Chinese Loans . . . A Crisis of Rumors

Conclusion: Reports out of China concerning the potential for a high degree of non-performing loans used to finance local government infrastructure projects appear alarmist and should not be given substantial credence at this time, which is confirmed by the CDS and equity markets.


In the past few days, there has been a great deal of news flow coming out of China regarding the potential for local government financing vehicles to struggle to service 23% of the 7.7 trillion yuan ($1.1 trillion) of outstanding loans which had been lent to finance local government infrastructure projects (highways, airports, etc.) – according to a person with knowledge of data collected by the nation’s regulator. With supposed at-risk debt near $261 billion (nearly five times the amount ($53.5 bil.) the nation’s five largest banks are raising to replenish capital) there is concern that the government may need to accelerate efforts to shore up its banks.


What cannot be overlooked here, however, is that Chinese government bailouts have helped bring the industry’s non-performing loan (NPL) ratio to 1.3% by the end of June – down 28bps since the end of 2009. Efforts to mitigate any potential buildup in NPL’s brought on by last year’s $1.4 trillion of credit expansion have been particularly successful (slowing loan growth, raising capital requirements, etc.). The Chinese government targeted a maximum of 7.5 trillion yuan ($1.1 trillion) of new loans this year – down from last year’s record 9.59 trillion yuan of credit expansion – and the central bank recently affirmed that, at the current pace of lending (which has decelerated each month since April), that goal will be met. Furthermore, last month, the China ordered its local governments to ensure repayment, concentrate on completing projects already under way, and stop spending within financing units that rely solely on the fiscal income of local governments. We expect these efforts to achieve a similar desired effect as the curbs on the Chinese banking system at large.


Chinese Loans . . . A Crisis of Rumors - 1


Still, any rapid expansion in credit always brings about a repayment risk, particularly when confounded by the complexity of China’s local government financing. Because of their inability to directly borrow money, local government set up financing vehicles to fund projects. These vehicles issue bonds in China’s exchange traded and interbank markets, which are then bought by commercial banks, asset managers, securities firms and other institutional investors – based largely on false pretenses, at least according to Dagong Global Credit Rating Co. They claim that because most companies can’t issue junk bonds, they have to be rated at least AA to apply for debt issuance, which causes local government-backed borrowers to “shop around” for the best rankings, giving business to whomever gives them the highest rating (sounds familiar? See: U.S. MBS market 2005-2008). According to China Lianhe Credit Rating Co., 43 construction companies affiliated with such financing vehicles issued 72 corporate bonds totaling 59.2 billion yuan ($8.7 billion) in 1H10. Of that total, 70 were rated AA or above.


Potentially faulty ratings, coupled with the repacking of such loans into investment products and shifting off-balance sheet by Chinese banks, does indeed mask the repayment risk of such ventures. Currently, China has more than 1,000 county-level governments and hundreds of city and municipal councils that get revenue from local taxes, land sales, and central-government transfers. Of those three, revenues from slumping land sales brought on by China’s efforts to cool its property market is most at risk.


When it’s all said and done, servicing loans has always been about the generation of aggregate cash flow – which is precisely why we like the health of China’s banking industry a great deal more than the its U.S. and European counterparts. In China, you have a consumer whose purchasing power is growing (wage inflation, currency strengthening) and has a history of thrift brought on by decades of minimal social services; that same thrift allows China’s banks to keep mortgage down payments north of 40-50%. Contrast that with the Western consumer, whose purchasing power is eroding due to austerity measures and currency debasement, is mired in stagnating-to-worsening high unemployment, and is in the early stages of a secular deleveraging.  Moreover, China, on an aggregate level, has the ability to grow into its ability to service loans.


All told, let’s just say that if China’s banking system is in a precarious scenario based on these recent reports of potential non-performing loans, domestically speaking, we better start heading for the hills.


Darius Dale



Chinese Loans . . . A Crisis of Rumors - China


Domino’s U.S. comp sales growth came in slightly below the street’s expectations with company-owned same-store sales growth up 8.3% but management’s tone continues to be extremely positive.  Management did not provide any color on quarter-to-date trends, but repeatedly commented that it thinks the current momentum behind its new and inspired pizza product is sustainable.  Specifically, management said, “We really like where we are….We are performing better than most or all within the pizza category.”


Even with same-store sales growth up over 8%, both one-year and 2-year average trends slowed rather significantly from the first quarter when the comp was up 14.7%.  This sequential slowdown spurred a lot of questions and concern on the earnings call about the sustainability of top-line trends.  Management defended its recent performance by pointing out that the new pizza is not a promotion and is driving significant repeat visits with the majority of the sales growth in 2Q10 driven by repeat customers and increased frequency relative to the heavy trial period during the first quarter. 


Relative to guidance, management stated that its full-year 2010 results should come in better than its stated long-term outlook on a lot of fronts, driven by a higher than typical range of comp growth in the U.S.


Pressure in 2H10:


Management reiterated its outlook for cheese prices to be in the $1.50 to $1.70/lb range in the back half of the year.  Although cheese prices remained below this level in the first half of the year, cheese is currently at $1.60/lb.  Management also stated on the call that for every $0.40 move in the price of a block of cheese, there is a 100 bp impact on food costs at the store level.  Relative to the recent move in wheat prices, DPZ locked in on all of its wheat needs through the first quarter of 2011. 


Foreign currency benefited earnings by about $0.02 per share in 1Q10 and a penny in 2Q10 but management expects this trend to reverse in 2H10 with currency hurting by a penny or two during the fourth quarter.




Howard Penney

Managing Director



Once again we are seeing a major plunge in Consumer Confidence, which came at 50.4, below expectations of 51.0, and down 7.1% from a revised (upward) prior reading of 54.3 (previously 52.9).  The Present Situation Index decreased to 26.1 from 26.8 and the Expectations Index declined to 66.6 from 72.7 last month.


Consumer attitudes are also being expressed in current sales trends.  According to Johnson Redbook, U.S. same store sales fell 0.7% month-to-date for the week ending July 24 (compared to the previous month); the seventh consecutive weekly decline in sales.


Today’s confidence reading is more indicative of where we are heading than today’s Case/Shiller data. 


As expected, home prices rose predictably in May and will rise again in June before heading lower in 2H10.  As our Financials analyst Josh Steiner noted in his Housing Black Book, May prices reflect March contract activity which was strong due to the April tax credit expiration.   


Pick your poison as to why you think confidence is going down, but I’m now focused on the incompetence of the people in Washington.  Washington is the epicenter of everything consumer - unemployment benefits, policies that enable job growth and a federal reserve that won’t pay the aging population an interest rate on its savings accounts.  The issues in Washington are impacting the whole country and individual states are also beginning to make significant cutbacks.


Nothing is getting done. 


The precipitous drop in confidence in Washington among the electorate has been shaped largely by the harsh economic reality facing many consumers today.  The approval rating of the president among 18-34 year olds is but one example.  Among 18-34 year olds polled by Quinnipiac University in November 2008, 73% viewed Obama favorably.   Last week, a poll conducted by Quinnipiac University revealed that only 46% of 18-34 year olds viewed Obama favorably (with 42% holding an unfavorable opinion).   Additionally, 37% of the same demographic would vote for a generic Republican in a presidential election versus 34% for Obama.  No age group has a tougher time finding a job at the moment than teenagers and young adults in their twenties.  In turn this is putting incremental pressure on their parents…..  A vicious cycle for sure!


The earnings season is been strong and as expected the corporate story telling is alive and well.  We are setting up for what could be a very interesting 3Q10 preannouncement season…


Howard Penney

Managing Director


CONSUMERS ARE NOT SEEING GREEN LIKE THE S&P 500 - conf board cons conf

Early Look

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R3: UA: Bullet Proof?


July 27, 2010


UA had a critical setup into this quarter. It delivered. But the market was ready for it.





The setup heading into this eps release was questionable at best. On one hand, apparel trends clearly looked good at retail, inventories were in check across the board, channel partners consistently leaked out indications that a bigger footwear push was happening sooner than later (in line with our view), and the consensus estimates were just flat-out low across the board. In fact, our estimate for next year still stands head and tails above the Street at $1.75 vs. the Consensus at $1.30.


But then Kevin Plank threw a changeup and booted his President of just 2-years just 2 weeks ahead of the quarter – and the seasonally weakest quarter at that. This thing was primed for fireworks. But every analyst came out and defended the stock in the face of the event. Even I thought the management change was perfectly rational – though would never have thought the stock would tread water (nevermind go up!).


In the end, this quarter was another outstanding one for UA. 24% top line growth with 1% inventory decline? Sweet…  Also, I love the fact that the company delivered its SG&A in spite of such big top line numbers. The punchline there is that it is spending when it should in order to sustain its growth trajectory – instead of printing unsustainably high margins in a period of questionable growth (i.e. Skechers).


The question here is whether the recent run has this stock priced for perfection. If so, then UA delivered. But if the company says anything remotely cautious on its call, I can’t imagine that the stock cannot be bought lower. Will be back after the conference call as warranted.





- Luxury retailer, Saks Fifth Avenue, is about to launch designer plus size apparel with partners including Chanel and Dolce & Gabbana.  However, the store’s merchandising approach will be slightly different than a traditional retailer which would normally have a “department” devoted to the larger sizes.  Saks will mix these items in with existing stock, extending the traditional size runs.


- According to the 2010 American Pantry Study, 93% of consumers expect to remain cautious with spending even when the economy improves.  Interestingly, 55% of those cutting back suffered no decline in income, but felt they “should be” cutting back.  When it comes to using loyalty cards and coupons, 81% of respondents indicated the process is “fun”.


- Sales of significant retail properties (over $5 million) slipped again in the second quarter, declining 9% sequentially from 1Q to $2.9 billion.  This marks the seventh time in eight quarters that investment spend in retail real estate has remained below $5 billion.  From 2001-2008, total investment in retail properties topped $5 billion consistently, quarter after quarter.





China Labor Shortages May Impact Fall Sporting Goods Deliveries - Of all the challenges facing the U.S. sporting goods industry in 2010, one would hardly think labor shortages in China would top the list but whether it comes to making golf clubs, toning shoes or hiking boots, the topic is dominating earnings calls and boardroom discussions across America. The deep recession and a steep rebound in orders this spring have made it difficult for Chinese factory owners to fill jobs. <>

Hedgeye Retail’s Take:  It’s been a long, long time since we’ve talked about out of stocks and product shortages.  Good for margins, not so good for the topline.   


Bangladesh Garment Factories Unwilling to Meet Minimum Wage Demands - As garment factory owners in Bangladesh are unwilling to offer workers as per their minimum wage demands, the government is indirectly intervening into the matter. The country’s Prime Minister, Sheikh Hasina, stressed that apparel factories paying their workers are insufficient as well as inhuman. The government will reveal the minimum wage structure for garment workers by July 28th. The Labor Ministry has been in talks with the garment factory owners to fix an apposite wage structure for their workers although the government cannot directly intervene into the privately-run industry.  <>

Hedgeye Retail’s Take:  More inflation.


China Shuts Down Five Tanners in Fuzhou City - Five tanneries in Fuzhou city, China are closing down their operation by October this year as part of a plan to eliminate outdated production capacity and clean up the environment. All 5 of the Tanneries have annual production below 20,000 pieces of standard cattle equivalent. The announcement has shown China’s plan to eliminate outdated production capacity. Production and effluent treatment systems that fall below environmental standards and those tanneries that have a low production volume under 30,000 pieces per year will be the target of elimination. <>

Hedgeye Retail’s Take:  Keep an eye on leather pricing as China continues to crack down on a substantial number of tanneries that are harming the environment.  China has said it expects to close 1,000 small and medium tanneries in its effort to eliminate harmful pollution created from such facilities.  Approximately 700 large and more environmentally friendly factories will remain.


Brazilian Footwear Brand Corso Como Growth Spurt - Since its 2006 launch, the Campo Bom, Brazil-based brand has been steadily adding new categories, expanding its retail and online presence and bolstering its name in the U.S. and abroad. Sold in 870 doors in the U.S., including Nordstrom, Bloomingdale’s and Anthropologie, and in another 250 shops internationally, Corso Como in May made its first move into branded retail with a website and e-commerce platform. The company also is eyeing expansion across Europe, particularly in England, France, Italy and Spain, and plans to up its trade show presence in the region. Corso Como has made its mark in the women’s market with its collection of low-key, sophisticated and comfort-driven designs at accessible price points, and is growing the category mix. <>

Hedgeye Retail’s Take:  While most brands see Brazil as a substantial end-user market, it appears competition is brewing on domestic soil.  Brazil has been a large player in the footwear market for years, but branded exports to the US have not been a huge part of the equation, until now.


Warnaco Names Jim Gerson President, Swimwear - The Warnaco Group, Inc. appointed James B. Gerson as president of its Swimwear division. Jim joins Warnaco from V.F. Corp, where he most recently served as president of Reef.  <>

Hedgeye Retail’s Take:  Another high profile defection from VF Corp.  Recall that VFC has been trying to build Reef into another of the company’s large lifestyle brands, like Vans and TNF.


Nike Saves Face on Honduran Labor Issue - Although this has virtually no financial impact, Nike saved face by pledging to pay $1.54 mm for a worker relief fund to Honduran workers after University of Wisconsin at Madison terminated its agreement and Cornell warned it would follow. Nike’s action is a reversal of its stance in April, when the company said the contract factories bore sole responsibility for paying the workers’ severance. <>

Hedgeye Retail’s Take:  For a company of its size, Nike is keenly aware of how important image and social responsibility is to today’s consumer. Score one for the college students.


Eastern European Malls Use Dinosaurs, Spas to Lure Shoppers - If Christian Dior’s brand name can’t attract customers, maybe dinosaurs will. That’s the plan behind Galerie Harfa, a half-built shopping mall perched above Prague’s Vysocany suburb that will have a dinosaur-themed amusement park, fitness center and rooftop swimming pool. As the economic slowdown squeezes retail sales in the Czech Republic and Hungary, companies such as Hochtief AG, Strabag SE and Skanska AB help construct venues with spas and electric-car tracks to lure shoppers. Mall space has more than quadrupled since the former Communist nations joined the European Union in 2004, exacerbating the need to offer more than just shopping. “It’s not enough to line up the usual suspects like Zara, Esprit and H&M,” said Lenka Hartmanova, a Prague-based analyst at real estate company DTZ Holdings Plc. <>

Hedgeye Retail’s Take:  If only they could take apart and move the failed Meadowlands, NJ mall, Xanadu, to eastern Europe. Branches Out - The e-retailer today unveiled, which sells vitamins and supplements as well as such items as shampoo, toothpaste and pet products. The site went live quietly a few weeks ago, but only announced it today. <>

Hedgeye Retail’s Take:  Competition is heating up in the vitamin and wellness category, this time is taking a stab at the market.  Haven’t we seen this before?  Remember St. John’s Wort?




As we look at today’s set up for the S&P 500, the range is 34 points or 2.4% (1,088) downside and 0.6% (1,122) upside.  Equity futures are trading above fair value in the wake of Monday's strong performance which followed a surprise jump in New Home Sales and another slew of positive earnings.  Today highlights sees May Case-Shiller Home Price Index and July Consumer Confidence.

  • Advance/Decline Line: +1875 (+38)
  • Volume: NYSE 1018 (-11.48%) - below LTM average
  • Sector Performance: Every sector positive (the RECOVERY trade outperforming the S&P 500)
  • Market Leading Stocks: Biogen +8.2%, Genzyme +7.7% and Devry -6.4%, FMC Tech -3.0%

Equity Sentiment:

  • VIX 22.73 (-3.2%) - The VIX is broken on TRADE - BULLISH for stocks
  • SPX Put/Call ratio - 1.73 (low on 07/15/10 of 0.87)
  • Consumer sentiment declining

Credit/Economic Market Look:

  • TED Spread - 33.302 to 33.029
  •  3-Month T-Bill Yield .14%
  • Yield Curve 2.407 to 2.406

Commodity/Growth Expectation:

  • CRB: 266.51 +0.02%
  • Oil: 78.98 unchanged
  • Copper: 321.5 (+1.2%) – trading above its TRADE line - BULLISH for growth expectations
  • Gold: 1,186 (-0.3%)


  • EURO: 1.30 (+0.6%)  - trading above the TRADE line
  • DOLLAR: 82.08 (-0.5%) - BEARISH formation

Overseas Markets:

  • ASIA - Major indices closed mixed despite a strong early start. China closed lower on fears about its banking sector.
  • EUROPE - Major indices were higher following Wall St's strong performance overnight - PIIGS outperforming 
  • Euribor moved higher overnight to 0.893% from 0.889% yesterday - (Bearish)
  • LATIN AMERICA - Major indices are higher
  • MIDDLE EAST - Mostly higher with the UAE trading down 0.19% 

Howard Penney

Managing Director


THE DAILY OUTLOOK - levels and trends













Pause To Wonder

“He who can no longer pause to wonder and stand rapt in awe, is as good as dead; his eyes are closed.”

-Albert Einstein 


My eyes definitely aren’t closed this morning. We are in day 6 of another low-volume, global macro, short squeeze that has expanded its multi-factor wings from Europe to China and back to the US. The interconnectedness of the modern day macro market continues to leave me in awe.


After moves like this it isn’t time to panic - it’s time to pause. Slow down your decision making and take the time to wonder what the potential scenarios are for the next big move. Every Euro Parity Parrot has been squeezed; most in the ‘China is going to zero’ camp have been too – and now the mean reversion associated with a global illiquidity squeeze has the 200-day Moving Monkeys in the US jumping around like they usually do when you throw them a banana.


Standing “rapt in awe” is not what you should do when you see perma-bulls, parrots, and monkeys alike get bullish when they see green on their screens. In the dynamic ecosystem that is the global marketplace, this is a constant. You don’t need fractal math to forecast this kind of proactively predictable behavior.


What you should do is have a risk management plan that’s duration agnostic and changes, real-time, as global market prices do – so let’s go through that in Europe, Asia, and the USA, from both an equity and currency market perspective, using our TRADE (3wks or less) and TREND (3mths or more) durations:


1. Europe

A)     Equities – all 3 of my current major leading indicators (DAX, FTSE, and IBEX) are flashing bullish TRADE and TREND as of this morning. Bullish immediate term TRADE isn’t new, but bullish intermediate term TREND is and I’ll need to see that confirm. The FTSE’s intermediate term TREND line = 5351 and this is the first day that we’ve seen that eclipsed to the upside. One day doesn’t a repeatable TREND make, but the German DAX and Spanish IBEX have been trading above their respective intermediate term TREND lines now for almost a full week – so stay tuned.

B)      Currencies – most European currencies look outstanding relative to the US Dollar. Both the Euro and British Pound are bullish TRADE and TREND with TREND line support levels for the Euro and Pound at 1.27 and 1.48 per USD, respectively.


2. Asia

A)     Equities – leading indicators for the entire region aren’t broadly bullish across both TRADE and TREND durations yet, but China has recently broke out to the upside from an immediate term TRADE perspective (2485 = TRADE line support for the Shanghai Composite) and the Hang Seng in HK has moved to bullish TRADE and TREND with TREND line resistance becoming support at 20,518. Japanese stocks look diametrically different than those in Singapore, Thailand, and HK, with Japan closing down again overnight and remaining broken on both TRADE and TREND durations.

B)      Currencies – most Asian currencies continue to look bullish relative to the US Dollar. India raising interest rates by a higher than expected 50 bps last night adds to the hawkish bias that Asian governments have moved towards in recent months (rate hikes in Thailand, Taiwan, Korea, etc). The one thing that can crush their domestic citizenries is inflation. It’s important to understand that inflation, like politics, is local.


3. USA

A)     Equities – all 3 of my current major leading indicators (SP500, XLY, and XLF) look the same – bullish from an immediate term TRADE perspective and bearish from and intermediate term TREND perspective with the following Bear Market Macro levels of TREND line resistance: SP500 = 1144; XLY  (Consumer Discretionary) = $32.99; and XLF (Financials) = $15.49. And no, we don’t use the 200 or 50 day Moving Monkeys to make our Macro Theme calls. We use our proprietary multi-factor, multi-duration model with a fundamental global macro overlay that considers country, commodity, and currency risk.

B)      Currency – the US Dollar Index continues to look awful from both a TRADE and TREND perspective with TREND line resistance now fortifying itself up at $84.21. Like a stock price for a company, the fiscal health of a country is reflected by the strength of her currency. As the European governments get austere, the US government continues to play chicken with a global game of reflation that is damning both the rates of return on American savings accounts and the currency that backs them.


So, in the aggregate, as we Pause To Wonder what this all means relative to our current positioning, this is what I am going to do:

  1. Europe – stay away from the short side of European Equities (we have no European equity shorts); get long some European equity exposure (preferably German) on a pullback; and remain long the British Pound (we are long FXB).
  2. Asia – buy more Asian Equities and Currencies. We are currently long Singapore (EWS) and the Chinese Yuan (CYB).
  3. USA – short the SP500 all the way up to 1144 (we are short SPY) and remain short the US Dollar (we shorted the UUP on June 7th).

Managing risk doesn’t happen in a price-momentum, performance chasing, vacuum. It’s both global in capital flows and interconnected across asset classes with a Darwinian function that will render long term parrots and monkeys “as good as dead. “ In the short run, our risk management task remains to not lose money and keep your hard earned capital alive.


My immediate term support and resistance levels for the SP500 are now 1088 and 1122, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Pause To Wonder - china