How Japan Is Leading the World Astray
The most interesting action of the past week hasn’t been with rising stock markets or contrived Chinese economic data (more on this later), but currency markets. Specifically, the continuing fall of the Japanese Yen after a brief respite and rivals’ warnings of so-called currency wars. South Korea and the E.U. are threatening to strike back at Japan’s currency devaluation policies by depreciating their own currencies. This could prove highly significant as currency wars often lead to trade wars as countries erect barriers to protect their own economies at the expense of others. This impacts global trade and is exactly what happened during the 1930s. Recent events haven’t been lost on Germany, which has made the decision to repatriate a major portion of its gold reserves from the U.S. and France. It has obvious concerns about the future of paper assets versus hard assets. As do I.
Japanese Currency and Bonds Bid Up
Is the Japanese government as incompetent as it appears? It’s a legitimate question given the events of the past week. On Tuesday, Japan’s Economy Minister, Akara Amari said the country faced risks from any excessive decline in the yen:
“If the yen excessively weakens, this would cause a spike in import prices. It would be beneficial for exporters, but would have harmful effects on people’s livelihoods.”
A perceptive comment. The only problem is that it contradicted everything the Prime Minister, Shinzo Abe, had articulated before and after the December election.
Understandably, the remarks caused a steep rise in the yen and sharp fall in the stock market. Everyone jumped to the same conclusion: that the government had wanted the currency to weaken but was worried about the pace of the decline.
Not so, it turns out. Later in the week, Mr. Amari suggested the media had not reported his remarks in full and that the yen was just falling from excessively strong levels. The Prime Minister’s off-siders had set him straight. Of course, the yen promptly rebounded to above 90 to the dollar, the strongest level since June 2010.
The bond market though appears to be having second thoughts about the ability of the government to get the country out of its deflationary rut. The 10 year bond yield has plummeted from 0.83% last week to below 0.75%, the lowest level since December 18.
Next week, all eyes will be on a Bank of Japan meeting, where the central bank is expected to adopt the Prime Minister’s 2% inflation target. This should support further yen depreciation. The government may soon realise that it’ll be impossible to keep the yen at levels which it’s comfortable with.
As for Japanese government bonds, it’s a trickier call. Like the bond market, I’m sceptical of the government’s ability to induce inflation as it’s been tried extensively before and failed. But success or no success, Japan will need foreigners to fund its exorbitant debt and that should mean higher yields going forward. With heavy government intervention in the bond market though, timing this move correctly is difficult.
Meanwhile, the Japanese stock market remains on fire. It’s amazing how the market has gone from the most neglected on the planet to one that’s now on everyone’s radar. It remains our favourite stock market in Asia in 2013.
Currency Wars Anew
Two weeks ago, Asia Confidential said:
“South Korea and other countries won’t allow their exporters to become totally uncompetitive against their Japanese counterparts … They’ll join the fight to trash their own currencies in order to help their exporters.”
So it’s come to pass. It wasn’t hard to predict but the issue has snowballed much faster than originally anticipated. And I don’t think the markets fully comprehend the seriousness of the issue.
Earlier this week, Russia’s central bank warned that the world’s leading economies were on the brink of a currency war to keep up with Japan by using devaluation to boost their competitiveness.
It came after the Bank of Korea threatened an “active response” to the Japanese moves. It wants a G20 meeting of finance ministers and central bank governors next month to focus on the adverse effects of easy money in the U.S., E.U. and Japan. It’s not hard to see why South Korea is worried.
Meanwhile, Luxembourg Prime Minister Jean-Claude Juncker, who chairs a group of E.U. finance ministers, suggested that the euro was “dangerously high”. Officials in Norway and Sweden also expressed exchange rate concerns.
It’s important to realise that currency devaluation isn’t simply about making a country’s exporting companies more competitive. As alluded to by Japan’s Economy Minister, it’s just as much about promoting domestic inflation.
When a country depreciates its own currency versus another, goods outside of that country become more expensive to import and consumers invariably pay more for these goods.
That’s the policy now being pursued by Japan and it could result in an ugly tit-for-tat game. My advice is to watch the Chinese and the yuan. If the Chinese move to depreciate the yuan, then it could be game on for global currency devaluation.
Multiple countries devaluing their currencies will inevitably increase tensions between the countries. These tensions could bring about further protectionist-type policies, hurting trade between countries. It’s not what a fragile world economy needs right now.
We Want Our Gold
It’s often said that the currency market is a zero-sum game. If one currency gains, another must fall. The saying is true, if you regard only paper money as currency. I don’t.
Because if a global currency race to the bottom lies ahead, as is my base case, then hard assets such as gold will be big winners. Gold could soon be regarded as money again, as it’s been throughout most of its history.
Germany knows the history of money better than most, having witnessed the Weimar era, when it’s local currency became worthless thanks to hyperinflation. The country remains haunted by this period to this day.
The reason that I bring this up is to provide some context to the decision by Germany to repatriate a 20% of its gold reserves from the U.S. and France. It’s a big deal because Germany has the world’s second-largest gold reserves behind the U.S. Most of the reserves were kept abroad for safety reasons during the Cold War.
Now Germany wants some of these reserves back on home turf. A spokesman from the country’s central bank, the Bundesbank, was amazingly blunt about the reasons for the move, telling Forbes : “We have no intention to sell the gold … [the relocation] is in case of a currency crisis.”
So we can infer that Germany is worried about a currency crisis and doesn’t trust central banks in the U.S. and France with its gold. It seems there’s no love lost in a time of currency devaluation.
It’s wise to keep any gold that you have and buy more on any dips (and don’t forget silver either).
An obvious question from all of this is whether we can look forward to inflation as a result of this race to the proverbial currency bottom? That’s what stock markets are betting on, and bond markets partially too. It’s what the vast majority of asset managers and financial commentators expect also.
If they’re right, stock markets could have another powerful rally from here. The reason is that history suggests rising inflation in developed markets is positive for stocks until it reaches the 4% level. We’re a long way from this level and that’s why markets could rally more.
But I remain sceptical of inflation coming our way. First, I’m cautious whenever there is such a strong consensus, as there now is when it comes to inflation expectations. Especially when I suspect these views are coloured by experiences of 1970s inflation ie. the vast majority of finance professionals have only lived through inflation, not deflation.
Secondly, I’ve studied Japan’s deflationary bust closely and it unnerves me. Here was a developed country that underwent a massive credit bust and despite extensive stimulus measures (don’t believe the Keynesians who say otherwise), it’s never recovered. There are many similarities between post-1990 Japan and the western world post-2008, as I written about previously.
The two most likely outcomes appear to be either deflation or serious inflation. My bet is on the former. Neither outcome will be good for stock markets in the long term. Let’s keep an open mind though and see how events unfold.
Contrived Chinese Data
Does anyone believe Chinese GDP figures anymore? Apparently markets still do as they rose in response to China GDP increasing 7.9% in the fourth quarter of 2012, compared with 7.4% in the prior quarter.
Last week, I suggested I was baffled by China’s December export figures, particularly the sharp rebound in EU exports. Three days later, several stock brokers, including Goldman Sachs, said the export figures didn’t add up. Many sited the wide discrepancies with the trade through ports and imports by trading partners.
If the export figures make no sense, how are you supposed to believe the GDP figures?
It’s embarrassing that it’s taken stockbrokers this long to openly question the data coming out of China. And if there is such a thing as a sure bet, a newspaper expose will appear this year detailing the extent of the data manipulation and numbers to prove it.
For the record though, the latest data seem to confirm that the Chinese economy is stabilising. But stimulus has played a major part, with up to 1 trillion yuan in federal infrastructure spending and many trillion yuan more at the local government level (collectively local governments approved a staggering 11 trillion yuan in projects in the fourth quarter). Much of this has been funded outside of the banking sector.
While that may provide some respite this year, the investment-driven, largely debt-funded stimulus is very risky for the long-term health of the economy.
Today Sydney had its hottest ever day, peaking at 46 degrees, and I thankfully missed it all as I was working on this newsletter. Fortunately I still made it to a pool in the evening to cool off.
It follows a long stretch of record-breaking heat across Australia over the past month. My New Year’s resolution (almost three weeks after the fact) is to study the climate change issue more closely!
Source: Asia Confidential
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James Gruber Archive
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