3 Nasty Looking China Charts

Takeaway: All clear in China? Not by a long shot.

Editor's Note: As our Financials analyst Josh Steiner remarked on The Macro Show today, "Markets were in free-fall earlier this year and pundits were saying a recession was imminent. Then, in mid-February, it all stopped. One of the reasons is that China started pushing credit like crazy, reflating commodities, emerging markets and the U.S. stock market. But China cannot keep rapidly growing credit like it has been. China is now an enormous systemic risk to the global economy."


3 Nasty Looking China Charts - China cartoon 05.09.2016

(STEEL) free fallin'

"Chinese Steel – Risk measures were subdued last week. However, the price for Chinese steel continued to drop, falling by another 5% last week, bringing the month-over-month change to -21% as the mid-February to mid-April artificial reflation trade unwinds. We use Chinese steel rebar prices to gauge Chinese construction activity and, by extension, the health of the Chinese economy." 


3 Nasty Looking China Charts - steiner3 5 25


"Chinese Non-Performing Loans – Chinese non-performing loans amount to 1,392 billion Yuan as of March 31, 2016, which is up +41.7% year over year. Given the growing focus on China's debt growth and the potential fallout, we've decided to begin tracking loan quality. Note: this data is only updated quarterly."


3 Nasty Looking China Charts - steiner2 5 25

Debt, Debt & More Debt...

"Chinese Credit Outstanding – Chinese credit outstanding amounts to 148.7 trillion RMB as of April 30, 2016, which is up +11.9% year over year. Note: this data is only updated monthly."


3 Nasty Looking China Charts - steiner1 5 25


*This is an excerpt from an institutional research note. To access our research email

Liquidation Risk, Durable Goods, #UKSlowing

Client Talking Points

Liquidation Risk

Bloomberg this AM: hedge funds have lost 1.8 percent this year, according to Hedge Fund Research's global index, the poorest performance since 2008.  The industry had net outflows of $16.6 billion in the past two quarters, the most since 2009, according to HFR.  In 2015, 979 funds closed, more than any year since 2009, according to the research firm.  To the extent redemptions and closures accelerate, expect to see crowded names and sectors like Kraft, Time Warner, Consumer Discretionary and Tech take a hit, while under-owned names and sectors like Utilities, Energy and Materials continue to thrive.

Durable Goods

Headline Durable Goods orders jumped +3.4% MoM and improved to +1.9% YoY but the internals were less sanguine with the bulk of gain stemming from the +65% MoM increase in commercial aircraft & parts, which is most aligned with what actual households buy - rose +0.6% MoM but remains down -.4% YoY.  Meanwhile, Core Capital Goods fell MoM for a 3rd consecutive month, dropping -0.8 sequentially and holding at -5% YoY -  continuing the epic run of declining capital spending with negative year-over-year growth in 15 of the last 16 months.   



The Financial Times was out w/ a piece this morning citing the risk to the FTSE All-Shares Index due to the downturn in the U.K. economy, which we’ve been forecasting since late last year and is being corroborate by every key category of high-frequency data slowing on a trending basis. This mainstream media’s first mention of economic risk to U.K. assets that doesn’t have anything to do with Brexit. Expect such headlines to accelerate even beyond next month’s likely “remain” vote.

Asset Allocation

5/25/16 58% 2% 0% 10% 28% 2%
5/26/16 58% 2% 0% 10% 28% 2%

Asset Allocation as a % of Max Preferred Exposure

5/25/16 58% 6% 0% 30% 85% 6%
5/26/16 58% 6% 0% 30% 85% 6%
The maximum preferred exposure for cash is 100%. The maximum preferred exposure for each of the other assets classes is 33%.

Top Long Ideas

Company Ticker Sector Duration

When Janet does have to acknowledge the deterioration in U.S. growth, we expect the policy shift to be dollar bearish on the margin. And, to the contrary, if the Fed RAISES RATES (June) into this slow-down, they’ll be the catalyst for DEFLATION (down yields) again anyway. And there’s nothing Gold (GLD) likes more than a falling dollar and falling interest rates which is why we added it to the long-side of Investing Ideas this week. Remember, this is the same week various Fed members were in public calling for a rate hike with the worst jobless claims print since 2012. #GoodLuck.


McDonald's (MCD) continues to evolve. The company's latest step is testing never frozen burgers at 14 units in the Dallas, TX area. This initiative could give them the ability to compete with better burger concepts such as Shake Shack, In-N-Out and Five Guys.


Meanwhile, there has been chatter about the lack of identity for their value platform in 2Q16. MCD is truly still in the testing phase as to what their national value message will be. We can appreciate the fact that they are testing multiple formats before fully committing.


In the meantime, the tailwind from all-day breakfast will continue to propel growth going forward, until lapping this initiative in 4Q16. We continue to favor MCD as one of the best LONGs in the market right now, due to actual growth and style factors that are friendly in volatile markets.


If you haven’t yet, you got another chance to buy long-term Treasuries at lower highs this week. If you’re already long of Long Bonds (TLT, ZROZ), stick with it. None of the relevant data released this past week suggests that growth could inflect and trend positive:

  • Thursday’s Jobless Claims Report was the worst print, in Y/Y rate of change terms, since 2012, and it was the fourth consecutive week of increasing jobless claims
  • Industrial Production declined -1.1% Y/Y for April, marking the 8th consecutive month of Y/Y contraction: #IndustrialRecession

Tying together a continued deceleration in growth with policy expectations, the most important callout is that our expectation for growth in Q2 is well below consensus and Fed expectations (which have been horribly inaccurate). 

Three for the Road


Had an interesting discussion on The Macro Show with @KeithMcCullough!



"There are three types of baseball players: those who make it happen, those who watch it happen, and those who wonder what happens."

-Tommy Lasorda


John Kruk batted exactly .300 over his 10 year MLB career. In his rookie season, he batted .309

Daily Market Data Dump: Thursday

Takeaway: A closer look at global macro market developments.

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: Thursday - equity markets 5 26


Daily Market Data Dump: Thursday - sector performance 5 26


Daily Market Data Dump: Thursday - volume 5 26


Daily Market Data Dump: Thursday - rates and spreads 5 26

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CHART OF THE DAY: A Look At S&P 500 Multiple Expansion Off February Lows

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


"... Valuation is Not A Catalyst: Valuation isn’t an anchor in our decision making process over shorter-to-medium-term durations but it is a prime factor for others so the influence on prices can’t be dismissed outright. With SPX forward earnings estimates up just +1.5% off the lows, multiple expansion has driven most of the rebound in prices off the February lows. Upside to cycle peak valuation (recorded in 1H15) implies +68 SPX handles or +≈3.3% from current levels. In other words, unless the thesis is for accelerating earnings, that’s the upside you’re playing for under an assumption for a return to peak multiples."


CHART OF THE DAY: A Look At S&P 500 Multiple Expansion Off February Lows - SPX PE CoD

Common Sense Mongering

“He’s been dying from the same heart attack for the last 20 years… he thinks he’s going to live forever.”

-Michael Corleone on rival Hyman Roth, The Godfather


Yesterday’s Markit PMI for May printed 50.8 – dropping -1.6 pts sequentially (to 50.8, marking the 2nd lowest reading of the current downcycle) and to a level consistent with 128K in payroll adds for the month.  


PMI activity has been experiencing the same “bottom” for the last 20 months … the expansion is going to last forever. 


Common Sense Mongering - z gfat


Back to the Global Macro Grind...


To be fair, 50 represents the expansion-contraction Mendoza line in diffusion indices like the PMI’s, so 50.8 still represents expansion, but only barely. 


Economies are path dependent, so initial conditions matter and flirting with 50 with a faux hawkish Fed and no fundamental catalyst for a 50 => 54 => 60 type progression is not a position of strength.


This is the part of the missive where the conventional strategist playbook calls for narrative strong-arming with sophisticated sounding analytics and technical jargon to raise the perceived scarcity value.


I’m smart. Not like everybody says ... like dumb … I’m smart and I want respect! – Fredo


I’ll get to contextualizing the recent and upcoming domestic macro data, but first some Common Sense mongering.


This isn’t the kind of sophistication that gets you paid "2 and 20" but it is a bit of sleep-well-at-night sensibility that probably makes you 2 while others are losing 20.


The layman’s, passive strategy frame-up goes something like this: 


We are 7 years and +200% into the current expansion. That is not a surprise, the Reinhart & Rogoff facts are well circulated. 


Balance Sheet recessions are characterized by a protracted slump in employment, consumption, and credit growth. And expansions following financial crises are typically longer in period and lower in amplitude with the average & median time to reach pre-crisis levels of income being 8 and 6.5 years, respectively.


Real per capita income in the U.S. reached pre-crisis levels at the beginning of 2014, so just about 6 years from the onset of the recession. 


So, even with unprecedented intervention and global policy coordination we still fell basically right on the average. This time, in fact, was not particularly different.


Now, 2.5 years out from reaching income break-even, this is where we are:  


  • At 85 months, the current expansion is late relative to any historical reference (the mean & median over the last century are 59-months and 50-months, respectively).
  • Global and domestic growth are slow and/or slowing and slower for longer will remain the prevailing reality given global leverage and demographic dynamics
  • The central banking #BeliefSystem has begun breaking down alongside discretely diminishing returns to monetary policy initiatives.
  • China increased credit by $1T in 1Q16 (as in (Dr. Evil Face) 1 Trillion Dollars). Perhaps – alongside a rhetorically dovish Fed - that helped quell the commodity contagion but that debt bender got them … another lower low in GDP.  
  • Employment Growth, Consumption Growth, Income Growth, Confidence and Corporate Profitability are all past peak and SPX sales and earnings growth have been negative for each of the last 6 quarters. 


Does passing those simple realities through your common-sense-filter suggest you should be ramping your high-beta, cyclical exposure or risk-managing the same defensive and style factor exposures that have been working for the last year?


To frame it up slightly differently:


So Nice, It’s Like I Hit My (late-cycle) Prime Twice: Let’s suppose the expansion lasts two more years and base effects help drive negative sales and earnings growth nominally positive. How much runway does that give in terms of price reflation in underperforming cyclicals before a re-rotation back into more defensive, late-cycling positioning. 3, 6, 9-months? 


Valuation is Not A Catalyst: Valuation isn’t an anchor in our decision making process over shorter-to-medium-term durations but it is a prime factor for others so the influence on prices can’t be dismissed outright. With SPX forward earnings estimates up just +1.5% off the lows, multiple expansion has driven most of the rebound in prices off the February lows. Upside to cycle peak valuation (recorded in 1H15) implies +68 SPX handles or +≈3.3% from current levels. In other words, unless the thesis is for accelerating earnings, that’s the upside you’re playing for under an assumption for a return to peak multiples.


To quickly round out the rest of domestic Macro: 


Housing: Headline New Home Sales in April were strong, rising +16.6% sequentially and marking the fastest pace of MoM growth since January of 1992. In our note to clients on Monday we highlighted two cautionary points: 

  • The Headline was distorted by a seemingly outlier increase in sales in the Northeast. Sales in the Northeast were up +52.7% MoM and a remarkable +323% YoY, driving roughly 40% of the reported increase in total sales.
  • NHS are the most volatile and highly revised housing data series there is and we don’t take an overly convicted view of any single month in isolation – regardless if the data are good or bad. The imprecision is captured explicitly in the standard error of the estimate - for example, the +23.8% YoY increase recorded in April carries a 23% margin of error. In other words, if we were to anchor on a single series in shaping our high frequency view on housing, NHS would be the last series we’d use. 


Pending Home Sales: We’ll get Pending Home Sales data for April this morning which represent signed contract activity in the 90% of the Housing Market that is existing sales. PHS have been decelerating for the last 11 months and face peak comps in April & May. For context, sales need to be up +0.6% sequentially just for year-over-year growth to be 0%. As we highlighted last week, -2%-to-+2% is your fundamental demand backdrop in the existing market for the next quarter+.


1Q GDP: The final Construction Spending, Trade Balance and Factory Order data for March – all of which saw positive revisions - will support a upward revision to 1Q GDP tomorrow morning.  Consensus at 0.9% (up from +0.5%) is about right.  


Income & Spending | Sequential ↑, Trend ↓: We’ll get the official income and spending data for April on Tuesday. The sum of aggregate hours and hourly earnings growth from the NFP report implies a modest sequential acceleration in aggregate income growth. The savings rate will remain the swing factor but if it’s flat with last April at 5.1% - and in combination with the acceleration in revolving credit growth - then it’s likely we get a modest sequential acceleration in consumption growth. That sequential improvement will come inside a larger trend of deceleration that will remain ongoing.   


So, that’s both the passive macro strategy playbook and the short-term fundamental setup. 


We plan to both tactically trade the immediate-term risk range while staying strategically positioned for the late-cycle Trend … but that’s just Hedgeye Cosa Nostra …. no Omerta, just real-time and transparent.


Our immediate-term Global Macro Risk Ranges are now:


UST 10yr Yield 1.69-1.90%

SPX 2031-2096

VIX 13.63-17.58

USD 94.01-95.95
YEN 108.45-110.79
Oil (WTI) 46.99-50.16

Gold 1


To Stand-Up (macro) Guys trying not to fall,


Christian B. Drake

U.S. Macro Analyst


Common Sense Mongering - SPX PE CoD


Takeaway: Both ECPG and PRAA have seen profitability on recent vintages utterly collapse. This is true both in the US and the European business.

When Encore Capital Group (ECPG) and PRA Group (PRAA) reported earnings two weeks ago, we highlighted that the former is showing growing signs of the slowdown ahead while the latter is already engulfed in a meltdown.


Those notes can be found here:




Today, we are providing an in-depth vintage analysis of exactly what is going on under the hood at ECPG and PRAA. At both companies, collections after costs on newer vintages are woefully short of the needed hurdle rates to justify current valuations. At PRA Group, the slowdown is so severe that the company is persistently booking allowance charges to reverse revenue and correct overly zealous collection estimates, driving top line growth into negative territory. Meanwhile, at Encore Capital Group, the decline in newer vintages' ability to cover their costs is even worse than at PRAA. In fact, ECPG's recovery rates are at their lowest levels in history. We see the deterioration at both companies continuing into the future.




Declining Recovery of Purchase Price

While Encore Capital Group’s management touts that things are going great, our analysis disagrees. Encore’s newer vintages, 2013, 2014, 2015 and 2016 in particular, were more expensive in comparison to collections than those purchased at the optimal point in the credit cycle, namely 2009, 2010, and 2011, and that dynamic is driving down the firm’s collection IRR. The following chart is a vintage comparison of the cumulative collections versus purchase price when each vintage was in the first quarter of its T+1 year, T+2 year, T+3 year, and T+4 year. (For example, Y1Q1 for the 2014 vintage represents all of that vintage's cash collections through 1Q15 versus the reported purchase price for that vintage. Y2Q1 for 2014 represents the vintage's collections through 1Q16.) Our calculations show that 2014 and 2015 are the worst performing vintages on record. The most recent data point for the 2014 vintage in the U.S. and Other Geographies portfolio, Y2Q1, shows that net of cost to collect it has only recovered 53% of its purchase price. That is a significant deterioration from the 77%-78% recovery that the 2009-2011 vintages experienced by the same point in their lives. Additionally, the 2015 vintage’s most up-to-date performance, through Y1Q1, is even worse than the 2014 vintage’s. 2014 had recovered 23% by Y1Q1 while 2015 has recovered only 20%, and both vintages are significantly underperforming the 32%-33% recovery that 2009-2011 vintages experienced by the same point in their lives.


The first two charts below show collections AFTER deducting cost to collect, but do not adjust for interest expense.




This problem expands beyond the U.S.   Encore’s European portfolio, which is 48% of the company’s estimated remaining collections (“ERC”), is showing similar deterioration. Given that the company entered the European market in 2013 with the Cabot acquisition, no pre-2013 comparison is available for Europe. However, the European 2014 vintage is underperforming 2013, and 2015 is doing worse than 2014. At Y2Q1, the 2014 vintage's cumulative cash collections net of cost to collect had only covered 41% of the purchase price versus 2013’s 50%. Additionally, just as in the U.S., the 2015 vintage is even worse than the 2014 vintage. Its most recent reading as of 1Q16 shows that it has recovered only 16% of its purchase price while 2014 had recovered 20% by Y1Q1 and 2013 had recovered 23%.






In addition to the net recovery charts above (collections after costs to collect), we present the following recovery chart which does not deduct cost to collect. This chart goes back beyond the 2009 vintage, before ECPG disclosed cost to collect, to show that 2014 and 2015 are indeed the worst performing vintages in the company’s history.




Translating to Declining Results

This cash collection deterioration of recent vintages is clearly seeping its way into firm-level results. First, post-2012 vintages, which are experiencing lower collections for every dollar of purchase price, are now 90% of Encore’s ERC. In other words, the bulk of the book that Encore is collecting on is now comprised of the worst-performing vintages in the company's history.




The growing share of weak vintages coupled with deteriorating results are finally bleeding into ECPG's firm-level IRR, Y/Y revenue growth, and Y/Y collection growth, all of which have been persistently trending downwards since late 2013~early 2014.






To dive still deeper and show how this decline is affecting operating income on a per-vintage level, the following table takes the revenue that Encore discloses for each vintage and subtracts out its pro forma cost, which is a Hedgeye calculation. The cost figures we use are not actual results reported by Encore, per se, since they don't provide them at the vintage level. However, we apply Encore's overall actual operating expense (excluding CFPB expenses and goodwill imparment) on a pro forma basis to the two major geographies (U.S plus other geographies and Europe) based on their share of the overall "adjusted cost per dollar collected" which Encore does directly report. We then apply the geographic operating expense to each underlying vintage based on share of cash collections within each geography. (Note that the dark blue figures are Hedgeye future estimates.) We believe this is a fair representation.


Our analysis finds a staggering decline in recent vintage profitability. In the U.S., operating income during the year of inception has fallen from $27 million for the 2013 vintage, to $3 million for 2014, and into negative territory for 2015 at -$9 million. In Europe, 2013 is doing fairly well, and 2014 appears to be a decent performer, but 2015 put up a massive decline to $11 million in Y0 operating income, down from 2014's Y0 operating income of $53 million.


Additionally, the regression below the table shows how our projections for total operating income through year 6 (e.g. 2015's cumulative operating income through 2021) relate to the prevailing expected-gross-collection multiple of each vintage. Most importantly, we expect the U.S. 2015 vintage to continue putting up negative opearating income, the U.S. 2014 vintage to put up a meager $22 million, and for the European 2015 vintage to perform just slightly better with $35 million in cumulative opearting income.


Here's the real takeaway. The cumulative operating income (revenues less collection costs) for the US2014, US2015, US2016, EUR2015 and EUR2016 vintages are close to (or below) zero and that's BEFORE taking into account interest expense from the debt used to finance the portfolio acquisitions. These five vintages currently account for 47% of total ERC.




Finally, to drive this point home we provide a simple analysis of a 7-year collection pattern. The first table below uses the firm-level cost to collect of 48%. Note that this differs from Encore's reported 39% cost to collect because the 39% excludes certain reocurring GAAP items that must be considered. The 48% cost to collect that we use is simply the trailing twelve months of GAAP operating expendes excluding expenses related to CFPB one-time charges and goodwill impairment divided by the trailing twelve months of collections. Our analysis also assumes debt financing with a 6.6% interest rate and a 32.5% tax rate. Based on those inputs, the breakeven multiple of expected gross collections (“EGC”) to purchase price is 2.44x. Meanwhile, the 2014, 2015, and 2016 U.S. portfolios are below that level. In Europe, the 2014, 2015, and 2016 vintages are all below 2.44x.


We also provide this analysis on a geographic basis. The second table below shows that when considering the higher 50% cost to collect (op exp ex-CFPB and impairment / collections) specific to the U.S., the breakeven multiple is 2.58x. Considering that higher hurdle, the mix of unprofitable vintages also includes 2012 and 2006. The third table analyzes the European breakeven with that business's lower 40% cost to collect. With European breakeven coming in at 2.15x, that business has more leeway, but the 2015 and 2016 vintages are still below that level.


This severely reduced profitability in newer vintages will continue to drive down firm-level results as older vintages roll off and are replaced by newer, unprofitable books. 








Declining Recovery of Purchase Price

At PRA Group, the 2012, 2013, and 2015 American Core vintages are deteriorating versus the peak vintages of 2009, 2010, and 2011. This is, again, driven by purchasing expensive paper and not making high enough collections on that paper to keep up with the pace of better performing vintages.




The decline in PRA's European business, meanwhile, is extraordinary. Each vintage in the European portfolio, which is 42% of PRAA’s ERC, is performing worse than the preceding vintage. As of 1Q16, the 2015 vintage has only recovered 17% of its purchase price versus 2014’s 29% at the same 1QY1 age. At 1QY2, 2014 has recovered only 64% versus 2013’s 93% at that age. Finally, 2013’s 90% recovery so far places it well below 2012’s 133% at 1QY3.






PRA does not break out cost to collect on a channel basis. As such, the previous charts do not deduct that cost. Therefore, we also provide the following net recovery chart on a firm-wide basis. Similarly to the before-cost recovery rates, 2012, 2013, 2014, and 2014 are underperforming the preceding vintages.




Translating to Declining Results

With the deteriorating post-2011 vintages now making up 92% of PRA’s ERC, similar to Encore, PRA’s firm-wide IRR has been deteriorating.






This dynamic at PRA has made its way into top line results even more severely than at Encore. In fact, PRAA’s firm-level revenue growth has gone negative, as the revenue growth from newer vintages is not high enough to outpace the revenue contraction in older vintages.




A big part of what’s going on here is that PRAA continues to book significant allowances to reverse revenue that it never should have booked for the 2013 and 2014 vintages. Management has argued that, under GAAP, it is being unjustly forced to record these allowance charges due to short-term changes in collection patterns while they are increasing longer term collection projections. They claim that the net present value of the upward revision to ERC for better performing vintages outweighs the shortfall of the vintages taking the allowances. However, we see this commentary as a distraction from the fact that significant allowances continue to occur. While management may be increasing projections, the shortfalls that force them to book losses continued in 1Q16 to the tune of a $9.9 million revenue hit, roughly in-line with the trend over the last few quarters.




Finally, as we did with Encore, we show that using PRA’s 41% cost to collect over the trailing twelve months, debt financing with a 4% interest rate, and a 32% tax rate, the breakeven multiple of EGC to purchase price is 1.96x. Meanwhile, the U.S. 2016 vintage being brought on is below that level, as is every European Core vintage other than 2014. It's also worth noting that unlike Encore, PRA's cost to collect is roughly the same between the US and Europe, which they showed in a footnote in a slide presentation a while back. 






In summary, with new vintages continuing to come on at lower recovery rates, we expect this deterioration to continue, to worsen, and to drive PRAA’s stock price down further from its current level.




Joshua Steiner, CFA


Jonathan Casteleyn, CFA, CMT


Patrick Staudt, CFA



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