The Evolving Complacency In Credit Markets

Takeaway: Complacency about the credit cycle is at YTD highs, especially in commodity-related sectors.

Editor's Note: Below is #CreditCycle analysis via our Macro team in a note sent to subscribers earlier this morning. 


The Evolving Complacency In Credit Markets - credit cycle

With renewed expectations for Fed intervention on growth slowing and the precedent of Central Bankers buying corporate bonds in Europe, bond market volatility expectations have been smashed.


The MOVE index is at a level not seen since 2014. High yield spreads have nearly returned to their 2015 averages. Energy OAS is below 2015 averages after trading +600 over that level back in Febraury, and materials and industrials spreads have nearly reverted back to 2015 levels.


What's changed? Expectations certainly have:


  1. Spreads being well-off 2014 cycle lows;
  2. Consumption rolling over; and
  3. Jobless claims picking up


A confluence of data suggests the cycle still cycles.


The Evolving Complacency In Credit Markets - credit spreads 5 13


Daily Market Data Dump: Friday

Editor's Note: Below are complimentary charts highlighting global equity market developments, S&P 500 sector performance, volume on U.S. stock exchanges, and rates and bond spreads. It's on the house. For more information on how Hedgeye can help you better understand the markets and economy (and stay ahead of consensus) check out our array of investing products




Daily Market Data Dump: Friday - equity markets 5 13


Daily Market Data Dump: Friday - sector performance 5 13


Daily Market Data Dump: Friday - volume 5 13


Daily Market Data Dump: Friday - rates and spreads 5 13

CHART OF THE DAY: Trump Beating Clinton? Not As Challenging As Once Thought

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.


"... Admittedly it is somewhat ironic to have a quote about losing from Donald Trump. To the chagrin of many, Trump has literally done nothing but win over the last year. He has won primary after primary and, if the most recent polls are any indication, beating Hillary Clinton might not be as challenging as pundits once thought either. In the Chart of the Day, we highlight this narrowing gap between the two."


CHART OF THE DAY: Trump Beating Clinton? Not As Challenging As Once Thought - 5 13 16 CoD

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Kohl's: The Ugly Path To The Inevitable Dividend Cut

Takeaway: In the path to the inevitable dividend cut, all that concerns us is an activist that does not know how to do research.

Editor's Note: Today's lackluster earnings release from Kohl's (KSS) sent the shares tumbling -9%, as the company missed on just about every important metric. The stock is off almost -15% on the week, handicapped by the broader economic malaise that hit other retailers like Macy's (M).


Meanwhile, Retail analysts Brian McGough and Alexander Richards have been bearish on the stock for some time now. In a note to clients today, McGough and Richards wrote:


"One thing we want to remind everybody of, however, is our thesis that the erosion in Credit income at KSS (30% of EBIT) will take up SG&A, pressure cash flow, and cause KSS to cut its dividend.”


In other words, the worst is yet to come.


Below is an excerpt from a research note published on February 3, 2016, in which they detail the troubles ahead for KSS. To read our Retail team's institutional research email 


Kohl's: The Ugly Path To The Inevitable Dividend Cut - kss images

KSS | …And This Is Only Stage 1 of 3


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 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.

Cartoon of the Day: The Spin Cycle

Cartoon of the Day: The Spin Cycle - The Cycle cartoon 05.12.2016


"While it should surprise no one who has been on the right side of the US economic, profit, and credit cycle call that the #LateCycle Sectors of the US Economy (Financials, Consumer Discretionary, Tech, Healthcare) are the biggest dogs for the YTD, the pace of the decline in the US Retail (XRT) sub-sector of consumer has caught many off-side this week," Hedgeye CEO Keith McCullough wrote in the Early Look this morning.

Retail Flirts With Crash Mode | $XRT

Takeaway: The Retail Sector (XRT) is down more than -18% since July 2015.

Retail Flirts With Crash Mode | $XRT - consumer slowing


As U.S. consumer spending mirrors the broader malaise of the U.S. economy, now is not the time to bet on Retailers.


Since the July 2015 peak, the retail sector has continued its slow slide and is now flirting with full-blown crash mode. Here's analysis via Hedgeye CEO Keith McCullough in a note sent to subscribers this morning:


"Not surprisingly, the US Consumer gets that they get the bill when US Growth Slows (Down Dollar = Tax on Real Consumption) and now the US Retail Sector (XRT) which has been a Best Idea in our Macro Themes since Q3 of 2015 is moving toward #crash mode at -18.3% since July 2015."


Retail Flirts With Crash Mode | $XRT - xrt 5 12

(In case you missed it, click here for our current big Macro theme investment conclusions referenced by McCullough.)


Leading the losers today is Kohl's (KSS).


(Note: KSS happens to be on Retail analyst Brian McGough's Best Ideas Short list.)


As McCullough wrote in today's Early Look:


"Not to pick on Kohl’s (KSS), but now that LINE is a bagel, I have to pick on something with market cap. KSS missed the top-line (same store sales were DOWN -4% year-over-year) and EPS came in at $0.31 vs. an Old Wall “expectation” of $0.37/share."



... He continued with this final cautionary note on KSS:


"Ah, but 'it’s cheap.' Yep. Getting cheaper.”


Heads up!

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