Conclusion: The Japanese sovereign debt markets are beginning to look stressed, as noted by CDS that have widened (particularly versus the rest of Asia), as the re-financing needs of the Japanese government accelerate in 2012. As such, we believe the massive issuance on the horizon for Japan sovereign debt will continue to limit economic growth, over the TAIL, which is negative for Japanese equities.
Position: Short Japanese equities (EWJ)
Earlier today, Keith shorted Japanese equities in our Virtual Portfolio. Adding this risk exposure is a continuation of our long-term bearish research thesis on Japan (Japan’s Jugular), which we published a presentation on in 4Q10.
In addition to that work, we’ve published detailed analysis of the puts and takes of Japan’s banking system and its exposure to JGB risk – which is on the table in a major way in 2012, as the economy has to roll over 30.9% of its QUADRILLION-plus yen sovereign debt balance via redemptions and new issuance this year. To the later point, new issuance is expected to cover 49% of all expenditures – a record high.
Thoughtful analysis of the aforementioned puts and takes has kept out of the way of the short side of the JGB/JPY markets, unlike other notable Japan bears. That said, our propriety analysis suggests that the Japanese banking system may be on the hook for over $80B in capital raises should Japan be downgraded to an A+ equivalent by two of the ratings agencies (using Basel II standards). Currently, both Fitch and Standard & Poor’s ascribe a negative outlook to the country’s LT sovereign debt. This potential headwind may erode what is the main structural demand tailwind for the JGB market (surplus liquidity in the banking system).
Ironically, our models have Japanese real GDP growth accelerating through 2Q12E, as the country comps up against one of the worst natural disasters in modern history. We think being long Japan for that trade is the kind of investment that can sucker in those that fail to do enough of the background work. As such, we are taking the other side of this obvious (and consensus) tailwind and are electing to trade Japanese sovereign debt tail risk with a bearish bias for now.
As always, we are happy to follow up with further analysis. Email us if you’d like to start a dialogue on the subject.