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

CAT: More Than Oil & Gas (Thoughts Into the Print)



We have probably written too much on CAT in the last few month, including Downtrend Resumed (9/11/14), 5 Reasons to Stay Bearish into 2015 (11/5/2014), E&T As The New RI, And Retrieving Your Excavator From Botswana (12/1/2014), and Short Christmas Come January 26th (12/16/2014).  But today, if we had a short position, we would probably be covering a bit of it into the print. 


The extent of CAT’s resources-related capital spending exposure is better recognized today, and estimates for 2015 have declined (but are still too high, we think).  Some of the oil & gas-related revenue declines won’t occur until 2H 2015, with backlogs likely to drop through 1H.  Managements’ incentives may point toward a more optimistic guide, easing some of the substantial pressure weighing on them.


Still, we think the market is missing a number of challenges for CAT beyond Oil & Gas.  There are reasons to remain bearish.  Here are a few:


  • CAT Financial Credit Exposures:  If you haven’t seen CAT Financials’ pitch books for Mining and Oil & Gas financing, please see here and here for background.  We expect material losses, and losses at captive finance subsidiaries tend to unsettle longs.  Perhaps TXT-lite?

CAT: More Than Oil & Gas (Thoughts Into the Print) - nbv1


  • Tier 4 Pre-buy:  The E&T pre-buy matters, and likely extends beyond just locomotives.  There is even a bit in Construction Industries, as we understand it.  The chart below shows abnormally strong Energy & Transportation (E&T) dealer sales growth, consistent with a Tier 4F pre-buy.


CAT: More Than Oil & Gas (Thoughts Into the Print) - nbv2


  • Mining Could Be Worse:  Commodity prices have declined further, and the credit outlook for some customers looks bleak.  Pricing may get more competitive.  The assumption that it “can’t get worse” is false, as the segment hasn’t even posted a quarterly operating loss.


Tough Comps, SEC Investigation:  CAT is facing very tough comps in Construction Industries, with margins in the year ago period supported, in part, by dealer inventory builds.  It will also be interesting to get an update on the S.E.C. subpoena/ongoing investigation.


Backlogs Matter:  As for Oil & Gas, we may see backlogs drop, but the actual shipments and revenues should remain reasonably healthy into the second quarter (we hit the timing of this in our Upstream Capital Equipment call - Materials: CLICK HERE, Replay: CLICK HERE).  The revenue drop-off is more of a 2H 2015 phenomenon.  Tier 4F pre-buy activity should also be reflected in backlog declines. 



2015 Outlook:  The outlook will matter more to investors than 4Q results.  We expect CAT to see guidance come in within the $5-$6.50 range, but that is a bit of a guess.  That said, the environment has clearly worsened since the 3Q 2014 earnings call, and to a surprising degree.  We would expect revenue guidance to be moved lower from the previous range.  Consensus has moved down to $6.70, pretty close to the high-end of our estimated guidance range. 


CAT: More Than Oil & Gas (Thoughts Into the Print) - nbv3




There are reasons to remain bearish on CAT, but some of the less recognized exposures – like potential losses at CAT Financial, lower O&G revenues, and Tier 4F – may play out a bit later in the year. 


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