RMG Investment Bulletins
A little over a year ago, we wrote several times about why we felt that the Japanese Yen would weaken quite dramatically and how this would help the equity market perform strongly. The basic thinking behind the theme was that Japan required a major change otherwise their fiscal burden would increasingly overwhelm the country. Japanese Prime Minister Abe was elected last December promising dramatic change and the "Japan Trade" (long equities and short the currency) worked really well until this Spring, since which time both the currency and the equity market have gone into hibernation. It feels that this period of hibernation is ending, the Yen is beginning to weaken again and the equity market is breaking higher (see first chart below).
So why should the trade start to work again now? Well, Abenomics is about "three arrows" which are essentially;
1. Monetary stimulus via QE.
2. Fiscal consolidation to try and start tackling the unsustainable Government debt position.
3. Structural reform.
It will be difficult to claim any major wins on the structural reform front for a long time simply because the results take a long time to appear. Fiscal consolidation will be extremely difficult to achieve simply because the problem is so large. We fear that changes here will be little more than symbolic for the time being. So that leaves good old money printing.
The scale of QE announced by the Bank of Japan in April was "shock and awe". They announced that they would double the monetary base in 2 years, and relative to the size of its own economy, the programme is about three times larger than the current US Federal Reserve QE. As with the US, the aim is to force investors out of safe, low yielding cash, and into riskier assets such as Japanese equities and overseas assets.
So far, Japanese institutions have been relatively slow to reallocate to riskier assets (Non Japanese investors were very early "adopters" at the beginning of the year), but we believe the pressure will build on these investors the higher the equity market rises and the further the currency devalues. We really should not underestimate the reality that the Japanese authorities are relying heavily on FX depreciation to generate economic growth and higher asset prices. They may try and hide behind QE being purely a domestic policy, but FX depreciation is a target of the authorities. And this is the crux of the matter. A one off 25% currency move is simply not enough for Japan to generate lasting economic growth and tackle their fiscal hole. They need constant FX depreciation for the policy to work in the longer term. So, with the currency depreciation starting over a year ago, the year on year depreciation is already slowing and we believe the authorities will be working hard to maintain a weak currency environment.
In terms of fundamentals, the Japanese equity market is trading on less than half the price to book value of US equities and are on a 30%+ discount to UK and European equities. This type of long term value could provide the support for much higher equity prices over time.
Last, and by certainly no means least, hedge funds will be keen to jump on a new leg in the "Japan Trade" and with momentum picking up in the last couple of weeks and chart breakouts being seen, we believe the fast money will jump on this trade in the weeks ahead.
So to conclude, the Japanese authorities remain fully committed to "Abenomics" and this should lead to a dramatically weaker currency and higher equity market over time. Having performed very strongly between November last year and May this year the "Japan Trade" went into hibernation in recent months. We believe that equities are breaking out and re-establishing the long-term uptrend and the currency is embarking on another period of weakness. We believe that both Japanese and International investors will be keen to participate in this trade and the recent upward momentum is the signal we have been patiently waiting for to increase our exposure.
The Bank of Japan rings in the changes and the US Employment report disappoints.
The major news this week was the move by the Bank of Japan. We thought that the bar had been raised to a high level and that it was possible they would disappoint the markets with a somewhat timid move. In the end, they produced the equivalent of military "shock and awe". The package of increased money printing (whereby the money supply will be doubled in a two year period) and the maturity and breadth of assets they will buy was simply staggering and we believe is a real game changer. Anyone who was uncertain as to their intentions was left in little doubt. The Bank of Japan have leaped to the top of the QE class and will print their way to reaching their 2% inflation target. There will be some nasty unintended consequences (as we have repeatedly warned about the US), but those can be tackled later. In the immediate aftermath of this game-changing move, we have made some changes to our portfolios. We have increased our exposure to Japanese equities (on a currency hedged basis) and have sold the Japanese Yen against the US Dollar.We got lucky. Early on Thursday morning after the Bank of Japan's announcement we managed to start buying US Dollars versus the Japanese Yen at 94.20. We also bought some longer dated call options when the rate was 95.60 and at 96.00. As can be seen on the chart below, the move on Thursday was very large indeed and was followed by more strength on Friday despite a poor employment report (see more below) - closing the week at a rate of 97.57. We have highlighted the move on the chart below.The last two days seem to mark a take-off in our eyes. The technical launch pad for this move was a rising 55 day moving average indicating the start of the next wave higher in what is a long term bullish trend for the US Dollar against the Japanese Yen.
As for the Japenese equity market, as can be seen in the graph below, the overall picture is similar to the currency. Our view is that Japan started to emerge into a new bull market late last year and this has not changed. We have added to our Japanese holding in our longer term portfolio by adding to our Banks exposure and we have hedged the currency exposure back to US Dollars. We are very comfortable with increasing our Japanese equity exposure from here. The message from the Bank of Japan must be that they want the pension and insurance funds and retail investors to abandon the bond market and buy equities and also overseas assets. This could produce a powerful wave higher in the equity market over time as these funds have a very low weighting to equities in their portfolios. What is also interesting to note (as depicted by the red arrow in the lower panel of the chart) is the increasing volume in the equity market since late last year. This is a sign of increasing investor appetite for buying, which is exactly what we want to see in a bull market.
The other big news of the week was the disappointing employment report from the US. In fact, this came at the end of a week that saw disappointing manufacturing and services reports as well, and is very much in line with our views that Q1 benefitted from seasonal adjustments as much as anything else and that Q2 may show an economy that is doing no better than muddling through. The headline figure showed less than 100,000 new jobs created when the market was looking for nearly 200,000 - quite a big miss. Furthermore, hourly wages stagnated which is a big problem (lack of aggregate income growth has been a feature of the US recovery since 2009 whichis really important). The household survey was even more disappointing, with employment down -206,000 and unemployment down -290,000. How can employment and unemployment both be down? Well, the labour force fell by -496,000 and the participation rate fell by -0.2% to 63.3%.
Simply put, this was a horrible report which has no positive features in it as far as we can see. We believe that the next few months could show a weakening in official growth (from a seasonally adjusted better Q1) and this will of course make it harder for companies to generate top line growth. Overall, margin contraction will continue which will make earnings harder to grow as well. We are at the start of the Q1 reporting season, and so we will be able to see how well corporate America is doing. As noted last week, we suspect that companies will beat lowered Q1 expectations but any guidance they may give will be disappointing.
If there was any potential positive conclusion from yesterday's US employment report, it is that the FED will not be ending their US$85 billion per month of QE. Will this be enough to boost equity prices higher? Perhaps, but with corporate earnings growth faltering, higher equity prices will only make equities more expensive and therefore depress future returns. We suspect US equities will move sideways over the summer, perhaps a bit lower as the positive glow from QE is offset by the elevated valuation of the market and lack of growth.To conclude, the Bank of Japan surprised the market in its aggressive stance towards stimulus. We have moved in to increase our Japanese equity exposure and have bought US Dollars against the Yen. This aggressive central bank stance is a game-changer. Investors need to take the Bank of Japan seriously, and think of being overweight Japanese equities versus Europe in particular.
After last week's outsized global equity market gains, it's been a more nervy week for peripheral European equity markets with Spain and Italy down by 5.4% and 7.1% respectively. By contrast, the Eurostoxx 50 is only down by 2.8% reflecting a better performance from the core European markets, and the US equity market is actually positive for the week, up 0.5%. The US Dollar has also been strong against the Euro this week rising by 1.9%, and so the US out performance has been boosted further by currency gains.
In our client portfolios, we are long US equities and short of European equities, and so we are very happy with the equity market performances this week.
US employment data announced on Friday showed a very disappointing 18,000 jobs created during the month of June. The official data is showing a moribund jobs market which is in line with our view that the recovery is stalling. Absent further stimulus, we are struggling to see how a sustained recovery can be seen. We have explained at length our concerns over Europe and equity markets, and rather than fill these pages with more of the same, we wanted to pick up on our comments last week on Asia.
We said last week "With Western Governments pursuing expansionary policies at a time when their debt levels seem to be pushing the envelope of what is acceptable in modern economics, we cannot help but look to Asia with their low debt levels, more dynamic growth and high savings rates, and wonder whether the recent correction in the regions equity and currency markets is not a good opportunity to start accumulating exposure for the long term."
We believe that Asian currencies could appreciate quite substantially over time, and with interest rates rising across the region, this has to be supportive of this view at a time when interest rates in the UK and US are zero, not much higher in Europe and likely to remain low for some time to come. The quid pro quo of rising interest rates in Asia is that policy makers are trying to slow economic growth and inflation, and this is proving to be a headwind for equity markets in the region. We have therefore initiated Asian exposure by investing in local currency Asian Government debt. We clearly expect the currency exposure to be positive over time, and we actually think that longer dated bond prices can rise as inflation falls in the future.
The exposure we now hold has a running yield of 5% and a yield to maturity of 4.2%, which is significantly better than comparable Gilt yields or US Treasuries. If our currency forecasts are correct, then we expect to achieve total returns that are higher than the simple yields available today.
We expect to increase our exposure to Asian bonds in the near future and continue to look for opportunities to initiate equity exposure in the region as well. The shift in economic power from West to East is a trend that has a long way to go, and we think that it is time to position client portfolios accordingly.
Chief Investment Officer
With all the economic woes affecting Europe and the US at the moment, it is all too easy to forget just how robustly the Asian economies have performed recently. The table below shows the growth rates for selected Asian economies, and as can be seen, these are significantly better than developed economies.
The question we have to ask as investors is "will this superior growth lead to greater equity market returns?". Over the long-term we believe that Asia will outperform developed markets.
We have been very cautious on developed economies because of the debt problems that still persist and the deleveraging that has to happen to alleviate the problem. Asia suffered greatly in the late 1990's and went through their own deleveraging at that time. The result is that balance sheet problems are not really an impediment - let's not forget how poorly Japanese equities have performed over the last 20 years as the corporate sector there has deleveraged.
We are not of the school that claims that Asia has decoupled from the US as it has not. Any shakeout that may occur in Western equity markets will drag down Asian markets, and when this happens, we believe it will be right to buy Asia at that time.
When could a global equity correction occur? We think very soon. QEII has undoubtedly helped markets in recent months and we believe the FED will stop QE in June. Economic growth is slowing in the US and Europe which will lead to lower earnings growth. Higher food and energy costs will hurt household consumption and corporate profit margins. Bullish sentiment towards equities is at record highs which is bearish for future returns (everyone has already bought the market).
We expect to be able to buy some Asian equity exposure during the summer months and we expect Asian equities to outperform European and US equities over the long term.
Chief Investment Officer
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