Setting Up for Another Summer Swoon?

On the surface, everything is hunky-dory in equity markets, at least from the U.S. perspective. The DJIA has hit a new high, the NASDAQ is much higher than its 2007 peak, and the S&P 500 finally broke out to a new high. Just looking at U.S. stock prices, one would assume that the world has completely recovered from the 2008 global financial crisis. However, by the time US economists realize the US economy is slipping into another summer swoon, stocks will have already been there, done that, so investors should play close attention to what Dr. Copper, the Shanghai Composite and the Eurostoxx Banks index is telling them, i.e., caution ahead. These yellow flags are not completely going unnoticed in US stocks, however, as the drivers to new highs have been the defensive sectors.

 

Source: Yahoo.com, Japan Investor

In the nearly four years since the 2008 financial crisis, global equities led by the S&P 500 have taken a summer swoon on renewed economic slowdown concerns. This three-year “sell in May and go away” proclivity is now accompanied by Dr. Copper, the Shanghai Composite and the Eurostoxx Banks index suggesting another summer swoon of as yet unknown proportions in 2013, while the red-hot Nikkei 225 is also beginning to sputter because JPY has recently counter-rallied some 3%, despite a renewed surge in JPY/USD “speculative” short positions as indicated by the CFTC’s commitment of traders.

Source: Oanda

Dr. Copper has broken down even as the S&P 500 was hitting new post financial crisis highs. Evidently, the industrial metal is not impressed by the bullish scenarios gushing out of the U.S., and with good reason. The Santiago-based Center for Copper & Mining Studies sees copper supply outpacing demand by between 100,000 and 200,000 metric tons in 2013 for the first time in four years on increased output from new and existing mines. Combine this with a forecast shrinkage of Eurozone GDP growth of 1%~1.5% and uncertain China demand (which accounts for some 38% of global copper consumption), as Beijing’s curbs on the nation’s property sector is a headwind for the red metal’s demand. 

The much-anticipated Abenomics wave in Japan has also yet to revive Japan’s sputtering growth engine, and as the emerging markets are dealing with their own versions of deleveraging, that basically leaves the US economy, where a sequestration fiscal drag is faced off with an energy sector revival and improving housing market. 

Source: 4-Traders.com, Japan Investor

The above chart shows suggests that things could get messy on the downside for copper, as the break down from the current flag pattern has the potential for a significant correction, especially if China demand does not take up the excess supply in 2013 as is currently expected. 

Although still comfortably above the 50 expansion make-or-break line, JPMorgan’s Global Total Output index fell to 53.0 in February from 53.2 in January as the rate of expansion eased to a four-month low. The index indicates France, Spain and Italy are dragging the Eurozone into a deeper downturn. On the other hand, the good news is that the March HSBC final China PMI climbed to 51.6, roughly in line with a flash reading of 51.7 and up from February’s 50.4. Although the speed of revival in the world’s No. 2 economy may not be as brisk as some think, the China numbers are apparently spilling over into Asia, where the HSBC/Markit survey of purchasing managers showed manufacturing activity in South Korea at its strongest rate in a year as new export orders picked up, and the Markit/JMMA survey for Japan showing manufacturing activity is growing for the first time in 10 months. However, Asia remains spotty, as the HSBC manufacturing PMI for India fell to 52.0 in March from 54.2 in February, marking the biggest month-on-month drop since September 11. 

China Stocks Acting Like China’s Growth Recovery is Still Much in Doubt 

Simply judging from the Shanghai Composite, China’s growth recovery is still very much in doubt, as the index is trending in a short-term bear, long-term neutral pattern. The index recently fell to a three-month low as declines by health-care and consumer-staple shares overshadowed gains by property developers. The index has already slumped 8.6% from a Feb. 6 amid concerns that steps to cool property prices will drag on economic growth, while company earnings are trailing estimates.

Source: 4-Traders.com, Japan Investor

Downward Revisions in Euroland Growth 

The renewed plunge in the Eurostoxx Bank index indicates the “Cyprus solution”, i.e., dragging in busted bank depositors into the equation, has rattled depositors in any bank, particularly those in Euroland where balance sheets are still chock full of dicey sovereign debt and solvency issues.

Source: 4-Traders.com, Japan Investors

Source: Markit

The Eurozone PMIs show this is also Eurozone-wide growth issue, as the latest readings show continued deterioration even among the core Euro countries like France, whose PMI is deteriorating faster than the rest of the non-Germany Eurozone. Corporate ouput is at a four-month low, services at a five-month low, manufacturing at a three-month low. 

Euro Bailouts: A Massive Debt Ponzi Scheme 

The Euro debt crisis came to a head from late 2009 as investors lost faith in individual countries and the Eurozone as a whole to effectively deal with rising private and government debt levels, while the ECB appeared organizationally hog-tied from acting as a lender of last resort. Since the weaker Euro countries forfeited their own monetary policy and currency for membership in the Euro, they could not respond to the decline in demand by lowering interest rates or devaluing their currency, and thus became ever-dependent on the “Troika” (IMF, ECB and EU) for bailouts. 

Until Greece and Cypus, the “rescue” of the Euro had in effect been one giant debt ponzi scheme, where debt was basically transferred from insolvent institutions to governments, then eventually to core Eurozone taxpayers under repeated bailout schemes. The bailout shell games essentially let core country Eurobanks, particularly German banks off the hook for losses, allowing them to quietly recapitalize while investors focused their attention on the crisis hotspots. 

U.S. Fed USD Liquidity Averts a Eurobank Liquidity Crisis 

European banks’US dollar funding increased significantly between 2000 and 2008. In the five years before the collapse of Lehman Brothers, European banks’ US dollar-denominated balance sheets almost tripled. European banks typically borrowed US dollars for two reasons: a) to fund their US dollar assets (i.e. to avoid a currency mismatch); and b) to fund assets priced in other currencies. After the collapse of Lehman Brothers, unsecured interbank lending virtually collapsed, meaning that banks that issued straight into unsecured US dollar funding markets had to resort to secured funding markets, particularly FX swaps and repurchase agreements. But suppliers of US dollar funding were unwilling to lend or roll over funding to these banks until they had gained a good handle on their own liquidity requirements. 

A deeper liquidity crisis was prevented by the U.S. Federal Reserve establishing currency swap lines with major central, including the ECB, in order to supply US dollar liquidity. At the peak at the end of 2008, the Federal Reserve supplied around USD 550 billion, most of which went to central banks in Europe. At the end of 2008, the outstanding amount of US dollar liquidity provided to Eurosystem counterparties by the ECB was almost USD300 billion, compared with Eurosystem reserves (in convertible foreign currencies) of only around USD200 billion. 

Negative Catch 22 Spirals Bad Debt 

The next phase of the crisis was severe balance sheet impairment (solvency) resulting from a sharp rise in not only private sector non-performing loans, but increasingly valuation losses on large holdings of sovereign debt of weaker southern European nations. The crisis worsened as Fitch, Moody’s and Standard & Poor’s lowered preripheral Eurozone credit ratings, driving up funding cost, and making it more unlikely that these countries could find the funds to repay debt. Sovereign bond buyers had assumed that a bond issued by one government in the EMU was equally safe as a bond issued by a core EMU nation. Further, the ECB’s ability to act as a lender and buyer of last resort was severely compromised by mainly German (Bundesbank) resistance to the kind of unconventional monetary policies rapidly implemented by the U.S. Fed. 

The investor crisis of confidence regarding the safety of periphery Euro sovereigns and the health of Euroland bank balance sheets was a negative feedback loop; e.g., the more values of weaker peripheral country sovereign bonds fell, the bigger the unrealized losses of large sovereign debt held by Euroland banks became. Banking stocks were plunging as sovereign debt yields in the peripheral and increasingly the core (Spain and Italy) countries soared. As the collateral used by Eurobanks authorized to borrow from the ECB was severely compromised, their ability to borrow from the ECB—and thus the liquidity of the economic system, was further impaired, drawing the ECB ever deeper into rescue operations. 

Both the weaker banks and their home governments were increasingly blocked from public funding routes by prohibitively high rates and the simple lack of demand for their paper. This was exacerbated by the European Banking Associations’ (EBA) action in December 2011, intended to restore rapidly disappearing confidence in the viability of Eurobanks, requiring “core” banks to bolster their capital base by some EUR115 billion. To do this, Euroland banks sold foreign (no EU) assets as well as peripheral Euro sovereign bonds increasingly viewed as toxic. 

The circular nature of the Euro debt crisis made a permanent resolution virtually unattainable. Market participants and rating agencies saw banks and sovereigns as inextricably interlinked, leading to acute pressure on funding costs. Boosting growth or re-capitalizing banks would require an injection of public money, money which countries with a sovereign debt crisis could not provide, forcing them to seek a bailout from the EU Troika.

Source: Wall Street Journal

Until Greece, Everyone Was Getting Bailed Out 

So far, no less than eight of the 17 EU member states have received cumulative bailouts exceeding EUR462 billion. The ECB bought around 220 billion euros in Greek, Spanish, Portuguese, Irish and Italian government bonds under its Securities Market Program (SMP) from 2010 until early 2012. Actually, the ECBs 17 member banks held the bonds on their balance sheets according to their countries’ sizes. The ECB has bailed out struggling some 800 struggling banks through a two-tranche long-term (3-year) refinancing (LTROs) worth EUR1,019 billion at an interest rate of just 1% to pay off maturing debts and to coax them to lend to strained governments and customers. 

While the LTRO program went a long way in stabilizing the bond yields of weak sovereigns, by February 2013, only EUR61 billion of these loans had been repaid. Many banks, particularly those in Spain and Italy, used portions of those funds to in turn buy higher-yielding sovereign bonds issued by their governments, or they simply deposited the money at other banks or with the ECB itself. Thus the money failed to trickle down into the real economy, while the quality of the ECB’s own balance sheet, which had rapidly swelled to over EUR3 trillion, rapidly deteriorated through the acceptance of a wider range of assets pledged as collateral for the loans.

Source: Wall Street Journal

ECB LTRO Helps Avert Financial Disaster 

While ECB’s LTRO operations were widely credited with averting a possible financial disaster, it did nothing to address the fundamental problem of the dangerous linkage between Eurobank balance sheets and increasingly toxic sovereign debt. As the political process required for bailout packages and new ECB programs was agonizingly slow and piece-meal, Euroland continues lurching from one crisis to another, as politicians focused on the most immediate crisis at hand, oscillating with every new development and triggering renewed intensity in another crisis area. The Euro crisis has long since become a battle which can’t be won – at least not in the short term. 

Destruction of the “Everyone Gets a Free (Bailout) Lunch” Myth 

Thus the ECB’s bank band-aid operation did little to help Greece. Greece’s sovereign bonds were downgraded to junk in April 2010, forcing Greece to seek a bailout that came with stiff conditions for the loan, i.e., a) austerity to ostensibly restore fiscal balance, b) privatization of government assets and c) structural reforms, which was the cookie cutter formula used by the Troika (IMF, EU and ECB) to impose “discipline” on the bailout recipient. This austerity however only exacerbated public finances, which in turn further deteriorated the value of sovereign debts, which in turn further impaired bank balance sheets, thereby making the cost of bailouts ever larger and the prospect of repayment even more remote. The Greek government was pushed to the brink of default in resisting the Troika’s bailout conditions, creating a political crisis as well. 

As part of a second bailout package for Greece, the IMF set a negative precedent that bondholders accept up to 50% haircuts on their Greek sovereign debt, thus fudging what effectively was a Greek default on its sovereign debt. Further forced austerity measures pushed Greece ever closer to an all-out depression. 

Euro is Being Propped Almost Solely by the ECB 

The ever-deepening catch 22 Eurocrisis led many to declare an eventual end or collapse of the monetary union, or a catharsis, such as Greece’s exit from the Eurozone. A consensus is emerging that a one-sided focus on austerity and structural reforms are causing a debt spiral because GDP is falling more rapidly than budget deficits, and structural reforms only begin to off-set this negative effect after years. At the same time, the core Euro nations that ostensibly are providing most of the backing for repeated bailouts are suffering from bailout fatigue. Ahead of impending elections, a prominent group of anti-euro German economists and business leaders has formed a political party to challenge Germany’s support for euro-zone bailouts. A recent poll showed 26% of Germans would be willing to vote for the anti-Euro party if the German elections were held today. When you consider middle-aged Germans, the percentage against the Euro rises to 40%. 

Facing the very real possibility of a breakup in Euro, soaring sovereign yields and plunging financial markets, the ECB’s Draghi came out with a credible promise to “do whatever it takes” to save the EUR, and followed this with a new program of “open-ended, unlimited buying” of distressed government bonds, which again was credited with stabilizing the crisis. 

A Litany of Acronyms for Failed Policy 

But a litany of Euro-centric acronyms tells a sad story of EU political solutions to the crisis. 

May 2010: The European Financial Stabilisation Mechanism (EFSM) was an emergency funding program reliant upon funds raised on the financial markets and guaranteed by the European Commission using the budget of the EU as collateral. The fund, backed by all 27 European Union members, had the authority to raise up to €60 billion, and was rated AAA by Fitch, Moody’s and Standard & Poor’s. 

May 2010: The European Financial Stability Facility (EFSF) was created with a mandate to “safeguard the financial stability in Europe” by providing financial assistance to Euro area within the framework of a macro-economic adjustment program. Although supersceded by the ESM, the EFSF continued with ongoing programs for Greece, Portugal and Ireland, while financial assistance for the recapitalization of Spain’s banking sector was transferred from EFSF to ESM. 

September 2012: the European Stability Mechanism (ESM) was set up to provide financial assistance to members of the eurozone in financial difficulty and was supposed to function as a permanent firewall for the eurozone with a maximum lending capacity of €500 billion. The ESM ostensibly replaced two existing temporary EU funding programs: a) the European Financial Stability Facility (EFSF) and b) the European Financial Stabilisation Mechanism (EFSM). With the launch of ESM, all new bailout applications and deals for any Eurozone member state with a financial stability issue would be covered by the ESM. 

On the Other Hand is the ECB

The Banks’ real mandates were to maintain price stability and promote the smooth operation of financial market infrastructure under the TARGET2 payments system, as well as issue Euro notes and coins–not effectively bail out individual member states or banks. The central banks of Germany, France and Italy contribute 19%, 14% and 12% respectively of the ECB’s capital, meaning these countries will bear the bulk of losses from the bailouts. The principal tool of the ECB to implement monetary policy is collateralized borrowing or repo agreements, and the collateral originally used by the ECB was typically high quality public and private sector debt. But the deeper the crisis and contagion became, the deeper the ECB was drawn in to demonstrate their role as lender of last resort. 

December 2011; The ECB first took a swing at reducing market uncertainty by announcing a plan to conduct two longer-term refinancing operations (LTROs) with a maturity of up to 36 months and the option of early repayment after one year. This program ended up providing about 1/5th of all liquidity provided by the ECB. 

September 2012; The ECB announced a new plan for buying bonds from Eurozone countries, i.e., an Outright Monetary Transactions (OMT) program that has no ex-ante time or size limit. 

Bailouts, Bailouts and More Bailouts 

To date, Cyprus, Greece, Hungary, Ireland, Latvia, Portugal, Romania and Spain have received multiple bailouts, from Troika, the World Bank, European Investment Bank, and/or the European Bank for Reconstruction and Development, but the only actions that have visibly reduced crisis risk have been the ECB’s LTRO and OMT programs. 

TARGET2 Payment System Imbalances and Risk… Target2 is a platform for a payment system jointly run by Euro member central banks and 190 financial institutions participating via the German Bundesbank, including German banks, German subsidiaries of foreign banks, and some 3rd country banks. While Target2 balances reflect cross-boarder fund flows, i.e., negative balances are debts of national central banks backed by collateralized loans to private banks, while positive balances generate interest for national central banks that carry those balances, the balances do not represent the real risk exposure of the national central banks. Germany, the Netherlands, Luxembourg and Finland have the bulk of positive balances, while, not surprisingly, Italy, Spain, Ireland, Greece and Portugal have the bulk of the negative balances. Target2 balances are an interest-earning asset for, example, the Bundesbank. In the event that a Euro member central bank defaults, the losses to individual countries would be proportional to their capital contribution to the ECB, with Germany providing about 27% of the ECB’s capital. 

German Bailout Hypocrisy 

Before 2008, German lenders were among the most profligate, channeling German savings into the Euro periphery. For example, Spanish banks borrowed heavily to finance a property boom, and still owe their German peers some EUR40 billion. These German banks were facing deep losses related to Spanish bank failures. Thus the bailout of Spanish banks, backed initially by Spanish taxpayers and potentially later by the ESM, was effectively a back-door bailout for reckless German lending. 

German lenders were by far the most exposed to Greece, Ireland, Portugal, Spain and Italy, with outstanding loans approximately EUR323 billion. Total periphery exposure equates to about 4% of the 7.3 trillion Euros of assets held by German banks and almost an eighth of the country’s annual GDP. 

But the public German narrative regarding southern European bailouts was much different that what the German banks experienced regarding the southern Europe bailouts. It was Germany who has lobbied heavily against private sector losses, such as the haircut on Greek sovereign debt. 

Germany’s Bundesbank has carefully cultivated this image fiscal and debt responsibility, whereas the German banks are actually the most leveraged in the Western world with a tangible assets to tangible common equity ratio of 28, versus just 11 in the U.S. by lending money to the peripheral countries, By lending bailout money to the peripheral to prevent fragile, over-leverage leveraged banks from collapsing, Germany was effectively bailing out its own banking system. Yes, German taxpayers would also be on the hook for bailout loans should a peripheral country default, but these loans have effectively been “socialized” throughout the Eurozone’s taxpayers in the proportion that each country contributed to the ECB. 

The situation was a little different for Cyprus. While Greek and German banks were ostensibly the Eurobanks with the most exposure, overseas lender exposure was some USD59.2 billion, Russian exposure was near USD40 billion. Germany’s HSH Nordbank had about EUR1.9 billion corporate loan exposure, versus total German exposure of some EUR7.6 billion. Thus it was much easier to stick it to the Russians. 

In Cyberspace We Trust?

To placate growing opinion in the core Euro countries against seemingly endless bailouts that let creditors and depositors off the hook, the Troika has broken the taboo of forcing depositor losses, which is perceived as expropriating people’s savings. 

With Ben Bernanke and the Fed alone creating the equivalent of 75 Bitcoin markets every month, Bitcoin (a peer-to-peer, digitised crypto-currency) has become the poster child for those seriously considering stripping conventional banking away from banksters, and money away from governments. The whole idea is that Bitcoin removes the need for trust in currency; trust in bankers, trust in governments, trust that the two won’t collude to do you over (we thought that was what gold was for), ostensibly replacing trust in institutions with the ultimate leap of faith,;trust in a string of code, wibbling around in cyberspace.

If you think central bank money printing is out of control, consider this; “On 6 August, a major vulnerability in the bitcoin protocol was found. Transactions weren’t properly verified before they were included in the transaction log or “blockchain” which allowed for users to bypass bitcoin’s economic restrictions and create an indefinite amount of bitcoins. On 15 August, the major vulnerability was exploited. Over 184 billion bitcoins were generated in a transaction, and sent to two addresses on the network. Within hours, the transaction was spotted and erased from the transaction log after the bug was fixed and the network forked to an updated version of the bitcoin protocol.” This was ostensibly the only major security flaw found and exploited in bitcoin’s history, but who knows besides a couple of code geeks? 

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

The Great Rotation and Currency Wars; Great Headlines, Dubious Investment Strategy

The Great Rotation is one of the best financial stories ever told, as it refers to a secular shift from cash (MMFs etc.) and bonds into risk assets. 

• Historically, however, such big picture regime changes have not suddenly run their course in a short period of one or two years, and investor sentiment indicators are pointing to a short-term extreme, leaving room for a 10%~15% correction in stock prices. 
• As for a great rotation-induced bond market crash, keep in mind that over 60% of US treasuries are held by the Fed and foreign governments (central banks) who are policy driven, and not driven by profits/losses during major market moves. Also keep in mind the Fed has promised “unlimited” bond purchases, ostensibly on the order of USD1.14 trillion.
• In the so-called currency wars, a more aggressive BoJ balance sheet expansion could leave the ECB holding the short straw and trigger a response if the Euroland situation again tips toward crisis. So far, however, actual Japan-US bond spreads aren’t backing the dropoff in JPY, i.e., market expectations are way ahead of fundamentals, leaving room for disappointment/profit taking. 

Investor Bullishness Has Reached an Extreme

It appears that investor bullishness has reached an interim extreme. The BoA Merrill Lynch Fund Managers Survey taken between 4th to 10th January 2013 showed that investors bullishness surged to the highest level in over 10 years, and the 2^nd highest in the history of the survey. ML observed, “Bullish expectations on growth, profits and margins have finally translated into higher equity allocations. A net 51% of investors are overweight equities, the most bullish reading since February 2011.” In February 2011, we all know what happened next, the stock market (S&P 500) peaked in late April and fell nearly 18% over the next three months in a classic “sell in May” growth scare. 

Source: BoA ML, The Short Side of Long

CNN Money’s Fear & Greed index shows similar extreme readings. The current reading of 86 is consistent with a market in which participants are extremely greedy, and when investors are extremely greedy, the capricious Mr. Market usually steps up and gives them some pain, meaning stock prices could over-react in the short-term to virtually any unforeseen negative news.

Source: CNN Money

Finally, there is the S&P 500 VIX “fear index” which of course moves in reverse to stock prices. The VIX, is already back to lows seen several times after and before the 2008 financial crisis, implying the next major move is up, ostensibly on a selloff.

Source: BigCharts.com

The optimism is not unique to the U.S., as the MSCI World Index looks poised to challenge its 2007 high. But investors often, wrongly, extrapolate past returns into future return expectations. Does all the current bullishness mean that investors really believe the financial and economic devastation of the 2008 financial crisis is “fixed” and its now back to “regular normal” and business as usual? Or, since asset prices change in response to unexpected fundamental information, are we guilty of being too bearish from licking our investment wounds from the 2008 financial crisis that we cannot see asset prices are discounting good news we don’t know about or perceive yet? It’s probably a combination of both, as the extreme bullishness is a short-medium term perspective. 

Source: The Short Side of Long

Long-Term, The Greatest Financial Story Ever Told is Gradually Falling in Place

Kimble Charting Solutions has looked at the monthly closings of the DJIA going back 100 years. As the Dow is closing the month, its closing price iss within 24 points of the 2007 monthly closing high, i.e., the core U.S. blue chips are not only already closing in on the 2007 closing high, but is at the tope of its 70-year rising channel. Rising support, created by higher lows is squeezing DJIA into a very tight spot, caught in-between long-term support and resist lines, from which a break-out appears imminent. A breakout to the upside will require enough buyers and momentum, a breakout to be viewed as a long-term technical positive. However, DJIA is trading above a trading channel in place since the 1930s, meaning it could also correct down to the lower line of the channel, especially with any serious setback in the still-fragile Euroland debt/bank balance sheet situation and a sputtering U.S. recovery. The Fed, ECB’s and BoJ’s commitments to “unlimited” QE substantially minimize the probability of this happening, but there is more than zero probability that massive central bank debt monetization and currency debasement simply stops working at some point. 

The greatest financial story ever told of course is the secular rotation out of cash (MMF, etc.) and bonds into risk assets, i.e., stocks. Since we have already experienced a near meltdown in the global financial system and survived, the next big wave is the Great Rotation, but it doesn’t all have to happen (and indeed is unlikely to happen) in just one year. Rather, more desireable (and historically realistic) is a gradual shift in funds that avoids creating yet another infernal bubble. 

Source: Kimble Charting Solutions

Shanghai Back from the Dead

While the short JPY, long Nikkei 225 has been the darling of hedge fund managers since October-November 2012, according to the BoA ML survey, global fund managers are especially optimistic abouth China, where, “Growth optimism surged to a 33-month high. Optimism on Chinese growth remains robust. A net 63% expect a stronger Chinese economy over the next 12 months, the second highest reading on record.” This represents basically a 180 degrees shift in investor sentiment over the past year, as many investors a year ago were convinced by hedgies such as Jim Chanos and Hugh Hendry that China was going to hell-in-a-hand basket. Unlike Japan where USD, EUR-based investors will see their JPY-denominated investments be undermined by JPY weakness, they stand to win both in capital gains and currency appreciation in the case of China. 

The recent spurt in the Shanghai Composite, which is more dominated by domestic retail traders, indicates that Chinese investors are also coming around to the idea that China is in for a soft landing, even though there is much repair work that needs to be done on the Shanghai Composite before its all clear skies and fair sailing. 

Source: Big Charts.com

Great Rotation = Bond Market Blowup?

The smart guys in the room, like Goldman Sachs, are growing more nervous about the bond bubble. Regardless of what they are telling clients, the investment bank in the past year has strategically cut the amount of money it could lose if interest rates were to rise. The bank has also upped its own borrowing in order to lock in low interest rates. The two top guys, Lloyd Blankfein and COO Gary Cohn recently warned at the Davos WEO and at a recent conference in New York that many banks and investors might not be prepared for the possibility of a “significant repricing” in the bond market. The moves are reminiscent of those Goldman took in 2006 and 2007 in the run-up to the housing bust, as the firm reportedly made bet against mortgage bonds to profit as the price of housing debt collapsed to protect its B/S even as they touted toxic mortgage-backed securities to investors.

To a certain extent, higher bond yields, as they reflect improving growth expectations, are positive for the stock market. Keep in mind that US 10yr treasuries were trading between 2.5% and 4% yields as recently as 2010 on rising growth expectations, when no one was seriously suggesting a bond market blowup. Also keep in mind that over half of Treasury holders are policy driven and not driven by profits/losses during major market moves. This is because the Fed owns some 15%, while foreign official (central bank) holdings are some 46%, meaning the vast majority of US treasury holdings are unlikely to rapidly dump their holdings just because rates have been rising and prices have been falling in the last three months, even though China’s CIC for example recently voiced their concern about the sustainability of the USD’s value. Of the foreign holders, China and Japan account for almost half (21%+ and 20%+ respectively) of foreign holdings of US treasuries. 

Source: FXStreet

Also keep in mind that the Fed will be buying some USD1.14 trillion of  U.S. treasuries in the QE4-unlimited version. Indeed, the biggest risk is that the Fed becomes so confident in the sustainability of recovery, ostensibly with unmistakable signs of sustainable job growth, it scales back or even ends “open-ended” quantitative easing within the next couple of years. A close look at the prior seven major tightening cycles in the U.S. since the early 1970s suggest that the 10yr bond yield will remain “docile” throughout 2013 and even most of 2014. On the Great Rotation scenario, Wall Street is still officially divided. Citi’s Tobias Levkovich believes the Great Rotation scenario is bunk at least for 2013 and much of 2014, while BoA strategist Michael Hartnett believes the Great Rotation has arrived, as does Bridgwater’s Ray Dalio, although he apparently sees a less bond-market-threatening shift, at least not like the 1994 debacle.

Thus shorting treasuries and going “all in” equities has short-medium term risks as well. 

Currency Wars vs the Big Mac Index

Japan announced that, as of January 2014, it will begin an open-ended, unlimited QE program to monetize Japanese debt (they are currently buying 36 trillion yen a month, or about $410 billion) and attempt to generate the magical 2% inflation target, thereby pulling Japan out of its structural deflation spiral.

While Germany, South Korea, the U.S. auto industries whose export competitiveness has benefitted at the expense of Japan since the 2008 financial crisis are warning of an escalation in developed market currency wars, the Economist’s infamous Big Mac Index index actually shows JPY as over 10% undervalued versus USD, while China’s Yuanis 30%+ undervalued and India’s Rupeeis over 50% undervalued versus USD. On the other hand, Norwayand Sweden’s currencies are around 50% overvalued, while EUR is also slightly overvalued vs USD. 

In reality, Japan’s BoJ is merely attempting to catch up to the surge in other major central bank balance sheets, who have been monetizing debt like crazy. The currency with the short straw is expected to be EUR, and if continued economic weakness in Euroland forces the ECB to respond, a currency war could break out in earnest, bringing JPY back to square one and well away from the 30% + depreciation needed to recover a significant amount of export competitiveness lost to South Korea and China, for example. 

Meanwhile, the Fed is already committed to “unlimited” QE, the Street expects the Fed to purchase USD1.14 trillion assets by Q1 2014 (i.e., a 30%-plus B/S expansion) , whereas the BoJ’s more aggressive program ostensibly won’t start until 2014, meaning for the rest of this year, the Fed will continue printing money a lot faster than the BoJ. Further we believe a move to a new trading range between JPY95 and JPY100/USD would merely bring JPY back to a trading range prevailing before the Great East Japan Earthquake, which the JGB (Japan Government Bond) market could easily handle without blowing up. Indeed, policy makers as well as investors would get spooked if JPY shot through JPY110 like hot butter, eliciting fears of a serious JPY crash–something that no one except perhaps Kyle Base would welcome. 

Source: The Economist Big Mac Currency Indices

JPY300~JPY400/USD: “Pie-in-the-Sky” JPY/USD Projections

Further, the hedgies and “smart” investors should be careful about what they wish for in forecasting a crash in JPY to JPY300 or even JPY500/USD. Such a crash implies Japan basically collapsing into a banana republic of excessive debt gone sour and fiscal collapse. Since domestic investors are by far the major holders of this debt, it is they who would take the hit, particularly large banks and other Japanese financial institutions. 

The IMF, the Bank of England and major Japanese banks themselves have warned of the balance sheet risk from holding some JPY40 trillion worth of JGBs. The IMF estimates that a 100bps jump in JGB yields would represent a 26% shock to regional banks’s Tier 1 capital, while major banks could withstand a “moderate” JGB shock. The Bank of England, however, has estimated that the Japanese banks’ JGB holdings represent 900% of Tier 1 capital, versus 25% for U.K. banks and 100% for U.S. banks. Given some other shock to the banking system, the Japanese government would be hard-pressed to backstop the system owing to the effects of its own position on bank balance sheets. 

These short sellers talk as if a fiscal collapse in Japan is an “opportunity” instead of a systemic risk to the global financial system. If big holes are blown in the balance sheets of Japan’s major financial institutions, one of the first places they will turn to for instant liquidity is US treasuries, meaning US treasury prices could also tank as JPY surges through Japanese financial institution repatriation of overseas funds. Thus as was seen during the height of the Euro debt crisis, a debt crisis virtually anywhere in the world has wide-spread and deep reprecussions, meaning the portfolios of JGB and JPY short-sellers could get heavily whacked even as these investors make quick money on their short JGB & JPY trades, not to mention the losses to sovereign wealth funds and central bank holders of JGBs. All-in-all, it is an outcome that policy makers around the world would like to avoid as much as an implosion of the Euro. 

Much Expectation Has So Far Seen Minimal Action

As I have frequently pointed out and my former ABN AMRO colleague Chris Wood has highlighted, the rapid plunge in JPY/USD has so far not been confirmed by an expanding expansion in the US-Japan 2-year bond yield spread. Chris suggests the JPY has much further to go if a “Bernanke wannabe” like Kazumasa Iwata becomes the new BoJ governor in Q2, 

Our reading is that the gap suggests market prices have already discounted traders’/investors’ vision of how Abenomics and a more aggressive BoJ policy plays out, leaving a lot of room for short-medium term disappointment, unless of course the new “Bernanke wannabe” BoJ governor decides to implement “unlimited” QE in 2013 instead of 2014, as was indicated by current governor Shirakawa, as the Fed’s buying of some USD1.14 trillion ostensibly represents a 30% expansion in their balance sheet; something that the BoJ must exceed in terms of change rate to ensure JPY depreciation has legs.  

Source: Chris Wood, CLSA

Expect to See Many More Earnings Upgrades from Japanese Companies

With JPY/USD already back to the JPY92 level, the Yen is again trading weaker than the aggregate average breakeven level for Japan’s exports as indicated in BoJ surveys, which is JPY85/USD. Goldman Japan is already forecasting a 14% increase in Japan corporate profits based on JPY88/USD, and as ever JPY10 of weakness raises Japan corporate profits by 6%~8%, growth could accelerate to over 20% if JPY averages 100-plus. 

Japan Tobacco (2914), Asia’s largest listed tobacco maker, has already raised its profit forecast as the weaker yen boosts the value of its overseas earnings, and we expect to see a lot more upgrades as 2013 progresses. Consequently, stocks with the most to gain from a weaker JPY like car maker Mazda (7261), struggling electronics major Sharp (6753), steel makers JFE (5411) and Kobeko (5406), bearing maker NTN (6472), as well as high beta broker/dealers like Nomura (8604) and Daiwa (8601)  have led the 30%-plus rally in the Nikkei 225 from October 12/13 2012 lows in surging over 80% in less than four months. 

Source: Tokyo Stock Exchange, Japan Investor

The surge in Japanese stock prices is of course being driven by foreign investors, who were net buyers by JPY2.893 trillion from the October lows, pushing market prices higher despite net selling by domestic institutions of JPY1.786 trillion and individuals of JPY1,013 trillion. While not yet “all-in”, broker/dealer prop trading added JPY111 billion of net buying, helping to tip the balance in the bulls’ favor. Meanwhile, the few losers included grounded Boeing Dreamliner battery maker GS Yuasa (6674), and overseas plant equipment majors JGC (1963) and Chiyoda Corp. (6366) that were directly affected by the terrorist takeover of a gas facility in Algeria. In addition, with the export stocks soaring, investors are abandoning pure domestic demand stocks whose costs will rise with the weaker JPY, including the beer makers Asahi (2102) and Kirin HD (2503). 

Source: Tokyo Stock Exchange, Japan Investor, JPY billion

We expect domestic institutions to continue selling through February and March ahead of fiscal year-end book closings as this is the first chance they have had to book profits on their holdings in a long time. Whether domestic institutions really believe in Abenomics and new BoJ leadership will become apparent from their Q1 FY2013 (April~June), when traditionally they have deployed their new year’s asset allocations. 

 

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

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

The Fed’s Insanity: Pushing Ever Harder on a Limp String. But Investors Love It

Marc Faber of the Gloom, Doom and Boom report has been talking about Q3, Q4, Q5 ad nauseum for some time. Ben Bernanke did him one better, i.e., why keep repeating the stimulate-wait cycle and not just implement open-ended QE?. What Mario Draghi and Ben Bernanke have done is hang a big neon sign flashing “go into risk assets, young man!”. They are not targeting “employment” or “growth” but asset prices. 

What we have here is a case of full-scale debt monetization, and if that leads to accelerating inflation, so be it, as higher inflation deflates the real value of all that excessive debt out there, and historically has been one way to work an economy out of excessive debt. The obvious victims are the USD, EUR and a general ongoing currency debauchery, ergo,, gold going to USD2,000 and equivalent levels in EUR. Good luck to the BOJ trying to hold JPY under JPY75/USD. Mr. Shirakawa and the BOJ are just to timid (fearful) of unleashing their own balance sheet blitzkreig, knowing full well it would risk a major blow-up in JGB yields.

Are we on the verge of Weimer Republic runaway inflation? Not by a long shot, i.e., not as long as there is heavy balance sheet deleveraging and excess global capacity. As to the question of whether the Fed’s massive balance sheet deployment has helped or hurt,
n his Jackson Hole 2012 speech, Bernanke maintained that,

1) “After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. This research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. LSAPs (Large Scale Asset Purchases) also appear to have boosted stock prices.”

“Appears” is quite an understatement, as we pointed out last week, the S&P 500 is up about 109% and long bond values are up some 51% since the Fed began to seriously deploy its balance sheet. This time, investors have been bidding up risk assets since late July when Mario Draghi signalled the ECB was moving to act. 

Source: Yahoo, Japan Investor

2) He also insists there has been a tangible favorable impact on the real economy. “A study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3% and increased private payroll employment by more than 2 million jobs,”

In summary, Bernanke insisted that provided important support to the economic recovery while helping to maintain price stability. If this is so, why did the Fed feel compelled to implement “unlimited” QE3?

1. The U.S. economic recovery is not self-sustaining without significant monetary support. Each time the Fed has tried to back away, economic growth has sputtered.

Source: Trading Economics, Japan Investor

2. In Bernanke’s own words, a) “the economic situation is obviously far from satisfactory. The unemployment rate remains more than 2 percentage points above what most FOMC participants see as its longer-run normal value, and other indicators–such as the labor force participation rate and the number of people working part time for economic reasons–confirm that labor force utilization remains at very low levels. b) the rate of improvement in the labor market has been painfully slow. growth in recent quarters has been tepid. Unless the economy begins to grow more quickly than it has recently, the unemployment rate is likely to remain far above levels consistent with maximum employment for some time.” While the headline number is now around 8.1%, or where the Obama Administration ostensibly promised it would be, FRED statistics measuring total unemployed, plus marginally attached workers plus total employed part time for economic reasons shows unemployment more like 15%.

Further, there has been a significant decline in the labor participation rate.

Source: Bureau of Labor Statistics

Finally, the U.S. misery index, i.e., unemployment + inflation, hit a 28-year high in October 2011, even though inflation remains well subdued. Further, median household income in the U.S. in 2011 fell to USD50,054, down for the fourth straight year. In other words, aside from the top 1% who receive a significant portion of their income in capital gains and other investment payouts, this has not been a “feel good” recovery. 

Fed Numbers Ignore Negative Impact of Dramatically Reduced Interest Income? 

Further, the Fed’s estimates of the positive impact from successive QE apparently ignores the losses in spending power, output and employment generated by artificially low interest rates. The George Washington blog, based on the $9.9 trillion in assets most directly affected by depressed yields on Treasurys, estimates an annual impact of this loss of interest income at $256 billion of lost consumption, a 1.75% loss of GDP, and about 2.4 million fewer jobs, the impact of course was most felt at the lower quintiles of the economic spectrum. Using these numbers, Bernanke’s claim of a 3% economic impact gets trimmed to 1.25%, and the 2 million job gains are actually a net 400,000 jobs loss. 

The Fed’s Insanity: Pushing Every Harder on a Limp String

If the definition of insanity, as Albert Einstein stated, is doing the same thing over and over while expecting a different outcome, then what the Fed is doing is totally insane, as they are merely pushing ever harder on the proverbial string. What needs to happen is very clear in the following chart, i.e., the Fed must somehow fix the velocity of money, i.e., the degree that monetary policy is being transmitted into the real economy, which the FRED chart shows has collapsed to levels not seen in 47 years.  

Rather than accomodating a controlled de-leveraging of financial institutions and consumers, while steering the economy toward more investment in productive assets, the Fed is busily trying to do what it can, i.e., reflate the credit bubble, which has been the primary source of growth. Unfortunately, steering the U.S. economy toward a more sustainable growth path while cleaning up the mess left after decades of speculative activity in the financial sector is beyond even the Fed’s pay grade. 

Enjoy the Financial Assets Fix While it Lasts

As the chart below shows, there is a very loose relationship between what is actually happening to economic growth and the stock market, with stocks frequently over-reacting to perceived moves in the real economy. Consequently, it is hard to know if the current melt-up in risk assets has any inkling of an upside economic surprise around the bend.

Our working assumption is that the Fed’s pushing on a string will end as all past episodes of QE, government stimulus have during such major financial crisis episodes–i.e., the party lasts only as long as the stimulus fix is on, but soon begins to sputter.

Consequently, we will enjoy the boost to risk assets while it lasts, but have no illusions as to its sustainability.

Source: Politics and Prosperity

Risk Assets Run-Down

Gold has obviously broken to the upside and remains the best-performing asset, despite a brief consolidation period. Gold producers as well as strategists are again talking about gold at $2,000/ounce, maybe within the year; which is not the pie-in-the-sky call it once was, because the GLD ETF is only some 17% away from this milestone.

While hampered by a weakening USD, US stocks remain the best-performing developed market, while the Swiss, Canadian and Sweden markets are running close seconds, for those who fear open-ended QE3 will hit the value of USD harder than EUR and certainly harder than CAD. With open-ended QE in the U.S., the USD will undoubtedly deteriorate further even against EUR, while the currency with the most bang for the Fed/ECB QE buck is the Australian Dollar, closely tailed by JPY and the Swiss Franc. The Swiss Franc in particular has seen a noticeable spurt of late.

Source: Yahoo.com

Source: Yahoo.com

In Asian equities, Malaysia is by far the best-performing and was so even before the Draghi statement, while Singapore and Australia have noticeably recovered. Compared to its neighbors, the Japanese market looks decidedly luke-warm neutral, while China and India should probably be avoided, even though India has been rallying. 

Source: Yahoo.com

In local currency terms, both the Shanghai Composite and the Nikkei 225 still look very top-heavy.
The recent news of new infrastructure spending by Beijing has barely caused a twitch in what is a very ugly-looking Shanghai Composite chart.

Source: Yahoo.com

Given that Japan’s trade is now joined at the hip with China, falling China imports are already a heavy weight on Japan’s deteriorating balance of trade. Given that a corresponding response to bold moves by the ECB and the Fed by the BOJ are seen as highly unlikely, JPY could very well see more pressure to appreciate beyond JPY75/USD, raising another red flag for Japan’s long-suffering exporters. 

While the Nikkei 225 could eventually break out of the increasingly narrow trading flag it currently is trapped within, this would only leave the index dealing with a longer-term flag pattern to deal with. We see a major turn in the market as unlikely as long as a) China growth continues to sputter and b) upward pressure remains on JPY. 

Source: Yahoo.com

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

U.S., Eurozone Policy Response is Essential for the Risk Rally to Continue

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Stock Markets (Traders) Respond to Renewed Affirmation of Draghi and Bernanke “Puts”

The S&P 500 index hand rallied some 10% since early June, Germany’s DAX has rebounded 15%, and Frances CAC has jumped 16%, while Italy is up 20% and Spain up 24% since mid-July. It is interesting to note that while all the sovereign bond pressure has been on Spain, Italy’s stock market actually sold off worse than Spain’s, and thus the rebound has been stronger.

Source: Yahoo.com

Thus hopes of more of the “Draghi Put” and the “Bernanke Put” have revived stock prices. As for the ECB Put, Mario Draghi is due to announce details of the plan on September 6, but the ECB cannot start buying Club Med bonds until all the conditions imposed by German Chancellor Angela Merkel under the secret deal have been met; a) Italy and Spain must first request a formal rescue from the European Stability Mechanism (ESM) or the old bail-out fund (EFSF), and sign a “Memorandum” ceding fiscal sovereignty to EU inspectors, and b) the German Constitutional Court on the legality of the ESM on September 12. At Jackson Hole, Bernanke was on cue with a carefully crafted message that traders/investors wanted to believe in, and risk markets responded positively, with many still expecting further Fed action in September.

Markets are not Priced for More German Resistance or a Fed on Hold

The surprising strength of the rally has some questioning if investors have become too bearish, on the suspicion that continuation of the rally could mean stock prices are “smelling” some good news/positive developments not fully realized by most investors at this point.

But ECB and Fed Puts notwithstanding, both Germany and France face double-dip recessions, while Spain and Italy are facing full-blown depressions, and the U.S. economic data is only better than the more bearish expectations, but everyone recognizes that the U.S. recovery is too weak to make a significant dent in either high unemployment or the U.S.’s growing debt problem. To us, this “vacuum rally” has the footprints of short-covering, by hedge funds and Eurozone bond vigilantes. U.S. trading volume is low and declining. The canaries in the coal mine could be the noticeable lag in the Dow Transports versus the DJIA, the secular low in the S&P VIX volatility index, the S&P RSI momentum indicator, massive deposit flight from Spanish banks, and the noticeable drop-off in U.S. earnings estimates.

Hat Tip: Crossing Wall Street

The July Markit Flash Eurozone PMI for August was 46.6, for the seventh consecutive month of contraction, and the decline in total activity was widespread across the union. Further, the rate of decline is accelerating in Germany, the core of the core. As the chart below shows, there is a good correlation between the PMI and GDP growth.

Further, neither “Put” is actually in the bag. As for the ECB put, Germany’s economy minister Philipp Roesler Bundesbank chief Jens Weidmann’s opposition to the European Central Bank’s plans to buy debt of weaker Eurozone countries, the reason being, “bond purchases cannot remain a permanent solution as they drive the danger of inflation”…”only structural reforms in individual countries can secure the competitiveness and stability of our currency, not bond purchases.” Like his predecessor, Jens Weidmann reportedly has threatened to quit several times in recent weeks over his frustration with the ECB plan, but has been dissuaded by the German government. The Germans simply cannot understand that the bigger risk at this point is debt-deleveraging deflation, not inflation.

While market participants only wants to talk about (and believe in) QE, the Germans are right however in that full-scale utilization of the ECB’s, Federal Reserve’s, the BOJ’s etc. balance sheets are merely interim countermeasures to offset the worst economic impact of balance sheet-deleveraging, and in themselves are incapable of restoring economic growth to a sustainable trajectory that is steep enough to make a serious dent in both high unemployment and the severe overhang of government debt. Two years later, the jury is still out on the Fed’s two rounds of QE. While obviously beneficial for risk assets, the fact that unemployment is high, inflation is subdued, and growth is mediocre implies it hasn’t been a raging success in terms of the Fed’s dual mandate.

The much-talked about paper at Jackson Hole by Columbia economist Michael Woodford, which gives a lot of evidence that what central bankers say and target is what acutally matters. JP Morgan’ cross-asset investment strategy team is going against much of the street strategists’ grain in forecasting the stock market will continue to power through September, but even the bulls admit that central bank policy response in Euroland and the U.S. is essential for the rally to continue. In addition, rather than what Ben Bernanke says, investors should be looking at actual changes in the Fed’s balance sheet, which is now USD115 billion smaller than it was on December 28, 2011.  

Hat Tip: Business Insider

China’s Official PMI Now Also Shows Contraction

HSBC’s China flash PMI manufacturing number has been declining steadily since early 2011 and trending below the 50 boom-bust line for 10 consecutive months, and took a somewhat larger tumble to 47.8 in August from 49.3 in July. Conversely, the official China PMI had been trending above 50, ostensibly because the official PMI places more emphasis on government-owned enterprises. But even China’s official PMI fell to a lower than expected 49.2 in August from 50.1 in July.

In the early months of 2012, economists were downplaying the slowing China data, and forecasting a rebound in the coming months, a rebound that has not come despite Beijing’s lowering interest rates in June and July and injecting cash in to money markets to ease credit conditions.
Company after company are reporting weak profits, reflecting the toll the slowdown is having on China’s corporate sector, including mobile operators, banks, automobile firms and basic material firms, leaving virtually no major industry untouched. Reports indicate that companies are awash with excess inventories. Despite local governments announcing new investment plans, investors are asking how these local entities will be able to pay for these investments.

Further, new lows in the Shanghai Composite indicate that more bad news for China is still ahead.

Li Zoujun, an economist at the Development Research Centre of the State Council, recently released a report, presumably at an internal meeting, which predicted that China could face an economic crisis in 2013. The only surprise in the report was that it was made by someone from the State Council as opposed to a Western investors talking their book. 

The ostensibly causes of the China crisis have been outlined by many. In Li Zoujin’s analysis,

a) a bursting of a real estate bubble and a local government debt crisis

b) a reversal of hot money and capital inflow that fuelled the bubble

c) a “lame duck” government, with a new government having to 1) sustain the bubble and kick a bigger problem down the road to 2015/2016, or 2) stand back and allow the bubble to burst.

d) a meeting of short-wave and long-wave cyclical troughs.

Like the western economies, China’s crisis would have hit in 2008/2009 were it not for the massive 4 trillion Yuan stimulus that was the catalyst for China’s bubble. 

China, Eurozone Slowdown Double Punch for Japan

The Markit/JMMA manufacturing PMI for Japan in August signalled the steepest decline in Japan’s manufacturing sector since April 2011, or immediately after the Tohoku earthquake/tsunami/nuclear disaster. New orders from China and Europe are particularly weak. 

Like the PMIs for other countries, the Japan PMI, as the graph shows, has a close correlation with GDP, implying disappointing Japan GDP numbers going forward, and increasing pressure for the BOJ to implement more monetary stimulus as well. 

Lighten Up on Risk Assets or Add Portfolio Insurance

Given the widespread evidence of renewed slowing in global economies, traders/investors shorting risk assets have flattened positions with the increased risk of central bank action. However, given the diminishing returns from the exercise of central bank “puts”, the more prudent course to us would be to sell the news, i.e., light up as central bank jawboning lifts risk asset prices in the anticipation that the actual announcement will represent the move’s peak.

When past central bank puts were exercised (QE1, QE2, Operation Twist), the S&P sectors that responded best were 1) energy, 2) technology, and 3) industrials. This time, energy and technology have again led, and there was noticeable catch-up in the financials, both in operation twist/the ECB LTROs and the latest rally.  However, as was seen in the decade-long period of underperformance for the technology sector after the IT bubble burst in 2000, we suspect the financial sector still has years and years of adjusting/consolidating ahead before balance sheets and business models have been restructured enough to lead a secular rally. 

Source: Yahoo.com

Globally, energy is not as dominant, and I.T. has led other sectors over the past 12 months, while consumer staples as well as discretionary stocks are not far behind. Further, basic materials have been hit harder than the financial sector. 

Source: MSCI/Barra In Japan, global sector boundaries are harder to identify from the “old-school” Topix sectors, which are very much heavy manufacturing, “old-economy” orientated. Here, the best 12-month performers have been the historically defensive and domestic foodstuffs, real estate, land transportation, other financials and retail, which would not be readily apparent from a global, top-down perspective. Yet foodstuffs, the stocks of the bigger companies of which are being driven by globalization, have managed to beat any other global sector except I.T. They are also net beneficiaries of the strong yen which has been such a nemesis to Japan’s traditional flag carriers, i.e., automobiles, electronics, trading companies, etc.

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

Risk On or Risk Off? The Answer is Buy the Extreme Ends of Both

S&P 500 Has a Bit of a Melt-Up

The S&P 500 is now up just under 13% for 2012 and appears to be breaking above the April 2012 high. From an intermediate perspective, the S&P 500 is 109.6% above the March 2009 closing low and 9.4% below the nominal all-time high of October 2007. Just looking at the S&P 500, concerns about a renewed recession at least in the U.S. are over-blown, and investors do not appear to be overly concerned about the looming fiscal cliff. While no one is claiming a strong recovery is in the works, the U.S. economy, judging from recently more positive economic announcements is continuing to recover. 

Sources: StockCharts.com, Yahoo.com

On the other hand, risk-off assets have taken a breather during this equity rally, but have yet to break down through long-term support at the 200-day MA. The USD index has also pulled back toward its medium-term trend line. Both however are in no immediate danger of seriously breaking down at this point, indicating there is still a great degree of skepticism about the sustainability of the budding equity rally. 

TLT Long-Term Treasuries ETF

UUP USD Index ETF

Eurozone Crisis on Vacation

Regardless of whether ECB president Mario Draghi’s July “we will do whatever it takes” speech was mere verbal intervention aimed at keeping the Euro sovereign bond vigilantes at bay through the summer vacation lull, or is indeed a precursor of a Eurozone commitment to build an enduring firewall around the crisis, the pressure on EUR and Spanish bond yields immediately eased following his remarks, and has remained docile since. 

Spain 10yr Sovereign Bond Yields

EUR (as measured by the FXE currency ETF) seems to be confirming a prior bottom, and Spain’s

10yr bond yields have quickly lost over 100bps fro the recent spike. How long this hiatus lasts however will depend on how much follow-through their really is on the “we will do what it takes to save the Euro rhetoric”. 

Despite the recent uptick in U.S. economic news versus greatly reduced expectations, global economic growth continues to slow. Eurozone output was down 0.7% in Q2 and even the German economy is limping along at 1.1% growth, while France’s output was down 0.2% and unemployment is over 10%–and that’s before you get to the deeply recessed/depressed Club Med nations. 

In Asia, China’s growth is slowing even on the suspect official numbers, with GDP growth and industrial production the slowest since the 2009 global crisis. More important for China’s major trading partners, China’s exports and imports have been falling. According to China’s Premier Wen Jiabao “The downward pressure on our economy is still big and the difficulties may last for a while, ” requiring more aggressive easing measures on the still bubble-cautious government. China started easing late last year and accelerated the pace recently, cutting interest rates twice, in June and early July, fast-tracking investment projects and encouraging energy-efficient consumer spending; but analysts maintain they need to do much more. 

Even in the U.S. the Philly Fed Survey has been negative for four consecutive months and the New York Empire state survey is below zero for the first time since October, and the small business survey was down for the 4th time in five months with particular weakness in revenues and profits. While there is now hope of a housing rebound, the mortgage purchase index has declined for five consecutive weeks and is down 11.3% YoY and down 8.6% the past four weeks, while existing home sales are at the lowest level since October and pending home sales declined in June–i.e., the economic picture in the U.S. also remains very mixed. 

Thus the fact of the matter remains that the U.S. economy is still too weak to make a big dent in unemployment, but may be strong enough to put any probability of QE this year on hold. Indeed, 

shrinking expectations for a Fed move may well be what is pushing Treasury yields higher. Others argue that it is not the Fed but expectations of what Mario Draghi will do in September that has been driving the “risk-off” bus since July. Here, the one constant is that what little forward progress there is in the Eurozone will come only after more political bickering and pressure from the bond vigilantes. 

The talking head commentary over the weekend in the financial media runs basically along the lines of “time to take some off the table”, implying it won’t take much to trigger significant profit-taking in U.S. equities. While the VIX is still well above previous bull market lows, it is at the lowest levels seen since the financial crisis, again indicating quite a lot of short-term complacency. The NYSE Composite and the Wilshire 5000 are now at resistance that has stopped rallies over the past few years, meaning stock prices probably need more than “better than downsized expectations” to really push higher. 

Source: Yahoo.com

Nikkei at Very Belated 6-Week High

In Japan, the Nikkei 225 has closed at a six-week high and is breaking above its April high, despite evidence that the Japanese recovery is beginning to falter. The catalyst was the sudden selloff in JPY vs USD and EUR, despite fears that JPY was poised for another run at a new high. Prior to the ECB’s Draghi’s comments about “doing what it takes” to save the Euro, these fears were credible enough for Japan’s finance minister to begin verbal intervention and to threaten intervention. The current momentum of the Nikkei 225 is probably enough to propel the index to the 9,500 level, as Japanese equities have badly lagged the recent melt-up in the S&P 500. 

The break to the upside in Japanese equities has been fueled by; a) mining, b) high beta broker/dealers, c) real estate and d) the automobile sector. Except for the automobile sector, the leading sectors in this rally are not exactly currency or export sensitive, but the weaker JPY on more willingness to take risk has led to the return of net buying for foreign investors, the pre-requisite for any rally in Japanese equities these days.  

Source: Yahoo.com

Risk On or Risk Off? The Answer is Buy the Extreme Ends of Both

Investors continue to be whip-sawed by ebbs and flows of the Euro crisis, the U.S. fiscal cliff, a China slow-down and the surge in developed economy debt. But if an investor calmly tuned out the talking head noise, he would realize that a contrarian, brass kahoonas approach to risk-on, risk-off investments since the global financial crisis in 2008 could have been very profitable. 

The table below gives a rough picture of the performance of various risk-on and risk-off asset classes since the March 2009 equity market lows. What you will find is that the best-performing sectors have been a) US REITs, b) the XLF financials sector SPDR, c) Emerging Market equities, and d) the S&P 500, followed by the Gold ETF (GLD) and commodities (DBC ETF). In other words, the best returns would have been gained from a barbell strategy of a) buying “the world is going to hell in a hand basket” scenario, or gold, while also buying b) those sectors that governments and central banks were trying most desperately to save, i.e., the banks, as the center of the global financial system. 

Source: Yahoo.com

The Benefit of 20:20 Hindsight and Total Emotional Detatchment

If one takes a step back and calmly looks at the big picture (and ignores any losses caused by the 2008 financial crisis, i.e., historical emotional baggage), the U.S. financials and REITs have been and continue to be supported by government/Fed bailouts and massive injections of Fed liquidity. Further, the most obvious beneficiary of successive QE1, QE2 and Twist operations has been the U.S. stock market, because the Fed has been far and away the most aggressive central bank in implementing unconventional zero interest rate-bound monetary policy and massive monetization of debt. Emerging market equities continue to outperform over time because capital markets have not yet caught up with high economic growth, while commodities and particularly gold are the ultimate hedges against the structural fiat currency debauchery through “irresponsible” emergency monetary policy. 

On the other hand, the Euro Stoxx Banks index has severely lagged the U.S. financials because these banks, like their Japanese counterparts in the early 1990s, are essentially insolvent, while no one in Euroland wants to have to deal with that.  

Source: Yahoo.com

If one really wanted to get fancy, you could have replaced the XLF financials SPDR with the XLY consumer discretionary ETF before you put it in your chest of drawers and forgot about it until  last week. In that case, your consumer discretionary SPDR would have returned nearly 180% instead of the 140% gain for the financials. 

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

Despite Eurozone Exposure, UK Stocks are Outperforming Japan

Despite all the gloom and doom about the Eurozone crisis, the U.S. fiscal cliff, slowing China growth, and “crisis of confidence” on Wall Street, the S&P 500 continues to recover and climb a wall of worry, after holding comfortably above the 1,250 level in the recent sell-off below its 200-D EMA. Signals of more concrete action by the ECB as reflected in Mario Draghi’s “we will do whatever it takes” speech, and in continued high expectations that the Fed will be compelled to move again by the end of September, has kept the equity shorts/bond vigilantes at bay for the time being.

 

 But a closer look at Spain 2-year bond yields versus 10-year bond yields shows traders bidding the 2-year down 270bps from 6.0% to 3.3%, while the 10-year bond yields have moved much less, implying continued concerns regarding a longer-term, lasting solution.

Spain 10-Year Bond Yields

Not Very Enthusiastic Participation

Trading volume in U.S. equities is tepid and individual investors are basically a no-show. About $171 billion has flowed out of equity mutual funds over the last year, according to the Investment Company Institute, while some $208 billion has flowed into the bond market over the same period. The fact that so few long-term (individual) investors are in the stock market has exacerbated already HFT-heavy volatility, since it often seems as if the only people who are trading stocks are the professionals. But the apparent apathy of retail investors toward individual stocks may also be a reflection of them investors just giving up on trying to make intelligent calls on individual stocks and parking the money mainly in U.S. equity ETFs as well as bond ETFs, which is much simpler.

Source: Bianco Research

While there appears to be a high central bank action expectation factor at work,  the Citigroup economic surprise index also indicates the economic news could begin to become more positive, or at least not as bad as feared. Goldman Sachs for one believes the recent economic data point to a modest improvement in US growth. They cite, a) a housing recovery that is picking up steam, b) a continued recovery in real disposable income, c) better financial conditions as measured by the Goldman Sachs Financial Conditions Index.  Better-than-expected-non-farm payrolls added to this conjecture.

Hat-Tip: Pragmatic Capitalism

On the flip side of the stock rally is long-bonds and USD, which are both taking a breather. The dip in the TLT index below its 50-day EMA suggests more than a touch-and-go correction.

Energy and Industrial Sectors See a Strong Bounce

The S&P 500 has been buoyed all along by consumer durables and consumer discretionary, but the sharpest gains since July have actually been in energy as well as industrials, suggesting those actually buying stocks are not as bearish about the economy as blogsphere chit-chat would have you believe, and that a “risk-on” component has definitely returned to the stock market. 

Source: Yahoo.com

Risk-On, Risk-Off Groups are Splintering

From a different perspective, market action has splintered from the simplistic “risk-on, risk-off” shifts seen over the last couple of years. In the risk-on camp, the S&P 500 financials has clearly been leading, although the more recent movement in commodities has been much sharper because of soaring agricultural prices and the impact of geo-political unrest on crude prices. 

In the risk-off camp, income-producing REITs have been the clear winner, as interest rates don’t look like they are going anywhere in a hurry, and there is evidence of at least a bottoming process in the U.S. housing/commercial property space. On the other hand, gold has been a major laggard.

Source: Yahoo.com

More Divergence in the Emerging Markets

There is also increasing divergence in the emerging markets space, with the MSCI EEM basic of emerging markets responding well to the latest risk-on shift, while China’s Shanghai Composite continues to March to the beat of a different, bearish drummer.

Source: Yahoo.com

While there is still insufficient evidence of a sharp slowdown in China’s economy, foreign investors don’t trust the economic numbers coming from China, and government efforts to re-stimulate the economy so far appear half-hearted. If the trend of the Goldman Sachs/NBS leading indicator of China’s economic activity is to be believed, the slowdown has been quite dramatic, and almost as dramatic as the prior slowdown, even though other developed and even developing nations would mortgage their grandmothers for the absolute level of growth that China is still producing.

Eurozone’s Problems Run Too Deep for Even a ECB Silver Bullet to Fix

Even if Mario Draghi can make good on his promise to “do whatever it takes” to save the Euro, the Eurozone’s problems run too deep for even an ECB QE silver bullet to fix. This is becaus one-sided funding via state-controlled banks and central banks will still inevitably lead to high debt-to-GDP ratios and a downhill vicious cycle of recession. Europe will not be able to bring Spain and Italy yields sustainably down to 4% anytime soon, and even if they could, it wouldn’t be enough to get Spain and Italy out of financial trouble. As PIMCO’s Bill Gross points out, interest rates over and above each country’s nominal GDP growth rate will inevitably add to a country’s debt as a percentage of GDP, even if budgets are in primary balance. At current yields, growth rates, and deficits, the spread may incrementally add 2-3 percent to Spain and Italy’s tenuous debt ratios. 

Thus the Eurozone crisis is likely to be with us for a long while, characterized by long periods of dismay, and only temporarily interrupted by flashes of hope that produce “dead cat bounces” in oversold EUR and Eurostoxx Banks index levels. As the secular trend remains down, generally avoid Euroland, and if you must, trade the bounces with eyes wide open. 

While More Exposed to the Eurozone, UK Stocks are Outperforming Japan

It is interesting to note the contrast in the performance of the U.K.’s FTSE 100 to Japan’s Nikkei 225. The FTSE 100 has noticeably outperformed the Nikkei 225 even though the U.K. is slipping back into recession and is directly exposed to the Eurozone crisis. Conversely, Japan’s economy and corporate profits are recovering from the March 2011 earthquake disaster. 

The main impediments keeping the Nikkei 225 in the doldrums vis-a-vis the U.S. and the U.K. are, 1) the continued strength in JPY, particularly against EUR, 2) the high dependence on trade with China, whose import demand has dramatically cooled, 3) the transitory nature of the “Tohoku bounce“, and 4) continued heavy structural net selling by domestic institutions.

Source: Yahoo.com

Flush with cash from middle east sovereign wealth funds and pension money fleeing the Eurozone crisis, GBP-based investors have shown much more interest in Japanese stocks because of the substantial appreciation in JPY vs GBP. Between Q3 2010 and Q3 2011, JPY appreciated nearly 20% against GBP, and has seen a more substantial appreciation over a longer period of time. Thus for GBP-based investors, just having flat Japan stock prices resulted in nearly 20% gains. In terms of total GBP-based returns, this meant strong 40%+ gains in a GBP-denominated Nikkei between December 2011 and April 2012. Unfortunately, the capital gain portion has since been all but completely erased. On the other hand, when viewed in USD terms (such as the EWJ MSCI Japan ETF), there has been no currency kicker to speak of .

Source: Pacific Exchange Rate Service

Looking at Japan equities performance by size, it is interesting to note that the Nikkei 225 is now the best performer, closely nosing out the JASDAQ in the past weeks. The large-cap Topix Core 30 remains a heavy burden on Tokyo stock prices, as it is populated by the oligopolistic electric power companies as well as the big cap electronic majors now in such deep earnings trouble, like Sony (6758, SNE) and Sharp (6753), whose stock prices are at multi-decade lows.

Looking at the year-to-date best and worst performers in the Nikkei 225, there is a dramatic divergence even in sectors. For example, the semiconductor related stocks like Advantest (6857) and Nikon (7731) are up well over 20% YTD, and essentially all of the real estate majors, Sumitomo Realty (8830), Tokyu Real Estate (8815) and Mitsui Fudosan (8801) are up between 34% and 20% YTD, while stocks like Sharp, Kansai Electric Power and Asahi Glass have virtually imploded.  The whole market is again selling under stated book value, but heavy losses in companies like Sharp mean equity in some cases is seriously at risk, and therefore historical PBRs do not fully account for the rapid equity erosion–meaning a not insignificant portion of the Nikkei and Topix are value traps.

While most international/global portfolios already have only a smattering of Japanese names left in their portfolios, we continue to see the Japanese stock market as a very selective market of individual stocks, not a stock market.

 

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