Japan’s Keynesian Crisis

Conclusion: It’s obvious that growth will continue to slow on the island economy. What is becoming more obvious by the day is Japan’s fiscal and monetary policy ineptitude, which, for the first time in recent years is being fully exposed to global investment community. In the report below, we detail how to manage risk around this tragic event.

Position: Bearish on Japanese equities for the intermediate-term TREND. Bearish on JGB’s for the intermediate-term TREND and long-term TAIL. Bullish on the Japanese yen for the intermediate-term TREND; bearish for the long-term TAIL. Bullish on Japanese CDS for the long-term TAIL.

It goes without saying that the situation in Japan is frighteningly tragic and our thoughts and prayers go out to the victims of this crisis, both surviving and deceased.

With that said, the critical risk management task to focus on is determining what to buy and what to sell – and at what levels. To do that, one must have a proactive risk management strategy that understands full well that risk is always “on”.

As Rahm Emanuel famously said in the wake of the collapse of Lehman Bros., “You never want a serious crisis to go to waste.” In the spirit of this quote, we were marginally encouraged by the occurrences in Japanese financial markets over the past two days, as consensus finally starts to come to grips with Japan’s Keynesian Debt & Deficit Crisis

  • The Nikkei 225’s (-16.1%) decline since Friday is the largest two-day drop since 1987 and today’s (-10.6%) drop is the largest since October 2008;
  • Bucking consensus’ “flight to safety” trend, JGB yields backed up across the maturity curve today as investors sold amid speculation of greater supply; and
  • Japan 5Y CDS climbed +26bps to a record 122bps – in spite of the widely held belief that Japan would never default on its sovereign debt obligations. 

Consensus will tell you that this price action is largely driven by hysteria surrounding Prime Minister Kan’s warnings of a possible nuclear disaster just 137 miles north of Tokyo, and, while we agree with that premise to an extent, we don’t think these moves are something to be written off as “panic selling”; nor do we think it’s wise to “buy the dips” here. Some dips are not to be bought – especially those that are broken TRADE, TREND, & TAIL. Today reminds us all that the “flows” work both ways:

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We’ll need to see the prices confirm over the next three days or so before we feel comfortable shorting Japanese equities.   There will be a throng of investors trying to get ahead of the Japanese recovery story, some that will buy the dip on valuation, and a few others that will buy them on the global growth story – which the data now suggests is increasingly eroding.

Of course, there will be an opportunity to get long the Japanese recovery trade eventually. As always, duration matters, however; after the January 17, 1995 Kobe earthquake, Japanese equities lost (-24.7%) before bottoming out nearly six months later on July 3. The Nikkei 225 did not break even until nearly 11 months later on December 7 of that year.

Addressing the point we made earlier, we think this most recent natural disaster serves as a wakeup call to the global investment community regarding the state of Japan’s finances. While certainly not “new news” to our Hedgeyes or to investors such as Kyle Bass and Marc Faber, we do think the broad-based weakness across Japanese asset classes exhibited today suggests that, on the margin at least, the world now understands that Japan is on the fast track to what we’ve termed the “Keynesian Endgame”.

To be clear, the Keynesian Endgame is a scenario whereby Big Government Intervention (known in academic circles as “countercyclical government stimulus”) in the form deficit spending, debt buildup, and cheap money monetary policy fail to produce the desired results. Instead, it produces depressed growth rates, which we have seen from Japan over the past two decades.

It’s important to highlight Japan’s fiscal and monetary policy response to this recent natural disaster and thus its latest contributions to its Keynesian Debt & Deficit Crisis:

Fiscal Response

  • Japan, which has yet to pass financing legislation for the government’s record ¥92.4 TRILLION yen ($1.1T) budget, currently has roughly ¥1.3 TRILLION yen in discretionary funds from the current budget that can be allocated to the recovery efforts;
  • By comparison, the ¥1.3 TILLION is less than half of the ¥2.7 TRILLION the government pulled together in the wake of the 1995 Kobe earthquake. Normalizing for the different JPY/USD exchange rates, current on-hand funding is roughly (-42.5%) smaller than it was sixteen years ago;
  • Going back to the budget specifically, which will take effect in two weeks, proposed measures to finance the budget, including a proposal to raise the consumption tax, were largely the source of recent political tension and the cause of a rift within the DPJ, as well as a growing divide between Japan’s central government with its local government officials;
  • The current natural disaster combined with severely depressed approval ratings for Kan and the ruling DPJ (81% of voters and 75% of local government heads disapprove of the current leadership) all but guarantee there will be no tax and fee hikes to help finance the budget;
  • Much like the US, the Japanese government will potentially face a shut down as early as July once all revenues are exhausted and a potential ¥20 TRILLION of short-term JGB debt is issued via a special provision to cover expenses; and
  • While we don’t think the Japanese government will stop functioning given the need to respond to this latest disaster, we do think its growing inability pay for what it spends will result in an serious acceleration of JGB supply growth over the intermediate-term. This will likely push Japan’s Debt/GDP ratio above 210% in FY11, from the current 208.2% using the most current debt balance and GDP figures. For those that prefer the Debt/Revenue metric, that’s 1,971.7% or 19.7x. 

Monetary Policy Response

  • Given the Japanese government’s inability to adequately fund the relief efforts, the Bank of Japan did exactly what they’ve been doing for years after having been encouraged by the likes of Paul Krugman and many other Keynesian academics (including Ben Bernanke) to “PRINT LOTS OF MONEY”;
  • In the last 48 hours alone, the BOJ created ¥42 TRILLION yen (~$520B) in newfound liquidity and BOJ Governor Masaaki Shirakawa pledged more “aid” should financial conditions warrant it (*i.e. if the equity market continue to plunge);
  • Breaking down the allocations specifically, we see that the BOJ pledged ¥15 TRILLION in same-day funds on Monday and an additional ¥8 TRILLION today after the overnight call loan rate rose to 0.13% from the target 0.0%; ¥5 TRILLION to buy JGBs via reverse repo agreements; ¥5 TRILLION in one-week loans; ¥5 TRILLION in one-month loans; and it doubled the size of its current Asset Purchase Program (think: Quantitative Guessing) to ¥10 TRILLION; and
  • This latest round of Big Government Intervention in attempt to fuel a publicly-levered stock market rally is on top of the BOJ currently monetizing JGB debt at a rate of ¥21.6 TRILLION ($267.2B) annually. 

It’s clear that Japan, much like the US, cannot afford to finance event risk – which includes things like recovery from natural disasters and war. Given, that shifts much of the burden to the central bank to print money. It’s worth noting that this concept is near the core of our bearish long-term thesis on the yen; this recent earthquake and tsunami merely inches Japan closer to a demographic fueled JGB supply/demand imbalance.

Further, one has to wonder how much the Bank of Japan can shower the financial system with yen before people stop bending over to pick them up. To this point, it comes as no surprise to us that only ¥8.9 TRILLION of the ¥42 TRILLION yen offered by the BOJ was actually met with demand from financial institutions. Japan has been in a classic liquidity trap for many years and we don’t expect the BOJ’s latest attempts at printing money to be met with a commensurate pick-up in private sector growth.

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Our view is in sharp contrast to current consensus expectations, as many Japanese investors have been trained to beg for stimulus at the first sign of a market crack after many years of Big Government Intervention. Consider the commentary offered to Bloomberg by the following investment professionals as a gauge of where Japanese investor sentiment is:

“If stocks continue to drop more and the yen gains further, it will probably have an adverse effect on corporate sentiment and household consumption… So the BOJ may need to take further action.” – Norio Miyagawa, senior economist at Mizuho Securities Research and Consulting Co.

“The Bank of Japan is missing the chance of doing something more aggressive… What the BOJ should do now is to anchor investors’ sentiment with accelerated purchases in its program” – Masaaki Kano, chief Japan economist at JPMorgan Chase & Co.

“The liquidity supply was a normal response to make sure the markets function in an orderly fashion. It was nothing more than standard operating procedure.” – Richard Jerram, chief economist at Macquarie Securities Ltd. in Singapore.

Phrases like “normal response” and “standard operating procedure” are exactly why we think the recent bullish bid across the US Treasury curve is supportive of the case for QE3. That is, if UST yields continue to trade below what used to be their intermediate-term TREND lines of support, we’d contend that the bond market is forecasting another round of Quantitative Guessing here in the US.

Of course, we’d expect to see those same yields eventually back up on the inflationary impact of QE3 policy; until that occurs, however, a compressing spread between UST 2Y yields and JGB 2Y yields is bullish for the JPYUSD exchange rate  – on top of any repatriation that will be done by Japanese nationals to help with relief efforts at home.

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Given this setup, we can foresee a scenario whereby the yen continues to appreciate over the intermediate term even in the face of accelerated easing out of the BOJ. For this reason, we think the Japanese yen will continue to strengthen over the intermediate-term TREND. Understanding full well that consensus will likely continue using the same one-factor model of yen up/Japanese stocks down, we remain bearish on Japanese equities over that same duration.

Monitoring the slope of the aforementioned spread and QE3 expectations will be crucial to a timely exit from this position. An additional risk to highlight here is outright intervention in the FX market by the Japanese government – which will come at time when Japan can least afford a weaker currency, given its raw material needs over the intermediate term. For reference, Japanese Import Price growth continued to accelerate in Feb, advancing to +7.6% YoY.

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On the other side of Japanese trade, we expect a continuation of slowing export and manufacturing growth as the damaged infrastructure and rolling blackouts delay both production and shipping – much like we saw in 1995 after the Kobe earthquake.

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Currently, Japan supplies about 20% of the world’s technology products – many of them key components that cannot be done without, such as the silicon wafers used in manufacturing microchips and batteries used in the production of everything from autos to tablet PCs. The lack of Japanese supply on the margin is likely to put upward pressure on technology and industrial input prices globally – a supportive data point for our current short XLI position in the Hedgeye Virtual Portfolio. Recent commentary offered by global multinationals like Boeing Co., Korea’s Samsung Group, Germany’s BMW AG, Sweden’s Volvo AB, and Taiwan’s HTC Corp. (among many others) lend credence to this concern.

All told, it’s obvious that growth will continue to slow on the island economy and that the fiscal and monetary levers that Japan can pull in the event of further crises continues to grow increasingly inadequate by the day.

Risk is always “on”.

Darius Dale

Analyst