Hedgeye senior macro analyst Darius Dale discusses what to expect from the Fed to Fox Business Host Liz Claman on "Closing Bell" ahead of their latest meeting.
This note was originally published at 8am on July 16, 2014 for Hedgeye subscribers.
“And a young prince must be prudent like that,
giving freely while his father lives
so that afterwards in age when fighting starts,
steadfast companions will stand by him and hold the line.”
As many of you know, I recently joined the ranks of fatherhood after a solid run as a bachelor. Fatherhood is great on so many levels, but also very intriguing intellectually. As my daughter emerges on her 6th week, her mother and I have started talking a lot about sleep training, or lack thereof.
It seems there are many different (and really divergent) views on how to encourage a baby to fall asleep on a timely basis and, also, how to to ensure she gets the right amount of sleep. On one extreme, there is the "cry-it-out method," in which the infant figures out how to sleep on their own. On the other extreme is "attachment parenting" in which the infant is basically brought into the familial bed.
After doing a survey of my friends, one suggestion that was most unique was to read Beowulf just before bedtime. I’m not sure if we will employ the so called “Beowulf Method,” but admittedly if it didn’t put our little Emmy to sleep, it would certainly work with her parents.
Speaking of sleep training, global asset markets continue to be in deep REM sleep. In our Q3 themes deck, we emphasized this with our theme: Volatility Asymmetry. A few highlights from that theme include:
- U.S. equity volatility is literally at an all-time low and well below the 20-year mean of 20.05;
- Fixed income volatility is also literally at an all-time low and the current reading is 54.03, which is in the 1.5% percentile versus the long run mean of 99.7; and
- Finally, the JPM Global foreign exchange volatility index is at 5.45 versus the long run mean of 10.6.
Yes, it is official -- the world’s central banks have lulled the markets to sleep, for now at least.
Back to the Global Macro Grind...
The interesting thing about global markets of course is that global risk can happen all at once. Any of you that have invested and thrived over the last decade know this fact only too well. As of late, so do those investors that have parked capital in Portugal.
No doubt most of you have been following the woes of Espirito Santo family of financial institutions in Portugal over the last month. This morning the news actually got incrementally worse. Specifically, Riforte Investments SA, a holding company in the Espirito Santo family, missed a $1.2Bn payment of commercial paper yesterday.
The Portuguese Central Bank Governor was quick to put on his super central banker cape and fly to the rescue. In prepared comments, Carlos Costa indicated that shareholders of the parent were standing ready to inject more capital if needed. In the short run, this has actually helped as Banco Espiritu Santo’s bonds and stocks have recovered a portion of their losses.
Nonetheless, as we’ve highlighted in the Chart of the Day below, Portugal has disconnected with Europe rather quickly in the last month or so. Over the month, Portuguese equities are down more than 12% and are now down on the year just over 4.2%. Of the major markets in Europe, only Russia is down more (for some obvious reason related to the Ukraine).
No surprise, Portuguese sovereign debt has seen a comparable spike in yields. While the 10-year yield of Portugal is still at a reasonable 3.73%, the fact remains that this yield has widened dramatically versus its peripheral peers Italy and Spain. We have also seen Portugal’s sovereign debt auctions have a much tighter bid-to-cover as of late.
The big question remains whether this is a canary in the proverbial global market coal mine, or, conversely, whether the bad news is priced in. Our Financials Sector Head Josh Steiner likely put it best in his weekly Risk Monitor note when he wrote the following (emphasis mine):
“Portugal's Espirito Santo Group continues to dominate news flow on the banking front. Both EU and US global bank swaps are widening sharply, and TED Spread is beginning to widen as well. For now, there appears to be no reason to assume that Espirito Santo's problems are widespread, but there is a rising level of uneasiness as investors ask how could this bank, which was under so much scrutiny for the last few years, suddenly be now having such problems?”
His point is an astute one and time will tell whether this is the awakening of risk that seems to be broadly not priced into global asset classes.
Unfortunately for Europe, which remains under the strains of too much debt, the economic data coming out of Europe as of late, with the exception of the United Kingdom, has been less than robust. Most telling this week was the reading from the German ZEW economic expectations index.
Expectations coming into the number were for a notable deceleration, but the actual number was much worse than expected. Specifically, July printed 27.1 versus expectations of 28.2 (29.8 prior). In reviewing the leading indicators for May, industrial production fell for a third consecutive month, missing expectations, and factory orders also missed. The ZEW Current situation survey also fell sharply from June while consensus expected a slight deceleration. That gauge printed 61.8 versus expectations for 67.4 (67.7 prior).
Growth slowing and banks imploding . . . perhaps our call that the U.S. Federal Reserve will be more dovish than consensus (read Jan Hatzius) believes will happen sooner than expected. But, hey, China just beat GDP by 0.1%, so there is that...
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.49-2.58%
BSE Sensex 24786-26149
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
Client Talking Points
If you ask front-month VIX, the continued relative weakness in early cycle stocks? It is real. Volatility continues to test a bearish to bullish TREND reversal with TREND support now = 11.94. There is no resistance to 14.41.
The XLI (Industrial Select Sector) lead decliners yesterday, closing down -1.3% (it’s down -2.2% for the month-to-date, and now only +1.1% year-to-date.) More importantly, the XLI is now bearish on both our TRADE and TREND durations for the first time in 2014.
The only thing not agreeing with our macro call right now is the U.S. Dollar UP. While a big part of this is Euro DOWN, it’s definitely worth watching as the USD retests where it was in January. It’s signaling overbought – so we’re waiting and watching to see the Fed’s next move.
|FIXED INCOME||24%||INTL CURRENCIES||10%|
Top Long Ideas
Hologic is emerging from an extremely tough period which has left investors wary of further missteps. In our view, Hologic and its new management are set to show solid growth over the next several years. We have built two survey tools to track and forecast the two critical elements that will drive this acceleration. The first survey tool measures 3-D Mammography placements every month. Recently we have detected acceleration in month over month placements. When Hologic finally receives a reimbursement code from Medicare, placements will accelerate further, perhaps even sooner. With our survey, we'll see it real time. In addition to our mammography survey. We've been running a monthly survey of OB/GYNs asking them questions to help us forecast the rest of Hologic's businesses, some of which have been faced with significant headwinds. Based on our survey, we think those headwinds are fading. If the Affordable Care Act actually manages to reduce the number of uninsured, Hologic is one of the best positioned companies.
Construction activity remains cyclically depressed, but has likely begun the long process of recovery. A large multi-year rebound in construction should provide a tailwind to OC shares that the market appears to be underestimating. Both residential and nonresidential construction in the U.S. would need to roughly double to reach post-war demographic norms. As credit returns to the market and government funded construction begins to rebound, construction markets should make steady gains in coming years, quarterly weather aside, supporting OC’s revenue and capacity utilization.
Legg Mason reported its month ending asset-under-management for April at the beginning of the week with a very positive result in its fixed income segment. The firm cited “significant” bond inflows for the month which we calculated to be over $2.3 billion. To contextualize this inflow amount we note that the entire U.S. mutual fund industry had total bond fund inflows of just $8.4 billion in April according to the Investment Company Institute, which provides an indication of the strong win rate for Legg alone last month. We also point out on a forward looking basis that the emerging trends in the mutual fund marketplace are starting to favor fixed income which should translate into accelerating positive trends at leading bond fund managers. Fixed income inflow is outpacing equities thus far in the second quarter of 2014 for the first time in 9 months which reflects the emerging defensive nature of global markets which is a good environment for leading fixed income houses including Legg Mason.
Three for the Road
TWEET OF THE DAY
TREASURIES: 2.47% 10yr Yield set to test YTD lows again if US GDP misses perma bull forecasts
QUOTE OF THE DAY
The strength of a family, like the strength of an army, is in its loyalty to each other.
STAT OF THE DAY
Home Prices growth slowed for a 6th consecutive month, decelerating -148bps sequentially in May to +9.3% YoY. This was the 2nd biggest month of deceleration since August of 2010 (last month was the largest at -155bps).
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Takeaway: Our concerns used to be about lofty expectations, now the story is getting hairy. How much longer will the street pay up for fake users?
- CRUSHED 2Q14, BUT NEW CONCERNS: TWTR beat the midpoint of its 2Q14 guidance by a whopping $37M (13.5% upside). Both revenue segments accelerated on a y/y basis, and US User growth sharply accelerated (see below). However, there may be an emerging trend around ad engagements that may mean its runway is shorter than initially believed.
- GUIDANCE RAISE DRIVEN BY ACQUISITIONS?: TWTR spent $134 million on acquisitions in 2Q, all within its Data Licensing/Other Segment, which saw considerable surge in revenue in 2Q (up 43% q/q vs. 6% in 1Q). TWTR raised revenue guiance by ~$100M; but 40M came from 2Q upside to guidance. The question is how much of the raise is organically driven when the Data segment saw a $10M surge in 2Q revenue alongside intra-quarter acquisitions. Waiting for the 10-Q on this one, stay tuned.
- USER NUMBERS ARE EXAGGERATED: This is the bigger story. TWTR has a large number automated accounts (Bots) that link into twitter. These aren't real users, so can't be monetized. More importantly, bots are growing as a percentage of its total, and have represented a substantial portion of its user growth over the past year (+40% of new MAUs), which begs the question, what is the real runway here?
CRUSHED 2Q14, BUT NEW CONCERNS
TWTR beat the midpoint of its 2Q14 guidance by a whopping $37M (13.5% upside). Both revenue segments accelerated on a y/y basis, with advertising revenue growing 129% y/y (vs. 125% in 1Q), and Data Licensing & Other up 91% (vs. 76% in 1Q). The big surprise was the acceleration in US User growth, which inflected higher after 6 quarters of decelerating growth (however, there may be some distortion, see next section for more detail). At face value, just a very solid quarter.
Another positive is that new ad formats and stronger advertiser demand around the World Cup led to its first q/q increase in cost per ad engagement (CPE). However, total ad engagements decelerated considerably q/q to 4% (vs. 28% last quarter). At face value, the combination of these two factors could suggest that TWTR isn't stuffing the channel with rising ad load as aggressively as we expected.
However, it could also mean that TWTR may still be stuffing the channel, but the engagement rate on that rising ad load is declining. 2Q14 marks the first quarter in its reported history where the sequential growth in timeline views outpaced that of ad engagements. If the ad engagement rate is declining, it would suggest that TWTR users are starting to fade/ignore ads. In turn, rising ad engagement would increase at a proportionately lower rate than the increasing ad burden it placing on its members. In short, the attrition risk rises for a waning yield.
GUIDANCE RAISE DRIVEN BY ACQUISITIONS?
TWTR spent $134 million on 7 acquisitions in 2Q, all within its Data Licensing/Other Segment, which saw considerable surge in revenue in 2Q (up 43% q/q). TWTR raised guiance by ~$100M; but ~40M came from 2Q upside to guidance, which translates to roughly $60 increase to its 2H14 outlook.
The question is how much of the raise is organically driven when the Data segment saw a $10M q/q surge in 2Q revenues alongside 7 acquisitions that were added intra-quarter, hence didn't contribute a full quarter of revenues. 2 more were announced in this quarter, both of which are likely factored into guidance as well, and we could see more coming. It's possible that we could see a meaningful shift in revenues toward its Data segment next quarter. We're waiting for the 10-Q to settle this one, so stay tuned.
USER NUMBERS ARE EXAGGERATED
This is the bigger story. TWTR has a large amount automated accounts that link into twitter with no user interaction ("bots"). These bots aren't real users, they do not engage in content, so they can't be monetized (don't click on ads).
During 2Q14, TWTR disclosed that these bots represented 14% of its MAUs (38M); that is double the percentage from 2Q13. Further, these bots represented a substantial portion of its user growth over the past year. Total MAUs increased by 53M y/y in 2Q14, 23M of those were bots (+43%). After backing out bots from its MAUs in 2Q14, real user growth was up only 15% y/y, vs. the 24% reported by management. On a q/q basis, TWTR's real user growth has dwarfed that of total user growth over the LTM, despite the relatively smaller user base
Management comments suggest this may be a growing issue. Timeline views per MAU have been declining on a y/y basis over the past 3 quarters as bots represent a growing percentage of total MAUs, in turn, inflating the denominator. Management stated during the 2Q14 call it expects timeline view per MAU will continue to decline due y/y to "product enhancements", but after backing out the impact of bots, per-user engagement is essentially flat y/y. If management expects the trend in declining timeline views/per MAU to continue, it likely means it expects the bulk of its MAU growth will come from bots moving forward.
So what is the real runway on MAU growth? What happens when the street catches on to the disparity between active and real users, and what happens when its real user growth slips into the single-digits? 15% growth in 2Q suggests we're not that far away. We remain short.
Let us know if you have any questions, or would like to discuss further.
Hesham Shaaban, CFA