Amidst a Red-Hot Japanese Equity Market, Are Banks a Short?

Abenomics has taken the investment world by storm. While Abenomics, and particularly BoJ chief Kuroda’s conventional central bank policy “blasphemy” makes investors nervous, this hasn’t hindered Japanese equity performance from trashing essentially any other equity market or asset class year-to-date.

Hat Tip: Business Insider

Bank Stocks are Noticeable Laggards

Japan’s three megabanks, however, have significantly lagged this surge, as investors first piled into reflation stories like real estate (including “hidden” real estate assets) and later the big exporters as the substantial weaker yen windfalls began showing up in earnings and company forecasts.

Source: Yahoo.co.jp

In USD terms, Mitsubishi UFJ FG’s ADR is performing somewhere between best-of-class JP Morgan (JPM) and 2008 financial crisis basket case Citigroup (C). 

Source: StockCharts.com

Japan’s Three Megabanks are Cheap, But.. 

Japan’s major banks largely dodged the US housing debacle, and have relatively strong balance sheets while profits in FY2012 were apparently good. Yet they are still selling below book value and well below market P/E multiples. Does this mean Japan bank stocks are due to catch up to soaring market benchmarks? 

In FY2012, the big three logged strong results due to brisk earnings from overseas operations that, together with income from market products, more than offset slumping domestic lending services. But despite relatively strong balance sheet health, they have yet to improve their profitability. Interest margins last fiscal year were unexpectedly low because they chose to play it safe by extending loans to Japanese companies and blue-chip local firms. They provided virtually no funds to local venture businesses, where the profit margins are high. 

The megabanks also remained weak in commissions-based businesses that help stabilize earnings without draining capital, while this is changing because of Abenomics. Sales of equity and real estate investment trusts risen since Abe’s government took power in December have soared. For fiscal 2012, combined sales reached JPY5.4 trillion, up 20% YoY. Three out of five lender groups, including Mizuho Financial Group Inc., posted record-high annual group sales of investment trusts. 

To offset a domestic lending margin squeeze that is being exacerbated by massive BoJ quantitative easing, Japan’s banking majors are for example hiring Spanish-speaking bankers to win new business in Latin America and giving loans to junk-grade borrowers in the United States to offset meager returns at home. They are also looking to increase lending denominated in local currencies, instead of the usual dollar-dominated loans. 

Kuroda’s No Holds Barred Monetary Policy is Squeezing Bank Profits 

While there are signs of recovery in loan demand from domestic companies, but the profits earned by the banks on their loan portfolios will fall if interest rates keep falling. 

The three megabanks led by Sumitomo Mitsui Financial Group (8316) forecast earnings will decline 27% to JPY580 billion this year as monetary easing makes loans less profitable even as borrowing picks up amid an economic recovery. Mitsubishi UFJ Financial Group (8306)’s if forecasting an 11% decline to JPY760 billion yen and Mizuho Financial Group (8411)’s also expects an 11% drop to 500 billion yen. 

Black Swan Risk Discount 

Further, there is one big black swan risk that investors cannot ignore. The massive volatility in the JGB market could punch a big hole in still substantial bank holdings of government debt. Virtually all of Japan’s banks have been earning healthy profits by purchasing JGBs, but these profits are now at risk. 

Banks’ large and increasing holdings of JGBs are a key source of vulnerability. With outstanding JGB holdings in Japanese banks (excluding Japan Post Bank) more than 30% commercial bank assets in Japan, the IMF warned in August 2012 that “JGB market exposures represent one of the central macro-financial risk factors”, where a 100bps (1% point) back-up in bond yields means 10% and 20% mark-to-market losses for regional and major banks respectively, which the current JGB move is rapidly approaching. In other words, a 100bps interest rate shock in the JGB yield curve would cause a JPY10 trillion loss for Japan’s banks, according to JP Morgan estimates. Regional and Shinkin banks are smaller than major banks, but they together hold a large JPY50 trillion of JGBs versus JPY120tr of JGB holdings for major banks. If Kuroda does deliver on his 2% inflation target, Japan’s banks stand to lose some JPY20 trillion on their government bond holdings as JGB yields rise to the sustainable inflation rate. 

Hat Tip: Zero Hedge

Further, in terms of sensitivity to JGB interest rate shocks, Japanese banks appear to be more vulnerable than they were in 2003, when a sudden reversal in 10yr JGB yields from 0.5% in June 2003 to 1.6% was caused by banks scrambling to control their value at risk (VAR). Then, the bond selloff was aided and abetted by a rise in Japanese stocks, as investors piled out of one market and into the other, similar to conditions today. Now, a 100bps adverse move in JGBs would cause a loss of JPY3 trillion loss for major banks, but a JPY5 trillion loss for regional banks and JPY2 trillion loss for Shinkin banks, or a hit to Tier 1 capital of some 35% for regional and shikin banks versus only 10% for the major banks. The hit this time will be larger than in 2003, where the expected theoretical loss from a 100bps rate shock was around JPY2 trillion for major banks, JPY3 trillion for regional banks and JPY1 trillion for Shinkin banks, or significantly lower than estimated currently.

As the shorter-term chart below shows, the direction of JGB yields has clearly reversed. But does this mean a) the BoJ has already lost control of bond yields BEFORE they really get started in their shock and awe easing campaign, b) this is the beginning of the long-awaited (by the Japan bears), JGB crash?

Source: BarChart.com

The long-term chart of 10yr and 5yr JGB yields puts this short-term move into perspective. In our humble opinion, people are making a bit of a mountain out of a mole hill. Firstly, the high volatility and sharp short-term backup in yields comes after an historical drop-off in bond yields that represented the final leg of a two-decade implosion of JGB yields from over 8%.

During this period, bond yields have periodically punched lower, followed by a sharp “dead cat bounce” as overly bullish bond trading positions were covered. Similar snap-backs can be seen in 1994, 1999 and 2003. 1994/1995 was the first dramatic break-up in JPY/USD to below JPY80/USD, The 1999 bounce came amidst the second round of bank capital injections and negative growth in 1998, prompting the BoJ to introduce its ZIRP (zero interest rate policy) for the first time. While a VAR “shock” was the ostensible reason for the sharp reversal in JGB yields in 2003, the bounce came as investors realized Japan’s banking and bad debt crisis was ending and stock prices began to soar. But for all of the excitement about Junichiro Koizumi’s bank clean-up and “no growth without reforms” recovery (i.e., talk of “Japan is back”), bond yields never breached 2% as the basic deflationary factors were never completely eradicated. 

In light of this 20-year history–including the 2003 VAR shock–the recent move in yields from a longer-term perspective is but a tempest in a tea pot, bank balance sheet sensitivity notwithstanding. 

Thus while bank stocks are lagging in (rightly) allowing for black swan tail risk in their substantial JGB holdings, JGB yields themselves are far from spiraling out of the BoJ’s control. 

Source: JPM, Hat Tip: FT Alphaville

Bottom line, we expect this “black swan” discount as well as the squeeze on bank loan spreads from an aggressive BoJ to continue hobbling a more significant relative move in Japanese bank stocks. On the other hand, the strong “tide lifts all boats” momentum of underweight foreign pensions and renewedly bullish domestic and foreign fund investors should also keep the bank stocks bouyant if not outperforming the Nikkei 225. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

BOJ’s Kuroda: Boldly Going Where No BoJ Chief has Gone Before

The BoJ’s “Shock and Awe” Unconventional Monetary Policy Experiment

Despite new LDP prime minister Shinzo Abe and his “Abenomics” road show creating a high expectations hurdle for his newly installed BoJ team, new BoJ governor Kuroda has come out swinging with “shock and awe” monetary policy that sent already rock-bottom 10yr JGB yields plunging from 55bps to 34bps, and the Nikkei 225 surging 6.75% to its highest level since September 2008. Kuroda’s BoJ has gone boldly where no BoJ governor has gone before (the infamous Koreikyo Takahashi as finance minister in the 1930s was able to browbeat the BoJ at the time to underwrite his reflation scheme), after decades of half-hearted BoJ tinkering to fend off political pressure. This is the ultimate test of monetary activism that will go down in history, regardless if ultimately a success or a disaster. The BoJ wants to “drastically change the expectations of markets and economic entities”, and jerk Japan’s economy out of a deflation rut its been for nearly 15 years.

To achieve its 2% inflation in 2 years target, the BoJ will

• Shift to monetary base control from uncollateralized overnight rates in growing the monetary baseJPY60~JPY70billion per year. 
• Increase JGB purchases along the curve to 40-year notes by JPY50 trillion per year, to JPY270 trillion by 2014. 
• Increase ETF and J-REIT purchases, but abandon the prior asset purchasing program
• Suspend the bank note principle, where new money created is limited to outstanding notes and coins in circulation.

The BoJ is now committed to doubling Japan’s monetary base, its holdings of JGBs all along the curve to 40yr notes, and ETFs, in two years. The average remaining maturity of JGB purchases will more than double to about seven years. The comparative scale of this move is monetizing at a rate of around 75% of the Fed in an economy that is one-third the size of the U.S., in essentially printing 15% of its GDP each year in new money. The monetary base will rocket from 29% to 56% of GDP by 2014. The pace of bond purchases will rise to JPY7.5 trillion yen a month.

Source: Bank of Japan

Uber-Bears More Strongly Convinced this Will End Badly

Japan uber-bear Kyle Bass of course is warning this “Giant Experiment,” will cause Japan to implode under the weight of their own debt much faster than previously. But even he is exorting, “if you’re Japanese, spend! …. (if don’t take your money out of the country), “borrow in JPY and invest in productive assets,” which of course is the whole object of the great Abenomics experiment exercise. George Soros chimed in with, “What Japan is doing right now is actually quite dangerous because they are doing it after 25 years of just simply accumulating deficits and not getting the economy growing,” …”So if what they’re doing gets something started, they might not be able to stop it. If the yen starts to fall, which it has done, then people in Japan think it’s liable to continue, and may become like an avalanche”. 

The IMF in its own bureaucrat speak has also warned of this risk, (despite being readily able to fund its debt to date) “the market’s capacity to absorb new debt is likely to diminish as the population ages and risk appetite recovers. Without a significant policy adjustment, the stock of gross public debt could exceed household financial assets in around 10 years, at which point domestic financing may become more difficult. Over the near term, domestic and external risks include, a) a decline in the supply of funds for financing JGBs as private spending picks up, b) an increase in market volatility could also push banks to shorten the maturity of their JGB holdings or reduce their JGB exposures to limit losses. As for external risks, the high correlation between yields on JGBs and other sovereign debts pose the risk that a sudden rise in global risk premia could spillover and affect the JGB market. In sum, a sustained rise in yields could dramatically worsen public debt dynamics, and threaten financial stability.

Source: BarChart

Source of Domestic JGB Demand: Huge Financial Surpluses in the Corporate Sector

The flip side of ballooning government debt has been an equally large financial surplus in the private sector as companies retrench and hoard cash. To us, the first sign of serious trouble in Japan’s JGB market could be companies drawing down excess funds to fund increased business activity and capital expenditures, thus forcing the financial institutions at where these excess funds are parked to liquidate JGBs. 

Historically, this has had only modest impact on pushing up yields, but Japan is now much more leveraged with government debt. 

Short JPY, Long Japan Stocks Still Works

The biggest money maker for hedge funds and speculators since November of last year has been the short yen/long Japan stocks trade, which has produced a combined 60%-plus gain (+40% for the Nikkei 225, -20% for FXY) but the hedge funds will tell you there is much more to go with this trade, as the BoJ is just getting started. One reason is that the domestic institutions have been selling Japanese equities, while Japanese corporates have been buying JPY.

Source: Yahoo.com

 MMT’ers: Countries That Hold Debt in their Own Currency Can’t Go Bankrupt

MMT’ers (Modern Monetary Theorists) like Cullen Roche, even though they may not like the Japan trade, still insist the whole insolvency scare thing is senseless, because even Austrian economists can tell you that a nation with a printing press and debt denominated in its own currency isn’t going to go bankrupt. 

Black Swans (Tail Risks)

As we have said many times, Abenomics and BoJ shock and awe entail potentially big risks for Japan, while we believe they have no choice but to try anything to revive Japan’s economy and turn the good ship Japan away from its slowly evolving debt spiral. The tail risks include,

1) Kyle Bass is right and the reflation effort merely accelerates the day of financial crisis reckoning. 

 Japan experiences a fiscal crisis and JPY collapses, possibly triggering a new global financial 

 crisis.

2) The BoJ huffs and puffs, but nothing happens. While Paul Samuelson infamously said, “inflation is always and everywhere a monetary phenomenon,” others insist that just printing money has never created inflation, unless there is excess money. The evidence is that the BoJ has already expanded its balance sheet to roughly 33% of GDP, but has had no appreciable impact on inflation. The Swiss National Bank has a balance sheet worth some 85% of GDP, but no positive inflation since 2011. After nearly a quarter century of poor economic performance and a deeply embedded deflation mentality, the real question should be how the banks, who actually credit credit/money supply, react. If they merely let the money sit in BoJ reserve balances (hoard it), there is no economic impact and the BoJ is still in a liquidity trap. This is what happened between March 2001 and March 2006, when the BoJ first implemented and invented “QE” (quantitative easing). Try as they might, academics have found no significant impact except for a slight downward bias in long JGB yields. Then, the Japanese banks were ostensibly hoarding cash to shore up decimated balance sheets. Now, Japanese bank balance sheets are relatively healthy. Surveys show consumers do have positive inflation expectations, but for the wrong reasons, i.e., the things they have to buy are rising in price (electricity rates, etc.), while the discretionary items they are deferring purchases on are falling in price. Seeing no solid evidence of reflation, foreign investors now piling into Japanese equities head for the exits. 

3) Japanese banks merely take the BoJ money and lend it overseas. If, as was pointed out via FT Alphaville Japanese banks take this money and lend it overseas, the effect would work to weaken JPY but the monetary stimulus would be felt overseas, not in Japan. Since the BoJ would still be buying truckloads of JGBs, however, the downward pressure on long rates would remain, but since rates are already at rock-bottom levels, an incremental change in and of itself would not move the domestic fund demand needle. Seeing no solid evidence of reflation, foreign investors now piling into Japanese equities head for the exits. 

4) Increased JGB volatility triggers a VaR shock. Some like Zero Hedge have made a big deal of the post announcement market snap-back in JGB yields, but JGB yields had already collapsed from 1.77% in 2009 to a new historical low. Given the very active trading around such a big event that compelled the CME to raise margin requirements to avoid over-leveraged speculation, this could merely be clearing, re-positioning of speculative positions. Since the global financial crisis, JGB futures have gained some 11%, which combined with a massive gain in JPY versus USD of some 47%, has produced a very decent 58% return. The great capital gains in JGBs to date, plus high expectations for aggressive BoJ action, were a big reason why risk-adverse domestic institutions were actually selling Japanese equities and piling into bonds ahead of their March 2013 fiscal year end. As the IMF has warned, however, too much JGB volatility could trigger domestic JGB selloffs like the “VaR shock” in 2003, where market volatility triggered risk hedging among Japan’s banks that tripled JGB yields from 0.45% to 1.6% in just three months. Japanese banks however have already been stress-testing their substantial bond portfolios. This would produce only a short-term, sharp back-up in JGB yields. 

Focus Remains on Domestic Reflation Plays

While the weak JPY is a windfall for Japanese exporters, global demand remains spotty at best, a good deal of exports are actually JPY denominated, and Japanese exporters have been able to significantly hedge their JPY/USD exposure.

Over the past three months, the Topix has gained nearly 17%, lead by nearly 40% surges in rubber products, real estate, warehousing/logistics and land transportation, which excluding rubber products are about as domestic demand dependent as it gets. The high beta broker/dealers and the banks are also up well over 20%, but the gains have recently mitigated vis-a-vis the late-comers.

Source: Tokyo Stock Exhchange

In terms of Nikkei 225 constituents, the stock of electric power zombie TEPCO has surged to lead the pack, followed by 2nd tier car company Mazda, two 2nd tier real estate companies, Sony?, more real estate companies, and now some big department store chains. For old Japan hands, its beginning to look like the good old “bubble” days, when latent asset plays were the force du jour. The department store stocks have perked up on evidence that surging stock prices are stimulating sales of luxury goods. 

Before this rally is over, essentially every constituent in the Nikkei 225 will get its turn to dance as index buying lifts essentially all boats. 

Source: Tokyo Stock Exchange

As of the final week of March (the end of the fiscal year), domestic financial institutions continued to heavily dump Japanese stocks, but the Nikkei 225 has soared despite this on massive foreign net buying. Thus Japanese equity prices remain and should continue to be driven by foreign buying or lack thereof.  From this perspective, who cares what domestic institutions think?

US-based investors caught up in the sudden storm of activity in Japanese equities can of course just go out and buy the MSCI Japan ETF (EWJ) or buy the few ADRs tradeable in the U.S. This group had previously been lagging the Topix by a significant margin, but generally over time track the Topix fairly closely. 

Source: Nikkei Astra, Japan Investor

The following table shows which Japan ADRs are available and what their vital stats look like. The vital stats of course do not reflect the growth, margin, etc. improvements now being discounted into virtually all Japanese stocks. 

Source: Nikkei Astra, Japan Investor

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Should We Continue to Ignore Warnings of Dire Consequences of Massive Government Debt and Swollen Central Bank Balance Sheets?

Eurocrisis: Its Baack!

While it never really went away, Italian voters put the Eurozone’s problems on the front pages again after anti-austerity parties appeared on track to win a majority of seats in the Italian parliament, vastly complicating efforts to forge a government able to carry through EU-imposed reforms. This plus a looming US sequestration forced investors to take another look at risk as US stocks attempted to reach pre-crisis highs. The sharp surge in the S&P 500 VIX volatility index shows just how much of a negative surprise the Italian elections were. With one Mario (Monti) gone, investors are beginning to wonder if the other Monti (Draghi) can pull another rabbit from the ECB’s hat to quell Eurozone concerns. The Italian elections sent EUR plunging against USD and JPY, triggering profit-taking in US stocks, and threatening to derail the weak JPY-driven rally in Japan stocks.

 

Investors may now take a step back to see just how much the Italian elections hurt the bailing wire and duck tape countermeasures that had so far kept a lid on Euro-crisis, and just how much economic pain the US sequestration political boondoggle in the US causes, and just how serious the Fed is taking concerns about the future risk of normalizing its over-swollen balance sheet. 

As we pointed out in market sentiment indicators flashing yellow/red, sentiment indicators were already signalling that US stocks were due for a correction, with increasingly nervous investors waiting for an excuse to take profits. For the time being, however, bulled-up investors are mainly viewing the new developments as a somewhat welcome a “speed bump” pause in the stock rally, i.e., a chance for those who missed most of the move since last November to participate in the rally. How long this “buy on weakness” depends on how resilient stocks are over the next few weeks.

 

The knee-jerk reaction so far has been classic risk-off, i.e., stocks fell, USD rose, EUR fell and sell-off in JPY temporarily reversed as US bond yields up-ticked and even Gold got a bid. As the short JPY technically was also over-extended, an unwinding of speculator short JPY positions could see JPY test JPY90/USD resistance, thereby stunting the Nikkei 225’s sharp rebound, at least for the time being. 

Source: Yahoo.com

Warnings of Dire Consequences of Massive Government Debt and Swollen Central Bank Balance Sheets

Lurking in the background is a big picture concern. The West faced a 1931 moment in late 2008. The cost of avoiding a 1931 moment has been soaring government debt and economies that are too weak to support growing entitlement costs, which in the U.S. are expected to grow to $700 billion over the next four years, according to hedge fund legend Stanley Druckenmiller. While Druckenmiller believes there is still time to tackle the U.S. debt issue, he warns that if it is not dealt with in the next four or five years, “we’re going to wake up, interest rates are going to explode and the next generation is going to have a tough time.” 

The irony is that the U.S. is the least dirty shirt in the closet. Even former EU commissioner Frits Bolkestein is among a crowd of investors convinced that a break-up of the sovereign debt-challenged Euro was inevitable, and speculators mercilessly pounded Greece, Spain, Italy and other southern European bonds until Mario Draghi put the hounds at bay by promising to “do whatever it takes” to save the Euro. Japan has long been on the short list of countries expected to see fiscal crisis for several years now, ostensibly as they have already crossed the debt spiral rubicon, according to absolutely convinced hedge fund managers like Kyle Bass. 

Scare Stories are Currently Not Affecting How Investors are Making Asset Allocation Decisions 

But even Druckenmiller admits the debt problem doesn’t change how investors currently make asset-allocation decisions. “(Because) the Fed printing $85 billion a month, this is not an immediate concern…but this can’t go on forever.” That said, most professional investors are having trouble assimilating such imminently reasonable scenarios with soaring stock markets, the performance in which they ostensibly get paid. Consistently profitable hedge fund maven Ray Dalio says 2013 is likely to be a transition year, where large amounts of cash—ostensibly previously parked in safe havens—will move to stock and all sorts of stuff – goods, services, and financial assets. 

At the same time, these same investors have little real confidence in the economic recovery upon which rising financial assets are supposedly predictated, and have wavered between “risk on” and “risk off” on several occasions since the March 2009 post crisis secular low in stock prices. On the past two occasions, the prospect of central banks backing away from extraordinary monetary policy has been enough to send them scurrying back into risk off mode, only to venture out again as central banks again re-assure that they are on the case. 

Nevertheless, supported by Fed assurances of “unlimited” QE, ECB assurances that they will do whatever it takes, and the prospect of the BoJ joining the full-scale balance sheet deployment party, US stock prices are near pre-2008 crisis highs hit in 2007, and growing investor complacency saw the S&P 500 VIX volatility (fear) index recently hitting its lowest point since May 2007. 

But Complacency Makes Some People Nervous… 

But investor complacency itself is cause enough to make some investors worried. After the S&P 500 VIX volatility index hit its lowest point since May 2007, investors were temporarily spooked last week by indications in the FOMC minutes that “many participants…expressed some concerns about potential costs and risks from further asset purchases.” The balance sheet risk issue first surfaced in the December FOMC, but was papered over by the launch of a $45 billion program to buy longer-dated TBs, and the continuance in the January meeting of $85 billion of purchases until the labor market improved “substantially” in the context of price stability around the 2% level. 

…And FOMC Fretting about Fed Balance Sheet Risk is Downright Disturbing 

Thus while hard money proponents have long warned of “wanton” and “dangerous” money printing, even FOMC members are beginning to fret about the growing risk its swollen balance sheet poses in the inevitable process of normalizing the size and composition of its balance sheet. 

In other words, the really tricky part for stock markets is when central banks are confident enough in the economic recovery, ostensibly an “all clear” sign to investors worried about the sustainability of the recovery,  to attempt normalizing their balance sheets. 

Nearly everyone recognizes that the first round of global QE prevented/forestalled financial collapse. But successive rounds of QE have demonstrably diminishing returns versus growing risks of swollen central bank balance sheets, a tidbit that financial markets are so far blithely ignoring. Specifically, the three key issues underlying the debate about burgeoning government debt swollen central bank balance sheet are: 

a) How long the fiscal path of governments can be sustained under current policies. 

b) If governments cannot or will not service this debt, central banks may be ultimately forced to choose between inflation spiral-inducing debt monetization, or in idely standing by as the government defaults. 

c) Central bank balance sheets are currently extremely large by historical standards and still growing, and the inevitable process of normalizing the size and composition of the balance sheet poses significant uncertainties and challenges for monetary policymakers. 

The 90% Solution and Debt Sustainability 

Even Paul Krugman cannot deny that excessive government debt has consequences. Reinhart and Rogoff (2012) documented that levels of sovereign debt above 90% of GDP in advanced countries lead to a substantial decline in economic growth, while Cecchetti, Mohanty and Zampolli (2011) found a threshold of around 85% for the debt-to-GDP ratio at which sovereign debt retards growth. Such data were the inspiration for “new normal” scenarios, which posited that potential economic growth would semi-permanently shift downward following the 2008 crisis as economies delivered. 

Furthermore, debt default is a clear and present danger. Greenlaw, Hamilton, Hooper and Mishkin (2013) as well as other studies observe that, since the more government debt is held by foreigners, the greater the political incentives to default on that debt, and therefore the greater perceived risk of this debt, which raises borrowing costs. Further, higher overall foreign debt—both public and private—also makes it more difficult for a country to continue making interest payments on sovereign debt, thus increasing perceived risk and the interest rate demanded for this risk. Current-account deficits are also highly significant; i.e., a country that increases its current-account deficit to GDP would be expected to face higher interest rates demanded for holding sovereign debt. 

The bottom line of such research is that, the larger the debt to GDP, the harder it is for a country to “grow” out of its debt, while high levels of sovereign debt held by foreigners in combination with high and consistent current account deficits greatly increases the risk of triggering a fiscal and/or currency crisis. The “great divide” in economic thinking is what should we be doing about it now. The Keynesians say continue throwing fiscal spending at the problem, and worry about the debt after the economy recovers. The monetarists say keep pushing on extraordinary monetary policy. The hard money traditionalists say both policies are a prescription for a renewed, deeper crisis, and that we only have a few years to act to reduce debt. 

Investors, whose careers have been based on the maxim that “price is truth”, say this heavy intervention has already seriously skewed the market pricing mechanism, It is also gut-level clear there are limits to how much fiscal spending governments and how much balance sheet deployment central banks can continue in the face of massive and growing debt. Problem is, no one knows exactly where these limits are. The only certainty is the extreme aversion to finding out; on the part of governments, central bankers and investors. Ostensibly, central banks could continue printing money and expanding their balance sheets indefinitely, but there is a good reason for the historically strong adversion to full-scale debt monetization by central banks, and that is again fiat currency debasement and runaway inflation. 

How Damaging the Risk of Fed Balance Sheet Losses? 

A recent paper by Greenlaw, Hamilton, Hooper and Mishkin (2013) stimulated debate in the Federal Reserve about the risk of losses on asset sales and low remittances to the Treasury, and how this could lead the Federal Reserve to delay balance sheet normalization and fail to remove monetary accommodation for too long, exacerbating inflationary pressures. 

Monetarists argue that losses on the Fed balance sheet are an accounting irrelevancy. 

While the value of bond holdings in swollen (USD 3 trillion) bond holdings in central bank balance sheets would get crushed along with bond-heavy financial institution portfolios, ostensibly reversing current unrealized gains of some USD200 billion to an unrealized loss of USD300 billion. The Fed’s contributions to the Treasury, which have reduced the annual deficit by some 10% over the past few years, would fall to zero. Monetarists claim the magnitude of such a change (USD 80 billion) ostensibly would not be that big a deal. An accounting “asset” could simply be created equal to the annual loss, in the form of a future claim on remittances to Treasury. 

Thus far, the Federal Reserve’s asset purchases have actually increased its remittances to the Treasury, at an annual level of about $80 billion from 2010 to 2012. These remittances are any rate are likely to approach zero as interest rates rise and the Fed balance sheet normalizes. But Bernanke and other central bankers are not monetarists, and what matters is what the central bankers think. 

In recent public remarks, Governor Jerome H. Powell quotes historical precedent in playing down these risks. Federal debt as a percentage of gross domestic product (GDP) increased significantly on two prior occasions in modern history–during the Great Depression-World War II era and, to a smaller extent, the two decades ending in the mid-1990s. In each case, fiscal policy responded by running sustained primary surpluses and reducing debt to levels below 40% of GDP. Thus the party line is, “the foundation of U.S. debt policy is the promise of safety for bondholders backed by primary surpluses only in response to a high debt-GDP ratio,” While this is the principal reason why the federal debt of the United States still has the market’s trust, no one wants to contemplate the consequences of the US Treasury or the Fed losing the market’s trust. 

Growing Probability of a 1994 Bond Scenario? 

When Druckenmiller says, “we’re going to wake up, interest rates are going to explode and the next generation is going to have a tough time,” he is talking about a sharp backup in bond yields, aka the so-called 1994 scenario, or worse. Ostensibly, any whiff of inflation would cause a bond market rout, leaving not only escalating losses on the Fed’s trillions of USD in bond holdings, but also wrecking havoc with private sector financial institution balance sheets. The longer the Fed keeps pumping away under QE, the greater the ostensible risk. Under Fed chairman Alan Greenspan, yields on 30yr treasuries jumped 240bps in a nine-month time span, that is seared into the memories of bond-holders. Talk of a “Great Rotation” from bonds into equities elicits the same painful memories. 

Great Rotation as a Process Rather than an Event 

Current market signals in the U.S., U.K. and Japan bond markets do not suggests that these countries are near the point of losing the market’s confidence, or that the bond market is “smelling” something afoot. More reasonable sounding scenarios come from people like veteran technical analyst Louise Yamada, who like Ray Dalio see a potential turning point comparable to 1946 when deflation was defeated and the last bear market in bonds began. Her point, which by the way we agree, is that the Great Rotation is likely to be a slow process, characterized by a “bottoming process in rates, or a topping process in price”. 

Alarmists Can’t Have it Both Ways 

The alarmist scenarios are internally inconsistent. On the one hand, they insist that the Fed’s (and other central bank) unconventional policies are not working to restore sustainable growth, and that central banks in desperation at the prospect of potential sovereign default, will be forced into full-scale debt monetization. On the other, they warn of a bond market rout, ostensibly on a recovery sufficient for these same central banks to attempt to “normalize” their balance sheets and a “great rotation” from bonds into equities, which is a big “risk on” trade if there ever was one. 

Worry About the U.K. First…. 

If investors closely examined the academic work on past periods of excess sovereign debt, they would be more worried about a fiscal crisis/currency crash in the U.K. rather than Japan. The punch line of said research is, to repeat, that debt-to-GDP over 90% chokes off economic growth, which certainly happened in Japan, but is now happening in the UK, Euroland and the US. The larger the debt to GDP, the harder it is for a country to “grow” out of its debt, while all-out austerity only ensures a more rapid deterioration in debt relative to the economy, and all the more central bank money printing to stave off the ravaging effects of this austerity—true for both Euroland, the UK and the US. 

Further, high levels of sovereign debt held by foreigners in combination with high and consistent current account deficits greatly increases the risk of triggering a fiscal and/or currency crisis. This factor is not relative to the case of Japan, where foreign ownership of debt is minimal and the current account deficit is a very recent phenomenon. 

JPY and GBP are currently the favorite currencies to short among currency traders. While the Japanese government has gained more notoriety for reflationary “Abenomics” and their wish to see JPY much cheaper, the UK authorities are if anything just as keen to see GBP much cheaper. While not as obvious about it, UK fiscal and monetary authorities are just as keen to see a weaker pound sterling. Ben Broadbent, yet another former Goldman Sachs banker and BoE Monetary Policy Committee member, stated that a weak pound will be necessary for some time to rebalance the economy towards exports. FT economist Martin Wolff observed, “sterling is falling, Hurray!”.  BoE governor Mervyn King proposed 25 billion pounds of further asset purchases, but was voted down. Not to be deterred, in February he said the U.K.’s recovery may require a weaker pound, right after a G7 statement to “not engage in unilateral intervention” on currencies. Governor King has also stated that countries had the right to pursue stimulus, regardless of the exchange rate consequences, while brushing off the potential negative side effects on inflation. In fact, the only difference between Japan’s and the UK’s efforts to depreciate their currencies is that the UK is more adept at sending the signal.

In terms of actual central bank action, the UK since 2010 has been expanding its balance sheet at a much more rapid rate than both the Fed, the ECB and certainly the BoJ.

Source: Japan Investor, respective central banks

Big Market Reaction to UKDowngrade by Moody’s

While the USD and JPY barely twitched when the respective countries’ sovereign debts were downgraded by rating agencies, the negative reaction in GBP was very noticeable, and GBP is now just as much a target of currency shorts as JPY is. While the dour economic mood in Tokyo has lifted dramatically with Abenomics, Moody’s sees continued weakness in the U.K.medium-term economic outlook extending into the second-half of this decade, given the drag on growth from the slow growth of the global economy, and from ongoing domestic public and private sector deleveraging, despite a committed austerity program. Indeed, the UKgovernment’s ability to deliver savings through austerity as planned is now in doubt. 

Then there is the UK’s total debt position. Including financial sector debt, UKdebt to GDP is over 900%, which makes Japan’s 600%-plus look relatively mild in comparison, and the US 300%-plus look rather small. Higher overall foreign debt—both public and private—also makes it more difficult for a country to continue making interest payments on sovereign debt, thus increasing perceived risk and the interest rate demanded for this risk. Like the US, UK national debt has increased sharply because of, a) the recession, b) an underlying structural deficit, and c) costs of a bailout of the banking sector.

So far, the UK’s current debt position is that it hasn’t led to a rise in government bond yields, because pound sterling looked absolutely safe compared to a very shaky Euro. The Centre for Policy Studies argues that the real national debt is actually more like 104% of GDP, including all the public sector pension liabilities such as pensions, private finance initiative contracts, and Northern Rock liabilities. The UK government has also added an extra £500bn of potential liabilities by offering to back mortgage securities, where in theory they could be liable for extra debts of up to £500bn.

High Foreign Ownership of Debt 

While the Bank of England owns nearly 26% of this debt, a big chunk, nearly 31% is owned by foreigners. But by far the biggest component of UK external debt is the banking sector. While the debt in the banking sector reflects the fact the UK economy is very open with an active financial sector and free movement of capital, the nationalization of some of the U.K.’s biggest financial institutions has shown that these debts in a pinch have a high probability of becoming government debts through nationalization. John Kingman, boss of UK Financial Investments, has stated, “No one can say a system is mended when the bulk of bank lending is dependent on huge government guarantees and where the government is the main shareholder.” BoE governor Mervyn King has also stated that ongoing Eurozone crisis is a “mess” that poses the “most serious and immediate” risk to the UKbanking system,

External debt to GDP alone is some 390% of GDP for the UK. and nearly four times that of Japanin absolute value.  Further, Japan is the world’s largest net international creditor and has been for nearly 20 years, while the U.K. is a net international debtor. While USD is still the prominent reserve currency for central banks (at some 62%), GBP and JPY are essentially the same (at 4%-plus), meaning there is no special inherent support for GBP from central banks like USD, EUR or German mark.  

Bank of England policymaker Adam Posen in 2010 outlined the very real risk to UK banks from the Euro crisis, as 60% of UK trade is with the Eurozone. The Bank of England has been pushing UK banks to shore up their capital positions, as the indirect exposures to Euro risk were “considerable”, and has been pushing UK banks to cut their exposure to this risk. Outgoing BoE governor Mervyn King went so far as to say the risk was still “severe” in late 2012 in a letter to Chancellor George Osborn, and pushed for further BoE asset purchases, but was voted down.

Thus while the short JPY trade has been front and center on traders’ radar since Abenomics hit the scene, GBP may have more downside for the foreseeable future as investors are reminded that the Euro crisis is far from over. 

Source: Yahoo.com

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Central Bank Ponzi Schemes? and the Madness of Crowds

Have Central Banker Priests of Money Gone to the Dark Side?

Jens Weidmann and the boys at the Bundesbank must think their priests of money central bank peers have gone to the dark side, preaching the blasphemy of ever-escalating debt monetization, now called “quantitative easing”. Germany’s Bundesbank has become essentially the only central bank in the world that has not embraced quantitative easing, continually warning at every opportunity that rampant and gratuitous debt monetization with fiat money has become addictive as a drug, and like any drug overdose, can be fatal. 

For the other central bankers, led by the Fed, this move to the dark side is a desperate response to fiscal paralysis, dangerously fragile financial systems and malaise-ridden economies; i.e., an aggressive bet that monetary policy remains a viable　force.These central bankers have ventured out on the limb of “unconventional” monetary policy to the nth degree in first ensuring the viability of the financial system, but increasingly to trying to revive economies. Naturally, they trot out research that shows QE is having a positive impact. Research by economists at the Fed last year estimated its first two rounds of asset purchases reduced unemployment by 1.5 percentage points and staved off deflation. The Bank of England estimated in July that 200 billion pounds ($311 billion) of bond buying between March 2009 and January 2010 raised UK GDP by as much as 2 percent and inflation by 1.5 percentage points.

As former Bank of England’s Danny Gabay told Bloomberg, everything in central banker eyes is a monetary problem…“What we have now is a monetary problem, so it’s time for a monetary solution,..It’s tough to make monetary policy effective, but it’s the only way.” “Old school” central bankers like Mervyn King (BoE), Jean-Claude Trichet (ECB) and Masaaki Shirakawa (BoJ) that question how much more monetary policy can achieve, and insisting monetary policy alone is no “panacea.” are being ignored.

No Currency Wars, Just a Symptom of Increasingly Desperate Stimulus Measures

The respected, conservative Economist magazine outright dismisses the current buzzword “currency wars” to describe what is happening, because weak currencies are merely a symptom of so far ineffective but increasingly desperate central bank efforts to revive economies stumbling under an ever-growing albatross of government debt. The recent round of GDP growth numbers underscores the continued fragility of the recovery, with Japan recording its third quarter of minus growth, and GDP being noticeably weak in Euroland, even Germany; underscoring the cold hard fact that all that QE is just about the only thing standing between investors and renewed recession. Ergo, investors remain particularly keyed on central banker machinations.

Source: Natixis, HatTip: Business Insider

Note: US GDP, Source: Brad DeLong

1 Trillion USD Coin Madness 

Everyone of the current generation has heard scare stories of the dangers of unmitigated fiat money printing since John Law invented the Mississippi scheme in the early 1700s. Over the past 100 years, Germany of course has seen first hand the devastating effects of hyperinflation or quintuple-digit inflation caused by unmitigated debt monetization during the Weimar Republic of the 1920s. What is really scary is US economists recently (half) seriously debating the merits of a USD 1 trillion platinum coin. In 1923, a 1 trillion mark Zeigenhain German Gutschein coupon was actually issued.

As with their predecessor French elite in the early 1700s, governments who, like France after Louis XIV’s death in 1715 found their finances “in a state of utmost disorder”, have fallen for central banker fiat money schemes such as John Law’s bank of Law scheme (later erected into the Royal Bank of France) to inundate their countries and indeed the world with paper fiat money.
To hard money proponents and the average person on the street, nations financing their own debt by simply printing more fiat money is essentially a Ponzi Scheme, the natural progression ostensibly of which is to issue ever-increasing amounts of new money is issued to pay off prior debt holders, the eventual result being an eventual collapse of the currency that devalues all wealth based on that currency, including all financial asset wealth.

All That Increased “Cash” On the Sidelines is the Flip-Side of Government Debt

On the surface, the pain from the 2008 financial crisis and Great Recession was rather mild compared to the 1930s, at least for the top 10%. The following chart from McKinsey Global Institute shows global financial assets have increased some $16 trillion from the 2007 peak, and have rebounded some $37 trillion from the trough in 2008. A closer look however shows that the increase has come from public debt securities ($16 trillion) and non-secured loans ($8 trillion), while stock market capitalization is still $13 trillion below its 2007 peak. In other words, all that debt being issued by governments has become someone’s financial asset, and that the surge in financial deficits in the public sector is behind the financial surpluses (excess financial assets) in the private sector. 

Hat Tip: Business Insider

Then Why Isn’t Gold Already At $3,000/Ounce?

As everyone knows, the US has been the most chronic currency debaser over the past 40 years, with the trade-weighted USD depreciating well over 30% since 1970. Despite this, USD has remained the primary currency for global trade and central bank reserves. Since USD is essentially a key component of the global money supply, any attempt by the Fed merely to reign in the growth of greenbacks negatively affects the global economy. In other words, if the Fed were to adopt a real “beggar thy neighbor” currency policy, it would be to reign in what hard money proponents consider rampant debt monetization. 

As the global financial meltdown morphed into a Eurozone meltdown, the US Fed was joined by the ECB, the BoE and now the BoJ in the race to debase, not as a policy per se, but as the result of desperate measures to revive their economies. Seeing nothing but endless QE on the horizon, hedge funds and large institutions were convinced that all this fiat money printing would push gold to $3,000 or even $5,000 per ounce, and gold for a period went almost parabolic.

Yet the smart money (like George Soros and Louis Moore) is now dumping its gold holdings and Bloomberg is saying that hedge funds have cut their bets on gold by 56% from highs in October as gold prices consolidate, ostensibly on increased confidence in the economic recovery. Technically, gold could drop below $1,600 as it has broken below key medium-term support levels, despite continued buying by the world’s central banks, ostensibly to keep something that is not rapidly debasing in their reserves.

Thus the rapid appreciation (i.e., parabolic move) in gold over the past five years vs the major currencies seems to be behind us, Given the proclivity of  central banks to flood the markets with newly printed script at the first signs of economic weakness. it is still very much in doubt that the secular bull market in gold versus all major fiat currencies since the early 70s is over. However, a break below 1,600 could signal a medium-term correction to as low as 1,100, especially if central banks begin backing off the QE accelerator and real bond yields began to back up.

It would probably take a serious setback in what progress has been made in the Eurozone debt crisis, or as some suggest, a crisis in Japan’s debt problems, to set gold surging again.

Source: Galmarley.com

MMT Theorists: Simply Printing Money Does Not Lead to Hyperinflation

As for unmitigated mone printing causing hyperinflation and therefore a melt-up in gold prices, James Montier and MMT’ers (modern monetary theorists) insist hyperinflation is“not just a monetary phenomenon, as money supply is endogenous (and hence that interest rates are exogenous), and that budget deficits are often caused by hyperinflations rather than being the source of hyperinflations. This is because money (credit) is created almost entirely by private sector banks, not central banks.

As a result, the government’s loss or even reduction in the power to tax the output base is the real foundation for many hyperinflations. Thus in the case of an extremely advanced nation (such as Japan) with a powerful productive base and a sovereign that can tax that output, the odds of a hyperinflation (ostensibly from a currency collapse) are extremely low, barring the presence of such factors as a) large supply shocks (like during wars), b) big debts denominated in foreign currencies, or c) runaway cost of living, wage price inflation. Montier’s conclusion is that those forecasting hyperinflation/collapse from aggressive central bank money printing in the US, the UK and Japan are suffering from hyperinflation hysteria.

Source: Wall Street Journal

Indeed, the movement in US 10yr bond yields suggests ongoing deflation, not inflation, with growth expectations incorporated in these yields having yet to recover from the 2010 and 2011 “growth scares”, as long-bond yields are still lower than they were even one year ago. The need for central banks to introduce successive QE stimulus strongly suggests the developed economies remain in a classic liquidity trap.

The Next Trigger for a Stock Market Correction

Given the above, the BoA Merrill Lynch and other surveys suggest that investors have for the time being over-done their optimism, with the February ML survey showing four consecutive months of rising sentiment about the global economy. These investors continue to perceive value in equities despite the strong rally since June of last year, as most remain convinced that bonds are due for a tumble, with 82% saying bonds are overvalued. Other market sentiment indicators also point to short-medium-term over-enthusiasm for equities.

The VIX has plunged from the last growth share, which admittedly was overdone in the VIX as the selloff was not as severe as the VIX’s reaction. While the balance of market commentators (i.e., investors, traders interviewed by the financial press) now say stocks are “over-done” for the time being, but with the same breath say they want to jump in again with any sign of weakness. What this means of course that stock prices will not correct as much as many who have missed most of the latest up-leg would like to see.

Source: Yahoo.com

Investors were also non-plussed by the latest round of disappointing economic news, partially because these are backward looking indicators, but also because anyone who does not understand that the price of every stock and every bond is being artificially altered by the fact that interest rates are being heavily manipulated by major central bank QE consistently has underestimated the staying power of this market recovery.

BoJ Will Have to Continue Battling Weak Euro Growth, Continued Fed QE to Keep JPY Weakening

Hedge funds have piled into the short yen trade convinced that JPY may well have crossed the rubicon. But hedge funds have already made a ton of money on the short JPY trade, with George Soros alone reportedly making a cool USD 1 billion. The plunge in JPY has also recently slowed by more dovish Japanese comments ahead of the G-20 meeting, which are of course politically motivated to ameleorate criticism at the conference. G-7 officials have muddied the “verbal intervention” waters by issuing a currency statement, “clarifing it” it and then criticizing the clarification. Japan’s government (and JPY bears) were relieved when the Group of 20 finance ministers and central bank governors avoided specifically going after Japan’s reflation efforts as currency manipulation. Instead, the pledged “to monitor negative currency spillovers to other countries caused by monetary policies implemented for domestic purposes, and to refrain from competitive devaluation.” Meanwhile, the G-20 also put off plans for new austerity-inducing debt-cutting goals.

As seen below, the Bank of Japan’s asset purchase program was already on track to purchase a cool JPY101.1 trillion (over 20% GDP), but investors/traders were largely ignoring this until new PM Abe began talking about even more aggressive BoJ action. After some uncertainty about whether the G20 would take Japan to task for the rapid JPY depreciation since late October 2012, investors/speculators took the mild  G20 statement as tacit approval for further weakening of JPY, and giving encouragement to those predicting an eventual fall in JPY/USD to 200~300/USD. But these bears are basically talking their book. Ex-Soros Advisor Fujimaki (who says JPY400/USD is possible), makes his living advising Japanese clients to move their money offshore. BNP Paribas economist Ryutaro Kono, who sees a Japan fiscal crisis in 2015, was passed up for consideration for a BoJ post.

Source: Morgan Stanley

Source: XE.com

Speculative Short Positions Already Beginning to Unwind

The CFTC net open short position of non-commercial traders already peaked on 24 November 2012 after reversing sharply from a net long position peak on 21 August. Given the massive gains, traders are now taking profits, with the net short position now down some 20%, and the hot money is now looking for an excuse to lock in gains. Consequently, we view it unlikely that short traders can repeat these gains over the next couple of months. Indeed, the true test of weak JPY sustainability will be how JPY/USD trends as these short positions are cleared, as the shelf life of such overhangs of long-short positions have historically lasted only about six months.

Source: Oanda

What investors/speculators can expect is, 1) more currency volatility, 2) more interest rate convergence as central banks succumb to the Fed’s “whatever it takes” approach, which implies continued downward, not upward pressure on rates. As a result, the so-called “great rotation” could be much more prolonged than those recommending you dump all your bonds would have you believe. Technically, the JPY sell-off has breached its first target (the 92 handle), with the next target just under 95, and currency markets should remain extremely sensitive to US, Japan and Eurozone comments about JPY or factors that would affect central bank stance, interest rates, etc.

Bond Yields at Some Point Will Have to Get in Sync with Currency Market

The JPY selloff to date has come mainly from the concept, not the fact. If the BoJ fails to deliver what is already discounted in JPY/USD price, there is room for a significant setback. Even investment banks like HSBC argue the currency market is “attaching a probability to excess success”.

While strong “behavioral bias” from over a decade of falling JGB yields may have domestic investors still (undeservedly) tilted strongly to JGBs over equities, the fact is that JGB yields are not signing off the same song sheet as JPY/USD, and, we believe, not merely because of the prospect of aggressive BoJ JGB purchases. Indeed, the latest drop in JGB yields could be more attributable to the disappointing third quarter of declines in Japan’s GDP. We are in complete agreement with JP Morgan’s Kanno that a weak JPY and more aggressive BoJ won’t be enough to provide Japan’s economy with enough velocity to escape from its decades long slump without some ‘ole Junichiro Koizumi-style structural reforms. Thus domestic investors will have to be shown that Abenomics is for real, that the new BoJ policy board is completely on board with Abenomics, and that Japan’s economy is really pulling up before they really commit, despite the GPIF now beginning to consider the price risk in their extensive JGB portfolio from Abenomics.

Hat Tip: FT Alphaville

Japan Crisis Begins with a Collapse in JPY?

While most mainstream strategists and economists that follow Japan closely continue to downplay Kyle Bass’s widow-maker trade, as previously outlined, the scenario does have its fans, especially among the fast money crowd. Last October, Atlantic magazine called the Japan debt problem “The Next Panic”, suggesting Japan could be the next Black Swan event that really derails the central bank money printing-driven recovery. As Mark Twain said, “it ain’t what you don’t know that gets you into trouble, its what you know for sure that just ain’t so”.  “Everyone” overseas is convinced the Japan debt situation is a bug in search of a windshield,  and that the crisis in Japan will most likely come from a collapse in confidence in JPY.

However, Japan does not fit the pattern of countries that have had fiscal/currency crises, a) because the vast bulk of the debt is owed to its own people and b) Japan (still?) remains the largest net creditor nation. Japan’s rapidly growing elderly hold the bulk of their savings in cash and bank deposits. The banks and financial institutions in turn hold the bulk of government debt, with the Bank of Japan becoming an increasingly large factor in JGB demand. If Japan is going to default, it will more likely “soft” default against its own citizens in a form of financial repression. Japan’s savers could also effectively lose their savings through high inflation,but as James Montier has pointed out, central bank money printing alone is unlikely to cause this.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

The Yen is Doomed Widow-Maker Trade: Is this Time Different?

The so-called “pros” have been periodically saying “JPY is doomed” since the late 1980s. But short JGBs and JPY trades have been the widow-makers of traders for a decade. Is this time really different?

We believe the Abe Administration would be ecstatic if JPY would weaken to the range it was trading at in 2009. Much beyond JPY100/USD, however, would, we believe, elicit growing alarm from Japanese corporates and financial institutions about JPY weakness fallout in the form of rising JGB bond yields. 

An Epoch-Making Change in BoJ Policy?

While hailed as “epoch-making” by Japan’s Prime Minister Shinzo Abe, who has quickly embarked on a campaign to reflate Japan’s long moribund economy, the BoJ’s new 2% inflation target and “open-ended” commitment to ending deflation in Japan has alarmed the Bundesbank and its hard money supporters within the ECB. Jens Weidmann, president of the Bundesbank, warned that Japanwas “politicizing” its exchange rate and warned of a possible competitive devaluation “currency war” as countries rush headlong to debase their fiat currencies. Excuse me, Mr. Weidman, Japan did not start the currency war, the U.S. Fed did. All-out currency debasement is exactly what the Fed and the ECB have already been practicing since 2009. Further, who are you to dictate economic or monetary policy to other sovereign nations? 

Going forward, Japan can also expect the usual chorus of overseas industry associations urging U.S.president Obama or their political leaders to denounce the move. 

If Japan really wants to extract itself from a 20-year long malaise, it should not only ignore such self-serving statements, but vigorously justify its actions as in the interest of not only reviving Japan’s moribund economy and increasingly alarming government debt problem, but also contributing to a sustainable recovery from the 2008 financial crisis. Japan‘s English-speaking finance minister and former PM Taro Aso has already lashed back at the the budding war of words against a weaker yen. The tirade from Taro Aso, Shinzo Abe’s point person on currency strategy, underscores the increasingly pugnacious stance of the fledgling Abe government against what it sees as a global trend of currency devaluations that is debilitating Japan’s economy and domestic industries. 

If the U.S., the Eurozone, Switzerland and many other countries justify their efforts to prevent a strengthening currency from slam-dunking their economies, why can’t Japan? Further, if other central banks or governments really want to avoid a currency war, why don’t they “lay down their swords” first?

Japan Only Working to Offset Four Years of Aggressive U.S./Eurozone Currency Debasement

In the aftermath of the 2008 financial crisis, it can be argued that the BoJ has been the more “responsble” central bank, judging from the extremely modest expansion in its balance sheet vis-a-vis the Fed, ECB, BoE and even China. Further, the BoJ’s decision to adopt a 2% inflation target and an  “open-ended”  commitment to ending deflation is so far merely words, and Japan is still far from turning the corner in its long fight to reflate a sputtering economy. The BOJ’s own forecast sees Japanese consumer prices to falling by 0.2% in the current fiscal year ending March 30, and and rising by just 0.4% next year

Since the stock and currency market has already reacted to all the talk of what the BoJ might and could do at its January 21, 22 monetary policy meeting, the Nikkei 225, which had already hit its highest level since April 2010 in recent trading, posted a 0.4% loss after the BoJ’s announcement, and JPY/USD was trading at JPY88.75 by early morning Tokyo time on Wednesday, backing off a JPY90.2/USD rebound high, whereas JPY was trading at JPY94.9/USD in early 2010, and over JPY100/USD in 2008. Thus the recent appreciation, while extremely rapid, is not exactly a full-scale debasement of the currency. 

We believe the Abe Administration would be ecstatic if JPY would weaken to the range it was trading at in 2009. Much beyond JPY100/USD, however, would, we believe, elicit growing alarm from Japanese corporates and financial institutions about JPY weakness fallout in the form of rising JGB bond yields. 

JPY/USD Rate: Source: 4-Traders.com

Buy the Rumor, Sell the News

Further, the signal from the markets after the BoJ’s decision was, “that’s an interesting first step, but we want to see more.” Investor and trader reaction to the much-anticipated monetary policy meeting was a classic “buy the rumor, sell on the news”, as the BoJ announcement disappointed in that the announced purchase of assets does not begin until 2014 (in terms of buying JPY12 trillion of debt every month from next year), and given the amount of debt maturing during the period, the total increase will be a modest ¥10 trillion for the entire year. That compares with the current planned purchases under the BoJ’s asset purchase program of JPY76, which has ballooned from an original JPY5 trillion since October 2010. 

Yet installing a new government-pliant governor and two new deputies may still not bring the monetary policy board completely in line with what PM Abe is trying to accomplish. The most dovish members of the nine-member BOJ policy board—while widely expected to back his pro-easing views—see the 2% inflation target as being unrealistic, and two members, Takehiro Sato and Takahide Kiuchi, actually voted against adopting the target. Most street analysts and economists also believe that it is unlikely that the BOJ will able to achieve the target before the 2014-15 financial year. The BoJ has already ramped up its asset purchase program 5-fold since October 2010, but the effect of this balance sheet expansion has been lost on JPY/USD and JPY/EUR because the Fed and the ECB balance sheet ramp-up completely eclipsed the BoJ’s actions. 

Source: Bank of Japan

Did the BoJ Just Kill the Short JPY Trade?

Given the extreme hype leading up to the January 21-22 BoJ monetary policy meeting, the BoJ’s decision was probably the immediate turning point in the recent JPY/USD selloff. Further gains now hinge upon how aggressively the BoJ follows through on its promises, which won’t happen until a new BoJ governor and two deputies are installed from April. Until then, expect more unwinding of very crowded non-commercial short JPY positions. 

Given the BoJ’s long legacy of dragging its feet, investors/traders need to be convinced that the BoJ is really committed to “doing whatever it takes” to reflate Japan’s economy, which they certainly aren’t getting from Mr. Shirakawa and the current BoJ monetary policy committee.

Consequently, we could see a further unwinding of the recent peak in short-JPY trading positions until it is clear that the new BoJ governor and his deputies are on the same page as the Abe Administration. 

Source: Oanda

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

BoJ Is Not the Biggest Fish in the Pond: Watch Your JPY Shorts

JPY was already weakening against USD and EUR before Shitaro Abe’s “Abe Magic” pushed JPY off the cliff versus USD and EUR. JPY peaked against EUR around the time that the ECB’s Mario Draghi looked straight into the global media cameras and resolutely stated, “we will do whatever is necessary to save the Euro”. Against USD, JPY’s high came in September 2011, forcing the BoJ to intervene in the currency markets to prevent JPY from surging through JPY75/USD and new historical highs. Since these respective highs, JPY has fallen about 18% versus EUR and about 11% versus USD, i.e., by significant amounts. 

Source: 4-Traders.com

Source: 4-Traders.com

However, with major exporter breakeven JPY/USD exchange rates at levels more like JPY85/USD, a strong JPY remained a significant hindrance to export profitability, the volume growth of which was already declining because of weakness particularly in Euroland and in China even before Japan-China tensions flared up over disputed islands (called Senkaku in Japan). Given the surge in energy imports as Japan went cold turkey on nuclear power supply and scrambled to shift electricity supply to imported LNG-fired plants, Japan’s balance of trade quickly plunged into deficit for the first time in 30 years, with the overall current balance of payments generally expected to eventually follow, thereby removing one pillar that had ostensibly been supporting JPY value over the past several decades. 

While the BoJ did introduce an asset purchasing program to counter the significant post-Great Japan Earthquake economic slump, i.e., more quantitative easing, the incremental and rather timid manner in which the program was expanded was no match for the tsunami of liquidity pumped into the financial system first by the U.S., then by the ECB and the BoA. The following graph of the change in the respective central bank balance sheets from August 2008 clearly shows this, even though the BoJ’s balance sheet to GDP began the period already over 20% and expanded to 30%, while the Fed’s balance sheet began the period at under 10% of GDP and is still under 20% of GDP. In other words, the BoJ has been losing the race to debase home fiat currencies, and the relative strength in JPY was basically a function of less BoJ notes compared to the truckloads of greenbacks, Euros and pound sterling notes flooding financial markets.

Source: Federal Reserve, BoJ, ECB, BoA

As the end of 2012 rapidly approached however, the monthly data for central bank balance sheets showed a clear flattening trend for the Fed, and an apparent peaking out of the ECB’s balance sheet, while the BoJ kept increasing its asset purchasing program. The relative expansion so far however only prevents new highs in JPY, not push it weaker than JPY90/USD. In our view, that would require a spurt in the BoJ’s balance sheet along the lines of the initial spurt in the Fed’s balance sheet in 2008, i.e., all-out commitment by the BoJ. 

Thus the brash comments by the LDP’s Shintaro Abe leading up to the December 16 lower house elections in Japan, and the LDP’s landslide victory, added the specific catalyst to the foreign investor and currency trader believe that the BoJ would have no choice but to more aggressively expand its balance sheet. Abe has threatened to introduce legislation which curtails the BoJ’s nominal independence unless the BoJ governor and monetary policy board introduce a formal inflation target of 2.0% at its next meeting on 20/21 January 2013, and JPY spurted JPY5/USD as investors and traders realized Abe intended to make good on his promise. 

The market fundamentals lead-up to the Shintaro Abe “event” did not go un-noticed by investors/traders; a) Japan’s government debt mountain has long been seen as a bug in search of a windshield, b) the reversal of Japan’s trade balance to structural deficit is seen as a major turning point, and c) any escalation of Japan-China tensions over territory would be a negative for JPY, d) Japanese industry had already been pushing the government (be it DPJ or LDP) to do something about the strong yen. Thus the Abe comments were just icing on the “bear JPY” cake. 

The following chart of non-commercial JPY short positions shows just how crowded the “short JPY” has become, with net non-commerical JPY short positions spiking to a four-year high, and the open interest surging. 

Source: Oanda

Time for Some Risk Assessment

Now that everyone is up to their eyeballs in the short JPY trade, its time for some risk assessment, i.e., what event or combination of events could cause the most pain to the short JPY crowd, or at least produce a much more mundane outcome than everyone is heavily positioned for. The risks to the short yen trade include.

a) The Fed and ECB continue pumping relatively more greenbacks and Euros into the global financial system. For JPY to continue weakening, the BoJ has to maintain a relatively faster expansion of its balance sheet than the Fed or the ECB. However, the Fed, ECB and BoE could well embark on more QE as a devalued JPY strengthens their currencies, and the rhetoric of “currency wars” gets ratcheted up. US-Japan 2yr bond yield spreads continued to shrink as JPY sold off, implying a disconnect between expectations and reality. 

b) US-Japan rate spreads fail to expand. If the US economy does sputter due to the fiscal cliff, US rates will continue to weaken even as Abe reflation efforts revive Japan’s economy and put some upward pressure on JGB yields, meaning no meaningful expansion in the US-Japan yield spread that is a major driver of JPY/USD rates. 

c) The Euro-crisis re-ignites, sending global investors scurrying into the risk-off corner.  

Source: Nikkei Astra, JapanInvestor

When Does the BoJ Cross the Rubicon from “Aggressive Anti-Deflation Measures” to “Debt Monetization” Fears?

But the worst-case scenario may be that aggressive BoJ balance sheet expansion and Abe expenditures to reflate Japan’s economy merely ignite inflation fears while not fundamentally improving Japan’s economy; leaving only more debt to be repaid at higher interest rates. An aggressive expansion of the BoJ’s balance sheet, i.e., a 50% spurt from here, could push investor sentiment past the rubicon, and perception of the BoJ’s action suddenly shifts from “aggressive anti-deflation measures” to “full-scale debt monetization”, unleashing a Pandora’s box of “default” and “hyperinflation” fears, triggering a major blow-up in the JGB market that could threaten the balance sheet health of Japan’s major financial institutions, particularly banks, the largest holders of Japanese government bonds. 

However, we would still place a low probability on this risk. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Armageddon Averted; Why Riskier Investments Could Outperform in 2013

The 2012 phenomenon was a range of escatological beliefs that cataclysmic or transformative events would occur around 21 December 2012, ostensibly because the Mayan long count calendar ended on that date. These doomsday predictions had people so worked up that NASA was hundreds of calls a day, to the point they felt compelled to post a video on the NASA site to quell fears and debunk the myth, despite the fact that professional Mayanist scholars had state all along that predictions of impending doom were no where to be found in any of the extant classic Maya accounts, and that the idea that the Long Count calendar ends in 2012 misrepresented Maya history and culture. 

A similar mania has gripped the financial world, and that is the so-called fiscal cliff, a phrase introduced by Fed Chairman Ben Bernanke to describe the potential fiscal drag in 2013 from the expiration of Bush tax cuts, payroll tax cuts, Alternative Minimum Tax patches and spending cuts from last summer’s debt ceiling agreement. The U.S. Congressional Budget Office has projected that the country will fall into a recession if legislators allow all changes to go through, and Wall Street investment houses followed through with projections that the US economy could shrink as much as 4.5% if the U.S. Congress sat back and did nothing. 

Investors further read and hear of an imminent fiscal disaster from the rapid build-up in US deficits following the 2008 financial crisis. From the movement in the financial markets, however, it looks as if we will usher in 2013 with no major blowups, and could even see a year of decent economic recovery and general recovery in risk assets. 

Armageddon Averted

In all probability however, fiscal Armageddon has already been averted. After the Lehman Brothers in September 2008 nearly triggered a global financial meltdown, both the U.S. Fed and Treasury intervened heavily, the ostensible objective being to stabilize the system and circuit-break the self-reinforcing fear that was already rippling through the global financial system. To sell it to Congress and the public, the Obama Administration, the Treasury and the Fed also threw in the mission of getting banks to loan out money they received, and helping to stabilize the battered housing market. In terms of its stated objectives, TARP, it is widely recognized that TARP did help prevent financial Armageddon, while it failed in stimulating bank loans to the more deserving businesses and in stabilizing the U.S. housing market. But saving the global financial system was not without costs, as some (particularly politicians) claim. Further, TARP does not include the $187.5 bailout of mortgage finance GSEs Fannie Mae and Freddie Mac. Even with $50.5 billion in dividend income, taxpayers are still out of pocket $137 billion from that rescue.

Source: CNN

But the original TARP criticisms fell far wide of the mark. Firstly, while tagged as a $700 billion program, only around $466 billion was actually dispersed. Secondly, just under $370 billion has been generated in direct government revenues from the program, including asset sales, capital gains, dividends, interest income and warrant premiums. Thirdly, the “too-big-to-fail” banks have already repaid their loans, and the Treasury Department has sold its remaining stake in AIG. Re-listed General Motors (GM, says it was buying back 200 million shares from the government. The US treasury still owns about 26% of the company, and would need about $53.00/share for these to break even, versus a recent quote of $25 +/share, for an unrealized loss of just under $14 billion. Thus by late 2012, TARP losses have been paired down to just under $14 billion, including $6 billion for programs to prevent foreclosure that were never meant to be paid back. In October, the Congressional Research Service was forecasting losses for the whole auto industry bailout of around $7.3 billion. However, a Center for Automotive Research (CAR) study reported that the automobile industry as a whole generated $91.5 billion in state and local tax revenue and $43 billion in federal tax revenue in 2011. As of October 2012, the Congressional Research Service was estimating $24 billion in costs, while the latest Office of Management and Budget estimates were for $63 billion in costs. 

Even Neil Barofsky, the original Special Inspector General and an outspoken critic of the bailout, has conceded that a lot of money has been paid back. “The loss will be much smaller than anyone thought in 2009.” 

Central Banks Still Backstopping Financial Sector and Governments 

Given a financial crisis of the scale seen in 2008, three groups needed to significantly adjust, i.e., a) the financial sector needs to recognize losses and recapitalize, b) both debt-ridden households and corporations need to deleverage, and c) governments went deeply into debt trying to keep economies from falling into recession/depression amidst private sector deleveraging. 

The financial crisis created a vicious cycle, where each sector’s burdens and efforts to adjust worsen the position of the other two. Central banks are caught in the middle, and are being pushed by governments and investors to use what power they have to contain the damage; pushed to directly fund the financial sector, and pushed to maintain extraordinarily low interest rates as well as quantitative easing to ease the strains on fiscal authorities, households and firms. This intense pressure puts the central banks’ price stability objectives, their credibility and, ultimately, their independence, at risk. 

For fiscal and monetary policy makers it was and is therefore critical to break the vicious cycle, thereby reducing the pressure on central banks. But this is much easier said than done. Private sector banks, the real creators of money in an economy, need to be speedily recapitalized and rebuild capital buffers. Financial authorities must implement financial reforms and extend them to shadow banking activities that prior to the crisis played a major role in credit creation, and limit the size and significance of the financial sector to the extent that a failure of one institution does not trigger a financial crisis. Revitalizing banks and reducing their relative size to the economy breaks the vicious cycle of destructive interaction with other sectors and clears the way for the next steps—fiscal consolidation and deleveraging of the private non-financial sectors of the economy. A move back to balanced economic growth will only be possible once balance sheets across all sectors are repaired. 

Souce: Bank of International Settlements

No Return to the Pre-crisis Economy, With or Without Stimulus? 

However, pervasive balance sheet repair takes years, if not decades. Regardless of whether TARP eventually is a net plus for government revenues, investors and economists all recognize that there will be no quick return to the pre-crisis economy, with or without additional stimulus. Great Recessions do not happen every decade — this is why they are called “great” in the first place. After the great 2008 financial crisis, the arteries of the global monetary system are now clogged with debt used to stabilize the situation, Since it simply cannot all be serviced or repaid, it won’t be. Further, the sheer size of the debt is choking off economic growth. Thus the pressure on central banks to provide monetary stimulus, ease fiscal strains while also easing funding strains is expected to continue for the foreseeable future. 

The following graph shows public debt to revenue for major economies. With public debt now at 750 times revenue and still rising, it is eminently obvious that particularly Japan cannot simply grow its way out of debt with any sort of realistic growth rate assumption (e.g., 3%~4% P.A.).

Source: Ithuba Capital

Wanted: A Post-Keynesian and Monetarist Approach

In terms of fiscal policy, the Keynes economic doctrine of demand management has made a striking comeback, after more than 30 years of intellectual eclipse from the mid-1970s to 2008—led by the likes of Larry Summers, Paul Krugman and Ben Bernanke. However, others like Jeffery Sachs are now suggesting that Keynesian policies such as a) big fiscal packages, b) record low interest rates, and c) “unlimited” QE, while ostensibly appropriate for recessions/depressions, may be the wrong tools to address deep structural change—i.e., these Keynesian policies are fighting the last war, whereas the new path to growth could be very different from even the recent past. 

Indeed, we may be fast approaching the tail end of a 40-year experiment in fiat money and the mother of all credit-fueled expansions that began when President Nixon severed the link between gold and the US dollar in 1971. Last week the US Federal Reserve yet again announced more QE through the purchase of $45 billion of US Treasuries every month. Between this program and the Fed’s QE 3 Program announced in September, the Fed will be monetizing $85 billion worth of assets every month; $40 billion worth of Treasuries and $45 billion worth of Mortgage Backed Securities, ad infinitum as the Fed tries to counter a dysfunctional U.S. Congress allowing the U.S. economy to fall over or slide down the fiscal cliff/slope. 

Thus investors have been reduced to central bank watchers looking for the next liquidity fix. What is disturbing, as was pointed out by the Zero Hedge blog, is the similarity between the stock market so far in 2012 and what happened to stocks when faced with a similar “debt ceiling” issue in 2011. The inference of course is that, contrary to consensus, stock prices are still not seriously discounting the risks to 2013 economic growth from the fiscal cliff and/or the ensuing austerity.

Source: Zero Hedge

A benign outcome from Democrat and Republican last-minute fiscal cliff negotiations of course would ensure a firm floor under stocks prices, being that these prices are strongly supported by renewed Fed QE balance sheet expansion. 

Bottom Line, QE Does Not Equal Runaway Inflation

Central bank balance sheet policies have supported the global economy through a very difficult crisis, but at what costs and risks of massive balance sheet deployment? Doesn’t this pose the risk of an eventual blow-up in inflation? Not according to the Bank of International Settlements. This is because these central banks are still largely pushing on a string. The relationship between increases in central bank balance sheets and base money has been rather weak for both advanced and emerging market economies since 2007. The correlation between central bank asset expansion and broad money growth has been even weaker; in advanced economies, and is even slightly negative. This reflects instability in the money multiplier (broad money over monetary base) over this period. Similarly, the correlation between the change in central bank assets and consumer price inflation has been virtually zero. In sum, bloated central bank balance sheets do not seem to pose a direct inflation risk, but there is a noticeable link to the value of that country’s fiat currency.

US Stock Market Volatility Yes, Serious Selloff, No 

As a result, it would probably take a particularly negative “no action whatsoever”, or worse, serious austerity as an outcome of a fiscal cliff deal, to trigger a significant selloff in U.S. stock prices, which investors are correctly assuming is highly unlikely, as any sharp selloff would act like a sharp pencil in the backs of U.S. politicians reminding them of what is at stake in terms of the financial markets. What financial markets are basically signaling to investors is that progress continues to be made in breaking the vicious debt deflation cycle, as long as the central banks remain committed to backstopping the adjustment process. While admittedly a simplistic view, a simple comparison of current S&P 500 levels and the prior 2007 high indicates the U.S. has repaired roughly 90% of damage wrought by the 2008 financial crisis. 

Source: BigCharts.com

It is interesting to note that 10Yr treasury yields have also bottomed despite the Fed’s renewed purchases of treasuries, given a quick 7% depreciation in USD (in terms of the UUP ETF), and the long-treasuries chart indicating a significant back-up in yields as possible, to 2.25%~2.50%, in fairly short order. Rising treasury yields imply growing inflation expectations, ostensibly arising from improved expectations for U.S. economic growth in 2013, not the recession that everyone is warning about when discussing the fiscal cliff. On the other hand, the financial media is reporting that investors/traders see U.S. bond yields as at or near the highs of a range investors see persisting into next year. 

The initial estimate of US GDP growth in Q3 (July, August, and September) was an underwhelming 2%. Since then, the numbers have been revised up, and then revised up again. While short of what can be considered a “robust” recovery, the 3.1% percent GDP reading is the best since the end of 2011, and the second-best quarter of the last three years. In Q2, real GDP increased only 1.3%. It remains to be seen just how much the psychological damage done to business and consumer confidence from the fiscal cliff debacle impacts the real economy.

Source: BigCharts.com

S&P SPDR Sector Performance: XLF is a Rally Bellwether 

The renewed vigor of the rally in the S&P 500 has been largely supported by the S&P 500 financials (XLF SPDR) as the bellwether for both Eurozone debt/banking crisis risk and U.S. economic growth expectations. As long as the XLF is matching or beating the S&P 500, perceived financial risk is low and investor attitude toward risk continues to improve. Conversely, should the S&P 500 see a significant selloff, it will most likely be led by the financials. 

The following chart shows the relative performance of the S&P 500 sector SPDRs since before the prior bubble, i.e., the IT bubble. In terms of relative performance, the financials “bubble” puts the prior IT bubble to shame, and underscores just how important the financial sector has become not only to the U.S. stock market, but to its economy as well. Thus in the U.S. at least, Wall Street is intricately connected to Main Street. 

The U.S. financial sector in turn has been backstopped by a sharp rally in the Eurostoxx Banks Index of some 56.8% from a late July low, on a clear commitment by the ECB to do “whatever it takes” to save the Euro. Even more dramatic has been the plunge in Greek sovereign bond yields from 35% to just over 10%, even though Greece was considered an irrecoverable basket case. The hedge funds that were brave enough to buy Greek bonds for just such a trade have so far been well-rewarded.

Source: Yahoo.com, Japan Investor

Source: 4-Traders.com

Greek 10Yr Bond Yield: Bloomberg

Gold versus US Treasuries: A Reversal from More Deflation to Rising Real Yields 

The other strong indicator of improving confidence in the economy and rising inflation expectations is the selloff in gold. While investors ostensibly find it difficult to determine a “fair” price for gold because it pays no yield and offers no earnings, it can be demonstrated that price of gold does respond to the trend in real interest rates, i.e., gold rallies when real interest rates are declining toward zero and especially rallies when real rates are below zero. Thus the recent price action in gold also reflects investor expectations that the foreseeable trend in real interest rates is more likely to be of rising real rates, i.e., a reversal from deflationary renewed lows. Long bonds (TLT ETF) have actually been outperforming gold (GLD ETF) since April of this year. 

The 30-year US Treasury bond tells us that the expected return over the next 30 years is a real return of 0.4 percent (2.8% yield minus a break-even inflation of 2.4%). This cannot last in a world of forced inflation via infinite monetary printing and a possible downgrade of the US if it fails to implement structural fiscal reforms. The Federal Reserve is expected to keep rates low for longer but in 2013 this could be challenged by the zero interest rate policy which forces investors to leave fixed income to attain any yield. 

With global bond markets worth some USD 157 trillion versus stock market capitalization of USD 55 trillion (McKinsey & Company), there is three dollars in fixed income for every one dollar in stocks. Thus every 10 percent reduction in mutual fund holdings of bonds moved to the equity market would produce 30% of net inflows into stocks, leading not only to higher US rates, but also creating one of the greatest stories ever told in the equity market.

Source: Yahoo.com

Source: Wealth Daily

China’s Soft Landing 

After months and months of debate, it now appears that China’s economy is not collapsing, but rather settling into a slightly slower, but still brisk pace of growth. Chinese GDP growth for 2012 of 7.7% to 7.8% is now looking very doable, just above former Premier Wen Jiabao’s target of 7.5%. After 9.2% growth in 2011, the first two years of the decade are averaging 8.5%, and 7.1% for the rest of the decade now seems very doable. With a trade surplus a quarter below its peak, stabilized housing prices, consumption rising as a share of GDP, and inflation below target, the situation in China looks decidedly benign as the government works to shift economic growth more toward domestic consumer demand. 

The narrower FXI China ETF of 25 blue chips has been reflecting this revisionist view among foreign investors for some time (i.e., September), while the Shanghai Composite—much more influenced by domestic individual investors trading more on rumors than fundamentals. At some point, higher stock prices will shake out even the most adamant China bears, which could well exacerbate the upward move.

Source: Yahoo.com

Macro Fundamentals Now Show Japanese Equities in a Much More Favorable Light 

Since the Nikkei 225 has historically had a good positive correlation with U.S. 10-year bond yields and the JPY/USD exchange rates is highly correlated to the spread between US and Japanese 2-year as well as 10-year bond yields, rising US bond yields offer good macro (top-down) support for rising Japanese equities. 

Since the onset of the 2008 financial crisis, Japanese equities have woefully underperformed other developed market equities, seriously hobbled by a) structural rot in Japan’s domestic economy, b) an incessantly high JPY, that c) is seriously harming both the volume and profit margins of exports, which have become the primary engine of extremely cyclical growth in Japan’s economy.

Source: Yahoo.com

The above chart dramatic long-term underperformance of Japanese equities, which are still in the mother of all bear markets. The only flash of hope during this period was the brief period when the unconventional, reformist-minded Junichiro Koizumi was in power, as represented by the cyclical rise in Japanese stock prices between 2003 and 2007 when foreign investors came to the view that Japan was “back”.

This secular bear market has essentially all but completely wrung growth expectations out of stock prices. As a result, valuations of Japanese equities have been very cheap for some time, with a median forward P/E multiple of 18.6X but no less than 2,364 individual stocks trading between 4X and 12X earnings, a median dividend yield of 2.15% while 1,456 stocks trade at dividend yields between 3.5% and 5.0%, and a median price/book ratio of 1.49X, while 2,300 stocks trade at PBRs between 0.3X and 0.9X book value.

The problem was, it was hard to see any catalyst that could allow investors to capitalize on what had become a value trap. As global investors were very underweight Japanese equities, Shintaro Abe’s aggressive statements about a weaker JPY, a more aggressive BoJ and specific price targets were just the potential catalyst that foreign and domestic institutional investors were desperate for. As Mr. Abe’s LDP took the recent elections by a landslide, foreign investors are now keyed on, a) a weaker JPY and b) a more aggressive BoJ.  

While the surging Nikkei 225 is looking over-extended short-term, there is potentially much more return available over the next six~twelve months. Assuming JPY does weaken to JPY90/USD or more, and the US-Japan bond yield spread continues to widen, the Nikkei 225 has the potential to challenge its post-2008 financial crisis rebound high of 11,286 (+11%), and even its pre-crisis May 2008 high of 14,338 (+41%) if the Abe Administration does indeed instigate a real recovery in Japan’s economy. 

Abe “Magic” a Convenient Catalyst to Recognize Improving Macro Market Fundamentals

While most investors readily recognized that Japanese equities were cheap, the biggest impediment was that most investors could not see any fundamental change that would act as a catalyst to unlock this apparent value; only inept political bungling by the ruling Democratic Party of Japan (DPJ), growing friction with China that was hurting trade, and continued over-valuation of JPY. 

However, rising US long-term yields provide a favorable macro backdrop for a rally in Japan’s Nikkei 225, which historically has exhibited a fairly high positive correlation with U.S. 10-year treasury yields, ostensibly because rising treasury yields tend to lead to wider spreads between U.S. and Japan long bond yields, which in turn is highly correlated with a weaker JPY. So far, Shintaro Abe has only provided a catalyst for hope, with his speeches about a weaker JPY, inflation targeting and a more aggressive BoJ on the campaign trail leading up to December 16 general elections hitting all the right buttons with foreign and domestic institutional investors.

Going forward into 2013, investors will continue to key on the BoJ. BoJ Governor Shirakawa’s term is up at the end of March, 2013, as is two other policy board members. Topping the short list of possible new BoJ governors is Kazumasa Iwata, who has publicly advocated BoJ should purchases of Y50tn worth of Eurozone government bonds with a view to weakening the yen as a natural extension of the central bank’s current asset purchase program. New prime minister Abe has also appointed Yale economics professor Koichi Hamada as a special adviser to his cabinet. Hamada has also advocated the purchase of foreign currency bonds as well as of longer dated Japanese government bonds. Thus outgoing governor Shirakawa is now extremely isolated politically, and the Abe Administration has one of the best chances in decades to ensure the appointment of not one but three BoJ board member reflationists.

For the Hope Rally to Morph into a Fundamental Recovery Rally, Abe Must Walk the Talk

But the litmus test for sustainability in the budding Japan stocks rally is, a) expanding US-Japan bond yield spreads supported by rising economic growth/inflation expectations in the U.S., b) faster growth in the BoJ’s balance sheet than either the ECB or the Fed, and c) a transformation from deflation to inflation expectations in Japan. 

Abe was advised by LDP peers such as his new finance minister and ex-prime minister Taro Aso to steer clear of more controversial issues and to just concentrate on the economy for the time being, and it appears that is what Abe is doing.

Abe’s erely managing to stay in office for his full four year term would greatly stabilize policy management. After having abruptly resigned as prime minister with less than a year in office five years ago, he will be under pressure to shed the stigma as a fragile leader by steadily showing progress on a number of fronts and maintaining the support of his political party and the voting public for at least one full term. This alone would be quite an accomplishment considering that Japan has seen seven prime ministers in the last six years.

In addition to a much more aggressive BoJ, the effectiveness of Abe’s economic policies will be greatly affected by the functionality of a re-instated Council on Fiscal and Economic Policy and the “headquarters for Japan’s economic revitalization” that Abe plans to set up. Early steps to create forward momentum in restoring Japan’s economic engine would go a long way in helping to address a plethora of thorny issues Japan faces, including a monstrous government debt burden, a creaking social welfare and pension system, territorial disputes with China, the highly contentious TPP negotiations and the consumption tax hike issue.

Yet while the LDP-New Komeito coalition has won a super majority in the Lower House, it is still the minority political group in the Upper House, meaning a split Diet. Like his predecessor, Junichiro Koizumi, he will need to heed and marshal voters, business and investors to make his case within his own party and with opposition parties to overcome the debilitating political gridlock that characterized the brief leadership of the country under the Democratic Party of Japan (DPJ). Fortunately, with the DPJ party in almost complete disarray and other political opposition splintered among many smaller new political parties, the heretofore main opposition DPJ is in no state to seriously impede Diet business.

Biggest Risk is a Dramatic Reversal in Inflationary Expectations

The currency and stock markets have reacted positively to Abe’s promises to a) instate an inflation target of 2%-3% by the BoJ, b) get the BoJ to purchase construction bonds to c) fund an immediate JPY10 trillion fiscal stimulus package and up to JPY200 trillion of fiscal expenditures over the next 10 years to revitalize Japan’s rusting infrastructure,

So far, these are merely campaign promises.

The biggest risk is that these reflation attempts are too successful, causing a dramatic shift from a chronic deflationary mindset to one of excessive inflation expectations, but in the current environment of deflationary expectations, not only in Japan but in the Eurozone and the U.S. as well. Rising inflationary expectations could trigger a lose in confidence in Japan’s bond market, triggering a serious blowup in bond yields that would a) dramatically weaken JPY and b) create big potholes in the balance sheets of Japan’s JGB-laden balance sheets. In the worst case, Abe and the LDP could merely return to the old LDP playbook of wasteful fiscal expenditures while avoiding unpopular but essential economic reforms, i.e., a repeat of the 1990s insanity, where, with the exception of the Koizumi-led reform years, the LDP kept repeating the same mistakes, each time hoping for a different outcome.

Such an approach will only not work, but would merely accelerate Japans fall over its own excessive debt fiscal cliff. Extremely low and stable interest rates on JGBs will end sooner or later, and the new government needs to recognize that it will only be buying time unless the thorny structural issues are addressed head-on. JGB yields have already bounced on the expectation of more stimulative economic policies, but have a long, long ways to go before crossing the rubicon, as again-in-recession Japancontinues to suffer from debilitating excess domestic capacity. Thus Abe effectively has only one choice, and that is to push forward in reflating and revitalizing Japan’s economy.  

Exporter Breakeven JPY/USD Exchange Rate Still Around JPY85/USD

The breakeven exchange rate for Japanese exporters has dropped dramatically from just under JPY115/USD circa 2003 to around JPY85/USD by late 2011, but is still above actual exchange rates, meaning the Abe-instigated selloff in JPY has so far merely pushed the JPY/USD rate back toward, but not significantly above the breakeven exchange rate.

A selloff to around JPY95/USD would create a significant positive windfall for Japanese exporter corporate profits in FY2013 and provide a very welcome upside earnings surprise, although stock prices of Japan’s exporters discount exchange rates in real time. A weaker JPY would also very likely prevent a further mass exodus of production capacity by Japan’s automobile section—still its most competitive and influential to the domestic economy in terms of ripple effects on the steel, plastics and chemicals, electrical equipment, and ceramics industries.

A Significantly Weaker JPY Will Alleviate, But Not Solve Japan’s Global Competitiveness Deficit

Economic development is a process of continuous technological innovation, industrial upgrading, and structural change driven by how countries harness their land, labor, capital, and infrastructure. For the last twenty years, all but a few Japanese companies and certainly all of Japan’s public institutions have steadfastly resisted the tsunami of globalization sweeping over Japan. Public organizations and the organizations of many corporations are unchanged from the emerging, high growth era of the 1970s.

Even Japan’s largest firms have muddled along with woefully out-dated business models, group-think insider boards of directors and generally poor corporate governance. While much of the developed world now seeks diversity in corporate boards that is more congruent with the sex and nationality of their employees, the global structure of their businesses and the demands of their institutional investors, Japanese companies still have an average of only 2 outside directors of dubious independence on their generally bloated insider boards, and have dramatically fewer outside directors than their peers in Hong Kong, Singapore or South Korea.

 Integrated Electronic Firms as Symbols of the Problem

Japanese electronic firms used to be on the leading edge of evolutionary and revolutionary new product development, as evidenced by Sony’s Walkman audio player, flat screen TVs, the VTR, CD ROMs and high definition (analog) TV and NTT’s iMode mobile phones. More recent attempts however such as Blue Ray discs have been hobbled by the lack of standard formats and commercial flops such as 3D TV.

As global demand shifted from the developed nations to emerging markets, Japanese electronic companies found that their products in many cases had too sophisticated designs that priced these products out of the reach of a growing aspirational middle class, while their high end product strategies were blindsided by new “outside the box” products that redefined mature product areas, such as Apple’s iPod, iPhone and iPad. This relegated Japanese firms to establishing assembly operations offshore in cheap labor countries, mainly China, while Japan’s exports shifted to niche components and sub-assembly products that were mere cogs in a regional supply chain.

An incessantly higher JPY and cutthroat price competition at the lower end “volume zone” cut heavily into profitability, forcing repeated bouts of restructuring that stunted new product development and capital expenditures, causing major integrated electronic firms to fall farther and farther behind in dynamic new industry segments.  At the same time, Japanese firms have been particularly inept at developing the consumer/user friendly software and applications make computers, new 3G/4G phones and other electronic products so appealing.

As in the aerospace industry, Japanese electronics firms were never able to establish and grow profitable foodchains/architectures such as the once all-powerful Windows/Intel or the Apple iPod/Phone/Pad empire, as the “soft” portions of the foodchain where the real money was made was always outsourced.

Significantly Weakening JPY May be Easier Said than Done, and if too Successful, Could Create a Global Crisis

JPY has been in a secular bull market versus USD since Nixon severed the USD link to gold and Japan allowed JPY to float. Over the past 20 years, annual growth in the supply of JPY or Japan’s monetary inflation rate, has averaged only 2% PA, and is presently near this long-term average. This means JPY, over the past two decades, has by far the slowest rate of supply growth of the major currencies, ergo, JPY has been in a secular bull market simply because there has structurally not been enough JPY supplied to meet demand for the Japanese currency. As a result, JPY has gained the reputation of a “hard” currency and safe haven despite a dramatically deteriorating public debt position, supported by Japan’s position as a net creditor nation with a structural current balance of payments surplus. 

Source: Speculative Investor

While Japan’s monetary inflation exceeded 10% PA during the 1980s boom years, growth collapsed in 1990-1991 with the crash in the stock and property markets. Conversely, US monetary inflation surged after the 2008 financial crisis as the Fed flooded the financial market with USD swaps to keep the global financial system afloat. Thus even the most aggressive BoJ (where “aggressive” is very much against character) would struggle to supply enough monetary inflation to offset the tsunami of greenbacks. The BoJ stands accused of doing too little too late to combat deflation and reflate Japan’s economy with a weaker JPY, but since the 2008 crisis, they haven’t stood a chance of depreciating JPY against the onslaught of currency debasement by the ECB and the Fed.

How Much Can the BoJ’s Balance Sheet be Realistically Expanded without Consequences?

The rapid ageing of Japanese society is a widely known phenomenon. Total population has recently started to fall, and the working age population had already started to fall around 1995 by the middle of this century, thus population shrinkage, particularly in the working population, is expected to be quite dramatic. With the working age population shrinking, unless technology allows a smaller workforce to produce more output per head, Japan’s GDP without a policy offset could essentially trend sideways to slightly minus. With Japanhaving one of the most rapidly graying societies in the world, nominal GDP should become the focus rather than real GDP, as GNP includes financial income from the rest of the world, and is a better reflection of the “feel” of the economy among people on the street.

One of Saxo Bank’s 10 Outrageous Predictions for 2013 has the BoJ formalizing nominal GDP targeting and ballooning its balance sheet to almost 50% of GDP to spur inflation and weaken JPY. But the question of just how far the BoJ can expand its balance sheet without triggering a bond rout is a very valid question. As of January 2012, major developed country central bank assets as a percent of IMF forecast nominal GDP showed that the BoJ’s balance sheet was already well over 30% of GDP, versus under 20% for the Fed, The BoJ’s balance sheet to GDP has already surpassed the 30% peak seen during 1995~1996 when the BoJ first experimented with full-scale QE. While high versus other developed nations, however, China takes the prize for having the largest central bank balance sheet to GDP by a mile.

Further, when converted to USD and shown in absolute USD amounts, it is very evident that the BoJ had fallen way behind China, the ECB and the Fed in terms of the sheer comparative volume of QE, and thus the relative supply of JPY (degree of debasement) has been much lower, making JPY much stronger relative to other fiat currencies.

Source: James Bianco

Continued Investor Faith in the Efficacy of Monetary Countermeasures is Key

If global investors were to lose faith in the efficacy of global quantitative easing, risk appetite could significantly retrench, vaulting JPY to the fore again for a time as the world’s strongest currency due to deflation and repatriation of investments, and the rapid unwinding of carry trades. In this case, JPY could surge to JPY60/USD and other JPY crosses head even more violently lower, possibly triggering a fiscal crisis in Japan that would force the LDP government and the BoJ to reach for even more radical measures to weaken JPY and reflate Japan’s economy amidst a renewed global financial crisis.

Shinzo Abe has already decided to scrap the country’s spending cap for the annual budget, previously capped at a measly JPY71 trillion, excluding debt-servicing costs, and JGB yields have already seen a noticeable uptick, with the biggest 5-day run-up in 10yr JGB yields in over 13 months. As the following chart shows, Japan’s 30-year bond yields have already reacted to a structural shift in Japan’s balance of trade from surplus to deficit by breaking out of a downtrend in place since early 2008, while the uptick in 10-year yields is still barely perceptible and still 125 bps below the 2007 high. Thus the BoJ and the Abe Administration have much heavy lifting ahead of them in convincing investors that Japan is really committed to reflating Japan’s economy, and the gap between the sharp Nikkei 225 rebound and still-low JGB yields reflects the current gap between bond and equity market investor expectations, as the Nikkei 225 has so far reacted primarily to the recent selloff in JPY.

Source: FX Street

Source: Nikkei Astra, Japan Investor

Foreign Buying Will Again Fuel the Rally

Since domestic financial institutions will be positioning their portfolios for the closure of accounts for FY2012 at the end of March 2013, the rally in Japanese stocks through the end of the year and into the first quarter of 2013 will have to be almost exclusively driven by foreign investors, and moreover in sufficient enough quantity to offset a noticeable drag from net selling by domestic institutional investors trying to book gains before the end of the accounting year.

Since Abe’s bullish comments triggered a JPY selloff in mid-November, foreign investors have already been net buyers of Japanese equity by some JPY1.13 trillion, while domestic individuals and institutions have sold some JPY1.09 trillion of Japan equity.

Source: Nikkei Astra, Japan Investor

 Sectors Leading Japan’s Rally

The rally in Japan is being driven by the high beta broker/dealers and the steel Topix sectors, while the airlines, other products (like Nintendo) and mining sectors have noticeably lagged. While the banks have been leading in the U.S., stocks in Japan’s banking sector are so far showing only an average rebound, perhaps because they are already widely held in many foreign portfolios. 

Source: Nikkei Astra, Japan Investor

The best performing Nikkei 225 stocks year-to-date are dominated by second-tier city banks (Shinsei, Aozora), broker/dealers (Daiwa, Nomura), and the real estate stocks(Tokyu, Sumitomo, Heiwa, Tokyo Tatemono, Mitsui Fudosan), all of which have offered year-to-date returns in excess of 40%.

Source: Nikkei Astra, Japan Investor

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Japan Passing

A recent article in the Washington Post was titled, “A declining Japanloses its once-hopeful champions.” The once-common species has been virtually wiped out. The group has turned gradually into non­-believers, with several of the last hold­outs losing faith only recently, as Japan has failed to carry out meaningful reforms after the March 2011 triple disaster. Here’s a rogue’s gallery of what’s wrong with Japan.

 

 Horrible Demographics. Japan’s population of 127 million, already hugely skewed towards the unproductive and costly elderly (e.g., average female life expectancy is 86 years) is set to shrink by 800,000 every year between now and 2060 or to 32% of its 2010 level.

Horrible Debt Position. Public debt is 239% of GDP, and taxes cover just about half of total government spending.The government has just launched an eighth round of quantitative easing in an attempt to weaken the yen, but Japan’s GDP, once nearly 20% of the global economy, will be down to less than 5% by 2042.

Hat-Tip: Trading Economics

Inept, Gridlocked Political Leadership. Japanis, as one reporter termed it, “a nation of individual quiet lions led by political donkeys”. Japan’s workers are a hard-working, dutiful, courteous, resourceful and steadfast people who deserve better leaders, but keep in mind that it is they who elect these leaders, at least indirectly.

Timid Central Bank Monetary Policy. While the Bank of Japan was actually the first to introduce quantitative easing (QE) and zero interest rate (ZIRP) policies a decade ago, Japan’s central bank has not been as aggressive as its U.S.or ECB peers in utilizing its balance sheet to weaken JPY. It continues to disappoint foreign and domestic investors with incremental, reactionary rather than proactive monetary policy. That is no match for the trillions of USD being marshaled by the Fed.

Gravity-Defying Yen Strength. The Japanese yen has been appreciating steadily since 1971, when Richard Nixon severed the last remaining link of the US dollar to gold. The yen has continued to appreciate because, a) Japan has remained a net creditor nation based on a heretofore chronic balance of payments.

Given the above, Japan’s GDP growth has remained extremely volatile, with sustainable growth being 1% or less. Since 2008, Japan’s GDP growth has swung from +1.3% to -3.9%, and has recently basically been trending flat. 

Hat-Tip: Trading Economics

Hat-Tip: Trading Economics

Scheloric Ex-National Champions. All the above has resulted in sclerotic ex-national champion corporations with in-bred, risk-adverse leaders. Corporate management in general lacks the will and vision to take risks and fundamentally re-think their businesses, whereas Japan’s success was founded on single-minded mavericks, often engineers who were willing to go against the grain, take risks and stick their necks out, like Honda’s Ichiro Honda, Panasonic’s Konosuke Matsushita, or Sony’s Akio Morita. Consensus-insisting (group think) refusal to take hard decisions is fatally weakening them, as structural reforms (retrenchment) has been only a short-term fix. For example, Japan’s national champions in the electronics sector between 2000 and 2010 saw electronics production in Japan shrink by 41% and exports by 27%, as Japan’s global market share fell by nearly half to 10% by 2009, whereas South Korea’s rose to nearly 10%. Over the past two years, such former bluechips as Sharp (Tokyo: 6753), Sony (Tokyo:6758) and Panasonic (Tokyo: 6752) have lost so much money as to threaten their very existence and earn them previously unheard-of nnear “junk” credit ratings like Baa1; versus a cash position that was so strong in the mid-1980s to earn nicknames like Matsushita (Panasonic) Bank. 

Given the strong yen and other high operating costs in Japan, Japan’s industrial production is basically in secular decline with industry after industry being hollowed out as companies move production facilities overseas in a vain effort to maintain international competitiveness. The Ministry of Finance’s corporate survey shows minimal top-line sales growth even from the depressed post-Tohoku earthquake-tsunami-nuclear catastrophe levels. As a result, corporate profits have become extremely volatile as sales muddle along just above or below corporate break-even levels.

Source: Japan Ministry of Finance

No Appetite for Stocks Among Domestic Investors. Japan’s individual investors as well as investing institutions have little appetite for stocks preferring instead to keep excessive cash balances and preferring bonds (JGBs) and/or higher-yielding overseas investments over domestic equity. Because of a rapidly aging population, Japan’s largest (as well as the world’s largest) public pension fund, the Government Pension Investment Fund, is seeing its pension assets declining at a rate of JPY6~JPY8 trillion a year, forcing them to sell equities and bonds for pension payouts, and forcing their domestic asset managers to become secular net sellers of Japanese equities.

Given the above, it is not surprising that Japanese equities continue to seriously underperform the U.S. and other developed equity market peers, as foreign investors come around to the view that Japan is not just in a prolonged slump, but also in what may be an inescapable decline. The following chart of the EWJ MSCI Japan ETF relative to the SPY S&P 500 ETF clearly shows just how massive this relative under-performance has been over the last several years, despite periodic “contrarian” calls that now is the time to buy undervalued Japan, most recently immediately after the Tohoku catastrophe. Those who bought the “Japan reconstruction” story are now regretting it. 

Source: Yahoo.com

Steady Erosion in Market Capitalization. Relative performance is not the only issue. As a result of the steady erosion in Japanese stock prices, some 1,270 of a total 3,600 listed Japanese companies (or nearly half) have market capitalizations of JPY5 billion (USD62.5 million) or less, which would be considered a micro-cap company and off the investible universe radar screen of most overseas investors. Further, fewer and fewer investing institutions now offer Japan-specific mutual funds or institutional portfolios; instead offering “international” (ex-US) and “global” (with US) portfolios in which the exposure to Japanese equities is well below 10%, as the benchmark weight for Japanese equities in a MSCI EAFE-benchmarked portfolio is around 8%. Thus typical EAFE or Global portfolios will hold only 100 Japan equity names or less. The major exceptions to this general rule are the Chinese sovereign wealth funds (China Investment Company and SAFE Investment Company) who hold mainly a Topix-index-based portfolio of Japanese stocks, and who have been heavy buyers near previous market bottoms.

Hat Tip: Trading Economics

Small Cap Value Still Rewarding Those With the Patience to Find Them

But the bleak top-down view of Japan however masks some seriously undervalued, overlooked and unloved small cap companies that most investors just don’t have the time to investigate. There are a few funds however like the Fidelity Low-Priced Stock Fund (FLPSX) that are full of such bargain basement Japanese small caps, and who have managed to keep up with the S&P 500 by focusing on small-cap value stocks, whereever they can be found,  

Source: Yahoo.com

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

In Gold We Trust: Global Economy Will Sputter Despite Unprecedented Monetary Stimulus

Global Economy is Still Slowing

The downturn that began in smaller euro zone economies is now clearly sweeping through Germany and France. That, in turn, is damaging many of Asia’s export-reliant economies.

(1) Global Manufacturing PMIs Continue to Deteriorate in August, Including Asia

The JPMorgan Global Manufacturing PMI fell to 48.1 in August from 48.4 in July, its lowest reading since June 2009 and dipping further below the 50 threshold that signifies growth. The new orders index fell to 46.8, the lowest since April 2009, pushing factories to reduce staffing levels for the second month. The U.S. ISM survey showed the American manufacturing economy shrank at its sharpest clip in more than three years in August, against expectations for stagnation. The Eurozone manufacturing sector contracted faster than previously thought last month but Britain bucked the trend by posting a surprise rise in its PMI – although it still showed contraction. China’s official PMI fell below 50 for the first time since November, while a similar survey from Markit, sponsored by HSBC, showed activity shrinking at its fastest pace since March 2009. South Korea’s reading was below 50 for the third month in a row and Taiwan’s PMI hit its lowest level since November. 

(2) Japan’s Trade Balance Continues to Deteriorate

Japan, after decades of chronic trade surpluses, is now recording a trade deficit. The country’s preliminary trade deficit hit JPY754.1 billion yen in August, marking the second straight month of deficit, as exports to Europe and China tumbled on weakening global demand and the yen’s continued strength. The August deficit was the 2nd-largest since comparable data began in 1979. Japan’s exports fell 5.8% percent YoY, down for the third consecutive month. Automobile exports were down 1.8%, and those of electronic parts, including semiconductors, dropped 3.5%. While exports to the U.S. rose 10.3%, EU exports plunged 22.9%, with exports China, Japan’s largest trading partner, seeing a sharp 9.9% decline. Imports into Japan were also down in August on a lower value of crude oil as well as nonferrous metals and coal.

The recent hostilities between China and Japan over ownership of an island chain off Okinawa are only exacerbating an already weakening trade trend. The latest OECD forecast shows G7 economic growth at 1.4% for 2012 or essentially the same as 2011, with the bulk of this being provided by the U.S., where growth is expected to accelerate from 1.7% in Q2 calendar 2012 to 2.4% by Q4. The numbers for the Eurozone and Japan however have worsened, with Japan growth going from 1.4% in Q2 to minus 2.3% in Q2 and basically zero in Q4. Euroland’s economy also continues to deteriorate, from -0.3% in Q2 to -0.7% in Q4. 

OECD September Forecast

The Reasons for the Additional ECB, Fed and BoJ Measures are Negative, Not Positive

With the U.S. growth apparently re-acclerating from a slowing in Q2 2012, one would wonder why Ben Bernanke and the Fed decided to go “all in” for an unlimited QE3 when they did. The hints are  , a) “unacceptably high” U.S. unemployment, which is one of the Fed’s dual mandates, and b) the looming fiscal cliff, which Ben Bernanke has warned against on several occasions. 

On the other hand, as the BoJ is always two steps behind market expectations, it’s “me too” additional easing has elicited a collective yawn among investors and traders. As a result, JPY since the global financial crisis began some five years ago is up a massive 81% against EUR, and some 59% versus USD, which has all but completely strangled Japan’s export competitiveness, in an age where exports (growth in the global economy) are a scarce source of growth for Japan’s moribund economy. This massive currency appreciation has been exacerbated by, a) the March 11 Tohoku disaster and the electricity supply/global supply chain problems it caused, b) a deepening Euro crisis and c) and now increasing political tension with China. Indeed, the winds blowing against Japanese companies dependent on external demand are beginning to look like a Sisyphean Punishment.

Source: 4-Traders.com

According to the OECD’s September economic forecast update, the loss of momentum in the G7 countries could well persist through the second half of this year, with the Euro recession and declining global trade, despite the boost to financial risk markets from additional central bank “puts”. 

Source: OECD

Could the U.S. Be the Negative Surprise for 2013?

As is shown in the table of OECD forecasts shown above, the renewed slowdown in the global recovery in the second-half of 2012 is already all but completely discounted in stock prices. Thus the question for 2013 is, will there be more of the same, are we in for some negative surprises? Unfortunately for Japan, we see nothing but more of the same. The surprises therefore could be in the Eurozone (better than expected) and in the U.S. (worse than expected). 

Thus at some point in the not-too-distant future, stock prices will again begin to sputter due to the lack of any meaningful support from economic fundamentals. Of the developed markets, the U.S. is the only equity market close to its pre-financial crisis highs. While there has been a lot of negative comment about Chinese equities of late, the China ETF (FXI) is actually bunched in the middle with the Germany, France and U.K. markets, while it is Italy that has clearly been the worst performer during this period. If, is as feared, the U.S. Congress splits along current, contentious Republican vs Democrat lines and cannot implement any measures to defray most if not all of the widely-expected U.S. fiscal cliff in 2013, it could be the U.S. market that ends up the worst performer in 2013, which is a risk scenario virtually no one is seriously betting any money on, despite the continued warnings of the “uber” bears. 

Source: Yahoo.com

In Gold We Trust

What appears to us to be the highest probability scenario is even more fiat money debasing, as central banks keep repeating the insanity they have for the past several years, while politicians continue trying to kick the can down the road. In other words, the prospect of ever more fiat money debasement is the strongest support for gold. Gold has clearly broken sharply to the upside, with USD2,000/ounce-plus being a done deal. 

Source: 4-Traders.com

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Is China the Next Market that Keeps Investors Up at Night?

The Eurozone debt/banking crisis really became the investor risk du jour from late 2009. As sovereign bond vigilantes began to heavily short selected Eurozone sovereigns through CDS (credit default swaps), Greece (Q1 2010), Ireland (Q3 2010), Portugal (Q1 2011), Cyprus (Q3 2011), Italy (Q4 2011), Slovenia (Q1 2012) and Spain (Q2 2012) saw their 10-year sovereign yields surge through 7%, a key sustainability level which forced many of these countries to seek bailouts. Once “risk free” sovereign debt held on Eurozone bank balance sheets became toxic, creating a significant number of “zombie” banks that were actually insolvent if holdings of public and private debt counted as assets were marked to market. 

Already weak economic activity in mainly the Club Med Southern European countries was exacerbated by demands from the Troika (the European Central Bank, the European Commission and the IMF) for draconian austerity measures in return for bailout funds, and only worsened the dependency on these countries for bailout funds to keep their fiscal finances afloat.

A serious political rift between the Northern European creditors led by Germany and their Southern European debtors seriously impeded the meaningful comprise needed to implement effective countermeasures, and thus the crisis has continued to metastasize, to the point that it seriously threatened the global financial system as well as the global economic recovery. 

Has Super Mario Discovered a Euro Crisis Game Changer? 

Now, it appears that “super” Mario Draghi, president of the ECB, has made some meaningful headway in dividing and conquering German opposition to the ECB’s acting as an urgently needed lender of last resort for the Eurozone. Germany, particularly the Bundesbank, continues to talk tough in resisting more bailouts without extracting another pound of flesh from its indebted Eurozone peers. The fact of the matter is, Germany is eye-deep in the crisis as well, and cannot afford a messy break-up of the Euro any more than their Club Med neighbors. 

Germany already has billions of Euros invested in preserving the currency zone, money that so far appears to have disappeared down a black hole, and their exposure to losses from a break-up or exit of other countries is significant via the TARGET2 Eurozone paymenst system. Jens Boysen Hogrefe, an economist at the Kiel Institute for the World economy (IfW), estimates the potential cost fo Germany amounts to about €1.5 trillion, the greatest share of which lies with the Bundesbank. Within the framework of the TARGET2 payment system, the Bundesbank has accumulated claims amounting to about €700 billion, which are expected to grow to €1 trillion by end 2012, of which it could probably only recoup a small portion if the Euro fails, including the €100 billion in bailout funds promised to countries like Greece, Portugal and Spain. 

Germany’s withdrawal from the Euro would be a disaster for German banks. Thus when push comes to shove in terms of saving the currency union, Germany and the Bundesbank is just as likely to blink as are the Club Med countries now in depression and drowning in debt, as Germany increasingly has more to lose. More details will be forthcoming from a September meeting of the Eurozone minds. If Draghi’s plan does work, investors could be facing a temporary melt-up in risk markets, as the worst-case scenarios for the Euro are taken off the table. 

But a China Crisis Could Replace the Euro Crisis

While the Eurozone crisis has been front and center on investors minds for the past two years, the movement of Eurostoxx 50 index suggests that the Eurozone is lurching, through fits and starts, in the right direction, while the divergence between the Eurostoxx index and the Shanghai Composite has become glaring. 

Source: Big Charts.com

As the one economy most responsible for expanding global demand for a range of commodities as well as finished goods such as automobiles and construction equipment, the shock of a marked slowdown in China or god forbid a financial blow-up along the lines of the Japan financial crisis could have even more serious economic consequences. 

– China’s economy grew at the slowest pace in three years in Q2 as Europe’s debt crisis hurt exports and a government drive to cool consumer and property prices damped domestic demand. The slowdown in China is due to overall industrial overcapacity accumulated in recent years. Coal inventories at Qinhuangdao port rose to 9.33 million tonnes on June 17, the highest since 2008, and stories that China is literally awash with excess copper inventories have been making the rounds for over six months. 

– Weiqiao Textile Co. says cotton consumption in China, the world’s largest user, may shrink 11% this year as deteriorating demand causes a significant overshoot in commodities supply.  China’s export growth collapsed in July and industrial output fell short of projections, after data showed the second-largest economy grew 7.6% between April and June. The world’s largest iron-ore producer flatly states that China’s so-called golden years are gone as economic growth slows.

-China’s shipping sector has been buffeted by weak global demand and an oversupply glut. An increasing number of Chinese shipbuilders are going under amid flagging demand for new vessels. Zhejiang Jingang Shipbuilding Co. which had been providing European customers with tank vessels, filed for bankruptcy with a local court in June. Ningbo Hengfu Ship Industry Co., which attracted attention in 2007 when it received a $160 million order for four bulk carriers from a German customer. U.K.-based research firm Clarkson Plc says nearly 90% of China’s shipyards have not received new orders since the start of 2012.

-Shipping sector woes of course are spilling over into China’s shipbuilding indusry. China’s Rongsheng Heavy Industries says that first half new orders were a mere $58m versus $725m in the second half of last year, resulting in an 82% plunge in net profit. Accounts receivable as of June surged 13-fold from the end of 2010 as the company allowed more time to settle their debts. 

– The HSBC China Manufacturing PMI (which is more reflective of the private sector in China than the official PMI which is more heavily weighted toward state sponsored corps) was 47,8 in August at at a 9-month low. The index has trended under the 50 boom/bust line for 10 consecutive months. The survey shows falling export orders and rising inventories.

– Foreign investors are steeling for bad news from China’s four biggest banks as they report first half 2012 earnings. Their interest is how fast these banks loans are turning sour. While the sharp selloff in the stocks of these companies makes their valuations on the surface look cheap, investors aren’t buying as they suspect the banks are under-reporting NPLs (non-performing loans), as banks all over the world do when markets start to go bad. Both property loans and exporter loans are a worry. As with Japan’s Heisei Malaise, bank analysts and even Bank of Japan officials are warning of major risk developing in the Chinese economy through the proliferation of the kind of “zombie companies” Japan made so famous in its 20-year malaise. Further, banks are reportedly throwing good money after bad to prop up zombie companies because the government is telling them to do so. 

The plunge in stock prices of the big four China banks, now among the largest in the world in assets, has exceeded 20%, and China Construction Bank is approaching its 2009 lows. The problems facing China’s banks are primarily domestic.

Source: Yahoo

– Kiyohiko Nishimura, the Bank of Japan’s deputy-governor and an expert on asset booms, is warning that the surge in Chinese home prices and loan growth over the past five years has surpassed extremes seen in Japan before the Nikkei bubble popped in 1990. Construction reached 12% of GDP in China last year; it peaked in Japan at 10%. Such bubbles turn “malign” once the working age of people to dependents rolls over, as it has long since done in Japan.  China’s ratio of working people to dependents will peak at around 2.7 over the next couple of years as the aging crunch arrives, and will then go into a sharp descent, compounded by the delayed effects of the government’s one-child policy.

-A report earlier this year by the World Bank and China’s Development Research Centre warned that the low-hanging fruit of state-driven industrialization is largely exhausted. They said a quarter of China’s state companies lose money and warned that the country will remain stuck in the “middle-income trap” unless it ditches the top-down policies of Deng Xiaoping. This model relied on cheap labour and imported technology. It cannot carry China any further. 

Thus China’s problem may not be simply a question of again opening the stimulus spigot wide. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com