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This Week In Hedgeye Cartoons

Our cartoonist Bob Rich captures the tenor on Wall Street every weekday in Hedgeye's widely-acclaimed Cartoon of the Day. Below are his five latest cartoons. We hope you enjoy his humor and wit as filtered through Hedgeye's market insights. Bob is on a much-deserved summer vacation. While he kicks back and relaxes, we're going into the Hedgeye Vault and highlighting some of his best work. (Click here to receive our daily cartoon for free.)

 

Enjoy!

 

1. Blast Off! (8/5/2016)

This Week In Hedgeye Cartoons - Rate hike cartoon 11.30.2015

 

After Friday's Jobs Report "beat" analyst expectations, Hedgeye CEO Keith McCullough wrote, "After going from hawkish to dovish to hawkish to dovish to hawkish, this Jobs print keeps Federal Reserve hawkish."

 

2. Choppy Waters (8/4/2016)

This Week In Hedgeye Cartoons - fed 6 9 14

 

Since Yellen & Co. have totally got this (for sure), we bring you another audience favorite.

 

3. Bull Bomb (8/3/2016)

This Week In Hedgeye Cartoons - Bull bomb cartoon 09.01.2015

 

As U.S. equity indices hang out near all-time highs, we bring you another audience favorite.

 

4. Happy Hour? (8/2/2016)

This Week In Hedgeye Cartoons - Oil cartoon 11.20.2015

 

With oil down 28% from its recent high, we bring you another audience favorite.

 

5. Currency Wars (8/1/2016)

This Week In Hedgeye Cartoons - currency wars

 

In light of all the monetary policy shenanigans, we bring you another audience favorite.

 

Click here to receive our daily cartoon for free.


The Week Ahead

The Economic Data calendar for the week of the 8th of August through the 12th of August is full of critical releases and events. Here is a snapshot of some of the headline numbers that we will be focused on.

 

CLICK IMAGE TO ENLARGE.

The Week Ahead - 08.05.16 Week Ahead


Investing Ideas Newsletter

Takeaway: Current Investing Ideas: HOLX, HBI, LAZ, FL, TIF, WAB, ZBH, UUP, LMT, GLD, TLT

Investing Ideas Newsletter - Rate hike cartoon 11.30.2015

 

Below are our analysts’ new updates on our eleven current high conviction long and short ideas. As a reminder, if nothing material has changed in the past week which would affect a particular idea, our analyst has noted this. 

 

Please note that we added PowerShares DB US Dollar Index Bullish Fund (UUP) to the long side of Investing Ideas and removed Junk Bonds (JNK), Dunkin' Brands (DNKN), Allscripts Healthcare Solutions (MDRX) and Treasury Inflation-Protected Securities (TIP). We will send Hedgeye CEO Keith McCullough's refreshed levels for our high-conviction Investing Ideas in a seperate email.

IDEAS UPDATES

TLT | GLD | UUP

To view our analyst's original report on TIPs click here and here for Gold.

 

We made some changes in this week's edition of Investing Ideas, with the removal of Junk Bonds (JNK) on the short side and Treasury Inflation-Protected Securities (TIP) on the long-side.

 

With the epic move in ten-year yields to all-time lows, corporate credit spreads (JNK) have floated off the “risk-free” rate. The pull-back in cross-asset volatility from the February highs in the VIX, OVX (oil volatility index), and the MOVE Index (Treasury volatility index), likely exacerbated the tightening in spreads.

 

The credit cycle WILL cycle, and deterioration in consumer and corporate credit remains an important Hedgeye Macro theme. This week the Q2 Fed Senior Loan Officer Survey was released which confirmed deterioration in credit conditions (see the chart below for our credit cycle indicator; the chart is busy but it’s worth a hard look).

 

Investing Ideas Newsletter - 08.05.16 Credit Conditions Indicator

 

Our team’s macro process is both fundamental and top-down, and we get the top-down signals in real-time. The bottom-line is that both the CRB Commodities Index and crude oil have recently broken down from a quantitative risk management perspective. While this is a key factor contributing to our recent addition of the PowerShares DB US Dollar Index Bullish Fund (UUP), it also signals that TIP does not have as much upside as we thought. As Keith McCullough wrote to subscribers this week:

 

“Changing my mind on longer-term longs has happened infrequently this year, but it should happen. That’s how the game goes.”

 

Getting out of a position if it’s not working is much more prudent than stubbornly sticking with it when your process signals otherwise.

 

Back to growth ... we’ll refrain from commenting on Friday’s headline non-farm payrolls number in isolation, and rather offer some perspective on the cyclical nature of the non-farm payroll data series (you’ve heard it before):

  • On a Y/Y rate of change basis, Non-Farm Payrolls peaked in February of 2015;
  • Once growth in this series peaks and rolls over, it doesn’t return and we move toward economic contraction on the margin. Read: Bullish for Long Bonds (TLT);
  • A print of +282K jobs was needed for July to avoid another Y/Y sequential deceleration in the series. NFP additions were +255K. While this beat expectations of +180K (which was cheered by just about every mainstream media outlet), the TREND in this series remains slow-moving, predictable, and most importantly past peak

HBI

To view our analyst's original report on Hanesbrands click here

 

Hanesbrands (HBI) reported 2Q earnings this week. Salesmanship was on another level this quarter, as Richard Knoll took his 10-year victory lap before officially handing the reins over to Gerald Evans. But, salesmanship on the conference call can't mask lack of sales dollars on the P&L, as HBI missed sales expectations for the 8th time in 10 quarters, and posted the 3rd worst organic growth rate since the company became a serial acquirer. Margins showed the first crack we’ve seen in over 2 years – down 75bps Y/Y as competition and the effects of bloated inventories began to rear their heads. Despite all the talk about inventory reduction actions, core inventory grew 11% on -3% sales growth – even more troubling when we consider tepid demand from the company’s wholesale partners.

 

Even with some recent weakness in the stock, we like the short even more after this print. All in, we think that HBI has another 40% downside until the risk/reward looks more balanced in our model, with the possibility of an even bigger move in the worst case scenario.

ZBH

To view our analyst's original report on Zimmer Biomet click here

 

As we detailed in our Healthcare Themes deck this past month, the US medical economy is on the edge of a massive deceleration. July Helathcare employment, which is a lagging factor, slowed again. Next week, we will get the leading/coincident indicator of demand in the Job Openings and Labor Turnover series on August 10th.

 

Since growth in insured medical consumers has slowed to 1.5% currently, and managed care payors are withdrawing from Obamacare Public Exchange business, we expect growth in this series to deteriorate further. Hospital admissions continue to slow through 2Q16, with operators cutting guidance.

 

While Orthopedic and surgical demand appears positive, we still expect declines to emerge and pricing to accelerate to the downside. The CJR has already hit post-acute care, reducing admissions by 40% anecdotally across joint replacements. The next step, again anecdotally, will be to pressure device costs.

 

Investing Ideas Newsletter - 0805 Hospital Employment

 

Investing Ideas Newsletter - 0805 Healthcare Employment

 

Investing Ideas Newsletter - 0805 Healthcare Employment Slowing

 

Investing Ideas Newsletter - 0805 Healthcare Employment JOLTS

HOLX

To view our analyst's original report on Hologic click here

 

In the latest data from MQSA, which has recently begun reporting placements of Digital Breast Tomosynthesis systems, it would appear that growth is slowing and Hologic's (HOLX) share of the incremental facility is dropping. According to the data, the market added 109 facilities in July after adding 107 in June, this conversion pace is similar to the 2D adoption curve post peak.

 

As it relates to our data, which shows 33 and 22 facilities converting to Hologic, the implication is that Hologic is losing out. In fact when we spoke to a former sales representative who sold mammography for Hologic, the benefits of one manufacturer over the other were scant at best. Going forward, we expect a slowing US Medical economy, as forecast using the slowing number of insured medical consumers, will provide the second leg of disappointing growth for our thesis.

 

Next Wednesday on August 10th BLS will update the JOLTS data for healthcare, a time series tightly correlated with market growth. We expect a declining number sequentially and slowing overall which will impact Hologic’s Diagnostic segment, the standout this past quarter.

LAZ

To view our analyst's original report on Lazard click here

 

No update on Lazard (LAZ) this week but Hedgeye Financials analyst Jonathan Casteleyn reiterates his short call on the company.

TIF

To view our analyst's original report on Tiffany click here

 

The government released June PCE data this week. As it relates to Tiffany (TIF), we again are looking at the spend in the luxury sector. Real luxury spending went negative in May for the first time since 2011 and the June number, which showed a slight inflection (lower highs and lower lows), was in negative territory once again. That marks the first time we’ve seen negative spending data at the high-end.

 

The comp sales trajectory has been one of the worst we’ve seen in retail at Tiffany, and some may argue that the company is facing easy compares. But we think that’s a simplistic analysis, given the weakness we are starting to see in the category. We think the negative macro pressure here will compound the already big demand issues TIF is facing. That means… more sales and earnings surprises to the downside.

 

Investing Ideas Newsletter - luxury spend

FL 

To view our analyst's original report on Foot Locker click here.

 

Diving in on what the Nike Wholesale and DTC dynamics mean for Foot Locker (FL), we outlined last week that given the likely Nike US wholesale growth scenario, FL needs an incremental $200mm from the likes of UA and AdiBok to hit current Consensus Estimates. This means that UA would need to grow FW 60% and AdiBok 20% with 50% of that growth coming from wholesale with the over arching assumption that FL captures 40% of the incremental share from each of the brands.

 

The only problem with those type of growth and channel assumptions is that Nike isn’t the only brand navigating around its wholesale partners. AdiBok is the worst offender with 70% of its incremental growth over the past 4 years coming from the direct channel. UA is at 32%, and we think FW growth for UA is more heavily weighted to the DTC channel. That means from here, the likes of AdiBok and Under Armour would need to take share from NKE, allocate over 40% of its wholesale growth to FL, and (not or) redirect a portion of its more profitable retail growth to the wholesale channel. A lot has to go right for that to happen.

WAB

To view our analyst's original report on Wabtec click here.

 

No update on Wabtec (WAB) but Hedgeye Industrials analyst Jay Van Sciver reiterates his short call. Hedgeye CEO Keith McCullough had this to say about the company in a Real-Time Alerts signal sent earlier this week:

 

"Again, our Best Ideas research list of SELL ideas is a lot longer than my live SELL list in Real-Time Alerts. Main reason for that = patience. I realize consensus is chasing US Equity Beta, so I'm happy to wait and watch for selling opportunities. 

 

Wabtec (WAB) has been an excellent SELL idea by Jay Van Sciver. We like it when we don't like a stock and it goes down when the market is going up. Jay's most recent comment on WAB was:

 

"We will let others summarize the WAB quarter, but would note that our WAB thesis continues to play out reasonably well.  We would caution longs that this is only the third quarter of down freight revenue, and both railcar and locomotive deliveries in the quarter remained well above likely ‘normalized’ demand."

 

To Patient Bears,

KM"

LMT

To view our analyst's original report on Lockheed Martin click here.

 

On Tuesday, the Air Force declared that Lockheed Martin's (LMT) F-35A has officially achieved “Initial Operational Capability” (IOC).  Specifically, this means that the Air Force now has "an operational squadron of 12-24 aircraft with Airmen who are trained, manned, and equipped to conduct basic Close Air Support (CAS), Interdiction, and limited Suppression and Destruction of Enemy Air Defense (SEAD/DEAD) operations in a contested environment.” 

 

It is hard to overstate the importance of this milestone for the largest Defense acquisition program in history.  There is now a clear sense of momentum for the program and the operational milestones are coming in bunches.  The commander of Air Combat Command declared that he would be getting the F-35A into operations either against ISIS or to Europe in the “near future.”  The Marines now have two operational squadrons and with the first deploying next year to Iwakuni, Japan for potential operations in Korea.   This week also saw the Navy beginning its third and final phase of developmental testing at sea on the George Washington.  

 

With operational flight data now available, speculative criticism of operational capability has almost completely withered away.  Concern for costs is still present but it is based on the volume of jets needed/desired (2,443 for US) rather than the unit cost of $80-85M for the A (B&C models cost 10-15% more).


[From The Vault] Cartoon of the Day: Blast Off!

[From The Vault] Cartoon of the Day: Blast Off! - Rate hike cartoon 11.30.2015

 

Our inimitable, in-house cartoonist Bob Rich is on a much-deserved summer vacation. While he kicks back and relaxes, we're going into the Hedgeye Vault and highlighting some of his best work. After Friday's Jobs Report "beat" analyst expectations, Hedgeye CEO Keith McCullough wrote, "After going from hawkish to dovish to hawkish to dovish to hawkish, this Jobs print keeps Federal Reserve hawkish." Here's another audience favorite ... Blast off!


MDRX: We Are Removing Allscripts Healthcare Solutions From Investing Ideas

Takeaway: Please note we are removing MDRX from Investing Ideas (short side) today.

Hedgeye CEO Keith McCullough is removing Allscripts Healthcare Solutions (MDRX) from Investing Ideas today. Below is an excerpt from an institutional research note written by Hedgeye Healthcare analysts Tom Tobin and Andrew Freedman in which they lay out their outlook for the stock and weigh the current upside and downside.

 

MDRX: We Are Removing Allscripts Healthcare Solutions From Investing Ideas - allscripts

MDRX | SHORT MORE | 2016 BACK-END LOADED WITH STEEP BOOKINGS COMPS | DOWNSIDE $8 / UPSIDE $16

 

MDRX: We Are Removing Allscripts Healthcare Solutions From Investing Ideas - mdrx

DISAPPOINTING SALES GROWTH; 2016 BACK-END LOADED

Allscripts (MDRX) reported 2Q16 Sales of $397 million and Adjusted EBITDA of $69.5 million, with both missing consensus estimates of $403.5 million and $72.7 million, respectively. Driving the miss was a lower revenue contribution from Netsmart of $43 million versus $50 million consensus, and disappointing organic sales growth of +0.6% YoY despite strong bookings performance.  The Netsmart joint-venture and financial consolidation masked what would have been a larger miss, with 2Q16 core Allscripts revenue of $353.6 million missing pre-Netsmart consensus sales estimates of $363.0 million, and our estimate of $357.8 million.  Note that 1H16 organic revenue growth of +1.8% YoY is below management's guidance for core Allscripts growth of 3-5%, and with guidance left unchangedorganic growth will have to accelerate to +6% YoY in 2H16 to hit consensus numbers and management's guidanceThis compares to our estimate of +3.5% sales growth in 2H16 and expectations the company will continue to miss estimates like they have for the past 3 quarters.

 

Non-GAAP EPS of $0.14 was in-line with consensus and slightly above our estimate of $0.13.  However, we would highlight that a combination of a higher R&D capitalization rate for Netsmart and an increase in stock-based compensationresulted in Non-GAAP R&D expense that was down sequentially, which provided a 190bps sequential tailwind to operating margins in 2Q16.  

ANOMALOUS BOOKINGS STRENGTH; LOTS OF QUESTIONS...

Bookings were the big positive surprise in the quarter, but were somewhat anomalous even considering seasonality.  Total bookings excluding Netsmart were +22% YoY with mix favoring higher margin software delivery bookings that were up +44% YoY.   Meanwhile, Client Services bookings were down -6% YoY, -26% QoQand marks a deviation from a 3 quarter trend where the mix shift had favored client services due to cross-selling of hosting and other outsourcing services to existing clients.  We have argued that the rate of 2H15 client services bookings was not sustainable as they max out wallet share with their largest clients. Total backlog growth excluding Netsmart was +5% YoY, which is down from +5.6% YoY in 1Q16 and +6.4% in 4Q15, and in-line with our model implying higher churn given our lower bookings estimate.

 

We have a hard time understanding the drivers of the strength in software delivery given reported deal flow compared to previous periods and our assessment of a slowing market, which we believe to be valid. Despite the many questions on the conference call, management would not provide transparency into the number.  We question the impact a single deal may have had on the number, specifically the strategic agreement with OptumCare to rollout the Touchworks EHR and Practice Management system across their network of providers.  OptumCare was the "commercial partner" tied to the warrant issuance for 4.1 million shares, and while it appears we were wrong to be skeptical about its near-term impact on bookings, we were right in that it was an atypical structure and more strategic in nature.  


"It's a long term, it's a strategic deal so you can imagine it doesn't look like a typical agreement. It's not a typical agreement. This is the platform which we expect to, over time, translate to a significant sized relationship between the two entities." -2Q16 Earnings Call

 

Near-term revenue impact from the deal will likely be modest, and while we have more to learn about OptumCare, it seems there may be hurdles to getting physicians to adopt.  Additionally, we place less value on the deal as they had to tradeoff economics in the company to close it.  

 

"...we're going to be methodical and make sure we get it right, get it plugged into the rest of their standardized platform and that they have the time to educate their providers on the benefit of the standard platform too. So they're not — nobody is interested in jamming it down anybody's throat." -2Q16 Earnings Call

TOUCHWORKS; TOO LITTLE TOO LATE

Despite management's positive commentary around improvements in Touchworks and the OptumCare deal, we view it as too little too late, with recent market share losses irreversible, especially at the large IDNs. Additionally, while we appreciate that Black Book "deploys one of the most statistically significant survey techniques in the industry", the results run counter to market trends.  We would like to see the characteristics and details of the survey population ourselves.  

 

We spoke to a 30-year CIO at one of the largest IDN's in Michigan who is currently migrating away from a combination of Touchworks and Pro EHR to Paul Black's alma mater who had the following to say about Allscripts:

  • "No CIO worth their salt would go with Allscripts"
  • "I am not close enough to retirement to make a bad decision like that [Choosing Sunrise]"
  • "Everyone in the industry knows they lost so many people because of their instability"
  • "No one in their right mind would be their career on Allscripts"
  • "Even if Allscripts was 50% of the money of Cerner or Epic, I wouldn't go with them"
  • "I look at their support and it is really poor because of all the employee turnover"

SHORT MORE; DOWNSIDE $8 / UPSIDE $16

We like the risk/reward on the short side given back-end loaded sales guidance, at a time where we face the most difficult bookings comparisons of the year.  We don't view strength in software delivery bookings as sustainable, which we believe was confirmed by management's guidance related to bookings mix in future quarters and for a return to normalized software delivery gross margin. Meanwhile, Netsmart acquisition brings more accounting shenanigans and is a low quality, highly levered, short-term "fix" to management's growth problems.


#RoadWarriors: Important Considerations for Every Investor

Keith and I have spent much of the past four weeks on the road visiting with existing and prospective clients the world over (~35 meetings in total). As always, the buysider-to-[former]-buysider nature of such dialogues allows for a higher order of debate and critical thinking that both parties typically find invaluable.

 

Below is a summary of what I found to be the most important, thoughtful and/or consistent topics of discussion, organized by theme (all quotations paraphrased); hopefully you find it helpful as well. Any associated charts, research notes or presentations are hyperlinked below for ease of review.

 

SENTIMENT

 

  • “Financial repression the world over is the primary reason for the rally in high-yield and EM throughout much of the YTD. The near-desperate search for yield and abundance of liquid vehicles for investors to attain it has pushed many investors dangerously far out on the maturity and CAPM curves relative to their respective risk profiles.”
  • “Investors the world over are systematically reducing their exposure to actively managed investment vehicles where they have found themselves overpaying for beta – or worse.”Hedgeye: This latest fund flow data confirm the existing trend. Specifically, U.S. equity mutual funds have suffered their two largest weekly outflows of the YTD over the previous two weeks, at -$10.3B and -$8.2B, respectively. Meanwhile, equity ETFs took in $3.7B of inflows over that same time period. Elsewhere, the $72B New Jersey Investment Council effectively cut its target hedge fund commitment in half to 6% from 12.5%. Lastly, eVestment data showed that investors redeemed $28B from hedge funds in 1H16 – the largest sum since they began tracking the data in 2009 – with $20.7B of that outflow coming in the month of June alone. The inability of active managers to generate the degree of alpha needed to attract and/or retain capital amid central bank-induced market melt-ups likely explains much of the general angst and frustration shared by many investors across the globe.
  • “What’s really frustrating to bottom-up, process-oriented investors like us is that operating metrics and valuations hardly matter anymore. Domestic equity and credit markets are now entirely driven by factor-based investing.”Hedgeye: ETFs, at ~$3T AUM, are now larger than the AUM of the entire hedge fund industry. Moreover, fund flow trends imply the growing prevalence of factor-based investing is here to stay. This is why we have found ourselves doing more and more business with funds that have traditionally eschewed macro research in favor of deep-dive security analysis.
  • “The Vanguard-ization of markets is not going to last. Just wait until the market crashes; investors will be pouring back into active and alternative managers in no time.”
  •  “If I told you a year ago that corporate profits would enter a protracted recession, domestic and global growth would slow considerably, Brexit would occur and Donald Trump would become the GOP nominee and a viable candidate for president of the United States, would you have bet that U.S. equities would be higher or lower on that? In that regard, what’s the bear case from here?”Hedgeye: This line of pushback upon our bearish bias is well-received. That said, however, naval gazing at all-time highs in the SPY completely misses the point of what is perpetuating said highs – i.e. the outperformance of the sector and style factors we like on the long side because of the aforementioned bearish catalysts: Utes at +18.3% YoY, REITS at +14.4% YoY, Defensive Yield at +13.8% YoY and Low Beta at +10.9% YoY are all trouncing the S&P 500’s paltry YoY return of +3.4%. The soft bigotry of low expectations that is trumpeting [mediocre] market beta is not a doctrine we will ever subscribe to.
  •  “Most of my colleagues think I’m crazy for being long Utilities and REITS at these valuations, but I’ve consistently pushed back on their criticism because they are actually cheap – when compared to bonds that is.”
  •  “The TTM outperformance of U.S. equities relative to European and Japanese equities can be largely explained by the higher quality of American companies and the fact that American management teams are laser-focused on creating shareholder value – much more so than their DM counterparts.”Hedgeye: While that narrative is both interesting and compelling, it is inconsistent with Treasury International Capital (TIC) data, which shows that foreigners have been net sellers of U.S. equites on a trending basis for over a year now.
  • “The global weighted average discount rate is at all-time lows. That equals all-time highs in equities – plain and simple.”

 

POSITIONING

 

  • “We’re as bearish as we’ve ever been and are receptive to your bearish views, but why do you think the SPX has held up so well in the face of a global equity bear market and obvious global growth slowdown?”… Hedgeye: One answer is NIRP and a paradigm shift in future discount rate expectations. Moreover, the S&P 500 has ~320 companies whose dividend yields exceed the 10Y Treasury yield. We’re not at all believers in the “this time is different” mantra, but we’d be remiss to downplay passive, income-oriented flows into this asset class.
  • “We want to be net short, but we simply can’t in this [bull] market. There is a whole community of investors who’ll get fired if they don’t participate in the upside. Our investors don’t get nearly as upset when we lose money as they do when we aren’t making money while the market appreciates.”Hedgeye: This is definitely true and we are empathetic to the plight of reluctant bulls. That said, however, the current net lean in futures and options positioning implies that investors fully capitulated to the upside in late-July insomuch as they fully capitulated to the downside in early-February. Even the most ardent bears are leaning long at these highs. When investors are broadly whipped around like this, it creates air pockets above and below last price that have the potential to be easily and demonstrably exploited by economic and/or political surprise factors.
  • “We are getting squeezed by central banks. Helicopter money = we can’t be net short.”Hedgeye: It would help you to actively manage your net exposure in the context of our immediate-term risk ranges; you have to trade the chop if you want to survive in this market. Buy low; sell high. Rinse and repeat.
  • “Rather than have one core position on, I’ve resorted to spreading out such bets to multiple stocks that are similar in nature. Being smallish in three stocks means you can change your mind and get out in 10 mins rather than in two days… And you have to change your mind constantly in a market like this.”
  • Volatility skew is so incredibly compressed right now because so many investors are bidding up upside protection. The market is basically paying you to hedge for a draw-down so that’s precisely what I’m doing – especially given that my prime broker’s data is currently showing the average net exposure of hedge funds across the entire strategy spectrum is at 1-2Y highs, depending on strategy.”Hedgeye: As previously mentioned, investors have completely capitulated to the upside and the skew data you cite is indicative of an investment community that has thrown in the towel in order to play catch-up with beta. We can see this intensified performance chase in the reversal of style factor performance; high beta stocks are up +5.1% MoM, while low beta stocks are down -0.4% over that same duration. This compares to their YTD returns of +5.2% and +13.5%, respectively.

 

U.S. ECONOMY

 

 

GLOBAL ECONOMY

 

  • Hedgeye: As we anticipated as part of our “no blow-up risk” view, China was conspicuously absent in many of the discussions. See more HERE and HERE regarding our increasingly less non-consensus view on Chinese economic and financial market risks.
  • “The Eurozone and Japanese economies are much more at risk of experiencing slowdowns due to NIRP than the U.S. because they rely much more on traditional banking for credit intermediation. The U.S. – with a relatively greater reliance upon capital markets – can see its economic cycle extended via yield-seeking flows into high-yield credit and equity markets amid falling interest rates.”Hedgeye: This is a very astute and accurate observation indeed. As a ratio to nominal GDP, domestic credit to the private sector provided by banks in the Eurozone and Japan is 145% and 110%, respectively; this compares to a lowly 79% for the U.S. As a proxy for reliance upon capital markets, the market capitalization of publically listed companies as a ratio to nominal GDP is only 54% and 95% in the Eurozone and Japan, respectively; this compares to a relatively inflated 152% for the U.S.
  • “The EUR is a structural buy because the ECB can’t cut rates much further without Germany having to eventually backstop a broad-based recapitalization of the Eurozone’s beleaguered banking systems – which is a politically unpalatable option given that they are already subsidizing the persistent sovereign deficits of Southern European economies. As countries balk at what is likely to be ever-increasing hardball out of Berlin and Brussels by opting to leave the common currency one-by-one (then likely all at once), what’s left behind is the DEM, the ever-hawkish Bundesbank and Germany’s massive current account surplus.”Hedgeye: That all is true, but don’t forget the role of the ECB prior to said outcomes. Draghi has made it his sworn life’s mission to defend the common currency at all costs, so the associated economic and financial market turmoil that is likely to stem from all of the aforementioned political chaos is likely to perpetuate unprecedented monetary easing out of the ECB. Moreover, said easing could occur at a time where the U.S. is recovering from recession, which would massively inflate swap spreads in favor of the USD – which already has a distinct demographic advantage in favor of relative rates of GDP growth and inflation over the next 5+ years. While the DEM is certainly a structural buy (meaning the structural net short position in the EUR eventually needs to be covered), we’re not so sure that the EUR doesn’t mean revert to its prior closing lows of 0.8272 per USD prior to the DEM’s assumed return.

 

POLITICS

 

  • “Do you view a Hillary Clinton victory as negative or positive for the market?”Hedgeye: Stability is positive, but it’s very likely that her campaign promise to implement sharp increases in minimum wages across the country will be bad for [already flagging] corporate profit margins on a structural basis.
  • “Who do you view as more favorable for the market?”Hedgeye: Clinton – with her likely move towards centrist pragmatism and ability to compromise with Speaker Ryan – is the obvious choice for most investors, but perhaps not the correct one. Trump’s desire to simplify the tax code (e.g. implementing a flat tax) and lower corporate taxes, his pledge of $500B+ in infrastructure spending (nearly 2x Hillary’s $275B proposal) and his plan to counter Chinese mercantilism [potentially] via targeting a weaker dollar might prove to be quite the bullish concoction for U.S. equities.

 

EMERGING RISKS

 

  • VERY IMPORTANT DISCUSSION: “I haven’t seen anyone talk about the stealth tightening that is the ~15bps back-up in 3M LIBOR over the past month. Everyone talks about where the Fed Funds Rate is headed next, but the reality is that global debt is priced off of LIBOR. I wonder how much the pending rule changes in the money-market fund industry have been and will continue to be a contributing factor to the tightening we’ve seen across the short and long end of several noteworthy yield curves globally over the past few weeks.”Hedgeye: That’s a very astute observation and one we do not yet have a proven answer for. Here’s what we do know: The sharp backup in Japanese interest and inflation swap rates across the curve over the past few weeks (5Y and 10Y JGBs +19bps since 7/27; 20Y JGB +27bps and 30Y JGB +34bps since 7/6; and 5Y5Y Forward Inflation Swap Rate +20bps since 7/16) has caught our attention and is indicative of one of the following two outcomes. On one hand, the market may be responding positively to the government’s recently announced ¥28.1T ($277B) stimulus package and pricing enough of a recovery in Japanese economic growth to perpetuate an increase in risk-taking among Japanese investors. Conversely, the market could be front-running the beginning of a global, politically-driven shift away from the dominance of monetary easing – which lowers interest rates by creating excess demand for sovereign debt securities – to fiscal stimulus – which may perpetuate higher interest rates via excess supply of sovereign debt (in the absence of helicopter money). The fact that Japan’s benchmark Nikkei 225 Index is down -2.5% since 7/27 is supportive of the latter [more-bearish] theory. Regardless of the underlying driver(s) of the aforementioned backup in Japanese rates, a lasting “JGB Tantrum” is likely to prove quite negative for now-crowded yield trades globally – just as the “Bund Tantrum” was before it. The $1.9B outflow from high-yield bond funds in the week to 8/3 – the first of its kind since June and the largest outflow in seven weeks – is evidence of said unwind risk.
  • Hedgeye: Going back to aforementioned discussion of money-market fund rule changes, it’s important that investors understand the drag on economic activity that may result from the associated tightening of capital markets. Specifically, the move to require prime money market funds to hold more short-term debt and allow their NAV’s to fluctuate (versus remaining at $1) has perpetuated a $420B outflow from the industry over the past year, leaving the industry with assets below $1T for the first time since 1999. This would seem to suggest companies reliant upon prime funds for liquidity are likely to have to find other ways to borrow, at the margins – either via costlier bank loans or long-term bond issuance. It’s probably not a huge deal given that government money-market funds have more than absorbed the aforementioned outflow (AUM +$509B YoY to $1.5T), but it’s just one more headwind to a U.S. economy that is facing cycle-peak comparisons for its lone growth driver (i.e. consumer spending) as far as the eye can see.
  • “Central planners are destroying the financial services industry. It’s as if they do not want us to exist – and the reality is they probably don’t. Yellen is critical of income inequality, no?”

 

Hopefully you’ve found these discussions helpful. As always, please feel free to reply with any follow-up questions.

 

Best of luck out there incorporating the aforementioned factors into your existing and respective research and risk management frameworks.

 

Happy Summer Friday,

 

DD

 

Darius Dale

Director


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