“The Death of Active Management” Just Accelerated
Q: What happens when stocks go up every day, across sectors, style factors and countries?
A: Volatility collapses and variance (i.e. return dispersion) disappears.
Q: What happens when there’s a globally coordinated Central Plan to inflate asset prices – effectively crushing volatility and variance in the process?
A: Asset prices inflate on thinner and thinner volume as investors increase their allocations to passive index exposure in lieu of active management, at the margins.
Q: What happens when there’s a globally coordinated beta chase facilitated through the rise of relatively liquid investment vehicles like ETFs?
A: Asset prices surge higher, forcing active managers to take on leverage and/or liquidity risk in order to keep pace – effectively calling into question the very need for active management in the first place.
We’re not trying to be trite about this. We won’t mince words either.
In that spirit of being frank, anyone who thinks the pension fund industry, retail investors and/or sovereign wealth funds aren’t seriously reconsidering how much they are willing to pay “2&20” or even 60-75bps (for a mutual fund) for exposure to a subpar return profile is smoking peyote.
In fact, the latest data would seem to suggest they are shunning active management at an accelerated pace across the globe: http://www.efinancialnews.com/story/2014-10-29/two-major-pension-funds-railpen-bt-pension-scheme-join-hedge-fund-pullback.
Obviously, we are in the business of servicing active managers so we do not approve of the risk central planners are imposing upon our livelihoods any more than you do. We are all in this [sinking] boat together…
Back to Japan… What a Freaking Disaster
At ~7pm on Friday evening (assuming anyone is even at their desks still “actively” managing risk), you probably don’t need me to rehash what happened in Japan overnight.
In short, the BoJ surprised investors by expanding its QQE program to an annual target of ¥80T (up from ¥60-70T prior) – just hours before the $1.2T Government Pension Investment Fund of Japan (GPIF) announced widely telegraphed changes to its target asset allocations:
- JGBs: 35% from a target of 60% prior
- Foreign Debt Securities: 15% from a target of 12% prior
- Japanese Equities: 25% from a target of 12% prior (NOTE: GPIF already has 17% of its assets in Japanese stocks, so the delta is less incremental than widely assumed)
- International Equities: 25% from a target of 12% prior
It’s hard contextualize how out-of-left-field this contested move by BoJ Governor Haruhiko Kuroda truly was (5-4 vote, to be exact). Our proprietary monetary policy and currency war models – which are far and away the most robust tools on the Street – suggested Japan had a fair amount of hay to bale in order to justify incremental easing – something Kuroda himself even agreed with us on just days ago!
Alas, as our early-2013 profile of the man clearly outlined, Haruhiko Kuroda has always been an outspoken proponent of “shock and awe” monetary easing. With the JPY down -2.8% vs. the USD and the Nikkei up +4.8% on the day, it’s clear to say he achieved his targeted shock value.
Interestingly, GPIF has to divest itself of ~¥30T in JGBs – the exact amount of the BoJ is targeting for its increased purchases. It’s also worth noting that the BoJ’s plan to now target ¥8-12T in JGB purchases per month is roughly in line w/ the Finance Ministry’s ~¥10 of net issuance per month. The BoJ is already the largest single owner of JGBs, at about 21% of the float.
Let’s follow the bouncing ball here…
Debt monetization = currency debasement:
Currency debasement = rising inflationary pressures; it’s worth noting that mineral fuels account for only 34% of Japanese imports (w/ crude oil accounting for roughly half of that total):
Rising inflationary pressures = an eventual rise inflation that threatens to slow Japanese consumption growth even further than it already has:
All told, yet another recession in Japan is not out of the band of probable outcomes over the intermediate term in the context of the recent loss of sequential economic momentum across a variety of key indicators:
Lots of red developing in the left-most columns of that table indeed.
We’ve Never Been in the Japanese Hyperinflation Camp, But the Risk Is Indeed Rising
To top that all off, the consumption tax is scheduled to get hiked by another +200bps on April 1st, 2015 and both Finance Minister Taro Aso and BoJ Governor would like things to proceed as planned.
The upside risk (to the economy) is that Shinzo Abe caves into rising political pressure stemming from a recent pullback(s) in public support for his cabinet and pushes out the fiscal tightening to some distant year.
In most cases, a lack of fiscal sobriety in Japan is a non-event. But now with such a large investor exiting the JGB market, on the margin, (and others sure to follow) and with Japan careening towards becoming a net capital importer, Abe backing away from his plan to halve the primary balance deficit by FY15 risks a loss of faith in the sustainability of the JGB #Bubble.
Who's at risk of having to blow out of their JGB exposures?:
- Banks, which are over-allocated due to persistent surplus deposits: 35.5% of the float
- Insurers: 19.3% of the float
- Public Pensions: 6.4% of the float
- Pension Funds: 3.4% of the float
- Foreigners: 8.5% of the float
- Households: 2% of the float
This we now know for sure: the more sellers of JGBs that emerge, the more the BoJ is likely to step up its role as a provider of liquidity in that market.
That risks triggering a pseudo-hyperinflationary spiral in the Japanese yen and, as it relates to the sustainability of the Japanese economy and everything we discussed above regarding active management, this chart all but confirms our fears:
Ladies and gentlemen, we are now fast approaching the other side of our then-bullish [contrarian] thesis on Japanese equities we introduced roughly two years ago.
Investment Conclusion: Remain Short of Japanese Equities and Long of the Japanese Yen… For Now
We’re inclined to maintain our short bias on the DXJ and our long bias on the FXY for now. We think recent moves are exaggerated in both directions in the context of a highly likely dearth of incremental Policies to Inflate over at least the next few months.
That being said, however, we are actively looking for a rise in cross-asset volatility as an opportunity to exit this position in the coming weeks. In short, we are now wrong on this trade and are seeking to minimize the damage by not covering high (DXJ) and selling low (FXY).
Have a great weekend,
Associate: Macro Team