The Economic Data calendar for the week of the 9th of August through the 13th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
On our Macro Morning Call a client asked "so what's your catalyst on the downside?”
My answer: price - humans will chase it when it cracks.
This is the reality of modern day risk management. Price momentum dominates decision making at the margin. In our risk management model, the immediate term TRADE zone of 1115-1118 that we have been focusing on this week can quickly become resistance again (as quickly as it became support). There is no immediate term support below 1115 to 1095.
What’s interesting about 1115 is that it’s also the line for the 200-day Moving Monkeys. This rarely happens, but our quantitatively driven line being the same line as the 200-day all of a sudden makes for an even scarier picture to the downside. However bad the back-testing is on using the 200-day as your risk management line in a bear market, the reality is that a lot of people use it.
In the meantime, we’ll keep using what we use – our own proprietary research process – and we’ll remain as bearish as the US employment data (jobless claims of 479,000 yesterday and this morning’s unemployment report of 9.5%) continues to look.
Have a great weekend,
Keith R. McCullough
Chief Executive Officer
Conclusion: The Chinese economy has three major risks to it: property prices, the U.S. consumer, and U.S. Treasury holdings – all of which have major implications for the global economy. These TAIL risks should be kept front and center when contemplating the outlook for both the dollar and global growth.
As risk managers, it is our job first and foremost to protect capital – which is exactly what we’ve been doing when it comes to China. Despite our bullish long term bias on China’s economic growth, we are not invested. Sometimes the answer is to do nothing and wait. Everything has a time and a price, and with China backing off of its TREND line of 2,690 at the tail end of its recent rally, policy risks within the Chinese economy continue to weigh on investor sentiment. In our analysis below, however, we look beyond the equity market’s favorite question of, “when will they ease tightening measures?” We highlight some intermediate and long term risks to the Chinese economy that you should keep front and center when thinking about a) investing in China and b) future global growth.
Risk One: China’s “Hot” Property Market
The recent news about China’s latest stress test highlights risks that are not news at all (the Shanghai Composite is down 20% YTD – the 2nd worst performance of any major equity market globally). As we’ve been saying since January, China’s property market is an inflationary by-product of last year’s easy-money stimulus. Moreover, as a result of Chinese tightening policies, we have been expecting further marginal deflation in real estate prices from here – though perhaps not the 50-60% extent China’s banking regulator has asked lenders in the “hottest” cities to stress test for. Results from China’s previous stress tests show the ratio of non-performing real-estate loans within the Chinese banking system would rise by 220bps from the current 1.3% if housing prices dropped 30% and interest rates rose by 108bps. In sharp contrast to “stress” tests done by European and American banks, this latest risk management move by China’s may serve to scare away incremental yield-seeking capital, though few actually believe that prices could exhibit a 60% decline from here.
Like we’ve pointed out in a previous note titled Chinese Loans… A Crisis of Rumors (7/30), China’s $1.4 trillion in credit expansion last year and an additional target of $1.1 trillion in 2010 obviously brings about a great deal of credit risk to the Chinese economy. As a result, China’s banking industry has been replenishing capital in the form of $54 billion in total IPO’s and bond offerings this year. While we certainly need more data to accurately access the likelihood of a massive meltdown in China’s property market, we can rely on historical datasets provided by Reinhart and Rogoff’s 2008 paper titled: Banking Crises: An Equal Opportunity Measure to make a reasonable assessment of the risk. They conclude that banking crises are more common in countries that: a) have a sustained surge in capital inflows; b) rapid credit expansion in a shortened duration; and c) a boom in real housing prices, whereby the banking crisis occurs just after the bursting of the bubble. By all accounts, China meets all three conditions, though we must be careful to interpret the data property. The probability of a banking crisis is greater when these conditions are met, but that does not necessarily imply a banking crises would ensue. The tables below show both the probability of banking crises related to capital inflows, and historical housing bubbles which led to banking crises.
The takeaway here is that the risk of a banking crisis is should not be written off without due diligence. We contend, however, that China, more than any other country, has the ability to grow into the right level of demand to meet its bubbly housing market supply. While equilibrium is not likely to be found without the combination of time and further price declines, we do think equilibrium can be found point where real estate depreciation does not facilitate a major banking crisis. The success of that theory, however, hinges largely upon the China’s next major risk.
Risk Two: US Demand Rolling Over
China growth model is very export oriented, which makes its economy particularly vulnerable to external shifts in its demand curve, as manufacturing products for Western consumers accounts for a great deal of Chinese employment. If we are right in our call that the U.S. consumer (and subsequently U.S. growth) will continue to slow, the Chinese economy will slow incrementally as a result. The extent to which it slows will largely depend on its ability to shift its economy towards domestic consumption as a larger percentage of GDP.
We’ve been vocal recently highlighting wage growth and the prospects of a stronger yuan as bullish for the Chinese consumer. What cannot be overlooked, however, is that China’s transformation will not happen overnight. The process towards rebalancing its economy will be a long, arduous one filled with marginal improvements over time and bumps and bruises along the way. Without going into too much detail, China likely needs to expand its service sector to absorb any potential loss of labor from weakening Western demand. That will be hard to do without public investment in social services including health care, education, and pensions – though it must be done in a way that does not limit investment and consumption in the form of higher taxes. Moreover, based on current population demographics and its one-child policy, China’s dependency ratio is likely to climb over the next several decades – further stimulating the need for public spending on social services to lower China’s world-leading savings rate and stimulate household consumption.
Regarding China’s high savings rate (+50% of GDP), recent estimates from Michael Pettis of Peking University suggest that because of low interest rates on household deposits (60% of total), Chinese savers may actually be receiving a negative real return (0.65% est.). As a result, Chinese savers are forced to save more to make up from a lack of interest income. That, coupled with a limited range of investment opportunities, further exacerbates China’s shift to consumption. When it’s all said and done, China’s shift to a consumption-driven economy will not happen nearly as quickly as some investors anticipate.
All told, the main global risks to China rebalancing are twofold: 1) higher labor costs among exporters will likely create imported inflation in the economies of Chinese export markets and; 2) China no longer has the current account surplus to finance U.S. deficit spending by way of U.S. Treasury purchases. That leads us to our final major risk to the Chinese economy – its U.S. Treasury holdings.
Risk Three: Concentrated Foreign Exchange Risk
As of the most recent data, China is sitting on $867 billion worth of dollar-denominated U.S. Treasury debt, which is likely to continue to depreciate over time based on the current trajectory of debt supply and dollar demand. In a recent study done by the Congressional Budget Office, U.S. federal debt held by the public as a % of GDP is likely to eclipse 185% in just 25 years under scenarios that we consider aggressive based on assumptions of above-trend tax receipts and below-trend expenditures – which certainly hasn’t been the case of late (see Daryl Jones’ note from 7/13: The Deficit Still Looks Ugly, Normalize for TARP and It Looks Uglier). The results of the mid-term elections may prove to be a positive catalyst on the margin for reigning in the deficit, but a slowing U.S. economy may ultimately prove to trump any form of American Austerity.
On Tuesday, we put out an extensive presentation regarding the future of U.S. sovereign debt (email us if you need the replay), with the key takeaways being: 1) current demographic trends will likely beget further deficit spending; 2) a low U.S. savings rate will necessitate that an increasing amount of foreign buyers will be required to fund new debt issuance; and 3) at current and conservatively-projected near-term debt levels (+90% of GDP), U.S. economic growth will be below-trend for years to come – likely furthering the “need” for additional government spending and investment. All told, the U.S. is likely to issue a great deal more of U.S. Treasury supply in the coming decades and buyers of that supply will be increasingly foreign entities, which increasingly makes the U.S. vulnerable to external shifts in demand for U.S. sovereign debt – which is currently near all-time highs. If we’ve learned anything from Greece’s sovereign debt woes, it is that, ultimately, the market can and will re-price sovereign debt and reset the cost of government borrowing.
It is important to note that we aren’t suggesting that U.S. Treasuries are following in the footsteps of Greek sovereign bonds. What is likely to happen based on historical precedent set by Japan is that Treasury yields stay low as a result of prolonged near-zero interest rates. From a central bank action perspective, there hasn’t been a threat to Japanese Government Bonds in decades and the United States has already started on that path. What matters to China, however, is converting those debentures into cash upon maturity. The U.S. Dollar Index continues to make as series of lower-highs and lower-lows from a intermediate and long term perspective, meaning that as time elapses, China is likely to receive less and less purchasing power from converting U.S. Treasury debt into actual currency. The U.S. dollar is still the dominant currency as a percentage of world currency reserves, but, as we say, everything that matters in Macro happens on the margin. In the last ten years alone, the dollar has declined over one thousand basis points as a percentage of world FX reserves, falling from 71.9% in 1999 to 61.5% in 2009, according to the IMF. The outlook for the U.S.’s economic growth and debt build-up over the next 20-30 years suggests the dollar will not likely regain any of its lost value any time soon.
All told, China has become increasingly aware of this risk and has decreased its U.S. Treasury holdings by nearly 8% since its July ’09 peak holdings of $940 billion. De-pegging the yuan to the dollar will help China reduce the need for additional purchases, but any rapid selling to diversify its FX portfolio will be more harmful than good as the market will react negatively to large selling, further compounding China’s problem. Unfortunately for some, China can’t sell them fast enough: according to Yu Yongding, a former Chinese Central Bank adviser, “U.S. Treasuries are not safe from an intermediate-to-long-term perspective”. He continues by saying, “Only God knows how much value that China has stored in the U.S. government securities.” Unfortunately for China, by the time it finally does need to drain its excessive FX reserves, the whole world will have found out the true value of those securities, which is likely to be a great deal less than anticipated upon purchase.
In summary, the Chinese economy has three major risks to it: property prices, the U.S. consumer, and U.S. Treasury holdings – all of which have major implications for the global economy. These TAIL risks should be kept front and center when contemplating the outlook for both the dollar and global growth.
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R3: REQUIRED RETAIL READING
August 06, 2010
“Expectation is the Root of All Heartache” – William Shakespeare. That’s one of the most common phrases used in our office. With 60% of retailers missing sales expectations in July vs. 52% in June and 28% in May, this is more relevant than ever.
TODAY’S CALL OUT
- Teens: ANF outperformed as it beat estimates while ARO and AEO missed meaningfully
- Department Stores: JCP underperformed with a miss versus its peers M, SKS, and KSS
- Discounters: Disappointing with misses across the board with ROST standing out as the worst in the group
- Food: Called out as a top performing category by COST, BJ, and TGT
- Home: Performed well for TJX, ROST, COST, TGT, and SMRT; weak for DDS and BONT
- Children’s Apparel: underperforming category in July for BONT, TGT, and ANF; positive for SSI
- Inventories: across the board inventories are still declining on a per square foot basis
- Margins: merchandise margins continue to grow, in a few cases because of fewer promotional events which hurt top-line
- Denim: mixed results with ANF citing weak denim while GPS noted strong
- Shoes: strength noted by BONT, DDS, SKS, ROST
- TV/Home Entertainment: weak trends noted by TGT, COST, BJ
- Back to School: Back to School continues the trend of getting pushed back further as consumer shop closer to the event, weakness in overall trends for July can be partly attributable to less school shopping in July
- California: remains a negative callout, notably it turned negative for ROST and called out negatively by TGT
- South: best performing region for ZUMZ, ARO, KSS
Raised Guidance/High End of Guidance
- LTD: raised to $0.34 - $0.36 vs. $0.27 - $0.32
- ZUMZ: raised to -$0.02 to -$0.03 vs. -$0.07 to -$0.10
- ROST: raised to $1.06 - $1.07 vs. $1.00 - $1.02, due to shift in distribution cost from Q2 10 to Q3 10
- TJX: guided to high end of $0.70 - $0.73 guidance
Lowered Guidance/Low End of Guidance
- HOTT: lowered to -$0.14 vs. -$0.07 to -$0.10
- ARO: guided to low end of previous guidance, $0.45 - $0.46 vs. $0.45 - $0.48
- AEO: guided to low end of previous guidance, $0.12 - $0.13 vs. $0.12 - $0.16
- WTSLA: guided to low end of previous guidance at $0.02 vs. $0.02 - $0.04
- JCP: guided to low end of the previous guidance $0.05 - $0.08
- SSI: guided to low end of the previous guidance $0.26 - $0.30
LEVINE’S LOW DOWN
- Despite expectations of cost inflation, WRC is one of the few retailers calling for gross margin expansion in the 2H driven by growth both at retail and internationally. Retail performance in July was particularly noteworthy with domestic comps accelerating in July to up +10% from LSD in Q2 as well as in Europe up +14% from +2.7% in Q2. Contrary to recent trends, Italy (WRC’s largest market in Europe) was one of the strongest regions in July up +16% from +6% in Q2 – undoubtedly catching the ear of GES shareholders.
- Add home to the list of 30+ categories LIZ will have at JCP in the 2H beginning next month. While new to the LIZ lineup, we expect additional category extensions are likely as the company looks to leverage core strengths of its new partner.
- With a shift underway towards direct/retail, CROX is clearly focused on ramping its Asia business having accounted for nearly 50% of new stores openings in Q2 and plans to open five new websites in Asia starting this quarter. With international accounting for 60%+ of total sales and aspirations of building China into a business nearing $100mm over the next 3-years, the success of these efforts will be closely followed by many.
NPD Bullish on Back to School Outlook - According to a survey conducted by Port Washington, N.Y.-based The NPD Group Inc., fewer consumers are reporting plans to spend less this year. Only 38% of consumers polled say they will shop less for back-to-school, compared with 44% of consumers last year. While school supplies top consumers’ shopping lists, footwear is also a priority. This year, 45% of shoppers plan to buy shoes during back to school, compared with 39% last year. And though shoppers said they are feeling better about buying this year, they are in no rush to begin the back-to-school shopping season. Only 3% of those surveyed have already started making purchases, compared with 6% who had begun by this time last year. When consumers start their shopping, most will head to national chain stores, followed by mass merchants, office supply stores, department stores and footwear specialty stores. <wwd.com/footwear-news>
Hedgeye Retail’s Take: I always take these surveys with a grain of salt. But so interesting to see apparel and footwear actually gaining share in planned purchases this fall. Two factors, however, are that 1) people do not plan for inflation in food, or other more essential categories . 2) No one plans for a double dip – or any other pinch to their wallets that might make that ‘plan’ for a third cashmere sweater seem less appealing.
India Sees Cotton Prices Stabilize With Strong Season - India, the world’s second-biggest exporter of raw cotton after China, is positioned to produce a healthy harvest this year that could help lower world prices and lift global garment manufacturers. During July, the wettest month in India’s June-to-September monsoon season, farmers planted 9.5 million hectares of cotton, up from 8 million last year. Cotton farmers have been encouraged to plant bigger crops to cash in on higher prices amid concerns over global cotton shortages. The U.S. Department of Agriculture has warned that demand this year may outstrip supply. World cotton production is forecast to increase to 113.9 million bales in 2010-11, an 11 percent increase from 102.9 million bales in 2009-10, the USDA said. However, world consumption may rise to 119.1 million bales next season from an estimated 115.9 million. India’s repeal of curbs on raw cotton exports also has given a boost to cotton farmers.While that’s good news for Indian cotton farmers and global textile manufacturers, especially in textile-dependent countries such as Pakistan and Bangladesh, Indian garment manufacturers are unhappy the ban has been lifted. As prices rise and cotton stocks fall, their margins could suffer. <wwd.com/business-news>
Hedgeye Retail’s Take: With prices up over 10% since the end of June and back at peak levels upwards of $0.85 /lb. last seen in early 2008, this crop will be one of the more highly anticipated in years as a strong yield is critical to keep prices from hitting new heights in the near-to-intermediate term.
Online Retailer Yoox Continues to Grow - International expansion and brisk orders pushed Yoox Group’s revenues up 39.2%. The 10-year old online retailer also manages e-commerce sites for designer brands such as Marni, Emporio Armani, Roberto Cavalli and Pucci. Sales in North America rocketed 85.8%, while Japan surged 51%. With a monthly average of 8.1 mm visitors, Yoox said its orders in the first half rose to 717,000 from last year’s 536,000, with an average order value of 174 euros or $231. <wwd.com/retail-news>
Hedgeye Retail’s Take: The initial growth of these models is obvious. The bigger question is the scalability thereafter. No one has succeeded yet, and there appears to be little about Yoox’ model that will allow it to succeed where others have failed.
Switzerland's Swatch Group Sees Strong Demand in 1H and Solid Growth in July - Strong demand for timepieces across all segments and regions helped grow sales 24.1% for 1H, sharply outperforming overall Swiss watch exports during the period. Growth has been solid in July, and they expect a strong result for the second half of 2010 in terms of both sales and profit. The major challenge will be to quickly overcome the capacity bottlenecks which already exist in some production areas. <wwd.com/business-news>
Hedgeye Retail’s Take: Missing out on top line opportunity due to capacity constraints is embarrassing. That said, the demand for the product is definitely notable given that Swatch is squarely in the mid-zone of the casual timepiece pricepoint.
Asics America Corporation Saw 17% Sales Growth in 1H - For the second quarter (April-June) all categories are seeing double-digit growth, which is in line with the momentum from the first quarter of 2010. Growth was attributed to a 20% increase in apparel and accessories while retail distribution expanded product offering for volleyball, wrestling, track and field, and field hockey. Footwear remains strong at a 15% growth rate. <sportsonesource.com>
Hedgeye Retail’s Take: Initially, the headline struck me as added fuel to the fire that Running footwear continues to outperform. But on the flip side, isn’t it interesting that a running brand like Asics mentioned 4 sports that aren’t running? Either the category is slowing, or they’re managing around increased competition from Nike, UA, and even SKX.
Columbia Sportswear to Acquire OutDry Technologies - Columbia Sportswear Company signed an agreement to acquire OutDry Technologies S.r.l., which owns the intellectual property and other assets comprising the OutDry brand and related business, via a cash purchase from Nextec S.r.l., based near Milan, Italy. The transaction is expected to close during Q3 and will not have a material effect on the company's 2010 operating results. OutDry's technology is the 'gold standard' for producing waterproof, breathable footwear and gloves that outperform products still relying on the 25-year-old method of internal booties and bladders. OutDry will be deployed across COLM's portfolio of outdoor brands, including Columbia, Mountain Hardwear, Sorel and Montrail. <sportsonesource.com>
Hedgeye Retail’s Take: This deal will undoubtedly be overshadowed by the company’s highly anticipated Omni Heat launch, but firm’s focus on delivering innovative technologies is clear – whether it be organic or by acquisition, Columbia is taking the right steps towards rebuilding the brands authenticity.
Strid Rite Rebrands Robeez - Robeez is officially moving under the Stride Rite banner. The baby shoe brand, which was acquired by Lexington, Mass.-based Stride Rite in 2007, will now be branded as Robeez by Stride Rite. According to the company, the move is designed to better streamline Stride Rite’s product offering and make the different developmental stages of the collection more understandable for consumers. Robeez by Stride Rite will continue to offer its Soft Soles and Mini Shoez collections, geared toward pre-walkers and early walkers. The Robeez Tredz line, designed for more confident walkers, will be discontinued. <wwd.com/footwear-news>
Hedgeye Retail’s Take: The consolidation makes sense. At this point, PSS’ biggest focus will increasingly to get more content – even acquired content – into its Payless stores. Getting the house in order for its existing content first makes a lot of sense here.
ZQK Introduces New Junior Line - Quiksilver is trying to lure teen shoppers from fast fashion with a new junior line to be marketed under its namesake brand. Starting next spring with more than 100 pieces, the line is intended to complement the surf styles from the company’s existing junior label, Roxy, and serve as a bridge for customers to its two-year-old young contemporary line sold under the Quiksilver label. Roxy targets a 17-year-old customer, the junior collection aims to reach a 19-year-old, and the young contemporary line pursues women age 25 who have outgrown Roxy and other junior brands. Seeking a quick global launch of the junior line, Quiksilver hired Pencil on Paper Studio, not the first time it has used some outside resources to augment design, but this is the first time it has outsourced an entire line. Priced similarly to Roxy, ranging from $24 for T-shirts to $88 for dresses, the junior line is promoting what Florie called “modern coastal classics.” <wwd.com/retail-news>
Hedgeye Retail’s Take: Natural extension in an effort to maintain customer retention – this is a solid step by ZQK to leverage one of its core brands (Roxy) to help ensure the success of its young contemporary line. The concern we’d have is that the attempt to lure a consumer away from fast fashion is probably a losing one – unless your spot-on with what the consumer wants and needs.
Victoria's Secret Launches NFL Team Branded Clothing - The National Football League and Victoria's Secret Pink have teamed up for a co-branded clothing collection to hit stores Aug. 10. The line will include tees, sweats, hoodies and tanks with the names and logos of the Chicago Bears, Dallas Cowboys, Denver Broncos, Minnesota Vikings, New England Patriots, New York Giants, New York Jets, Oakland Raiders, Philadelphia Eagles, Pittsburgh Steelers, San Diego Chargers, Washington Redskins and Carolina Panthers. <licensemag.com>
Hedgeye Retail’s Take: This makes more sense than one might think. Mariah Carey arguably started the trend in 2003 by wearing a Jordan #23 dress at the NBA All-Star game. Since then, wives of NBA players, and more importantly, European Footballers, have been requesting similar garbs. It makes perfect sense for the NFL and MLB to get involved.
Kmart Rolls Out Kmart Smart Campaign for BTS - Kmart Smart is Kmart's value proposition for back-to-school this year with a three-pronged strategy involving more fashion, more value, and more ways to shop. In apparel, Kmart has introduced three new brands. In addition to GLO [the Jones Apparel Group jeans and accessories line], there’s also Dream Out Loud by Selena Gomez, Bongo and Rebecca Bonbon. More value is presented in lower prices and higher quality product with a longer shelf life. More ways to shop is seen in mobile apps and Kmart.com. <brandweek.com>
Hedgeye Retail’s Take: This is counter to what we’ve seen by other retailers that have pared back the number of brands offered…we’ll see if others care to follow Kmart’s lead. Our sense is no. Is it me, or is ‘Kmart Smart’ one of the biggest Oxymoron’s in retail?
UK Shop Price Inflation Unchanged, Food Inflation Increases - Overall shop price inflation remained unchanged at 1.5% in July. Food inflation increased to 2.5% in July from 1.7% in June. Non-food inflation slowed to 1.0% in July from 1.4% in June. Shop prices have remained stable largely due to aggressive discounting driving non-food inflation down to its lowest rate since November 2009. The price of furniture and flooring fell for the first time in seven months. Food inflation was higher than the previous month - driven by global factors putting pressure on the cost of fresh food, such as meat and fruit. The recent dry weather has increased the price of animal feed and poor harvests have reduced some fruit crops. Problems with production in large wheat exporting countries, such as Russia and Canada, could put pressure on overall food inflation in the coming months. <brc.org.uk>
Hedgeye Retail’s Take: Now that Russian Prime Minister Putin as officially banned grain exports through year-end, expect more of the same in terms of rising food inflation.
The brand management story of a few years ago hasn’t materialized.
Was anyone wondering where those supposedly lucrative resort division and the CityCenter management fees were hiding? We were and we’ve discovered they reside in the $102.3 million revenue line item Management Operations. Not bad until you look at the profit, or should I say loss contribution of the division. Management Operations lost $3.7 million in the quarter. And we thought development fees and management contracts brought fat margins.
That is why we had a chuckle when one analyst suggested that MGM should look at spinning off that part of the business to get a Four Seasons multiple. Oh yeah? I don’t recall Four Seasons generating negative margins on their fee business. To be fair, no MGM branded hotels have opened yet so there is potential. However, MGM has a long way to go before their brand moves into the same category as Four Seasons. On second thought, MGM isn’t even known for non-gaming hotels so Sheraton would even be a stretch at this point.
We’ve gotten comfortable with the higher R&D. Here we’d like to address the incremental $40m in capital investment.
Unlike the R&D which is expensed as incurred, WMS will capitalize the $40 million in incremental Capex. Investors are not freaking out about that as much as the $10 million R&D ramp which is strange as both expenditures are investments with real ROI. Oh well, we thought we’d address the additional spend here:
The $40MM of incremental investment
It’s actually 3 buckets: