RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS”

Takeaway: We remain bearish on the Japanese yen and Chinese financials stocks with respect to the intermediate-term TREND and long-term TAIL.

SUMMARY BULLETS:

 

  • To quickly get up to speed on our bearish bias on the Japanese yen, please review the following two research notes: “THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN” (NOV ’12) and “REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS” (JUN ’13).
  • To be clear, Japan has already experienced a currency crisis (as defined by a peak-to-trough decline of -20% vis-à-vis the USD). And, as the title of the latter note would suggest, we think the there is more downside to come with respect to the intermediate-term TREND and long-term TAIL. Sell-side consensus is at 110 on the USD/JPY cross for EOY ’14; we expect them to once again be dragged up by last price towards the ~125 range over the intermediate term as monetary policy at the Fed and BoJ continue to diverge at the margins.
  • A dwindling current account surplus and a compressing real interest rate differential will also put pressure on Japan’s currency from an FX flows perspective. Consensus expects Japanese real 2Y rates to average -1.8% in 2014 (down from 0.1% in 2013E), which compares to -1.1% the for the US (flat vs. 2013E). Our bearish bias on China’s fixed assets investment bubble keeps our expectations for a rebound in Japan’s export earnings rather muted.
  • To review our bearish bias on Chinese financials stocks, please review the following two pieces of research: “ARE YOU SHORT CHINA [AND OTHER EMERGING MARKETS] YET?” (deep-dive presentation) and “EARLY LOOK: UNCERTAIN CHINA” (cliff-notes version).
  • We think the outlook for Chinese credit growth is structurally impaired as the rate of incremental liquidity slows as a result of declining inflows of foreign exchange and/or declining corporate profit growth. Moreover, we anticipate that growth in non-performing loans will accelerate sustainably over the long term – regardless if they are reported or not. In fact, delaying the natural charge-off cycle will only slow Chinese growth even further, as incremental credit is diverted away from marginal economic activity towards servicing existing debt. Lastly, we believe that net interest margins across the Chinese banking industry face immense regulatory headwinds that may ultimately have dire consequences for China’s fixed assets investment bubble. The confluence of these three factors should perpetuate a reflexive cycle of slower earnings growth and depressed valuations for Chinese banks.
  • Contrary to the title of the latter note, we think the outlook for Chinese growth is rather certain – sustainably slower.China’s 10Y GDP growth targets are set in stone and policymakers across the fiscal and monetary policy spectrum continue to talk down market expectations for economic growth over the intermediate term. Regarding the aforementioned 10Y growth targets, it’s interesting to us to see the Politburo stick to their “doubling of 2010 GDP by 2020” as the baseline target amid their economic rebalancing agenda. That means China’s nominal GDP only has to compound at +6.4% per annum from here in order to reach the CNY80.3 trillion target by 2020. Either the target is going to be revised meaningfully higher in the coming years, or consensus needs to dramatically rein in its structural outlook for Chinese economic growth.

Our Macro Team is represented via three positions within our firm-wide Best Ideas product: SHORT Japanese Yen (FXY), SHORT Chinese Financials Stocks (CHIX) and SHORT Emerging Market Equities (EEM). We obviously have a number of other fundamental biases – such as LONG US Dollar (UUP), LONG US  Financials Stocks (XLF) and SHORT Emerging Market USD Debt (EMB) – that were outlined most recently on our 3Q13 Macro Themes call (see slide 11 for the full list).

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 1

 

Having just published a detailed research note updating clients on our EEM short bias this past Friday, we’ll focus this note on our views on the Japanese yen and Chinese financials stocks (specifically banks and property developers) from here.

 

QUANTITATIVE SETUP

From a quantitative perspective, both the JPY and Chinese financials stocks remain broken across all three of core risk management durations. In Hedgeye speak, that essentially means day-traders, trend-followers and long-term investors are all being forced to react to the same [bearish] PRICE/VOLUME/VOLATILITY signals.

 

In addition to perpetuating a negative feedback loop in the marketplace, a Bearish Formation in any security or asset class essentially means that there is no real support to the prior closing lows. From a mean reversion perspective, that’s roughly +10-25% higher on the USD/JPY cross and roughly -30% lower for Chinese financials stocks (using the CHIX ETF as a proxy).

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 2

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 3

 

A REVIEW OF RECENT FUNDAMENTAL CATALYSTS

In Japan:

 

  • The LDP took the Upper House in a firestorm (the LDP-NKP coalition is projected to claim a total of 135 of 242 seats), as expected. Now it’s on to the next series of catalysts for the LDP and its Abenomics agenda. Specifically, a slew of economic and fiscal reforms – including reducing the corporate tax rate, delaying the 2014 VAT hike, broader fiscal consolidation, labor market liberalization, etc. – will be debated by Japanese policymakers over the intermediate term.
  • This is  as good as an opportunity for meaningful reform as Japan has had in many years, so we have very high expectations that something grand will be introduced. We expect that to be positive for sentiment across Japanese financial markets, as well as for economic growth expectations throughout the Japanese economy. In this scenario, we expect Japan’s household sector to allocate financial assets to equities (currently 6.8% of the total), at the margins, in lieu of cash and bank deposits (currently 55.2% of the total, which are traditionally then intermediated into JGBs). All that being said, a failure for the Nikkei and USD/JPY to make new YTD highs pre/post any major announcements on the reform front(s) would be an ominous sign as it relates to investor, corporate and consumer enthusiasm for Abenomics.
  • With a likely improved consensus outlook for growth among global investors and Japanese corporates, we expect Japanese inflation expectations (via 5Y breakevens, which peaked at 1.84% in MAY and are now trading at 1.13%) to resume their upward trend after making a higher-low in recent weeks; that should drag the dollar-yen rate up with it in the process.

 

In China:

 

  • One by one, Chinese policymakers continue to guide the market towards its structurally slower economic growth targets. As highlighted by our previous work, China’s GDP growth potential is structurally impaired relative to the previous cycle due to a confluence of slowing credit growth that itself is a function of declining marginal liquidity and rising NPL’s – which continue to go largely unreported (1% recorded for 1H13).
  • Scrapping the interest rate floor will structurally compress NIMs as SOE borrowers demand a lower cost of capital, while the PBoC’s explicit admission of the risks associated with scrapping the deposit rate ceiling all but confirms our view that the Chinese economy is essentially one grand experiment with levered financial repression. A potentially higher cost of bank capital – in real terms – will put pressure on the ponzi scheme nature of China’s on-and-off-balance-sheet investment vehicles (LGFV debt and WMPs in particular) that tend to be rife with maturity mismatches.
  • Interestingly, the PBoC’s recent decision to heighten statistical scrutiny of China’s banking industry will make it harder for banks to raise cheap equity capital to extent they have to raise capital to maintain current CARs (as much as $50-100B is required over the next 2Y, per ChinaScope Financial estimates).

 

STRUCTURAL OUTLOOKS

Abenomics:

 

  • To quickly get up to speed on our bearish bias on the Japanese yen, please review the following two research notes: “THINKING THROUGH A POTENTIAL CURRENCY CRISIS IN JAPAN” (NOV ’12) and “REMEMBER, WE’RE IN THE VERY EARLY INNINGS OF ABENOMICS” (JUN ’13).
  • To be clear, Japan has already experienced a currency crisis (as defined by a peak-to-trough decline of -20% vis-à-vis the USD). And, as the title of the latter note would suggest, we think the there is more downside to come with respect to the intermediate-term TREND and long-term TAIL. Sell-side consensus is at 110 on the USD/JPY cross for EOY ’14; we expect them to once again be dragged up by last price towards the ~125 range over the intermediate term as monetary policy at the Fed and BoJ continue to diverge at the margins.
  • A dwindling current account surplus and a compressing real interest rate differential will also put pressure on Japan’s currency from an FX flows perspective. Consensus expects Japanese real 2Y rates to average -1.8% in 2014 (down from 0.1% in 2013E), which compares to -1.1% the for the US (flat vs. 2013E). Our bearish bias on China’s fixed assets investment bubble keeps our expectations for a rebound in Japan’s export earnings rather muted.

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 4

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 5

 

Xi-Li-Nomics:

 

  • To review our bearish bias on Chinese financials stocks, please review the following two pieces of research: “ARE YOU SHORT CHINA [AND OTHER EMERGING MARKETS] YET?” (deep-dive presentation) and “EARLY LOOK: UNCERTAIN CHINA” (cliff-notes version).
  • We think the outlook for Chinese credit growth is structurally impaired as the rate of incremental liquidity slows as a result of declining inflows of foreign exchange and/or declining corporate profit growth. Moreover, we anticipate that growth in non-performing loans will accelerate sustainably over the long term – regardless if they are reported or not. In fact, delaying the natural charge-off cycle will only slow Chinese growth even further, as incremental credit is diverted away from marginal economic activity towards servicing existing debt. Lastly, we believe that net interest margins across the Chinese banking industry face immense regulatory headwinds that may ultimately have dire consequences for China’s fixed assets investment bubble. The confluence of these three factors should perpetuate a reflexive cycle of slower earnings growth and depressed valuations for Chinese banks.
  • Contrary to the title of the latter note, we think the outlook for Chinese growth is rather certain – sustainably slower. China’s 10Y GDP growth targets are set in stone and policymakers across the fiscal and monetary policy spectrum continue to talk down market expectations for economic growth over the intermediate term. Regarding the aforementioned 10Y growth targets, it’s interesting to us to see the Politburo stick to their “doubling of 2010 GDP by 2020” as the baseline target amid their economic rebalancing agenda. That means China’s nominal GDP only has to compound at +6.4% per annum from here in order to reach the CNY80.3 trillion target by 2020. Either the target is going to be revised meaningfully higher in the coming years, or consensus needs to dramatically rein in its structural outlook for Chinese economic growth.

 

RISK MANAGING “ABENOMICS” AND “XI-LI-NOMICS” - 6

 

THE OTHER SIDE(S) OF THE TRADE(S)

Below we outline the three most probable counter-catalysts we’d need to see occur prior to closing either of these positions.

 

USD/JPY (up +28.2% since we introduced our bearish bias back in SEP ’12):

 

  1. TREND support on the USD/JPY cross is violated to the downside and is subsequently confirmed.
  2. A Japanese bureaucrat (either at the Cabinet Office or BoJ) extends the duration in which the LDP’s +5% “monetary math” targets are to be met, thus effectively narrowing the scope for aggressive easing out of the BoJ with respect to the intermediate term.
  3. The rolling 3M trend in US economic growth needs to inflect to the downside, which is becoming increasingly probable now that crude oil is back in a Bullish Formation. We’d likely see commensurate weakness in domestic interest rates as expectations for Fed tapering are reigned in. A violation of TREND support for the US Dollar Index and the 10Y Treasury Yield would likely front-run and confirm such expectations.

 

Chinese financials stocks (CHIX is down -8.3% since we introduced our bearish bias on JUN 7):

 

  1. TREND resistance for the CHIX is violated to the upside and is subsequently confirmed.
  2. In the event of a marked acceleration to the downside with respect to Chinese economic growth, either the Politburo introduces a meaningful stimulus package or the PBoC lowers its benchmark policy rates and/or RRRs in a meaningful-enough fashion to reinvigorate liquidity across the Chinese banking system.
  3. Either Central Huijin or the MoF introduces a policy to protect bank share prices ahead of what is a likely to be another dramatic round(s) of capital raises.

 

Obviously, we don’t view either of these counter-catalysts as being more probable than the aforementioned structural outlooks we laid out above, so we’re still going strong in both positions. As always we’ll let know you if that changes in real-time.

 

That’s about as much certainty as you’ll ever get from us. In fact, recent experience has hardened our view that consistently outperforming the field in Global Macro risk management requires a daily embracing of said uncertainty.

 

It’s not sexy, but neither is not getting blown up!

 

Darius Dale

Senior Analyst


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