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Is the Topix just the Yen in disguise??

9 May

Investors love to find deep and academic excuses for the movements of markets, but sometimes things are so obvious they fail to be noticed.

The chart below shows the progression of the Japanese Yen and the Topix over the last year.

Yen and Topix

It is nothing short of remarkable how correlated the two are. One could argue that this makes perfect sense given that Japanese companies become more competitive as the Yen devalues. This is, of course, true, except that according to the World Bank exports of goods and services account for less than 15% of the Japanese economy compared to 50% in Germany. Like the US, where the figure is 14%, Japan relies far more on the domestic market and should therefore have less sensitivity to the weakness in the Yen than most other countries.

So why have Japanese equity markets been so correlated to the Yen?

The most likely answer is that it has been driven by foreign investors keen to profit from Japan’s new inflationary policy. The cheaper the Yen gets, the more USD-based investors can afford to buy Yen denominated equities.

The eventual outcome for Japanese equities could be astronomical. Domestic investors are still sitting on the sidelines, instead sitting on return-free risky government bonds. As inflation picks up, assets flowing out of bonds and into equities could be enormous. Great for equities but very damaging for bonds and the Japanese Government that will have to pay higher interest rates on its monstrous debt pile. This is clearly very bad for the Yen as panic ensues and investors seek safer havens. A currency collapse is, not only plausible, but now increasingly probable.

A long term buyer of Japanese equities could realistically make a significant return, potentially multiple times their initial investment. But only – and this is absolutely crucial – if the Yen exposure is completely hedged. The last thing you’d want is for your stocks to triple yet still lose as the Yen proves to be worthless.


Will Japan experience hyperinflation?

18 Apr

The broad definition of hyperinflation is generally regarded as excessive price rises, usually over 50% a month. Such rises are hugely damaging to economies leading to a huge loss of productivity, severe economic depression and mass unemployment. Central bankers have fought for decades to take control of inflation and, in most cases, have done a very good job.

Now they are acting with complete disregard to monetary theory and ignoring all the valuable lessons of the past. Are we in for the hyperinflationary ride of our lives?

In early April Japan’s Central Bank announced its commitment to double the monetary base over the next two years from 29% to 55% of GDP (Y135tn to Y270tn) – an increase of a over 1% of GDP per month.

Should the newly created currency flow equally throughout the economy and if we assume that all else remains equal, the simple expectation would be that the purchasing power of the Yen should halve (i.e. that the average price of goods should double in Yen terms). This rather naïve analysis assumes the world is simple and equal. People adapt when things change leading to far graver consequences than our naïve analysis would assume.

Investors have picked up on the Bank of Japan’s aggressive stance and have reacted by pumping money into the Japanese stock market, while selling the Yen. The next leg usually involves large institutional investors which, move slower but control enormous assets, selling their bond holdings and using the proceeds to buy equities, both Japanese and overseas, and other real assets where they can protect their purchasing power. Pension funds (who invest over 85% in bonds) are next and finally, the man or woman on the street, who also control vast sums of savings, adapts to the realisation that their risk free assets are in fact return free risks.

This, again, is a very simplistic and perhaps a naïve assessment of possible events, bit given Japan’s immense debt load (total debt is 500% of GDP, gross government debt is 240% of GDP, net debt is 140%) Japan needs to maintain yields at very low levels so they can afford to pay the interest on their debt. A 1% rise in yields would soak up nearly 25% of tax revenues!

Eventually investors will realise that they are lending money for 0.5% a year to a government that is effectively insolvent. If they then begin to worry about inflation they will offload bonds en masse demanding the BoJ to purchase even more bonds to maintain yields at the depressed levels they are today. How do they do that? Print more! And so the self-fulfilling prophecy ensues.

So will Japan experience hyperinflation?

With each stage the crisis deepens and central bank control slips further away. A currency and bond market collapse may seem a slim possibility but the probability of such an event has increased dramatically. In such a case it is likely that Japan would experience bouts of hyperinflation.

Japanese investors who are worried about their savings would be wise to diversify out of Japanese bonds and into overseas bonds and, for the less risk averse, overseas equities, preferably of companies with strong balance sheets that generate strong free cash flow. And, of course, gold!

For those wishing to read further Gordon Long’s post is a fascinating read.

Has gold peaked or is the bull run still underway?

16 Apr

Commentators love simplicity.  Most news sources blame gold’s precipitous fall on the expectation that the Fed will tighten monetary policy soon. If that’s the case, why have bond yields been so muted?

It doesn’t add up.

QE has been supporting numerous assets, the main one being government bonds which have been the main beneficiaries of the newly created dollars. If there was any real risk that the Fed really would stop printing, government bonds would have felt the impact immediately with yields rising sharply.

Given that 10 year Treasury yields actually fell by 4 basis points yesterday to 1.68% there is very little evidence that QE is going away any time soon.

There are a number of reasons for this. The economy continues to stall and unemployment remains persistently high. Until key economic indicators start to improve meaningfully, the Fed has little reason to stop. Ironically, the drop in food and energy prices actually takes pressure off the Fed to end QE soon.

So why has gold fallen so steeply, so fast? Data points to the closing of speculative longs rather than any significant change in demand for gold use in jewellery, which accounts for approx. 45% of gold demand.

Will it continue to fall? The risks appear to point to the upside:

QE is not going away soon (Japan has vowed to double its monetary base over the next two years) and the cost of capital remains at historically depressed levels.
At the current price, producers fail to make a profit on gold mining which should lead to a fall in production.
Central bankers continue to buy (with the possible exception of Cyprus in the short term).
Demand for jewellery in Asia and other emerging markets continues to rise.
Global currency debasement will ultimately lead to inflation.

Gold is a volatile asset but its long term fundamentals remain intact. The canary in the coalmine must be government bonds, so worth keeping yields in check.

Whatever the reason, gold is no Bitcoin!

Japan economy to grow 2.5% in fiscal 2013. Really???

28 Mar

Japan has unveiled its growth forecast for the fiscal year starting in April, saying the economy is on track to expand 2.5% thanks to fresh stimulus and a recovery in key overseas markets.

Prime Minister Shinzo Abe’s cabinet approved the forecast on Monday morning. The government is trying its very best to convince everyone that its monetray stimulus will lead to economic growth.

But can it succeed? The chart below shows that 2% growth was last achieved back in 1996!

Japan GDP

The latest weakening of the JPY could definitely help, but it would need to remain undervalued for some time before its effects were felt in the real economy.

The chart below shows the JPY’s purchasing power parity vs. the USD.


As can be seen, when Japanese GDP was last above 2% the Yen had been undervalued against the USD for some time. The JPY is reasonably close to fair value currently and would need to be nearer  vs the USD at current PPP to have any meaningful effect on the economy.

While inflationary expectations have consistently risen since the credit crisis in 2008, the chart below showing the 7 year breakeven rate in Japan (a measure of inflationary expectations for the next seven years) shows that little has changed since Mr. Abe took office. i.e. no one is yet taking his claims very seriously.

Japan 7 year breakeven

(Source of charts: Bloomberg)

But the tide has started to turn. Tokyo’s new forecast will be used to produce a fresh budget with Abe’s cabinet set to endorse a Y92.6 trillion in spending on Tuesday, Japanese media reported.

The JPY’s rapid decline has left it exposed to a mean reversion in the short term and may well reach the low 80’s in the weeks ahead (at current implied volatiltiy on the USD/JPY short term Yen calls could provide attractive asymmetry should a wider market sell-off take hold). But longer term the Yen will continue to fall substantially and Mr. Abe will succeed in raising the economy – initially – before inflation finally gets out of control, bringin Japan’s endgame ever closer.

Central Banks are seeking to devalue currencies. Will it ultimately destroy trust?

22 Mar

Fiat money is worth nothing without trust. History has shown that the general populace has great distrust of paper money, hence the need for its backing with some form of physical currency such as gold, silver or copper. Yet here we are, with no such backing (the gold standard was abandoned some 40 years ago), and Central Banks appear to be acting with very little regard to the value of trust.

The new Bank of England Governor, Mark Carney wants to adopt more unconventional monetary policies, Ben Bernanke has indicated that the Fed will continue to print and the Bank of Japan’s new governor has set his sights on aggressively tackling deflation through monetary easing. When everyone is so focused on one thing, it is easy to lose sight of what is really going on.

Inflationary expectations have risen consistently over the past three years. Equity markets have more than doubled from the market lows. The top 1% of US earners now account for over 21% of US total income. Inequality, not surprisingly, has risen substantially – see chart below.


(Source: Gini Co-efficient, Bloomberg)

The Gini coefficient is a measure of equality, where 0 corresponds with perfect equality and 1 corresponds with perfect inequality. US inequality has consistently been rising since the 1970’s along with the percentage of top earners that account for a greater portion of total income:

Top earners

(Source: Dylan Grice, The Edelweiss Journal)

Every crisis has a breaking point. That day may still be a long way away, but there is no doubt that we will face greater headwinds down the line.

Dylan Grice, the former global strategist at Société Générale, has recently joined Edelweiss Holdings Limited where he published last week an very interesting report on the value of trust.

The report is very much worth a read and while there is little one can do to prevent the ensuing crisis, there is no harm in being aware of what can happen when trust disappears within a society.

What is inflation?

4 Mar

For those of you wanting a fantastic overview on inflation and what effects it can have on society, you must read Culture and Inflation in Weimar Germany.

Here is a short summary what inflation means:

In economic terms, inflation is a measure of the change of prices for goods and services over a period of time.

Different measures of inflation track different goods and services to give consumers and producers an idea of how the overall price of goods and services they use changes over time.

The three most frequently used measures of inflation are:

  1. The Consumer Prices Index (CPI)
  2. The Retail Prices Index (RPI)
  3. Producer Price Index (PPI)

The objective of all these measures is similar but each will vary slightly and, in different countries, their calculation might also vary a little.

CPI, for example, typically takes into account cheaper alternatives if a specific product get too expensive whereas the RPI does not, hence why CPI is usually lower. In the US CPI includes certain housing costs such as rent whereas in the UK, while RPI takes into account mortgage interest payments and council tax, CPI does not.

In the UK the measures of inflation are calculated by the Office for National Statistics and in the US by the Bureau of Labor Statistics.

Is inflation bad?

It depends who is asking.

Simply put, inflation will erode the purchasing power of your money over time. For example in 1970 $10 would have bought you over 16 Big Macs whereas today it barely buys you 2.

In more general terms, $100 in 1970 had the same buying power as almost $600 today. The Bureau of Labor statistics has an entertaining CPI Calculator to measure how much purchasing power the dollar has lost over time.

So is inflation bad?

As a saver, unless you are able to achieve a level of return equal to the level of inflation, your purchasing power will be eroded over time. Typically, interest rates will be higher than inflation meaning that investors are able to achieve a real return on their cash – i.e. a return, net of inflation, that is positive.

However, in today’s zero interest rate environment, with inflation running at approximately 2%, cash savers will get a negative real return of 2% – i.e. their purchasing power will decrease by 2% a year.

Savers are therefore forced into seeking real returns into real assets that entail risks (such as equities, property etc.) if they are to stand any chance of achieving a positive real return. Not great. But this is exactly what the Federal Reserve is trying to get people to do. By keep real interest rates negative, they force savers into investments that, they hope, will kickstart the economy once again. A risky strategy, but more on that later.

Is inflation good?

As a borrower inflation can have its advantages so long as it does not impact your ability to repay your loan.

For example, let’s assume you get a 30-year $100,000 mortgage to buy a house today. For every year that inflation erodes the value of the dollar, the size of your debt – in real terms – falls. Just like the example above, we can assume that if the next 30 years experience similar levels of inflation to the past 30, the real value of your debt will have fallen by approximately 60%.

Mortgages are usually structured to be paid monthly rather than at the end of the term, so the average fall would be closer to 30%, but the example illustrates very clearly that inflation can aid those who borrow in nominal terms.

I wonder why the Fed would want to spur inflation at this moment in time..? I’m sure it’s got nothing to do with the $16.5 trillion in nominal debt owed by the US government…

Don’t be fooled by the FOMC minutes. QE isn’t going away quite yet.

25 Feb

Last week’s minutes from the FOMC’s January meeting showed divided opinion on the effectiveness of QE and how much longer it should be employed for.

But reading between the lines we can get a clearer view as to why the minutes drew attention to the split and what the resulting policy going forward may be.

Why the attention on the costs of QE?

Esther George, president of the Federal Reserve Bank of Kansas City, voted against continuing asset purchases at the central bank’s January meeting out of concern about “the risks of future economic and financial imbalances,” according to the minutes. Prices “of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels.”

Farmland in the Midwest was up 16% in 2012 (Iowa saw prices rise 20%), according to the Federal Reserve of Chicago, the third largest annual gain since the 1970’s.

Fed Governor Jeremy Stein is concerned with corporate debt as yields reach record lows, driven ever lower by investors seeking any form of yield. Equity markets have seen a significant rise, the S&P 500 is up almost 40% since October 2011, raising questions as to who is benefiting the most from the Fed’s ultra-loose monetary policy.

So what is the message between the lines?

In 2010 Janet Yellen  was asked to chair a new FOMC communications subcommittee to focus on central bank transparency to minimise confusion over Fed policy.

But its purpose extends far beyond that of providing markets with a transparent message. Instead, it has allowed the Fed to utilize communication as a further tool;

Communicating that certain members are concerned by specific financial imbalances enables the Fed to highlight that it is aware of these imbalances and can act if it needs to. Emphasising this concern can, they hope, dampen excessive speculation in certain areas without affecting the overall policy objective of maximising employment while maintain price stability.

Unemployment remains persistently high. The Bureau of Labor Statistics U6 unemployment figure, which unlike the reported unemployment number (U3), includes discouraged workers and those who would like to work, either full-time or part-time, but cannot due to economic reasons, is at 14.4% – some 40% above the long term average (see chart).

US unemployment U6

(Source: Bloomberg)

Inflationary expectation remain subdued. The attached chart, published in The Economist, shows that 10 year breakeven rates remain low, although Japan has seen a meaningful rise since 2011.

Breakeven rates

(Source: The Economist)

The message remains clear: until proof begins to emerge that economic figures truly reflect an improvement in the economy we will see very little change from Fed policy. Unless you believe that the fed’s communication tool can effectively dampen asset price bubbles, risk assets have some way still to go.

Trust, hyperinflation and the end of the dollar

13 Feb

Economists love debating the reasons for inflation. Many argue that money supply alone can result in inflation, whereas others believe it is down to capacity constraints in an economy or advancements in technology. The reality is that the causes of inflation are immensely diverse and one reason is never the sole contributor, nor is there a unique common cause of inflation in previous hyperinflationary times.

Instead, hyperinflation is typically caused by a very severe exogenous shock, that then usually forces policymakers to take overly aggressive action in order to overcome their difficulties.

War, the collapse of regimes and currency pegs all feature as severe shocks in previous cases of hyperinflation. Clearly we have none of these yet, but the credit crisis was as close to a severe shock as one could possibly imagine. And how have policymakers responded? Br printing money. We are now 5 years into the crisis and the rate a which central banks globally are printing money is only accelerating.

So why haven’t we seen hyperinflation yet?

It takes time. For the last 40 years Monetary supply in the US (M2) has been growing at an average pace of about 6.75% a year vs. average annual inflation of 4.3%. Clearly the increasingly efficient economy and advancement of technology of the past 40 years have been deflationary enough to keep the CPI below money supply. John Edwards, of Shadowstats, argues that M3 is a better indication of inflationary expectations but sadly the US stopped reporting this some years ago.

m2 and cpi

In any case, if we overlay the monetary base chart over the M2 chart, it is clear that 4 years ago these decoupled SUBSTANTIALLY! This is the effect of QE which has essentially flooded the US monetary base with newly created dollars. It takes time but this will eventually feed through to M2.

monetary base and m2

As it does feed through, prices have to re-adjust (i.e. rise) as people’s perception of the value of that currency diminishes. As trust in a currency’s value disappears, so do people’s willingness to hold onto it, opting instead for alternative currencies or real goods such as property, gold etc, once again compounding the effects of rising prices. And so the spiral goes.

I have no doubt the FED intends to halt QE before we get close to this. But as every episode in history has suggested once the floodgates are opened it is very very difficult to close them again.

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Could hyperinflation in the US be a reality?

11 Feb

Since 2007 the Federal Reserve has expanded its balance sheet by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years.

Like the Fed, many of the world’s central banks have employed the unorthodox (yet now very conventional) monetary policy known as quantitative easing. It is impossible to know what the effects might have been if no intervention had taken place – and policymakers do at least deserve some credit for attempting to tackle the enormity of the credit crisis – but nothing hides the fact that QE is one enormous experiment that could undermine the trust in the perceived value of paper money.

Most cases of hyperinflation occur when governments abuse their trust and monopoly over currency issuance. As pointed out by Reinhart & Rogoff in their excellent book, “This time is different”, a systematic analysis of the data set show that inflation crises and exchange rate crises have travelled hand in hand in the overwhelming majority of episodes across time and countries. Combine this with the fact that most crises are associated to excessive levels of debt (the US national debt now stands at $16.5 trillion, a very excessive 103% of GDP) and we are left with a nasty combination of factors that could have severe consequences for the US dollar.

debt to gdp dec 31

Source: Zerohedge

The economy encompasses such a huge set of variables that determining its precise direction is clearly impossible. Many economists and analysts actually predict deflation as a result of consumers saving more and spending less to reduce the record levels of leverage that has been built since the 1970’s. Others use Japan as the example of a nation that attempted QE and is still mired in inflation.

True Japan attempted QE (although it dwarfs in comparison to the Fed’s QE) and yes consumers will save more. But the crucial and vital point is that the value of a $100 note will only persist for as long as consumers believe its value will hold. No central banker in history has ever attempted to produce hyperinflation. They have all attempted to print money as a short term measure to help fund wars, reparations and… to debts. They all believed they could end it as easily as they started it.

Unfortunately 800 years of financial crises tell us otherwise.

What is the best hedge against hyperinflation in Japan?

28 Jan

With the BoJ entering the Currencies War, how can investors protect their capital?

Will gold act as a decent hedge??

It’s a boring old story now and despite the rally of recent years gold remains one of the most attractive hedges against the destructrion of Fiat currencies.

Take a look at the Gold chart below, which is priced in Yen as opposed to USD. Although the Yen has strengthened against most major currencies, its value has actually fallen against gold consistently over the past 5 years.

Gold in JPY

(Source: Bloomberg)

Bear in mind that this has actually been a period of deflation for Japan. The chart below shows the 7 year breakeven rate in Japan (a measure of inflationary expectations for the next 7 years).

Japan 7 year breakeven

While inflationary expectations have risen consistently since the bottom of the credit crisis, they have actually changed very little since Mr. Abe took office. This implies that investors have little faith in his ability to encourage economic growth, but beware. Mr. Abe is very serious about fighting deflation and will do all he can. In fact, many of the world’s key central bankers have raised concerns that the Japanese government will force its own monetary policy on the supposedly independent Bank of Japan. With the election of the new BoJ governor in April all is possible.

The Nikkei as a hedge to hyperinflation?

Japanese banks and pension funds are loaded with Japanese Government Bonds. With 10 year yields on JGB’s at 0.73% these investors will be forced to look elsewhere for real returns. Having been scarred by the equity markets for the last 20 years, pension funds, which hold about 10% in equities, might finally start to buy equities but this will take time. They won’t start buying en masse until the Nikkei is way over 25,000. If inflation really hits, it will go well beyond that. Didn’t Dylan Grice at SG predict 68,000,000 for the Nikkei??

But as an overseas investor, don’t be fooled into thinking that the Nikkei will prove to be a great investment. While you might double your money in Yen, hyperinflation will considerably erode the purchasing power of the Yen causing a steep decline in its value against other currencies. So as a dollar-based investor, for example, you might actually lose.

Japanese equities do seem cheap and hyperinflation will siginificantly raise the nominal prices of equities, but investors should hedge all their Yen exposure to ensure they don’t lose out.

If expectations of further QE by Japan materialise (very possible with a new ‘government friendly’ governor at the BoJ in April) gold could rise substantially, and not only in Yen.

This clearly has implications for Japanese investors, but given the enormous size of the country’s savings (most of it invested in Japanese government bonds), once this enormous wave of savings changes course in search of real assets, its effects will be far far reaching.

The gold rally could be just beginning.


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