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Perfect Storm

Client Talking Points

USD

The immediate term risk range for the USD is 96.99-98.99 (bullish). We keep getting asked…If this is the beginning of the end for the dollar?…Is the Fed going to devalue? It could happen but we would warn you what happened was much more of a perfect storm of a day trade in USD rather than a new trend signalling that the currency war is over. To break intermediate trend support you would have to break down below and sustain a level below 94 and that doesn’t look like its anywhere in the area code of working. 

NO #OPEC CUT

Recent rumors of emergency meetings and agreements with countries outside of OPEC on a production cut are just that.. Rumors. With the USD getting tagged for nearly 3% and a ten-year yield re-pricing #growthslowing at 1.87% this morning, central planning storytelling is the only game in town. Don’t mistake a short-covering rally for the new bull case. WTI is leading CRB divergences this morning, trading down -1.5%

S&P 500

We reitaertate there is a difference between a trade and a trend, we have been bearish on the S&P 500 since July of last year. Intra-day yesterday we got an oversold signal right around 1874, that doesn’t mean there’s  a new bull market for the S&P it just means it was a good signal. The immediate term risk range for the S&P 500 is 1855-1949 (bearish).

 

*Catch the replay The Macro Show with Hedgeye CEO Keith McCullough  - CLICK HERE

Asset Allocation

CASH 61% US EQUITIES 0%
INTL EQUITIES 0% COMMODITIES 0%
FIXED INCOME 25% INTL CURRENCIES 14%

Top Long Ideas

Company Ticker Sector Duration
XLU

After a busy week of domestic data, you probably don’t need us to tell you that growth continues to slow. Despite the short-covering squeeze in energy stocks, Utilities (XLU) closed out January as the only sector in positive territory (+5%), other than Consumer Staples which eeked out a +0.5% gain. It was an awful start to the year for the S&P 500 (-5%). Don’t expect +10% of relative outperformance every month, but if you stuck with us on this trade, you’re in much better shape than most.

GIS

GIS remains one of our top Long ideas in the consumer staples space. As we have continued to say it boasts style factors that are ideal in turbulent times; high market cap, low beta and liquidity.

 

Recently, General Mills has been attacked by Chobani commercials, claiming that Yoplait yogurt contains the same ingredients used in pesticide. GIS filed a false advertising lawsuit against Chobani demanding that they stop showing that commercial because it could be detrimental to sales. GIS just got word that a federal judge has barred Chobani from continuing the ad campaign. This is a win for GIS, but it is unclear right now if there was any damage done to the brand. At this time we do not believe it had any serious impact on the company. We will keep you informed of any material information regarding this lawsuit as it moves forward.  

TLT

Long-Term Treasuries (TLT) continues to preserve capital against the slow-moving trainwreck in Junk Bonds (JNK). Week-over-week, 10-year bond yields crashed 13 basis points to 1.92%. That helped lift the best play on U.S. growth slowing (TLT) by 0.85% on the week as credit spreads continued to widen (JNK gained +0.76% on the week, underperforming TLT marginally on a relative basis).

Three for the Road

TWEET OF THE DAY

The #NetNeutrality Ruling: Implication For $NFLX $VZ $CHTR https://app.hedgeye.com/insights/48924-the-net-neutrality-ruling-potential-implications-for-netflix-verizon?type=video… @KeithMcCullough @PotomacResearch

@Hedgeye

QUOTE OF THE DAY

The very substance of the ambitious is merely the shadow of a dream.

William Shakespeare

STAT OF THE DAY

A survey given to 477 undergraduate and graduate students at three Bay Area campuses, found that just 6% of them knew how long they would be repaying their student loan debt and only 8% knew the interest rate on their loan.


KSS | …And This Is Only Stage 1 of 3

Takeaway: This is the 1st Stage of KSS EPS permanently being held below $4.00. Stage 2 goes to $3.25. Stage 3 = $2.50 and dividend cut.

All along we’ve been saying that KSS would never earn $4.00 again. While today’s rather dramatic guide-down will make this premise seem a reality for some doubters, what we find most interesting is that this is only midway through Stage 1 of what we think is a Three Stage process to KSS cutting its dividend. Here’s our thinking…

 

Stage 1: Weak sales results as a result of the fact that KSS sells less and less of what consumers want to buy. Sounds overly simple – but it’s reality. That flows through to the gross margin line as online sales cannibalize brick and mortar, and come at a gross margin 1000bps below the company average. True SG&A growth becomes apparent as credit income stops going up as newly emphasized non-credit/loyalty shoppers become a bigger mix of the pie due to launch of Yes2You rewards program.

 

Stage 2: Here’s where credit income (currently about 25% of EBIT) erodes WITHOUT a rollover in the broader credit cycle. The company’s much-touted (but ultimately fatally flawed) Yes2You rewards plan cannibalizes credit income as shoppers can move to a loyalty program that offers similar rewards to the branded credit card but gives the consumers the opportunity to get 2x the points. Once at KSS and once on a National Credit card. That takes SG&A growth, which has been artificially suppressed as credit sales grew from from 50% to 60%+ of total sales over a 5 year time period, from a run rate of 1% to 3%-4%. For a company that comps 1% in a good quarter, this is incredibly meaningful.

 

Stage 3: This is the doomsday scenario, and within the realm of possibility as the credit cycle rolls. On top of the self-inflicted pain we see in Stage 2, we see consumer spending dry up (sales weaken – down 5-10%), gross profit margins are down 2-3 points due to excess inventory, SG&A grows in the high single digits due to credit income (which is booked as an offset to SG&A) eroding, and EPS falls to $2.00-$2.50. Look at any data stream on the credit cycle and you will see that delinquencies and charge-offs are at pre-recession levels. Translate that to KSS, and it means that the credit portfolio is currently at its most profitable rate. Because the company shares in the risk/reward with its partner COF, any weakening in the consumer credit cycle exacerbates the problems brought on by Yes2You cannibalization and puts 25% of EBIT and half of the current FCF at risk. The result, cash flow dries up and by our math, cuts its dividend within 12-months.

 

Other Notables on The Release

The comp in this quarter missed, and believe it or not, the comps from here get much more difficult. This pre-announced $0.30 (7%) earnings miss for a fiscal year is monstrous. The last time a company with the cap and sales base that KSS owned (pre-blowup) missed at this magnitude in a fiscal year was back in 2012 at JCP under RonJon. Prior to that, we have to go all the way back to 2003 when TGT and KSS printed a miss of 11% and 8%, respectively.  

 

This is now the 5th straight quarter of positive SSS comps for a company that hasn’t put a string like this together since 3Q10 – 3Q11. By our math, given that e-commerce sales grew at 30%, brick and mortar comps were down 4% in the quarter. Gross margins were down to the magnitude of 100bps+ assuming SG&A growth of 3-4%.


CHART OF THE DAY: Another Flashing Red Indicator That Portends A Recession

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye U.S. Macro analyst Christian Drake. Click here to learn more.

 

"... The Fed Senior Loan officer survey for 1Q16 showed a further tightening in corporate & commercial credit. Specifically, a net percentage of banks tightened C&I (commercial and Industrial) lending standards for the second quarter in a row. Moreover, demand for C&I loans inflected into negative territory this quarter. Eleven percent of banks saw C&I loan demand decrease from large and medium firms (13% saw it decrease from small firms), signaling that borrowers expect a decreased need for capital.

 

This matters because, historically, when two of the three C&I questions have turned negative, it has portended a recession in the near future (see Chart of the Day below).

 

This isn't coincident, it's causal."

 

CHART OF THE DAY: Another Flashing Red Indicator That Portends A Recession - EL C I Spreads Demand standardsl


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Old Enough To Know Better

“Old Enough to Know Better, Young Enough Not To Care”

-Billy Zane

 

Let me tell you a story.

 

Since my cold is getting worse at an accelerating rate this morning, it’ll be a short story:

 

The year is 1980 and interest rates in the U.S. are cresting to their stagflationary peak (Fed Funds peaked at 22.4% in 1981). 

 

Our early chapter protagonist – one iconoclastic central banker – Mr. Paul Volcker successfully broke the inflationary cycle and in an ironic plot twist also birthed our story’s antagonist: policy and the multi-decade accommodative interest rate cycle.  

 

Mysteriously (or not), #Inequality – hereto a noncharacter – is unwittingly thrust into the spotlight and begins his ascent higher alongside the progression of the interest rate cycle.

 

Ahh … the plot thickens.   

 

But before further character development, a bit of backstory.

 

35+ years of falling bond yields:

  1. Gets bond bulls paid (you must own bonds to benefit mind you)
  2. Increase the value of assets via the Present Value effect (again, you have to own financial assets to benefit)
  3. Serve to drive financial innovation, the “financialization” of markets and disproportionate growth in the finance economy

 

For those not holding financial assets, the benefits of expansionary policy and declining interest rates are more insidious as it:

  1. Spurs household demand by making credit cheaper and reducing the incentive to save, driving investment and household consumption of goods and services higher
  2. Lower highs and lower lows in interest rates in each successive cycle support onboarding of incremental debt as the costs of servicing debt are marched lower (see the beauty of a graphic by Bob Rich below). 

 

Old Enough To Know Better - Fed Chairmen cartoon 02.03.2016

 

Back to the Global Macro Grind …

 

Perhaps perversely, under a bureaucratic system perpetuating political short-termism and a monetary policy mandate calling for full employment, the solution to rising debt-to-income levels stemming from lower interest rates and accommodative monetary policy, is even lower interest rates, more expansionary policy, and currency devaluation.

 

Lower interest rates and a depreciating currency reduce the cost of servicing debt while further increases in aggregate demand and financial asset price appreciation support an ongoing rise in incomes. 

 

Under this story arc, policy supports a growing economic pie and the wealthy benefit directly - and can increase consumption while maintaining a static income-to-consumption ratio (…also, remember, they are the ones financing and getting paid on the cumulating debt). 

 

The lower income quartiles, meanwhile, can enjoy increased consumption at the cost of rising leverage. Rising Household debt can offset consumption differences created by rising income inequality and policy can support the perceived prosperity dance so long as there remains cushion for further reduction in rates.   

 

With our Stasis, Trigger and Conflict thus established, this leaves us with 5 points in a typical story structure:

  1. The Surprise
  2. The Critical Choice
  3. The Climax
  4. The Reversal
  5. The Resolution

 

The last three (or four) points are unfolding in real-time as NIRP and the currency war race-to-the-bottom crescendo and drive us towards some version of a tragi-comical catharsis. 

 

So let’s detail the Surprise and the Critical Choice with some relevant digression along the way.

 

The (Un)Surprise:   For our story here, the net of a multi-decade credit cycle are a few fold:

  1. Rising income inequality: the income distribution is increasingly top heavy with the top quintile/decile/1% taking down a larger share.
  2. Rising consumption skew: Consumption trends are increasingly hostage to what we’ll call the ‘wealth economy’ with the top 5% on the income distribution accounting for something on the order of ~40% of total consumption
  3. Credit: an outcropping of the credit cycle and financialization of the economy is that inflections in credit growth remain a primary marginal driver of aggregate spending. 

 

So, the expansion and contraction of credit and the ebb and flow of high end consumerism are critical to understanding and projecting the slope of consumption growth. 

 

Enter the (Growth) Foil: couple of developing realities:

  • High End: High End consumption shows a strong relationship to financial market volatility with new home sales and higher ticket discretionary consumption a decreasing function of volatility. Volatility is marching steadily higher and as the climax of this weaving macro narrative progresses, the plot twists will continue to manifest as bouts of rising volatility.
  • Credit: The Fed Senior Loan officer survey for 1Q16 showed a further tightening in corporate & commercial credit. Specifically, a net percentage of banks tightened C&I (commercial and Industrial) lending standards for the second quarter in a row. Moreover, demand for C&I loans inflected into negative territory this quarter. Eleven percent of banks saw C&I loan demand decrease from large and medium firms (13% saw it decrease from small firms), signaling that borrowers expect a decreased need for capital. 

 

This matters because, historically, when two of the three C&I questions have turned negative, it has portended a recession in the near future (see Chart of the Day below).

 

This isn't coincident, it's causal.

 

Banks tightening the screws, increasing the price of money or reporting reduced demand for money all portend a slowing of economic activity.

 

Credit is pro-cyclical and just as it can serve to jumpstart or amplify a virtuous cycle on the upside, it can similarly serve to catalyze a negative self-reinforcing downcycle. 

 

In other words, banks tighten credit => consumption/investment decline => job growth slows or workers are laid off => delinquencies rise => banks further tighten credit => and so on and so forth.

 

Very Dalio-esque, but it’s also how I lean towards intuiting the “economic machine”. But then again, I’m just a guy in a room with creative analytical license spinning commonsense narratives around data at 5am with minimal editing. 

 

If you’re an Old Wall shop, you traffic in contrived sophistication and perceived scarcity value, it’s what you do.

 

If you’re consensus, you forecast 3% on the 10Y and serially revise your earnings/growth forecast lower every year, it’s what you do. 

 

If you’re an active participant in this democratization of investment research experiment we’re conducting @Hedgeye, you try to simplify the complex. That and buy long bonds and bond proxies (Utilities, REITs, etc) when growth is slowing. 

 

7-months of boring allocations to long bonds isn’t the positioning fabric dazzling macro narratives are weaved on or sexy marketing campaigns based but that’s okay. We’re old enough to know better, but still young enough not to care. 

 

Post-Script | Recession Mongering: To be clear, our call has been that the probability of recession is rising and insufficiently discounted by markets. We don’t need an outright technical recession for our #GrowthSlowing call to manifest as recessionary price action in equities – we only need the prevailing opinion/sentiment/consensus to recouple with the more dismal underlying macro and corporate profit reality. Across a growing swath of companies (namely, smaller cap/lower liquidity/higher beta/higher leverage style factors) bear market price action has already commenced. 

 

…. Oh yeah, and the domestic services sector showed further slowing yesterday as the ISM Services reading slowed to its lowest reading in two years and the EU cut its growth and inflation forecasts again this morning.

 

To real-life page turners and harmonious Resolutions,

 

Christian B. Drake

U.S. Macro Analyst

 

Old Enough To Know Better - EL C I Spreads Demand standardsl


INVITE | 1Q16 Internet Best Ideas Call (TODAY)

Takeaway: Please join us for our today at 1:00pm EST. Dialing instructions below

We will be hosting our quarterly INTERNET BEST IDEAS Update Call today at 1pm EST.  We will be reviewing the major themes and incremental developments to our Best Idea Short theses (YELP, TWTR), and will be discussing two recently-closed Best Ideas that we have added to our Bench in the opposite direction (LNKD as a potential Short, P as a potential Long).  The emphasis of this call will be to outline our view over various durations (particularly 2016) as well as the upcoming catalyst calendar; identifying the major catalysts and risks to each company over the near-to-intermediate term.

 

Join us for our call today at 1:00pm EST.  Dialing instructions below

 

 

KEY TOPICS WILL INCLUDE

  • TWTR: Aggressive monetization tactics creating structural headwinds; why there is at least one more leg down to the short.
  • YELP: Sell-side refuses to acknowledge its attrition, so estimates still too high.  Question if mgmt will repeat 2015 mistake and guide to them
  • LNKD: Closed Long, Potential Short.  Selling environment appears to be deteriorating, could be beginning of challenging trend
  • P: Covered Short, Potential Long.  Dead money or Call Option? Depends on how mgmt chooses to proceed post Web IV

 

Participating Dialing Instructions

  • Toll Free:
  • Toll:
  • UK: 0-
  • Confirmation Number: 13629885
  • Materials: CLICK HERE

 

Hesham Shaaban, CFA


@HedgeyeInternet 


The Macro Show Replay | February 4, 2016

 


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