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MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED...

This insight was originally published on June 22, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED SETTING STAGE FOR WORSE DOWNTURN

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THE BOTTOM LINE
May existing home sales were much worse than expected in spite of the continued effect of the April 30 tax credit expiration pull-forward. May sales came in at 5.66 million (seasonally adjusted annualized rate) down from 5.79 million in April (revised a tad from 5.77 million). Expectations were for sales to rise north of 6.2 million units. Sales coming in 9% below expectations reflects a major incremental negative datapoint.
 
Summary
Remember that this May print is a lagging indicator as it reflects deals closed two to three months ago (Mar/Apr) because of the 30-60 day lag between signing and closing.
 
In our view, the relevant benchmark is how it compares with October 2009's print of 5.98mn. Against that measure, it's down considerably (5.66). The original tax credit expired in November, 2009, putting October 1 month ahead of that expiration. The current credit (for closing) expires June 30 (April 30 for signing), which means 1 month ahead equals May.
 
In other words, it's now clear that tax credit round two is having a less substantive effect on sales than round one did back in late-2009.

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - chart 1

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - chart 2

 

 

Inventory, on a units basis, fell a modest 3.4% to 3.89 million units from 4.04 million units in April.

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - chart 3

 

 

Inventory, on a months supply basis, fell slightly to 8.25 months from 8.4 months last month. While inventory is down nominally on a months supply basis, this is somewhat misleading because its keying off an artificially high May 2010 sales rate. If we assume that the same dropoff in sales occurs following this tax credit expiration as followed the last tax credit expiration we can expect to see a sales rate of 4.25-4.5mn a few months from now. Meanwhile, inventory is at 3.89mn units. In other words, inventory could rise to 10-11 months or higher very shortly.

 

 

MACRO: HOUSING FIZZLES EARLIER THAN EXPECTED... - Chart 4

 

 

Our view is that this pull forward of activity is setting the stage for a much weaker-than-usual summer housing environment. Housing-sensitive stocks could be at risk heading into the 2H10 and 2011 time frame.
 
We have an extensive report coming out on this topic on Friday for subscribers and prospects of our Financials Vertical, which we will summarize on a conference call at 11am on Friday.
 
 
Joshua Steiner, CFA
Managing Director
 
Allison Kaptur
Analyst


MACRO: The End of Quantitative Easing...

This insight was originally published on April 8, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS subscribers in real-time.

 

 

MACRO: The End of Quantitative Easing, As We Know It

 

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“It’s the end of the world as we know it and I feel fine.”
-R.E.M.
 
R.E.M. is an iconic American rock band that was founded by Michael Stipe in 1980.  While the band is not known for its thoughts on monetary policy, the line quoted above from their song, “The End of the World Was We Know It”, provides a good metaphor for the Federal Reserve’s recent decision to halt quantitative easing.
 
While many market observers expected this planned ending of policy to lead to an increase in interest rates, particularly for mortgages, we have seen only a marginal change in rates.  In fact, over the last three weeks 30-year fixed mortgage rates have only increased marginally from 5.05% to 5.25%.  In essence, the quantitative easing world has ended, but those still borrowing via mortgages “feel fine”.
 
To its credit, the Federal Reserve did an effective job at prepping the market for the end of this policy, so new buyers stepped in and the mortgage market has remained stable.
 
Backing up for a second, though, what exactly is quantitative easing?
 
Central Banks have basically two key tools to implement monetary policy:  interest rates and reserve requirements.  By lowering interest rates, central banks can stimulate money supply by making borrowing rates more reasonable to borrowers and the margins from lending more compelling to lenders.  On the reserve front, the central bank can alter the reserve requirements, which is the ratio of cash a bank must hold compared to customer deposits. Any increase in reserve requirements will limit a bank’s ability to lend, or vice versa.
 
In the scenario where the interbank interest rate is zero and reserve ratios have been maxed out, central banks can initiate another form of policy: quantitative easing.  In simple terms, central banks will begin to purchase financial assets from banks through open market operations.   So the central banks print money to buy assets from banks, which increases the excess reserves on the balance sheet of banks.
 
Quantitative easing was used by the Bank of Japan in the early 2000s in an attempt to offset deflation with limited results.  In November of 2008, the United States implemented their first ever policy of quantitative easing.  The policy had two aspects to it.  First, the Federal Reserve indicated they would purchase direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  Second, the Federal Reserve indicated they would purchase mortgage back securities.
 
The objective of this program according to the Federal Reserve was to, “reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”  In effect, as credit markets ground to halt in late 2008, the Federal Reserve had to take the extraordinary and unprecedented measure of quantitative easing to offset the potential risk of deflation.
 
While the program started on a smaller scale with $500 billion of mortgage backed debt, the program was increased in March of 2009.  As the program ended on March 31, 2010, the Federal Reserve had purchased $1.2 trillion of mortgage-backed debt from banks and $200 billion of direct obligation debt of Fannie Mae and Freddie Mac, for total purchases of $1.4 trillion.  As a result of these actions, the Federal Reserve now owns almost 25% of the stock of mortgage-backed securities.
 
In the chart below, we have charted the increase of excess reserves on bank balance sheets.  The current amount of excess reserves is estimated to be around $1.2 trillion.  Assuming that these excess reserves were turned into loans at a 10:1 ratio, the increase in money supply into the system would be $12 trillion.  This is larger than the current amount of outstanding mortgages in the United States!
 
The reality is simply this: we have no idea what the consequences of this quantitative easing policy action will be.  It is an unprecedented move that, in time, will have to be unwound.  If the unwinding is natural, which would involve banks reducing their excess reserves to a more normal level, the inflationary impacts on the U.S. economy could be extraordinary.
 
At this point, I’m not going to predict the “end of the world as we know it” due to this massive increase in excess reserves, but this policy will have to be unwound at some point.  Either the Federal Reserve will have to pay competitive interest rates on these reserves so as to discourage loans, or the banks will begin to lend.  And lend.  And lend.
 
I can promise you this, if the $1.2 trillion in reserves starts to make its way into the economy, money supply will increase dramatically, and with it, inflation.  While there is increasing discussion of inflationary pressures, very few people are currently considering the unintended consequences of quantitative easing.

 

 

MACRO: The End of Quantitative Easing... - Chart 1

 


Daryl G. Jones
Managing Director


MACRO: Watching the IRS

This insight was originally published on May 12, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

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Conclusion: Keep your Hedgeyes on the IRS and how 2011's tax rate increases will affect the economy at large. Expect more attention to be paid to this as we progress through the year, and for it to be priced into the markets as early as this summer.

 

With sovereign debt concerns, the EU bailout package, accelerating inflation, and fat fingers garnering so much investor attention globally, we thought  we'd give you a quick global macro break and focus you on a domestic issue that will become increasingly important as 2010 progresses - 2011 tax hikes.
 
Since I collected my first paycheck some 8-9 years ago, I've been duly focused on taxes - i.e. how much of the money I made I wasn't actually going to be able to spend. After all these years (joke), the only thing I've come to learn about taxes is they don't get less annoying with time. And in 2011, I expect to become even more annoyed (along with a lot of other taxpayers).
 
Changes to be enacted in 2011:

  • Income tax brackets are scheduled to change for 2011, with the highest rate increasing from the current 35% to 39.6%. Each of the lower brackets will also be increasing. It has yet to be determined where the income threshold will be for each bracket, but taxpayers can rest assured that their federal tax burden will be increasing for 2011;
  • Capital gains tax rates are also scheduled to change. The top rate for long-term capital gains is expected to rise from 15% to 20%; and
  • The preferential qualified dividends tax rate of 15% is scheduled to expire, so all dividends will be taxed at ordinary income tax rates.

Obviously, this will be a headwind for the American consumer and will have negative implications for discretionary spending in 2011 (we may see a marginal pull-forward in spending on larger-ticket purchases this year as consumption is all but sure to decline next year). Less obvious, however, are the implications the tax rate hikes will have on the certain markets and M&A activity.
 
Under the new tax structure, we could see investment money flow towards capital gains away from equity income - especially those monies that will be taxed at or near the highest rate (39.6%). With so many retirees dependent on dividend funds, however, Congress may be inclined to level the playing field by either raising capital gains taxes or lowering the tax rate on dividends. Time will tell on that matter.
 
The far right column of table below shows the Y/Y percentage change in the after-tax income from a variety of investment sources. We have used the top tax bracket as a proxy for wealthy investors, simply because the flow of their monies will have greater impact on the overall investment community.

 

 

MACRO: Watching the IRS - Chart 1

 

 

It is important to also note that municipal bonds and municipal bond funds will become more attractive on the margin vs. taxable bonds and taxable bond funds. While we believe the state budget and U.S. sovereign debt issues will have a greater impact on municipal bonds inflows, we'd be remiss not to call out this additional tailwind for the investment vehicle.
 
Regarding M&A activity – which should pick up with capital gains taxes headed higher – private businesses will be looking to sell prior to the tax rate hikes, and, as the year progresses, those looking to acquire with cash will have a more favorable environment. Sellers will certainly feel the pressure to unload by year's end rather than face a 33.33% higher effective tax rate in 2011. Aware of this selling pressure, buyers equipped with cash will be hunting for discounts late in the year. As an aside, buyers looking to acquire with deferred payments may be subject to a premium to offset the seller's increased 2011 tax burden.
 
In short, keep your Hedgeyes on the IRS and how 2011's tax rate increases will affect the economy at large. Expect more attention to be paid to this as we progress through the year and for it to be priced into the markets as early as this summer.
 
Darius Dale
Analyst


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MACRO: Is the Yuan a Yawn?

This insight was originally published on June 21,2010.  MACRO Intraday updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

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Conclusion:  The potential revaluation of the Yuan is positive for Chinese equities, but likely negative longer term for Treasuries.  It will also benefit the currencies of those nations that supply basic materials to China – Australia, New Zealand, Canada, and Brazil.
 
The global macro news of the day is, of course, the statement by the People’s Bank of China that they are going to end the two year peg of the Chinese Yuan against the U.S. dollar.  The timing is apropos as the G20 Summit is occurring this coming weekend in Ontario, and increased pressure on the Chinese to let their currency more freely float was very likely.  At the least, the Chinese have bought themselves time in that debate, though it does seem likely that this is the first step in a more freely floating currency.
 
Per the release from the People’s Bank of China:
 
“The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.”
 
While this announcement is certainly bullish for the Yuan, it must be taken with a grain of salt as it doesn’t dictate a revaluation of the Yuan or even a change in the daily trading range, but emphasizes flexibility.  So, in effective, it was the bare minimum in terms of policy to support a Yuan revaluation.  Clearly, though, with increasing signs of inflation within China, this is a way to dampen housing and consumer price increases that threaten the Chinese economy.
 
So far the reaction from the U.S. government has been muted at best.  Treasury Secretary Timmy Geithner released a statement yesterday in which he stated:
 
“This is an important step, but the test will be how far and how fast they let the currency appreciate.  Vigorous implementation would make a positive contribution to strong and balanced global growth.”
 
Translation: Timmy likes this, but he wants to see more action.  While obviously Timmy’s statement may be politically convenient within the confines of the domestic U.S., Chirping Our Creditor has implications in its own right, specifically as it relates to the appetite of the Chinese to continue to fund U.S. deficits.  Moreover, a revaluation of the Yuan will fundamentally lead to lower demand for U.S. Treasuries over the long run.
 
The longer term impact of this change in policy will likely be a decreased demand for U.S. dollars.  In order to maintain the fixed exchange rate with the U.S. dollar, the Chinese government had to get long of the U.S. dollar.  Their method for doing this was to purchase U.S. Treasury bonds in large sums.  With the decision to let the Yuan float, the need to purchase U.S. dollars decreases and with it, on the margin, Chinese demand for Treasuries, which will be negative for the price of Treasuries (and positive for yields).  The chart below outlines this point as it shows that Chinese purchased more than $450 billion in U.S. Treasuries over the last two years, while the currencies were pegged, which was almost the same as the prior eight years combined.
 
So far this morning, the movement in the Yuan has been a bit sleepy.  With no specific policy action, the Yuan is still confined to its 0.5% daily trading range.  That said, even as this announcement is somewhat rhetorical in the short term, the long term implications are positive:
 
1)      It is indicative of the Chinese showing a willingness to play by the rules of free and open markets, which will increase confidence in investing in China
 
2)      The potential of trade wars will be somewhat alleviated on the margin as the argument that China has a structural competitive advantage due to an undervalued currency is less compelling
 
3)      A stronger Yuan will combat internal inflation within China, which offsets a key potential risk for the global economy – an overheating of the Chinese economy followed by a dramatic decline (think POPPING of a bubble)
 
As it relates to global trade, a more highly valued Chinese currency will increase China’s purchasing power for commodities, which are priced in U.S. dollars.  Therefore as the Yuan appreciates, it will have positive fundamental impacts for those countries that sell commodities into China. Think Australia, New Zealand, Canada, and Brazil.  Not surprisingly, the currencies of these nations are acting accordingly and are up between 0.75% and 1.00% across the board today (with Brazil up a little less).
 
While the movement in the Yuan today may be a bit of yawn, the longer term implications of a meaningful revaluation will have a real investable impact on various asset classes globally. And positioning for this revaluation will be critical.

 

MACRO: Is the Yuan a Yawn? - Chart 1

 

 

Daryl G. Jones
Managing Director


MACRO: CHINA: THE GREAT SHIFT FORWARD

This insight was originally published on July 6, 2010.  Macro select  intraday updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

 

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Conclusion: After a series of shrewd moves by the government which have centered on raising domestic consumption, China is positioning itself as a defensive play in late 2010 and heading into 2011.
 
Here’s what we know – growth in China is going to slow. After posting +11.9% Y/Y 1Q GDP, calling for a sequential erosion from here in the midst of a sovereign debt scare in Europe which has eroded the purchasing power of China’s largest export market isn’t exactly a tough call to make. The government even said on Friday that their full year growth estimate is 9.1%, explicitly implying a deceleration from 1Q. With the Shanghai Composite down 27.3% YTD as of today, prices confirm this. Using marked-to-market prices as leading indicators, however, Chinese equity prices have been telling us to expect slowing growth all year long.
 
At a price, China’s growth will become attractive on the long side irrespective of slowing growth in the U.S. and in Europe because their government is proactively preparing them to weather the storm by fueling domestic consumption. Over the past several weeks, China has taken a number of steps to increase their citizenry’s purchasing power – none arriving with more fanfare than the de-pegging of the yuan.
 
Since relaxing the fixed exchange rate on June 19th, the yuan has gain roughly 0.7% vs. the dollar and today’s 12-month non-deliverable forwards suggest an appreciation bet of roughly 1.5% in a year’s time. Despite the prospects of a stronger currency, the People’s Bank of China has ruled out any sudden large appreciations and still mandates that the currency only fluctuates 0.5% from the daily official rate. As a result, we caution that the yuan’s appreciation may not likely be the silver bullet China is looking for to stimulate domestic consumption, which has fallen from 46.4% of GDP in 2000 to 35.6% of GDP in 2009. As a percentage of GDP, personal income has had an even more dramatic decline: 53% in 1999 down to just 39.7% in 2009.
 
There have, however, been a number of positive developments regarding wage growth and government stimulus that will help move China forward towards a more consumption-oriented economy, rather than one that has been fueled by manufacturing and exports in recent years. Those developments are listed below and are by no means limited to this summary:

  • In April, Shanghai raised minimum wages 17% to 1,120 yuan per month. Guangdong (China’s largest export base) took up minimum wages in five locales within the province by an average of 21%.
  • On June 3rd, China extended its home appliance trade-in program until 2011. Sales of such appliances have reached 54B yuan and 5B yuan of subsidies were handed out since the start of the program.
  • On June 8th, a survey of Chinese employer’s hiring  plans reached a six-year high.
  • On June 11th, the IMF reported that the surplus of rural workers for labor-intensive work has fallen to about 25 million from roughly 120 million in 2007, which is bullish for wages in that sector (less supply). Conversely, research from China International Capital Corp. that suggests that 31 million Chinese will return to the labor market in 2011 after the completion of projects resulting from the government’s 4T yuan stimulus package. Net-net: supply of labor-intensive workers is still shrinking but perhaps at a slower rate, which is net bullish for wages.
  • On July 1st, Bejing increased monthly minimum wages by 20% to 960 yuan. In a similar fashion, Henan (China’s most populous province) raised its minimum wage by 33% to 600 yuan per month.

All told, more than 20 provinces and municipalities plan to increase minimum wages this year, according to the Ministry of Human Resources and Social Security. As a result, we should begin to see evidence of accelerating domestic consumption in the coming months. Furthermore, companies that are positioned to service the Chinese local economy (i.e. domestic retailers and savings deposit institutions) will see an added kick from this wave of wage inflation.
 
Currently, both the Shanghai Composite and Hang Seng are broken from a TREND perspective and last Tuesday’s 4.3% and 2.3% respective declines in both indices on the heels of a downwardly revised Conference Board Leading Index suggest that consensus still has some ground to cover on the slowing Chinese growth story. When consensus finally catches up, our Hedgeyes will be looking to buy their capitulation on sale.

 

 

MACRO: CHINA: THE GREAT SHIFT FORWARD - chart 1

 


Darius Dale
Analyst


MACRO: 2Q10 THEME: APRIL FLOWERS/MAY SHOWERS

This insight was originally published on May 4, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS in real-time.

 

 

 

MACRO: 2Q10 THEME - APRIL FLOWERS/MAY SHOWERS - MACRO SUSTAINABILITY?

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"The central principal of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merits, the investment is inevitably too dear and therefore unattractive.”
  ~Warren Buffet
 
Our 2Q10 theme, APRIL FLOWERS/MAY SHOWERS, suggested that the S&P 500 could sees a 4-7% correction in 2Q10.  We did not think it would happen in a matter of days.  While Buffet took some heat over the weekend for talking up his book, he is still the ORACLE OF OMAHA.  As he suggests in the quote above, the persuasive bullishness of late is just to “dear” to the masses.   
 
Last week, the government reported that real GDP increased 3.2% annualized in the first quarter.  This print was slightly below consensus +3.3% and vs. prior +5.6%.  Personal consumption expenditures (PCE) were +3.6%; higher than consensus +3.3% and prior +1.6%.  PCE accounted for 2.5% of the reported gain and business investment accounted for 1.6% points, of which 1.5% was due to a continuing relative buildup in inventories.  The big concern with the Q1 GDP report is whether or not the trends in PCE are SUSTAINABLE.
 
As I wrote the other day, SUSTAINABLE growth in PCE requires continued growth in real disposable income.  Without growth in income consumption can only be borrowed from the future quarters through borrowing more and/or the consumer spending his/her savings.  In the current environment, neither of those sources is real or sustainable.  In 1Q10, the quarter-to-quarter trend in real disposable income was contracting.  Real consumer credit, which has been reported only for January and February, was also contracting in the first-quarter versus the fourth-quarter.  
 
If the U.S. banking system were able to function normally, it would be lending more money, not contributing to a slow downward spiral in consumer and business credit outstanding.  Needless to say, these trends show no basis for SUSTAINABLE growth in the economy or PCE.
 
The US market bulls expect the market to continue to move higher on stronger earnings.  A Bloomberg survey suggests expectations for total profit from Standard & Poor’s 500 Index companies of $88 to $90 a share this year, and close to $100 a share in 2011.
 
It seems unlikely that these strikingly bullish estimates incorporate proactive slowing of the free money trail in a number of regions around the world in 2H10 and 2011.  With the Chinese market down 13% year-to-date, worries about a slowdown in China are increasing.  The Government is proactively saying things are too hot.  The number of countries that are “proactively slowing” growth is increasing every week; it’s becoming the norm not the exception (Australia joined in last night and India has a real inflation problem to address).  Just to name a few….
 
With this trend solidly in place, and critical component to overall earnings growth, we would argue that over the next four quarters the risk/reward points to the downside in emerging economies; thereby placing much more pressure on the developed world recovery to meet the S&P 500 earnings growth numbers.  Such a recovery is not a likely event!
 
We have been very vocal about the mounting sovereign solvency issues in Europe.  In many ways, the European crisis echoes the way the U.S. banking crisis brought the global banking system to its knees.  At that time, the global monetary policy-makers allocated trillions to prevent systemic collapse.  In total, the sovereign debt crisis in Europe could also threaten systemic collapse.  As with the U.S. banking crisis, I expect that everything possible will be done to prevent that type of massive melt down.
 
As a result, U.S. fiscal stability is the key to keeping global systemic risk in check.  Unfortunately, our balance sheet issues are very much the same as those facing the PIIGS.
 
April Flowers/May Showers
 
 
Howard Penney
Managing Director


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