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.
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| 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.
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| 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.).
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| 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.
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| 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.
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| 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.
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| 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.
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| Source: Yahoo.com, Japan Investor |
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| Source: 4-Traders.com |
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| 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.
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| Source: Yahoo.com |
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| 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.
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| 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.
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| 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.
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| 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.
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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.
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| 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.
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| Source: FX Street |
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| 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.
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| 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.
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| 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%.
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| Source: Nikkei Astra, Japan Investor |
st1\:*{behavior:url(#ieooui) } <![endif]–>While merely recognizing a secular trend that has been in place since mid-2011, we believe that allocations in emerging markets including China, commodities and fixed income (bonds) should be reduced in favor of a) US equities and b) Japanese equities. This is not your plain vanilla envelope global recovery.
Japan investor tokyo takes 