Japan/BRICS in trouble?

The market is transfixed by the continuing saga in the Euro Zone (EZ) and the “fiscal cliff” in the US. However, worrying developments in Japan and in the BRICS (I’ve included S Africa), are been ignored.

Chinese official November PMI, whilst slightly below the forecast of 50.8, came in at 50.6, a 7 month high and above 50.2 in October. The new orders, exports and prices paid components improved, though, interestingly, the employment component was weak – coming in at 48.7, the lowest since January. Historically, as Chinese PMI data does pick up at this time of the year, an improvement was to be expected. The bottom line is that the higher reading in November is not convincing enough, even though October trade data, retail sales and investment has improved. GDP is expected to rise above 8.0% Y/Y in Q4.

However, the ongoing political problems with Japan over the ownership of the disputed islands continues, suggesting that Japanese FDI (one of the most material investors in China) will decline in coming months – not good news. The new leadership takes over in March and based on current data, I would expect, will have to introduce some stimulus measures soon thereafter, if not even earlier. The Shanghai composite has been a laggard for quite some years and is trading below the psychologically important 2000 level for the first time since 2009 – no bullish signal. Indeed, the Shanghai composite has underperformed materially this year, once again. I certainly do not want to short China, at these levels, given a likely stimulus programme is coming shortly. The A$ (which I treat as a China derivative) rose to near US$1.05 last week, though has backed off somewhat – still seems over done to me and I will continue to hold my short, which I will increase if the A$ rises to nearer US$1.05.

Indian Q3 GDP came in at +5.3% Y/Y, the lowest for some 3 years. With a budget deficit likely to exceed estimates, combined with a rising trade and current account deficit, the Indian authorities need to take remedial action as a matter of priority. There remains a serious risk that the ratings agencies will cut India’s credit rating to junk. The new finance minister has proposed to enact a number of structural reforms, including the right of foreigners to own a majority stake in multi-brand retail operations – a highly politically charged issue in India. A (non-binding) vote has been called. However, the markets have welcomed the proposed reforms by the new finance minister and have risen materially last week, in anticipation of a number of the measures being ratified. As a result, its watch and see on India, though there are some hopeful signs.

Recent data reveals that recent Russian consumer debt (ex mortgages) are to repay interest on existing debt. With declining inflation, real interest rates have risen from around 7% in 2008 to around 20% at present. Whoops. Continuing capital outflows (capital flight in reality – expected to amount to US$75bn this year) are keeping interest rates high. The country does have significant forex reserves, some US$148bn, but down from US$230bn before the 2009 crisis, in spite of the high oil prices, as the government continues on its spending binge, which is plagued by corruption. Whilst there is no immediate threat, given its material reserves, is there a threat of a potential banking crisis in Russia and, if so, how will that impact Mr Putin? (Source FT);

South Africa posted a record trade deficit for October – Rand 21.2bn, well above forecasts of Rand 15.5bn and just Rand 13.8bn in September. Exports were up by +7.8%, though imports surged by +16.7%. Yes, strikes in the mining sector hurt exports, but exports of other commodities rose. Year to date, the trade deficit has risen to Rand 104.6bn and is 10-times larger than a year ago, according to Bloomberg. Inflation rose marginally to +5.6% in October, though will be much worse as a new inflation basket is introduced in 2013. Businesses are shedding labour and cutting back on investment. President Zuma is likely to be reappointed head of the ANC in mid December and is expected to win the general elections in 2014. However, his stewardship of the South African economy has been questionable to say the least – some would say disastrous. The Rand is approximately 9% lower this year – more to go – I think so. Please note I remain short the Rand against the US$.

However, by far the most shocking data set was that from Brazil. Mr Mantega, the Brazilian finance minister, reported last Wednesday that Brazilian GDP would rise by 4.0% on an annualised basis in Q3 this year and expected that rate of growth to continue into next year and 2014. However, just 2 days later, Q3 GDP data revealed that the Brazilian economy grew by just +0.6% Q/Q, half the rate expected – 1st half GDP was also revised lower. Year on year growth came in at +0.9%, far, far below the +1.9% expected and as compared with +2.7% last year and +7.5% in 2010. This has got to be the worst clanger by a finance minister (I suppose other than from his Zimbabwean colleague) for a very long time.

Investment has been declining since Q3 2008 (indeed its been negative for the last 3 quarters) and was -2.0% lower Q/Q in Q3, the weakest performance since early 2009. The country’s savings rate is at a 10 year low – does not sound encouraging for the future. Mr Mantega suggested that investment will rise by 8.0% in 2013. You can believe Mr Mantega, if you wish – I’ll decline. Brazil’s problems is that it is (grossly?) uncompetitive, with an inflationary problem (likely to rise above the upper limit of +6.5%), not least as wages are rising by +10% nominal, or +4.0% real. The government has a policy to keep the Real around US$2 to US$2.10 (actually traded around R$2.12 against the US$ on Friday, the lowest since 2009), well below the R$1.50 rate last year – not going to help with inflation. Interest rates have been reduced to a record low of just +7.25% – rate rises coming? if inflation rises, as expected. All in all, its not going to be easy for the country.

Japan faces general elections on the 16th December. The head of the opposition party Mr Abe is likely to gain the most seats in Parliament and is expected to form a coalition with the Japanese Restoration Party (+ others?), though even such a coalition may not be enough to form a stable government – I believe Japan has, on average, one PM every year !!!! recently. Mr Abe has backed off some of his wild ideas, including his proposal to increase inflation to 2% to 3% and to exercise control of the Central Bank, the BoJ, together with forcing them to underwrite/buy construction bonds directly from the government. However, he continues to push for the BoJ to target an inflation rate of 2.0%. Furthermore, he advocates more of the traditional capex based stimulus programmes which Japan has employed in previous years, including presumably the usual bridges to nowhere. The new Japanese PM will be able to appoint the new governor of the BoJ, as Mr Shirakawa retires in April next year. In addition, two other slots at the BoJ will be available in March next year. This could well lead to a material change in BoJ policy as two existing members on the 9 member board dissented from the more hawkish views and proposed further stimulus last time around, minutes revealed. The prospective changes in March/April next year should ensure that 5 out of 9 members, including the governor, are more dovish – OK, it will not take place till March/April.

Japan has to fix its deflation problem, which has plagued the country for over two decades. However, even a watered down version of the policies proposed by Mr Abe is a particularly high risk strategy. Just one example. Barclays have estimated that interest costs on accumulated debt amounts to 25% of the Japanese budget, with JGB’s yielding 1.0%. If interest rates rise to 2.0% (Mr Abe new proposed inflation target), interest costs will exceed total government tax revenues !!!!!. Furthermore, Japan reported a seasonally adjusted current account deficit – a real game changer if it continues. How will the massive budget deficit be financed ?.

Japan faces a future with dreadful demographics, a massive amount of government debt (over 220% of GDP on a gross basis), a recessionary economy (GDP declined by -3.5% in Q3 Y/Y, with a further decline expected this Q), weakening businesses, conflict with China, trade deficits, weaker exports, declining savings, deflation, unstable governments and most importantly recently, a current account deficit in September – the first since 1981, etc, etc. Furthermore Japanese companies seem to be increasing FDI, ex China. Yes Japan, finally, is trying to weaken the Yen and reverse its two decades of deflation by increasing inflation, but can it, without increasing interest rates – me thinks not. In addition, Japanese banks and financial institutions are extremely large holders of JGB’s – higher interest rates will materially reduce the value of their bond holdings – whoops. The Yen as a carry trade funding currency?.

Of equal importance, is Japan’s political problems with China over the ownership of the disputed islands. Mr Abe and the Japanese Restoration Party are likely to push Japan to become more nationalist. At the very least Japan will increase defence spending, which will increase tensions with China. Furthermore, the losses incurred by Panasonic and Sony, for example confirms the problems of Japanese companies. South Korea is far more agile and successful these days. Shorting the Japanese Yen has been the “graveyard trade” for decades, but this time around, I believe its worth playing – indeed, I have against the US$ – so far effectively. Japanese markets on the other hand have risen as the Yen has weakened. Unfortunately I missed that trade, but given the uncertainties, I will avoid Japanese equities and concentrate on shorting the Yen. What about shorting JGB’s? – seems logical, though I’ll stick to shorting the Yen for the moment. Furthermore, a credit downgrade is likely, which should weaken the Yen further.

To be balanced, there are a number of arguments made by some analysts, published in the FT, which warn against expectations of a Yen weakening. They include:

recent Yen weakness has been foreign driven – domestic money has not participated (Deutsche Bank);
changes to the BoJ board have not taken place and the results of the elections are uncertain (HSBC, Soc Gen);
if the short end of the US yield curve remains stable (as is the case), historically any depreciation of the Yen has been short-lived (Citi);
the new PM may not deliver on the radical plans currently being discussed (HSBC).

All good points, but I continue to believe that, based on current info, the Yen should weaken, though I will remind myself constantly, that this has been the “graveyard trade” in the past.

The EZ, well the saga continues. At the third attempt, the EZ finally agreed to measures to “reduce” Greek debt to GDP to 124% by 2020 and below 110% by 2022. However, a Troika report reveals that debt to GDP will be above these levels at those dates (126.6% in 2020 and 115% in 2022) confirming that the whole exercise is a sham, Furthermore, the higher debt to GDP levels reported by the Troika are based on optimistic assumptions, in particular in respect of employment and growth, the key drivers of their model. In any event, the German Bundestag approved the deal last Friday (needed the support of the opposition parties), which, given the reduced interest rates charged, will reduce Germany’s “income” by E730mn next year – the start of a fiscal transfer regime in the EZ ? – early days, but sure does look like it. The problem is that, other than Germany which itself has constraints, which other EZ country can afford a fiscal transfer regime, at present ?. Answers on the back of a microdot in block capital please.

However, the deal is a nonsense and everybody knows that Germany and other EZ countries will have to write off a large portion of their loans, in spite of the exceptionally favourable financing terms offered. Interestingly, Mrs Merkel and her finance minister Mr Schaeuble hinted at write-offs last week, though, of course, after the September elections. Credit Suisse, states that the loans from the EZ/EFSF (which following the debt buy back from private sector investors will represent 65% of outstanding Greek debt – 80% when IMF lending is included) are, in effect, a zero-coupon perpetual bond. Interest rates are below 1.0% on bilateral loans, while interest payments have been deferred for 10 years. The loan maturity has been extended to 30 years, with a 10 year grace period. Effectively, Greece is borrowing at much cheaper rates than the vast majority of the EZ and has the longest maturity profile. Whilst Germany, at the end of the day can “afford” such generosity, what about countries such as Spain, France, Italy………How do they explain this deal to their people ?

At present, Germany will argue that the deal on Greece will just reduce its revenue and that they have not taken a write off – oh yeah. Mrs Merkel’s general election next September remains her key concern. However, even with these terms, will Greece play ball till then ?. They certainly should, but……

The regional elections in Catalonia are over, which were not the resounding success for the major centrist Catalan “independence”party, the CiU. The CiU will probably have to form a coalition with the left-wing Esquerra Republicana Party (ERC), not a natural ally. Unfounded fears of Catalonia gaining independence are wide of the mark – the EU will not want to create further instability and Spain will object to Catalonia becoming a member of the EU. Furthermore, the Spanish constitution requires that the Spanish central government approve a referendum for independence, which it wont. However, the reality is that Catalans will not be able to stay in the Euro if they gain independence, a situation which the majority of Catalans will not vote for.

Mr (ditherer) Rajoy has the opportunity to seek a bail out. Spanish 10 year yields have declined to 5.32%, from close to 6.0% recently, which suggests that the market expects the Spanish PM to seek a bail out shortly – well he has little choice, quite frankly. Just on this point, Italian bond yields have also declined and I would expect Spanish and Italian bond yields to decline even further, whilst yields of the core countries to widen. I sold my Italian 10 year bonds far too early – damn. Furthermore, and ignored by most, Ollie Rehn confirmed that Spain will not meet its budget targets but added, more importantly, that as long as the country sticks to its structural reform programme, it will be deemed eligible to receive a bail out from the ESM. Mr Rehn’s comments suggests to me that the EZ may not be as wedded to an austerity only policy, though the German position will be critical. However, the Spanish economy looks set to contract into next year and further austerity measures will make the situation worse, as the fiscal multiplier for Spain, (Portugal and Greece, as well) is almost certainly above one ie further austerity measures will result in Spanish, Portuguese and Greek debt to GDP increasing – totally counterproductive. Furthermore, by spring of next year, the threat of civil disorder in a number of Mediterranean countries, will increase. Some kind of growth measures must be introduced.

The deteriorating situation in France is beginning to be understood. With government spending around 55% of GDP, a worsening competitiveness position, rising unemployment (for 1 1/2 years), declining GDP, increasing debt to GDP and trade and current account deficit etc, etc, France looks like the real basket case within the EZ. President Hollande does not appear to be pushing the measures necessary to tackle the crisis in the country. France’s credit downgrade by Moody’s, following S&P’s earlier downgrade, will be followed by Fitch in due course. Having said that, markets are relatively complacent at present. Anti business sentiment abounds, as can be seen from the extraordinary government reaction to AcelorMittal’s proposal to close down certain steel plants in France. Such outbursts will not encourage inward investment and associated employment – indeed, quite the reverse – many French businesses/business people are exiting the country – the UK should benefit, the most I believe. Quite frankly I really don’t think anyone knows how France will be dealt with. Its just too big and, historically, politically and socially difficult to handle. It remains the real canary in the coalmine, within the EZ. Relations between Mrs Merkel and President Hollande remains strained to say the least and given their very different beliefs and, indeed, approaches to this crisis, I cannot see how they can improve. Whilst aware of the issue, the markets focus is elsewhere at present – that will change in due course.

Mrs Merkel did propose additional spending in her recent domestic budget – electioneering becoming the most important issue for her ? – certainly looks like it. Recent economic data suggests, unsurprisingly, that Germany is not immune to the downturn – unemployment is rising, consumer spending falling and capex declining. Q4 German GDP could be flat, indeed quite possibly negative – not something Mrs Merkel will want, going into an election. Construction and consumption, which were expected to hold up, and would compensate for weaker production/exports, are not. No great surprise – I have never understood why analysts thought otherwise.

A recent poll reveals that 46% of Germans do not want to provide Greece with more aid, though 43% do – pretty split, but the high numbers of German’s who are willing to continue to provide aid is surprising. Portugal and Ireland are certainly going to ask for similar terms to that granted to Greece. However, the Dutch PM, Mr Rutte has dismissed such ideas, but is that a feasible position. I certainly do not think so. If a country cannot be rewarded for sticking to and delivering on its commitments, as is the case for Ireland, whereas countries that fragrantly breach their targets are provided with materially softer terms, what incentive is there for countries to continue to meet their targets. Basically, none. That’s impossible to sell. The Irish government has been pretty “circumspect” to date, but presumably will push for a better deal. One could reasonably ask as to why Ireland has not really pressed for a better deal so far.

Early days, but given the German elections next year, Mrs Merkel’s will want to keep the situation in the EZ as calm as possible. As a result, the austerity only policy may/will? be watered down. I certainly believe that the policy is way past its sell by date. Pushing for structural, including labour reforms, combined with some growth measures (yes, keeping control of expenditure as well) will, in my humble view, be far more successful. It may be premature, but there are some (not conclusive, as yet) signs that the EZ is moving that way. Indeed, unlike in the past, there was a muted reaction by Germany recently to EU proposals for a common treasury for the EZ, together with Euro bonds. Would you believe it – I still find it hard to believe. Furthermore, there are even signs that Germany may be willing to consider ECB oversight of its state banks – good God !!!.

The ECB is, I believe, certain to cut rates further, if not this week, early in 2013, which should help. Under Mr Draghi the ECB has kept the EZ afloat – can you imagine if Trichet was around – Mon Dieu. Inflation (CPI) in the EZ in November came in at +2.2%, much lower than the +2.5% in October and the +2.4% forecast – it should continue to decline. The Euro has recovered from its recent lows and is trading just below US$1.30, having traded marginally above that level. A request by Spain for a bail out may help the Euro, but I believe that the Euro will weaken. Having closed my short in anticipation of a rise against the US$ following a “deal” on Greece, I am eagerly looking to restore it pretty shortly.

UK data is mixed. Whilst Q3 data came in better than expected, GDP this Q is expected to decline materially from Q3. Consumption numbers are all over the place. The government seems to have lost its way and unemployment, which inexplicably remains under control, is expected to rise in 2013. The UK is likely to lose its AAA rating – in 2013? – likely. Having said, losing your AAA rating is not the big deal it once was. Having said all that, the UK should bumble along and, personally, I believe is in better shape than the market believes. The country will benefit from its perceived “flight to safety” attractiveness, in particular given the turmoil in the EZ and, indeed, in many parts of the world. Having said that, the UK will miss its fiscal targets for this fiscal year. Will Sterling remain at these levels, in particular against the US$ – I very much doubt it. The most interesting news was the appointment of the head of the Bank of Canada, Mark Carney, as the next BoE governor – has been viewed positively, though the banks are nervous, given his previous calls for banks to increase capital and/or reduce assets.

The US is, by far, the most intriguing economy. I continue to believe that the US is performing (much?) better than most analysts believe. The key is the housing market, which, as you know I believe has been on the mend for over a year. There certainly seems to be clear evidence I believe, but a number of analysts remain unconvinced. In my humble opinion, they continue to be wrong. Housing, in 2013 will, in my view, actually contribute meaningfully to GDP – it has already started to and, furthermore, employment in the sector will rise. US GDP should rise materially – too early to forecast given the fiscal cliff” issue, but I believe better than 2.25%/2.5%. Businesses had held back on capex and hiring ahead of the Presidential election and the fiscal cliff – that will change in 2013, as the uncertainty ends.

Republicans and Democrats continue to squabble over the “fiscal cliff”. I don’t want to appear to be too casual about this issue, but I believe that this matter is totally overblown. There will be a deal – probably just after the deadline for presentational purposes for the Republicans, but I cant see how a deal cannot be reached. The Republicans will be blamed far more, irrespective of the situation, if a deal is not done, which will cost them dearly. The party remains in shock, following the recent election – they actually believed that they would win, even though sites such as Intrade etc, were clearly calling for a win by President Obama. As you know I had pointed this out repeatedly, but a number of my Republican friends continued to tell me that I was wrong, even until the last minute !!!!

Inflation, in DM’s in particular, is likely to fall. Indeed, US short term inflation spreads suggest precisely that, with one year break-evens making a one year low, with the 5 year flat – initially, not good for Gold, though more QE is coming. The FED shows no signs of letting up on its QE programme. Yes, it is true that the impact of additional QE programmes are less obvious, but inflation is low at present. US velocity of money and money multiplier data does not suggest inflationary pressures either. However, if inflation starts to rise, …..Nevertheless, FED action is market positive for the present. Finally, the FED has been talking about replacing a calendar related date (mid-2015 at present) for forward guidance purposes, to a numerical threshold, such as the unemployment rate (around 6.0%?). If this happens – likely – markets should rise.

There has been much talk of the resurgence of unconventional energy (gas and oil) in the US. The market is deeply divided on the issue. A number of well respected analysts suggest that it is a myth (they cite depletion rates as being a major problem, amongst others), though others are extremely bullish. I am in the process of completing my research on the sector, given its potential importance, though my initial view is that this is for real and will prove to be a major positive factor for the US in coming years. The prospect of the US being self sufficient in energy is transformational for the global economy. I have long believed that Brent is overpriced and, if I am right, a decline in prices will have a material positive impact on Asia and Europe. Clearly the Middle East, Russia and other energy producing countries will suffer. Early days, but watch this carefully.

Recent consumption data has been impacted by Hurricane Sandy, but a strong rebound should be expected. I continue to believe that analysts have underestimated the likely pick up of the US economy.

I remain net long equities – bought some (not enough) during the recent dip and wanted to buy more, though markets recovered too far too fast. I expect (hope) that markets come off a bit as I intend to increase my equity holdings – energy, financials, home builders (London focused), property companies (London and certain US regions), building material (UK/US focused) and will start buying into the tech sector. I will concentrate on US and UK companies. Dividend paying stocks have been sold off due to the “fiscal cliff” issues – a rebound coming – I think so. A number are pushing the mining sector (better Chinese data), which whilst high beta, seems more of a shorter term trading play, though potentially rewarding. In theory, lower yields of the peripheral EZ countries should support equity markets in these countries – however, I well tread carefully – may look at Italy though.

EM’s are dependent on DM’s – no further silly talk of decoupling. Whilst EM’s are another higher beta play, I will concentrate on the developed markets, in particular, though will consider EM investments at a later stage. Overall, I am bullish of the equity market in coming months – yes, I can see the problems, but based on the current info, I believe that developed markets (US, in particular) are attractive. I will wait for some direction from the new Chinese leadership before considering China and its derivative plays, eg Australia, though the miners look as if they will pop. Whilst I will not short China at current levels (I’ve been bearish for some 3 years), I’ll wait for clues/direction – please note that capital flight out of China continues at a massive rate – not a good sign.

A particularly interesting observation from Ulick Burke of Credit Suisse. I quote.

“Imagine if you had written this a year ago…..
……The worst case scenarios of 2012 will fail to materialise because the Fed and the ECB will go“ all-in” on liquidity. Equities will outperform bonds .MBS, peripheral European bonds, and bank stocks will significantly outperform. The best performing bond markets will be Portugal and Greece, the best performing sector in credit and equity will be Financials. The only visible bear market will be in Volatility.

Well done if you did…. Would anyone have given you any money if you had told them that was what you were going to do.?”

Me thinks he has a point.
Overall, I believe that the current gloom and doom is way overdone. There appears to be a convergence of factors, which if executed as I expect, will actually be positive for markets such as the US and possibly even Europe in coming months. However, I’m particularly wary of Japan and will hold off on EM’s/BRICS for the moment. Sure there are risks, big risks indeed, but that to me confirms that this is not a buy and hold market, rather than anything else.

Currency trades, as indicated above, remain a particular focus, at present.

Kiron Sarkar

2nd December 2012

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