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By Stewart Richardson on 30/04/16 | Category - Asia
The main event of last week was the failure by the Bank of Japan to introduce new stimulus (having led or allowed the market to believe they would), and the resulting sell off in the equity market and rally in the Yen. The market reaction was exactly the opposite of what the BoJ would be hoping for, just as it was after they cut rates into negative territory at the end of January. On the surface, it would seem that the BoJ is damned if they do and damned if they don't.
The primary aim of Bank of Japan policy since 2013 has been to reflate the economy with QQE, or Quantitative and Qualitative Easing. To be more specific, the Bank aims to achieve 2% inflation and has been printing money increasingly aggressively since 2013 to try and meet their objective. As it stands today, inflation is at minus -0.3%, and the Bank of Japan recently pushed rates into negative territory (after approximately 20 years close to zero per cent - what do they really think they will achieve with this move?) in another attempt to get things moving in the right direction.
As with all central banks, the BoJ likes to build a narrative and spin it such that we believe they have everything under control and are just about to meet their objectives. Our favourite Bloomberg headline from Kuroda's post meeting press conference last week was:
Now, we are very happy to admit that Kuroda was dealt a pretty poor hand when he arrived at the Bank of Japan some three years ago. With disastrous demographics and mountainous debts (to name just two structural headwinds), we always felt that achieving his 2% inflation target (and nominal GDP growth of 4%) was not going to be easy. But to talk about a virtuous economic cycle is pure fantasy. Nobody believes him and he only damages his own credibility when he talks like this. The reality is that Japan are into their third lost decade. Chart 1 below shows nominal GDP which has not grown in over 20 years - not exactly a virtuous economic cycle and more like a patient on life support.
Chart 1 - Japan nominal GDP
As noted above, the move into negative interest rates at the end of January was taken badly by markets. The Japanese Yen has risen by about 12% against a relatively weak US Dollar over the period and the equity market is down over 5% compared to the MSCI World Index up over 7%. The evidence is that banks do not like negative interest rates as it makes it much harder for them to generate profits. Furthermore, there is plenty of anecdotal evidence that households are protecting themselves against the prospect of negative rates on savings accounts, as they go out and buy safes and physical gold. Kuroda seems to be one of the few in Japan who thinks that negative interest rates is a good idea.
We have written before about demographics and the situation is clear. It is almost impossible to have a growing economy when the population, and especially a working age population, is declining (chart 1 being clear evidence of this). Unless productivity growth exceeds the rate at which the working age population is declining, then the economy will not grow in real terms. As can be seen in chart 2 below, as a percentage of the overall population, those of working age in Japan peaked in about 1990. Having already declined from about 70% to approaching 60% today, those of working age are set to make up only about 50% of the population in Japan by 2050. Unfortunately, Japan is simply showing the rest of us our future, and this is not positive for the Global economy in the years ahead.
Chart 2 - Size of working age/total population for selected countries
Not only is Japan struggling with a declining population, it is also ageing rapidly. Retired workers have by definition stopped being productive (in the economic sense) and require an income to live off. With retirees holding a much greater share of their assets in low risk cash and bonds, the zero and now negative rate environment is simply crushing their income. Older people tend to spend less anyway, but with monetary policy crushing their income, it is possible that the Bank of Japan's policies are actually making matters worse. As shown in chart 3 below, having once been viewed as a nation of savers with a savings rate well over 10%, Japanese households save almost nothing nowadays. With interest rates pegged near zero and a declining working age population, the only way for households to increase their spending power is to either be paid more or to increase debt. With the latter unlikely (older generations are more likely to de-leverage), and the former just not happening as exporters hoard their currency gains, we fail to see how pushing interest rates further into negative territory will help.
Chart 3 - The Japanese Household Savings Rate
So the Bank have Japan (and PM Abe) are in a dreadful mess. We wonder whether they see themselves as struggling to add any more stimulus through more negative rates. They chose not to add more stimulus via QQE, which may be because they are trying to leave themselves with a tiny amount of ammunition in case they need it, or perhaps they realise that increasing QQE and owning an ever greater part of the bond and equity markets has its own limits. Either way, they have painted themselves into a very dark corner indeed.
The current Japanese experiences in terms of demographics, ever increasing Government debt and now increasingly impotent monetary and fiscal policies should be a lesson to the rest of the developed world. The trouble is that if Japan is in a dreadful mess, then the rest of the world are only a few steps behind. Monetary policy everywhere is just unsustainably loose, and yet raising interest rates will risk killing the economy. At the same time, we seem to need to take on increasingly levels of debt for a given unit of economic growth (China being the current worst offender on this front). So central banks are trying their very best to maintain the status quo whilst cajoling markets higher, and yet we know that this cannot continue forever whilst economic growth remains so anaemic.
At some point, something will change. Either central banks wake up and smell the coffee and try and induce a mild recession as they normalise policy and purge previous excesses. Or more likely, central bankers and politicians carry on with their increasingly reckless policies until the whole system comes tumbling down with its own weight, not unlike 2008, but most likely worse.
Of course, as the next crisis unfolds, the siren calls will be for helicopter money - we can clearly hear these calls already. But to paraphrase Rudolph von Havenstein, President of the German Reichsbank from 1908 to 1923, when asked why he kept printing more and more money; "to not do so would have been even worse".
We obviously hope that our monetary and political leaders refrain from the helicopter money route, but we are struggling to see how they can maintain the current status quo. We continue to believe that 2016 will see much higher levels of volatility and lower equity and credit markets. The recent experience in Japan should serve as a clear warning.

By Stewart Richardson on 16/08/15 | Category - Asia
China surprised nearly everyone in the financial markets when it devalued the Yuan last week. Although the move was relatively small (2.9% for the onshore rate and 3.7% for the offshore rate), what happens next is extremely important for global markets. If last week's move was a one off, then the impact will be limited. If, however, this is the start of a 10% or more devaluation, the implications could be serious.
Taking a step back, we need to place last week's policy change in perspective. We all know that the Chinese economy has slowed down in recent quarters. Official data does not give us a true picture, but the slowdown is probably much worse than the authorities would like. To try and stimulate the economy, China has followed the usual policy mix. First, interest rates were cut and then reserve requirements were cut. At times, targeted liquidity injections were used and it would appear that infrastructure spending will be ramped up as well. With all this stimulus in place, surely the economy would have started to recover soon anyway? Why did they resort to what could easily be viewed as a controversial new policy and possibly a sign of panic?
We also need to recognise that in real terms, the Chinese currency has actually been incredibly strong as can be seen in the chart below from the BIS. During the last cycle, the major currencies have all seen periods of currency weakness, with the Euro down by 20% in the last 14 months and the Japanese Yen down by over 60% in the last three years. Emerging market currencies, some of whom compete directly with or trade with China, have also been weak in recent months. Perhaps China has just had enough and believes that it needs to weaken the Yuan to remain competitive.
The timing of the move, coming days after a very poor trade report showing exports down 8.3% year on year, was also very interesting. The chart below shows the performance of exports for China, Taiwan and South Korea which have generally been on a slowing trend. With no signs of a sustained pick up, and with other Asian currencies finally beginning to weaken, China appears to have had enough. Although the stimulus in place will help their export sector to a degree, they have chosen to start weakening the Yuan. Assuming that this is a deliberate policy objective, we have to assume that the trend now will be towards further currency weakness over time.
Of course, we could be wrong here, and the benign story is that China is simply moving to a free floating exchange rate which may not involve any depreciation at all if it is fairly valued. However, if we are right, the currency should fall by quite a lot. Yuan weakness is just another ingredient for a full blown emerging markets crisis along with weak global growth, falling commodity prices and liquidity outflows as global investors retreat back home.
Furthermore, debt levels (in China especially) rose dramatically in the last cycle and those who borrowed in US Dollars will be at real risk as their currency falls. History never repeats, but it does rhyme, and the parallels to the 1997 Asian crisis are striking. What is more, the Japanese Yen depreciated by nearly 50% in the two years before the 1997 Asian crisis, with some commentators believing that this was one of the tipping points for that crisis. So, the more than 60% depreciation in the Japanese Yen since 2012 is yet another sign of potential troubles for Asia as a whole.
How does this all relate to the global economy? Well, currency devaluations are basically a zero sum game. They are in effect a transfer from one set of economic agents to another, and in the case of countries that are suffering from deflationary forces, currency weakness will effectively "export" deflation. There should be little doubt that the strong Dollar in the last year or so has been a headwind for the US economy and US companies that operate globally. So the question here is can the US handle further currency strength if China adds to the deflationary forces from abroad?
The vast majority of pundits dismissed the Q1 weakness in the US, and although the Q2 rebound was modest, the consensus is very comfortable with the theory of a second half pick up. Indeed, forecasts are for 2.7% and 2.8% in Q3 and Q4 after 0.6% and 2.3% in Q1 and Q2. However, mainstream economists have a poor track record of forecasting, and the Atlanta Fed model seems to have become the most accurate of all. Yes, there are issues with such models, but at the moment, it seems that the Atlanta Fed is an accurate predictor of growth in the final weeks of each quarter. As can be seen below, this model is predicting growth of only 0.7% in Q3, way below consensus.
Assuming the Atlanta Fed model is correct and Q3 GDP growth is only 0.7%, then the year on year growth rates for the US economy will be about 1.5% real and 2.7% nominal. This is basically stall speed at a time when the Fed is thinking of raising interest rates after the biggest monetary policy experiment in history.
As well as another burst of deflation coming from overseas, the weaker oil price presents another threat to the important energy sector. Furthermore, we have shown before how the business investment component of GDP is the most volatile, and how corporate profits lead business investment which is the swing factor between expansion and contraction. With corporate profits (via the national accounts with data up to Q1) stagnating, and revenues (as per corporate accounts) falling for two consecutive quarters year on year, we should not expect a huge pick up in US growth. Indeed, looking at the chart below, we would argue that very high levels of inventory need to be liquidated in the months ahead.
In recent weeks, we have highlighted how we see parallels to both the 1997 Asian crisis and the 2007 peak prior to the financial crisis. A sustained period of weakness in the Chinese Yuan will only add to the global troubles. As we have said recently, the emerging markets appear most vulnerable in the months ahead and the possibility of a full blown crisis will rise in the event of Yuan weakness. Prospects for the US economy may not be as good as the consensus believes and the last thing the US wants is a weak Yuan, leading to an emerging market crisis that will eventually export deflation to the US.
We continue to believe that a tactical and very defensive strategy is best suited to the environment we see at the moment. Equity markets are vulnerable to steep declines, emerging market assets should be avoided and high quality assets with strong income potential should perform well. It is possible that Japanese and European equities will outperform because of their QE programmes, but these have become very crowded trades. If global investors really do become risk averse and want to liquidate assets, these two markets may also be vulnerable. Suffice to say that if the bearish scenario does play out, the Fed is not going to be raising rates. In this event, US interest rates and bond markets should perform well for a few quarters despite being overvalued. 

By Stewart Richardson on 16/11/13 | Category - Asia

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.



By Stewart Richardson on 06/04/13 | Category - Asia

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.
By Stewart Richardson on 09/07/11 | Category - Asia

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.

Stewart Richardson

Chief Investment Officer

By Stewart Richardson on 21/04/11 | Category - Asia

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.

Stewart Richardson
Chief Investment Officer




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RMG Wealth Management LLP is authorised and regulated by the Financial Conduct Authority (FCA). These reports are for general information purposes only and do not take into account the specific financial objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed.