Iron Harbor Open Market – Japan (update)

Open Market - AsiaMonthly Macro Advisor

January 2013

Gravelle Pierre, [email protected]

Chris Nicholson, [email protected]

Jacqueline [email protected]

Eva [email protected]

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/

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’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.


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


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,


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


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)


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


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.


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


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


Billion Yen


Percent

Source: Ministry of Finance Source: Markit/Nomura Securities

-1,500

-1,000

-500

0

500

1,000

1,500

2,000


Trd&Svc Balance (SA)

Inv. Income (SA)

-60

-40

-20

0

20

40

60


US Exports % YoY 6mma

EU Exports % YoY 6mma

Asia Exports % YoY 6mma

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%


Investment Income Cum. % YoY

-150%

-100%

-50%

0%

50%

100%

150%

200%

250%


Current Account Bal cum. % YoY (SA)

Percent Percent

1313131313

Gravelle Pierre is the Founder and Chief Portfolio Manager of IronHarbor.

[email protected]

Jacqueline Hayot is the Chief Operating Officer of Iron Harbor.

[email protected]

Christopher Nicholson is the Senior Portfolio Strategist of Iron Harbor.

[email protected]

Aditi Thapar, PhD is the Head of Global Economics for Iron Harbor.

[email protected]

Eva Yun is the Senior Markets Analyst of Iron Harbor.

[email protected]

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

Iron Harbor Open Market – Japan (update)

Documents

Transcript of Iron Harbor Open Market – Japan (update)