The S&P 500’s Price to EBITDA has risen from 7.2 at the start of the year to 8.2 now, some 20% above its long term average. Technicals are looking very overbought, economic numbers are grim and commodity prices are pointing to lower demand.

Marc Faber, well known economist and investor said last week…” In the 40 years I’ve been working as an economist and investor, I have never seen such a disconnect between the asset market and the economic reality … Asset markets are in the sky and the economy of the ordinary people is in the dumps, where their real incomes adjusted for inflation are going down and asset markets are going up.”

Can equities really rise any higher? As Keynes famously declared ” the market can remain irrational far longer than you and I can remain solvent.” So yes, but perhaps not for much longer.

The bull case is that optimism can be self-fulfilling. The rise in optimism can get people to start spending and hiring. This in turn could lead to GDP recovery and upgrades in response to lower interest rates and credit spreads, optimism in the banking sector encouraging lending and greater levels of disposable income from lower oil and commodity prices.

But nothing goes up in a straight line and for every quarter of disappointing economic news the chances of a sustained rally become ever slimmer. With investor confidence near record highs and volatility at levels last seen in 2007 one must be very optimistic to remain invested in markets such as these.

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

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.

How long before equities fall?

The Fed’s preferred measure of inflation, the personal consumption expenditure (PCE) deflator, has been declining consistently for a year sitting currently at 1.1%. As CPI usually tracks PCE it is likely that the index will fall towards the 1% mark raising questions from markets on whether the US could fall into a deflationary spiral. The QE impact on markets may finally be coming to an end.

Agricultural commodities, oil and metals, have all been trending lower pointing to weak support from the overall economy. Copper, which typically tracks the S&P very closely, has finally broken down, just as it did in 2007.

With corporate profit margins at record highs it is far more likely that they will revert to the longer term mean rather than continue to expand as is predicted by most Wall Street analysts. Once earnings disappoint a mass re-rating could add substantial pressure to equity prices.

When the penny will finally drop is anyone’s guess but given the odds are increasingly stacked against equity markets and valuations no longer offer easy pickings investors might want to reflect on their equity exposures. 

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.

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!

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.

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!

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.

(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.

The under-employment rate remains above 14%, the employment ratio is the lowest in decades (today’s younger generation will probably be the first to be poorer than their parents), GDP growth has stalled and income inequality is rising. 

The economy is under serious threat.

The Fed’s solution is clear: do whatever is necessary to cheapen the cost of capital enough to encourage savers to invest and cheapen the cost of loans for highly indebted borrowers.

The effects have been striking. Bond yields and mortgage rates have plummeted to historic lows. It has never been so cheap to borrow and never has cash earned to little (cash in facts yields a negative return if adjusted for inflation). So why is the economy struggling to recover?

The way that the Fed has achieved its goal has been through printing enormous quantities of money and then distributing it to holders of Governments bonds, mostly banks. 

So rates have successfully fallen but what has happened to all that cash? Most banks have parked it back with the Fed resulting in little net increase in the supply of money flowing through most people’s hands. Inflation on the whole has therefore, so far, been contained.

But the little capital that has seeped into the real economy has, in fact, caused considerable inflationary effects on some asset prices.

Equity prices have more than doubled, commodity prices have risen substantially as has the general price of food.

So who has won so far? The rich, mostly at the cost of the poor and those retired.

Those closest to the Fed’s printing press are clearly the first to benefit. Banks have been able to unwind a great deal of their highly toxic and irresponsible balance sheets enriching bankers and their clients in the process. But lower income families, those furthest from the printing press, are the worst hit. Not only does the freshly printed money never reach their pockets, but it’s effect on the price of oil and food causes a meaningful reduction on their disposable income.

For as long as current monetary policy is maintained we are likely to see this disparity worsening as income inequality continues to rise. Such direction is not only unsustainable but very dangerous to society as a whole.

The rich might become wealthier in the short term but unfortunately, in the long run, there are no winners.

Once the backbone of society breaks we are very much all losers.

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:

(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.

According to Richard Duncan, author of the brilliant yet very gloomily named book ‘The New Depression“, the answer is very much a yes.

It is time for another ‘Space Age’. As Kennedy announced in 1961 that the US would put a man on the moon, today’s governments should also announce an equally ambitious space project. But instead of sending a man into space, this time our attention should be focused on harnessing the energy that’s out there in space, coming straight from the sun.

Setting a target to get the entire economy fuelled solely by solar power within a specified period could leverage the economy in many ways; such a statement of intent should cause oil prices to fall rapidly resulting in an immediate boost to consumer’s disposable income and reducing the government’s trade deficit. Military spending on energy security in volatile regions would fall, further improving the budget deficit.

Mr. Duncan estimates that a $1 to $1.5 trillion investment over 10-15 years by government (potentially in association with the private sector) would boost jobs in manufacturing, R&D and lead to considerable overseas investment into the economy.

When governments can borrow at 2% for 10 years (and having very willing domestic and overseas central bank buyers of those bonds) it is difficult to argue that such investment would not yield vastly superior returns to the government, the economy and for future generations.

If only politics didn’t have to get in the way…

NRJ