Reflation's Gravity

“Gravity is a contributing factor in nearly 73 percent of all accidents involving falling objects.”
-Dave Barry

The top 2 stories on Bloomberg this morning have the following headlines: 1. “Dollar rises most in two months against Yen as Bernanke signals exit plan” and 2. “Bernanke says Fed will be ready to tighten policy when economy improves.”…
Now let’s understand where these headlines are coming from. This is what Bernanke said last night at the Board of Governors conference in Washington:


“My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period”…“At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”

Then, this is what Larry Summers said at a Bloomberg Forum:
“He made it very clear that our commitment is to a strong dollar based on strong fundamentals…”
So, no matter where you go this morning, there the change in rhetoric is. The long awaited shift in US monetary policy is in motion. No, these are not explicitly hawkish comments on rates. But, on the margin, this is an important shift from only dovish and ignoring a Burning Buck, to at least recognizing gravity. Maybe $1049/oz Gold or a Russian Stock market +111% YTD focuses the mind. ZERO percent interest rates in America is NOT a perpetual policy. This is progress.
Or is it progress? For a lot of investors, the answer to that questions has multiple durations and perspectives. My answer is Australian. Raising rates to levels in line with at least those of the BOE (0.5%) and ECB (1%) is the only option for America, unless we’d like to become the world’s funding currency.
Until most recently, the Japanese Yen has been that carry trading currency. After hitting a 9 month high versus the US Dollar earlier this week, the Yen is getting pounded this morning, trading down a full percentage point. Yes, in FX trading, that’s a lot!
We are short Japanese Equities via the EWJ etf. From an immediate term TRADE perspective, a weakening Yen doesn’t help drive continued alpha points in that short position. But being short of US Dollar denominated REFLATION positions does. I am short Oil’s curve, via the USO. I am long China via the CAF closed end fund. China doesn’t like Burning Bucks. China’s stock market voted yes on US rate hikes last night, closing up +4.8% - it’s largest move in 5-weeks.
I have been looking for two fundamental factors to drive a Bombed Out Buck here in Q4:
A Q4 sequential acceleration in reported inflation (Reflation’s Rotation from the lows of reported y/y Deflation)

2.      A Q4 signalling from the US Federal Reserve that we no longer have Great Depression like growth and the need for “emergency” rates of ZERO percent

The only two things that matter to US Federal Reserve policy SHOULD be growth and inflation. Understanding that this is the most politicized US Federal Reserves in modern history, however, reminds me that SHOULD doesn’t equal and objective will to obey the laws of gravity. That said, however marginally less dovish these comments from Bernanke and Summers are, this is progress.
The US Dollar was down -0.66%, yesterday at $76.03. That was another higher-low for 2009.
The SP500 was up +0.75% yesterday at 1065. That was another lower-high for 2009.
Lower-highs and higher-lows are what they are in my macro models. In the immediate term, they are not bullish for everything priced in what were Burning Bucks. We currently have everyone from The Politico to Glen Beck chirping bearish on the US Dollar. That consensus gravity, and the perpetual ring tones from the manic media over at CNBC, make being short the US Dollar at higher-YTD-lows a position I am no longer willing to take.
I respect that bottoms are processes, not points. I respect that being early with my macro calls can equate to my being wrong. I respect gravity.
My immediate term downside support levels for the SP500 are 1050 and 1044. A breakdown through the 1044 line, combined with a US Dollar Index breaking out above the $76.92 line, will be very bearish in the immediate term for everything REFLATION. Risk managers beware.
Best of luck out there today,

EWT – iShares Taiwan
With the introduction of “Panda Diplomacy” Taiwan has found itself growing closer to mainland China. Although the politics remain awkward, the business opportunities are massive and the private sector, now almost fully emerged from state dominance, has rushed to both service “the client” and to make capital investments there.  With an export industry base heavily weighted towards technology and communications equipment, Taiwanese companies are in the right place at the right time to catch the wave of increased consumer spending spurred by Beijing’s massive stimulus package.

EWG – iShares Germany Chancellor Angela Merkel won reelection with her pro-business coalition partners the Free Democrats. We expect to see continued leadership from her team with a focus on economic growth, including tax cuts. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; with fundamentals improving in a low CPI/interest rate environment, we expect slow but steady economic improvement from Europe’s largest economy.

CAF – Morgan Stanley China Fund
A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the more volatile domestic equity market instead of the shares listed in Hong Kong. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth. Although this process will inevitably come at a steep cost, we still see this as the best catalyst for economic growth globally and are long going into the celebration of the 60th Anniversary of the People’s Republic.

GLD – SPDR Gold We bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.   

XLV – SPDR Healthcare We’re finally getting the correction we’ve been calling for in Healthcare. We like defensible growth with an M&A tailwind. Our Healthcare sector head Tom Tobin remains bullish on fading the “public plan” at a price.

CYB – WisdomTree Dreyfus Chinese Yuan The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP – iShares TIPS The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.


USO – US OIL Fund We shorted oil on 9/30. The three Fed Heads put rate hike rhetoric right on the table. If the Buck stops Burning, Reflation stops working.

EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

SHY – iShares 1-3 Year Treasury Bonds
 If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.


On October 8, 2009, BYI announced what we believe is the first casino-wide sale of iVIEW Display Manager Controllers ("DM") across the 5,000 slots at Pechanga Resort & Casino. Pechanga has been testing iVIEW DM since May on its Bally, Aristocrat, and Konami machines. The first 600 iVIEW DM's will in be installed this month, with the remaining 4,200 installed over a two-year period.


iVIEW DM is a hardware solution that allows gaming operators to present content through a service window on the game screen itself instead on a separate display (like the original iVIEW). Unlike IGT's Service Window solution, which is built into the game itself for IGT and WMS branded games, iVIEW DM is a standalone solution that can be added to any Bally, Aristocrat or Konami game.


We estimate that this contract is worth roughly $7.5MM in revenue and $0.04 in EPS to BYI.  iVIEW DM will also be installed on Bally, Aristocrat and Konami machines at City Center when they open this December.


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LIZ: The -$0.88 to +$0.88 Swing

This LIZ/JC Penney deal is an absolute no-brainer. It’s also no surprise to us whatsoever. The core of our call is that LIZ has hit bottom, is taking a ‘no holds barred’ approach to its portfolio, and will realign in a way that actually makes investors remember that this company exists. 


What’d we get today? The announcement that LIZ is taking virtually all Liz Claiborne brands solo into JC Penney, and is taking LCNY/Mizrahi into an exclusive with QVC is absolutely, positively, 100% the right move. It rids LIZ of nearly 75% of its exposure to Macy’s, swings to a positive profit contribution (if only due to the royalty structure of the deals), aligns with retailers that actually know what they’re doing as it relates to exclusive content, takes down LIZ corporate infrastructure and capex, and, as a kicker, meaningfully reduces working capital as LIZ leverages JCP’s superior sourcing structure.


Are there risks? Of course. Now there’s key customer risk with JC Penney. There’s also the potential for a brutally ugly transition as existing wholesale accounts blow out Liz inventory (though LIZ now has no incentive to share in markdowns). There’s also the morale issue given that the corporate structure at LIZ will take a hit – again – as resources that are no longer necessary are nixed from the equation.


But add it all together and what do you get? An $0.88 loss this year (our estimate) goes to $0.88 profit in 2010. My sense is that our number will still be meaningfully above consensus once the beans are counted. At the same time, free cash flow should go from -$30mm in ’08 to roughly $275mm in 2010. Yes, that’s almost a 10% FCF Margin.


So what happens when a highly-levered company that everyone has left for dead starts generating cash (note: 14% of the float is short, and of the 8 analysts covering there’s not a single Buy, 3 Sells, and 5 Holds)? It turns from a ‘Will this company remain viable’ call, to being a ‘let’s start to model margin improvement and financial delevering’ call.


LIZ: The -$0.88 to +$0.88 Swing - 1


LIZ: The -$0.88 to +$0.88 Swing - 2


Trust me, despite our best effort over the past six months I’ve had so few people willing to bite on this one. Now, sadly, with a 29% move on the day, people will start to pay attention.  For someone willing to look at ’10 numbers, I think it makes sense. Why? A sub $7 stock with a buck in earnings power and an improving balance sheet in a rising cost of capital environment makes a heck of a lot of sense to me.

Jobless Recovery in Europe?

Position: Long Germany (EWG)


In our post “Bear Cubs” on 10/1 we discussed rising unemployment as a headwind facing the Eurozone into year-end. On further reflection however, we think that it is worth considering that European economies may better weather a rise in unemployment than their global counterparts.


It’s a question worth qualifying and quantifying as a rise in joblessness has a potential to ripple through a country’s and a region’s economic performance. If you’ve been following our US strategist and food industry analyst Howard Penney’s research, you’d know we’ve struggled to make a case for resurgence in the US consumer, especially concerning discretionary spending like casual dining. Conversely our Retail team has become incrementally more bullish, highlighting in our call this morning that a slow and gradual recovery in underway, supported by better sales, tighter inventories, and favorable compares that led to several upside earnings revisions in the September numbers.  Could the outlook of the European Consumer differ in appearance?


Though we’ve cautioned against speaking about Europe in aggregate due to the divergence across countries on multiple factors, one aspect that much of the region shares collectively is a significantly stronger foundation of social services than those available to US citizens, and certainly greater than the safety net provided by governments in developing economies like China. One take away to note here is—without a job the fear of losing (for example) healthcare benefits and the inability to pay for comparable services is far greater in the US or in China (where all expenses are out of pocket), than in Europe due to government social programs, a comment astutely made by my colleague and Asia strategist Andrew Barber.


Secondly, it’s worth considering savings rates that may better pad one’s economic outlook.  As our European clients on the ground have so eloquently compared European to American spending: “Americans spend everything they have.” If this translates to on balance Americans having less cash reserves to fall back on in a weaker economy with tight access to capital, could it be that European sentiment, and therefore consumption, is more resilient in the face of adversity than that of Americans? Could a more cushy savings account and social network lead to increased optimism?  The chart below of unemployment levels in the US versus Eurozone over the last ten years speaks to the point that Europeans are more accustom to a higher jobless rate than Americans.  


As we measure the impact of rising unemployment in Europe, we keep in mind the vast divergence in joblessness among European countries—Spain is pushing 19% unemployment while Germany has hovered around the 8.2% level. While comparing the structural nature of Spain to Germany is far from comparing apples to apples on numerous counts, we do believe that the sequential rate of change in many of the fundamental metrics we follow in Europe will slow over the next months.


But the reality remains, a jobless recovery in Europe may actually be more bullish than in the United States.


Matthew Hedrick


Jobless Recovery in Europe? - a1



Chinese Auto Industry executives are worried about swelling capacity. They should be.


The CEO of China Auto Logistics was quoted yesterday saying that the 40% increase in auto sales in China this year, which has brought the total new cars sold to over 1 million per month, was a “one-time event”.  We agree with this assessment. The stimulus measure which drove these sales, particularly the tax incentives for rural buyers, created a lot of “replacement” sales: farmers and rural tradesmen trading up from ancient vehicles. The pace of those types of buyers coming to market should decline as we head into next year, but as the euphoria of the stimulus fades and “real” demand kicks in, we expect auto sales growth to continue at a healthy pace even if it looks weaker on a year-over-year basis compared with this year’s flood of purchases.




The critical question now is whether a moderation in the pace of sales growth will reveal excess capacity after a massive wave of investment by domestic and foreign JV producers.  Any supply glut could create a chain reaction through the industrial complex. Officially, the National Development and Reform Commission estimates domestic automotive industry capacity utilization at 80% with a drop to 70% projected by 2013 as more new plants come on line.


The Beijing plans outlined in Q1 called for consolidation that would alleviate some of these issues by creating a handful of dominant producers who control the entire manufacturing process internally rather than the present diverse network.  Any M&A cycle inside the Chinese automotive industry would be a welcome source of capacity reduction, but we see it as unlikely that new efficiencies through consolidation will be sufficient to offset the tide of diminished expectations as monthly sales figures comp to impossibly high 2009 levels. As such, the DBN 600 Automotive Sub Index current level appears likely to be unsustainable in the intermediate term after a 150% increase YTD and we are inclined to shift the group out of our industry focus group for Q4.




Land of Opportunity


The strategies adopted by US and European JVs pursuing market share in the Chinese market have produced  predictably mixed results to date, and recent developments suggest that some (primarily the US firms) will continue to flounder.


With under 3% of the total market Ford is playing catch up with the announcement of a third plant with partner Chonqing Changan to be on line by 2012 which will lift total annual capacity on the mainland to 600,000 units.  Given the macro factors  outlined above, and the fact that the focus segment –the compact market, is so heavily competitive,  this growth strategy appears to be too little too late. In contrast, French producer Peugeot Citroen has recently announced that its plan to construct a third facility citing looming excess capacity.


The luxury import segment has become lucrative enough for European manufacturers to start building domestic production facilities –with the Audi/FAW JV reportedly considering a plan to begin  complete A3 and A5 production on the mainland. Audi has had great success in China on the heels of Parent VW’s early and successful entry into the market there .


NOTE: Domestic Chinese Markets have been closed for the first 3 sessions of this week in observance of National Day and the Mid-Autumn celebration.



Andrew Barber



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