Takeaway: Don't blame China (or energy); the U.S. consumer is slowing markedly; and QE4 likely won't form an investable bottom in equities or credit.
Today, Keith and I dove head first into the usual gauntlet of marketing that follows our Quarterly Macro Themes presentation. Having started with a full slate of meetings NYC, he and I will then be visiting clients and prospective clients in Boston, San Francisco, LA, Chicago, Dallas, Austin, Houston and ultimately back in NYC and southern Connecticut over the next ~3 weeks.
Besides the opportunity to build lasting relationships, my favorite part about meeting face-to-face with clients is learning where our economic and market views are generally most differentiated from buyside sentiment. This is where Keith and I learn what calls to press, what themes to do more work on and what topics we need to start doing work on if we are to stay 1-2 steps ahead of macro consensus. To everyone we have met or will soon meet with, we are truly grateful to have such open and honest dialogues. We are hopeful that each of you finds value in this reflexive feedback loop.
Aggregating buyside consensus is a far more difficult task. It’s nearly impossible to disassociate the macro views we hear from how a particular investor(s) might be positioned – either out of desire or mandate. Moreover, since not every buyside shop has a institutionalized process to contextualize meaningful trends and inflections across the macroeconomic and policy landscape, we’ve been known to spend a decent amount of time just agreeing on a platform upon which to have such debates.
That is most certainly not to say we are smarter; we have and continue to learn a great deal from the collective knowledge and experience of our client base. We thank each of you for that as well. It’s humbling to consistently learn what you didn’t know you did not know.
Having said all that, when we hear the same premises or similar lines of questioning meeting-after-meeting, it is easy to interpolate that sentiment upon a much larger collection of investors.
In meetings today, I consistently heard three conclusions that we [very respectfully] disagree with:
- The narrative fallacy that China and/or energy deflation is the root cause of the economic and financial market malaise we are experiencing domestically.
- The narrative fallacy that the U.S. consumption economy is good.
- The narrative fallacy the U.S. equity market will form an investable (read: not short-lived) bottom if/when the Fed announces QE4.
Regarding #1: We put out a research note back in mid-November titled, “Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht?” in which we detailed why a rising U.S. dollar is the root cause of the aforementioned problems. China’s economic downturn and subsequent currency debasement are merely symptoms of a broader disease. To the extent you disagree with our view, we encourage you to review the second half of that note starting with the following passage:
“All told, while we are comfortable reiterating our explicitly dour outlook for Chinese economic growth, it bears repeating that we continue to view the Chanos “economic collapse” view as misguided given that the “Beijing Put” continues to largely offset that outcome. China’s trending GDP growth deceleration just feels like a collapse to the rest of world given China’s outsized contribution to global growth.”
Regarding #2: We put out an extensive chart book on the state of the U.S. consumer last night [appropriately] titled, “U.S. #ConsumerSlowing”. It’s worth reviewing if you, like many investors, hold a sanguine outlook for domestic consumption growth and consumption-oriented assets.
Regarding #3: While ZIRP and LSAP have proven to be powerful tools in perpetuating income-inequality generating asset price inflation throughout this economic and corporate profit expansion, the Federal Reserve has yet to demonstrate the effectiveness of monetary easing during concomittant recessions in economic activity and corporate profit growth. If our bearish call on the domestic business cycle continues to resonate with the data, investors will have to adjust their expectations for a pending market bailout accordingly. Assuming QE4 is, in fact, introduced (the presidential election cycle is big risk in terms of popping the bubble in U.S. monetary policy), we think it will only work to produce a lasting bull market to the extent it is introduced at/near the depths of what we view as a likely #USRecession and bearish #CreditCycle.
Source: Bloomberg; Hedgeye Risk Management
Source: Bloomberg; Hedgeye Risk Management
Source: Bloomberg; Hedgeye Risk Management
Enjoy the rest of your respective evenings and best of luck out there tomorrow.
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We have not previously added short UAL Equity to our firm’s Best Ideas list, despite numerous issues with UAL’s “adjusted” financial reporting and the broader airline renaissance thesis. We have had the CDS on the list, which were very tight in mid-2014 and we believed offered an attractive asymmetric return potential. However, with employment at or very near a peak for this cycle, we expect demand growth to slow and potentially turn negative in 2016. At the same time, lower fuel prices have allowed the industry to rapidly grow capacity. Weaker demand and rapid capacity growth are likely to prove a toxic combination...particularly for UAL.
This isn’t a call on UAL’s report tomorrow, which should be roughly in line with the Investor Update. UAL’s outlook may well be just as rosy as DAL’s, even though we have observed some modest pressure on UAL’s fares in recent readings. The equity market could also bounce, taking shares of UAL higher. However, this is a longer-term view, informed by capacity growth amid changing fleet dynamics, an expected softening of demand, and our firm’s Macro process. Ping us for our prior Black Books and EQM/data sets for additional background.
Fade Ideal Environment: Following a 70%+ drop in the price of oil and a halving of the unemployment rate, it would be hard for the airline environment to be better. Our firm’s Macro team makes a strong argument for a recession, or at least a recessionary environment, in 2016. The data are compelling. For example, credit losses are coming from resource-related industries from coal mining to oil & gas to metals. Credit losses typically bring broadly tighter credit. For airlines, as we show below, the economy need not experience a downturn on the scale of the Financial Crisis for the shares to sell off sharply. Airlines typically perform horribly on both an absolute and relative basis in periods of economic slowing. Even the 2H 2012 slowdown took a third off shares of UAL from a much lower level. In a recession, even “high-quality industrials” would continue to sell-off sharply.
h/t Hedgeye Macro
Airlines Still Beloved: Amazingly, 100% of analysts rate Delta Airlines a Buy. Perhaps more amazingly, 88% rate UAL a Buy. Yet, if the recession/significant slowdown call is correct, airline shares face a disproportionately large downside. Higher cost airlines often fail in recessions; there is little historical precedent to expect airline shares to perform defensively through a downturn.
UAL As Tide Goes Out: We have detailed what we view as series of accounting gimmicks that have served to boost UAL’s adjusted numbers. We won’t rehash all of them, but here are a few:
- Writing-up frequent flier deferred revenue on emergence and in CAL purchase accounting allocations, only to drain it through later changes to FFP assumptions at ~100% margin (we estimate this at well over $1 billion)
- Categorizing cash paid to employees as a one-time expense; GAAP allows it, but doesn’t require exclusion from adjusted results
- Special charges for uniforms, aircraft painting which seem fairly operating to us
In recent years, UAL has only generated free cash flow on the firm’s own metric with employment trends peaking and jet fuel prices cratering. We see the mismatch between cash and adjusted profits as noteworthy.
It is not as though capacity additions have been driving the cash drain. Domestic capacity has generally contracted and UAL has steadily dribbled away market share.
Domestic Capacity No Longer Disciplined: Domestic airline capacity growth is outpacing its typical relationship to economic growth amid lower fuel costs. This is shown below as a residual from the regression of Industrial Production to ASM growth.
Which tends to be explained by fuel prices….
So far, demand has kept pace as lower airfares and higher employment generated adequate traffic. In a recessionary environment, however, we expect capacity trends to prove troublesome. Capex is up, and capacity is coming on rapidly into a deteriorating macroeconomic environment. We have generally explained accelerated capacity growth as resulting from flattening of the incremental capacity cost curve in a lower fuel price environment (e.g. economics of older planes work better at lower fuel prices).
AAL is still roughly playing the game, but this is partly company specific.
And capital spending has ramped higher.
UAL Cost Challenges: For a company which has twice promised billions in cost reductions (Project Quality & Merger Synergies), UAL’s cost efforts may have limited how quickly costs have grown, although it is hard to tell if that is the case. At a November conference appearance, UAL claimed to have cut “$800 million” in 2015 non-fuel operating expenses in November, which is odd since non-fuel expenses are generally higher vs. 2014.
Liquidity & Net Debt: In the best airline operating environment in a generation, UAL did not make much progress on net debt or liquidity. The relatively small buyback activity (net of converted debt, that is) may be viewed as an error in a recessionary environment.
Senior Management Uncertainty: We very much hope that UAL’s CEO Oscar Munoz makes a speedy recovery. As unfortunate as it is, senior management has been lacking at the firm since Jeff Smisek was pushed out following the Port Authority scandal. That may prove an additional challenge.
2015 Fuel Profits: UAL has benefited enormously from the decline in fuel prices. We expect airfares to compete away lower fuel on a lag. Since airfares are readily tracked daily, investors may need to move well ahead of actual changes.
Upshot: We see UAL as a high cost airline with dubious financial reporting, a combination that seems a straightforward short in a recessionary environment. Airlines are historically among the most cyclical groups, but UAL is still very much “up” and investor sentiment remains very positive despite signs of an inflection in economic activity. We expect the shares to trade lower before airfares fully reflect the changed environment. While this does not represent a view on UAL’s soon-to-be reported quarter, the tide appears to be moving out amid a loss of capacity discipline.
Takeaway: Notes like the one below are precisely why we launched our firm back in 2008.
Editor's Note: Below is a note we received this past Friday from a Hedgeye subscriber. Amidst all the tumult in financial markets, it is extremely rewarding and gratifying to receive messages like this validating why we do, what we do. At its core, our firm was designed to help investors protect, preserve, and grow their wealth through treacherous market environments just like today.
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Here's the video mentioned in the note above where Hedgeye CEO Keith McCullough explains how Hedgeye was founded. It all started with a personal conversation he had with his mother.
Editor's Note: The U.S. stock market is getting pummeled again today. Below is a particularly prescient Early Look written by Hedgeye CEO Keith McCullough on July 14, 2015, just before the July/August selloff in stocks. We've been bearish ever since and warning that the stock market's fundamentals have been breaking down. That's been the right call all year. Click here to learn more.
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“Ask ourselves why we do what we do…”
The big picture
That’s a pretty basic leadership and risk management question. And I sincerely hope that you ask yourself that question every day. I do. Being transparent and accountable isn’t easy; especially where it all starts – with yourself.
Why did we build a firm that dares recommend you actually SELL things? Whether it’s hyped up “social” cloud stocks with “TAM multiples” or Ponzi-like MLP schemes that could only be concocted by Old Wall bankers, I’m sure glad we did.
How about the simpler market SELL calls, like the ones you should have heeded every time the SP500 is up +2-3% for 2015 YTD? The US stock market has mean reverted to DOWN YTD multiple times. I wonder if both growth and earnings slowing have had anything to do with it? Ask yourself. And be honest. Did you buy stocks expecting earnings to be down in 2015?
When top-down GDP growth slows, consensus needs central-planning to reflate markets. And when bottom-up earnings slow, we definitely need to beg the company to “buy back the stock.” This happens at the end of every economic cycle, fyi.
Another way to look at growth (when both US and Global growth are slowing) is to buck up for the growth that you can find. Our buddies at Morgan Stanley call this “New Tech” and, oh boy, are the chart chasers loving that stuff.
As you can see in the Chart of the Day, the “New Tech” trades at, on average 149.5x earnings. So no worries there. As long as the products are cool, I’m sure this time will be different (until they miss a sales growth whisper).
Instead of debating why you shouldn’t sell some Netflix (NFLX) at 278x earnings this morning (why not just buy one of these names that has no earnings at all? #EasierToDebate), allow me to get back to doing what I do - risk managing growth.
Let’s do #EuropeSlowing because, unfortunately post Greek Gong Show, they still had to report their data this morning:
- Eurozone ZEW (economic sentiment) slows again in JUL to 42.7 from 53.7 in JUN
- German and Spanish inflation (CPI) stalled at +0.3% and +0.1% year-over-year, respectively
- Swedish and Finnish #deflation came back online with year-over-year prints of -0.4% and -0.1%, respectively
- Swiss Producer Prices (PPI) maintained #deflation at -6.1% year-over-year
- UK CPI of 0.0% y/y (JUN) and PPI of -1.5% y/y were pretty much flat with where the data was in MAY
In bottom-up-stock-picker speak:
- If you are a producer and you have no pricing power, that is bad
- If you are a consumer and you get lower-prices, that is good
The problem is that corporate profits lose during the #Deflation inasmuch as the consumer takes that spread. Now that would be a great thing for US and Global consumption demand, if only we were at the beginning (not the end) of a cycle.
NEWSFLASH: you can’t centrally plan economic cycles, age, and/or time
But you can squeeze the poor hedgie who chases high and shorts low. And, to a degree, I think that was the main driver of yesterday’s global stock market ramp to lower-all-time-highs. Here are 3 nuts to consider within that thought:
- CFTC non-commercial futures/options data showed a net SHORT position of -162,467 SP500 contracts
- Thursday’s front-month VIX close of 19.97 was at the top-end of my 13.52-20.63 risk range
- High Beta Stocks (in SP500 Style Factor terms) were -5.1% (vs. Low Beta +0.5%) on a 1-month duration
Oh, and Total US Equity market Volume (including dark pool) was -16% and -17% yesterday vs. its 1-month and 1-year averages, respectively. We former hedgie guys call that a no-volume squeeze.
So what do you do today? You sell.
Yep. That’s it. That’s my “call.” You look at everything you own and ask yourself whether or not what you own is at the top-end of its immediate-term risk range or not. And if it is (like SBUX is for example), you sell some.
If I’m the bad guy for thinking that way, so be it. Where I was bred in this business, when both top-down growth and bottom-up profit cycle earnings started to go from good to bad, I was taught to sell.
That’s what I did at the end of the 2000 cycle. That’s what I did at the end of the 2007 cycle. And that’s what I am telling you to do now at the end of the 2015 cycle. That’s what I do. Ask yourself what you did/do.
Our immediate-term Global Macro Risk Ranges (and intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.19-2.47% (bearish)
SPX 2041-2105 (bearish)
RUT 1228-1270 (bearish)
Nikkei 19899-20501 (bullish)
VIX 13.52-20.63 (bullish)
USD 95.61-97.42 (bullish)
EUR/USD 1.09-1.12 (bearish)
YEN 122.14-124.10 (bearish)
Oil (WTI) 49.08-53.14 (bearish)
Nat Gas 2.65-2.89 (bearish)
Gold 1148-1165 (bearish)
Copper 2.43-2.62 (bearish)
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer