The U.S. Federal Reserve has consistently indicated to investors their intentions to raise short-term interest rates this year. One of the more outspoken proponents of raising rates has clearly been Atlanta Fed President Dennis Lockhart. In a Wall Street Journal interview earlier this month, Lockhart indicated that he expected rates to increase in September. Then, just this past Monday in a speech in Berkeley, California, he once again reiterated the call for short-term rates to increase this year, even if not in September.
Right now, the consensus view of mainstream economists echoes the public statements of Lockhart and his Fed colleagues on rates. In fact, according to a recent survey from the National Association of Business Economics, 77% of economists surveyed indicated they believed the Fed would ultimately raise rates before the end of the year.
So, notwithstanding the strong consensus view that interest rates will increase this year, our firm is sticking with our long-held view that rates will remain both lower and near zero for longer than most people believe. From our analytical perch, there are five key reasons we believe this:
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Takeaway: 2Q looks fine. The back half is a stretch. 2016 needs to come down.
We don’t like TIF into the print as we think 1) back half numbers look too high, and 2) this model is extremely poorly positioned for the consumer climate we’re forecasting. There are definitely redeeming qualities about the name – most notably the Brand (and that’s pretty much it). But it is trading near a peak multiple (18.5x) on peak margins (21%), peak earnings ($4.24E), peak returns (18%), has the worst cash conversion cycle we’ve ever seen (490 days), while sentiment is sitting at all-time highs. It’s feast or famine – if one of those metrics breaks, then they all do.
Common perception seems to be that “just because TIF blew up earlier this year, it can’t blow up again.” We simply disagree. The environment has changed significantly, and the company’s guidance for back half growth “in the double digits” is not going to happen. Could the company grow earnings in the 4-6% range? Yes. It can. But that implies at least a $0.15 guide down. Importantly, that could/should cause the consensus to revisit its $4.75 estimate for next year, which we don’t think is achievable. We think a base case is $4.50, with downside to $4.00 as the macro environment worsens.
Historically, TIF’s multiple change has been fairly explosive. As you can see, when earnings have been revised meaningfully up or down, we’ve seen TIF’s multiple relative to the S&P move by up to 40%. The point is that a $4.00 earnings number won’t get a high-teens multiple. It will get something in the low teens while the market waits for earnings to find a bottom. Using that logic, it is not unrealistic to model a $50 stock -- $30 lower. Are we making a call right now for such severe downside? No, we’re not. But that’s where the research initially appears to be headed.
Mother Macro Could Make $4.00 (or less) A Reality?
Consider the following… Domestic economic growth is now well past-peak in rate-of-change terms for this economic expansion, with US GDP growth getting tougher in the 2nd half of 2015 vs. the 1st half. That means, if you held all other risks equal, the probability is higher that growth slows in Q3 and Q4 than Q2. And the last two cycle tops didn’t have this mother of all demographic secular slowings – and note that this isn’t just the US -- the chart below represents better than 90% of Tiffany’s earnings.
2Q: Overall, 2Q looks ok to us. Street estimates imply a slowdown in the 2 year constant currency comp by ~200bps. That seems fair. LVMH and Kering both noted rebounds in jewelry sales in their second quarters. Additionally, TIF's comp has directionally followed the organic growth of LVMH watch and jewelry sales for the past 4 quarters. A potential positive is the Tiffany T collection which could/should boost penetration of the higher margin gold/silver fashion product. TIF’s US e-commerce business implies healthy demand in 2Q – though the trends look problematic into 3Q. It’s only 6% of TIF’s business, but is a good barometer for overall demand. Furthermore, TIF’s SIGMA chart looks very bad. Inventories are out of whack with the P&L in a way that is unlikely to be a 1-quarter fix without a meaningful margin event.
Here’s where we think the problem lies. Comp estimates are reasonable against easy compares, but Q3 margin comp is toughest of the year (even worse on 2 year rate). SG&A growth was just 1% in Q4 last year, yet the street looking for SG&A leverage in this Q4 as the company despite the company putting more capital into its new watch collection and "Will You" engagement campaign. FX pressure is likely to ease in Q4, but what helps revenue and GM will hurt SG&A. The Street has 11% EPS growth in Q3 and Q4. We see it more as flat Q3 and HSD Q4.
Takeaway: Below is a report by Hedgeye macro analyst Darius Dale detailing why we removed DXJ from Investing Ideas.
Japanese shares have remained one of the best performing DM global equity markets as of late. That being said, we don't believe it makes a ton of sense to bet that this outperformance continues from here (at least not in the immediate-term). A confluence of domestic and international factors suggest it is now appropriate for investors to book gains – be they absolute or relative – on the long side of Japanese equities (DXJ).
I) No Easy Money Anytime Soon: Despite that fact that Headline CPI, Core CPI and PPI all continue to slow on a sequential and trending basis, recent commentary out of the BoJ – led by Governor Haruhiko Kuroda – continues to be [inappropriately] sanguine on the outlook for reported inflation in Japan. In addition to that, Prime Minister Shinzo Abe was out over the weekend effectively granting the BoJ leeway in its pursuit of the +2% inflation target amid the recent plunge in crude oil prices while also confessing his complete faith in the BoJ’s handling of monetary policy. The key takeaway here is that the Cabinet Office is unlikely to lean on the BoJ to ease in the near term, which, on the margin, reduces the likelihood of QQE expansion in 2H15. Specifically, increased wiggle room in obtaining key policy objectives delays the advent of presumably desired policy support measures from the perspective of Japanese equity market participants.
II) China Headwinds: Clearly the recent devaluation of the Chinese yuan put dour outlook for regional and global growth at the center of investors’ concerns. Last Friday, Chinese growth – in Manufacturing PMI terms – hit a 77-month low with the advent of the flash Caixin-Markit report for the month August. As such, we can reasonably conclude that investors are commensurately worried about the outlook for corporate earnings growth in Japan given the headwinds to exports stemming from Chinese #GrowthSlowing (Japan’s 2nd largest export market at 18.1%), as well as the recent bout of defensive strength in the yen amid global contagion.
III) Correlation Risk: Speaking of global contagion, the recent melt-up in the Japanese yen (up +3.1% since Thursday’s close) and melt-down in the Nikkei 225 (down -11.1% since Thursday’s close) should remind investors that the Japanese equities remain tightly correlated to monetary policy expectations – despite growing calls for a sustainable decoupling. Specifically, cyclical bouts of global risk aversion have historically proved positive for the Japanese yen. This is largely due to the yen’s status as both a global funding currency and Japan’s status as an international capital allocator. Its net international investment surplus of ~$3.1T is equivalent to 75% of the country’s GDP and compares to a -$6.8T deficit for the U.S.
All told, while we still continue to see long-term upside for Japanese equities amid sustainable higher-highs in the USD/JPY exchange rate as the LDP and BoJ’s +3% GDP and +2% Core CPI targets clash with heinous demographic dynamics that should lead to perpetually easier monetary policy at the margins. Given the immediate-to-intermediate-term headwinds outlined above, however, we consider it prudent for investors to step to the sidelines for now.