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Last August in our Japan Economic Outlook, we argued that economic and political events were developing in such a way as to make continued sustained yen and JGB strength untenable. This had been a trend that we began tracking as early as February 2012. While the worsening economic data trend has been long established (balance of payments, national savings, industrial production), political events have more recently begun to accelerate.Elected officials are approaching debt consolidation with increasing urgency. This urgency indicates that, if not publically, they are privately aware that time is running out.
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Open Market - AsiaMonthly Macro Advisor
January 2013
Gravelle Pierre, CFAgpierre@iharborcap.com
Chris Nicholson, CFAcnicholson@iharborcap.com
Jacqueline Hayotjhayot@iharborcap.com
Eva Yuneyun@iharborcap.com
www.iharborcap.com
Japan Economic Update
Economic fundamentals have continued to deteriorate
• National savings are very likely already negative, which forces a change in
the JGB price trend
• Japan’s export driven model is better implemented by its neighbors
• Balance of payments is worsening and shows no sign of a quick reversal
The political dialogue in Japan has shifted and indicates that officials are urgently aware that time to address budget imbalances is short
• The new administration is aggressively backing pro-growth strategies
• The political establishment has finally mustered the courage to pursue the
appropriate policy despite voter unease with inflation
• A regime of higher inflation and a weaker yen is taking hold in Japan
Inflation and credit/currency risk premia need to be priced into JGBs
• Home bias has created artificial demand for JGBs and fooled the broader
market
• A new inflation regime justifies a JGB inflation premium of 2% or greater
• A higher inflation target has meaningful consequences for growth—it
creates real incentives for households and businesses to invest
• Japanese companies will return to competitive ROE levels and attract
substantially more investor interest
• Higher inflation will also be quite favorable to real estate assets
© 2013 Iron Harbor Capital Management. All rights reserved.
2222
Iron Harbor Open Market
“Fasten your seat belts and return your tray tables to their full upright position.”
Last August in our Japan Economic Outlook, we argued that economic and
political events were developing in such a way as to make continued
sustained yen and JGB strength untenable.1 This had been a trend that we
began tracking as early as February 2012. While the worsening economic
data trend has been long established (balance of payments, national
savings, industrial production), political events have more recently begun to
accelerate. Beginning with the announcement of snap elections in mid-
November (2012), the political dialogue in Japan changed—LDP leadership
has communicated ardent support for broad monetary and fiscal stimulus
where outgoing DPJ leadership focused exclusively on consumption tax hikes
and budget consolidation. Incoming PM Shinzo Abe has communicated
three areas of policy focus:
1. Measures to weaken the yen via a fund designed to buy foreign securities. These
measures could amount to 50 trillion yen ($558 billion);
2. Fiscal measures worth 10.3 trillion yen ($115 billion), representing one of the largest
spending plans in Japan’s history. Targeted spending aims to raise economic
growth by 2 percentage points and add 600,000 jobs;
3. Bold monetary policy targeting a firm 2% inflation target from the present 1%
inflation goal and much higher than average inflation which has been close to 0%
for twenty years.
The initial market response to Abe’s aggressive stance has been fast and
furious: over the past two months, the yen has weakened in dramatic form—
nearly 14%. The Nikkei has rallied 22%. Government bond rates have likewise
moved higher from historic lows set in early December. Going forward, we
expect that government policies will continue to pressure the yen and JGB
prices much lower, and in turn significantly inflate the value of equities and
real estate.
Gravelle Pierre, CFAChris Nicholson, CFA
1 http://iharborcap.wordpress.com/2012/08/08/iron-harbor-open-market-japan/
3333
Outlook. The fiscal, demographic and economic issues that Japan faces are
well documented. The bond market, however, is pricing no meaningful
sovereign risk premium into Japan government debt yields. 1 This is a mistake.
Underlying fundamentals which previously supported the JGB market are
now unwinding. Japan’s self-funding mechanism is critically impaired, and it
is only a matter of time before the market prices into government debt yields
an appropriate risk premium. We believe the resulting increase in yields and
interest payments on JGBs will be the catalyst for an acute crisis of
confidence that undermines the value of Japan sovereign debt. We also
expect the value of the yen to substantially decline and to bear the brunt of
the near-term adjustment.
The Incredible Case of the Missing Risk Premium. There are two elements
which together explain what we will call the “Japan conundrum”, namely
the absence of a seemingly well-justified JGB risk premium. First, Japan has
been able to meet all its funding needs internally due to the availability of
abundant national savings. One measure that illustrates the scale of these
national savings is the surplus of domestic private sector financial assets to
government debt. The surplus ratio in 2012 was approximately 130% of GDP
(from a high of nearly 175% in 1995) and helps to explain why less than 8% of
existing debt is held by foreign bondholders.
Japan Economic Update
Japan’s self-funding mechanism is
critically impaired, and it is only a
matter of time before the market
prices…an appropriate risk premium.
1 As is the case with other sovereign nations with the ability to issue unlimited amounts of their nationalcurrency, Japan theoretically need not ever formally default on its debt obligations. Monetaryauthorities could, however, inflate away some portion of the value of existing debt by pursuing anexpansionary policy. We believe that inflation risk to JGBs is greater than the risk of outright default. Asignificant increase in inflation would lead to impairment without necessarily jeopardizing thegovernment’s ability or willingness to maintain the guarantee of payback.
4444
In addition to being abundant, national savings in Japan are effectively
“captive” or bound to the domestic economy due to strong behavioral bias.
Japanese investors, like all investors, have a preference for investing
domestically—in recognizable names and in a currency in which they
transact ever day. This natural tendency to favor domestic over international
opportunities (home bias) means that default risks are underpriced. Said
another way, home bias in Japan and a general preference for fixed income
assets has created extreme demand for JGBs that is not driven by a rational
evaluation of all the attributes and risks of that asset.
Japan Economic Update
Box 1. Home Sweet Home!
Data for the IMF’s Coordinated Portfolio Investment Survey (CPIS) provides the
necessary input to determine the relative degree of home bias among countries for
both equities and bond allocations. Based on a framework developed by Sercu &
Vanpee (2012) and refined by Bakeart & Wang (2009), we have ranked the leading
industrialized nations by degree of home bias:1
1 Rosanne Van[pee and Lieven De Moor, “Bond and Equity Home Bias and Foreign Bias: an International
Study “,(KU Leuven, 2012).
Equity Home Bias (Scaled)
Bond Home Bias (Scaled)
Japan 82.3 82.3
Australia 81.3 88.7
Canada 74.5 92.3
US 66.9 91.6
France 64.5 62.6
Switzerland 59.8 36.1
UK 58.7 64.6
Sweden 55.1 75.0
Italy 54.2 85.0
Germany 49.9 57.3
Netherlands 34.0 64.2
5555
The second element of the Japan conundrum is financial institutions’
(primarily banks and insurance companies) role as agents of the private
sector and the incentives they have to “appear” safe. Financial
intermediaries in Japan have enormous holdings of domestic sovereign debt.
Because the size of these holdings is so large, there is a high degree of
disincentive for short-termists to acknowledge the risk of impairment because
it would entail significant write-downs on existing assets. Quite simply, banks
hesitate to acknowledge the absence of risk premiums and the complexity
of the banking system allows them to elude public scrutiny for a long time.
We also believe that this reality will soon become a focal point among bank
investors and cause meaningful stress in that market.
balance of payments fundamentals will soon force bondholders to factor an
appropriate default risk premium into Japan sovereign debt.
It is easy to get lost in the quickly deteriorating demographic and fiscal
trends when analyzing Japan‟s economy. There are, however, four issues on
which to focus. First, national savings are quickly declining in Japan. This
means that the self-funding mechanism is critically impaired. Household
savings as a percent of disposable income have declined as the population
Source: Bank of Japan (September 2011), Our calculations
Tokyo Hold „em: Breakdown of JGB Holders
Japan Economic Update
44%
21%
13%
6%
4% 9%4%
Banks
Insurance Co.s
Pensions (Pub/Pvt)
Foreigners
Households
BOJ
Others
For these reasons, the bond market
has not priced-in an adequate risk
premium. We estimate this
premium at well over 2% even after
the value of the yen has made a
serious adjustment and the debt to
GDP ratio has moved toward a
reasonable benchmark. Yet, the
economic circumstances which
have allowed the market to ignore
risks have changed. The decline in
national savings, deteriorating
economic prospects, and poor
6666
Box 2. Why do banks hold so many JGBs?
There are a handful of reasons which explain why financial intermediaries hold such large
amounts of sovereign debt. First, there is home bias—the tendency of investors to maintain
heavy portfolio exposure to domestic names. Economists believe that much of home bias is
explained by some combination of perceived information advantages of proximity or fears of
currency translation losses which can be hedged. Yet, there are more interesting theories. For
instance, there has been some speculation that Japanese banks (to simplify, we will refer to all
financial intermediaries as banks) are being coerced by the government to hold sovereign debt.
The theory being that there are no other “willing” lenders and the government has identified
banks as the “lucky” buyers of last resort.
Regardless of the reason, there may be one perceived benefit of such high sovereign debt
concentrations among banks. By loading the domestic credit channel with so much sovereign
debt, the government may be signaling to the global financial community that under no
circumstances will it default due to the dire national consequences. It is perhaps this perverse
logic that has convinced international bondholders that JGBs are appropriate “safe haven”
assets during risk-off episodes.
necessarily “dissaves” in retirement. Further, Japan’s corporations are
increasingly uncompetitive with those of its fast-growing neighbors. Japanese
companies are losing record amounts of money and also have less capacity
to save. The unavoidable consequence is a lower national savings rate that
may already be negative and, until recently, was perhaps masked by “safe-
haven” yen inflows.
Second, failing economic prospects show no sign of reversing. On a relative
basis, Japan’s export-driven model is now more efficiently implemented by its
increasingly productive, well-governed Asian neighbors (Korea, China, and a
number of southeast Asian countries) and others outside the region. These
economies offer labor forces that are increasingly highly skilled, lower wage,
Japan Economic Update
7777
and creative. On an absolute basis, Japan’s labor force is shrinking due to an
aging population, lower birth-rates, and no meaningful immigration.
Moreover, Japan is losing its productivity edge. Slower economic growth,
going forward, is unavoidable. An improved inflation and yen policy,
however, can provide some degree of new incentives for investment and
productivity gains and allow Japan to participate in a portion of Asian growth
overall.
Third, the factors underlying Japan’s current account balance are worsening
and show no signs of changing course. The decline in Japan’s trade balance
is being driven principally by a now overvalued currency that is still relatively
close to historic highs. Meanwhile, investment income growth, the other
component of the current account, has flattened due to a global economic
environment dominated by low rates and low growth. Factor onto these
trends Japan’s overwhelming dependence on imported energy and the end
result is a current account that will be consistently negative until the yen
adjusts much lower.
Percent
Source: OECD
Household savings will soon be negative… Trillion yen
Source: National Bureau of Statistics
…while corporate profits suffer.
0
4
8
12
16
1992 1996 2000 2004 2008 2012
Household Saving Rate
0
30
60
90
120
150
180
Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12
Ordinary ProfitsOperating Profits
Japan Economic Update
8888
Finally, and most important, the inflation regime in Japan is changing—a
change directly related to the level of outstanding debt. For some time,
elected officials have approached debt consolidation with increasing
urgency. This urgency indicates that, if not publically, they are privately
aware that time is running out. The government has three options in
reducing the level of outstanding debt to an economically healthy level:
1) Increase revenues via higher taxes
2) Increase revenues via a pro-growth (inflationary) policy
3) Default
Given available information, it is
very unlikely that Japan will default.
As mentioned earlier, any
government with the ability to
issue unlimited amounts of its
national currency never need
default. For investors, a massive
currency depreciation will look very
similar. And though consumption
taxes are scheduled to increase
over the next ten years, the
outright amount of existing debt
means that tax increases alone are
not a complete solution. It is thus unavoidable that a stimulative (read
inflationary), pro-growth economic policy plays a commanding role in the
fiscal balance adjustment. As a result, inflation in Japan will almost certainly
be higher than it has been in the recent past. While recent discussions in
financial markets and the political arena have more frequently
acknowledged this likelihood, the market has been slow to price this risk into
bond yields.
Percent
Source: Ministry of Finance
The Hangover (Part 3): How do we get out of this?
0
100
200
300
400
500
600
700
800
0
5
10
15
20
1975 1980 1985 1990 1995 2000 2005 2010
Gov't bonds outstanding (RHS)Interest Payments (LHS)
Japan Economic Update
Trillion yen
9999
Past the point of no return. The momentum behind present economic trends
in Japan has been steadily building for many years. We believe that the
country is rapidly approaching an inflection point in its ability to fund itself
exclusively from national savings. As the government necessarily comes to
rely more heavily on international funding, domestic lending rates will rise to
more accurately reflect a wide variety of financial risks. Not only will
government debt be revalued significantly lower, in part due to higher
inflation, but the yen will experience an epic devaluation that brings the
debt load more into balance with GDP. The Japan conundrum is already in
the process of resolving itself.
50
100
150
200
250
300
350
400
Jan-73 Jan-83 Jan-93 Jan-03 Jan-13
USD/JPY
0
2
4
6
8
Jan-88 Jan-93 Jan-98 Jan-03 Jan-08 Jan-13
10 YR JGB Yields
Japan Economic Update
Source: Bloomberg Source: Bloomberg
The yen has started to retrace The JGB correction—on its wayYen/$ Percent
10101010
Box 3. Ready, Steady….Paradigm Shift!
At Iron Harbor, the primary input of our asset allocation model is a deep understanding of
economic fundamentals. We focus particularly on the frequent divergence between these
fundamentals and the market’s expectations. In the case of Japan, the market’s pricing
assumptions for both JGBs and the yen diverge quite substantially from that which is justified by
economic fundamentals. Yet, new information suggests that a higher inflation target will be a
game-changer in Japan. Higher targeted inflation increases the probability of a sharp re-
adjustment in Japan sovereign debt as the market factors into yields an appropriate risk premium
where very little now exists.
Based on a large body of work in behavioral economics, the absence of an appropriate risk
premium despite the overwhelming evidence should not come as a surprise. Empirical data has
long established the market’s inability to quickly factor new information into asset prices. There
can thus exist frequent episodes during which asset prices deviate from fundamental value for
extended periods before quickly moving to a new equilibrium level. The absence of a
meaningful sovereign risk premium in Japanese debt in light of new information related to
inflation is a perfect example.
The paradigm of low inflation in Japan has persisted for twenty years. Despite the presence of
new information—political willingness to tolerate higher inflation and the unavoidability of higher
inflation as a policy solution—the market has not yet fully incorporated it into its pricing
assumptions. JGB yields are still dramatically below any reasonable equilibrium level suggested
by a new, higher-inflation paradigm. It is simply a matter of time before yields adjust to this new
equilibrium level in what could be a sharp correction that the market is not presently anticipating.
Japan Economic Update
11111111
Figure 1. Broad Economic Weakness
Leading indicators worsen… …and suggest that an upturn in activity is far off.
Capital goods show further decline
after the Fukushima recovery bump PMI Prognosis: Negative
Source: Economic and Social Research Institute
Index Value
Source: Ministry of Economy Trade & Industry
Percent
Source: Japan Machine Tool Builders‟ Association Source: Markit/Nomura Securities
Index ValueIndex Value
85
87
89
91
93
95
97
99
Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13
Leading Indicator
Coincident Indicator
-40
-20
0
20
40
Jan-06 Jan-08 Jan-10 Jan-12
IP % YoY
0
20
40
60
80
100
120
140
160
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
Machine Tool Orders
25
35
45
55
65
Jan-06 Jan-08 Jan-10 Jan-12
Japan PMI
50
12121212
Figure 2. Deteriorating Balance of Payments
Weak trade data and stagnant income underline
an awful balance of payments trend. Japanese exports are weak to all markets
Cumulative year-over-year investment income Cumulative year-over-year current account
Source: Ministry of Finance
Billion Yen
Source: Ministry of Finance
Percent
Source: Ministry of Finance Source: Markit/Nomura Securities
-1,500
-1,000
-500
0
500
1,000
1,500
2,000
Jan-05 Jan-07 Jan-09 Jan-11
Trd&Svc Balance (SA)
Inv. Income (SA)
-60
-40
-20
0
20
40
60
Jan-06 Jan-08 Jan-10 Jan-12
US Exports % YoY 6mma
EU Exports % YoY 6mma
Asia Exports % YoY 6mma
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
Investment Income Cum. % YoY
-150%
-100%
-50%
0%
50%
100%
150%
200%
250%
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
Current Account Bal cum. % YoY (SA)
Percent Percent
1313131313
Gravelle Pierre is the Founder and Chief Portfolio Manager of IronHarbor.
gpierre@iharborcap.com
Jacqueline Hayot is the Chief Operating Officer of Iron Harbor.
jhayot@iharborcap.com
Christopher Nicholson is the Senior Portfolio Strategist of Iron Harbor.
cnicholson@iharborcap.com
Aditi Thapar, PhD is the Head of Global Economics for Iron Harbor.
economics@iharborcap.com
Eva Yun is the Senior Markets Analyst of Iron Harbor.
eyun@iharborcap.com
The views expressed herein are for information purposes only and ARENOT intended as trading or investment recommendations.
Iron Harbor Capital Management IS NOT a Commodities TradingAdvisor and IS NOT offering these views as investment advice or as asolicitation for investment.
Iron Harbor Open Market
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