (inclusive of a -31.4% peak-to-trough decline from MAY ’11 to OCT ’11).
Now, we hold a neutral-to-slightly-bearish fundamental bias on Hong Kong equities on our TRADE and TREND durations. On one hand, Hong Kong does not necessarily screen bearishly on our G/I/P processes; on the other, its exposure to mainland China – which itself screens poorly on our quantitative factoring in spite of recent policy easing – is worrisome to say the least.
All told, when it comes to property prices in Hong Kong, even Sir Isaac Newton would find this opportunity asymmetric, favoring short-sellers, as “what goes up, must [eventually] come down”.
Greece has been the flavor of the week for some time now, drawing the most criticism over the European financial crisis. Spain recently made its foray into headlines after accepting a €100 million bailout from the IMF, which will presumably get worse over time. It appears that the next country to make headlines will be Italy.
Hedgeye Director of Research Daryl Jones recently penned a piece for Toronto’s Globe and Mail that focuses on Italian debt. Italy has a €255 billion repayment schedule over the rest of the year that will force it to address its problems in an accelerated fashion. Truly, the worst is yet to come.
Italy, not Spain or Greece, should be on the mind at G20 meetings [Globe and Mail]
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Hedgeye Restaurant Sector Head Howard Penney hosted a conference call with industry expert John Hamburger on Tuesday to discuss the risks revolving around heavily franchised restaurants. The main takeaway is that franchisors are realizing that it’s easier to sit back and collect royalty payments than to own and operate a store, but areas of difficulty in the industry have arisen that plague weakly franchised companies.
They include, but aren’t limited to:
- Poor asset quality: concepts that allow their asset bases to unduly deteriorate tend to fall behind and aren’t able to rectify the situation. Cash-hungry private equity firms do not help with the situation as they focus on the cash and not the subsequent consequences.
- Franchisor/Franchisee disharmony: The disagreements between management and franchisees has been well documented over the years. Communication is more crucial than ever and when a franchisee goes “rogue” by going around corporate-directed rule sets, it raises concerns about the relationship.
- Inconsistent unit performance: Management teams resorting to short-term, promotional strategies to “dress up” the numbers tend to produce choppy results.
The current turnaround strategy at Burger King and Wendy’s (WEN) have been particularly capital intensive as older stores remodel to comply with the new image management has created for them. To quote John Hamburger: “Half of the current restaurants operated by chains are not at the current prototype standard and it’s very capital intensive when remodeling.”
McDonald’s (MCD) will always be a top dog, but Burger King and Wendy’s have their work cut out for them over the next few years.
“Duration neglect is normal in a story, and the ending often defines its character.”
I’m a storyteller. So are you. We tell ourselves, our families, and firms stories every day. We tend to frame each story within the framework of how we think. How we think drives our decision making. In the end, we are all accountable for those decisions.
I made a decision to go to 100% Cash in the Hedgeye Asset Allocation Model yesterday. That’s a first. If you’ve been reading my rants for the last 5 years, I don’t have to explain why at this point. You know where I stand. I do not think that this ends well.
Some people think that it will end just fine. Some people think doing more and more of what has not worked is the only way out. Many people thought the very same thing in 2008, and the moneys in their accounts are still underwater to prove it.
Back to the Global Macro Grind…
You can call me short-term. You can call me the longest of long-term. You can call me whatever you want – that’s all part of the storytelling too. I was never supposed to be a name in The Game. The Old Wall was never supposed to fall.
The Old Wall used to get away with making up Perma characters in their storytelling. Someone was always the Perma Bull. Someone was always the Perma Bear. Some of us call that fiction. Some of us just permanently manage risk, both ways.
I have by no means perfected the risk management process. The day that you think you have is the day you are about to get clocked. The plan is always grounded in uncertainty. The plan is always that the plan is going to change.
As The Game changes, the process evolves. Sometimes the process signals that it’s time to just get out of the way.
To review why I am already out of the way this morning:
- I have no idea what our Central Market Planner in Chief is going to say
- If Bernanke delivers the Qe3 drugs, food/energy inflation will slow real growth further
- If Bernanke doesn’t deliver the drugs, a world full ofCorrelation Risk comes into play
In other words:
A) You cannot beg for Qe and have Accelerating Growth at the same time – the world needs growth, not more debt
B) If you do not get Qe, the US Dollar stops getting debauched, and Commodity Bubbles continue to pop
So that’s why, at this time and price, I have a 0% asset allocation to Stocks and Commodities. Why I have a 0% asset allocation to Currencies and Fixed Income is simply because I know how to manage my immediate-term risk.
I sold both our US Dollar (UUP) and US Treasury (TLT) positions before yesterday’s plundering. That doesn’t mean I cannot buy either of them back. There are no centrally planned rules associated with how much Cash I can be in. At least not yet.
Back to the #1 thing that Bernanke will not mention today that is driving both causality and correlation in real-time market pricing –The Correlation Risk. Here’s how the last 2 months of Correlation Risk between the US Dollar and everything “risk” has looked:
- SP500 = -0.91
- Euro Stoxx600 = -0.96
- MSCI World Index = -0.95
- CRB Commodities Index = -0.94
- WTIC Oil = -0.94
- Copper = -0.93
No matter what storytelling they continue to feed you (and they is all encompassing at this point, from the Old Wall to Washington, DC and Paris, France), this is all that matters right now.
Get policy right (causality), and you’ll get the US Dollar right. Get the US Dollar right (correlation), and you’ll get a lot of other market things right.
We’ve been right 32 out of 33 times since firm inception (2008) on the US Dollar. That’s probably why I haven’t spent the last 5 years trying to get back to a bull market top break-even. I may be wrong this time. If I am, I’ll at least know why.
European central planning storytellers have played their hands. In my own accounts, with 100% liquid Cash (and illiquid Hedgeye stock), I’m holding a hand of kings. For their last no-volume hurrah,Bernanke Beggars better hope he has 4 aces.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1589-1640, $94.84-97.59, $81.32-81.97, $1.24-1.27, and 1329-1362, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
It is tempting to say that the worst is over for McDonald’s, but we don’t think that it is. Our view is that domestic sales trends in June are continuing to be soft and the outlook for the summer is not positive.
Soft Traffic Trends
In early March, we wrote a note titled, “MCD – THE NEW VALUE MESSAGE”, which discussed the changes the company was making to the menu at the time and the importance of the April sales release for investors. We wrote, “investors will be watching closely for an indication of whether or not the new menu strategy is working.”
The April and May sales releases have suggested that the new menu strategy is not working as well as the company might have hoped, with management warning yesterday that “customer traffic will be difficult to grow near term”. On the positive side, the company did highlight an emphasis on staffing to grow the peak lunch rush hour from Noon to 1 o’clock yielding an improvement in guest count growth year-to-date through May.
If customer traffic is flat-to-down but the core lunch business is showing some improvement, where is the slow down coming from? Two thoughts:
- The core menu implemented in March has caused slower traffic as the company’s effort to force consumers to trade up from the $1 menu
- There is little-to-no growth in the afternoon day part
Difficult Summer Comps
Going forward, we are concerned about the ability of the company to comp the comps. Summer 2011 was a period of rapid growth for McDonald’s in the U.S. with beverages being a key driver. Changes on the margin are all-important and we see the decrease in emphasis on beverages as a strategy going forward as being important. While management said that “the U.S. also continues to strengthen its position as a as a beverage destination”, total beverage units were only up 6% versus up 20% in 4Q11, 16% in 3Q11, and 29% in 2Q11. In fact, the word “beverage” was only mentioned twice on the 1Q12 call. The 4Q11, 3Q11, and 2Q11 calls included 4, 8, and 18 mentions of the word “beverage”, respectively. The word “McCafé” was mentioned twice on the 1Q12 call. The 4Q11, 3Q11, and 2Q11 calls included zero, 7, and 11 mentions of the word “McCafé”, respectively.
The evidence suggests that beverages are increasingly becoming a less important part of the vocabulary from McDonald’s’ management team. With that in mind, foremost in our thoughts is what the company’s strategy will be to maintain top-line momentum over the next few months.
Below is our note from March 9th which described our initial concerns about the new menu strategy.
MCD – THE NEW VALUE MESSAGE 03/09/12 02:49PM EST
Some incremental changes coming to a MCD menu near you – what are the implications?
As first reported by Reuters, McDonald's “will be tweaking and expanding their value-priced items” at the end of March. MCD has not discussed this with the street due to competitive reasons.
As we learned in conversation with the company, they are focusing the menu on four tiers (not including combo meals):
- Premium: $4.50-$5.50+
- Core: $3.50-$4.50
- Extra Value Menu (new): $1.20 to $3.50+
- Dollar menu
In trying to understand the implications of what McDonald’s is doing, a restaurant industry consultant and associate of ours had this to say: “I get a kick out of these corporate guys at WEN and MCD pretending they have some magical formula for value pricing. It's 100% driven by food costs and customer behavior.” Given that MCD is seeing increasing inflation in 2012, we believe they are trying to manage check and margin by forcing consumers to trade up to the “extra value menu” from the “dollar menu.” This makes more sense when we consider that one of the biggest changes is to remove small drinks and small fries from the dollar menu and replace those items with fresh baked cookies and ice cream cones.
HEDGEYE: We see this as a big risk for MCD. If customer preference is to have the drink and fries as part of the dollar menu then there is a risk that this change negatively impacts customer satisfaction. The company told us that a “mini-combo meal” offering may bundle the fries, burger, and drink but a decision has not been made on that yet. Still, ordering the $1 items individually is being taken off the table.
The new "Extra Value Menu" will be advertised on March 26th. According to Reuters, “the new menu will include 20-piece chicken McNuggets, double cheeseburgers, chicken snack wraps, Angus snack wraps, medium iced coffees and snack-sized McFlurries, plus up to four regional options, that were previously listed elsewhere on its menu.” The idea for McDonald’s is to streamline and change what is highlighted on the menu. The company likes to phrase this differently, saying that they are, “making it easier for customers to find them [‘Extra Value Menu’ items]”.
HEDGEYE: From our perspective, the big problem is that the "Dollar Menu" has been around for a very long time. Inflation has made it an unprofitable but necessary evil. Customers, also pressed by inflation, have been migrating from the combo meals on the core menu, which can cost $6-7, over to the Dollar Menu where the value customers get is almost double from a price perspective. We view this latest change as an attempt by the company to stem this flow of business from the core menu to the dollar menu. This adds an extra emphasis on the importance of April sales; investors will be watching closely for an indication of whether or not the new menu strategy is working.
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