***After receiving feedback from several clients, we’ve decided to make some fairly dramatic changes to our weekly risk monitor products. We hope you enjoy the new, more in-depth format whereby we focus solely on the three key risks we think will most impact your respective portfolios to the upside or downside. We encourage you to follow up with questions/comments/concerns and/or if you’d like to dive deeper into a theme or topic that you may or may not see below.***
Virtual Portfolio Positions in Asia: Long Chinese equities (CAF); Short Japanese equities (EWJ).
Japan’s Eroding Current Account Bodes Poorly for Long-term JGB Demand
Japan, whose local-currency sovereign credit profile cites the tailwind of a persistent current account surplus, saw the figure fall to a 15yr-low of 2% of GDP in 2011. This is a very important statistic because it directly calls into question Japan’s ability to be a net creditor nation in perpetuity.
Japan’s eroding current account is one of several key long-term tailwinds for JGB demand that look to inflect in the months ahead – putting a noteworthy level of Japanese sovereign credit risk on the table for, really, the first time ever in 2012. The others include:
- An acceleration in long-term inflation expectations as the BoJ looks to dramatically step up its share of JGB ownership (from 8.5% of total outstanding currently) by ether printing new banknotes or altering their mandate;
- A potential sovereign debt downgrade(s) to A+, which will trigger capital raises across the Japanese banking system to the tune of ~$80 billion; and
- A realization by market participants that the Diet has no credible plan for fiscal consolidation – in the face of a world-beating $3.2 trillion financing refinancing schedule for CY12. Further, staunch political gridlock will prevent any meaningful reform(s) from passing through the legislative process – per recent public statements from key policymakers in both leading parties (DPJ and LDP).
Turning back to Japan's current account dynamics, the country posted an annual trade deficit in 2011 for the first time since 1980 (-$32 billion) – with weakness not being singularly driven by the MAR '11 tragedy. Recall that both Japanese exports and industrial production growth came in flat-to-down from a YoY perspective throughout the entirety of 4Q11.
While investment income more than offset the precipitous decline in the trade balance, the dramatic slowing of foreign inflows from a trade is worrying in that there appears to be little respite on the horizon from a long-term perspective. To that tune, the trend of Japanese corporations off-shoring manufacturing production amid persistent currency strength (JPY up +56.8% vs. the USD over the previous five years) looks to continue accelerating (email us for company-specific details).
The swing into deficit territory from a trade balance perspective was also driven by an -85% decline in power generation from the country’s nuclear generators (34,417 megawatts pre-quake/tsunami vs. 5,058 in mid-JAN ‘12), which forced Japan to import energy products in size. All told, Japan lost roughly 25% of its total power-generating capacity as a result of the MAR ’11 tragedy.
Today, only three of the nation’s 54 nuclear reactors are in operation, with little political will to turn them back on as the nation shifts its energy policy towards more renewable energy generation – one of the three preconditions to convince former Prime Minister Naoto Kan to step down in AUG ’11.
Looking ahead, these growing headwinds facing Japan’s current account dynamics are unlikely to inflect in any material way, given that Japan needs a strong yen to limit the cost of energy imports. That will continue to put pressure on the country’s ability to be a manufacturing and export economy going forward, slowing domestic growth and weigh on the sovereign’s ability to tax its economy. Currently, Japan relies on debt issuance to fund nearly half (49%) of all expenditures. Expect that figure to continue to make all-time highs going forward.
***If you have not yet seen our Japan’s Jugular 2.0 presentation, please email us and we’ll get it over to you promptly.***
Chinese Inflation Data Complicates Domestic, Global Growth Outlook
Growth Slows as Inflation Accelerates – period. Only in an Ivy League introductory macroeconomics textbook is faster inflation a precondition for sustainable economic and employment growth – of course, following the chapter whereby currency devaluation strategies are professed to boost GDP via export competitiveness.
China – where Keynesian economics are far less in vogue than in Washington D.C. – saw its headline CPI reading accelerate to +4.5% YoY in JAN from +4.1% prior. While Lunar New Year distortions may have contributed to the gain, the +3.4% increase in Brent crude oil prices during the month also “fueled” a sequential uptick (+1.5% MoM vs. +0.3% prior).
As we have articulated in many notes over the past six months, China is not particularly close to cutting interest rates and the JAN inflation reading + the potential for another round of The Bernank Tax will not sit well with the PBOC. Both the data and China’s sovereign debt market + interest rate swaps markets agree with our long-held conclusion that a Chinese rate cut(s) continues to be uncomfortably out of reach – so much so that the likely acceptance of this viewpoint prompted Singaporean Prime Minister Lee Hsien Loong to say earlier this week that “China’s economy may be headed for a rough landing”.
China delaying any meaningful monetary easing takes away a key supportive catalyst for global growth in the intermediate term. In the near term, China’s JAN economic growth data was actually quite bad (again, accepting some level of Lunar New Year distortions):
- Exports: -0.5% YoY vs. +13.4% prior
- Exports To EU: -3.2% YoY vs. +7.2% prior
- Exports To US: +5.5% YoY vs. +11.9% prior
- New Loans: +738.1B MoM vs. +640.5B prior
- YoY: -29.2% vs. +33.2% prior
- Slowest pace of JAN MoM credit expansion in five years
- M2 Money Supply: +12.4% YoY vs. +13.6% prior
All told, we can’t help but take the view that consensus is continuing to dramatically misinterpret slowing Chinese economic data as a catalyst for monetary easing. Refer to our JAN 17 note titled, “China, With Context” for more details behind our conclusion.
The Bernank vs. Asia: Interest Rate Duel
We introduced the following equation back in a NOV 2010 research note to describe how the Fed’s policies inflate would impact a globally-interconnected economic system:
Quantitative Easing = accelerating inflation [globally] = monetary policy tightening [globally] = slower growth [globally]
This equation is particularly predictive for emerging markets, where the food and energy components of headline CPI readings garner more weight than their developed market counterparts.
In the second full week post the Fed’s pledge to maintain ZIRP through 2014, we’ve already seen a couple of noteworthy shifts in the scope for Asian monetary policy, most notably South Korea and Australia’s decision to hold off lowering their benchmark interest rates after dovish talk and/or previous rate cuts.
From a market signaling perspective, we see that 1yr O/S interest rate swaps are pricing in less monetary easing across various Asian economies (based on spreads relative to benchmark interest rates) – a trend that, while intact from roughly the start of the year, is only perpetuated by The Bernank Tax:
For reference, Indonesia, which the lone outlier in the previous chart, saw its equity market close down -2.6% wk/wk into and through a -25bps rate cut to 5.75%. The Jakarta Composite was only equity index in the region to close the week lower (-2.6% vs. +1.1% wk/wk on a regional median basis). Its currency also suffered amid this potentially lax monetary policy decision, closing down -1.2% wk/wk against the USD vs. a regional median of -0.8%.
Asian currencies as a whole, which are up +2.5% vs. the USD on a median basis in the YTD have been recently outperforming food and energy prices, on the margin, from a YoY perspective – a trend that has been supportive of slower CPI readings across the region. We expect this trend to reverse and re-inflate Asian CPI and PPI readings in the coming quarters if Qe3 is explicitly pursued:
The quantitative setup in the U.S. Dollar Index will continue to tell you all that you need to know regarding whether or not the risk of Qe3 is real or merely hearsay: