(By Darrel Whitten) Takeaways
1) The while knuckle part of the 2008 financial crisis has been contained, but the wreckage has been extensive and the secondary fallout could still tip the global economy into depression if handled badly. Economies, banks and financial markets remain heavily dependent on unprecedented central bank intervention. Further, the ongoing Euro sovereign crisis is a pox on global economic growth expectations and global financial system stability.
2) The deleveraging process could take a decade or more even under more benign scenarios, meaning economic growth will remain tepid and the debt burden of developed economies will remain heavy for the foreseeable future, while emerging markets will remain plagued by inflationary pressures and sputtering growth rates.
3) The economic crisis began in the U.S., laid waste to the Euro monetary system, and could end in Asia, either in China, Japan or both, meaning that U.S. equities still represent the least risk and best medium-term value of the world's equity markets, with additional upside potential provided by a secular USD rally on the U.S. energy revolution.
4) If the last phase of the economic crisis ends in Asia, the secular commodity boom may have already peaked in 2008, with a weaker secondary peak also seen in 2011. Also, don't look to emerging markets for a performance boost. Emerging markets need good growth in global trade and, in many cases, strong commodities demand, i.e., they are a warrant on the global economy.
The Wreckage from the 2008 Financial Crisis is Still Extensive
The white knuckle part of the global 2008 financial crisis has been contained, i.e., financial markets and global economies are no longer in free-fall, but the wreckage has been extensive and the secondary fallout--sovereign debt crises, deleveraging, austerity, fragile economies and financial institutions, could still tip the global economy into depression if handled badly.
This economic crisis began in the US, laid waste the Euro monetary system, and could end in Asia., either in China, Japan or both. Easy money and central banks as well as regulators asleep at the regulatory switch allowed a massive, highly leveraged "shadow" banking system and a derivatives monster with a nominal value of USD600 or 10 times the global GDP to grow unchecked off the balance sheets of the world's deposit-taking institutions, infusing the global financial system with dangerously complex web of systemic instability. This systemic instability has yet to see any regulatory solution, and remains the 500-pound gorilla in the room.
Although the epicenter of the financial crisis was the U.S. and the U.S. Treasury made a serious strategic mistake in allowing Lehman Brothers to fail, the U.S. has coped better and earlier, with a totally committed Federal Reserve leading the great experiment in unconventional, "irresponsible" monetary policy at zero bound interest rates to print enough money so that the nominal growth rate of the U.S. economy (inflation plus real growth) is above the nominal interest rate. Under normal circumstances, this "helicopter" money would be wildly inflationary, but the fractional banking system money multiplier function is broke, and money poured in at the top into the banking system is primarily being used to repair financial sector balance sheets, thereby allowing deflationary debt restructuring and austerity to proceed in a balanced way over a fewer number of years without pushing the economy into deep recession.
Before the U.S. cruises on the golden road to energy independence and becomes a major energy exporter, investors have to deal with a much anticipated "fiscal cliff", i.e., a looming combination of spending cuts mandated by the 2011 debt ceiling compromise and the expiration of income, payroll and capital gains tax cuts that could mean withdrawing from the U.S. economy some 4% of the national income that could derail the U.S. economic recovery, according to Pimco's Mohamed El-Erian.
Global PMIs Indicate Global Expansion, Hobbled by Euroland
JPMorgan's Global Manufacturing and Services PMI, which is designed to track global GDP trends, slipped to 52.2 in April from March's 54.4, raising investor concern about the sustainability of the global recovery. But the index remained above the 50 mark for a 33rd month, indicating there the global economy is still expanding, albeit at a weak pace. The April numbers however are suggesting the Euro Zone economy worsened markedly in April. A sharp slowing of the Euro Zone's economy of course would be a weight on U.S., Japan and China growth.
The other hot button is U.S. unemployment, where the numbers are suggesting the U.S. jobs recovery is recently sputtering. While the Fed remains totally committed to doing whatever it can to revive the U.S. economy to a full employment level, the successive bouts of monetary largess are beginning to remind us of Japan in the 1990s, i.e., the economy and stock market perked up everytime the government/BOJ moved to stimulate, but relapsed and began to sputter everytime the stimulus was removed--i.e., the economic recovery was not sustainable without repeated shots of stimulus.
Longer Term, U.S. Energy Revolution Will Ameliorate U.S. Deleveraging Pain
The U.S. deleveraging and repair of fiscal and private sector balance sheets could continue for the next 10 years, were it not for the energy supply revolution that is rapidly evolving in the U.S. The shale revolution is already spreading prosperity all over the U.S., bringing jobs and production back to "old" industries in states like Pennsylvania and Texas. The new economies of substantially lower energy costs are prompting Dow Chemical Co. and Shell Oil to announce plans to build new North American ethylene crackers and other plants. Other companies, including Chevron Phillips Chemical and Formosa Plastics, have announced plans to increase their North American polyethylene output as a result of the shale gas wave. North Dakota leads the country in shale-related prosperity, with the lowest state jobless rate of 3%, the highest growth in per-capita personal income since 2000 at 79%, or more than twice the national average of 37%.
U.S. Becomes Net Energy Exporter for the first Time in 30 Years
In 2011, the U.S. became a net exporter of energy products for the first time in 60 years. The Bakken oil field in the Midwest has gone from no production a decade ago to 500,000 barrels a day, with predictions that output could double. Texas fields are suddenly producing vastly higher volumes. New possibilities for natural gas are even greater. Natural gas is now so cheap and plentiful that it will make new coal-fired energy plants almost impossible to build, and elbow aside oil in some areas such as fuel for vehicle fleets.
Daniel Yergin, author of The Quest, suggests that perhaps as many as 20 billion barrels of recoverable tight oil exist in the U.S. Such deposits, he writes, would be the equivalent of 1½ Alaska North Slope deposits. Broker Raymond James Ltd., suggests the U.S. may no longer need to import any oil by 2020 and could be a new oil exporter by 2030, whereas the U.S. was still importing 10 million barrels a day in 2011. The United States consumed 18.8 million barrels per day of petroleum products during 2011, making it the world's largest petroleum consumer. The cost of oil imports to the United States in 2012 could reach a record $426 billion in 2012, up from $380 in 2011. This imported oil bill acts as a tax on the U.S. economy.
Citigroup analysis suggests oil and gas production in the U.S. and North America will skyrocket in the next eight years, completely transforming the domestic U.S. economy as total liquids production ostensibly doubles over the next decade, allowing the U.S. to eclipse both Russia and Saudi Arabia in oil production by 2020. This potential for a major transformation of the domestic U.S. economy, balance of payments, USD strength, etc. is keeping investors from becoming too bearish on the U.S. despite concerns over the upcoming "fiscal wall" and the U.S. debt issue.
S&P 500 Most Resilient of the Global Equity Markets
As a result of a very pro-active Federal reserve monetary policy and an across-the-board capital infusion and stress tests of major financial institutions, the S&P 500 has been the most resilient of global equity markets, recovering 82.5% of the 56.2% decline in the index from a 1,561.80 peak in October 2007 to a low of 683.38 in March 2009. The rebound to a March 2012 high of 1,408.47 basically represents a doubling of the S&P 500 from the March 2009 low , driven by, a) repeated bouts of stimulus from the Fed, including QE1 and QE2, who has stepped in every time it appeared the economy and the stock market was running out of gas.
Make no mistake about it, however, the U.S. and global stock markets are still very dependent on extraordinary monetary support, as the real economy is as yet too fragile to stage a strong enough recovery to allow the Fed to "normalize" monetary policy.
S&P 500 Continues to Underperform Bonds
Further, the fact of the matter is that stocks have significantly under-performed bonds for the last decade, calling into serious question the "stocks for the long term" thesis, at least for retail investors being jerked around by High Frequency Trading and leveraged hedge funds, and as long as both the economy and stocks remain heavily dependent on monetary intervention, this situation could persist. While many in the U.S. still insist that the U.S. has not become Japan, bonds (JGBs) in Japan have outperformed a shrinking stock market for the last two decades, to the point that domestic individuals as well as institutions have all but completely abandoned equities in favor of fixed income or overseas investments.
While the S&P 500 YTD has been driven by rallies in the financials, consumer discretionary and the technology space, it is these same sectors that are bearing the brunt of current profit-taking on growth and renewed systemic fiscal sector fears. U.S. financials are believed to be in better financial shape than their Euroland peers, but the recent JPMorgan (JPM) negative surprise of $2 billion in trading losses show that even the best are not immune to bad hedges, meaning investors will remain wary of potential hand grenades lurking on bank balance sheets.The financial stocks however will have to be an integral component of any rally attempting to take stock prices beyond 2007 highs, as will the top-heavy basic materials companies most sensitive to global growth expectations.
Serious Structural Flaws in Monetary Union Strongly Imply Partial or Full Euro Breakup
The adjustment in Euroland is not going well at all. Heavily indebted countries are teetering on the verge of depression because they can't print money and the ECB isn't printing fast enough to get nominal interest rates below shrinking nominal growth rates. As a result, the debt burden continues to build, and the austerity-heavy measures insisted upon by the Euro trioka, i.e., Germany, the ECB and the IMF are a miserable failure because the electorate of crisis southern nations is simply refusing to take the bitter medicine while the German public is in no mood to pour their hard-earned savings down the sink-hole of southern Euro debt for the sake of saving a seriously flawed monetary union.
Further, the European Union was the hardest-hit of industrialized regions on oil import costs because, when converted into euros, the average EU oil price is running higher than in 2008.
The easiest way to track fiscal and financial stress in Euroland is to watch the Eurostoxx Bank Index. Two tranches of the ECB 3-year loan program late in 2011 and in February 2012 helped to alleviate some of the stress building in the Euroland banking system, but the political events of the last couple of weeks has this stress again building, with the Eurostoxx Bank index falling back to 2009 lows, indicating systemic risk is as high as ever in Euroland. In other words, there is more than just headline risk that overseas investors would rather ignore.
China's Adjustment Challenge
Not all investors are convinced that China is poised to overtake even the U.S. economy over the next decade. While China was kicked, then stumbled and fumbled during much of the 19th and 20th centuries, it began shaking off much of its ideological shackles as Maoism gave way to Deng Xioaping's party rule in the early 1980s, opening China's doors to the world — on China's terms.
China's ruling Communist Party is seriously considering a delay in its upcoming five-yearly congress by a few months amid internal debate over the size and makeup of its top decision-making body, indicating that China may no longer be the monolithic juggernaut poised to overtake the world, or is undergoing an evolution to a more open, global stance not straight jacketed by out-dated hardline Communist doctrines. Any delay in the Congress, however, no matter the official reason, would likely fuel speculation of infighting over the remaining seats in the nine-member Politburo Standing Committee which calls the shots in China.
China's clamp down after an immediate and massive liquidity and credit infusion following the 2008 global financial crisis has created a substantial degree of excess and maladjusted investment in infrastructure and property that some see as a bad debt train wreck in the making. Beijing has been trying to reign in inflationary pressures and credit to reign in these excesses, and in the process has squeezed the Shanghai Composite index into consolidation since the global peak in equities in 2007. The index bottomed before other major indices because the Chinese government was quick to introduce a massive stimulus package that unleashed a torrent of loans--the after effects of which are now being negatively felt as a bad debt overhang in the Chinese economy.
Shanghai Composite: Nearing a Break to the Upside?
China has announced a flurry of financial liberalization measures that were perceived by many in the U.S. and Europe as a sign of confidence about China's growth prospects. In reality, these measures (widening the trading band on the yuan, allowinging greater capital inflows, permitting a domestic pension fund to invest in the stock market, etc.) could be defensive steps intended to protect the economy from a coming slowdown. China's economy is slowing because of weaker demand for exports in Europe and the U.S. and because of the limits of its investment-driven growth model. Growth in electricity consumption and railway cargo has halved since last year and data show that the transition to consumer-led growth is going slowly.
Chinese leaders are now encouraging capital inflows particularly into the domestic stock market. The Qualified Foreign Institutional Investor quota has been expanded to $80 billion from $30 billion for approved foreign investors to buy mainland-listed Chinese stocks. The government also announced it would allow the Guangdong province pension fund to invest in domestic stocks.
However, the CEO of property developer SOHO China Ltd. insists that at least the commercial property market bottomed in January of this year, and will be showing a strong recovery by the time credit conditions are visibly easing. As a barometer of tight credit conditions, the Shanghai Composite also looks to be nearing a break-out point, ostensibly to the upside. Thus the movement of the Shanghai Composite itself suggests that the current investment stance of outside observers is overly cautious/bearish. Sure, China's economy is slowing from the break-neck 10%-plus, but ~7% may be a much more sustainable, healthy pace going forward, causing less friction between China and its trading partners. That said, a break out of the current triangle formation would be justification for the bears' view that things are about to get worse, not better in China for investors.
EEM Emerging Markets ETF
Continued weak growth and ongoing Euro crisis are not what emerging market bull markets are made of. While global institutions piled into the emerging markets again in early 2012 expecting a repeat of the 2009 surge, they have been disappointed as the EEM Emerging market ETF aptly shows the wilting of emerging market stock prices. In emerging markets, there is little to no correlation between economic growth and equity returns. Further, investors tend to overpay for recent growth.Emerging markets need good global growth in trade to shine. Japan is Ex-Growth, Ex-Dynamism
Foreign investors remain seriously concerned about the lack of any visible progress on what they perceive to be a serious government debt problem. As in the U.S. and Europe, the burden of trying to revive Japan's economy through monetary policy alone, as a seriously gridlocked government bickers about the imposition of higher consumption taxes many observers say is necessary to stem the current alarming increase in already massive government debt, yet with no comprehensive debt management, growth stimulus policies.
The Bank of Japan's response, while increasingly aggressive as regards utilization of its balance sheet, is seen as visibly insufficient in terms of printing money or buying long-term financial assets to stem the yen's damaging appreciation and ensure that Japan's nominal GDP growth rate is above the nominal interest rate.
The estimates of how much time Japan has before hitting the debt wall and triggering a crisis ranges from "it could blow up at any time" to five years or more. Most are in agreement that the BOJ should more aggressively monetize debt and engineer a weaker exchange rate, thereby making good their inflation target. The more aggressive investors are still trying to short JGBs yet remain stymied by the strong support JGBs have among extremely cash-rich domestic institutions and corporates.
Over a shorter-term horizon, however, foreign investors are content to play the periodic catch-up cycles as Japanese equities increasingly lag global equities, then experience three to six months of out-performance. Despite the disparaging views of Japan top-down, foreign investors as a whole remain consistent net buyers, and have remained so throughout the Heisei Malaise (from 1990), albeit being much more selective in focusing on still globally competitive Japanese names,smaller capitalized companies and the emerging Internet venture companies.
A comparison of the trend in net foreign buying of Japanese equities and the Topix clearly shows that foreign investors are THE driving force in Japanese equity price formation. However, the positive uptick given to Japanese stock prices by foreign buying is nowhere near what it once was. As the following charts show, this is because of not only heavy unwinding of strategic stock holdings by Japanese financial institutions and corporate, but also because of consistent net selling by domestic portfolio investors, who are abandoning their traditional "home bias" in their equity investments in favor of more attractive alternatives in overseas stocks. Indeed, in many domestic pension portfolios, foreign equity exposure is just as high or higher than domestic equity exposure.
Net Selling by Strategic Holders Remains Heavy
Foreign Buying Offset by Domestic Selling
Fundamentals Aside, There are Serious Structural Supply-Demand Issues
Since the beginning of FY2009 (April), domestic city and regional banks have unloaded a net JPY644.9 billion of Japanese equities, while domestic life and non-life insurers have unloaded a net JPY2,034.4 billion, mutual and pension funds have unloaded JPY832.5 billion, and individuals have unloaded another JPY4,004.8 billion for a total JPY7,516.6 of net selling, which has largely offset the net buying by foreign institutions of JPY10,900.4 trillion. Despite substantial net buying by foreign investors, Japanese stock index benchmarks (Nikkei 225 and the Topix) have been underperforming not only the US benchmarks, but ironically the Euro stoxx benchmark as well.
Essentially, every risk-off phase that has global institutions trimming equity exposure causes a temporary air pocket in Japanese stock prices, were a constant nominal amount of foreign buying is needed just to keep Japanese stock prices from collapsing under the weight of structural domestic net selling. While corporates have been nominal net buyers by around JPY274.5 billion, other corporates have also been heavily unloading their strategic stock holdings when stock buyback programs are factored out.
High Expectations for a GDP and Corporate Profit Rebound in 2012
2011 was a perfect storm for Japan's GDP and corporate profits--a once-in-100-years massive earthquake and tsunami, a nuclear and electric power crisis, serious flooding in Thailand which is a major offshore production base for Japanese exporters, a surging JPY, and slowing import demand in China, Japan's largest trading partner.
Thus a nice rebound is widely expected in 2012 from a very low GDP base (nominal GDP has actually back-tracked to mid-1990 levels) as well as a depressed corporate profit base. Yet a surprise move by the BOJ to deploy more of its balance sheet in February that was followed by further action in April has failed to turn the gravity-defying JPY, because of widely expected QE3-like action by the Fed, and the dire situation in Euroland where only more ECB action can temporarily stave off bond and bank stock vigilantes. While Japan's manufacturing has bounced back from the perfect storm in 2011, the manufacturing PMI suggests manufacturing will remain hobbled by weak overseas demand and continue strength in JPY, which of course is leading for continued government calls for the BOJ to stimulate more.
Markit/JMMA Japan Manufacturing PMI
Government initiatives to stimulate the economy have overwhelmingly proved ineffective, even when they are actually implemented. Domestic wage-earner consumer purchasing power continues to be eroded by higher electric power costs, wage reductions, employment uncertainty, as well as "stealth tax increases" in addition to the proposed consumption tax increases, meaning personal consumption is being supported by rebuilding in the Tohoku region and the active elderly, who of course control the bulk of Japan's personal savings. While housing demand has upticked on Tohoku rebuilding as has corporate capital expenditures, exports, which in recent history have been the driver of cyclical recoveries, are being stunted by the strong JPY as well as weaker import demand in China as well as Euroland.
Japan Nominal GDP Component Growth
The consensus is for around 2% growth in 2012 supported by the recovery in the Tohoku region. While uncertainties include continued JPY strength, weak import demand in China and Europe and reduced purchasing power among wager-earner households, the economic indicators suggest the expansion will continue, albeit at an anemic rate.
Japan CI Economic Indicators
In late April, Bloomberg compiled analyst consensus forecasts (over 2,600 analyst estimates) still have Japanese corporate earnings surging some 69%, after falling 31% in FY2011, while the Nikkei EPS growth estimate is showing 22% growth. However, JPY continues to trade above widely assumed JPY/USD and JPY/EUR exchange rates in corporate budgets. Demand is rebounding in the Tohoku region breathing life into selected retail and consumer-related stocks, and Japan's Internet start-ups are alive and well.
The main feature that continues to attract foreign investors to Japanese stocks is apparently very cheap valuations and the ever-present (but as yet unfulfilled) promise of a major turning point. However, instead of catching-up to the recent rally in the S&P 500, the mini-rally in the Nikkei 225 triggered by the BOJ's surprise move in February that temporarily weakened JPY has already peaked, as investors are now looking to the Fed for the next stimulus move.
As we have pointed out many times before, the Japanese market, if one wants to play, should be approached as a market of individual stocks
, not a stock market
, being ever mindful that any slowing of the flow of net buying by foreign investors in aggregate means Japanese stock prices immediately begin to crumble under the weight of structural domestic selling. Yes, The Japan Stock Market is Cheap, But There Are Almost No Growth Expectations
That said, since both the entire Nikkei 225 and the Topix indices are again trading at under book value
and dividend yields are over 2% or roughly twice that of JGB yields, the downside risk appears limited to prior lows hit during the March 11 and November 2011 lows, or somewhere between 8,200 and 8,600. On the upside, the important point to remember for both indices and their major constituents is that almost no medium-term earnings growth is currently being discounted in stock prices
, even though nominal forward P/Es are currently at around 15X for both indices based on EPS growth of over 20% in FY2012 (to March 2013).
Despite all the hype overseas about the Facebook IPO, even stocks of Japan's Internet start-ups are flat-to-down over the past 52 weeks. High flyers like Gree
(3632) have been shot down by what the Consumer Protection Agency in Japan considers "predatory" charges for a certain type of game that has been a very lucrative source of revenues, which has also hit the stocks of rival DeNA
(2432) and even So-Net
(3789). This has caused individuals and small cap investing institutions to shift funds to the consumer-oriented sites like Cookpad
(2193, a site about cooking recipes), which is the only stock in the group we looked at showing good positive momentum in its stock price.
Tokyo Takes provides additional commentary on Japan stocks to The JapanInvestor.com weekly newsletter. To obtain a free trial subscription to The Japan Investor market letter, please visit: www.japaninvestor.com