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PCE Deflator points to equity market sell-off in 2014

16 Dec

The Personal Consumption Expenditure (PCE) Deflator is a United States-wide indicator of the average increase in prices for all domestic personal consumption. Along with the CPI, it is commonly used as a measure of inflation.

The PCE has very rarely dropped below 1.0%. Global macro-economic forces, however, are pushing the PCE down towards a very dangerous level. As countries battle to devalue their currencies they become more competitive as their goods are cheaper for foreign consumers to purchase. This cheapening of goods leads to downward pressure on the average price of goods.

The recent devaluation of the Yen has is a good example of how this is affecting prices in the US presently. The drop in the Yen has substantially increased the competitiveness of Japanese manufacturers in global trade. As Asian manufacturers struggle to retain market share they also drop the prices of their USD goods. This compounding effect raises serious issues for importing nations such as the United States as their manufacturers become less competitive and consumers become accustomed with the idea that goods will continue to cheapen, hence preferring to save for when they are cheaper than to invest and buy goods today.

The chart below shows that the PCE deflator (in blue) has been dropping consistently for the past 20 months. The yellow line shows the 5-year breakeven rate, a measure of the market’s future expectation of inflation, in this case in five years’ time. The breakeven rate shows that the FED has, so far, been very successful at buoying the market’s expectation of future inflation by promising to keep monetary policy very loose for a long time.

PCE Deflator

The issue, however, is that the enormous quantity of money printed by the FED is not making its way down to consumers. Instead, it has inflated equity markets and created the largest credit market bubble in history. At some stage the perception of the FED’s efficacy in easing will fade and inflationary expectations will fall to more realistic levels.

Equity markets on the edge of a precipice

This could cause a serious re-rating of equities as market participants set more realistic expectations of companies’ future earnings.

The chart below shows that inflationary expectations tend to move in sync with equity market movements.

Breakeven vs SPX

Unfortunately, as seen in the previous chart, inflationary expectations tend to follow the PCE deflator which is most certainly on a downward trajectory.

George Magnus, the well known economic consultant and former chief economist of UBS, recently wrote an interesting article in the Financial Times link highlighting the risks of ever richer equity markets fuelled by monetary easing in a world facing anaemic growth.

Investors should always expect return when taking risk. The current environment doesn’t offer a very rewarding environment for risk takers. Savy investors would be wise to take profits and watch the events unfold from the sidelines.

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.

Move aside Bernanke. Bank of Japan blows away expectations with its boosted QE

5 Apr

On April 4th the Bank of Japan announced an enormous shift in policy and the largest monetary injection ever announced by a major Central Bank. The new governor, Haruhiko Kuroda, had been expected to come up against opposition from other policy members who had been tied to the BoJ’s previous philosophy on monetary policy. The reaction was so surprising not only because of the scale of action in itself, but also because of the approval Mr. Kuroda received from all but one of the nine board members.

The flood gates are not just open, they have been blown away.

In order to change the deflationary expectations so ingrained in the Japanese psyche only a major boost in asset and consumer prices would suffice. This is exactly what the BoJ is trying to do. By committing to doubling 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 compared to the Fed’s 0.5% – the BoJ has very dramatically stated that inflation will no longer elude Japan.

The effects to equity, bonds and the Yen should be sizeable. Indeed, we have already seen a sudden drop in the Yen and, more importantly, a dramatic fall in bond yields of longer duration (up to 40 years), where the BoJ is attempting to remove duration risk from the private sector, hence encouraging investment in real assets. Equities should continue to surge as capital flows away from the bond market but investors should be very wary of inflationary expectations. Should bond yields start to rise the great monetary experiment could very easily end in disaster.

Party while the music plays but beware that the endgame for Japan has been brought meaningfully closer than ever before.

Zombie bond holders

25 Jan

Investors have shown they do not believe Japan will be able to pull itself out of defaltion.

Debt due in 2042 has yields below the central bank’s 2 percent goal, announced this week after a proposal by Prime Minister Shinzo Abe. The BOJ won’t even achieve its previous 1 percent target consistently in the coming five years, according to the gap between rates on bonds indexed to price changes and those on conventional debt. The spread of index-linked bonds, was 0.9 percentagepoint in Japan, compared with 2.2 points in the U.S.

As pointed out by a fixed-income investor,  “the bond market is well aware that the BOJ has no chance of achieving the 2 percent inflation target,” Demand for inflation hedges is very low among domestic investors.”

Japan’s 30-year bonds yield 1.995 percent, compared with 3.05 percent for equivalent Treasuries. The nation’s 40-year debt rate was 2.17 percent, less than the 2.44 percent yield when the bonds were first sold in November 2007.

Its additional yield to 10-year debt has risen since March 2009, reaching a more than four-year high of 1.45 percentage points on Dec. 5 after Abe called on the BOJ to conduct unlimited easing. The spread has stayed below the peak and was 1.44 points yesterday.

It is trued that Japan’s core inflation rate hasn’t been above 2 percent for more than a year since 1992 and has averaged zero over the past two decades. It is also true that Shinzo Abe had has a shot as prime minister and was unable to lift Japan out of deflation. But he now has a blueprint. He no longer has to be unconventional. Simply pushing the BoJ to follow what the largest Central Banks of the world have done is far easier than at any other time in Japan’s deflationary histrory.

Inflationary expectations won’t change quickly, but when they do investors will soon be rushing for the door (a door they won’t ber able to find having not used it for 20 years) causing a severe spike in JGB yields.

Sensible, contrarian investors might find it difficult to identify a better opportunity for the ‘trade of the decade’ than shorting JGB’s!


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