TREND Support: 3.17
TAIL Line: 3.19 (Previous resistance level and critical breakout line)
Copper ripped +1.8% Thursday after a big manufacturing PMI beat and sold off -83bps on Friday to finish the week +1.7% (up another +12bps today). We added it (ETF: JJC) to real-time alerts on 7/18 and booked the gain on an oversold signal last Friday.
On the move, copper broke out above its previous $3.13 intermediate-term TREND line of resistance last week and remains above its long-term TAIL Line (Refreshed TREND support now at $3.17).
Consensus macro leans on the strength of the Chinese economy as a leading indicator for base metal demand (as it should). China consumes over 40% of the world’s industrial metals (up from 5% in 1980).
2013 Consumption (% global demand):
- Nickel: 47.4%
- Aluminum: 46.1%
- Zinc: 45.6%
- Copper: 42.4%
An equally weighted index of Chinese GDP and industrial production to industrial metals prices (CRB metals index) is running an r-squared of 0.50 currently, down from a December 2011 peak. Although diverging from the 2011 highs, the relationship cannot be ignored as a market catalyst.
I have read the supporting research around the following data points from fundamentally focused sell-side research teams. Most of it supports the argument for the unsustainability, and thus bearish pressure, on Chinese base metal demand:
- Copper and aluminum consumption has increased six-fold since 1999
- China is 3x the size of the United States and, since 2011, base metal demand per capita is trending higher than the United States.
- China’s consumption to investment ratio (consumer demand/cap-ex ) is at historical highs:
- China: 0.7x
- USA: 3.5x
- UK: 4.6x
- Eurozone: 3.3x
- Chinese credit growth has manifest at incredibly rapid rates:
- Aggregate debt level has reached 251% of GDP as of June which is a 20% increase from late 2013.
Note: The commodity-collateralization fueling this rapid increase in credit growth has been continuously highlighted as a bubble in base metal markets. Speculation as to how much commodity-backed financing has contributed to credit growth, along with an investigation into the Qingdao Port warehouse has continuously been labeled a catalyst for volatility in base metal prices. With the opaqueness in obtaining information as to whether multiple parties within the Chinese financial system have used the same metal stockpiles as collateral to access otherwise unavailable credit markets, we choose to focus on the observable. Goldman estimates that $160Bn has flowed into China through commodity-backed loans since 2010. Regardless, the argument that this scandal has helped fuel an unsustainable credit boom has been labeled a bearish signal for base metals.
- Debt/GDP levels have increased 100% over the last five years
- China’s $26 trillion of debt is more than the entire commercial banking system of the U.S. and Japan combined
- On the supply side, an increase in late cycle mining cap-ex flooding the market requires an unsustainable amount of consumption from China
Although we must always look to reported numbers from China with caution, it’s difficult for me to make a fundamental case to buy copper more long-term.
Most of the sell-side research we have consumed points to the unlikelihood of a Chinese economy capable sustaining a rapid increase in base metal consumption. The statistics above may appear staggering, but without a contextual overlay and a market catalyst they fail to provide enough conviction for us to marry the story. Risk moves quickly, and we need to know that the market believes a research call before we would get in front of it. So far, this inflection point has not happened as reflected in base metal prices, especially in copper.
We continue to field mixed economic data out of China, but both the fundamental and quantitative picture turned more bullish late last week. For additional color, click on the link below to access the note:
On one hand the Chinese property market remains a disaster…
- JUN E-House Home Price Index (288 cities): 5.3% YoY from 5.8% prior
- Prices of new homes in 288 cities fell -0.1% MoM in JUN, the third sequential decline in a row
- JUN China Real Estate System Index (CREIS) Home Price Index (100 cities): 6.5% YoY from 7.8% prior
- Average prices in the 100 biggest cities fell -0.5% MoM, the second consecutive sequential decline
With both housing prices and overall construction sequentially decelerating, the outlook for slowing demand of raw materials seems probable.
On the flip side of the coin, after digging into the various forms of stimulus out of local and municipal stimulus, we believe the Chinese government is directly targeting what has been a deteriorating real estate market with its recent stimulus measures which have proven a bullish catalyst for Chinese equities (and base metals):
Excerpt from the above note:
“But perhaps the real reason Chinese policymakers were content to ease monetary and fiscal policy of late was to shore up the country’s crashing property market.
Along those lines, many local governments have taken matters into their own hands by easing home purchase restrictions (27 of 46 cities did so yesterday). Moreover, last week’s statement out of the Ministry of Housing and Urban-Rural Development (MOHURD) would seem to suggest that such easing in property markets at the local level have the official blessing of Beijing as well”.
For now the flow-through from an unconventional mix of stimulus has proven more positive for the slope of Chinese growth than we previously expected. The easing-induced credit growth and positive manufacturing data support trading China with a bullish bias for now.
The correlation between base metal prices and Chinese economic data remains intact. Because we have no other incentive other than to be on the correct side of inflection points across the globe, we absorb the data, and watch the market’s reaction:
- HSBC Mfg. PMI: 52.0 July vs. 50.7 expected (huge blow-out).
- Front-Month copper rips to the upside:1.84%.
- We rode this move for a gain in real-time alerts (ETF: JJC) before selling Friday morning as the move was exhausted to the upside.
If my macro teammates asked my opinion as to whether or not we should go acquire some physical copper and throw it in a warehouse, I would have a tough time passing along a vote of confidence. We absorb, organize, and analyze a slew of economic and behavioral market data on a daily basis, and must be willing to change our opinion if it’ll put us in an alpha-generating position. For those of us who are price-sensitive near-term on both the entry and exit points, we have a few options in the commodity space: futures, derivatives, and ETFs.
Studying the volume, volatility, and critical capitulation levels of the market as a whole provides insight into the behavioral conviction behind a move. Enjoy the electronic trading or not humans and machines have levels, and a sharp directional move eventually becomes exhausted. At Hedgeye, we refer to these short-term TRADE exhaustion levels as OVERBOUGHT and OVERSOLD.
When we then utilize these levels (think of directional moves from a standard error perspective) with a directional bias from an intermediate-term TREND standpoint, the absolute price movements become second derivative changes. Therefore, absolute measures of risk may seem underpriced when multiple durations are observed (which is why we plot and model our perception of risk relative to the markets on multiple durations).
If copper is making a series of higher lows from a TREND perspective (critical observed capitulation levels moving higher) on aggregate futures volume (last Wednesday prior to the HSBC Mfg. PMI print) that is:
~35% below 1,3, and 6-month volume…
Volatility being sold for -3%,-10%, and -16% below 1, 3, and 6-month averages….
Shorting copper on a Chinese supply and demand call for physical copper is a risky position without a catalyst.
Open interest (Open, and un-closed positions both long and short) in the spot market for copper was just 2.3% of average daily trailing 6-month trading volume.
Because the front-month is now illiquid, those holding positions are probably stuck with a position, or intending to transact in physical copper. With so much speculation in commodity markets from both man and machine, a directional confirmation in observed trading activity remains the most important catalyst that must agree with a fundamental call. Feel free to ping us with any questions.
Takeaway: Recent adjustments in monetary and fiscal policy strengthen our conviction on the short side of the South Korean won (KRW).
In line with our forecasts, South Korea posted its first sequential deceleration in headline GDP growth since 3Q12 last week and, underneath the hood, the data showed a fair degree of deterioration in domestic demand.
- 2Q Real GDP: 3.6% YoY from 3.9%; 0.6% QoQ from 0.9%
- Private Consumption: 1.5% YoY from 2.5%; -0.3% QoQ from 0.2%
- Gross Capital Formation: 6.2% YoY from 4.3%; -0.1% QoQ from -0.9%
- Government Consumption: 1.8% YoY from 2.9%; 0.4% QoQ from flat
- Exports: 3.8% YoY from 4.5%; 1.9% QoQ from 1.5%
- Imports: 2.4% YoY from 3.5%; 0.8% QoQ from -0.8%
Looking to the JUN and JUL growth figures, we see that the preponderance of South Korean economic data continues to show meaningful deterioration relative to their 3M, 6M and 12M trends. The negative deltas in PMI, BSI, retail sales, and export trends are some key things to focus on in the following table:
In response to contracting consumption and investment, South Korean policymakers have ratcheted up support for the ailing economy in recent weeks. Key initiatives include:
- Easing home loan restrictions: The Finance Ministry rolled back tightening measures first introduced in the mid-2000s by increasing the maximum loan-to-value ratio to 70% while also increasing the debt-to-income cap to 60%. While obviously a positive development for the South Korean housing market, this is likely to exacerbate what various South Korean officials publicly acknowledge as a debt bubble. For example, household debt as a % of disposable income is 163.8% in South Korea, which is well above the OECD average of 134.8%.
- Introducing a multi-trillion won stimulus package: The government recently unveiled 11.7 trillion won in government spending initiatives while also directing state-backed lenders to extend 29 trillion won in credit. The BoK also stepped in by expanding a low-cost credit facility for SMEs to 15 trillion won from 12 trillion prior.
- Rhetorical easing out of the “BoK”: While the BoK’s main policy rate has been on hold since a -25bps cut last MAY, Finance Minister Choi Kyung Hwan has really stepped up pressure upon the central bank to ease monetary policy by stating Friday that the two institutions share the view that the South Korean economy “needs quantitative easing”. That and his official view that the economy is in a “very difficult situation” have fueled an expectation among investors in the South Korean bond and interest rate markets that the BoK will be “forced” to resume cutting rates over the intermediate term, which is in line with our initial thesis. 2Y sovereign debt yields have come in -21bps MoM while 1Y OIS spreads have tightened -12bps MoM and are now in negative territory.
In spite of these efforts, we continue to see signs of negative momentum reverberating throughout the South Korean economy as highlighted above. As such, our GIP model still has South Korea mired in Quad #3 for the remainder of the year.
Simply put, slowing momentum + a toughening base effect = a likely continued slowdown on the GDP front, while accelerating momentum + a dissipating base effect + easier fiscal and monetary policy =a likely continued acceleration on the CPI front. The growth data may start to surprise to the upside as we get into the fourth quarter, but we’re currently in wait-and-see mode with respect to the efficacy of the aforementioned stimulus efforts.
Our proprietary valuation models see 3-6% downside to fair value on a REER basis and 7-9% downside to fair value on a carry basis. As such, if you have capital allocated to South Korean financial markets, we strongly encourage you to think about hedging away that exposure to potential KRW weakness for at least the next 3-6M.
We say “at least” because the over-leveraged South Korean consumer economy coming unglued remains a key tail risk for investors to ponder over the long-term TAIL. On a consolidated basis, South Korea remains a relative safe-haven in the EM space, but that doesn’t mean it’s without its own unique set of key risks – namely the threat of a material downturn in the credit cycle.
We introduced this thesis back on APR 28 and the KRW has edged up +0.8% vs. the USD since then, which is right in line with the average performance of the 21 currencies we track across Asia and Latin America. Will the -1.2% MoM decline be the start of the KRW unwinding its strong outperformance on a 1Y, 18M and 3Y basis? Stay tuned to find out…
Associate: Macro Team
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Takeaway: Potentially noisy print may send mixed signals to street. We'll be focusing on its core growth strategy, and its shrinking runway.
- NEW MOVING PARTS: Acquisitions, new ad formats, World Cup, management shakeup, potentially new metrics. There will be a lot of noise in this print distracting the street from the underlying trends in the core business.
- WHAT'S MORE IMPORTANT: We believe TWTR's chief source of growth over the LTM has been, and will continue to be, surging ad load. Ultimately, we expect this strategy has limited runway since it risks pushing its users away.
- WILL IT BE ENOUGH?: Upside to estimates is the ongoing street expectation; its quarterly sell-offs on strong results suggest as much. The question is how much upside is the street looking for? We don't know the answer, but either way, it's asymmetric setup to the downside.
NEW MOVING PARTS
TWTR has been very active this quarter. The company has made 7 acquisitions in 2Q14, which we believe is a record for the company. We are not sure how much they will contribute to the top-line, but if anything, it offers some upside to 2Q14 and guidance, especially considering the potential impact of the World Cup on engagement trends.
We've also seen some churn at the management level. The company has eliminated its COO position, hired a new CFO (Noto), moving Gupta to oversee a group focusing on start-up acquisitions, in addition to replacing heads of Finance and Engineering.
There may also be some added noise to the print. WSJ reported that TWTR may introduce new metrics, supposedly to provide another perspective on user engagement (link).
A series of acquisitions, management shake-up, and potentially new metrics sound like management is scrambling; the question is why. Maybe they're seeing what we're seeing: it's going to get that much tougher to deliver the type of growth the street is expecting under its current growth strategy.
WHAT'S MORE IMPORTANT
The issue we see to future growth is how we believe the company is deriving it today: surging ad load (supply). This isn't a reported metric, but the company's trends in reported ad engagements and ad prices paint the picture.
The metrics in the chart below are the sequential change in ad engagement and ad pricing as reported by management (-.86 correlation dating back to 2Q12). We believe the ongoing deceleration in pricing is a reflection of an accelerating level of available ad inventory (supply).
Twitter's ads are purchased through its self-service ad exchange, where the price is determined through a bidding process. We estimate the average cost/ad engagement (price) has cumulatively declined 85% over the last 2 years. We believe a continued surge of increasing ad inventory led to this decline. The tight correlation between ad engagements and pricing during the period suggests rising supply has been its largest source of monetization growth.
It's important to note what happened in 2Q13, when TWTR saw its sharpest drop in ad price, which we see as massive supply shock in ad inventory. In order to sustain its growth trajectory, TWTR needed a comparable surge in ad supply in 2Q14, which is what we believe they've done. We ran a small poll of twitter users asking if they have noticed rising ad load, 71% said yes (link). Remember TWTR's ads are scattered throughout a user's timeline, so far such a high percentage of users to notice suggests the increase is considerable.
Now the issue with this strategy is that there will be a point where rising ad load will push the user away because TWTR's ad revenue/engagements are primarily driven by mobile (smaller screen). We're not saying they will lose the loyal user, but the quasi-plugged-in casual user, who are more likely its newer members. In turn, user growth will become more challenging because the company will have to produce growth alongside a growing churn issue. If user growth starts to meaningfully decelerate, the street will likely punish the stock for it, even if revenues are climbing. One way or another, something has to give: revenue or user growth.
WILL IT BE ENOUGH?
TWTR's short public history suggests it has fallen victim to outlandish expectations. Despite the beats and raises on both the 4Q13 and 1Q14 prints, the stock has sold off on each. With TWTR, the expectation isn't consensus, its beating consensus, so the question is how much of a beat is the street expecting?
We don't know the answer to that, but we do see an asymmetric setup to the downside. Further, with upside comes a higher hurdle later on, as consensus increases estimates for 2014, but more so for 2015.
So the longer-term question is what happens when to the stock when TWTR can no longer jump the ever-increasing hurdle?
Let us know if you have any questions, or would like to discuss further.
Hesham Shaaban, CFA
We are bumping up short MCD to the Investment Ideas list.
MCD is under siege on three continents (America, Europe, Asia) and senior management's response to these crises will determine the future and the future profitability of this company. Hopefully we don't see a pattern of missteps similar to those that created one of the biggest public relations nightmares in the history of McDonald's.
Students of McDonald's history know that the "McLibel" case was a very dark period for McDonald's Corporation. This case was an English lawsuit for libel filed by McDonald's Corporation against environmental activists Helen Steel and David Morris over a pamphlet highly critical of the company. The litigation, drawn out over a ten-year period, embarrassed McDonald's and caused the U.K. business to underperform for more than a decade.
McDonald's is currently under attack from different groups over varying issues in three key countries across three separate continents. How management handles these issues will be critical to the future of the company.
- In the U.S., McDonald's (and other QSR chains) are under attack for poor wages and inferior food quality compared to other, more "fashion forward," restaurants.
- In Russia, the country's Consumer Protection Agency has filed a claim accusing the restaurant chain of violating government nutritional and safety codes in a number of its burger and ice cream products.
- In China, the meat supplier issue is creating serious issues in the form of availability and product quality concerns.
How management responds to these issues is critical to the future performance of the company, as they are not insignificant markets. If the company's initial response to the meat supplier issue is any indication, we could be in for an extended period of underperformance.
China - Last Thursday, McDonald's said it is sticking with a Chinese meat provider, even after saying earlier in the week that it may have been misled regarding sales of allegedly expired meat. The supplier is Shanghai Husi, which is owned by U.S. based OSI Group, a longtime supplier of McDonald's. Clearly, the company's ties to its Chinese supplier run deep. Today, however, news came out that McDonald's cannot sell its core menu items in China. China is the last bastion of growth for McDonald's and, prior to today's news, the company was not able to meet its unit growth targets.
Russia - We haven't seen any official response to the Russian lawsuit from McDonald's, but how they respond will be critical. Is McDonald's a pawn in the ever-increasing tension between the U.S. and Russia or did McDonald's bring on this pressure by shutting down its three restaurants in Crimea after Russia's annexation of the peninsula in March? Either way, McDonald's is in a very difficult spot. They need to settle this issue immediately and not let another legal case be played out in the press.
U.S. - Wages are headed higher for McDonald's in the U.S. and the company needs to get ahead of the curve. Unfortunately, being a franchised system, the issue is in the control of the franchisees. They won't want to pay higher wages with same-store sales and margins declining.
Turning back to the McLibel case, some of the leading allegations were that McDonald's:
- Wastes vast quantities of grain and water
- Sells unhealthy, addictive fast food
- Alters its food with artificial chemistry
- Exploits children with its advertising
- Is responsible for torture and murder of animals
- Poisons customers with contaminated meat
- Exploits its workers and bans unions
- Hides it malfeasance
McDonald's is a strong global brand that must protect itself against erroneous allegations. It appears that any one of these could be made again today. With that being said, how management proceeds with all the issues the company is currently facing will determine the financial performance of the company for the balance of the decade.
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