Sayonara to the Yen

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Welcome back to Asia Confidential and I hope you're feeling refreshed as we begin 2013. I once played a lot of chess, less now with a young family, and my Great Grandfather was a player of the highest standard, a so-called Grandmaster of the game. I n chess, there's a commonly used German term called Zugzwang, which is when a player finds themselves in a situation where any move they make will worsen their position. It usually foreshadows checkmate.

I couldn't help but think of Zugzwang after the market events over the New Year. In economics as in chess, you start off with many choices and these choices narrow the further you go along and sometimes you reach a point where there are no good choices left, only bad ones. Given its unsustainable debt load, the fiscal cliff debacle is likely to have accelerated the U.S. approach towards Zugzwang. And in Asia, Japan has probably already reached Zugzwang and checkmate is close. In this issue, I'll run through the investment implications of the recent events and how you can best prepare for them (and possibly profit from them).

Fiscal Farce

Let's take a quick look at the partial resolution to the U.S. fiscal cliff issue. First to the facts. The fiscal cliff issue was all about whether various tax cuts and tax breaks would be extended into this year. And whether government spending cuts agreed to in 2011 would be allowed to come into effect. Unsurprisingly, the politicians cut a deal on the easier issue of taxes and delayed an agreement on the harder issue of government spending cuts.

The biggest hit to the U.S. economy will be the expiration of the payroll tax cut. This is a US$126 billion hit, equivalent to a 0.6% reduction in 2013 GDP according to Goldman Sachs. If you add in all of the other increased taxes, it totals US$225 billion or a 1.5% impact to this year's GDP. If there was no deal, the impact would have been much larger at US$575 billion, or a 4% reduction to GDP.

The numbers on the GDP impact are estimates. It depends on the so-called multiplier effect of tax increases on the economy. There's been much academic work done into this, with multiplier estimates ranging from 1 to 3. In other words, if the fiscal multiplier is 1, then a 1% change in taxes will impact the real economy by 1%. The estimated impact from of the fiscal cliff deal of 1.5% is based on an assumed multiplier of about 1.3. We'll see if that turns out to be the case.

Technicalities aside, the markets cheered that a deal was done, thereby avoiding the larger economic impact had there been no agreement. In my view, the cheer should prove short-lived as:

  • Negotiations on government spending cuts and raising the debt ceiling haven't concluded. This means more political uncertainty during the first quarter of this year as the two political parties fight it out over these issues. Markets usually don't like uncertainty on these big issues.
  • The tax deal will do little to encourage business investment, a key component of economic growth. As I have mentioned previously, U.S. business capital expenditure and investment have been slowing as profits flatline.

I'm sticking to my call that the U.S. economy will slow down in the first half of this year and possibly enter recession. The call isn't just based on the effects of the fiscal cliff deal. Instead, it's more focused on slowing business profits and investment, and the resultant impact on growth. The ongoing political uncertainty will hurt business investment further.

And the long-term issue remains that U.S. politicians are unwilling to make the tough decisions to reduce the country's unsustainable debt load of US$16.4 trillion, equivalent to 103% of GDP. Instead, the Federal Reserve is attempting to pursue the most politically expedient option: printing money in order to reduce the U.S. dollar and thereby U.S. debts.

The bond markets will accept the risks and meagre returns of holding U.S. government debt ... until they don't. That endgame is closer, thanks to this deal.

Abe's Insane Policies

In Asia, Japan's unsustainable finances mean its endgame may have already arrived. It could well prove a forerunner for what will happen to the likes of the U.S..

Over the holidays, I did a CNBC interview on the 2013 outlook and I suggested that Japan would be the centre of the next financial crisis. Because of this, I was portrayed on the show as an uber-bear. That's unfortunate as I prefer to think of myself as a realist: being prepared for likely outcomes is better than merely hoping for the best.

Anyhow, let's take a brief look at the events in Japan since the election of the Liberal Democratic Party (LDP) on December 16. The new Prime Minister Shinzo Abe has been a busy man, promising to use whatever means possible to defeat deflation, including:

  • A 10 trillion Yen (US$116 billion) stimulus program of new infrastructure programs and tax breaks for the March quarter, with more to come after that.
  • A Yen target of 90 to the U.S. dollar.
  • Pressuring the Central Bank set a 2% inflation target, an increase from the current 1%.

Abe subsequently appointed an experienced government hand as Finance Minister, Taro Aso, to carry out the various measures.

It's hard to under-estimate the stupidity of Abe's policies. If he's successful in lifting inflation to 2%, higher government bond yields are likely to follow. If yields increase to just 2%, interest costs to service Japan's debt will be more than 80% of government revenues.

If unsuccessful, as I suspect, Japan's debt will spiral higher and at some point, the bond market will revolt, demanding much higher returns for the risks that it's taking on (current 10 year government bonds yield just 0.83%).

Either way, Prime Minister Abe's policies should bring forward the end-date for Japan's financial crisis.

Japanese Endgame Nears

To better understand why, let's skip back a step. Japan's debt issues are well known. Gross government debt of 235% to GDP, or US$93,000 per person, dwarfs other countries.

sovereign debt percen gdp
Source: Bloomberg

Government debt now approaches a staggering 2000% of government revenue.

2010 sovereign debt revenue
Source: Zero Hedge

Including private debt, total Japan's debt is more than 500% of GDP. Around 25% of current government revenues goes toward paying interest costs of debt.

Japan also runs the world's largest structural budget deficit, at more than 9% of GDP.

japan budget deficit as percent gdp

And yet for the past decade, bond prices have continued to rise and the Yen has shown remarkable resilience. In fact, so many traders have tried and failed to bet against Japanese government debt that it's become known as the widow-maker trade.

Why haven't bond prices and the Yen collapsed? The primary reason is that the vast majority of Japanese government bonds are owned by locals, who see them as the safest bet in town.

There are two things currently happening that are expected to change this equation. First, Japan is now running a trade deficit, where imports exceed exports. By the third quarter of this year, Japan will probably be running a current account deficit. This means that the government will need to fund its budget deficit via loans from other countries rather than from its own citizens.

Second, Japan's population is ageing to such an extent that locals are dipping into their savings to fund their retirement. A startling fact: there are more adult diapers sold in Japan than baby diapers! Jokes aside, the Japanese people won't have the capacity to loan money to its government in future.

It's becoming clear that the Japanese government will need foreigners to fund its debt needs. And these foreigners are very likely to demand higher government borrowing costs. This will weaken the Yen and probably bankrupt the economy.

Remember that bond yields need to rise to just 2.8% for government interest costs to equal government revenues. Then there won't be any money left to fund government spending. There could be a run on the Yen well before it reaches that point though.

Implications for Japan and the World

If I'm right on Japan, the implications will be enormous. For Japan itself, a deflationary/hyper-inflationary spiral could well follow. The Yen could collapse. Anyone for 200, perhaps 300, Yen to the dollar? And bond prices could collapse too. Betting against the Yen and government bonds may prove enormously profitable trades.

Many Japanese exporters will benefit from a falling Yen, some tremendously so. This, plus the relative cheapness of the stocks, means Japanese stock market could hold up ok even under the worst case scenarios. It doesn't mean the market couldn't decline a lot further from here, but it's already down 75% from 1989 highs.

The impact from any Japanese financial crisis will go well beyond Japan though. After all, Japan is the world's third largest economy, accounting for 8.3% of global GDP. Its banks finance a lot of business both in Asia and elsewhere. Japan is also a major exporter competing with South Korea and Taiwan on high end electronics, auto and industrial goods.

Think about the potential impact on South Korea for a moment. Exports account 52% of GDP there. The five largest conglomerates, or chaebol in Korean terms, are prodigious exporters - namely Samsung, Hyundai, Lotte, SK and LG. What would 300 Yen to the dollar do to these companies? These big five chaebol alone account for 57% of South Korean GDP.

South Korea and other countries won't allow their exporters to become totally noncompetitive against their Japanese counterparts though. They'll join the fight to trash their currencies in order to help their exporters.

The resulting currency wars could prove a boon to commodities, particularly precious metals. As I've suggested previously, gold and silver should be a core component of any investment portfolio.

Source: Asia Conf.

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About James Gruber