Fed Policy is Not one of the Global Canaries in the Coal Mine

U.S.: Making Mountains Out of Molehills?

The past couple of weeks have seen a shift to risk off and an unwinding of carry trades triggered by the U.S. Federal Reserve’s infamous “taper” comments. The following chart comparing the S&P 500 and Bloomberg’s U.S. economic surprise index (hat tip: Zero Hedge) shows the growing disconnect from March of this year onward between economic expectations and stock prices—i.e., U.S. stock prices were reaching new highs while the macro index was hitting new lows. Thus a “mark to economic reality” for US stock prices was overdue before Chairman Ben’s comments. The only investors that should have been “shocked” by the move in US stocks recently are those who had heretofore been waiting for a meaningful correction but already caved in and bought the market…just before Chairman Ben set traders scurrying to unwind positions. 

However, the equity market’s sanguine reaction to worse-than-expected Q1 GDP data does indicate a) underlying confidence in the US economy’s ability to continue recovering and b) that the factors supporting stock prices are not all central bank cool aid. Despite the inevitable backing and filling, the trend in the S&P 500 is still up. With the point & figure chart of the 30-year bond indicating some 8% more downside for 30yr treasuries, the point & figure chart for the S&P 500 is indicating something more like total downside risk of some 11% to 1,500, i.e., not a new secular bear market. Assuming the S&P 500 corrects to its current post-crisis recovery trend line, it is obvious there is still some more short-term downside risk in stock prices….but not, as yet, evidence of a serious cracking of US stock prices.

Hat Tip: Zero Hedge

Bonds Were Beginning to Selloff Before Chairman Ben’s Infamous “Tapering” Comments

30yr US treasury prices already peaked mid-year at the height of risk aversion in 2012. Since then, the 30yr TB has sold off nearly 13%. Since the early 2012 low of 135.38 is not apparently holding, the Point & Figure charts are indicating another 12% or so of downside risk. Weighing on bond prices is a) better confidence in the sustainability of the US economy (housing, employment, etc. improvement), and b) the possibility that the Fed begins backing off earlier than latter, and c) waning concerns about the strength of the global economy. 

From a long-term perspective, the writing is on the wall for bonds, US treasury prices are clearly breaking down. The issue then becomes if the unwinding of the great bond rally becomes a gradual selloff or a full-scale rout. Since long bond prices were already consolidating before any hint of Fed tapering, we would guess that the the “good” upward pressure on bond yields, i.e., improving economic expectations, as well as reduced global tail risk are not insignificant factors in current bond yields.

On the other hand, since the repair process in the Eurozone and Japan significantly lags that of the U.S. and growth in the emerging markets is less than stellar, inflationary expectations remain, in Fed-speak, “well-anchored”. 

Hat Tip: StockCharts.com

Historically, rising rates have not always meant falling stock prices. In the great run-up of bond yields culminating in the oil crisis peak, the worst damage to stock prices (then, a secular bear market) was as bond yields rose from 4% to 8%. Thereafter, however, stock prices entered a 28-year bull market even as yields were spiking to 16%–implying that the mix of economic factors is just as important or perhaps even more important than interest rates alone. 

Hat Tip: The Big Picture

Watch the Global Canaries in the Coal Mine 

From a tail risk perspective, investors are less afraid of the impact on US equities from an easing of the Fed’s heavy $85 billion/month boot on the US bond market than they are of, a) the potential downside in bond prices, b) renewed crisis in the Eurozone and c) a sputtering Chinese economy. Thus compared to other financial markets, the correction in US stocks so far is a tempest in a teapot because US stocks remain the best game in town, or alternatively, the least dirty shirt in the closet to those of a more bearish persuasion.  

Globally, the real canaries in the equity coal mine are the Eurostoxx Banks index (as an indicator of renewed Eurozone sovereign debt crisis risk) and the Shanghai Composite (as an indicator of the state of the Chinese economy). The Eurostoxx Bank index is in the process of confirming 2012 lows, while the Shanghai Composite has collapsed to a new low. 

Both of these indices remain in long-term bear markets after a brief but sharp bounce in 2009. The Eurostoxx Bank index, which has surged some 75% as sovereign bond yields in the troubled southern Eurozone nations plunged on assurances by Mario Draghi and the ECB that they would do whatever it takes to “save” the Euro, has quickly given back over 20% of the recent high above 127. However, the index remains well above the 2012 low, although it is in the process of testing downside resistance. On the other hand, the rebound in the Shanghai Composite from the 2012 low has been much more anemic as the Chinese central bank struggles to contain a property/housing bubble, and the interbank liquidity squeeze has sent the Shanghai Composite plummeting below its 2012 low. The renewed selloffs in both indices bears close watching, because a dramatic slowdown in the China economy and renewed crisis in the Eurozone are something that “got your back” Chairman Ben cannot help you with.

Hat Tip: 4-Traders.com

The Implications for Other Emerging Markets and Commodities are Not Good 

The implications of renewed lows in both of these indices are already being discounted in the commodity and emerging markets, both of which are more sensitive to risk asset flows. This can be seen in the breakdown of support in both Copper and the EEM MSCI Emerging Market ETF. While the recovery in the US housing market should be good news for copper, everyone knows that demand from China has been the incremental driver of demand for copper and other major commodities. Emerging markets in Asia are of course closely tied with slowing import demand from China, whose real GDP growth is looking much less than the headline 7% or so quoted by most public and private sector economists. 

It is too early to tell if trying to catch these falling knives will yield short-term results, while the road back to prior highs is becoming more difficult with each day. Hear again, US equities remain the default choice.

Hat Tip: 4-Traders.com, BigCharts.com

Investors Can No Longer Hide Out in Gold 

Gold (especially paper gold) as an alternative currency and safe haven is rapidly losing its luster, as the relative attractiveness of the yellow metal dramatically shifts as real interest rates turn positive and the serious “infernos” around the world (e.g., Eurozone crisis, etc.) begin looking more like brush fires. 

Gold bugs and precious metals analysts will give you all sorts of technical reasons why gold prices are about to bottom, but (paper) gold prices have plunged through 1,550 and 1,350 support like hot butter, and while dramatically oversold short-term (and thus susceptible to short-term bounces), the dramatic rally since 2009 is clearly over, with previous calls for $2,000 or $3,000/ounce now looking like a pipe dream. 

We see driver of lower paper gold prices as being fairly straightforward, i.e., positive real interest rates, and believe those who are in paper gold as an “investment” are in for more pain. On the other hand, the strong underlying demand for physical gold as an emergency fund is stronger than ever. 

Hat Tip: 4-Traders.com

The Eventual Success of Abenomics Hinges on Structural Reforms 

The LDP (Liberal Democratic Party) winning back power and the bursting of Abenomics on the scene generated a quick nearly 90% gain in the Nikkei 225 from mid-October 2012, as JPY/USD dropped nearly 25% in equally quick fashion. A sharp back-up in JGB yields on high volatility from a new low of around 30bps to over 1% however shook some short JPY, long Nikkei 225 macro traders out and even encouraged some opportunistic futures short selling, and the stock index remains extremely sensitive to JPY/USD, which also saw a sharp short-term snap-back—against the background of continued heavy net selling of Japanese equities by domestic institutions. 

The accelerated downtrend in the Nikkei 225 as Japan was hit by the Great East Japan earthquake/tsunami/nuclear power plant disaster only exacerbated the damage done to Japan’s economy and financial markets by the 2008 financial crisis, delaying recovery well beyond what was happening in the U.S. An ineffectual Democratic Party of Japan (DPJ)-led government only made matters worse. Thus in the very least, the Abe Administration has managed in a few months to repair the damage to stock prices from the Great East Japan disaster by drawing record amounts of foreign buying and giving long-suffering domestic businesses and individuals reason for hope. 

Hat Tip: 4-Traders.com

Domestic Institutions Remain Structural Net Sellers of Japanese Equity 

The sharp reversals in both the Nikkei 225 and JPY/USD indicates that the big money has already been made in the Abenomics trade. The biggest quarterly rally in Japanese stocks in 25 years did not impress domestic institutions, who if anything have been accelerating their unloading of Japanese equities. As of end March 2013, Japan’s insurers, lenders and trust banks pared their holdings of Japanese shares to 28% of total market value, as the share held by foreign investors surged to 28%. Domestic institutions have been net sellers of Japanese equities every week since mid-November 2012 through June 14, 2013. 

Basically, domestic investors aren’t buying Abenomics. Too many past governments have come and gone with grandiose promises that never made much of a dent in Japan’s structural problems. Thus domestic institutions remain very much in a “show me” mode, and structurally constrained from a more constructive “risk-on” mode. Basically, these institutions have little incentive to pursue higher returns (risk) while they have many reasons to avoid risk. Thus their share of total market trading fell to a mere 4.7% last month. On the other hand, individual investors are now accounting for more than 40% of trading volume, making the Japanese stock market one of the most volatile in the developed world. In terms of stock price formation, it is anywhere and everywhere foreign investor driven. 

What this means is that Japanese stock prices are likely to remain volatile, as foreign hedge funds and domestic traders whip around market prices at significant inflection points. Abenomics still has forward momentum, but the “shock and awe” factor has melted away to reveal deep underlying skepticism. 

While Japan’s giant GPIF (government pension investment fund) did hint at higher future allocations to risk assets including equities, new asset allocations announced on June 7 are in line with those as of end December 2012. Basically, it is very unlikely that these institutions will in the foreseeable future ever play a meaningful role as a net buyer of stock. Market volatility has given domestic instituions another excuse to stay away from equities. 

With foreign investors more risk adverse and trimming back on more volatile trades, it is unlikely that a new high in the Nikkei 225 or new lows in JPY/USD will be hit anytime soon. More likely is a fairly well-defined trading range as these markets consolidate the sharp moves of the past six months.

Making the Most of Borrowed Time? 

Despite the recent jitters about Chairman Ben’s tapering comments, the fact remains that the US Federal reserve is still the most trusted central bank among investors in the world, regardless of disparaging comments to the contrary. While the Fed’s tapering comments may have appeared to some to come out of the blue, recent comments by the Bank of International Settlements are probably a good reflection of the debate that is going on within the walls of the world’s central banks. 

Central banks can be commended for having bought the private and public sectors the time need for adjustment from the 2008 financial crisis and worst recession since the 1930s depression years. Since the beginning of the financial crisis almost six years ago, central banks and fiscal authorities have supported the global economy with unprecedented measures. Policy rates have been kept near zero in the largest advanced economies, and central bank balance sheets have ballooned from $10 trillion to more than $20 trillion, and the stimulus has surged 500% since 2000 to $16 trillion. Meanwhile, fiscal authorities almost everywhere have been piling up debt at an alarming rate, which has risen by $23 trillion since 2007. Half a decade ago, most, if not all, of these measures were unthinkable. 

Their preeminence of central bank policy shows how much responsibility and burden central banks have taken on. Problem is, nobody knows exactly how central banks will exit from this unprecedented monetary stimulus, or what they will exit into. What the BIS is sure of is that central bank stop-gap measures are reaching their limits, and are now warning that “more bond buying would (actually) retard the global economy’s return to health by delaying adjustments to governments’ and households’ balance sheets. In other words, the central bankers’ bank is now making the same warnings about excessive monetary policy as QE skeptics have been making for some time. 

According to “Making the Most of Borrowed Time”, by Jaime Caruana, General Manager of the BIS; “Six years have passed since the eruption of the global financial crisis, yet robust, self-sustaining, well balanced growth still eludes the global economy. If there were an easy path to that goal, we would have found it by now.” The conclusion is “central banks need to begin heading for the exits and stop trying to spur global recovery”. 

Why? The bottom line is that monetary stimulus alone simply cannot provide the answer. The roots of the problem are not monetary. Central banks cannot repair the balance sheets of households and financial institutions, cannot ensure the sustainability of fiscal finances, and most of all cannot enact the structural economic and financial reforms; all needed to return economies to real growth paths. To be fair, without these forceful and determined policy responses, the global financial system could easily have collapsed, bringing the world economy down with it. Thus monetary policy has done its part, and real recovery now requires a different policy mix, one with more emphasis on strengthening economic flexibility and dynamism and stabilizing public finances. 

In Addition to a Dysfunctional Money Multiplier and Depressed Velocity of Money, the Keynesian Multiplier is also Dysfunctional 

The chart from GaveKal below shows clearly just how clueless the “don’t worry about the debt, just add more Keynesian stimulus” crowd are. The chart shows that the marginal efficiency of public debt, at least in the US (public spending in emerging markets from a low base usually improves productivity) has been declining structurally since 1981. Further, it seems that this marginal efficiency has now reached a negative level, i.e., more debt is just not going to cut it.

Hat Tip: John Mauldin

Significant Tail Risk? 

The implications of both the BIS observations and the Gavekal points about the Keynesian multiplier are that BOTH fiscal and monetary policy are near their limits in terms of having an actual positive impact on the real economy. Simply stated, the real role being played by central banks is becoming more of a confidence game than statistically demonstrable positive effect. In reality, the pace of repair and reconstruction is now up to the private sector, not government fiscal or central bank monetary policy. Real economies remain burdened with heavy debt loads and impaired balance sheets. While unprecedentedly unconventional monetary policy that has tried to alleviate/prevent the pain of adjustment, the recovery in the real economy continues to significant lag that in the financial markets. 

This “bubble” central bank stimulus bubble component in asset prices implies significant tail risk if investors ever lose faith in the ability of central banks to at least provide a backstop. Should this faith dissipate, it could get ugly very quickly, such as a dramatic surge in financial repressed bond yields causing crippling, systemic losses, amounting to trillions of dollars for bond and stock investors around the globe, to the tune of 8% of GDP (or more than USD1 trillion if yields were to rise by 3 percentage points across the maturity spectrum). In Japan the potential losses would be a mind-blowing 35% of GDP. Losses in France, Italy, and the United Kingdom would range from about 15% of GDP. In the understatement of the century, the BIS concludes, “interest rate increases pose risks to the stability of the financial system if not executed with great care”. 

Federal Reserve Chairman Ben Bernanke has likened monetary policy to landing a jet on an aircraft carrier; i.e., at lot could go wrong between “unlimited QE” and the eventual exit. Bouts of positive correlation of equities, bonds and commodities, suggest that extraordinary monetary stimulus has created bubbles in a broad range of financial assets. Any untoward removal of said stimulus could therefore create a tail event in which prices of all assets dramatically go down. 

Let’s hope that Chairman Ben and other central bankers are humble enough to realize the real short-comings of monetary policy, while at the same time are politically savvy enough to continue playing the confidence game–i.e., being brutally honest and telling investors/businesses that there is nothing further they can do is not the message that should be sent. 

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

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

The Set-Up for the Next Growth Scare

The January PMI (purchasing managers’ index) data was overwhelmingly positive. The January globally weighted PMI comes in at 51.8, up from 50.5 in December. The biggest improvements came from the eurozone, U.S., China, Japan, and Brazil. There was some deterioration in India, but the country remained well in the contraction range over 50. Despite a slightly disappointing reading of the official China PMI, the unofficial HSBC PMI was robust. Yes, Europe is in bad shape, but most of the manufacturing metrics appear to be improving.US PMI slipped, but beat expectations and the subindices were quite healthy.  US ISM Manufacturing also crushed estimates. This upbeat data was reflected in institutional investor surveys the same month, which show visible improvement in investor views of the global economy in 2013 and equity risk/reward, especially vis-a-vis bonds. Not surprisingly, stock prices surprised on the upside. 

But as we begin to wrap up February, investors are now talking about the market taking a breather–not a serious selloff, mind you–but a speed adjustment as market prices get ahead of themselves. As we pointed out in Most investor surveys, market sentiment indicators flashing yellow/red , with stock prices looking over-extended, markets are susceptible to some second thoughts about the bull scenario.

The Fed’s latest FOMC minutes provided one excuse for some profit taking, but that is not the only item making some traders/investors nervous. The takeaway by the media and investors was that the Fed may consider slowing the pace of asset purchases, as the Fed’s own notes mentioned the possibility of the FOMC tapering off or ending asset purchases before the Fed judged that its bogey, i.e., a substantial improvement in the outlook for the labor market, had occurred. Goldman also released its leading economic index (consisting of the Baltic Dry Index, Global PMIs, new orders less inventories, Goldman’s Aussie and Canada Dollar TWI) which shows rapid rotation from expansion to slowdown. 

Source: Goldman Sachs, Hat Tip: Zero Hedge

Other flies in the “global recovery is OK” ointment include Doc Copper, which has broken down through a four-month uptrend and failed well below 2012 highs. 

Source: Kimble Charting Solutions

Source: Yahoo.com

So, copper and gold prices are breaking down and oil is also looking toppy, while bond yields are creeping up. What could be happening with gold, as well as copper, oil and other commodities is, a) USD strength and b)  positive real rates takes the fun out of aggressive speculative positions, to the point that the hedge funds abandon these trades in search of greener pastures, ergo, equities.

Source: Yahoo.com

Being Set Up for the Next Growth “Scare”?

We could also be setting up for the next growth scare, the kind which has led to 16% to 7%  corrections as we climbed out of the depths of the March 2009 financial crisis low. To date, these have coincided with central bank attempts to move the needle back to more “normal” monetary policy. Once it starts, economists/analysts will come out with many other reasons for the pull-back; U.S. sequestration, more Euroland austerity (e.g. France), etc., but the scariest prospect probably remains the prospect of the central banks backing away from all-out QE and debt monetization. Thus this growth scare could also come from surprisingly strong economic growth as much as real concern of renewed slowdown. But since the upleg from the November 2012, while a pleasant surprise, has not been particularly dramatic, the next growth scare bull market correction could be well below 10%, given the progression of 16%, 10%, 9% and 7%+ corrections in this recovery rally. 

Source: Yahoo.com

Growth Scare Could Put a Noticeable Crimp in the Let’s All Short JPY Trade

A decent growth scare could also shake out at least some of the short JPY trade, which has recently lost some momentum as traders back off to see who the Abe Administration picks as the next BoJ governor and two deputies. There has been a lot of talk about the difference of opinion between FM Taro Aso and PM Shinzo Abe, but our sources say these differences are being way over-played in the media. 

As the Nikkei 225 remains very sensitive to USD/JPY movements, any significant pull back in the JPY selloff will have an immediate impact on the Nikkei, which is also looking very over-extended short-term. 

Source: 4-Traders

Source: Yahoo.com

Goldilocks Scenario for the Time Being is Continued Central Bank Intervention and Gradual but Not Too Rapid Economic Recovery

Thus the “goldilocks” scenario for the time being remains continued heavy central bank intervention and gradual but not too rapid economic improvement. Real normalization on the other hand will most likely involve a significant interim correction as stock prices shift from excess liquidity drivers to economic/corporate profit fundamental drivers. 

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

Chinese and Japanese Equities Revive Amidst U.S. Fiscal Cliff Soap Opera

Takeaways;

1) U.S. equities, until the fiscal cliff debate came front and center, have been strongly outperforming other global developed, and many emerging, markets. Unless a temporary slip off the fiscal cliff really derails the U.S. economy in 2013, which stock prices aren’t currently discounting, U.S. equities are likely to continue outperforming in 2013. 

2) The Eurozone sovereign debt crisis that nearly derailed equity markets this summer has noticeably cooled, but remains a danger. Ironically, however, the Greece equity market has been the best performer of the developed markets as Euro authorities patch together a rescue package few believe will actually work. Faith in the Draghi commitment to “do whatever it takes to save the Euro” continues to act as a put supporting lower peripheral bond yields, as well as higher Eurozone bank stock prices and a stronger EUR. 

3) The sick men of Asia, i.e., China and Japan, are recently showing some signs of life. In Japan’s case, political stumping by LDP politicians is creating hope for a weaker JPY instigated by a much more aggressive BoJ, which remains to be seen. A new government after the December 16 elections does have a chance to install three more pliant members on the BoJ’s monetary policy board, including the BoJ chairman. In China, stock prices look cheap, but domestic investors who account for much of the price action on the Shanghai Composite, are looking to  new leaders for assurance of policy continuity and stability. The recent pop in the Shanghai market is indicative of the potential move if domestic investors turn bullish. 

Four Years after Lehman…Still Far from Normal

It has been a little over four years since Lehman Brothers filed for bankruptcy protection under Chapter 11 on September 15, 2008 and nearly triggered a global financial meltdown. There are encouraging signs that global financial markets as well as the economy are on the mend, and central banks remain in full-out support mode, but many hurdles remain before the world economy and financial markets return to “normal” recovery mode. 

Source: Yahoo.com

The MSCI EAFE, representing non-U.S. developed markets, has significantly lagged the S&P 500 over the past year, as, despite all of its perceived faults and being the epicenter of the 2008 financial crisis, the U.S. economy has showed the most resiliency to the post-crisis malaise, i.e., rapid debt accumulation, recessionary/depressionary economies,persistently high unemployment. Yet the S&P 500 and EAFE equity markets remain in a general uptrend, supported in large part by repeated monetary policy initiatives. 

Pressure from Eurocrisis Abates; Germany and Sweden Equities Continue to Lead
The Eurocrisis, which has from time to time threatened to ignite yet another global financial crisis and is focused on sovereign debts in the periphery and impaired bank balance sheets, remains dangerous. Yet key institutional/political groundwork has been laid. Signs of stress in the system, such as France, Italy and Spain CDS spreads, periphery sovereign bond yields, bank stock prices and the Euro are showing their most benign levels in 2012. CDS spreads are back to 250bps from as high as 450bps, Spanish 10-year sovereign bond yields are back near 5.0% from a peak approaching 8%, while the Eurostoxx banks index has rallied some 56%, and EUR is back to 1.30/USD from nearly 1.20/USD.

Sources: Trading Economics, 4-Traders.com

According to the U.S. Conference Board Leading Economic Index (LEI), the outlook for the Euro Area economy remains weak as the LEI declined again in October. However, the six-month growth rate of the LEI has become less negative, which the Conference Board suggests points to a smaller chance of a deep contraction. Markit’s Eurozone PMI however shows further contraction in manufacturing activity to an eight-month low in November, and indicates a meaningful recovery is still a long way off. Even the two largest economies, France and Germany, appear on course to shrink this quarter.

Source: Markit

Eurozone Stock Prices Rallying Despite Deteriorating Economic Outlook

This increasingly glum economic scenario however has not led to new lows in the regions equity benchmarks, which have been rallying since ECB president Mario Draghi promised the ECB “would do whatever it takes to save the Euro”, thereby placing a re-assuring put under bond and stock prices in the region in investor/trader eyes…at least to the point that aggressively shorting stocks, sovereign bonds or EUR is seen as a significant risk. Backed by greater fiscal stability, stock prices in Germany and Sweden are showing high two-digit gains over the past 52 weeks, while Spain’s stock market has surged some 60% since Draghi’s announcement in July.

Source: Yahoo.com

Investors Non-Plussed by the U.S.Fiscal Cliff Soap Opera

Talk about the U.S. fiscal cliff has become a soap opera, with everyday presenting a new twist and the financial media wringing every angle they can find. One thing is pretty clear, which is that U.S. taxes are going up, and the government is most likely to shift into austerity mode in reaching the required savings, while at the same time most likely extending the debt ceiling, even given an eventual (either within this year or within Q1 of 2013) deal. 

Aside from the short-term volatility if a deal is not agreed upon within the next four weeks or so, the key question for investors basically boils down to, is the budding U.S. economic recovery strong enough to sustain modestly higher taxes and fiscal austerity? Here, the jury is still out, even though the stock market has rallied from June/July lows on yet another round of quantitative easing by the ECB, the Fed and the BoJ, and better-than-bearish expectations economic stats.

Source: Yahoo.com

The S&P 500 remains in an uptrend, rallying from the March 2009 low to just a stone’s throw (6%) below the 2007 pre-crisis high. That said, the S&P 500 is looking toppy, having held its 200-day MA, but unable to break convincingly above its falling 50-day MA. The S&P 500 VIX volatility indicator has creeped up a bit, but remains below 16,. 

The USD, after 2008 a barometer of investor risk appetite, sold off below its 200-day MA with ironically the announcement of the latest round of QE marking the rally’s peak, but is now consolidating between its 200-day and 50-day MAs after an October dead cross between its 50-day and 200-day MA. Meanwhile, long-term bonds are trading virtually flat, giving no significant signal of either more bearish economic growth expectations or another uptick in these same expectations. Consequently, U.S. stock prices remain buoyant, but still susceptible to short-term investor disappointment of a failure to reach a fiscal cliff deal in December 2012-January 2013.

Source: Yahoo.com

By major sector, the basic materials, energy and technology SPDRs have seen the most profit-taking pressue, suggesting investor concern about the robustness of the U.S. and global economy in 2013. The financials SPDR saw seen a good bounce before the post-November election fiscal cliff positioning between Democrats and Republicans really began to ramp up, but are also recently consolidating.

For 2013, the big picture is that noticeable deleveraging in the private sector has been the biggest drag on the U.S. economy, while the public sector (including the central bank) has so far absorbed most of this deleveraging through a sharp jump in fiscal deficits and massive debt purchases by the Fed. If, as some bearish strategists claim, the public sector also begins to deleverage in a meaningful way, 2013 2014 could mere represent more of the same, i.e., anemic economic growth and no recovery in jobs, as the public sector, which had moved in to bridge the private sector demand gap, also begins to deleverage. In an environment of continued private and public sector balance sheet deleveraging, it is hard to see the S&P 500 making any significant gains in 2013.

Over the next couple of months, there remains the definite possibility that no “deal” is made on the fiscal cliff, while most investors continue to believe the U.S. Congress and the Obama Administration would not allow this to happen and consequently, have not fully discounted a no deal scenario. We believe a more likely scenario is that the deep philosophical divide between Democrats and Republicans regarding key issues in the fiscal cliff (such as higher income taxes for the “rich”, or those that make over $250,000/year) will continue until a significant selloff in stocks forces them to make a compromise. How much of a selloff would be needed? We are guessing 10%+.

What’s Wrong with the ShanghaiComposite?

Once seen as a leading indicator of developed equity markets, the Shanghai Composite has completely de-linked, having declined some 16% for the last 12 months. The performance of the China equity index is even worse than Spain or Greece, the sick men of the Eurozone, and Chinese equities have continued to decline despite repeated attempts by the government to stimulate the market. The government has pressed Chinese companies to buy back stock, are limiting new capital issues to restrict supply, have further liberalized domestic insurance company investment in equities, loosened rules on market trading and have extended quotas for foreign investors to buy Yuan-denominated shares—all so far to no avail. 

On the surface the market looks very cheap, trading at some 10 times estimated 2012 earnings, and foreign investors again appear to be re-buying the market. Unlike the Hong Kong Stock Exchange, however, the Shanghai Stock Exchange is still not entirely open to foreign investors, due to tight capital account controls exercised by the mainland authorities. Foreign investors can only acquire B shares listed in the exchange. 

Every positive, even if it’s off-hand, comment about the Chinese stock market by the likes of Warren Buffett or George Soros has been enthusiastically promoted by the domestic media/analysts as the prelude to an influx of foreign investment capital that could help kick-start a bull run. Much domestic investor trading on the Shanghai market is speculative and very short-term oriented, and these local investors remain skeptical of stocks after having been burned by the 2008 financial crisis selloff, and remain shell-shocked by the market free fall in recent months. Thus a significant recovery in the Shanghai Composite is unlikely until domestic investors become more confident in the new government under the new President and Communist Party Secretary General Xi Jingping’s policies. However, the FXI China 25 ETF is a different story. The FXI is in recovery because of foreign buying, while the Shanghai remains hobbled by cautious domestic investors. 

Since the FXI historically has tracked the other China stock indices, however, it is unclear how long this divergence can continue. The Shanghai Composite recently spiked from an oversold level ostensibly on comments by the new leaders that were taken to mean there will be policy continuity and stability, and the leaders indicated confidence in meeting 2012 economic as well as social goals. This bounce indicates that domestic investors trading in the A shares may come around to a more constructive view of Chinese stocks, i.e., following the foreign investors’ lead.

Source: Yahoo.com

Global Investors Again Consider Japanon Talk of a Weaker JPY and More Aggressive BoJ

The sudden decision by current Prime Minister Noda of the floundering Democratic Party of Japan (DPJ) to dissolve the Diet and hold general elections on December 16 has greatly accelerated the splintering of not only the DPJ, but also former prime minister Shinzo Abe’s Liberal Democratic Party (LDP) as well as the other major parties, the LDP is nevertheless expected to win the most seats in the Diet’s more powerful lower house. There are now no less than 11 parties vying for posts in the new election. 

The DPJ, which wrested power from the LDP three years ago, has proven unable to create any sustainable positive momentum in Japan’s economy, and Prime Minister Noda expended a significant amount of political capital he could not afford to lose in pushing through a very unpopular but probably necessary consumption tax hike and has been a vocal proponent for Japan’s joining the equally unpopular TPP multilateral negotiations. 

Japan’s economy, wracked by a serious interruption in the automobile and electronic sector’s global supply chains due to the massive Tohoku earthquake/tsunami and nuclear power crisis, first bounced back after the disaster, but again is slipping into recession, as about 1/4th of over JPY880 billion of stimulus supposedly earmarked for Tohoku reconstruction was re-routed by bureaucrats into pork-barrel expenditures, and was at any rate severely delayed. Meanwhile, JPY resurged to new historical highs against USD and EUR, China (which had become Japan’s largest export market) demand noticeably slowed, and Japan’s import energy bill surged on a dramatic shift to LNG and fossil fuel power alternatives as essentially all of Japan’s nuclear electric power facilities—that had provided some 30% of total power output—were shut down after the disaster; tipping Japan’s balance of payments into structural deficit after decades of chronic surpluses. 

On December 16, Japanese voters will vote, not only for a new government, but also as a referendum on nuclear power. If they vote for the “no nuclear power, whatever the cost”, they are effectively voting for continued electric power shortages, much higher electricity costs and continued balance of payments deficits as Japan has to continue importing significant amounts of LNG to fire domestic electric power plants—meaning these issues will remain as a drag on economic growth. 

On the other hand, if they vote in the LDP along with Shinzo Abe, expect a more gradual approach to phasing out nuclear power, meaning less pressure on the balance of payments, more reasonable electricity costs and more available power, in addition to ratcheted-up pressure on the BoJ to more aggressively use its balance sheet to weaken JPY and purchase government bonds, as well as implement a clearer inflation target. Governor Masaaki Shirakawa and policy board members Hirohide Yamaguchi as well as Kyohiko Nishimura’s terms end next March, giving the new ostensibly LDP-led government a chance to put three more stimulus-inclined members on the policy board. 

Potential BoJ replacements an Abe Administration would be looking at include, Kikuo Iwata, Gashuin University professor, Kazumasa Iwata, president of the Japan Center for Economic Research, ex-Junichiro Koizumi Administration finance guru Heizo Takenaka, and Asian Development Bank president Haruhiko Kuroda. 

In anticipation of a more pliant BoJ, JPY has already retreated 6% from an October 2012 high, and some 9% from a November 2011 high. Pushing JPY back below JPY100/USD would provide an even greater psychological boost to Japanese equities, which are already rallying on JPY weakness already seen. Thus an LDP return to power led by Shinzo Abe is seen as a bullish development for Japanese equities. 

The positive response of JPY and Japanese stock prices to Abe’s election stumping promises has foreigners again allocating money to Japan, especially as U.S. equities meander through negotiations about the fiscal cliff. Japan in terms of the MSCI indices is still lagging the Eurozone, Nordic countries, Australia, New Zealand and Hong Kong in Asia. YTD and over the past year, the lag in Japanese equities is even more pronounced. Thus we question the sustainability of the budding rally in Japanese stocks, given that past outperformance rallies have lasted all of six months or less, and because we believe Mr. Abe is over-stating the LDP’s case as well as their real ability to forge substantial change for the better in policy management. This notwithstanding, there is room for a 25%-plus rally in the Nikkei 225 as it breaks more decisively to the upside. For USD and EUR-based investors, the very catalyst for this rally, i.e., a weaker JPY, will mitigate USD- and EUR-based returns. 

Source: MSCI

Source: Yahoo.com

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

Investors Behind the Curve on Normalization, U.S. Conversion to Energy Exporter?

Euroland Economic Data Still Glum

Despite continued investor hope that the ECB will backstop financial and sovereign debt risk in the Eurozone, the economic numbers for Euroland continue to look pretty glum. Markit’s latest Eurozone PMI  (hat tip: FT Alphaville) shows the Eurozone sinking further into decline at the start of the fourth quarter, with combined output in the manufacturing an service sectors dropping the fastest since June 2009–i.e., more economic contraction. PMI indices in the Euro periphery are particularly ugly. 

Eurozone bank balance sheet deleveraging of course has been a major drag, but progress is evidently being made. Barclays reckons there is still about USD1.04 trillion of deleveraging left among the major European banks they cover, but nevertheless significant progress versus the USD2.4 to USD4.0 trillion being discussed last year. However, all key measures of Eurozone money supply contracted in September and private credit fell at an accelerating pace, much like what happened in Japan in early 1990, suggesting Euroland is on the verge of a deflationary spiral and a possible lost decade (s), as the perception is that the twin problems of bail-out fatigue in the North and austerity fatigue in the South are slowly getting worse, not better.

U.S. Q3 Impact on Financial Markets Fizzles

In the U.S., the S&P 500 and gold are now lower than when the Fed announced “unlimited” QE3, suggesting the Bernanke Put has lost its mojo and investors doubt whether even more QE will have much traction in goosing U.S. economic growth as well as corporate profits. According to Bloomberg, the $4 trillion-a-day foreign- exchange market is also losing confidence in central banks’ abilities to boost a struggling world economy. More professional investors, like David Eihorn, are coming to the view that too many jelly donuts (QE) is actually harmful, not beneficial.

Source: BigCharts.com

Yet according to the following chart from Morgan Stanley, stocks prices in the current cycle as measured relative to bonds and the G7 leading index are expecting a recovery that has yet to manifest itself in the OECD G7 leading indicators, ergo, stocks are increasingly vulnerable to bad news, and too many investors still expect bad news, although they are currently along for the market rally ride. Earnings growth in the third quarter likely turned negative for the first time in over three years while stock prices are back to December 2007 levels.

Are Investors Behind the “Normalization” Curve?

However, the economic data has been better than the bearish expectations. The Citigroup Economic Surprise Index for the Group-of-10 countries, which measures when data is beating or trailing the forecasts of analysts, climbed to a seven-month high of 18.4 last week, from this year’s low of minus 56.2 on June 26. The caveat is that this uptick could be more attributable to the Fed’s announcement of QE3 than any “real” improvement.

Are investors missing the big picture forest from looking too closely at individual trees? What do the big picture economic cycle theories say? The Business Insider Blog has taken a look at the various long-term economic cycle theories. The Kondratieff Long Waves approach suggests we are currently in a blank period and at least 30 years away from the next economic expansion, while the Schumpeter Cycle suggests we’re on the downswing from the most recent innovation cluster. Both however are too long-term for most investors to pay much attention to. On the other hand, the Kitchin Cycle indicates prices are in an upswing period, the Juglar Cycle indicates we’re at the beginning of an upswing in capital investment, and the Kuznets Cycle, based on current high income inequality, suggests that the U.S. should be at a new stage of development.

At least one strategist, i.e., Hajime Kitano, head of JPMorgan’s Japanese Equity Strategy, suggests that if the S&P 500 VIX volatility index stays subdued near current levels next week, it will mark a “phase change” for markets – i.e., a transition from a period of crisis into “normal time,” as the VIX is the last of the three indicators to confirm that markets have moved from “crisis” to “normal time.” According to Kitano, if the VIX index remains at its current level (16.6) next week, furthermore, its 52-week moving average will fall below the July 2011 level to its lowest point since February 2008. If the VIX index’s 52-week moving average falls below the long-term average (20.3) and the most recent low (19.1 in July 2011) this time, he sees a change of phase from crisis to normality.

Two Potential Game Changers; The Next Secular Recovery in U.S. Housing and the U.S. Surpassing Saudi Arabia as the World’s Largest Energy Producer

While there has been a lot of detailed discussion about what could go wrong, i.e., breakup of the Euro, hard landing in China, fiscal cliff in the U.S., etc., investors could be behind the curve regarding the favorable impact of two megatrends in the U.S. economy, i.e., a bottoming/recovery in U.S. housing and the U.S. becoming a major energy producer. 

Come-Back in US Housing

For all the continue bad news about the U.S. housing sector, the three big housing stocks (DR Horton, Toll Brothers, Lennar and PulteGroup) have actually been on a tear, surging some 120% from 2011 lows and leaving the S&P 500 rally in the dust. According to major homebuildings, the U.S. housing market has realized a meaningful increase in the volume of new home sales for the first nine months of 2012. In September, Americans bought new homes at the fastest pace in two years, another sign the industry whose decline was at the heart of the recession is coming back.  The major homebuilders of course are hopeful that housing could again help drive the economy forward and accelerate the pace of a recovery, and the industry is responding to increased sales by hiring additional workers and purchasing more building materials. They apparently are increasingly optimistic that the combination of ever higher rental rates, record low interest rates and limited housing supply can continue to support improved housing demand.

Source: BigCharts.com

Deutsche Bank economists believe the U.S. deleveraging cycle is past the midway point which suggests that the recent gains in household debt profiles should be a positive development for the U.S. economy going forward.
“Household debt as a percentage of nominal GDP peaked at 97.5% in Q2 2009 and in absolute dollar terms, household debt peaked in Q1 2008 at $13.8 trillion. Since then, debt outstanding in this sector has declined -6.3% (-$880 billion) and at 83% it now stands at its lowest share of GDP since Q4 2003 (82.9%),  they note. “Provided that income growth improves, households may actually begin to modestly increase their absolute amount of debt. Further, debt in proportion to other measures should continue to decline and may in fact reach more “normal” levels within the next few years assuming modest assumptions.”

U.S. Revolution in Energy Production

Investors have also yet to fully appreciate the game-changing impact of a resurgence of the U.S. as a major energy producer. U.S. oil output is surging so fast that the United States could soon overtake Saudi Arabia as the world’s biggest producer. Driven by high prices and new drilling methods, U.S. production of crude and other liquid hydrocarbons is on track to rise 7% this year to an average of 10.9 million barrels per day. This will be the fourth straight year of crude increases and the biggest single-year gain since 1951. The Energy Department forecasts that U.S. production of crude and other liquid hydrocarbons, which includes biofuels, will average 11.4 million barrels per day next year. That would be a record for the U.S. and just below Saudi Arabia’s output of 11.6 million barrels. Citibank forecasts U.S. production could reach 13 million to 15 million barrels per day by 2020, helping to make North America “the new Middle East.” Thanks to the growth in domestic production and the improving fuel efficiency of the nation’s cars and trucks, U.S. imports could fall by half by the end of the decade, creating a significant windfall for the economy and the creation of some 1.3 million jobs by the end of the decade (eight years), 

The Hamilton Project estimates the current job gap, i.e., the number of jobs the U.S. needs to create to return to pre-Great Recession employment while absorbing the 125,000 people who enter the job market each month, would take to October 2023 (12 years) to close if the U.S. economy continuously created 208,000 jobs per month, and much less if the two game changers of housing and energy production really kick in. While many in the U.S. remain very pessimistic about the future of the U.S. due to heavy government intervention and debt levels, the U.S. in our view is still one of the most resilient of the developed economies–certainly in better shape than either Euroland or Japan–and could have surprising upside given a come-back in housing and the new dimension of a major energy exporter.  

China Coming Back?

The HSBC Flash PMI for China has risen to 49.1, a 3-month high. While 49.1 is still below the 50 boom-bust line, it would appear the pace of contraction in China is slowing, consistent with the view of some kind of firming or even “green shoots”.  In particular new orders and new export business has up-ticked. This has China stock prices as measured by the MSCI China index beginning to discount recovery.

Hat Tip: Business Insider

China’s exports recently spiked, taking many by surprise. China’s exports in September grew by around 10% from a year earlier – about 2% higher than expected. A great deal of that increase came from iPhones, iPads, Android phones, and other popular electronics orders. Thus the US has once again become China’s largest export market, offsetting weak Euroland demand.

The movement in the FXI ETF of China blue chips also shows a break to the upside, while the Shanghai Composite continues to lag. Confirmation with a convincing break out of the downtrend in the Shanghai Composite would be a stronger signal that China’s economy has indeed bottomed and has reached cruising speed somewhat below the torrid pace of growth seen in past years. The FXI ETF has only 26 China stocks and is heavily weighted toward the financials (55.9% of the index), but if China’s economic prospects improve, the financials will likely perform better. While lagging, the Shanghai Composite recently hit a six-year support line as well as two other support lines,  \and has broken out of its falling channel resistance line, suggesting the rally has further to go.

Source: Yahoo.com

Price is Truth, or At Least the Perception Thereof

The bottom line for investors is to forget the news flow and concentrate on the price action, as the headlines often have little correlation to actual performance, while the true impact of headlines on shifting investor expectations is at the end of the day reflected in the market price. 

Source: Yahoo.com

From the price perspective, the S&P 500 has broken its 50-day moving average, but at the current junction only has immediate downside risk to 1,375.52 (just over 2%), its 200-day moving average, while the point and figure chart also indicates downside risk to 1,380 or essentially the same level. While some are also concerned about the gap between the Dow Jones Industrial Average and the Dow Jones Transports that hasn’t been this wide in six years, during the two previous instances of a widening gap in the last ten years, the gap was closed by by a rally in the transports within six months.

The financial sector (XLF S&P 500 Financials SPDR) has led this rally just as it did leading up to the April high. As long as the financials are holding up, there is little probability of a big sell-off even if Wall Street’s darling, Apple (AAPL) loses its shine. The financials have held up despite the new estimate of lost earnings due to Dodd-Frank and the bad Euroland economic news, implying that the gradual but steady improvement in bank balance sheet quality is putting a firmer floor on the downside for bank stocks, even if many questions remain about intrinsic growth of the top line. 

Source: Yahoo.com

By the same token, the chronically poor performance of Japan stocks tells you more than you can ever learn from the periodic “revisionists” who claim Japan is now on the verge of a comeback. The fact that Japanese politicians are still at loggerheads over a bill to allow the government to borrow the JPY38.3 trillion (USD479 billion) it needs to finance this year’s deficit clearly underlines the degree of gridlock in Japanese politics.

The inevitability of Lower House elections and of big losses by the ruling DPJ cabinet has investors looking toward the re-emergence of the LDP as a trigger for increased political pressure for more aggressive BoJ monetary policy. The ever-cautious BoJ governor Masaaki Shirakawa is due to step down next April, and unlike Ben Bernanke’s departure from the Fed in January 2014, a new, more conservative government ostensibly led by the LDP could lead to more aggressive measures such as a JPY50 trillion purchase of foreign bonds to stem the ever-rising JPY, whereas a Republican-chosen Fed Chairman could begin reigning in Helicopter Ben’s helicopter money, a further impetus to a weaker JPY. 

Thus the peaking-out of JPY instigated by a shift to risk-on from QE3 and more BoJ asset purchases is getting some boost on the conjecture  of a more aggressive BoJ and a less aggressive Fed in the foreseeable future, widely considered a major pre-requisite for a trade-able rally in Japanese stocks, as the 52-week correlation between the Nikkei 225 and JPY is negative 0.909, compared to positive 0.838 for Emerging Markets, 0.802 for EAFE markets and 0.751 for the China market, the other factors which appear to have the highest 52-week correlations with the Nikkei.  

Source: Yahoo.com

While a weaker JPY will definitely help, the other drag to Japanese stocks has been the deep concerns about growth sustainability as reflected in JGB yields. Any sustainable recovery in stocks  would be definition need to be supported by increased expections for higher growth, not decelerating growth, as is indicated by the depressed level of JGB (government bond) yields. While JPY has begun to level off, there is as yet no clear bottom forming in JGB yields. 

Source: Japan Investor, Nikkei Astra

While more Topix subsectors have been rising than falling over the past month, even the best sector gains have been extremely modest compared to the U.S. and the rebound in selected Euro stocks. On the other hand, air transport (with the re-listing of JAL), steel, broker/dealers, banking, wholesale/trading and real estate have sold off, despite a strong rally in the overseas financial sector, as Japanese companies and investors seriously re-assess Japan’s high exposure to China, where a 1% slowdown in China’s GDP ostensibly produces a 10% hit to Japanese corporate profits. 

Source: Japan Investor, Nikkei Astra

In this light, Japan would also be an obvious beneficiary of a major re-appraisal of China’s economic prospects, albeit in a more cautious mode than China stocks themselves because of simmering political tensions between the two countries. While China’s exports have surprised on the upside of late, Japan’s exports to China and overall have surprised on the downside.

Further, buying Japanese equities on the conjecture of a significant weakening of JPY triggered by a) an LDP win that prompts a more aggressive BoJ stance and b) a U.S. Republican win that puts a crimp in the Fed’s helicopter money policies in our view is skating on very thin assumptions.

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

Stocks in Longest Rally Since 2007 as they Climb a Wall of Investor Worry

Summary Points:

1. Stocks are outperforming bonds and commodities in the longest rally since 2007.
2. U.S. stocks continue to lead supported by a more resilient economy and fully-committed Federal Reserve monetary stimulus. While the plumbing that supports the re-cycling of money in the U.S. economy remains plugged and much liquidity (cash) remains unproductively pooled in excess bank reserves, total credit so essential to maintaining economic growth is again increasing. 
3. Global economic activity continues to sputter, as does global trade. Weakening Eurozone-China trade is creating a negative feedback loop for “feeder” economies in Asia (including Japan) that are heavily dependent on China for their trade growth.
4. As a result, larger Asian markets (Japan, China and India) continue to significantly lag the U.S., while smaller Asian markets like Thailand and the Philippines have regained momentum.
5. As a result, there may be better opportunities in the Eurozone than Asia, in markets like Germany.

Despite All the Doubts and Worries, Stocks Are Outperforming 

Despite all the bearish news and prognosticators in the recovery from the 2008 financial crisis, stocks are beating bonds and commodities in the longest rally since 2007 as unprecedented stimulus from the developed world’s central banks who are trying to fix post-crisis tepid and sputtering global growth. In other words, stocks continue to claw their way up a wall of not inconsequential investor worry.

The advance in stock prices continues despite continued warnings by bears such as Gary Shilling, Nouriel Roubini, and David Rosenberg, to name a few, that higher stock prices are not reflective of corporate and economic fundamentals, and the ECRI’s Lakshman Achuthan’s insistence that the U.S. has again fallen into recession. The top-down numbers on the global economy clearly show renewed slowing, with the global economy forecast to expand at just 2.2% in 2012, or at the slowest pace since the 2009 contraction. Going forward, consensus estimates from surveys by Bloomberg show a mild acceleration in growth to 2.6% in 2013 and 3% growth in 2014, versus average growth of some 2.7% for the past 15 years.

Source: JP Morgan, Markit

The September JP Morgan/Markit global manufacturing and service PMIs show a modest improvement, with the rate of expansion showing a six-month high, while remaining below the trend of the recovery since August 2009. The JP Morgan all-industry PMI of course tracks global GDP quite closely. The global economy is forecast to expand 2.2% this year, or at the slowest pace since the 2009 contraction, according to the median estimate from economists surveyed by Bloomberg. Gross domestic product may increase 2.6% in 2013 and 3% in 2014, the forecasts show. While that’s not exactly a robust recovery, it does compare with average growth of 2.7% for the past 15 years. 

This uptick in global economic activity however is heavily reliant on the U.S., while the Eurozone remains the largest drag.

Developed Central Banks Continue to Provide Unprecedented Monetary Support

On the other hand, the developed world’s central banks continue to provide unprecedented monetary support. The U.S. Federal Reserve has pledged to keep U.S. rates at historical lows and is now it its third round of “open-ended” QE as it pushes ever-harder on the string that leads to improved employment. The ECB prior to the Fed’s move committed to an unlimited bond buying program, and the BoJ felt compelled to expand its asset purchase fund in response to the actions of the ECB and the Fed.

But whether QE 3 is as effective as QE 1 and QE 2 (which we doubt), will depend on its impact on the U.S. monetary base. The surge in the monetary base during QE 1 and QE 2 was what boosted risk asset prices.

Source: St. Louis Federal Reserve

Problem Is, It Still Feels Like Recession, and People/Businesses Continue to Behave That Way 

Based on the most important grass-roots measures, i.e., employment, confidence, and wage growth, it still feels like a recession, and people as well as companies are behaving as though we’re in one. The world economy will take at least 10 years to emerge from the financial crisis that began in 2008, Further, those expecting a return to “normal” (e.g. prior to the 2008 financial crisis) are in for a long wait. The International Monetary Fund’s Chief Economist Olivier Blanchard says it will take the world economy at least 10 years to return to that “normal”.

The continued decline in the velocity of money being supplied by the central banks shows that much of this liquidity is still not finding its way into the “real” economy.

Source: St. Louis Federal Reserve

This notwithstanding, the Fed has managed to engineer a re-expansion of total credit, which is even more important as a contraction of credit immediately means recession in the modern leveraged, credit driven economy.

Source: St. Louis Federal Reserve

Meanwhile, the recovery is still susceptible to not inconsequential risks, the more prominent of which Whitney Tilson of hedge fund T2 Partners believes are, 

1. Euro crisis re-intensifies

2. U.S. housing market bottom collapses

3. China’s slowdown becomes a hard landing

4. Sovereign debt crisis in Japan

We would add “U.S. fiscal cliff”, but also believe Congress will have no choice but to react once financial markets begin pressing the issue.

U.S. Stock Market Remains the Best-Supported 
While investors are becoming increasingly leery of the good gains seen so far in 2012, given the fact that the U.S. economy remains the most resilient of the developed economies and the Fed is the most aggressive in providing monetary stimulus, it is not surprising that U.S. stocks have been outperforming other global equities. The SPY ETF has steadily worked its way through cumulative trading volume resistance levels and remains in a trajectory that points to a renewal of the 2007 high, with not uncommon backing and filling.

SPY: S&P 500 SPDR ETF Source: BigCharts.com

The irony of the recovery in the S&P 500 is that it has been led by the consumer discretionary sector (XLY) despite chronically high unemployment, decimated home asset values and other factors hitting the net worth and disposable income of individuals. Closely following is technology (XLF), where U.S. technology giants like Apple continue to their world dominance. In addition, health care is also an increasingly high tech area where U.S. companies tend to dominate global markets. On the other hand, the financials have and should continue to be the biggest drag on aggregate indices like the S&P 500, because they were at the center of the global financial crisis and still have a long way to go before downsizing their balance sheets and re-inventing their business models to align them with the new world order in finance. Like tech after the 2000 IT bubble, the consolidation in financials will probably be measured in decades, not years.

S&P Sector SPDRs: Source: Yahoo

Europe is Where the Biggest Risks, and Potential Rewards, Lie
Despite Mario Draghi and the ECB’s commitment to maintaining financial stability in the region and EUR intact, the Eurozone economy as a whole is in recession, with the debt-laden, fixed currency restricted southern European states effectively trapped in depression.

Despite having again fallen into recession, Euro area GDP is still in better shape than it was in 2009, albeit with dramatically more divergence within the region.

Source: Trading Economics

Like the USD, the EUR remains in a secular downtrend because of central bank fiat currency debasement, but has recently been staging one of its periodic rebounds from a cyclical low. But the current counter-trend move looks to have a fairly low upside of around 132 on the FXE ETF, meaning a re-test of the 120 level looks more likely than a break-up through the 132 level.

Euro FXE Currency ETF: Source: Big Charts

While an out-of-control Euro crisis would also hit Germany hard, because Germany (EWG ETF) remains the biggest beneficiary of a weaker EUR and continues to benefit from massive haven fund movement from Spain, Portugal and Italy that has pushed German bunds to rock-bottom levels, it remains the best-performing EUR market and is dramatically out-performing the non-US EAFE ETF (EFA). While the bond market vigilantes have backed off their attack on Spanish 10-year bonds and Spanish bond yields are again comfortably under the 7% danger line, Span’s economy is in shambles.

This notwithstanding, there has been a nice trading turn in both Spanish (EWP) and Italian (EWI) equities on hope the ECB’s bond-buying program will backstop a significant degree of EUR sovereign risk, making both among the best performing markets in the past couple of months.

Source: Yahoo.com

While the pall has noticeably lifted, the Eurozone still has many politically contentious meetings and uncertainties to endure before reaching its final goal of sustainable monetary union. Thus we continue to monitor two indicators of risk for the Eurozine, i.e., Spain 10-year bond yields and the Eurostoxx Banks index. Both are now showing a much more relaxed attitude by investors regarding the state of the Euro crisis.

Sources: Bloomber, 4-Traders.com

Asia Growth Expectations Get Trimmed

Downward revisions in Eurozone as well as China GDP growth and import demand have belatedly led to lower growth expectations for most of the rest of Asia, which is increasingly linked to China. China’s GDP growth continues to slow from the near-12% surge on a massive, bubble-creating fiscal stimulus in late 2010. More analysts now suspect that the days of consistent 10%-plus growth for China are over.

Falling demand for Chinese exports in the Eurozone is generating a negative feedback loop in Asia, as China has heretofore been a voracious consumer of basic materials as well as key exports from Japan, South Korea, Taiwan and Australia. 

Source: Trading Economics

China’s Shanghai Composite is beginning to resemble Japan’s Nikkei 225 during Japan’s Heisei Malaise, i.e., it is moving independently in a negative direction from global equity markets, and no longer can be viewed as a leading indicator of the direction of developed, especially the U.S. equity market. While the index has recently bounced on clearer signs of expanded stimulus from Beijing, it is still far from clear whether the Chinese government has managed to reverse slowing growth, and indeed whether it can avoid a “hard” landing, which in emerging China terms would be low one-digit growth.

With rising wages and increased animosity toward, for example Japan, which has been one of the most aggressive investors in China in recent years, China is losing its allure as the mecca for global manufacturing, and we expect to see a significant re-assessment of China strategies particularly among Japanese companies unless both countries make a special effort to paper over simmering territory disputes and old wounds from Japan’s imperialistic past.

Source: Yahoo.com

While Better than China, Japan is Too Closely Linked to What is Now a China Albatross

Source: Trading Economics

Japan’s GDP growth remains extremely cyclical, overly dependent on now-slowing China/Asia trade and limping along with a deflationary domestic economy. As Japanese politics is hopelessly grid-locked, there is little scope for bold measures to turn this rapidly aging economy around–leaving only austerity through budget controls and rising taxes to fend off a looming fiscal crisis once a mountain of government debt engulfs still-significant domestic savings and Japan has to increasingly go hat-in-hand to foreign investors to fund their deficit. 

While not an immediate risk, this debt question is a discount factor for stock prices–but JPY remains a “hard” currency among currency traders, leaving JPY as the best-performing asset class over the past five years. 

Since market valuations are so cheap in absolute and relative terms, foreign investors continue to search for the catalyst that will ignite a sustainable rally, but are continually frustrated by a) structural net selling by large domestic institutions, b) the continued strength in JPY which depresses stock prices and c) a much more aggressive Fed monetary policy that will continue to keep US-Japan rate spreads at historically thin levels, thus precluding any prospect of a significant weakening in JPY for the immediate future. 

Central bank action has backstopped downside risk in the EWJ Japan ETF just as it was on the verge of breaking down because declining exports and surging imports were snuffling out the Tohoku reconstruction-led recovery. The long-term EWJ chart as shown below however shows a strong downward bias despite the contribution of a strong JPY, A heavy accumulation of trading volume around $10 is likely to cap the upside for EWJ, while there is visible support below $9. Bottom line, Japan equities top-down are a neutral call at best. 

Source: BigCharts.com

Smaller Asian Markets are Showing Some Spunk

With the biggest Asian markets of China, Japan and India (INDY) severely lagging their U.S. and even selected European counterparts, it would not be a surprise if many international and global funds were now light in Asia. Among the smaller markets, Malaysia (EWM) has the best 5-year performance on more consistent GDP growth, but performance has flattened over the past year, and Indonesia (EIDO) has shown a similar pattern. On the other hand, Thailand (THD) has come roaring back from big hits due to serious flooding and political unrest. Regional specialists are also positive again on the Philippines (EPHE). 

Source: Yahoo.com

Source: Trading Economics

Source: Trading Economics

Reference: Asia Trackers

U.S. Listed Asia Funds

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

China Related Japan Stocks Feeling the Heat of the China Slowdown

As China has now become Japan’s largest trading partner and exports to Asia, where linkages run deep with China, the Nikkei has compiled and tracks 50 Japanese stocks they selected as “China-related” stocks based on, (1) the number of articles related to China, 2) degree of involvement with China, 3) preference for larger-cap companies.

As the graph below shows, Japan China-related stocks were hot property before the 2008 financial crisis, with the composite index near 1,800. The stocks staged a revival between the 2009 low in global equities and Q2 2010 as China unleashed a 4 trillion Yuan stimulus package and global investors were hoping that emerging economies, particularly the BRICs nations would pull the global economy out of the crisis. 

Source: Nikkei

Time has shown however that these hopes were overly optimistic, as a worsening Eurozone debt crisis and continued weak U.S. demand began to drag on the BRICs nations as well, and China began to show unmistakable signs of a credit bubble hangover. As the numbers out of China increasingly weakened, the China card became a negative instead of a positive for the 50 stocks in the Nikkei China 50 index. As a result, the Nikkei China Related 50 has fallen with each new renewed low in the Shanghai Composite. 

But the impact on the 50 stocks is showing significant divergence. Nippon Steel (NISTY.PK) and Komatsu (KMTUY.PK) are among the hardest hit, after soaring when Beijing first announced the massive fiscal stimulus. On the other hand, automobile electronic component major Denso (DNZOY) has outperformed the group on the strength of recovering demand in the U.S., toiletry producer Kao (KAOCF.PK) has managed to retain positive bias as a defensive name, and trading firm Itochu (ITOCY) has basically trended flat, even though Japanese trading companies do well when global commodity prices are rising. The other group that has been particularly hammered is the shipping companies, given the supply glut crisis in global shipping. 

Source: Yahoo.com

We see China-related Japan stocks continuing to weigh heavily on the Japanese benchmark indices given a) their relatively higher markt cap weights and b) continued new lows in the Shanghai Composite index. This linkage to China is a major reason the Nikkei 225 and Topix have significantly lagged the S&P 500 rally. Further, rising expectations for a positive outcome from Mr. Draghi’s ECB machinations will have noticeably less positive impact on such Japanese stocks because the primary issue of course is China, not the Eurozone. 

Given the now-significant drag from China and China-related Asia links, it is not surprising that the Nikkei 225 has de-linked from the recent S&P 500 rally and instead is gravitating to the Shanghai Composite, as weakness in China and Asia demand has a substantially larger impact on Japan’s exports, which in turn has been the primary source of Japan’s GDP growth in recent years, Tohoku recovery demand notwithstanding. 

Source: Yahoo.com

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

What Keeps the BOJ Up at Night

Despite sometimes making noise about contrarian bets on European equities, professional investors remain underweight the Eurozone, even though it might surprise most investors to know that of only four developed markets that have performed the US to date in local currency terms are Eurozone markets, namely Austria, Belgium and Germany, and by a handy margin.

Source: MSCI

It may also surprise most investors to know that since early September 2011, the German DAX has been the best performing market, recently beating out the U.S. NASDAQ, while China’s Shanghai Composite has been a major laggard, declining nearly 20% during the period while the DAX was rising well over 20%.

Source: Nikkei Astra

Stock Prices Defying Weakening GDP Indicators

Excluding the Shanghai index, the rally in developed stock markets–centering on the 11% gain in the S&P 500 since June 1 ,2012 appears to be in direct contrast to the top-down economic numbers, which still show noticeable weakness in the global economy, a large part due to the Eurozone, which is again sliding into recession, as is shown in the Markit Eurozone PMI including Germany, whose PMI has also dipped below the 50 boom-bust line. 

Hat Tip: FT Alphaville

The US market (S&P 500, NASDAQ, etc.) has led the developed world equity rally since June, because for all its warts, it is still relatively stronger than economic conditions in the Eurozone and China. But even the US PMI has seen noticeable deterioration of late. 

Hat Tip: Business Insider

If world economic conditions have deteriorated over the past few months, what are investors smoking as stock prices are apparently being bid up in the face of negative news? Global bond yields for the “safe haven” countries and currencies have tanked to new lows, reflecting both a) the glummer economic prognosis and b) the inevitable response by central banks from the Fed, the ECB, the BoE and the BOJ, i.e., more money printing. Thus we are in an upside-down world where “bad” news is actually taken as “good” news that central banks will shower more liquidity on the financial markets. 

Source: Nikkei Astra

Granted, the U.S. economic news is apparently not as bad as was feared just a couple of months ago, judging from the uptick in the Markit flash PMI index for August, which was up  0.50 to 51.90 and suggests the U.S. economic recovery is still intact, and the recent uptick in the Citigroup US economic indicator surprise index. This after demand for U.S. capital goods such as machinery and communications gear dropped in July by the most in eight months, suggesting US manufacturing will contribute less to the economic expansion going forward.

Hat Tip: Pragmatic Capitalism

Hat Tip: The Big Picture

But other traditional indicators of the health of the global economy like “Dr. Copper” show no agreement with the rally in equities. This indicator however is probably distorted by the fact that China, which undoubtedly is going through its own unique set of problems, had accounted for the bulk of new demand over recent history, and is now literally drowning in hoarded copper inventories. The world’s shipping and shipbuilding industries, also historically viewed as bellwethers of global trade, remain in a world of hurt with massive excess capacity and “last man standing” pricing of shipping rates. Again, the weakening China economy has left a larger than life footprint, where a preliminary reading of 47.8 for the August HSBC PMI and Markit Economics compares with July’s final 49.3 figure shows a 10-month string of readings below 50, the longest run of weakness in the index’s 8-year history.

Hat Tip: The Short Side of Long

The China slowdown is heavily reverberating on other countries and trading partners in Asia, with Japan showing an 8.2% decline YoY in exports on a 25.1% plunge in exports to Europe (the largest since October 2009) being compounded by an 11.9% plunge in exports to China–versus a 2.1% increase in imports on significant rises in imported fuel to run non-nuclear electric power generators. Other countries like South Korea and Taiwan are also showing a significant slowing in export demand, despite the significant advantage they have over Japan given the ultra-strong JPY.

Investors Still Hoping that the Central Bankers Can Still Goose Returns

Thus despite growing evidence to the contrary, investors remain fixated on utterances by central bankers, beginning with Ben Bernanke’s remarks at the annual U.S. Jackson Hole meeting of central bankers and economists later this week. In the previous two years, Bernanke has used the Jackson Hole event to flag the Fed’s intention on more easing. For example, “We expect Bernanke to clearly signal that Q3 is in the pipeline and our expectation remains that this will be delivered at the 12-13 September FOMC,” says Societe Generale. 

Despite the inevitable derogatory remarks by the Bundesbank and German politicians to “super Mario’s” telegraphed moves to battle the euro zone’s debt crisis, investors remain hopeful, as they see eventual QE by the ECB as inevitable, despite all the saber-rattling by the Bundesbank. The ECB will nevertheless wait until Germany’s Constitutional Court rules on Sept. 12 on the legality of the ESM permanent bailout fund before unveiling the much-expected “new plan”, and full details could be a month away.  

Even if the Fed and the ECB can manage not to disappoint investors too bitterly with their next moves, we believe market movement in the lead up to these moves over the next couple of months are a classic “buy on the rumor, sell on the news” play. 

Market Volatility Index Suggests the Next Big Market Surprise will be Negative

Further evidence for the “buy the rumor, sell the news” approach is the S&P 500 VIX index, which is again trading at the 15 level. While not yet as low as the 2007 lows, investors still have a lot on their plate even if super Mario can pull off a major coup against the Bundesbank–namely, a full-fledged rout in the Chinese economy, for starters. Further, an all-hands-on-deck ECB, while doing a great deal to fill the current vacuum in meaningful Eurozone action against a  metastasizing debt and banking crisis, only puts the Eurozone where the U.S. is now, i.e., with a stable financial sector but no lasting solution for curing what ails the economy. 

Source: Yahoo.com

Japan’s Recovery is Already Fizzling on a Rapid Slowing of Exports

The ostensible catalysts for foreign investors to capitalize on on-the-surface very cheap Japan equity market valuations, i.e., a Bank of Japan committed and actively battling ongoing deflation as well as working to move JPY meaningfully off historical highs, remains an elusive goal.

However, when viewed in USD, GBP or EUR terms, performance of selected investments in Japan looks very attractive because of the super JPY. For example, JPY is up some 60% vs EUR since 2008, and up some 40% vs USD. If foreign investors had put on the JPY trade by purchasing JGBs, they could have added 9% in capital gains, for total returns of 69% and 40% respectively, compared to a 13% gain in the USD-denominated MSCI index of world equities. If they had chosen instead to put on a Nikkei 225 trade, however, their EUR-denominated return would be a more mundane 20%, while their USD return would be basically flat. 

Source: Nikkei Astra

Source: Nikkei Astra, Japan Investor

What Keeps the BOJ Up at Night

In reality, foreign investors have been essentially trading the BoJ, piling in when Japanese markets sold off in March 2011 with the Tohoku disaster, taking profits a half-year later, piling in again when the BOJ moved in late 2011, and again in February 2012 when the BOJ surprised with further action. Each time, they have been disappointed by the timidness of the BOJ. In reality, what keeps (or should keep) the BOJ up at night is the prospect that currency traders wake up one day and realize the JPY emperor has no clothes, i.e., that it is not only a “haven” currency, and moreover is at risk of an inevitable effort by the government and the BOJ to inflate Japan out from under a growing mountain of debt. 

Any such scenario would also trigger the long-futile “widow maker” Kyle Bass trade,i.e., short JGBs, which would decimate the balance sheets of Japanese banks almost as badly as Eurozone banks’ balance sheets have been decimated by increasingly toxic sovereign debt. 

The real irony about Japanese equities is that those stocks most likely bought in any BoJ-triggered, knee-jerk “buy Japan” wave are exactly those stocks that should NOT be bought, i.e., the most visible stocks on foreign exchanges, such as Japan ADRs.

Source: Nikkei Astra

Source: Nikkei Astra

Japan’s ADRs Underperform

Normally, the stocks of any country listed as depository receipts on foreign exchanges are the bluechips of that country and the more widely traded/held stocks of that market. In Japan’s case, the dwindling list of Japan ADRs is now populated with “old Japan” companies in dying, seriously challenged industries that have market capitalizations no longer justified by future revenue and profit growth prospects. As a result, buying a basket of Japan ADR stocks will only guarantee that you underperform the market benchmark indices such as the Topix. 

Consequently, if you want to be contrarian to a) differentiate yourself from the competition and b) generate US market-beating alpha, we would suggest taking a hard look at those Eurozone market “babies” that have been thrown out with the Club Med wash. 

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

What’s the Cathartic Event? Waiting for the Next Shoe to Drop

Takeaways

1) The Euro crisis continues to deepen. Greece is done, regardless if it stays in the Euro or leaves.  A Greece default while staying in the Euro is the mildest of the horror story alternatives. By some accounts, the Spanish are a lot more likely to pull out of the Euro than the Greeks. Italy’s economy, the third largest in the Euro, is heading for a double-dip recession.

2) The Euro crisis is already hobbling a tepid global recovery, and the drag will get worse. Greece accounts for a mere 0.4% of the world economy, but even Greece is inflicting collateral damage. JP Morgan Chase estimates a 1 percentage point slump in Euroland’s economy drags down global growth by 0.7 percentage points. Exporting nations from the U.K. and Japan to China are feeling the impact and commodity producers like Russia face falling prices. Euro-area imports account for around 5% of global GDP, meaning a 15% decline in Euro imports shaves global growth by 0.5 percentage point. If Greece or Spain leave the Euro, BofA Merrill Lynch strategists estimate the monetary union’s GDP would contract at least 4%, A complete breakup of the Euro would mean a cumulative GDP loss of more than 12 percentage points over two years.

3) Consequently, China’s GDP growth could be well below the 7.5% target, not above, and more like 6% and change, as the slowdown in external trade is exacerbated by structural shifts in the domestic economy. With shrinking import demand from China, and shrinking trade credit from Euroland banks, Hong Kong Singapore, Malaysia, Taiwan, South Korea and Japan’s economies could see renewed weakness and/or recessions, removing what has been a big boost to global growth.

3) The Greek elections and subsequent confusion alone wiped almost $3 trillion from worlwide equity market capitalization.  We shudder to imagine the impact of a messy Euro breakup,  given that the region’s banks are some Euro 2 trillion undercapitalized, and the notional amount outstanding Euro-denominated derivatives is roughly 13X the size of the $14 trillion US economy.

4) Yields on Spanish, Portuguese, Italian, French, etc. sovereign bonds continue to rise, as do their CDS. European banks alone hold $1.2 trillion of debt issued by Spain, Portugal, Italy and Ireland, implying substantial unrealized losses that the plunging Eurostoxx 600 banks index is trying to discount, and could fall further to below 110 from around 123 now.

5) Given the risk of Club Med country withdrawal, the Euro falling to 1.20/USD and ever closer to parity with USD would come as no surprise. The haven currencies are, 1) USD, 2) JPY and 3) GBP, in that order.

6) By the same token, the haven sovereign bonds are 1) German Bunds, 2) US treasuries, 3) Japan government bonds (JGBs). Don’t be surprised if all fall below significantly 1%. During Japan’s banking crisis, JGB yields hit a low yield of a princely 0.44%. 

7) U.S. equities are holding up better than other equity markets, but U.S. stocks are not made of teflon. All of the nine S&P sector SPDRs have seen “dead crosses” between their 50- and 200-day moving averages except the utilities SPDR (XLU).  Thus while the S&P 500 is still bumping along its 200-day EMA, it is basically being held up by only the utilities sector. Investors are already clearly defensive, and should stay that way. 

8) Outside of U.S. equities, the “cheap” Nikkei 225 has seen another 50-d, 200-d EMA dead cross, while we expect to see increasing support nearer to 8,000. London’s FTSE 100 is also showing a (50-d, 200-d) dead cross, with a defense line of 5,000. China’s Shanghai Composite was already in an extended bear market and is seeing upside resistance at its 50-d EMA, but is trying to rally on expectations of more aggressive stimulus by Beijing, who continues to deny the rumors.

Euroland: Delusions of Control

To date, Europe’s crisis has been a series of supposedly “decisive” turning points that in reality were just another step down a slippery slope. The Euro Troika (European Commission　(EC), European Central Bank (ECB), and the International Monetary Fund (IMF)) has failed in providing the prospect of recovery in any periphery country using basically the same old IMF playbook used during the Asian currency crisis. Not only European politicians but also some analysts are saying that an orderly exit for Greece, and Greece being the only nation that leaves the Euro, could actually be bullish for the Euro. They are wrong, not only because it could be Spain that leaves the Euro first. Greece’s exit is simply another step in a chain of events that with increasing likelihood leads towards a chaotic dissolution of the Euro. It is Spain’s banking system and regional debt problems are now becoming the key driver behind the latest risk aversion wave sweeping the Eurozone.

The size of funds needed for an all-out backstop are beginning to exceed the capacity of any one and perhaps several institutions, including the ECB, the IMF and yes, even the Fed, to deal with.

In the next stage of the crisis, Europe’s electorate suddenly awakens to the large financial risks which have been foisted upon them in the failed Euro experiment. If and when Greece quits the Euro (ostensibly by January 2013), its government will default on approximately Euro 300 billion of external public debt, including some Euro 187 billion owed to the IMF and European Financial Stability Facility (EFSF). Greece will also likely default on Euro 155 billion directly owed to the Euro system (the ECB and the 17 national central banks in the Eurozone), including Euro 110 billion automatically provided to Greece through the TARGET2 payments system. As depositors and lenders flee Greek banks, they will fail, with the capital flight being financed by other (northern) Euro area central banks through the Target2 account. The vast bulk of this is effectively done by the Bundesbank, since most of this flight capital is going to Germany, as the following graph clearly shows.

Hat Tip: http://karlwhelan.com

The Eurozone “D” Word

Last December, The Economist magazine warned that the Eurozone faces a depression barring dramatic intervention. Unemployment is worsening throughout the Eurozone, with the aggregate unemployment rate touching a new record high in March: 10.9%, up a full percentage point from the prior year. Youth unemployment rates are staggering—over 50% in Greece and Spain, 36% in Portugal and Italy, rising sharply in all four. The Eurozone economy is large and overwhelmingly driven by domestic demand. That demand has been steadily squeezed by a broad, sustained fiscal tightening. Monetary policy is providing almost no relief. Greece in depression is one thing; a double dip recession in Italy, the region’s third largest economy, is another.

Intervention by Whom?

According to the U.K.’s The Telegraph, the ECB’s incompetence is on par with the errors of 1931. The Bank allowed the broader M3 money supply to contract for the whole Eurozone late last year, badly breaching its own 4.5% growth target not because of purist hard-money discipline, but simple incompetence. The Polish finance minister recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery. He is wrong. The flight from periphery banks and sovereign debt, heretofore a trot, is about to become a full-scale rush to the exits. Ostensibly, the Eurozone nations would need unlimited funding for at least 18 months to provide an adequate firewall. The Polish finance minister is right however in assuming the ECB or other Eurozone institutions are not prepared (or able) to provide such a firewall. For that matter, neither the IMF nor the U.S. Fed, may have the capacity, legitimacy or the political will to do so.

Instead of circling the wagons with the IMF, the Fed and anyone else who will listen and organizing a “pull-all-the-stops” contingency plan for a Lehman-like event triggering another freezing up of the global financial system, the ECB is recently talking like it has suddenly discovered the growing risk to its own balance sheet that analysts have been pointing to for some time. The ECB is apparently concerned about capital outflows from the periphery being replaced by TARGET2 inflows, and how TARGET2 imbalances might lead to a more fragmented policy. In other words, the ECB, led by the Bundesbank, is moving to protect itself in case of a Grexit, just like any other rat trying to abandon ship.

The still dillusional ECB would probably need more pronounced stress across markets, a combination of peripheral yields rising above 7%, rising bank CDS spreads, and stress on 3M EURIBOR (interbank) rates as well as EUR basis swaps spreads (a proxy for US dollar – USD – funding availability) before being forced to move in with another LTRO, the effect of which could be even more transitory than the prior two. Meanwhile, the Bank is trying to limit the flow of information about so-called Emergency Liquidity Assistance (ELA), which is increasingly being tapped by distressed euro-region financial institutions. However, there is increasing attention being paid to the program as the ECB moved some Greek banks out of its regular refinancing operations and onto ELA until they are sufficiently capitalized. Under ELA, the 17 national central banks in the euro area are able to provide emergency liquidity to banks that can’t put up collateral acceptable to the ECB. The risk is born by the central bank in question, ensuring any losses stay within the country concerned and aren’t shared across all euro members. Street estimates indicate Eurozone central banks are currently on the hook for about Euro 150 billion of ELA loans.

The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies. But between TARGET2 and direct bond purchases alone, the Euro system claims on troubled periphery countries are now approximately Euro 1.1 trillion, or the equivalent of over 200% of the broadly defined capital of the Euro system. As a percent of nominal GDP, the ECB balance sheet is now the largest of the developed nation central banks at well over 30%.

Hat Tip: Mish’s Global Economic Trend Analysis

 Greece is Done, Stick a Fork in It

With Greek sovereign bonds yields at a ridiculous 30%, they are not even worth the paper they are printed on. Thus Greece is totally dependent on the funding handouts of the Euro Troika. ekathimerini.com is describing a situation in Greece approaching a total breakdown in the financial system. Political uncertainty and fears of a Greek Eurozone exit are greatly exacerbating a protracted recession and choking lack of liquidity that is accelerating the downturn in the real economy to near crash conditions. The clearest sign of disintegration is in public revenue collection, which nose-dived right after the May 6 elections, and is recently falling on the order of 20% as Greek taxpayers put off paying dues, while the government, facing the threat of a delay in the disbursement of bailout installments from the Euro Troika, has suspended rebates and payments to suppliers of the public sector.

The inability of banks to maintain liquidity in the economy means that loans have been cut off even to businesses with sound finances. Since the beginning of the crisis, deposits in the Greek banking system have fallen by about Euro 70 billion. Bank officials estimate the drain in the last four weeks on the level of Euro 2.5 billion, while loans to households and enterprises have fallen by about Euro 11 billion in the last two years. The suspension of credit between businesses is indicated by the decline in the number of bouncing checks, which is due to anything but brisk business. A recent survey by business consultants ICAP showed that for 74% of businesses, the priority is not an increase in sales but to reduce bad credit and protect their viability.

Further, the prevailing uncertainty about the economic future of the country has caused a partial black-out in transactions with foreign firms, some of which have begun suspending payments over fears that either that they will lose their money or that Greek products and services will soon cost much less when denominated in drachmas. Foreign suppliers are refusing to send merchandise to Greece if they are not paid cash or without letters of guarantee from foreign banks: those from Greek banks are not accepted. Credit is being refused not just by foreign firms but also by European institutions. The European Investment Bank (EIB) demanded a change-in-currency clause in its loan contracts with Greek enterprises, such as the Public Power Corporation (PPC). The demand created an uproar and was subsequently dropped but EIB seems to be withholding disbursement on various pretexts.

Greek-Bund 10Yr Bond Yield Spread

 Spain Is Closer to Collapse than Previously Believed

By some accounts the Spanish are a lot more likely to pull out of the Euro than the Greeks, or indeed any of the peripheral countries. They are too big to rescue, they have no political hang-ups about rupturing their relations with the European Union, they are already fed up with austerity, and there is a bigger Spanish-speaking world for them to grow into. There are few good reasons for the country to stay in the euro — and little sign it has the will to endure the sacrifices the currency will demand of them.

According to the U.K.’s The Telegraph, Spain’s collapse is also the mathematically certain – and widely predicted – result of ferocious monetary and fiscal contraction on an economy struggling to deal with a housing bust. Spain’s 5-year CDS is now implying 44% probability of default in the next 5 years, assuming a 50 cent on the Euro recovery. The shares of Bankia SA, the Spanish bank now asking for a huge bailout, continue to plunge. The cost of bailing out just one of Spain’s doom-stricken banks has shot up from €4.5 billion to €23.5 billion. This is money that Spain’s cash strapped government doesn’t really have. Further, the president of Catalonia says the regional government is running out of money and needs a bail out of its own. Catalonia, a region in northeastern Spain which speaks its own language and hosts an independence movement, is bigger than Portugal in terms of GDP and accounts for one fifth of Spain’s economic activity. What this means is that Spain is likely to come to the EU much sooner than expected with a much bigger bailout request than anybody thought. Catalonia is by no means unique. Some indebted regions and hundreds of municipalities have fallen into arrears on payments owed to suppliers and service providers, including pharmaceutical groups and rubbish collectors. 

The political ability of the Spanish authorities to manage their country’s dire financial predicament is closer to collapse than most European officials realize. Spain’s trump card had been that it had successfully issued well over half the sovereign debt it needs to in 2012. Spain is being pushed by the Euro Troika to reduce its deficit, and the Spanish government is actually trying, taking a multi-pronged approach which includes tax hikes, budget cuts and structural adjustments that would improve the labor situation. But while recently proposed austerity measures were welcomed by the Troika, they were largely and vociferously condemned by Spain’s populace. Between the banking and the provincial debts and the politics of the whole sorry mess, Spain’s government, like Greece’s, is in an untenable position. The Euro Troika is demanding actions from Spain that the country’s government is increasingly politically unable to implement.

Spain’s savers are not waiting around for the next shoe to drop. The chart from SoberLook.com shows quarter over quarter changes in total deposits by the “real economy” (excluding deposits by banks with each other) at German and Spanish banks. The data is through Q1 of 2012. Given the record spreads of Spanish 2-year notes to German bonds, it is highly unlikely the situation has improved since the end of the first quarter. The premium on Spanish government bonds to German bunds is now the highest since the Euro was created–i.e., Spain is rapidly following Greece down the slippery slope. 

Eurozone Banks Severely Undercapitalized

Euroland banks are under-capitalized by as much as Euro 2.9 trillion, a sum of such size that no one entity can backstop the entire crumbling edifice. As highlighted by UBS and relayed by Zero Hedge, the BIS Basel Quantitative Impact Survey, “Results of the Basel, III monitoring exercise as of June 2011” states that the June 2011 shortfall of common equity to a 7% common equity tier 1 ratio for major banks globally was Euro 486 billion, which implies the shortfall to a 10% common equity tier 1 is Euro 1.02 trillion. The shortfall to the Liquidity Coverage Ratio (LCR) is Euro 1.8 trillion and 40% of banks have a LCR below 75%. The shortfall to the Net Stable Funding Ratio is Euro 2.9 trillion.

Compare this to total global bank debt issuance in the last 12 months of Euro 1.1 trillion, meaning the shortfall in the Net Stable Funding Ratio is almost three year’s worth of the global banking system’s issuance capacity. With global GDP at some Euro45 trillion,  the shortfall is equivalent to over 6% of global GDP. An EBA (European Banking Authority) publication implies a Euro 511 billion equity shortfall to a 10% common equity tier 1 ratio, or 90% of the Euro 565 billionfree float market capitalization of the entire Eurozone bank sector. The Basel III leverage ratio of large banks as of June 2011 would have been a measly 2.7%; the LCR just 71%, representing a shortfall of Euro1.2 trillion. 

In plain English, this means the entire equity buffer of the European financial system, or 90% to be exact, would vaporize if Europe’s banks were to actually seek to transform themselves into viable, financially sound entities by marking their massively mis-marked asset base to market. Ergo, the problem is too big for Eurozone banks to fess up to and try to fix, and this is why the Eurostoxx Bank Index continues to crater.

4-Traders: Eurostoxx Banks Index

USD is in Short Supply and Could Get a Lot Scarcer for Liquidity-Starved Eurzone Financial Institutions

Given the lost cause nature of the Greece problem and very likely Spain, more serious contagion in the Eurozone could very well tear the European Monetary Union asunder, during which time virtually all risk assets will at least be volatile, and ever subject to massive selloffs.

International investors and financial institutions that are required to own only the highest quality assets to meet investment guidelines or new regulations are finding fewer options beyond dollar-denominated assets. According to Bloomberg, the U.S. is now one of only five major economies with credit-default swaps on their debt trading at a “risk-free” level of less than 100 basis points. These five economies with default swaps trading at less than 100 basis points have a combined $14 trillion in debt, of which the U.S. accounts for some 75%. A year ago, when there were eight nations, the total was $24 trillion, with America making up 38% .

With supply still falling short of demand, it is no surprise USD is gaining mainly against the Euro as well as against a basket of major trading partners. Having bottomed at the same level it did in 2008, the trade-weighted USD index is poised for a 20%-plus appreciation as investors seek the (for the time being) haven of deep U.S. capital markets, even if global financial markets do not freeze up, as they did during the 2008 financial crisis.

The Global Economic Fallout from the Eurozone Mess

While Greece accounts for a mere 0.4% of the world economy, even a Greek departure from the Euro would inflict “collateral damage” on the global economy. At worst, it could spur sovereign defaults in Europe as well as bank runs, credit crunches and recessions that may spark more Euro exits. The enforced austerity on the “Club Med” Euro nations is already a drag on global growth. JPMorgan Chase estimates a 1 percentage point slump in the Euro countries’ economy drags down growth elsewhere by 0.7 percentage point. Exporting nations from the U.K. to China are feeling the impact and commodity producers like Russia face falling prices.

Euro-area imports account for around 5% of global GDP, meaning a 15% in Euro import demand would drag down world economic growth down 0.5 percentage point. Even if just Greece leaves BofA Merrill Lynch strategists estimate the Euro-region’s GDP would contract at least 4% in the recession that follows, A complete breakup of the Euro could provoke a cumulative GDP loss of more than 12 percentage points over two years

Despite Talk of a Looming U.S. “Fiscal Cliff”, Treasury Yields are at Record Lows and Foreign Official Demand Remains Strong

While there is much talk in the U.S. of a looming fiscal cliff that, if left to its own devices, would shave as much as five percentage points off U.S. GDP growth, the financial fires raging in the Eurozone are a much more pressing and apparently unsolvable dilemma facing global investors. There is strong demand for U.S. treasuries trying to offset Euro risk. Foreign official holdings of U.S. government debt increased in each of the first three months of 2012, climbing by 3.24% to $3.73 trillion in the best start to a year since 2009, according to data from the Treasury Department. Demand from outside the U.S. is of course helping the Obama administration to finance a budget deficit forecast to exceed $1 trillion for a fourth year, at historically low interest rates.

There is also strong demand for USD from Eurozone financial institutions strapped for liquidity and with balance sheets cratered with toxic and potentially toxic Euro bonds.  The new BIX rules on capital reserves will “increase the price of safety” embedded in assets deemed a reliable store of value, the IMF wrote in an April 18 report. As a result, the cost for banks to convert Euro interest payments into USD through the swaps market for three years has increased to 67.8bps below the Euro interbank offered rate, or Euribor, from 34.8bps below in March 29. These negative spreads show a premium for dollar funding.

USD Q3 Risk Mitigated by Strong USD Demand?

The Fed was criticized for devaluing USD with its QE between December 2008 and June 2011, as the USD index fell 14% during the two rounds of asset purchases, but USD demand now to put out raging Eurozone fires could engulf future USD supply increases. Despite the Fed’s already flooding the financial system with an extra USD2.3 trillion, the supply of USD is still scarce and about to get a lot scarcer as the Eurozone sovereign/financial crisis worsens and the availability of highest-quality assets worldwide continues to shrink.

This should keep the big money (global pension funds, etc.) flowing toward German Bunds, U.S. treasuries, Japan JGBs and U.K. gilts despite already low coupons, as the exercise is about capital preservation, not capital gains.  U.S. equities are the default risk asset if you must, while gold is the alternative to commodities, which are out because there is no demand from China.

Hat Tip: The Privateer

Gold: The Final Haven?

If there is any way out of the Eurozone mess without triggering another global financial crisis, it will be through even more debasing of the world’s major currencies. Big hedge funds that made big bets on gold surging uninterrupted through $3,000 are now puking out these positions,

As reported in the New York Times, some of the world’s biggest hedge funds have been piling into gold as a safer place to park cash in a very uncertain financial landscape. But hedge funds have been ratcheting down their positions in gold futures since early August, and they are also blamed for the latest sell-off. Whether this represents a positioning for a major upward move in USD, or is merely selling to meet redemption or increased collateral requests as some of the legendary hedge funds’ performance is down sharply. Everyone knows what happened to gold during the Lehman and AIG crises, when gold plunged short-term on a liquidity crunch, then rapidly rebounded as the central banks turned on the spigots.

Like 2008, gold (the GLD ETF) has again fallen below its 200-day EMA, but is still well above its long-term trend line from lows in 2005. Like 2008, it may take a cathartic turning point to push central banks into another bout of full-scale liquidity pumping to prevent another global financial system freeze-up to clear the decks for gold as well as instigate another liquidity-driven rally.

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