However, it is just possible that Japan's experience with debt deflation for two decades offers an alternative, mutually exclusive hypothesis. For Japan, I would contend, continues to sign its own suicide note by not following Adolph's real bills doctrine. Instead, it offers a glimpse of a society
that has done everything to prevent a destabilising purge of its bad debts from its system. It has printed a lot of money. The Bank of Japan's balance-sheet holdings of domestic sovereign debt are now almost triple those of the Fed as a percentage of GDP. And having initially de-geared its economy, debt has risen remorselessly to almost six times GDP. What do they have to show for it? Within twenty years the US ruled the world, but, over a similar time frame of public sector meddling, Japan's economy has become an also ran. Who had it right Donald?
Japan's policy elite includes very few gamblers and writers such as Karl van Wolferen have noted that the unpredictable scares them to an extraordinary extent. It was arguably this frame of mind that recommended a policy of quantitative easing in the first place. It has undoubtedly succeeded in sustaining the economy's substantial debt load, allowing them to increase debt leverage. Furthermore, the private and public sectors can borrow more cheaply than anywhere on the planet. But at what cost? I believe the pain is self-evident.
The Japanese are no longer interested in the future and are now pursuing a policy of instant gratification; of living hand-to-mouth. Freed from the conventional shackles of worrying about the uncertainty of profit and economic trends extending out beyond the present, they are displaying worrying signs of poor judgment. Consider the financial establishment. The banks have lost their economic rent – no playing the yield curve for them. Finding themselves bereft of the financial gains from positive roll down, and without the risk temperament to make commercial loans, they humbly accept ten-year corporate paper yielding one per cent and compound their risk further by selling credit protection to augment their paltry income. However, the stock market has an acute sense of foreboding: the Topix Banks Index is making all-time lows. It may be that having sought to avoid unpleasant shocks our Japanese contemporaries have made their plight more precarious today than it was at the peak of the asset price bubble; I fear they have forsaken their financial security.
They say that coming troubles cast their shadows
before them; the only oddity is that the
catastrophic share price performance of the banks underwriting the world's third largest economy with a $5trn GDP (vs. India's $1.5trn and Germany's $3.5trn) receives so little attention in our daily financial press. Investors' lack of curiosity can be traced back to Japan's dwindling share of the MSCI World Equity Index effectively means that a major global financial institution can ignore the Japanese stock market. But with gross debt of almost $30 trillion dollars or 60% of global GDP we choose to ignore this economy at our peril, especially as credit risk has become so endemic to their system.
Chuck Prince Would Be Proud
Those who dance are fools; those who don't are fools. Since both are fools, it's better to dance.
Traditional Japanese Saying
The Japanese are chasing yield. But not any kind of yield. Now if it where the shares of NTT DoCoMo which yield almost 4% I could understand; the business is a dull but dominant mobile phone oligopoly. The company runs modest net cash balances and pays out less than half its annual earnings. If I were running a domestic pension fund, it would represent the sum of all my joys: a stable, low risk and domestic yen asset that if gently re- leveraged through modestly raising the dividend pay-out ratio over time would yield 4% and have an attractive positive nominal growth rate. But the dominant social mood in Japan is bleak and regardless of the facts, the notion of owning a high- yielding equity is very unappealing.
Hyperbolic Discounting
Much better to think of sunnier climes that have not endured a bear market: fixed income. The ten year JGB yields just 1.1%. Now here is where it gets weird. Nippon Steel, a mammoth and operationally cyclical business with $37bn of sales and $16bn of debt, issued ten year paper in August yielding ten basis points over the prevailing JGB or 1% to you and me. What were they thinking? For this is not discounted cash flow, it is hyperbolic discounting. Academic studies show that when confronted with the choice of $100 today or $110 tomorrow, most
choose the cash up front. But lengthen the time horizon to one month and one day and most defer for an extra day to secure the higher payment. In other words as the present encroaches shorttermism prevails.
The Sun Always Shines On TV
But to aggravate matters more, the same institutions that are willing to tolerate such insanity will sell you five year credit protection for 50 basis points on the same name. This is addressing risk by looking backwards. Japan historically has not suffered a large incidence of default and the central bank stands ready to inject more liquidity, so there is the presumption of a free lunch in selling credit protection. It is reminiscent of the sub-prime disaster in America. In Japan, the mispricing of credit has encouraged corporates to issue more and more debt. But of course the more they issue, the less likely the debts will be repaid. Nationwide house prices can never fall, right? And Japanese companies can't go bankrupt?
In September, and more recently in October, as they slowly wake up to what is spooking the market for bank shares, Japan's omnipotent bureaucrats expressed an intention to buy $60bn of risk assets such as corporate bonds. Note how small the intervention is versus the economy's gross indebtedness of $30trn and when the net debt of just one issuer, Tokyo Electric Power (TEPCO), amounts to $90bn. It is true; they are pushing on a wet noodle.
Astute readers may have noted that TEPCO was at last persuaded of its potential financial jeopardy and announced a $6.6bn rights issue in October, the shock and awe of which promptly knocked the shares down 25% from their high of the year. I truly question the value of Japanese shares when their principal function today seems to be that of a sop to prevent further credit downgrades by the ratings agencies. To borrow from the colourful language of Nassim Taleb, Japan has never been as fragile and its policy prescriptions make homeopath and alternative healers look empirical and scientific.
I own some one year, at-the-money puts on
Nomura. Whilst its Basel III equity tier one ratio of
10% is positively gigantic versus the 5% class of
Bank of America, my niggle is that the Swiss may insist that UBS and Credit Suisse run tier one ratios of 15%. And with Japanese finance appearing so brittle, and with numerous press stories indicating their desire to buy another overseas financial franchise, my fear is that the long suffering shareholder in Nomura will be asked once more for extra equity funding. Note the shares fell 15% on the day of their last rights issue and still trade a further 15% below the issue price; call me old fashioned but I don't like companies that issue paper below the previous rights price.
But returning to our steel example the fundamental risks become obvious. At its peak during the bubble economy, Japan consumed 80 to 90mt of steel slabs and pig iron annually. Today it consumes 60mt, or slightly more than half of domestic capacity. Nippon and JFE, the country's largest two producers, each run close to 40mt of capacity;JFE has $31bn of sales and $18bn of net debt. This industry should be a bloodbath like in cement where domestic demand has halved from its peak and demand runs at a 40 year low; the largest cement player, Taiheiyo Cement, has a market cap just one fifth of its net debt or 15% of sales.
But Nippon and JFE are thriving because they can export 45% of their output to the rest of Asia and utilisation rates runs at over 90%; for steel companies they are very profitable. US Steel by contrast is unable to export from the States into Asia and therefore the subdued nature of domestic steel demand means that plant utilisation hovers close to breakeven (in the low 70s) and there is no earnings visibility. US Steel's revenues are a third of their Japanese peers and it carries $3bn of net debt; its dollar CDS trades at 500 bps.
I'm actually long some one-year US Steel and Mittal puts. I figure the market's psychology is the reverse of where it was six years ago. A friend recounted his experience as a long investor in another steel company back in 2003/04. Earnings had risen fourteen times between 2003 and 2004. However the stock only doubled and was incredibly cheap. Like him, I was long every "old economy" cyclical stocks and indeed the Fund made 50% in the calendar year of 2003. But the idea of a big super commodity cycle was still alien to the majority of investors. Accordingly investors had shorted the
stock despite the best steel dynamics since the 1950s. There was a huge disconnect between reality and sentiment: these stocks had been dogs for years and any period of out-performance was an opportunity to sell. Once perceptions caught up with the earnings power however these stocks went up another six times.
Today I believe sentiment and fundamentals are similarly out of whack. These stocks levitate and any period of under-performance is viewed as an opportunity to buy more, owing, I suspect, to their spectacular price performance between 2004 and 2007. Except you need global capacity utilisation rates in the nineties to have any hope of real pricing power and I just don't believe that is coming back anytime soon. With both ArcelorMittal and US Steel's blast furnaces running in the low seventies you can forget about upside surprises to earnings forecasts. Eventually I anticipate a reverse of what we saw five years ago. When sentiment aligns with reality once more these stocks could have huge movements to the downside.
Something extraordinary and difficult to bring about may unexpectedly occur.
The Iron Tree Blossom
Now what could go wrong for Nippon and JFE Steel and those financial institutions that are long their credit? In short, it is their exposure to the value of the yen. Mercantilist regimes are ultimately undone by a double whammy of the rest of the world adopting their strategy and/or by having too much of their specie held overseas; Japan is no exception. It is like a one product, one customer, company. Its biggest customer imploded and its biggest competitor stole its magic formula and gained an enormous cost advantage.
To aggravate matters, the forty years of persistent trade surpluses invoiced in dollars has led to little of the trading currency, the dollar, being held within the country. Instead Japan has accepted the accumulation of a huge foreign dollar asset. But under conditions of economic duress and domestic asset price deflation Japan could, and is, finding that it needs to convert its dollar claims back into yen. This process of repatriation can prove debilitating as it typically sends the value of the mercantilist's
currency (the yen) spirally higher and so robs it of its most precious commodity, its price and cost competitiveness just when it is needed most.
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