Here's Why You Stay Short Junk Bonds

Here's Why You Stay Short Junk Bonds - junk pile


It's the #CreditCycle.


Despite the recent rally, we're holding the line on our short Junk Bonds (JNK) call. Here's analysis and a chart via our Macro team from a note sent to subscribers earlier this morning:


"Junk bonds have rallied +3% in the YTD, inclusive of a +6% squeeze over the past 3M alone. Option adjusted spreads continue to narrow dramatically, compressing -30bps in the past week alone to 586bps wide. This is down from a peak of 839bps on February 11th.


Is the trough of the domestic credit cycle in the rear-view mirror, leaving us holding the bag on a stale thesis? Not at all. Our work has shown that once the horse leaves the barn on the domestic credit cycle, there is no recovery until HY spreads are north of 1,000bps and corporations have sufficiently delivered their balance sheets – neither of which has occurred."


Click on the chart below to enlarge. Note: We think we're headed for a nice, big red dot (a.k.a. a blowout in high-yield credit spreads).


Here's Why You Stay Short Junk Bonds -  CreditCycle Bubble Chart DD


More on the credit cycle...


According to Standard & Poor's, there were 5 more corporate defaults this week, bringing the grand total to 51 year-to-date. FYI, that's the most since 2009.


Here's Why You Stay Short Junk Bonds - defaults


There you have it...


We're sticking with our short Junk (JNK) call.

Dale: ‘Brexit Is The #1 Risk In The U.K.’


With the U.K. divided over whether to stay or leave the European Union, Hedgeye Senior Macro analyst Darius Dale discussed the potential impact on the pound, equities and consumer/business confidence on The Macro Show this morning.

FLASHBACK: Howard Penney Says Buy McDonald's

Takeaway: More good news for McDonald's investors.

Editor's Note: Lovin' it... Veteran Hedgeye Restaurants analyst Howard Penney's bullish, non-consensus call on McDonald's continues to pay off for those who listened. See WSJ story today, McDonald’s Profit Climbs, Showing Turnaround Is Sustainable. Shares of MCD are up over 21% since his article was published on Fortune. The stock is up 27% since it was added to Investing Ideas on August 11, 2015 versus 0.36% for the S&P 500. 


FLASHBACK: Howard Penney Says Buy McDonald's - z how 


The fast-food chain’s stock will likely pop next year, thanks to its real estate holdings and its ‘All-Day Breakfast’ menu.


Last week, McDonald’s shares jumped 1.5%, amid speculation that the fast-food giant might spin-off its massive real-estate holdings. That looks increasingly likely under the activist-like new CEO, Steve Easterbrook. It’s another welcome development and a broader sign that McDonald’s is finally turning the corner. Our prediction: This year will be the last time McDonald’s stock sees a price below $100.


Let’s be clear. A lot has changed at McDonald’s in the past year. Within the first two months of becoming CEO earlier this year, Easterbrook announced $300 million in cost cutting measures, a move that includes refranchising 3,500 stores of its 36,290 stores globally and shutting down an additional 700. McDonald’s  MCD -0.35%  will soon use technology, such as self-ordering kiosks, to change the customer experience while rejiggering its menu, dropping some, adding others and improving its existing products. In October, for instance, McDonald’s announced that it would take “All-Day Breakfast” nationwide. Meanwhile...


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Slow Global Growth Snails

Takeaway: The latest read through on U.S. and Euro-area economies isn't good and confirms both economies remain mired in this slow growth environment.

Slow Global Growth Snails - Slow growth snails cartoon 07.14.2015


Here's analysis from our Macro team in a note sent to subscribers this morning:


"Eurozone April preliminary PMIs were released this morning... drum roll... both the Manufacturing and Composite (Manufacturing + Services) fell month-over-month, in-line with our theme of #EuropeSlowing. Eurozone Manufacturing recorded 51.3 vs. 51.6 prior and the Composite fell to 53.0 vs. 53.1. Services rose 10bps to 53.2. Meanwhile, coming late to the party, the ECB released the results of the Q2 2016 survey of professional forecasters, which sees the inflation forecast revised down by 0.4% to 0.3% for 2016 and growth at 1.5% in 2016 vs. a prior estimate of 1.7%."


Slow Global Growth Snails - eurozone


Meanwhile, in the U.S., more souring economic data. According to Markit, its survey of U.S. Manufacturing PMI fell to its lowest level in six-and-a-half years:


Slow Global Growth Snails - us pmi


Here's analysis from Markit: 


"US factories reported their worst month for just over six-and-a-half years in April, dashing hopes that first quarter weakness will prove temporary... With prior months’ survey data pointing to annualized GDP growth of just 0.7% in the first quarter, the deteriorating performance of manufacturing suggests that growth could weaken closer towards stagnation in the second quarter."


Then there's China. Earlier this week, we noted that the PBoC would enact more "prudent" monetary policy even as China's economy continues to slow.


Add all of this to the laundry list of dour economic news we've seen of late.

CHART OF THE DAY | U.S. 2016 Growth Estimates: Us Versus Consensus

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye Director of Research Daryl Jones. Click here to learn more.


"... So to summarize, our view is that key economic statistics will begin to miss consensus estimates as the year progresses. We’ve highlighted our view on GDP growth for 2016 in the Chart of the Day below. Specifically, while we were in line with consensus for Q1 2016 GDP growth, we are close to 100 basis points below consensus for the remainder of 2016E. In our views it’s hard to see how disappointing data will buoy the stock market, especially when the growth rates being reported are barely above recessionary levels in the best case scenario."


CHART OF THE DAY | U.S. 2016 Growth Estimates: Us Versus Consensus - 4 22 16 EL

FCC Action on Special Access Next Week (T, CTL, VZ, LVLT, WIN, CMCSA, TWC, CHTR, S, TMUS)

At next week's agenda meeting (April 28), the FCC will likely consider the imposition of new special access pricing regulations, rejecting incumbent phone carrier claims that competitive conditions in the dedicated enterprise private line market justify continued deregulation.  The FCC also plans to issue an order modifying volume and term conditions in special access contracts that are deemed unreasonable under traditional common carrier standards. 

The FCC estimates that special access is a $40 billion market that will grow substantially as high capacity connections become increasingly critical to furnish backhaul to expanding wireless facilities in metro markets.  Thus, lower backhaul costs should benefit wireless carriers like Sprint and T-Mobile.  For top tier wireless players like AT&T and Verizon Wireless, lower backhaul costs could be beneficial in geographic territories outside their wireline footprint.

We previously noted the upcoming FCC action, a proceeding raising concerns for incumbents like Verizon and AT&T, and even raising concerns for cable operators (like Comcast (CMCSA), Charter (CHTR) and Time Warner Cable (TWC)) seeking to expand their enterprise service offerings (Potomac Research, FCC Tees Up Special Access, April 5, 2016).  The upcoming action is positive for competitive local exchange carriers (CLECs) like Level 3, XO Communications, Windstream (which acquired PAETEC) and others.

Tariff Investigation:  The FCC tariff modification would close an ongoing investigation of the special access contracts of Verizon (VZ), AT&T (T), CenturyLink (CTL) and Frontier (FTR).  Competitive carriers, including Level 3 (LVLT, which acquired tw telecom), have complained the incumbents impose volume and term commitments, enforced by significant penalties, that effectively shut out alternative sources of private line supply and discourage CLEC investment in private line extensions into enterprise buildings.  The FCC is expected to mandate modifications that will benefit CLECs.  Such competitors lease access to special access connections to provide service for off-net locations (buildings not served by CLEC proprietary lines).

Potential Rule Changes:  Apart from action on the tariff investigation, the FCC will commence a rulemaking to consider substantial changes to the special access regulatory regime.  Verizon and an industry association representing competitive carriers (INCOMPAS) have jointly proposed a new regulatory approach that would end tariffing and deregulate special access in markets deemed competitive.  In markets not considered competitive, rate restrictions would be imposed but would apply on a technology-neutral basis to all providers of enterprise private lines.

Defining when markets are competitive and non-competitive, and the size or granularity of markets under consideration, would be issues explored in the upcoming rulemaking proceeding.  The FCC would need to establish criteria for setting reasonable rates and develop an effective system of enforcement.

Cable operators oppose the Verizon/INCOMPAS regulatory principles, rejecting the notion that they should be subject to any type of pricing regulation as an emerging provider making new facilities-based investment in the enterprise services market.  Competitors agree that cable private line options have been expanding to serve enterprise buildings and provide backhaul from cell towers, but they contend a functional duopoly still results in supra-competitive rates, justifying regulation of both incumbent telco providers and cable operators.

The FCC is interested in the Verizon-INCOMPAS approach as it represents the potential foundation of a consensus industry solution.  But without support from AT&T, CenturyLink and cable operators, the fight over final rules will be intense.  The Commission hopes to wrap this up late in the year, recognizing that potential changes in FCC personnel next year could derail possible rule changes for the special access market.

Cable Operators at Risk:  The proceeding poses two major enterprise market risks to cable providers.  First, any regulatory mandate that drives down incumbent telco special access rates would affect the retail pricing flexibility of cable operators.  They have generated double-digit growth in enterprise services and have plans to grow more substantially in this market, particularly in the provision of backhaul for wireless services.

Second, the FCC is now considering, consistent with the Verizon proposal, the imposition of rate regulations on all special access providers, renaming the offering "business data services."  This would extend pricing rules to cable operators and other providers of enterprise private lines.  Cable operators have not been subject to federal special access regulation and direct pricing regulation would become a new and potentially substantial burden.

Although the FCC would apply Title II common carrier telecom regulation to all special access services -- even if labeled as "business data services" -- the risk to cable operators appears to be complex rate regulation, not the more ominous regime involving mandatory network unbundling.  Under existing statutes, only incumbent phone carriers (essentially the former Baby Bells) are subject to loop unbundling.  The obligation does not extend to cable operators or CLECs.

Moreover, the FCC, backed by senior telecom policy officials in the Administration, generally does not favor network unbundling mandates to promote competition.  They have an expressed preference for facilities-based competition, avoiding the regulatory and litigation burdens associated with estimating wholesale pricing and other requirements for an unbundling regime.  After years of experience with the 1996 Telecom Act local phone competition rules, the Commission seems to acknowledge that genuine competition only comes from facilities-based alternatives.

Absent such alternatives, however, the FCC appears willing to intervene in a market deemed non-competitive, ensuring prevailing special access rates are reasonable.  The upcoming proceeding will be complicated and highly adversarial, but the regulatory trend looks favorable for competitors like Level 3 and introduces new enterprise regulatory uncertainty for cable operators.


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