Japanese Outlook: Weaker Currency, Strong Nominal Equity Prices; as Debt Crisis looms

January 28, 2013

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Japanese equities remain depressed and inexpensive, having recently traded for 0.7 of book value and below long term averages. image

Inflation is great for equities, in nominal terms. A copious amount of domestic public debt, and the ability to print, are among the best leading indicators of high or hyperinflations “The way rich countries default is through inflation,” points out Ken Rogoff (2009).

“Speculators, wealthy industrialists who can borrow cheap, debtors like the government, farmers, and those with mortgages have benefitted the most from hyperinflations.” ~ Adam Ferguson, author of When Money Dies.”

An undervalued real estate market and inflation risk provide attractive opportunities to capitalize on this potential inflationary tail event in Japan.

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However, one needs to hedge the currency debasement and sovereign debt risk. For example, recently Japanese equities were up 21% in local currency terms over the past 12 months, but since the ¥/$ fell 14%, real gains were only 7% in U.S. Dollar terms.

The yen has fallen recently, but over the long term, the Yen remains overvalued. Real exchange rate overvaluation is useful for predicting currency market crashes (Frankel and Saravelos, 2011).

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The weaker yen need not lead to a JGB crash right away. For example, a central bank could pledge to buy all securities in excess of some interest rate. In fact, people floated this idea in the U.S. and may do so again if central banks become concerned inflation will drive interest rates up, and governments into a debt crisis.

Surely, central banksters would prefer inflation risk over sovereign debt risk. Regardless, Studies exploring the consequences of currency crashes in industrial economies have shown that currency crashes have generally not led to an increase in bond yields (Gagnon 2009a).

Efforts to create inflation will likely work all too well. Inflation is expected to rise by 40bps for every 10% decrease in the value of the currency, according to Credit Suisse, adding to pressure on JGBs. ~ FT

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Japanese equities are not without their risks; notably, an expected China hard landing, reduced competitiveness, and escalating political tension with China could create several negative shocks along the way.

Since 2002, Japanese export volumes to China are up +76% while they are down -30% in the EU and -27% in the US, highlighting the importance of the Sino-Japanese relationship.

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Weakening exports on anti-Japanese backlash has hurt the current account. Current-account reversals are usually accompanied by sudden stops in capital flows and large exchange rate depreciations, which in turn trigger banking crises ~ De Mello, Pier Padoan, Rousová (2011).

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Financial Times

When the time comes for a crisis in JGBs, Japanese banks will suffer like the European banks did when sovereign yields came under pressure.

Japanese Banks hold JGBs worth 900% of their Tier 1 capital, according to the UK’s Telegraph. Their portfolios would be decimated if long rates punched above 2%.

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One can look at this level as a “tipping point.” Waiting for a trigger to hedge or speculate on a crisis in Japanese Bonds will be too late.

News:

  • “The Course Towards JPY Weakness” ~ Morgan Stanley (pdf)
  • Gold Lures Japan’s Pension Funds as Abe Targets Inflation ~ bloomberg
  • Japan’s Property Prices May Have Fallen Too Much, Nishimura Says ~ bloomberg
  • Japan Defense ministry is to request extra $100 billion budget Increase ~ fx live

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