One of our top three 3Q16 Macro Themes is #EuropeImploding.
Takeaway: Here's our take on some of today's top financial stories.
It's time to borrow, says noted Keynsian and NYTimes columnist Paul Krugman.
"... The federal government can borrow at incredibly low interest rates: 10-year, inflation-protected bonds yielded just 0.09 percent on Friday. Put these two facts together — big needs for public investment, and very low interest rates — and it suggests not just that we should be borrowing to invest, but that this investment might well pay for itself even in purely fiscal terms."
Fellow economist Kenneth Rogoff echoed the sentiment on Project Syndicate.
OUR TAKE: Classic Keynsian economics. When all else fails, spend, spend spend...
"Recent economic data show consumers are saving more in Germany and Japan, and in Denmark, Switzerland and Sweden, three non-eurozone countries with negative rates, savings are at their highest since 1995, the year the Organization for Economic Cooperation and Development started collecting data on those countries," the Wall Street Journal reports. Apparently, WSJ continues, negative rate policies (NIRP) have the unintended consequence of undermining confidence in these respective economies.
OUR TAKE: Macro markets have already sniffed out slowing economic growth and NIRP negativity. Year-to-date, Euro Stoxx 600 is -5.8% and the Nikkei is down -11.9%.
Reuters writes, "Oil edged further above $45 a barrel on Tuesday as forecasts for a drop in U.S. inventories and speculation of producer action to prop up prices countered concern about a supply glut." The OPEC oil production "freeze" speculation is ongoing, with Venezuela, Kuwait and Ecuador pushing a production freeze in response to the recent dip in oil prices.
OUR TAKE: As Hedgeye Potomac Senior Energy Analyst Joe McMonigle wrote today, "We believe the sequel to the production freeze will end the same with no agreement in September."
The pound briefly slipped below 1.30 today as Bank of England policy maker Ian McCafferty wrote in The Times newspaper that “more easing is likely to be required” if the U.K. economy continues to slow. McCafferty wrote that the BoE could cut rates to zero or expand QE. The central bank “faces a set of economic circumstances that make assessing the appropriate amount of policy stimulus more difficult,” McCafferty writes. “I prefer to learn as we go, providing some stimulus while using our available ammunition cautiously.”
OUR TAKE: What makes McCafferty so sure additional easing will save the already dormant U.K. economy.
"Companies worldwide are poised to raise more than $100 billion [in corporate bonds] so far this month," Bloomberg reports. That's the most for the period going back to 1999. Meanwhile, reporters for the Wall Street Journal write that, "Companies and government agencies are “calling” bonds at the fastest pace in four years, taking advantage of provisions that let them redeem securities under certain circumstances and save money by reissuing at lower rates."
OUR TAKE: We are the original authors of #LowerForLonger rates, making the claim well over a year ago now. Good call. It's still playing out in real-time.
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Takeaway: We remain bearish on the EUR/USD and reiterate our Q3 Macro theme of #EuropeImploding.
The latest poll indicates that a third Spanish election would do nothing to resolve the political impasse.
Separately, Italy’s high court has approved a constitutional referendum, setting in motion a vote from Italians on whether to strip the Senate of most of its powers in order to streamline legislation. If defeated, PM Renzi has vowed to resign.
Uncertainty breeds contempt and contempt breeds investors heading for the exits, like they have been for the past year (see below). Remember, this says nothing about the slow moving trainwreck that is European economic data. We remain bearish on the EUR/USD and reiterate our Q3 Macro theme of #EuropeImploding.
Editor's Note: The snippet above is from a note Hedgeye CEO Keith McCullough wrote for subscribers this morning. Click here to learn more.
Making & Paying for Stuff: In a most basic sense, how much stuff everyone can have depends on how many people are making stuff times how much stuff each person can make. And corporate profits equal the difference between the price at which that stuff can be sold and the cost to produce it.
Productivity = ↓ | How much stuff each person can make (productivity) fell for the 3rd quarter in a row in 2Q16, dropping -0.5% QoQ (-0.4% YoY) and marking the longest streak of negative sequential growth in 37 years. Protracted declines in productivity inevitably flow through to real earnings growth and can persist for only so long until it feeds back negatively on hiring decisions.
Input Costs > Output Prices | Payroll growth rising faster than output growth is a different way of saying that productivity is going down. And with Unit Labor Costs rising +2.1% YoY and growing at a premium to output prices, the cost to produce stuff continues to grow faster than the price at which that stuff can be sold. This, as we’ve seen in recent quarters, manifests as margin compression and lower corporate profitability. Labor market strength is paid for via lower profitability and a declining share of natinal income flowing to capital.
Given the labor and GDP data for 2Q we knew the official productivity and cost data for the quarter were going to be underwhelming but the print reflected a worsening trend. If productivity remains negative and aggregate wages continue to rise faster than Nominal GDP, the current expectation for mid-teens SPX earnings growth over the next year will look increasingly quixotic.
Christian B. Drake
Takeaway: WMT/Jet deal raises bar for rest of competitive set. 1st wages, now e-comm. Growth in the space just got more expensive.
It was only 10 months ago that WMT came out and ripped the band-aid off at its Fall 2015 Analyst Day. There was a lot of detail embedded in that day (the transcript alone is 42 pages), but the key takeaway was that WMT wouldn’t hit 2015 earnings levels again until 2019 due to investments in three key buckets: Employees, E-commerce, and to a lesser extent, Price. While a struggling WMT has been a terrible barometer for all of retail, the company re-upped its commitment to the e-commerce bucket with the acquisition of Jet.com.
Let’s get it out up front and say that we think purchasing an unproven e-commerce business for ~6x sales, when AMZN trades at 3.7x, at the tail-end of an economic cycle is a poor use of shareholder capital. With that out of the way, we think that WMT just threw down the gauntlet for a second time to the rest of its competitive set, doubling down on the e-comm channel by bringing in outside assets. That lays down a precedent for everyone that the company competes against, telling its competition that WMT is willing to spend up in order to seek out new growth. We think the roadmap for the space from here gets increasingly more difficult as companies fight for dollars online and spend up to hold/win market share. That has obvious implications for TGT, KSS, M, etc.
1) What’s Growthy? E-comm: This isn’t new insight by any means, but we think this provides a compelling visual to both a) explaining WMT’s decision to spend up in order to purchase talent/technology in the form of Jet.com and b) the need for the rest of retail to compete in the new e-comm arms race. In 2015, the average reported growth rate ticked down to just 1%. But what we think is even more damning to retail as we know it (or once knew it) is the fact that Brick and Mortar growth excluding e-comm went negative for the first time during this economic cycle and the spread between the two opened up to 3% – the widest margin ever.
2) One Reason…Unit Growth Done: Outside of the consumers’ willingness to shop for a bigger percent of more categories online – the other obvious explanation for the bifurcation between reported growth and brick and mortar growth for traditional retail is that the sq. ft. has all but dried up. The decline in aggregate sq. ft. began in 08/09, but that didn’t trickle up the supply chain to WMT/TGT and mid-tier department chains until 2015. There have been periodic closings along the way (JCP, SHLD) but not to the extent we saw at the end of the last fiscal year in the form of a) Macy’s closing 40 doors about 4x a normal year, b) KSS closing 18 doors for the first companywide closing in history, and c) WMT closing 102 Neighborhood Markets and 52 Supercenters (the first closing since calendar 2006).
Fast forward to where we are today for WMT, and it’s pretty clear why the company made the decision to pay up 6x sales to buy Jet.com. Yes, AMZN is a threat and sq. ft. growth will never be part of the equation again, but WMT recognized that it had to shake things up after years of underinvestment in digital. Will it work? We’re not convinced that it will. But at the very least, WMT laid its battle plan down for everyone to see, and the rest of retail can either ante up or continue to lose relevance.
3) Margins A Consideration: By making this strategic decision, WMT all but confirmed where all of its growth could be attributed. Instead of sticking to the original build-it-internally plan, the company decided to bring in talent and technology to supplement what the company has been trying to build internally for 15 years. The difference here is that WMT, unlike just about every other competitor, has the balance sheet flexibility to absorb a deal of this magnitude without skipping a beat – we think it speaks volumes when we consider what type of investment is necessary from the rest of competitive set to keep pace.
From here, the setup for the space looks like this: i) net sq. ft. decline as concepts reconcile footprints and invest incremental capital to grow online biz, ii) brick and mortar growth continues to head negative with e-comm adding a buffer to prop up the top line, iii) margins head lower as companies continue to invest in e-comm precipitated by the moves from WMT and AMZN while deleveraging on the fixed cost of the vast store networks. We’ve already begun to see that roadmap take hold as the e-comm penetration ramped ~500bps over a two year time period after pretty measured growth from 2008-13. In turn, margins came off ~200bps as the reliance on e-commerce stepped up considerably.
That margin drag has been exacerbated by the fact that e-commerce has proven to be, for the most part, cannibalistic instead of incremental (despite what management buzz might suggest). That’s a problem when the e-commerce channel comes in at a gross margin well below that of a brick and mortar sales. In the case of KSS, there is an 1000bps delta between the two channels – a heavy headwind to absorb when there isn’t a lot of fat to trim on company expense lines now facing wage inflation. Layer on the need to invest in DTC now that WMT upped the ante, paints a pretty bearish picture for the margin trajectory of this space over the near and long term.
4) Its not just WMT That’s Far Behind: WMT has the lowest e-commerce penetration in the group, which the company all but confirmed provided the impetus for the Jet deal yesterday. Fair enough, but the company isn’t the only laggard in the space. The obvious callout is TGT, with sales penetration in the ballpark of WMT-US, and well below 5%. TGT already backed off it’s 40% online growth CAGR targets it articulated at the 2015 Analyst day, and talked down the need to invest more heavily in that channel back in March. The WMT decision to spend up is the new data point, and we think the combination of pressure at both ends of the spectrum – WMT on the low end, AMZN on the high end – will make incremental growth from here more difficult. And that’s not just for TGT. As everyone (KSS, JCP, M) that competes with WMT/AMZN in this space must continue to invest in the direct channel in order to keep its share of the market.