***Please note we are removing Japanese Stocks from Investing Ideas (long side) today.
We will send out a full report explaining our decision later today by Hedgeye macro analyst Darius Dale.
Through August 17th, Japanese shares were handily the best performing DM global equity market since we added to the long side back in mid-December:
Now, after a week of crisis and turmoil that saw each market give back well over 1,000bps of absolute performance, Japanese shares continue to outperform from our hypothetical cost basis date of 12/16/14:
That being said, however, it doesn’t make a ton of sense to bet that that outperformance continues from here at least not in the immediate-term. Specifically, a confluence of domestic and international factors suggests it is now appropriate for investors to book gains – be they absolute or relative – on the long side of Japanese equities (DXJ) and on the short side of the Japanese yen (FXY):
I) No Easy Money Anytime Soon: Despite that fact that Headline CPI, Core CPI and PPI all continue to slow on a sequential and trending basis, recent commentary out of the BoJ – led by Governor Haruhiko Kuroda – continues to be [inappropriately] sanguine on the outlook for reported inflation in Japan. On top of that, Prime Minister Shinzo Abe was out over the weekend effectively granting the BoJ leeway in its pursuit of the +2% inflation target amid the recent plunge in crude oil prices while also confessing his complete faith in the BoJ’s handling of monetary policy. The key takeaway here is that the Cabinet Office is unlikely to lean on the BoJ to ease in the near term, which, on the margin, reduces the likelihood of QQE expansion in 2H15. Specifically, increased wiggle room in obtaining key policy objectives delays the advent of presumably desired policy support measures from the perspective of Japanese equity market participants.
II) China Headwinds: Clearly the recent devaluation of the Chinese yuan put dour outlook for regional and global growth at the center of investors’ concerns. Last Friday, Chinese growth – in Manufacturing PMI terms – hit a 77-month low with the advent of the flash Caixin-Markit report for the month August. As such, we can reasonably conclude that investors are commensurately worried about the outlook for corporate earnings growth in Japan given the headwinds to exports stemming from Chinese #GrowthSlowing (Japan’s 2nd largest export market at 18.1%), as well as the recent bout of defensive strength in the yen amid global contagion. For more details regarding our structurally bearish outlook for Chinese economic growth, refer to slides 7-19 of our recent presentation titled, “IS CONSENSUS RIGHT ON CHINA?” (7/16/15).
III) Correlation Risk: Speaking of global contagion, the recent melt-up in the Japanese yen (up +3.1% since Thursday’s close) and melt-down in the Nikkei 225 (down -11.1% since Thursday’s close) should remind investors that the Japanese equities remain tightly correlated to monetary policy expectations – despite growing calls for a sustainable decoupling. Specifically, cyclical bouts of global risk aversion have historically proved positive for the Japanese yen. This is largely due to the yen’s status as both a global funding currency and Japan’s status as an international capital allocator. Its net international investment surplus of ~$3.1T is equivalent to 75% of the country’s GDP and compares to a -$6.8T deficit for the US.
All told, while we still continue to see long-term upside for Japanese equities amid sustainable higher-highs in the USD/JPY exchange rate as the LDP and BoJ’s +3% GDP and +2% Core CPI targets clash with heinous demographic dynamics that should lead to perpetually easier monetary policy at the margins. Given the immediate-to-intermediate-term headwinds outline above, however, we do consider it prudent for investors to step to the sidelines for now.
Please feel free to email us with any follow-up questions.
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...You see, this most recent rout (SP500 and Russell 2000 experiencing 11.1% and -14.2% drawdowns from all-time highs) is, after all, from the all-time highs! And there are compelling things to consider on the long side here that I personally missed (Gold’s most recent ramp) that are coming off 4-yr lows. As you can see in today’s Chart of The Day, the 1st blast higher in US Equity Volatility in 2011 wasn’t its last.
"Seek to understand more than to be understood.”
That’s an important quote about one of the most important attributes of a great analyst (or leader for that matter): empathy. Can we find it within ourselves to see someone else’s point of view? If we can, we’ll learn a lot faster – and make less big mistakes, as a result.
In #behavorial psych, one of the glaring risks of not being empathetic and open-minded is called the Fundamental Attribution Error. “At the heart of it is the tendency of human beings to attribute the negative or frustrating behaviors of their colleagues to their intentions and personalities, while attributing their own to environmental factors.” (The Advantage, pg 32)
Sound familiar? It sure does to me. I can assure you that both in my business and life I have made this mistake more times than I can count. Whether or not I’ve had this stage of the “market call” right or wrong isn’t the point this morning. Win or lose, my #1 goal should be to seek and understand the #truth; not data and excuses that support my position.
Back to the Global Macro Grind…
Understanding the bounce (in stocks, oil, etc.) this morning has to start with understanding what caused some of these big things to crash to begin with. If we can’t contextualize reality, the mistakes we’ve made along the way are going to compound.
So, like a good Bayesian, reset. Like, every day.
No, it’s not easy. Yes, it’s a grind. And yes you’re going to be humbled many more times than you feel “smart.” Most people in this profession are smart. That doesn’t differentiate us. What does is how you behave into and out of big macro market Phase Transitions.
What were the causal factors behind China, Emerging Markets, Oil, Junk Bonds, Bond Yields, etc. crashing?
1. GROWTH: the #LateCycle is meeting the secular = #Slowing
2. INFLATION: #Deflation continues to win the debate; inflation expectations have crashed
3. EARNINGS: with 480 of 500 companies (SP500) reporting, Q215 Revenues -3.9%, EPS -2.7%
I’d say those are 3 pretty important causal factors that all proved to be A) true and, more importantly, B) non-consensus. And that’s really the other place (alongside risk managing our behavior) to differentiate oneself in this profession - not being a groupthinker.
Alongside ramping SUPPLY and slowing DEMAND (happens at the end of every cycle), what else proved to be causal?
1. CHINA: slowing, panicking, centrally-planning
2. VOLATILITY: undergoing a very bullish Phase Transition from its all-time cross asset class lows (JUL 2014)
3. LIQUIDITY: chart/performance chasing on decelerating volume (higher); puke on accelerating volume (lower)
Ok, there are 6 things we should have had right. I can keep going, but I won’t. Because the point of this morning’s strategy note is to seek truth and position for what happens next.
Since “valuation” isn’t a catalyst in a #GrowthSlowing market where rev/eps forecasts are too high, what (if anything) is going to change what caused this?
1. GROWTH: US and European growth expectations remain way too high given the Q3 and Q4 #LateCycle comps
2. INFLATION: the #Deflation could stop crashing (if the Fed does Qe4), but is that really the bullish camp’s catalyst?
3. EARNINGS: revenue and earnings expectations for Q3 and Q4 remain way too high as well
4. CHINA: oh great, they’re cutting rates this morning – look how well that worked last go-round
5. VOLATILITY: what does “investing” look like in High Beta, High Growth Style Factors in a 29-47 VIX range?
6. LIQUIDITY: yesterday’s US equity volume was +58% and +40% vs. its 1mth and 1yr averages, respectively
Sure, you can blame the “machines”, my brother’s father-in-laws’ son, or we simpleton’s paying “too much attention to the data”? Or you can ask yourself what you missed and question whether or not you should be selling what you should have on today’s bounce.
You see, this most recent rout (SP500 and Russell 2000 experiencing 11.1% and -14.2% drawdowns from all-time highs) is, after all, from the all-time highs!
And there are compelling things to consider on the long side here that I personally missed (Gold’s most recent ramp) that are coming off 4-yr lows. As you can see in today’s Chart of The Day, the 1st blast higher in US Equity Volatility in 2011 wasn’t its last.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.98-2.13%
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.