The Great China Property Bubble Debate

China’s Government Continues Trying to Reign in its Property Market

In the last years of Japan’s stock market and property bubbles, Japan’s MoF and the LDP conspired to support the Nikkei 225 from crashing in the October 1987 to prevent it from crashing as the New York stock market did, thereby ostensibly breaking the daisy chain of global stock market panics. Then, it was inconceivable that Japan’s property market would collapse as it subsequently did, thereafter declining for 14 consecutive years. In the lead-up to the crash in the US property market in 2007, the Fed was still confident they had the situation under control in late 2007, and ignored warnings of its effect on the financial markets, even though it was increasingly obvious the bubble had burst,

In 2009, China provided a significant underpinning to global growth by unleashing a massive stimulus package that triggered a record surge in credit (bank lending) that fueled overcapacity in a range of industries (notably steel), a booming stock market, inflation. and one of the biggest property booms. China’s economy showed signs of extreme imbalance, where infrastructure (fixed asset) investment accounted for around 50% of economic growth, while consumer spending accounted for just 35%. Historically, these readings are on the extreme end of the scale. Foreign observers have been warning going on four years that a collapse in this boom could trigger a hard landing for China’s economy and even social unrest in a Confucian “Arab Spring”. While China’s leaders recognize the problem and have taken countermeasures sooner than later, China’s property market remains buoyant, while history shows (most recently, in the U.S.) that such bubbles are virtually impossible to deflate without causing a crash.

Hat Tip: The Daily Reckoning

If it Waddles and Quacks Like a Bubble, It Must be a Bubble

People have invested three generations worth of savings — grandparents’, parents’, and children– into properties, and there are some 50 million construction workers working on all of these projects around China, even though middle class families and the local people being displaced by these developments cannot afford the new housing. Since 1998, when the government ended its practice of allocating housing units, property investment has jumped by more than 1,700 percent, according to the National Bureau of Statistics. Further goosing the boom was aversion to a roller coaster stock market, the inability to invest outside of China, the lack of property taxes and the government’s failure to keep inflation in check. The latest round of real estate controls is the ninth in the last 10 years, and include a 20% tax on gains from a sale, higher down payments and mortgage rates, as well as requirements that cities set annual price easing targets. While causing stock market jitters, the latest government countermeasures only spurred a surge in existing home transactions.

A recent 60 Minutes special in the US was filled with video of massive ghost towns that hedge fund managers tried to convey several years ago to a then non-believing world, where both commercial and residential buildings as well as the streets are virtually empty ghost cities. Unsold apartments, as measured by floor space, increased 40% last year. At the same time, the Chinese government is pressing local planning authorities to speed up plans for land supplies for housing, requiring cities affected by tight housing supplies to increase and stabilize residential land supplies. Chinese cities have all failed to fulfill residential land supplies plans over the past three years.
The real estate market in China is already quite distorted, and the repeated rounds of repressive policies may be merely layering on more distortions.

While China’s housing market experienced a brief cooling-off in 2010 when tightening policies such as higher down payments and restrictions on third-home purchases were introduced, the People’s Bank of China triggered a reflation of the bubble in the middle of last year when it added even more liquidity to the economy. As a result, prices in China’s 100 largest cities rose 2.5% in February year-on-year, according to a private survey conducted by China Real Estate System, up from January’s 1.2% pace. February was the third-straight month of year-on-year increases and the ninth-straight month of month-on-month price growth. Home inflation in February was especially pronounced in the top 10 cities, where prices jumped 4.3% from the previous February. The National Bureau of Statistics reports that residential prices rose 6.8% in 2011 and 7.7% in 2012. A Reuters poll shows that economists think prices will rise 7% this year. This after average housing prices already tripled in the country from 2005 to 2009.

Hat Tip: Trusted Sources.co.uk

Further, there is a massive price gap between what a middle-income family can afford and market prices, where the price of a 1,100-square-foot apartment in Shanghai is equivalent to about 30 years of disposable income for a middle-income Chinese family. In second-tier cities such as Chengdu, homes run about 20 times annual wages after taxes. The United Nations’ price-to-income ratio deems property affordable if it can be bought with three to six years’ worth of disposable income — a level more in line with the real estate market in the United States.Thus the colossal glut of too-expensive housing may only be sold off if prices collapse, as Chinese officials already plan to build, during the current 12th five-year plan, 36 million units of “affordable” housing,

Source: New York Times

China Even More Exposed to the Dangers of a Real Estate Collapse than the US or Japan Was?

China’s property market has been described with some hyperbole as the “most important sector in the world”, ostensibly because China has been until recently a major engine of global growth, in demand for basic commodities, and as an export destination. Firstly, urban housing stock constituted 41% of Chinese household wealth in 2011, versus 26% in the US, while real estate investment generated 13% of Chinese GDP in the same year. A crash would ostensibly cause a hard landing in China’s economy, possibly leading to widespread social unrest. Secondly, the sector consumes a significant amount of the iron ore China imports that makes the steel that makes the girders that hold up China’s new buildings, and these buildings are wired with imported copper, and trade with Germany and Japan would especially be hit with a hard landing in China’s economy. 

The Chinese government already ordered its banks in 2011 to conduct stress tests to see how they would be affected if property prices fell by up to 50%, but the game can continue as long as the money supply keeps expanding aggressively (15%+ per year), and people remain willing to plow that money into real estate and hold it, because so much financing has gone outside the banking system. As a result, the standard measures of money supply (M1, M2) in China don’t tell very much any more about the amount of credit in the Chinese economy. In other words, China has its own “shadow banking” system, and it is hard to tell how much of that credit expansion is being eaten up by the need to roll over bad debt at interest, rather than financing new investment. 

As investors know from the recent experience of the bursting of the US housing bubble and of Japan’s property bubble, what is left is a mountain of bad debt. Beijing has yet to publish a figure for local debt for last year, but Roubini Global Economics estimates as 17.5 trillion yuan. While not insignificant numbers of developers are already simply abandoning projects because of a lack of money to go forward, Reuters is reporting that investor money continues to flow into Chinese high-yield property bonds, much of it from private banks unable to earn a decent return elsewhere. Outstanding loans to Chinese property companies rose 13% last year to Rmb12.11trn, while loans to developers (land and property) rose 11%. By early 2012, the average ratio of debt to assets for publicly traded property-development companies had risen to 72.3%, the highest level in 10 years. Generally, a debt-to-asset ratio above 50 percent indicates liquidity problems.

Thus Chinese property companies have been refinancing short-term debt where they can with longer-term facilities, and on pretty cheap terms. For what its worth (international rating agencies have long since been defrocked for failing to call out the dangers in toxic US housing asset-backed securities, Moody’s sees no bubble, and sees the recent spate of bond issuance by China’s property developers as actually shoring up the sector’s liquidity and generally extending the issuers’ maturity profiles. However, Morgan Stanley reports that China’s property companies are not just taking advantage of low rates and abundant liquidity to refinance debt, they are also aggressively taking on more debt in the form of loans. Thus their credit risk is about more than just liquidity and refinancing risk. It is also about the fundamental ability to repay debt, and that is the shakier part of the equation.

Municipalities in China are already reeling from the deteriorating property market. According to a Chinese central government study, provincial administrations, which had to borrow heavily to finance the 2009 stimulus spending ordered by authorities in Beijing, depend on land sales for 40% of revenues. But land sales in 13 major cities came in at 66 billion yuan ($10.5 billion) in January and February, down 47.5% from the first two months of 2011, according to Centaline Group. In Beijing alone, the value of land sales fell by 30% in 2011, a dismal performance that’s expected to be repeated.

Are the China Risks Being Overstated?

As with the bursting of all bubbles, the panic could start anywhere. However, China property has already seen one mini-crash come and go…in Phoenix Island, a development project in the Chinese island province of Hainan, where property prices imploded 6-fold when interest rates began rising in 1993. Phoenix Island property was so inflated and outrageously expensive it became known as the Dubai of China. The Hainan government was still cleaning up the mess left after the bursting of that bubble as recent as 2002. 

Some China watchers unconvincingly argue that these wasted investments are not really a big deal, saying the money was better blown on developments rather than even more excess manufacturing. They also maintain the residential development is not excessive, with the “handful” of empty urban districts not being indicative of a property bubble. Chinese property investment may be inefficient, they say, but it is sustained by a huge, growing and sustainable demand for new housing. 

China’s current modern housing stock, defined as homes with individual bathrooms and kitchens, is around 150 million units, while some 200 million migrant workers currently live in dormitories or slum housing. If these urban poor were to live in proper flats, Chinese cities actually have a significant shortage of affordable housing – somewhere in the region of 70 million units. From this perspective, China is not building too many new apartments; but too few. Problem is, all the new developments are priced out of the market for those who actually need housing. In metropolitan centers like Beijing, Shanghai and Shenzhen, there are chronic shortages of housing for low- to middle-income residents, whereas scores of smaller cities with populations of up to 3 million face a severe oversupply. 

Stephen Roach of Yale University takes a different tact, telling CNBC that a crash in residential property actually won’t be that big a deal for China’s, let alone the global, economy. By Roach’s reckoning, residential property accounts for only around 5% of China’s GDP, of which just 2%~3% supposedly is at risk, which is in his view not enough to hard land China’s economy. 

The IMF’s latest article IV (based on a working paper by Ashvin Ahuja and Alla Myrvoda) report on China’s economy tries to quantify the global spillovers from a collapse in China’s property bubble, which is shown in the chart below.

Hat Tip: The Economist

The IMF’s Article IV report observes that, given the importance of the property sector in the Chinese economy and its extensive forward and backward linkages, the Chinese government is attaching high priority to carefully monitoring price and transactions developments and ensuring that they remain on a stable trajectory. An Economist article on the IMF report described the potential impact as significant, but not a disaster for China’s economy. What they were describing however was a modest decline of about 10% in real estate investment, not a crash.  The IMF spillover analysis suggests that a disorderly decline in real estate investment “could have significant implications for growth in China and the global economy.” With the forecast impact of just a 1% decline in China’s real estate investment being 0.2% of China’s GDP in the first year, a 10% decline ostensibly would shave off 2%, while a 20% decline would slash GDP growth by 4%, leaving China’s GDP growing at just 3.5% versus the government’s target of 7.5%, or well below what is considered tolerable (6~6.5%).

Further, the IMF scenario indicates that Germany and Japan’s GDP could take an even bigger hit in terms of percentage of GDP than China, while Zinc, Nickel and Lead prices in the commodity space would take a bigger hit than Copper or Aluminum would. Thus the property bubble question continues to weigh on China stock indices as well as copper prices, even though investor sentiment regarding global economic recovery has noticeably improved.

Source: Yahoo.com

Source: Yahoo.com

Source: Yahoo.com

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

Corporate Japan: The Strong Yen and Poor Macro Environment are No Excuse for Low ROIC and Evaporating Stock Prices

 Strong Yen and a Poor Macro Environment are Not Sufficient Excuses for Pitiful Returns
Japanese companies hoping to explain away their poor stock price and financial performance with the challenging macro environment and a relentlessly strong yen still need to explain why sales growth is so lethargic and why profitability is so low compared to U.S., European and Asian peers.

During this year’s rush of shareholder meetings, Japan’s senior executives expressed regret for their companies’ disappointing stock prices, but still need to explain why they are increasingly losing out to foreign competition, have persistently low profitability, poor capital efficiency and have such lethargic top line growth vis-a-vis their U.S., European and Asian competitors. In the game of baseball, both in Japan and the U.S., a skipper that cannot produce wins over a period of several years is replaced. In Japan, entrenched managements (and boards) remain and go through their normal evolutionary insider selection process regardless of how poor profitability is or how far the stock price has plunged. Poor performance alone is not evidently sufficient justification to boot the senior executive, because everyone’s return on capital is just as bad.

Using August 2008 as a base for reference, or just before the Lehman Brothers failure precipitated a near melt-down in the global financial system,  the Stoxx Europe 600 index is at 86, the S&P 500 is slightly positive at 103, but the Nikkei 225 average is significantly lower at 67.  Bottom line, Japanese companies are the least resilient to today’s global turbulence. The poor stock performance is most closely linked to poor profitability. In terms of profitability, using FY2007 as the base year, net profit at Japanese firms was only 46 in FY2011 (54% lower), or even worse that the 66 for European firms, and not even close to the 124 reading for US businesses, as even Japanese corporate sales have failed to recover to pre-Lehman levels.  Further, the average return on equity in Japan was 4.8% in FY2011, versus 10.4% in Europe and 15% in the U.S. Overall ROIC (return on invested capital) for large, listed companies in FY2011 was 6.4% versus an 8-9% range pre-crisis level. 

Reasons for Low Returns on Capital
Ironically, decades of ZIRP (BOJ zero interest rate policy) has significantly lowered the cost of capital bar for Japanese companies, and although designed to stimulate corporate activity, easy money has in fact pampered Japanese companies and harmed their ability to increase profits.  Basically, the average borrowing rate in Japan is a mere 1.5%.

The second reason for the low ROIC is poor capital allocation, including the mishandling of the often-quoted “selection and concentration” process. Japanese companies talk about improving efficiency but usually end up simply downsizing without securing alternative sources of growth. Some are slow to cut loss-making operations, while others go overboard and slash investment or jettison crucial businesses. For example, Sharp Corp. (6753), Sony Corp. (6758) and Panasonic Corp. (6752) have been downsizing their loss-leadingTV operations, but have yet to come up with new businesses to fill the void. Cash, instead of going for investments in future revenue generators, has largely been used to pay back debt or merely languishes in bank accounts.

But Japan’s capital stock is rapidly aging, reaching an average of 15.61 years by end 2011, meaning that aging plants could lead to further losses in productivity and global competitiveness if not reversed. Investments made in R&D on the other hand have not significantly boosted sales, as Japanese companies all tend to flock toward the same research themes or potential sources of growth, meaning these new markets are already excessively competitive by the time commercial products begin to hit the market. In new businesses like cellular phones, companies continue to pile into the space until profit margins are arbitraged away through excessive price competition.

Based on TSE-1 listed company aggregates, sales growth has been basically flat for the past 20 years, but Japanese companies have nevertheless been able to generate average pre-tax profit growth of 12.8% per annum, or substantially more profit growth than Japan’s retreating nominal GDP would indicate. As the graph below shows, however, aggregate profits have been extremely volatile, with the only period of sustainable expansion being seen during the Koizumi years, when reform and restructuring, as well as the ending of the banking crisis, temporarily appeared to put Japan back on the path to sustainable growth. Stock prices staged a powerful rally as aggregate pre-tax ROIC surged from around 5% to over 9%, i.e., returns available to shareholders nearly doubled. Since then, the 2008 financial crisis and the 2011 earthquake disaster whacked corporate ROIC very hard, with aggregate ROIC only now returning to the 7% level but again looking unsustainable.

Sources: Japan Investor, Nikkei Astra

While the recent deterioration in major electronic manufacturer profitability has been dramatic and the stock prices of these companies have fallen to 30-year lows, one of the biggest and most chronic sources of shareholder value destruction in Japan has been the finance sector, where returns have not only been extremely volatile, but also miniscule in the best of times, with ROA (return on assets) just making 2% (or 70% less than the TSE-1 average) even during the “comeback” period of 2004~2007. Given extremely low profitability in addition to extreme volatility, it is no surprise that the Topix financial and the Topix banks subsector has been a major, major drag on the Japan equity aggregates. In other words, Japan’s major financial institutions, after struggling for upwards of a decade to clean up NPL (non-performing loan)-ridden balance sheets and having undergone a massive consolidation that has shrunk the major banks from 17 to three too-big-to-fail megabank groups, continue to struggle finding a new business model that will allow them to return to some degree of revenue growth and stable profitability.

Source: Japan Investor, Nikkei Astra

Not Keeping Up With the Rapid Pace of Globalization
Today, the whole planet is being transformed by a dramatic, nonindustrial revolution based on intangibles such as knowledge workers, intellectual capital, collaborative networks, low-cost interactions, and globalization. While changes in Japan have often been driven by the influence of foreign capital and ideas, Japan is increasingly falling behind the rapid pace of globalization, while the pace of change will only intensify. Unless there is a fundamental change in approach by Japanese corporate management based on an understanding of the strategic implications of these changes, Japanese companies will only fall further behind.  Domestically, nominal GDP is actually moving backwards, to levels last seen in the early 1990s.

Source: Trading Economics

Many investors now see ROIC (return on invested capital) as an essential measure of the intrinsic value-creating capability of a company, and focus on inflection points in a company’s strategy, new leadership, new compensation systems, asset dispositions, or other circumstances – that lead to significant improvements in a company’s ROIC. The degree of change in a company’s ROIC that is a key predictor of long-term stock price out-performance, and this was clearly illustrated in the 2.3-fold surge in the Nikkei 225 from a banking crisis low of 7,831 in April 2003 to a June 2007 high of 18,138, when aggregate pretax ROIC for TSE-1 listed companies surged from under 3% to over 9%.

Corporate managements have many options when it comes to investing their company’s capital, including expansions of their core businesses, acquisitions, dividends, stock buy-backs, and M&A. When companies make these capital decisions, they are either creating or destroying value. Capital invested in a business that delivers strong returns should eventually be reflected in that company’s share price, while mal-invested capital that produces returns less than the cost of capital destroy shareholder value and therefore the stock price as well.

The Bank of Japan has kept monetary policy extraordinarily loose (at the zero interest rate bound level) since the 1990s, thereby allowing “zombie” companies to survive with ROIC of 2% or less. The adverse side effect has been to put off the deep structural changes needed to align Japan’s domestic economy with the fast-changing global economy, thereby killing off growth potential in the economy as a whole.  

Current Stock Price Levels Assume No Future Growth
Using a simple dividend discount model to measure the intrinsic value of the Nikkei 225, and assuming current sub-1% JGB yields as the risk-free rate and a low 2.5% equity risk premium, the Nikkei 225 is discounting mere 1% medium-term earnings growth, or essentially the same potential growth rate of Japan’s GDP.

Source: Japan Investor, Aswath Damordaran

Even Modest Improvement in Earnings Growth Expectations Would Produce a Nice Rally
If however investor growth expectations even modestly improve to 5% assumed 5-year earnings growth per annum–either through a greatly improved forecast for growth in global trade, and/or a significant change in the political landscape/government policies as was seen during the Junichiro Koizumi revolution, the fair value of the Nikkei 225 surges to over 10,000, implying a 20% rally in the Nikkei 225, as was seen in the rally from 7,568 in February 2009 to 11,057 in April 2010.

Source: Japan Investor, Aswath Damordaran

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

Individual Investors Looking Pretty Smart by Shunning Equities for Bonds

The Perfect Equity Market Storm: Euro Crisis, US Fiscal Cliff, China Slowdown

The shock that hit the world economy in 2008 was on a par with that which triggered the Great Depression in the 1930s. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed…yet. Now as then, never has so much been staked on politicians “doing the right thing”, but as history has repeatedly shown us, elected politicians have a disturbing talent for group-grope, gridlock and general chaos just when decisive action is most required. If the fate of the equity market is indeed in the hands of Euro, US and even Japanese politicians, stocks are headed for a rough ride indeed.　

The talking heads in the financial media treat the absolute mess in Euroland as if it were a minor irritant. “If only this Euro thing would settle down, my stock picks would be working”. Unfortunately, the “Euro thing” combined with criminal negligence by the U.S. Congress in failing to resolutely address the US “fiscal cliff” as they jostle for advantage before the November elections as if it were political business as usual. The fallout from this Euro thing is already beginning to permeate the global economy, with the World Bank and other international agencies trimming their forecasts for the global economic expansion, and warning that both the developed and the developing nations will be negatively affected by the Euroland crisis and its impact on the global economy.

Global stock markets beginning with the strongest, i.e., the U.S., are again breaking down, like they did in 2010 and 2011 on yet another global growth scare. After unsuccessfully trying to hold its 50-day EMA, the S&P 500 last week broke down below its 200-day EMA. The S&P 500 benchmark is now down over 15% from its April 2, 2012 high, compared to the “sell-in-May” corrections of 16% and 17.6% respectively in 2010 and 2011. In both those cases, it took additional stimulus by the FED to renew the rally (QE 1 and QE 2), while the rally from the October 2011 low was instigated by a similar move by the ECB and its two LTRO 3-year loan program (in two tranches, the latest being February 2012).

By S&P 500 major sector (sector SPDRs), the financials led the S&P rally from the September-November 2011 lows, followed by consumer discretionary and technology. The energy sector peaked before the general market and is now basically where it was when the rally began late last year. The only sector now holding its own is the traditionally defensive utility sector, which never really participated in the 2012 rally in the first place.

Greece Euro Exit. If Greece Thinks its Bad Now, It Could Get a Lot Worse

Greece as the first line of defense against Euro contagion is increasingly looking like a lost cause. The capital flight from Greece is becoming a deluge, with flows from individuals and corporations reaching 4 billion Euros a week since the May elections. Greek banks have already lost some 30% of their deposits since late 2009 and everyone is wondering why not more has left. Greece is to hold new elections in June, as the May elections resulted in political chaos and the collapse of the prior government when the majority of Greeks voted against austerity measures imposed by the Euro Trioka. But Greece may already be out of time, as the government will run out of money in six weeks.

The economy has shrunk by 8.5% in the last year, more than a fifth of the population is out of work and youth unemployment is almost 54%. The country has already been bailed out twice by the EU and International Monetary Fund, and the EU, ECB, IMF Trioka has run out of patience with a fractured government, even as they continue to insist Greece should stay in the Euro. The main beneficiary of the May elections was the hard-left Syriza coalition, who came in a surprising second on a promise to tear up the Trioka’s austerity deal with Greece in lieu of additional funding support. The Greek radicals think the Trioka is bluffing, believing even the Germans need Greece in the Euro and will never throw them out.

It is almost certain, however, that Greece will not get more money to pay its debts if it refuses to take the bitter reforms and austerity medicine. While insisting that the ECB’s “strong preference” is for Greece to stay in the Euro, ECB President Mario Draghi acknowledged that Greece could leave the euro area and signaled policy makers won’t compromise on their key principles to prevent an exit. ECB Executive Board member Joerg Asmussen said that if Greece wanted to remain in the Euro, it had “no alternative” than to stick to its agreed consolidation program. As far as the Germans are concerned, German Finance Minister Wolfgang Schaeuble said, “the (rescue) program is agreed. We need a (Greek) government that’s capable of making decisions,” and “if (Greece) wants to stay in the Euro, they have to accept the conditions.” The IMF’s Christine Lagarde recently stated that “If the country’s (Greece) budgetary commitments are not honored, there are appropriate revisions to do, which means either supplementary financing and additional time or mechanisms for an exit, which in this case must be an orderly exit.”—in other words, honor your commitments to reforms and austerity or leave the Euro.

The ECB has reportedly stopped routine funding operations with four Greek banks because they are basically insolvent. What is left is Emergency Liquidity Assistance (ELA) that is channeled through Greek’s central bank. Greek banks have already exhausted their collateral used for loans from the ECB. A refusal by the ECB to ease rules would amount to expulsion, forcing Greece “to issue its own money,” i.e., drop out of the Euro monetary union. Greek polls indicate most Greeks want to stay in the Euro, but also don’t want to have to endure the pain of the debilitating austerity required for more assistance. According to Greece’s deputy prime minister Theodoros Pangalos, “What [the anti-bailout forces] are really asking from the EU is not just to pay our bills, but also to pay for the deficit which we are still creating”. For the Greeks, there are no good choices, either staying within the Euro or leaving.

The Trioka is betting that the specter of what will happen to Greece if it drops out of the Euro is motivation enough for its people to drink the bitter austerity medicine, while Greek’s radicals are betting the Trioka doesn’t want to find out how much Euro-wide contagion and financial market mayhem would be caused by a Greek withdrawal. The Greeks and the “Club Med” countries however continue to underestimate the depth of Germany’s inflation/debt dependency phobia.

Further, if you think the situation in Greece, Spain or Portugal is bad now, revisit Germany in 1930, when chancellor Heinrich Bruning became known as Germany’s “hunger chancellor” because of his stiff austerity programs. Germany had borrowed so much during the boom years that when bad times came and it really needed the money, it had exhausted its credit lines and loans were no longer available. After Germany’s banking system collapsed in 1931, it really got bad. Production plummeted another 20% over the next six months and eventually shrunk to only half 1928 levels and putting one-third of the labor force out of work. People were starving to death. In either case, the crisis could drag on for years, if the experience of 1930s is any indication. Granted, Germany was much more important to the global economy in the 1930s than what Greece is today, but Greece is a key fulcrum for much more serious Euro contagion.

Greece Euro Exit = Stock, Euro Rally?

Ever helpful with a positive spin on a bad situation, some global investment banks now say that global stocks and the Euro could stage a strong rally if Greece drops out of the Euro. This is based on the assumption that the ECB, the FED and the BOJ would pull out all the stops like they did in 2008~2009 to flood the international financial markets with liquidity, triggering a massive short squeeze on those betting against the Euro and the Club Med countries. Under this scenario, the ECB would slash rates, launch QE and back-stop Spain and Italy with mass bond purchases, bank capital injections and a pan-Euro system of deposit guarantees. Further, as suggested above, a Greece return to the Drachma turns out to be a disaster, thereby a strong deterrence for Portugal, Spain and others from also dropping out of the Euro.

Worst Case Scenario is Greece Successfully Withdrawing from the Euro

Ironically, the worst outcome for the Euro and monetary union would be a double whammy, where authorities fail to control EMU-wide contagion, yet Greece somehow manages to claw its way out of crisis and make a success out returning to a devalued sovereign currency, as Argentina did after breaking the dollar-peg in 2002. In this case, the Euro would fall dramatically on the assumption there were more drop-outs to follow.

Last week, financial markets were discounting the worst case scenario, as the Eurostoxx 600 banks index hit a fresh low, below the 2009 trough, and German Bund futures hit a fresh high as everyone in Euroland scrambles to get on the bus to Berlin. 

Source: 4-Traders.com

Speculators have been pounding the Eurobanks, and the plunge in Euroland bank stocks accelerated as Moody’s downgraded a batch of Spanish and Italian banks. The outflow from Greek banks, as noted, is already becoming a deluge, while there is noticeable outflow from other Club Med banks as well, with all the haven money flowing in the direction of Berlin–thus the new high in Bund futures. In other words, there are now effectively two Euros, Euros of “hard currency” Germany, Netherlands, Luxembourg and Finland, and “worthless” Euros in Greece, Spain or Italian banks.

Hat Tip: FT Alphaville

The Euro for the first half of the crisis remained above the fray, because there was no serious talk of any Club Med country dropping out. The Euro did however peak against USD in May 2010 during the first growth scare and is now down some 14% and is breaking support hit this January on optimism about the ECB’s LTROs. It is also plunging against GBP, as Gilts have also become a haven. The most amazing feature of EUR is that it has yet to return to parity with USD, still some 22% away.

Source: Pacific Exchange Rate Service

 The U.S. Fiscal Cliff: As Big a Threat as the Euro Crisis?

In late February of this year, Fed Chairman Ben Bernanke started warning lawmakers about the looming “massive fiscal cliff”—i.e., a) the expiration of Bush-era tax cuts, b) a 2% payroll tax holiday, c) extended unemployment compensation, c) and $1.2 trillion automatic spending reductions related to the U.S. debt ceiling, etc., the U.S. economic recovery is toast. U.S. economy to its knees if Congress cannot agree before January 1, 2013.  The IMF is so worried that U.S. lawmakers will drive the U.S. economy over this fiscal cliff that it ranks the possibility as a threat equal to that posed by the Eurozone Debt crisis.

Economists, which usually don’t agree on much of anything, agree that tax hikes and spending cuts will drag down economic growth in 2013, yet the estimates vary; a) Moody’s Analytics predicts the fiscal drag next year could be to closer to 1.5 percentage points of GDP, b) the Congressional Budget Office calculated the impact at 3.6 percentage points of GDP in fiscal 2013, while Morgan Stanley economists belief the fiscal drag could slash 5 percentage points off 2013 GDP, versus expected GDP growth over only around 2%–i.e., if the fiscal drag turns out to be greater than 2%, the U.S. gets flat or minus growth in 2013, which is definitely not what U.S. stock prices are discounting.

Further, there are also suggestions of a U.S. government shutdown before that when the new U.S. fiscal year begins on October 1, 2012. The strong proclivity of already grid-locked U.S. lawmakers will be to “kick the can down the road” instead of addressing these pressing policy issues before the November elections, meaning the  “fiscal cliff” is more likely to be averted at the last hour by a Congressional vote for a short-term band-aid to renew the expiring programs for at least the first quarter next year. For example, Gregory Meeks, a Democratic congressman from New York, said politicians “are aware” of the cliff, but that nothing will happen during campaign season, although he tried to assure the audience that Congress would avert disaster by, as usual, always “waiting until we get close to the wire” before seriously addressing the issue. 

Individual Investors Looking Pretty Smart by Shunning Equities for Bonds

Euro crisis and U.S. fiscal cliff help explain why U.S. individual investors have continued to shun equities and equity funds, even though the “smart guys” were warning them that moving into bonds with bond coupons at historical lows was a bad idea.


Lipper data for April and March show flows into stock and mixed equity funds of $2.4 and $6.2 billion respectively, compared to bond fund inflows of $20.6 billion and $30.0 billion respectively. Further, if individuals had listened to the “pros” touting risk-on in the first quarter of the year, they would be nursing losses as the S&P 500 peaked in April and is now down about 15% from that peak. Conversely, the TLT long-term TB ETF is up nearly 30% over the past 12 months, the Bund futures ETN (BUNL) is up some 18%, and even the “bug in search of a windshield” Japan government bond ETN (JGBL) is beating the S&P 500 merely by not going down. Further, over this same 12 months, the S&P 500 has never outperformed the TLT or the BUNL at any time, even temporarily.

Source: Yahoo.com

 Japan GDP Surprise  Virtually Ignored by Stock Prices


Japan announced a surprisingly strong Q1 calendar 2012 GDP number, indicating annualized growth of 4.1% versus street expectations of 3.5%. Stock prices however were not surprised. Basically, the 25.7% rally in the Nikkei 225 from late November 2011 to a March 2012 high of 10,255 already discounted this recovery. Investors are also very aware that the GDP number is coming off a very depressed GDP number for 2011, when Japan’s economy was hit by its own perfect storm of a) a once-in-100 year massive earthquake and tsunami,b) a nuclear crisis, c) severe flooding in Thailand that further interrupted Japanese manufacturing’s global supply chains and d) an electricity supply shortage.


Investors are also aware that the Q1 number is about as good as it gets in terms of the growth pop on the rebuilding of the devastated Tohoku area. Japan’s 2012 Q2 and Q3 GDP growth should slow to 2% and change, while Q4 growth could slip back below 2%, i.e., not very good incremental momentum. Both foreign investors (who now have been selling for four consecutive weeks) and domestic investors are concern the Euro crisis and slowing US growth will result in another test of historical highs in the USD/JPY and EUR/JPY rate, and Japan still has to survive another summer of what could be a serious electric power shortage, particularly in the Kansai region, where the shortage could be as much as 15%. 


That said, the benchmark Topix and Nikkei 225 are again selling in aggregate at below stated book value, meaning any lifting of the heavy pall now hanging over Europe could produce a nice rebound in Japanese stocks. The problem is that investors do not know exactly when.

Source: Yahoo.com

Some brave brokers like Credit Suisse are suggesting that the most crushing balance sheet de-leveraging and recession in modern history is ending in Japan. They see growing evidence that after 20 years, the Japanese corporate sector is finally “healing”, and focus on three signs: (1) the corporate sector is no longer reducing debts or increasing cash; (2) private investment is no longer declining; and (3) ROE and ROIC are gradually recovering (though from depressed levels). At the same time, Japan’s labour productivity growth rates continue to offset the poor demographics, while competitiveness, innovation and complexity indices remain strong. 

The implication is that Japan’s corporate profits could surprise on the upside (growth of over 20% is currently expected in FY2012) in 2012 and going forward, despite the waning reconstruction boost to Japan’s GDP. 

On the bearish side of the ledger, everyone is aware that a slowdown will and already is crimping a recovery in Japan’s exports, both direct to China and within the region. Lombard Research has a piece out that observes the China slowdown will hit Hong Kong, Taiwan, South Korea, Australia, Japan, Indonesia and India the hardest, in that order. The Euro crisis is also hurting growth in Asia through Euroland banks, which heretofore had been a big factor in regional trade financing. 

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

Ghosts of the 2008 Financial Crisis Continue Haunt Stock Prices

Takeaways

1) The while knuckle part of the 2008 financial crisis has been contained, but the wreckage has been extensive and the secondary fallout could still tip the global economy into depression if handled badly. Economies, banks and financial markets remain heavily dependent on unprecedented central bank intervention. Further, the ongoing Euro sovereign crisis is a pox on global economic growth expectations and global financial system stability. 

2) The deleveraging process could take a decade or more even under more benign scenarios, meaning economic growth will remain tepid and the debt burden of developed economies will remain heavy for the foreseeable future, while emerging markets will remain plagued by inflationary pressures and sputtering growth rates. 

3) The economic crisis began in the U.S., laid waste to the Euro monetary system, and could end in Asia, either in China, Japan or both, meaning that U.S. equities still represent the least risk and best medium-term value of the world’s equity markets, with additional upside potential provided by a secular USD rally on the U.S. energy revolution. 

4) If the last phase of the economic crisis ends in Asia, the secular commodity boom may have already peaked in 2008, with a weaker secondary peak also seen in 2011. Also, don’t look to emerging markets for a performance boost. Emerging markets need good growth in global trade and, in many cases, strong commodities demand, i.e., they are a warrant on the global economy.

The Wreckage from the 2008 Financial Crisis is Still Extensive

The white knuckle part of the global 2008 financial crisis has been contained, i.e., financial markets and global economies are no longer in free-fall, but the wreckage has been extensive and the secondary fallout–sovereign debt crises, deleveraging, austerity, fragile economies and financial institutions, could still tip the global economy into depression if handled badly. 

This economic crisis began in the US, laid waste the Euro monetary system, and could end in Asia., either in China, Japan or both. Easy money and central banks as well as regulators asleep at the regulatory switch allowed a massive, highly leveraged “shadow” banking system and a derivatives monster with a nominal value of USD600 or 10 times the global GDP to grow unchecked off the balance sheets of the world’s deposit-taking institutions, infusing the global financial system with dangerously complex web of systemic instability. This systemic instability has yet to see any regulatory solution, and remains the 500-pound gorilla in the room. 

Although the epicenter of the financial crisis was the U.S. and the U.S. Treasury made a serious strategic mistake in allowing Lehman Brothers to fail, the U.S. has coped better and earlier, with a totally committed Federal Reserve leading the great experiment in unconventional, “irresponsible” monetary policy at zero bound interest rates to print enough money so that the nominal growth rate of the U.S. economy (inflation plus real growth) is above the nominal interest rate. Under normal circumstances, this “helicopter” money would be wildly inflationary, but the fractional banking system money multiplier function is broke, and money poured in at the top into the banking system is primarily being used to repair financial sector balance sheets, thereby allowing deflationary debt restructuring and austerity to proceed in a balanced way over a fewer number of years without pushing the economy into deep recession.

Before the U.S. cruises on the golden road to energy independence and becomes a major energy exporter, investors have to deal with a much anticipated “fiscal cliff”, i.e., a looming combination of spending cuts mandated by the 2011 debt ceiling compromise and the expiration of income, payroll and capital gains tax cuts that could mean withdrawing from the U.S. economy some 4% of the national income that could derail the U.S. economic recovery, according to Pimco’s Mohamed El-Erian.

Global PMIs Indicate Global Expansion, Hobbled by Euroland

JPMorgan’s Global Manufacturing and Services PMI, which is designed to track global GDP trends, slipped to 52.2 in April from March’s 54.4, raising investor concern about the sustainability of the global recovery. But the index remained above the 50 mark for a 33rd month, indicating there the global economy is still expanding, albeit at a weak pace. The April numbers however are suggesting the Euro Zone economy worsened markedly in April. A sharp slowing of the Euro Zone’s economy of course would be a weight on U.S., Japan and China growth.  

The other hot button is U.S. unemployment, where the numbers are suggesting the U.S. jobs recovery is recently sputtering. While the Fed remains totally committed to doing whatever it can to revive the U.S. economy to a full employment level, the successive bouts of monetary largess are beginning to remind us of Japan in the 1990s, i.e., the economy and stock market perked up everytime the government/BOJ moved to stimulate, but relapsed and began to sputter everytime the stimulus was removed–i.e., the economic recovery was not sustainable without repeated shots of stimulus. 

Longer Term, U.S. Energy Revolution Will Ameliorate U.S. Deleveraging Pain

The U.S. deleveraging and repair of fiscal and private sector balance sheets could continue for the next 10 years, were it not for the energy supply revolution that is rapidly evolving in the U.S. The shale revolution is already spreading prosperity all over the U.S., bringing jobs and production back to “old” industries in states like Pennsylvania and Texas. The new economies of substantially lower energy costs are prompting Dow Chemical Co. and Shell Oil to announce plans to build new North American ethylene crackers and other plants. Other companies, including Chevron Phillips Chemical and Formosa Plastics, have announced plans to increase their North American polyethylene output as a result of the shale gas wave. North Dakota leads the country in shale-related prosperity, with the lowest state jobless rate of 3%, the highest growth in per-capita personal income since 2000 at 79%, or more than twice the national average of 37%. 

U.S. Becomes Net Energy Exporter for the first Time in 30 Years

In 2011, the U.S. became a net exporter of energy products for the first time in 60 years. The Bakken oil field in the Midwest has gone from no production a decade ago to 500,000 barrels a day, with predictions that output could double. Texas fields are suddenly producing vastly higher volumes. New possibilities for natural gas are even greater. Natural gas is now so cheap and plentiful that it will make new coal-fired energy plants almost impossible to build, and elbow aside oil in some areas such as fuel for vehicle fleets. 

Daniel Yergin, author of The Quest, suggests that perhaps as many as 20 billion barrels of recoverable tight oil exist in the U.S. Such deposits, he writes, would be the equivalent of 1½ Alaska North Slope deposits. Broker Raymond James Ltd., suggests the U.S. may no longer need to import any oil by 2020 and could be a new oil exporter by 2030, whereas the U.S. was still importing 10 million barrels a day in 2011. The United States consumed 18.8 million barrels per day of petroleum products during 2011, making it the world’s largest petroleum consumer. The cost of oil imports to the United States in 2012 could reach a record $426 billion in 2012, up from $380 in 2011. This imported oil bill acts as a tax on the U.S. economy. 

Citigroup analysis suggests oil and gas production in the U.S. and North America will skyrocket in the next eight years, completely transforming the domestic U.S. economy as total liquids production ostensibly doubles over the next decade, allowing the U.S. to eclipse both Russia and Saudi Arabia in oil production by 2020. This potential for a major transformation of the domestic U.S. economy, balance of payments, USD strength, etc. is keeping investors from becoming too bearish on the U.S. despite concerns over the upcoming “fiscal wall” and the U.S. debt issue. 

Source: Citigroup

S&P 500 Most Resilient of the Global Equity Markets

As a result of a very pro-active Federal reserve monetary policy and an across-the-board capital infusion and stress tests of major financial institutions, the S&P 500 has been the most resilient of global equity markets, recovering 82.5% of the 56.2% decline in the index from a 1,561.80 peak in October 2007 to a low of 683.38 in March 2009. The rebound to a March 2012 high of 1,408.47 basically represents a doubling of the S&P 500 from the March 2009 low , driven by, a) repeated bouts of stimulus from the Fed, including QE1 and QE2, who has stepped in every time it appeared the economy and the stock market was running out of gas. 

Make no mistake about it, however, the U.S. and global stock markets are still very dependent on extraordinary monetary support, as the real economy is as yet too fragile to stage a strong enough recovery to allow the Fed to “normalize” monetary policy. 

S&P 500 Continues to Underperform Bonds Further, the fact of the matter is that stocks have significantly under-performed bonds for the last decade, calling into serious question the “stocks for the long term” thesis, at least for retail investors being jerked around by High Frequency Trading and leveraged hedge funds, and as long as both the economy and stocks remain heavily dependent on monetary intervention, this situation could persist. While many in the U.S. still insist that the U.S. has not become Japan, bonds (JGBs) in Japan have outperformed a shrinking stock market for the last two decades, to the point that domestic individuals as well as institutions have all but completely abandoned equities in favor of fixed income or overseas investments.

While the S&P 500 YTD has been driven by rallies in the financials, consumer discretionary and the technology space, it is these same sectors that are bearing the brunt of current profit-taking on growth and renewed systemic fiscal sector fears. U.S. financials are believed to be in better financial shape than their Euroland peers, but the recent JPMorgan (JPM) negative surprise of $2 billion in trading losses show that even the best are not immune to bad hedges, meaning investors will remain wary of potential hand grenades lurking on bank balance sheets.The financial stocks however will have to be an integral component of any rally attempting to take stock prices beyond 2007 highs, as will the top-heavy basic materials companies most sensitive to global growth expectations.  Serious Structural Flaws in Monetary Union Strongly Imply Partial or Full Euro Breakup

The adjustment in Euroland is not going well at all. Heavily indebted countries are teetering on the verge of depression because they can’t print money and the ECB isn’t printing fast enough to get nominal interest rates below shrinking nominal growth rates. As a result, the debt burden continues to build, and the austerity-heavy measures insisted upon by the Euro trioka, i.e., Germany, the ECB and the IMF are a miserable failure because the electorate of crisis southern nations is simply refusing to take the bitter medicine while the German public is in no mood to pour their hard-earned savings down the sink-hole of southern Euro debt for the sake of saving a seriously flawed monetary union.

Further, the European Union was the hardest-hit of industrialized regions on oil import costs because, when converted into euros, the average EU oil price is running higher than in 2008.

The easiest way to track fiscal and financial stress in Euroland is to watch the Eurostoxx Bank Index. Two tranches of the ECB 3-year loan program late in 2011 and in February 2012 helped to alleviate some of the stress building in the Euroland banking system, but the political events of the last couple of weeks has this stress again building, with the Eurostoxx Bank index falling back to 2009 lows, indicating systemic risk is as high as ever in Euroland. In other words, there is more than just headline risk that overseas investors would rather ignore.

Source: 4-Traders.com

China’s Adjustment Challenge

Not all investors are convinced that China is poised to overtake even the U.S. economy over the next decade. While China was kicked, then stumbled and fumbled during much of the 19th and 20th centuries, it began shaking off much of its ideological shackles as Maoism gave way to Deng Xioaping’s party rule in the early 1980s, opening China’s doors to the world — on China’s terms.

China’s ruling Communist Party is seriously considering a delay in its upcoming five-yearly congress by a few months amid internal debate over the size and makeup of its top decision-making body, indicating that China may no longer be the monolithic juggernaut poised to overtake the world, or is undergoing an evolution to a more open, global stance not straight jacketed by out-dated hardline Communist doctrines.  Any delay in the Congress, however, no matter the official reason, would likely fuel speculation of infighting over the remaining seats in the nine-member Politburo Standing Committee which calls the shots in China. 


China’s clamp down after an immediate and massive liquidity and credit infusion following the 2008 global financial crisis has created a substantial degree of excess and maladjusted investment in infrastructure and property that some see as a bad debt train wreck in the making. Beijing has been trying to reign in inflationary pressures and credit to reign in these excesses, and in the process has squeezed the Shanghai Composite index into consolidation since  the global peak in equities in 2007. The index bottomed before other major indices because the Chinese government was quick to introduce a massive stimulus package that unleashed a torrent of loans–the after effects of which are now being negatively felt as a bad debt overhang in the Chinese economy. 

Shanghai Composite: Nearing a Break to the Upside?

China has announced a flurry of financial liberalization measures that were perceived by many in the U.S. and Europe as a sign of confidence about China’s growth prospects. In reality, these measures (widening the trading band on the yuan, allowinging greater capital inflows, permitting a domestic pension fund to invest in the stock market, etc.) could be defensive steps intended to protect the economy from a coming slowdown. China’s economy is slowing because of weaker demand for exports in Europe and the U.S. and because of the  limits of its investment-driven growth model. Growth in electricity consumption and railway cargo has halved since last year and data show that the transition to consumer-led growth is going slowly. 

Chinese leaders are now encouraging capital inflows particularly into the domestic stock market. The Qualified Foreign Institutional Investor quota has been expanded to $80 billion from $30 billion for approved foreign investors to buy mainland-listed Chinese stocks. The government also announced it would allow the Guangdong province pension fund to invest in domestic stocks. 

However, the CEO of property developer SOHO China Ltd. insists that at least the commercial property market bottomed in January of this year, and will be showing a strong recovery by the time credit conditions are visibly easing. As a barometer of tight credit conditions, the Shanghai Composite also looks to be nearing a break-out point, ostensibly to the upside. Thus the movement of the Shanghai Composite itself suggests that the current investment stance of outside observers is overly cautious/bearish. Sure, China’s economy is slowing from the break-neck 10%-plus, but ~7% may be a much more sustainable, healthy pace going forward, causing less friction between China and its trading partners. That said, a break out of the current triangle formation would be justification for the bears’ view that things are about to get worse, not better in China for investors. 

EEM Emerging Markets ETF

Continued weak growth and ongoing Euro crisis are not what emerging market bull markets are made of. While global institutions piled into the emerging markets again in early 2012 expecting a repeat of the 2009 surge, they have been disappointed as the EEM Emerging market ETF aptly shows the wilting of emerging market stock prices. In emerging markets, there is little to no correlation between economic growth and equity returns. Further, investors tend to overpay for recent growth. Emerging markets need good global growth in trade to shine.

Japan is Ex-Growth, Ex-Dynamism
Foreign investors remain seriously concerned about the lack of any visible progress on what they perceive to be a serious government debt problem. As in the U.S. and Europe, the burden of trying to revive Japan’s economy through monetary policy alone, as a seriously gridlocked government bickers about the imposition of higher consumption taxes many observers say is necessary to stem the current alarming increase in already massive government debt, yet with no comprehensive debt management, growth stimulus policies. 

The Bank of Japan’s response, while increasingly aggressive as regards utilization of its balance sheet, is seen as visibly insufficient in terms of printing money or buying long-term financial assets to stem the yen’s damaging appreciation and ensure that Japan’s nominal GDP growth rate is above the nominal interest rate. 

The estimates of how much time Japan has before hitting the debt wall and triggering a crisis ranges from “it could blow up at any time” to five years or more. Most are in agreement that the BOJ should more aggressively monetize debt and engineer a weaker exchange rate, thereby making good their inflation target. The more aggressive investors are still trying to short JGBs yet remain stymied by the strong support JGBs have among extremely cash-rich domestic institutions and corporates. 

Over a shorter-term horizon, however, foreign investors are content to play the periodic catch-up cycles as Japanese equities increasingly lag global equities, then experience three to six months of out-performance. Despite the disparaging views of Japan top-down, foreign investors as a whole remain consistent net buyers, and have remained so throughout the Heisei Malaise (from 1990), albeit being much more selective in focusing on still globally competitive Japanese names,smaller capitalized companies and the emerging Internet venture companies. 

A comparison of the trend in net foreign buying of Japanese equities and the Topix clearly shows that foreign investors are THE driving force in Japanese equity price formation. However, the positive uptick given to Japanese stock prices by foreign buying is nowhere near what it once was. As the following charts show, this is because of not only heavy unwinding of strategic stock holdings by Japanese financial institutions and corporate, but also because of consistent net selling by domestic portfolio investors, who are abandoning their traditional “home bias” in their equity investments in favor of more attractive alternatives in overseas stocks. Indeed, in many domestic pension portfolios, foreign equity exposure is just as high or higher than domestic equity exposure.

Net Selling by Strategic Holders Remains Heavy

Foreign Buying Offset by Domestic Selling

Fundamentals Aside, There are Serious Structural Supply-Demand Issues

Since the beginning of FY2009 (April), domestic city and regional banks have unloaded a net JPY644.9 billion of Japanese equities, while domestic life and non-life insurers have unloaded a net JPY2,034.4 billion, mutual and pension funds have unloaded JPY832.5 billion, and individuals have unloaded another JPY4,004.8 billion for a total JPY7,516.6 of net selling, which has largely offset the net buying by foreign institutions of JPY10,900.4 trillion. Despite substantial net buying by foreign investors, Japanese stock index benchmarks (Nikkei 225 and the Topix) have been underperforming not only the US benchmarks, but ironically the Euro stoxx benchmark as well.

Essentially, every risk-off phase that has global institutions trimming equity exposure causes a temporary air pocket in Japanese stock prices, were a constant nominal amount of foreign buying is needed just to keep Japanese stock prices from collapsing under the weight of structural domestic net selling. While corporates have been nominal net buyers by around JPY274.5 billion, other corporates have also been heavily unloading their strategic stock holdings when stock buyback programs are factored out. 

High Expectations for a GDP and Corporate Profit Rebound in 2012

2011 was a perfect storm for Japan’s GDP and corporate profits–a once-in-100-years massive earthquake and tsunami, a nuclear and electric power crisis, serious flooding in Thailand which is a major offshore production base for Japanese exporters, a surging JPY, and slowing import demand in China, Japan’s largest trading partner. 

Thus a nice rebound is widely expected in 2012 from a very low GDP base (nominal GDP has actually back-tracked to mid-1990 levels) as well as a depressed corporate profit base. Yet a surprise move by the BOJ to deploy more of its balance sheet in February that was followed by further action in April has failed to turn the gravity-defying JPY, because of widely expected QE3-like action by the Fed, and the dire situation in Euroland where only more ECB action can temporarily stave off bond and bank stock vigilantes. While Japan’s manufacturing has bounced back from the perfect storm in 2011, the manufacturing PMI suggests manufacturing will remain hobbled by weak overseas demand and continue strength in JPY, which of course is leading for continued government calls for the BOJ to stimulate more.

Markit/JMMA Japan Manufacturing PMI

Government initiatives to stimulate the economy have overwhelmingly proved ineffective, even when they are actually implemented. Domestic wage-earner consumer purchasing power continues to be eroded by higher electric power costs, wage reductions, employment uncertainty, as well as “stealth tax increases” in addition to the proposed consumption tax increases, meaning personal consumption is being supported by rebuilding in the Tohoku region and the active elderly, who of course control the bulk of Japan’s personal savings. While housing demand has upticked on Tohoku rebuilding as has corporate capital expenditures, exports, which in recent history have been the driver of cyclical recoveries, are being stunted by the strong JPY as well as weaker import demand in China as well as Euroland. 

Japan Nominal GDP Component Growth

The consensus is for around 2% growth in 2012 supported by the recovery in the Tohoku region. While uncertainties include continued JPY strength, weak import demand in China and Europe and reduced purchasing power among wager-earner households, the economic indicators suggest the expansion will continue, albeit at an anemic rate.  

Japan CI Economic Indicators

In late April, Bloomberg compiled analyst consensus forecasts (over 2,600 analyst estimates) still have Japanese corporate earnings surging some 69%, after falling 31% in FY2011, while the Nikkei EPS growth estimate is showing 22% growth. However, JPY continues to trade above widely assumed JPY/USD and JPY/EUR exchange rates in corporate budgets. Demand is rebounding in the Tohoku region breathing life into selected retail and consumer-related stocks, and Japan’s Internet start-ups are alive and well. 

The main feature that continues to attract foreign investors to Japanese stocks is apparently very cheap valuations and the ever-present (but as yet unfulfilled) promise of a major turning point. However, instead of catching-up to the recent rally in the S&P 500, the mini-rally in the Nikkei 225 triggered by the BOJ’s surprise move in February that temporarily weakened JPY has already peaked, as investors are now looking to the Fed for the next stimulus move.


As we have pointed out many times before, the Japanese market, if one wants to play, should be approached as a market of individual stocks, not a stock market, being ever mindful that any slowing of the flow of net buying by foreign investors in aggregate means Japanese stock prices immediately begin to crumble under the weight of structural domestic selling. 


Yes, The Japan Stock Market is Cheap, But There Are Almost No Growth Expectations

That said, since both the entire Nikkei 225 and the Topix indices are again trading at under book value and dividend yields are over 2% or roughly twice that of JGB yields, the downside risk appears limited to prior lows hit during the March 11 and November 2011 lows, or somewhere between 8,200 and 8,600. On the upside, the important point to remember for both indices and their major constituents is that almost no medium-term earnings growth is currently being discounted in stock prices, even though nominal forward P/Es are currently at around 15X for both indices based on EPS growth of over 20% in FY2012 (to March 2013).

Despite all the hype overseas about the Facebook IPO, even stocks of Japan’s Internet start-ups are flat-to-down over the past 52 weeks. High flyers like Gree (3632) have been shot down by what the Consumer Protection Agency in Japan considers “predatory” charges for a certain type of game that has been a very lucrative source of revenues, which has also hit the stocks of rival DeNA (2432) and even So-Net (3789). This has caused individuals and small cap investing institutions to shift funds to the consumer-oriented sites like Cookpad (2193, a site about cooking recipes), which is the only stock in the group we looked at showing good positive momentum in its stock price. 

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

Japan No Longer a Developed Nation by 2050?!

Think you have heard the gloomiest Japan scenarios from overseas Japan bears, think again. 
A think-tank linked to Japan’s Keidanren business federation called the 21st Century Public Policy Institute paints a pessimistic scenario of Japan’s GDP falling behind India in 2014 after already falling behind China last year, and by 2050 could “significantly” lose its economic presence, dipping to only one-sixth that of China and the U.S. and one-third that of India. The Institute points out that Japan’s economy is already a “no growth”, with nominal GDP having reverted to levels 20 years ago.

The Institute’s scenarios are not just idle speculation of some ivory tower intellectuals, as the Institute’s Global Japan and other committees boast teams of special advisors consisting of CEOs and chairmen of Japan’s largest companies.  In its most pessimistic scenario, the Institute sees Japan’s economy continuing to contract because of continued deterioration in its fiscal condition, a dwindling workforce caused by a chronic low birth rate, lower savings and shriveling investment. Even if Japan’s productivity recovers to the average level of the world’s top economies, Japan’s economy could still start structurally shrinking at some point in the 2030s.

The report warned, the nation’s public debt could swell to nearly 600% of GDP by 2050 without further curative measures. A government report released earlier this year also predicted Japan’s economy could shrink to a third of its current size over the next century. 

The decline in Japan’s population over the next 40 years will be dramatic. Total population is projected to shrink by 31 million, from 128.1 million in 2010 to only 97.1 million in 2050, while the working population is projected shrinking by 21.5 million, from 65.9 million to 44.38 million by 2050. The shrinkage of Japan’s population during this period is roughly equal to the entire population of California, itself the most populated state in the U.S.!  Given the dramatic decline in population, Japan’s per capita GDP will actually increase even as its nominal GDP shrinks. Japan’s per capita GDP is seen growing from US$31,899 in 2010 to US$41,791 by 2050, making Japan still number two in terms of per capita GDP, as China’s per capita GDP in 2050 is still expected to be only US$18,908.


The dramatic aging of the population will hit Japan’s prefectural regions to different degrees. For example, no less than 41% of the population of Akita prefecture will be old-timers by 2050, while “only” 29% of the population in Aichi prefecture will be elderly.

Report Link (in Japanese) 

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

Global Economic Growth Being Revised Up, But Investors are More Worried About the Waning Surprise Factor

<!–[if !mso]>st1\:*{behavior:url(#ieooui) } <![endif]–>
IMF Revises Global Growth Forecast Upward Slightly from January Forecast

In its April 2012 World Economic Outlook, the IMF sees the global economy as gradually strengthening after a major setback during 2011. The organization is now more upbeat on the global recovery, projecting that the world economy will expand 3.5 % percent in 2012, up 0.2 points versus its January estimate, and will rise 4.1% percent in 2013, up 0.1 point from the prior forecast. The threat of a sharp global slowdown has eased with improved activity in the United States and better policies in the Euro area. However, recent improvements are very fragile, and the weak recovery will likely continue in the major advanced economies, and activity will remain relatively solid in most emerging and developing economies.

 

<!–[if !mso]>st1\:*{behavior:url(#ieooui) } <![endif]–> The U.S. Economy is Rebounding Faster

The U.S. economy is showing the best signs of recovery, even though the housing market in general remains depressed and the recovery in employment is lagging. The earlier recovery is attributable to,

1. Corporate investment. a) There were more non-bank options available to provide financing for investment, and b) there was less spillover from euro area risks on the U.S. banks than in the U.K., for example. 
2. Household consumption is recovering. a) There was significantly less net withdrawal of fiscal stimulus, and b) the rise in energy costs hurt consumers in other countries more.

While Japan’s economy saw a sharp Q1 2012 rebound of 3.4% annualized, Q2 2012 annualized growth slipped back to only 1.4%, or less than the G7 average, while the U.S. economy in Q1 and Q2 grew at nearly 3% annualized—i.e., the U.S. recovery looks more sustainable. 

 

Source: OECD, Reuters

Encouraged by economic surprises and two LTROs by the ECB to shore up Euroland bank balance sheets, the S&P 500 gained 12% from January through March, its best first quarter since 1998. That followed a gain of 11% in the October through December 2011 quarter.

 

But Citibank’s Economic Surprise Index for the major economies peaked in February and continues to decline in April, with the deterioration wrong-footing stock prices, with the recent S&P 500 peak being April 2 at 1,413.4.

 

Source: Citibank

Risks to the Recovery Outlook

 

The OECD sees a main culprit being Euro zone nations, which are falling far behind the fragile recovery taking root in the United States and Canada. The Eurozone PMI is pointing to more weakness in Euroland economies as enforced austerity measures really begin to bite. The OECD’s  advice to central banks is to keep easy money flowing so the rebound does not prove short-lived. “This is going to be a delicate period over the next quarters,” OECD chief economist Pier Carlo Padoan said. The other risk to the recovery outlook is surging oil prices, which have risen 15% since the beginning of 2012, and will add a quarter of a percentage point to inflation in developed countries and knock 0.1-0.2 points off growth on average over the next year. The European Central Bank (ECB) said loans to the real economy fell in February, scotching claims that radical long-term refinancing operation (LTRO) would stem the crisis. The waning LTRO effect has led to a renewed rise in particularly Spanish government bonds, which saw weak demand in recent bond auctions. 

 

Source: Reuters

 In Asia, the risk is China, where the mixed (official versus HSBC) PMI data is showing clear deterioration from the 2010 peak, but just how much weakness is still an open question. Slowing exports from Japan to China however make it clear that China is no longer the “black hole” of demand it once was, driving global commodity demand as well as Japan exports, and what key commodity demand there is is being distorted by hoarding demand.  

 

Source: Wall Street Journal

Business Sentiment Remains Very Cautious in Japan, Adding Growing Pressure on the BOJ to More Aggressively Use its Balance Sheet 

 

The IMF also raised its growth estimate for Japan due partly to eased risks in the Eurozone, but prodded Japan and the United States to take additional monetary easing steps to support growth. The IMF is now projecting the Japanese economy will grow 2.0% in 2012 in real terms, which is 0.4 percentage points higher than its January estimate, but sees only 1.7% growth in 2013. Given ongoing deflation, further monetary easing is needed in Japan to ensure the BOJ meets its 1% inflation objective over the medium term.

While Japan’s trade surplus returned in February after a record trade deficit in January, YoY export growth in March (+5.9%) on stronger automobile exports to North America were not enough to maintain the trade surplus because increased energy imports pushed up total imports 10.5% YoY, although the trade deficit was smaller than consensus. Renewed worries about Euroland’s debt crisis and continued concern JPY will rally again is weighing on manufacturer business confidence after a sharp rebound in March, according to a Reuters poll. Exports to the U.S. are recovering but shipments to China, Japan’s largest trading partner, remain weak, meaning Japan’s trade will continue struggling as long as China’s economic growth continues to slow. 

The weaker the economic data, the stronger the calls for further balance sheet utilization by the BOJ, which is already under intense pressure from politicians to provide more stimulus, even though non-manufacturer business sentiment as measure by Reuters is showing noticeable improvement (to 2007 levels) on restructuring demand for the Tohoku region. 

All eyes are on the BOJ’s monetary policy board meeting next week as a signal of how committed the BOJ is to “continuing powerful monetary easing through various measures, including maintaining the policy interest rate at practically zero and purchasing financial assets, until the current goal of year on year CPI inflation at 1% is deemed to be achievable.” BOJ governor Shirakawa told a gathering of the Foreign Policy Association in the U.S. Signs the BOJ is willing and able to provide as much balance sheet as needed to a) eradicate deflation and b) push JPY weaker than JPY85/US will be bullish for Japanese equities, while signs of reluctance and continued caution will encourage more JPY strength and weaker stock prices. 

 

Source: Cabinet Office, Trading Economics

 

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

Jump in Capital Spending Good News for Japan’s Recovery

In Q4 2011, Japanese company capital spending jumped the most in five years, which is welcome news for Japan’s long-suffering economy.  Capex as measured by the MOF rose 4.9% YoY after an 11% decline the previous quarter.  The boost came from a weakening JPY, industrial production and retail sales gains, and government spending on reconstruction in the Tohoku region, with reconstruction demand probably being the biggest support, with the government allocating JPY21 trillion since the March 11, 2011 disaster, and the BOJ boosting its total stimulus (nominal) to JPY65 trillion. 

Bloomberg

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

Japan’s Q4 Real GDP Down 2.3% Annualized, Nominal Down 3.1%

The Cabinet Office released Japan’s Q4 GDP numbers (preliminary), which shows Japan’s GDP in the October-December 2011 quarter falling 2.3% annualized (0.6% Q-Q) in real terms and 3.1% in nominal terms, which is weaker than the consensus for a 1.4% decline. The weakness in Q4 GDP resulted in Japan’s real GDP in calendar 2011 declining 0.9% YoY to JPY506.83 trillion, and nominal GDP falling 2.8% to JPY468.74 trillion, the second annual decline in two years. At the end of 2011, Japan’s GDP was still about 9% lower than the peak hit in 2007 (JPY512.97 trillion).

For the quarter, personal consumption was up 0.3% Q-Q on a bounce-back in auto sales and stronger clothing sales because of the cold weather. Housing investment slipped 0.8%, while private sector capital expenditures were 1.9% higher. Given the more uncertain outlook, the contribution from business inventories was minus 0.3%, and public works expenditures were also down 2.5% as the government’s third supplementary budget did not get passed until later in November.

Exports fell 3.1% on weaker overseas demand and supply chain interruptions due to the Thai flooding. On the other hand, imports rose 1.0% on increased energy imports of LNG for electricity production. Deflation continued as the GDP deflator fell 1.6% YoY for the 9th quarter of declines.

Japan’s GDP had just come off two quarters of recovery from the March 11 Tohoku disaster, but the strong yen, failing overseas demand and long delays in the government support measures for Tohoku reconstruction are again dragging GDP lower. The Cabinet Office’s January economy watcher survey was pointing to weakness in domestic demand as the index fell 2.9 points for the first time in 2 months as the strong yen is hurting foreign tourism into the country and a cold wave from January weighed on personal consumption. 

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

Corporates and Individuals Shun Risk, Accumulate Cash

Both individuals and corporations continue to accumulate cash since the 2008 financial crisis as they refrain from investing in risk assets and making longter-term capital commitments even as the developed world’s central banks continue pumping record amounts of liquidity into the global financial system.

According to central bank flow of fund statements, cash and bank deposit balances held by individuals and corporations in Japan is around $13 trillion, while US corporates and individuals have some $9.6 trillion and Euroland individuals and corporates have a similar amount of cash and bank deposits on hand.

Stock holdings in Europe among households are down 9% YoY, while they are down 7% YoY in Japan. As a result, the outstanding balance of investment trusts on a global basis are down 6% from the end of 2010 to USD23 trillion. As a percent of GDP, cash and bank deposits have grown from 1.9X GDP 2006 to 2.2X GDP as of last September, while bank loans are flat to slightly lower. Bank loan growth in Germany, for example, is also waning.

The quantity theory of money holds that MxV = P x Y, where M is the money supply, V is the velocity of money, P is the price level and Y is the quantity of output. In other words, high cash and bank deposit balances indicate that the turnover of money in the developed  economies is very low, and is negating much of the efforts of central banks to revive their economies with more than abundant amounts of liquidity, as households and corporates hoard cash balances and the banking system uses the excess cash to repair balance sheets riddled with impaired assets.

By the same token, the developed economies cannot be seen as “recovered” until the velocity of money recovers to normal levels and money is again circulating smoothly from the central banks through the banking system into the “real” economy.

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

World Bank: Developing Economies Need to “Prepare for the Worst”

The World Bank sees continued risk for the European turmoil to turn into a global financial crisis reminiscent of 2008. Euro-area industrial production declined for a third straight month in November, a report last week showed, adding to signs the economy failed to expand in the fourth quarter as leaders struggled to quell the region’s fiscal crisis. The institution has slashed is forecast for world growth to 2.5 percent from a June estimate of 3.6 percent. The Bank sees the euro area contracting 0.3 percent in 2012, compared with a previous estimate of 1.8 percent growth. Other instituions are more bearish, seeing a 1%~2% contraction in Euroland.

The U.S. outlook was cut to an expansion of 2.2 percent from 2.9 percent, while Japan is no longer expected to grow above 2% in 2012. Emerging markets are also feeling the pinch of Euroland turmoil. In the second half of 2011, gross capital flows to these countries fell to 55 percent of the level in the year-earlier period. Emerging markets are more vulnerable than in 2008 to a renewed global crisis because rich nations wouldn’t have the fiscal resources they had back then to support their economies,

 The Bank expects China’s growth slow to 8.4 percent this year, the same as an interim revised projection released in November. India’s forecast has been cut 1.9 points to 6.5% growth.

Rueters: China Harbringer of Global Slowdown?
Europe Threatens Emerging Markets

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