EFTA01137117.pdf

Eye on the Market March 18.2013 J.P.Morgan Topics: The possible economic and investment impact of Japan's monetary and fiscal bazooka; and the latest round of historical revisionism in Europe This week's note focuses on Japan's rising equity markets, but first, a comment on Europe. Jean Claude Juncker, Prime Minister of Luxembourg and former President of the Euro Group, was quoted in Der Spiegel last week as saying that there are disturbing parallels to Europe in 1913, before the First World War, and that "those who think that the question of war can never be raised in Europe any more may be massively wrong. The demons are not gone, they are only sleeping." He proceeded to use this as a justification for keeping the Euro and sticking to the austerity program. What should one make of such remarks? If the Euro makes sense in the long run, it will be because of its economic advantages, not its political ones. I have doubts about the former (see our May 2012 chart on EU economic dispersion vs countries starting with the letter "M"), but time will tell. In any case, using the threat of war as a justification for the Euro is ridiculous. From 1900 to 1945, tens of millions of Europeans were killed in wars with other European countries; practically none' have been killed since, and this has nothing to do with Europe using a single currency. The explanations for Europe's demilitarization are complex (the Cold War, the Marshall plan, Germany's demobilization), but history shows that a lasting peace in Europe was won decades before the Euro was introduced. "Where have all the soldiers gone? The Transformation ofModern Europe" by Stanford's James Sheehan shows how 1945, rather than 1968, 1989 or 2001, was the turning point for the continent. As a result, comments like Juncker's appear to be part of a Creation Myth advanced by some EU politicians: the idea that European citizens must accept further supranational governance to prevent future conflict. For what it's worth, if there are rising regional tensions in Europe, it's not difficult to identify what's causing them. There is a common denominator at work below: the Euro is the primary catalyst for the continent's dislocations, imbalances, and painful adjustments. While the European Union has been an anchor for peace, the Euro has not. In the end, economics trumps politics. Germany vs Italy: Industrial Production Unemployment: Euro Periphery minus Current account deficits Index 1999=100 Germany, Percent Percent of GDP 140 Euro fixed 14% 4% 12% Euro fixed 130 Germany 2% France. Germany, I 10% U.K. 120 8% 110 6% 100 4% 2% 90 Greece. Italy. Ireland, I CIV Portugal. Spain 80 .2% 70 .4% -8% 1982 1986 1990 1994 1998 2002 2006 2010 1971 1979 1987 1995 2003 2011 1975 1980 1985 1990 1995 2000 2005 2010 Source: OECD, GaveKalSeetrities. Source:JMAIN, Bo S, BoP, OECD, NSS, IMF. Source: OECD. I would downplay for now some of the issues you might read regarding contagion risk from Cyprus, which is a bit of a special case2. In the U.S., the private sector is doing OK, with household demand, housing, spending, production and employment all running at a solid pace. And now, onto Japan, which has registered among the highest equity market gains of the year, particularly for investors that also positioned for the Yen's decline. This number would be 140,000 if casualties resulting from the disintegration of Yugoslavia in the early 1990's were included. The Balkan countries are "European" (they are almost all candidates or potential candidate countries for EU accession), but the disintegration of a multi- ethnic/religious country is not something likely to repeated elsewhere. Another 15,000 were killed in the 1956 Russian-Hungarian conflict, and 5,000 during the 1974 conflict between Turkey and Greece on Cyprus. However, for these purposes, I would not characterize Russia, the North Caucuses or Turkey as "European", despite their membership in the "Council of Europe", an umbrella organization of 47 countries which also includes Azerbaijan and the Ukraine. 2 Germany's Federal Intelligence Service (the BND) concluded last fall that an aid program for Cyprus would benefit certain Russian depositors with billions of dollars in deposits in Cyprus, and that "Cyprus is a gatewayfor money laundering activities in the EU". The politics of the EU seem to require harsher treatment for Cypriot bank depositors (partial confiscation), but I am not so sure this is a paradigm for what will happen elsewhere, and why this would be more of a problem for depositors or financial markets than private sector losses already imposed on Greek bondholders while the ECB was kept whole. The Eurozone makes its idiosyncratic decisions based on different circumstances, and frequently changes its mind; that is the lesson of the last 4 years. Europe's destiny, whatever it is, will likely not be shaped by what happens in Cyprus. The bigger issue to me, as we have shown in recent weeks, is how growth conditions in France. Italy and Spain are weaker than they have been in a century, other than during the deprivations of wartime. EFTA01137117  Eye on the Market March 18.2013 J.P.Morgan Topics: The possible economic and investment impact of Japan's monetary and fiscal bazooka; and the latest round of historical revisionism in Europe Desperately Seeking Shinto. Pressures from low growth, stagnant profits and lost competitiveness have apparently reached a breaking point not just economically, but politically. The Shinzo Abe Administration differs from its predecessors, and appears intent on breaking the cycle of deflation. As mentioned in our 2013 Outlook, while there are structural problems in Japan, aggressive monetary and fiscal policy could move those issues to the back-burner as far as markets are concerned in 2013. This looks more like a "trade" than a long-term investment, but for investors able to hedge the Yen exposure (given Japan's intention to debase it), Japanese equities may continue to perform well for a while longer, even after the rally since last fall. Like the cicada which lives underground for 17 years and then emerges for a short period above ground, 2013 is a year in the sun for Japanese equities after 2 decades of underperformance. Background on the Japanese economy in 5 simple charts Both nominal and real growth in Japan have stalled since 1990, with Japan exceptionally low in nominal terms. Corporate profits have stagnated as well while the rest of the world has seen corporate profits rebound. Cash earnings by employees have collapsed, and are now back (amazingly) at the same level they were in 1990. For context: in the US, average hourly earnings have doubled over the same period. Another sign of pressure: Japan's long-standing trade and current account surpluses which prevailed since 1980 have evaporated. And of course, there is Japan's gargantuan government debt which is over 200% of GDP. If Japan had grown at just 3% (nominal) over the last 20 years, we estimate that its debt ratio would be 130% instead. The surprise to me is it has taken this long for Japan to find the situation intolerable. My guess is that the pressure for change is coining from the corporate sector, rather than from aging households. Japan growth, 1991-2012 US vs. Japan corporate profits Nominal GDPgrowth Billions, USD TrillionS,JPY 10% 2,000 18 8% 1,750 16 6% • 1,500 14 • • 4% • 12 IMF Advanced Economies 1,250 10 2% 1.000 8 0% 750 6 -2% 3% 4% 500 0% 1% 2% 5% 6% 7% 1999 2003 2007 2011 Real GDPgrowth Source: International Monetary Fund. Source: BEA, Japan Ministry of Finance. Total cash earnings per employee in Japan Japanese current account and trade balances Index. 2000 = 100. sa. firms with 5+ employees Percent of GDP 120 7% 6% 5% Current account 115 4% 3% 110 2% 1% 105 0% -1% 100 -2% Trade account -3% 95 4% 1990 1993 1996 1999 2002 2005 2008 2011 1968 1979 1990 2001 2012 Source: Ministryof Health. Labor& Welfare. Source: OECD, Bank of Japan. Ministry of Finance. Japanese general 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 government debt/GDP IMF) _• Actual 67 71 83 99 118 140 164 181 186 192 215 237 If nominal GDP had grown at 67 73 82 94 107 118 128 134 131 126 128 130 3% instead of 0% EFTA01137118  Eye on the Market March 18.2013 J.P.Morgan Topics: The possible economic and investment impact of Japan's monetary and fiscal bazooka; and the latest round of historical revisionism in Europe What is Japan planning to do about it? Shinzo Abe's government intends to ease monetary and fiscal policy until nominal GDP growth hits 3 percent, and until core inflation hits 2 percent. How they will execute the plan is still a mystery: will they run large fiscal deficits and public works projects? Will they buy foreign bonds to weaken the Yen and risk the wrath of the G7? Will they buy risky domestic assets and encourage greater-risk taking by cash-rich Japanese households? Will they adopt massive tax breaks for R&D and capital spending to promote private sector investment? Not clear yet. What we do know is that it may take a LOT of money printing to get the job done, since as shown, it has been 20 years since Japan generated nominal growth and inflation at the target levels. The benefits of announcing the plan helped to weaken Yen/$ from around 80 to the mid-90's. As shown in the second chart, that corresponds to a decline in the trade-weighted Yen as well. The trade-weighted Yen is still 10%-15% higher than it was during prior periods accompanied by consistent trade surpluses. Japan core CPI and nominal GDP growth rate Japanese Yen trade weighted index Percent change Index. January 2000 = 100 8% - 120 Nominal GDP, 3-year annualized 110 6% - Appreciation 100 4%. --- 90 80 2% - 70 60 0% 50 40 -2% - 30 20 -4% - 10 1985 1990 1996 2001 2007 2012 1980 1988 1996 2012 Source:Mi fleshy of Internal Affairs an d Communications, J. P. Morgan Securities LLC, Cabinet Office oIJapan. CPI adjusted forchanges in tax rates. Sou ce: Goldman Sachs 8 Co., Bloonberg. We don't know exactly what Japan will do, and there is a chance they will reverse course. However, my sense is that something has changed in Japan's attitude towards deflation, and that they are prepared to take economic and political risk to confront it. The losers might include holders of long-duration Japanese government bonds, if the plan entails higher domestic interest rates; but if US-style central bank purchases are used, government bond yields might remain stable. Who holds them? Private sector and quasi-nationalized Japanese banks and insurance companies own 75% of all Japanese government bonds. What about Japanese equities? Japan has been on a strange and sad odyssey in global equity markets. Incredibly, Japan used to represent over 40% of the MSCI World Equity Index. Influential books were published on its economic miracle ("Theory Z", "The Art ofJapanese Management", "The Key to Japan's Competitive Success", etc) and then the Nikkei sank 65% starting in 1989. At the peak, Japanese equities were trading at 40-70 times earnings; now they are between 10x and 15x. Japan still trades at slightly higher P/E's than other countries, but the margin between them is a fraction of what it once was. MSCI World Index market cap in Japan Valuation of the MSCI Japan Index Percent Multiple 45% 80x 6x 40% 70x - Price-to-forward 12-month EPS 5x 35% 60x - 50x • 4x 30% 25% 40x • 3x 20% 30x • 2x 15% 20x • lx 10% 10x • 5% Ox Ox 1988 1991 1994 1997 2000 2003 2006 2009 2012 1988 1992 1996 2000 2004 2012 Sou ce: MSCI,J.P. Morgan Securities LLC. Sou ce: MSCI, J.P. Morgan Securities LLC. 3 EFTA01137119  Eye on the Market March 18.2013 SP.Morgan Topics: The possible economic and investment impact of Japan's monetary and fiscal bazooka; and the latest round of historical revisionism in Europe During Japan's descent into deflation, many global equity managers and asset allocators with the flexibility to avoid Japan did exactly that. The first chart below shows the cumulative benefit of not owning any Japanese equities in a global equity portfolio since 1998. This is one of the most consistent regional investment differentials ever seen. While the magnitude of the benefit was somewhat smaller in the 2000's, this is a function of the collapse in Japan's weight in the MSCI index; it still generated consistent portfolio benefits with few lapses. The second chart is an indication of why many investors have been so comfortable underweighting Japan: its corporate sector has inferior margins compared to others. The benefit of being underweight Japanese equities Return on Equity Cumulative outperformance of MSCI World ex-Japan vs MSCI World, Percent rolling 2 years 20% Emerging 35% US Markets 30% 15% 25% 20% 10% 15% 10% 5% 5% 0% .5% 0% •10% Last appearance of the Cicadas Japan .15% (Japanese outperformance) .5% 1988 1992 1996 2000 2004 2008 2012 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: Bloomberg. Source: Datastream. The cicadas emerge The table below shows the four major equity markets in dollar and local currency terms. I have written before about the benefits of a portfolio tilted to the US and Emerging Markets over Japan and Europe. This has been a consistently positive strategy over the last 20 years, and in particular over the last few years as the financial crisis exposed severe structural problems of Europe. Since last fall, however, while Europe has lagged the US as we expected, the Nikkei has been on a tear as markets anticipate easier financial conditions and shifts in Japanese household and corporate behavior. The Nikkei rose from 9,000 to over 12,500, for a 40%+ return. Unfortunately for non-Yen based investors, more than half of this return was eroded by the decline in the Yen mentioned earlier. The chart below shows how closely the Nikkei's rise and the Yen decline have been linked. If an investor had purchased Japanese equities and hedged the Yen exposure (by shorting the Yen vs their home currency), returns would be much closer to the Yen returns shown. This, it seems to me, represents the most sensible strategy for purchasers of Japanese equities. US Dollar and Local currency total returns by region Japanese equities & the Yen since last September Index level, JPY USD/JPY Year to date 2007-2012 13,000 100 USD Local USD Local Nov 16 Jan 15 12,500 NIkke1225 Dissolution of Supplementary S&P 500 10.0% 10.0% 15% 15% 12,000 Lower House budget 95 Sept 26 Dec 16 11,500 Abe becomes 11,000 head LDP Lower House 90 MSCI Europe 5.8% 9.2% -5% -4% election Euro Stoxx 2.7% 3.8% -17% -17% 10,500 10,000 85 9,500 MSCI Japan 11.5% 22.6% -22% -44% 9,000 80 Nikkei 9.0% 20.9% -7% -33% 8,500 8,000 75 MSCI EM -1.0% -0.3% 36% 39% 9/3/2012 10/18/2012 12/2/2012 1/16/2013 3/2/2013 Source: Blooirbe g. Data as of March 15, 2013. Source: Bloomberg, Nomura. If Japan does continue to modestly pressure the Yen downwards vs its trading partners, it should benefit: Japan has one of the highest sensitivities in the world of export prices to exchange rates. According to a paper from the Federal Reserve in 2007, a 10 percent depreciation of the EU currencies, the Canadian dollar, or the Asian emerging currencies would raise the price of exports from these regions by 3 percent, whereas a similar decline in the nominal effective yen would boost the yen price of Japanese exports by 5 percent. In effect, Japanese companies benefit more from currency devaluation than other regions. 4 EFTA01137120  Eye on the Market March 18.2013 J.P. Morgan Topics: The possible economic and investment impact of Japan's monetary and fiscal bazooka; and the latest round of historical revisionism in Europe Other long-term factors to keep in mind There are well-known structural headwinds that Japan faces as well, such as the world's most unfavorable demographics, and its decision to shut down nuclear power and rely on much more expensive forms of energy. The second chart shows Japan's 2031 power generation targets. Renewable energy (ex-hydro) is estimated to rise from 1.25% to 12%-25%, which is very ambitious once you take into account that offshore wind is the largest projected expected increase in the plan. Offshore wind is substantially costlier than onshore wind; we have seen projects in Europe where the cost of building the connection of an offshore wind turbine to the grid is more expensive than building an entire brand new combined cycle natural gas plant. Japan has limited experience with either onshore or offshore wind, and something tells me that in a few years, nuclear power will be turned back on so as to maintain reasonable electricity prices for Japan's export sector. Japan power plant capacity utilization by fuel type Contribution to Japan power generation Percent Percent 100% 100% I 90% Coal 90% - Co-generation 80% LNG 80% Renewables 70% 70%- 60% - Hydro 60°i Oil 50% - LNG 50% 40% • 40% 1 30% • Coal 30% 20% • 10% - Nuclear 20% 0% I. 10% Csi C, 0% Nuclear R 2007 2008 2009 2010 2011 2012 2013 Potential 2031 Source:Federalonof Electric Power Companies of Japan 2012 Electricity targets Review, J.P. Morgan Commodities Research. Source: Fed eraion of Electric Power Companies of Japan. METI Advisory Committee. Conclusion If investors have the capacity to hedge away Yen exposure, it makes more sense to hold some Japanese equities than it has in a long time. The Abe administration appears committed to boosting private sector wages, activity and profits. The Finance Minister has referenced efforts during the 1930's by Finance Minister Takahashi that were ultimately successful in combating deflation (see chart). Takahashi policies included a 40% decline in the Yen, lower tax revenue and a rise in public works spending (note: the only spending Takahashi cut was military spending, which led to his assassination by Japanese military officers in 1936). There are differences in Japan between now and then: Japan's government debt was only 56% in the 1930's. However, the parallels are similar to those drawn by Bernanke when discussing successful stimulus undertaken by President Roosevelt. Many of Japan's structural problems will almost certainly resurface, but in 2013, changing policies may outweigh them in the financial markets. Be prepared to take profits on this position at some point; cicadas don't live forever. The end of Japanese deflation period in the 1930's Percentchange YoY Inception of the Takahashi linandal policy 30% Nominal 20% GNP Real GNP 10% GNP deflator 0% -10% Period of severe -20% deflation 1926-1931 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 Source: Nomura, Japan's Economic Planning Agency Michael Cembalest J.P. Morgan Asset Management 5 EFTA01137121  Eye on the Market March 18.2013 J.P.Morgan Topics: The possible economic and investment impact of Japan's monetary and fiscal bazooka; and the latest round of historical revisionism in Europe - Exchange rate pass-through to export prices: assessing some cross-country evidence", Vigfusson, Sheets and Gagnon; Federal Reserve Board, June 2007. 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