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Late-Cycle Macro Factors Matter

Client Talking Points

#DEFLATION

Sorry for sounding like a broken record on this, but not really – because #deflation remains grossly misunderstood. CRB Index hit another new low yesterday at 216 (-6% year-to-date, -31% last 6 months) with Nickel chasing Copper lower -3.4% as Chinese Industrial profits of -8% year-over-year are as bad as their marked up stock market has been good. 

UST 10YR

UST 10YR gets the global #GrowthSlowing + #Deflation theme; they tried to bounce rates intraday yesterday, but that only lasted a few hours and the UST 10YR is right back down at 1.81% this morning with no immediate-term support to 1.75%, then 1.52% after that – don’t forget that Q414 GDP report is pending on Friday and should slow vs. Q3.

EARNINGS

The mainstream/sell-side is about anything but this right now – worst start to an EPS season in 6 years. Only 33% of companies are registering sequential acceleration in sales growth thus far, only 40% registering sequential margin expansion, and just half registering sequential acceleration in earnings growth.

 

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Asset Allocation

CASH 52% US EQUITIES 5%
INTL EQUITIES 3% COMMODITIES 0%
FIXED INCOME 33% INTL CURRENCIES 7%

Top Long Ideas

Company Ticker Sector Duration
EDV

The Vanguard Extended Duration Treasury (EDV) is an extended duration ETF (20-30yr). As our declining rates thesis proved out and picked up steam over the course of the year, we see this trend continuing into Q1.  Short of a Fed rate hike, there’s no force out there with the oomph to reverse this trend, particularly with global growth decelerating and disinflationary trends pushing capital flows into the one remaining unbreakable piggy bank, which is the U.S. Treasury debt market.

TLT

As growth and inflation expectations continue to slow, stay with low-volatility Long Bonds (TLT). We believe the TLT has plenty of room to run. We strongly believe the dynamics in the currency market are likely contribute to a “reflexive deflationary spiral” whereby continued global macro asset price deflation and reported disinflation both contribute to rising investor demand for long-term Treasuries, at the margins.

HOLX

Hologic (HOLX) is a name our Healthcare Sector Head Tom Tobin has been closing monitoring for awhile. In what Tom calls his 3D TOMO Tracker Update (Institutional Research product) of U.S. facilities currently offering 3D Tomosynthesis, month-to-date December placements signaled a break-out quarter after a sharp acceleration in October and slight correction to a still very high rate in November. We believe we are seeing a sustained acceleration in placements that will likely drive upside to Breast Health throughout FY2015. Tom’s estimates are materially ahead of the Street, but importantly this upward trend in Breast Health should lead not only to earnings upside, but also multiple expansion and a significant move in the stock price.

Three for the Road

TWEET OF THE DAY

Oil continues to suck wind at $45.21 WTI (-15% YTD - started 2015 at $53.27)

@KeithMcCullough

QUOTE OF THE DAY

The revolution is not an apple that falls when it is ripe. You have to make it fall.

-Che Guevara

STAT OF THE DAY

Craft brewers on average use 4.17 times as much barley as brews from U.S. beer giants InBev and MillerCoors, according to the USDA. Non-craft beer brewers use an average of 16.5 pounds of barley per barrel, while craft beer producers use a whopping 68.7 pounds per barrel.


CHART OF THE DAY: Late-Cycle #Earnings Slowdown

CHART OF THE DAY: Late-Cycle #Earnings Slowdown - chart

 

Editor's note: This is a brief excerpt from Hedgeye CEO Keith McCullough's Morning Newsletter today. 

 

With US Earnings Season underway, here are some early highlights (with ~20% of SPX constituents having reported – see Chart of The Day for color coded rate of change breakdown):

 

  1. From an operating momentum perspective this is about as ugly as it’s been in recent memory
  2. Only 33% of companies are registering sequential acceleration in sales growth thus far
  3. Only 40% registering sequential margin expansion, and 50% seeing sequential acceleration in EPS growth



Late-Cycle Slowdown

“Each thing is of like form from everlasting and comes round again in its cycle.”

-Marcus Aurelius

 

Until you’ve survived a few cycles in this business, you haven’t really lived. Cycles come in many styles and durations. Sometimes they’re cyclical. Sometimes they’re secular. Most of the time, you can front-run them – in rate of change terms.

 

Yes, the ole rate of change. As in the thing that helps you analyze time/speed – accelerations vs. decelerations. No, it’s not what most traditionally-trained-linear-economists use. That’s why what you read here every morning is different.

 

What is not different this time is that there will be an economic cycle. While central planners will try their damndest to “smooth” and “stabilize” it… in the end, the gravitational force of the cycle will prevail.

Late-Cycle Slowdown - cycle arrows small 

Back to the Global Macro Grind


It’s a lot easier to make bold statements like that about the economic cycle when:

 

A)     The cycle is already slowing

B)      The Bond Market is already pricing it in

 

“So”, while our call on global #GrowthSlowing + #Deflation isn’t yet consensus on the sell side, the buy-siders (and self directed individuals) who are set up for it are the ones who are getting paid.

 

To review the #process of measuring markets and economies in rate of change terms, I always try to contextualize the rate of change in indicators as either EARLY-cycle, or LATE.

 

For the purpose of this morning’s discussion, I’ll focus on a USA trifecta of LATE-cycle macro factors slowing. Oh, and by the way, they started slowing in the following order (not all at once):

 

  1. INFLATION (classic late-cycle) has undergone a full phase transition to #deflation in the last 6-8 months
  2. JOBS (as late-cycle as late-cycle gets) peaked in the back half of 2014, and Jobless Claims are breaking out now
  3. EARNINGS (yes, they are cyclical) peaked, in rate of change terms, when pricing and FX impact did (2014)

 

That last one (EARNINGS) is going to drive the people who are pitching “SP500 isn’t expensive” (if you use peak sales growth and margins to derive SPX earnings) right batty. The rate of change slowing in cyclical data generally does.

 

With US Earnings Season underway, here are some early highlights (with ~20% of SPX constituents having reported – see Chart of The Day for color coded rate of change breakdown):

 

  1. From an operating momentum perspective this is about as ugly as it’s been in recent memory
  2. Only 33% of companies are registering sequential acceleration in sales growth thus far
  3. Only 40% registering sequential margin expansion, and 50% seeing sequential acceleration in EPS growth

 

Now if all you do is look at absolutes vs. Old Wall “expectations”, I lost you at rate of change. But, since most of you reading this pay for it, I’m highly confident that you get it. Calculus was a 12th grade pre-req to the Early Look.

 

For your stock picking friends who don’t do macro math and don’t get rate of change, ask them the following questions:

 

  1. If a company’s growth rate is about to slow, will the stock go up or down until the slow-down is priced in?
  2. What if a company’s margins are about to compress from an all-time peak?

 

Seriously. It’s not rocket science. You just have to doggedly track the second derivatives and #grind.

 

You also have to do the required #history reading to respect that #Deflation hasn’t been a sustained reality for nearly a decade now. If you expand your analytical horizons to past cycles, you’ll find ones like the 1 #Deflation (i.e. the ugly kind) and the more beautiful ones like 1 (even though America had to go through the ugly to get there).

 

Delaying the ugly (btw, Dalio coined the “ugly vs the beautiful deleveraging”, not me) via some cochamamy central plan only postpones the inevitable. Draghi and Yellen know that. They’ve been trying to delay the mismatch between falling demand and inflated prices with the illusion of growth (Policies to Inflate via currency devaluation), for what, 6 years?

 

Thankfully, not everyone shares our view of holding both large cash and long-dated Treasury positions (see Asset Allocation Model) so that we can buy the riskier things we like when they really deflate. Our current strategy doesn’t hold us hostage to an inevitable late-cycle slowdown, and makes us a nice, low-volatility absolute return, while we wait…

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 1.75-1.84%

SPX 1

VIX 14.64-23.04

Oil (WTI) 44.03-46.85

Gold 1

Copper 2.48-2.58

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Late-Cycle Slowdown - chart


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THE HEDGEYE MACRO PLAYBOOK

Takeaway: Today we contextualize the relief rally in emerging market asset prices and discuss what would cause us to abandon our bearish thesis.

THEMATIC INVESTMENT CONCLUSIONS

Long Ideas/Overweight Recommendations

  1. iShares U.S. Home Construction ETF (ITB)
  2. Consumer Staples Select Sector SPDR Fund (XLP)
  3. Health Care Select Sector SPDR Fund (XLV)
  4. iShares 20+ Year Treasury Bond ETF (TLT)
  5. PowerShares DB U.S. Dollar Index Bullish Fund (UUP)
  1. LONG BENCH: Vanguard REIT ETF (VNQ), Utilities Select Sector SPDR Fund (XLU), Vanguard Extended Duration Treasury ETF (EDV)

Short Ideas/Underweight Recommendations

  1. iShares TIPS Bond ETF (TIP)
  2. iShares MSCI Emerging Markets ETF (EEM)
  3. Industrial Select Sector SPDR Fund (XLI)
  4. SPDR Barclays High Yield Bond ETF (JNK)
  5. CurrencyShares Japanese Yen Trust (FXY)
  1. SHORT BENCH: SPDR Oil & Gas Exploration & Production ETF (XOP), CurrencyShares Euro Trust (FXE), WisdomTree Emerging Currency Fund (CEW)

 

QUANT SIGNALS & RESEARCH CONTEXT

We’ve Been Wrong on Emerging Markets For ~6 Weeks… Why?: On 12/16, we hosted a conference call titled, “#EmergingOutflows Round II: This Time Is Actually Different” to reiterate and expand upon our bearish bias on emerging market asset prices and economies.

 

Since the aforementioned call, EM asset prices have actually gone up; in fact, 12/16 marked the low in many EM capital and currency markets amid the height of the Russian ruble crisis. On the call, we introduced 10 new EM ETF short ideas (EEM, EMB, EMLC, EMCB, CEW, GML, EWZ, ICOL, NGE and RSX); on average, those 10 ETFs have moved -368bps against the direction of our thesis. Not our best work; far from it, actually.

 

Not to beat ourselves up, however, the two long ideas we introduced on the call (EPHE and TUR) are performing as well as any asset class in all of Global Macro over that time frame and have moved +784bps and +1,520bps, respectively, in the direction of our thesis.

 

THE HEDGEYE MACRO PLAYBOOK - EM Idea Flow Monitor

 

Since we switched from being bullish to being bearish on emerging markets in our 9/23 note titled, “EMERGING MARKETS: THE EM RELIEF RALLY IS LIKELY OVER”, the MSCI EM Index has fallen -4.3%, the JPM EM Currency Index has fallen -9.0% and the Bloomberg USD EM Composite Bond Index has fallen -1.2%. Those returns compare to a gain of +3.8% for the S&P 500 Index, a gain of +11.9% for the U.S. Dollar Index and a gain of +4.5% for the Bloomberg U.S. Treasury Bond Index.

 

Clearly being bearish on emerging markets over the past ~4 months was the right call to make.

 

But is being bearish on emerging markets the right call going forward?

 

Specifically, are the factors which are driving the current relief rally across EM capital and currency markets likely to remain in place for the foreseeable future?

 

In order to answer that question, we have to first figure out what’s been driving the relief rally in the first place. Rather than use conjecture and/or assumptions, we’ve deferred to math in the following chart:

 

THE HEDGEYE MACRO PLAYBOOK - CUSTOM PERIOD MDCS

 

What you’ll quickly note (likely thanks to our highlighting of key, non-intuitive correlations) is that it’s more than reasonable to attribute the relief rally to the recovery in European financial assets in expectation for and reaction to the ECB’s recent QE announcement due to the tight positive correlations with European equities.

 

Additionally, one can also conclude that the sharp rally in European fixed income has left European investors yieldless, at the margins, and has perpetuated a massive yield chase across global financial markets which has benefitted EM assets, which are typically higher yielding than their DM counterparts. Yes, this is the same yield chase we’ve seen benefit U.S. Treasury bonds over the past 6-9 months. We can deduce this by noting the tight positive correlations to DM high-dividend stocks, global REITs, USD-denominated and EUR-denominated high-yield debt, as well as the U.S. dollar itself – that latter of which has historically been inversely correlated to EM asset prices.

 

THE HEDGEYE MACRO PLAYBOOK - 1 27 2015 7 26 05 AM

Source: Bloomberg L.P.

 

Will the rally in European equities and the ECB-induced global yield chase last? Of course we can’t know the answer to either question on an ex ante basis, but what we do know is that the higher the U.S. dollar climbs, the more risk there is to the downside in EM asset prices and economic growth.

 

THE HEDGEYE MACRO PLAYBOOK - EM   The Great Unwind

 

THE HEDGEYE MACRO PLAYBOOK - EM   Carry Trade

 

THE HEDGEYE MACRO PLAYBOOK - EM   GDP

 

THE HEDGEYE MACRO PLAYBOOK - EM   Foreign Non Official Holdings of Govt Debt

 

THE HEDGEYE MACRO PLAYBOOK - EM   Change in Foreign Non Official Holdings of Govt Debt

 

More importantly, our quantitative signals continue to support maintaining a bearish bias on EM asset prices. Specifically, our Tactical Asset Class Rotation Model (TACRM) continues to generate a “DECREASE Exposure” signal for EM Equities as a primary asset class.

 

THE HEDGEYE MACRO PLAYBOOK - TACRM EM Equities Backtest

 

That being said, however, any persistent strength in the breadth of this asset class is likely to perpetuate a bullish signal in the coming weeks/months. Moreover, that would likely coincide with a bearish-to-bullish TREND reversal on Keith’s quant signals as well. Either event would cause us to remove our bearish fundamental thesis on this asset class.

 

THE HEDGEYE MACRO PLAYBOOK - TACRM GMRS

 

***CLICK HERE to download the full TACRM presentation.***

 

TRACKING OUR ACTIVE MACRO THEMES

Global #Deflation: Amidst a backdrop of secular stagnation across developed economies, we continue to think cyclical forces (namely #StrongDollar driven commodity price deflation) will drag down reported inflation readings globally over the intermediate term. That is likely to weigh heavily upon long-term interest rates in the developed world, underpinning our bullish outlook for U.S. Treasury bonds.

 

Draghi Delivers the Drugs! (1/22)

 

#Quad414: After DEC and Q4 (2014) data slows, in Q1 of 2015 we think growth in the US is likely to accelerate from 4Q, aided by base effects and a broad-based pickup in real discretionary income. We do not, however, think such a pickup is sustainable, as we foresee another #Quad4 setup for the 2nd quarter. Risk managing these turns at the sector and style factor level will be the key to generating alpha in the U.S. equity market in 1H15.

 

The Hedgeye Macro Playbook (1/23)

 

Long #Housing?: The collective impact of rising rates, severe weather, waning investor interest, decelerating HPI, and tighter credit capsized housing in 2014.  2015 is setting up as the obverse with demand improving, the credit box opening and 2nd derivative price and volume trends beginning to inflect positively against progressively easier comps. We'll review the current dynamics and discuss whether the stage is set for a transition from under to outperformance for the complex.

 

EHS | RoC Solid (1/23)

 

Best of luck out there,

 

DD

 

Darius Dale

Associate: Macro Team

 

About the Hedgeye Macro Playbook

The Hedgeye Macro Playbook aspires to present investors with the robust quantitative signals, well-researched investment themes and actionable ETF recommendations required to dynamically allocate assets and front-run regime changes across global financial markets. The securities highlighted above represent our top ten investment recommendations based on our active macro themes, which themselves stem from our proprietary four-quadrant Growth/Inflation/Policy (GIP) framework. The securities are ranked according to our calculus of the immediate-term risk/reward of going long or short at the prior closing price, which itself is based on our proprietary analysis of price, volume and volatility trends. Effectively, it is a dynamic ranking of the order in which we’d buy or sell the securities today – keeping in mind that we have equal conviction in each security from an intermediate-term absolute return perspective.          


January 27, 2015

January 27, 2015 - Slide01

 


Golden Tickets

This note was originally published at 8am on January 13, 2015 for Hedgeye subscribers.

“Almost only counts in horseshoes and hand grenades”

 

Golden tickets are, by definition, an exceedingly scarce commodity.  Occasionally they’re found at the nexus of chance and preparation.  More often they’re the product of randomness; the nebular nursery of accidental billionaires.     

 

Golden tickets are not like horseshoes or hand grenades.  Unfortunately, as I’ve learned, half-tickets don’t count.  Neither does simply recognizing a ticket…..even if only a few others have. 

 

Here’s a selection of some of my personal misadventures in golden ticket recognition:  

Golden Tickets - goldenticket 

2002:  I called a fledgling energy drink company and tried to invest $9,500 – all the money I could scrape together as a middle-class college kid with no connections.  They showed some minor interest – mostly I think they were just amused by a kid trying to pitch them on an inconsequential capital investment – but mostly gave me the blow-off.  I followed up a couple times but ultimately abandoned the pursuit.   You’ll know the energy drink company as ROCKSTAR – pioneer in the fastest growing beverage category of the last half-century.

 

2008/09:  I encouraged Hedgeye to pursue an investment in a young yogurt company located in central New York.   That upstart grew into the yogurt juggernaut known as Chobani which catalyzed the Greek yogurt renaissance and jumpstarted the fastest growing food category of the last decade.  Hedgeye was young itself and in the midst of a bid for the Phoenix Coyotes – it just wasn’t the right time.  

 

2015:  I have another idea in pocket but I’m not divulging….yet.

 

Back to the Global Macro Grind...

 

Golden tickets, however, are not the exclusive right of chocolate factory contestants or the providentially charmed.  Modern Macroeconomies of the last century have generally been born with a golden economic ticket that sits latent until the correct demographic and cultural factor cocktail pushes it out of dormancy. 

 

The story of the U.S.’s Golden Ticket can be contextualized simply and is key to understanding both its current economic situation and its intermediate term prospects.  Pulling back the charts and detaching from the myopia of every market minute can be a refreshing exercise as well.

 

Back to Basics:  GDP | Having ‘stuff’ is dependent on making ‘stuff’

 

Real GDP per capita = Average labor productivity * share of the population that is employed

 

More simply, at its core, GDP is the product of how many people you have making stuff and how much stuff each person can make. 

 

That’s about as fundamental as it gets, but the reality underneath that simplicity carries a lot of economic gravity.   The amount of goods and services the collective consumer can consume, on average, can increase only to the extent that each person can produce more (increased productivity) and/or the fraction of the population that is employed increases. 

 

1970-2000:  Accelerating Population Growth + Rising Labor Force Participation = Golden Ticket in per capita output

 

The rise of the Baby Boom generation in combination with an acceleration in immigration and the secular rise in female labor participation was a golden ticket event for the domestic economy.     

  • Employment & Participation:  from 1980 to 2007 employment grew 47% while the over 16 YOA population grew 35%, driving the fraction of the population employed from ~59% to greater than 67%.   The concurrent acceleration in the working age population and employment-to-population ratio catalyzed an epochal rise in per capita output and improvement in living standards.  This benefit was a one-shot deal.
  • Immigration:  Foreign born residents grew from 9.7M (~5% of the population) in 1960 to over 40M (~13% of the population) by 2010.  Indeed, from 1970-2010 immigration accounted for nearly 30% of total population growth in the United States.  Clearly, immigration has played a central role in U.S. population growth over the last half-century.  Immigration trends over the next decade+ will play an equally important role in determining how gracefully the U.S. traverses the demographic cliff. 

In the 1st chart of the Day below we show the 3 major inflections in labor force participation along with the projected decline in participation through 2020 based singularly on changing age demographics.   The multi-decade rise in participation peaked at the turn of the century and should remain in secular retreat through the back-half of the decade.  Improvements in per capita GDP enjoyed over the 1960-2000 period stemming from the rise in the fraction of Americans employed will likely prove somewhat transient.  

 

Golden Tickets - LFPR

 

Real Wage Growth:   Remember that time demand went down, supply went up and price rose…me neither

  • Labor Supply:  The Boomer generations entre into prime working age along with increased labor participation by women drove an acceleration in labor supply.  In isolation, rising supply of labor should have a depressive effect on the price of labor (i.e. the real wage)
  • Labor Demand:  That the US production function is Cobb-Douglass with the marginal product of labor proportional to average labor productivity is very ivory-tower.   More simply, remember that the real wage is the price paid to labor in units of output.    If productivity rises such that each unit of labor can produce more output (and assuming stable prices and end demand)  then the demand curve should shift to the right with both total employment and real wages rising – that’s the basic theory anyway.  As the 2nd Chart of the Day below illustrates, empirically, the data supports the theory with real wage growth closely tracking the trend in productivity growth. 
  • Looking Forward:  Rising labor supply and slower growth in productivity in the decades following 1970 combined to depress real wage growth.  If those secular trends are slowing and/or reversing as most believe they are – i.e. slower employment growth, lower LFPR, moderating population growth – then labor supply growth should slow with tighter supply supporting gains in real wages.  Remember, however, that we’re talking about secular trends and that supply is only half of the supply-demand equation…..

 

Wild-Cards and Inconvenient Truths:  In the long-run productivity gains are the primary driver of economic growth….policy makers have a model for that, right?

 

The fading tailwind of rising population and labor participation suggests that, from here, the onus on real growth will fall increasingly on gains in productivity.      

 

To the extent tech innovation and the ICT driven productivity gains of the late 90’s can re-assert themselves in the back half of the current decade, real wage growth stands to benefit.   Whether higher entitlement spending, debt service costs and an accelerating dependency ratio emerge as material offsets to gains in real income remains to be seen. 

 

It’s also important to note that, despite its centrality to sustainable growth and canonical growth theory, policy makers don’t really know how to model and/or forecast productivity.  They more-or-less just plug something close to 2% into any intermediate and LT forecast because that’s what it’s been, on average, historically.  With growth itself only expected to average ~2% over the intermediate term, that is a huge assumption.    

 

Degree of Difficulty Doesn’t Count:  The discussion above is necessarily simplified but, in this instance, “almost” is probably sufficient  as it captures ~80% of what matters from a Trend perspective and offers an intuitive, tractable review of the growth, employment and income dynamics that have characterized the domestic, Golden Ticket improvement in living standards over the last 50-years. 

 

Understanding the implications of a secular shift in those dynamics alongside a reversal in the multi-decade monetary policy to inflate will be central to effectively navigating the forward Trend. 

 

From a Trade perspective, with Japanese 5Y yields at 0%, 10Y Bunds at 0.47% and the U.S. 10Y at 1.88% this morning, we continue to watch global deflationary forces swamp enervated inflationary policies in real time.    With Global growth slowing and deflation predominating, our most important macro call remains Long the Long Bond. 

 

It’s not a particularly sexy position or an especially complicated thesis but as Buffett is fond of saying… ”Degree of Difficulty Doesn’t Count” in (macro) investing. 

 

Our immediate-term Global Macro Risk Ranges are now:

 

SPX 1995-2090

Russia (RTSI) 708-796

VIX 17.31-21.99

USD 91.77-93.22

Oil (WTI) 44.41-49.98
Gold 1212-1240 

 

Best of luck out there today,

 

Christian B. Drake

U.S. Macro Analyst

 

Golden Tickets - Productivity


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