Asia is the real story

The world is worried about oil, and rightfully so. The Middle East is in turmoil – I get it. However, as an investor, now is the time to focus on the marginal buyers and sellers, and while securing energy supplies is a key theme for my energy focus, I am now more focused on the stories that are being under-reported in Asia.

Yesterday, I mentioned the social unrest that is happening in China, which few are talking about. The day before we pointed to the bank runs in South Korea. Today, Bloomberg ran a story with the following heading: “World’s Biggest Pension Fund ‘Will Likely’ Sell Japan Bonds” (h.t. Mish’s Global Economic Analysis). Here are the opening paragraphs:

Japan’s public pension fund, the world’s largest, said it may become a net seller of bonds to cover payments in the world’s most rapidly aging society.

The Government Pension Investment Fund, which oversees 117.6 trillion yen ($1.4 trillion), in September forecast that it would sell 4 trillion yen in assets in the business year ending March 31 to fund payouts. Sales may be less than that in the year starting April as bonds reach maturity, said Takahiro Mitani, president of the fund, known as GPIF.

Why is this important? Because internal purchasers, most notably the pension system, have allowed the Japanese government to continue printing endlessly, and have made Japan the single most vulnerable developed country (in terms of finances, not politics). If Japan’s pension plans will become net sellers, the governments printing will only exacerbate the increase in yields and will force either a massive cut in spending, massive cut in entitlements, or massive inflationary pressures. This is zero hour for Japan. It also does not bode well for local Japanese sellers as they’ll face ever-higher input costs. It could be OK for exporters who will benefit from currency differentials, although that might be negated by internal taxes and politics. I’m staying short the yen and will look to increase the position in the next few months.

Japan’s example should serve as a warning for governments and inflation-mongers alike. Governments can print endlessly and still face deflationary pressures for years and decades, with no net benefit, and with huge eventual costs placed on their citizens.

Relevant ETFs: YCS, FXY, DXJ

Have we seen the top in Yen?

I’ll admit that I’m biased. Japan’s macro-economic picture has looked bleak for years, and in late 2009, after months of researching, I determined that I wouldn’t be able to find the absolute top, so I initiated a short position in the yen. My timing was early – not unusual – but the data continued/s to support the thesis that Japan has finally reached a point where tax revenues aren’t covering interest payments, demographics aren’t improving, and the government policy is working against any yen strengthening. Taken together, these factors have given me confidence in my position.

Some might argue that G3 currencies are all doomed together, but I still believe there is a relative advantage to the USD. That being said, I am also short yen versus Japanese equities, with the thinking that when the yen finally breaks, equities might benefit, especially given their current undervaluation on an absolute level.

Here’s the weekly chart for the yen:

Relevant ETFs: YCS, FXY, DXJ, UUP, UDN

Japan’s credit rating downgraded

S&P cut Japan’s credit rating to AA-, lower than some of the dominant Japanese companies! Why? Too much debt, bad tax demographics, and no strategy for turning the situation around. (From BusinessWeek: http://tiny.cc/3y9rm.) I am only surprised it took this long and that it doesn’t get downgraded more. Yen is down 1% against USD as of this writing. I’m maintaining my short yen position.

Relevant ETFs: FXY, YCL, YCS

The end of the relief

It’s 1:25 … do you know where your euro is?

Euro went ballistic on news that the US was backing more money from the IMF for a eurozone rescue. So, yeah, we went back above 1.31, but shifting creditors doesn’t change the fundamental/structural issues facing the euro. Congratulations Portugal on selling a few bonds! But really, who wants to long this currency long term?

We always talk about sifting through the noise, and here’s a perfect example. We haven’t changed our stance on the euro nor the yen, for that matter. Staying short both.

Oil, in the meantime, and energy in general, have been clear winners for us. NLR is up about 15% since we discussed it a few months back. We’re looking to increase exposure to energy through various ETF’s (KOL is an example, but we have no position yet).

All about the dollar

The euro and the yen are both weaker, sending the USD index higher – everything else is just being priced off the currency markets now:

Sure, gold:euro is going to break out to new heights. Yes, the asian currencies ex-Japan, will benefit against the yen and the euro. For me, the story is still in the G3 and hard assets, and then the resulting implications for the financial assets. I don’t see equities rallying in any sustainable fashion alongside the dollar. At least the curve is coming in a little, which eventually should help stimulate some lending, instead of just generating NIM.

Of course, it’s happening because 10-year yields are rising faster, which means that in the short term, borrowing costs will rise. Talk about unintended (but completely predictable) consequences: dollar is getting stronger, alongside higher interest rates – exactly the opposite of what Obama, Bernanke & Co. wanted.

Should Germany be happy about Ireland (?) and why BoJ should make a statement now

Let’s think this through: Germany is the strongest economy in Europe, is export oriented, and through no manipulation of its own is getting a weaker currency which will probably boost exports in a 6-12 month lag. Sounds like a good deal. Now, all Germany has to do is provide just enough support to keep Ireland from crumbling, but not enough to force a bid in the euro, and it will put itself in an even stronger economic position.

On the other side of the pond, the yen is finally weakening. The BoJ has an opportunity to achieve its long term objective of driving inflation by announcing a massive yen selling program. It will catch countless longs who went in to the yen as a store of value and USD-diversifier. For an interesting take, click here.

Maybe it’s Cisco…

Maybe today’s markets are down because of Cisco (CSCO). I say maybe because so many other things are in play today that it’s tough to assign “pure” causation.

• Ireland is on watch and borrowing costs continue to rise. If a new rescue fund isn’t set up soon, we could see an Irish default. Euro can’t catch a bid without cleaning up the uncertainty, and it’s down below 1.37 again, and I believe on its way much lower.
• DXY (USD index) is up above 78, so maybe the unwind of short dollar-long equities is taking place as well. Yes, the euro is the big drag on DXY, but the dollar-yen is now above 82 and heading higher.
• Phil Falcone’s Harbinger Capital is unwinding.
• And I still haven’t heard what happened with that missile in the Pacific.

So yes, Cisco mentioning a challenging environment going forward is probably part of the problem, but it’s not the only one.

Do we need to fear gold and USD going up together?

Spoiler alert: If you’re a serious inflationista, stop reading here. For those readers who are still open-minded and like to look at some other ideas…

For a while, we’ve been tossing around the different implications of inflation or deflation, stagflation or biflation. The ideas get complicated with ZIRP because at the limit, free money makes all relationships incoherent (think of the implications of negative TIPS yields, while experiencing deflation-like low rates in the 5 year treasuries; or the blowing out of the 10-30 spread – good for banks riding the curve, but for economy when banks prefer to lend to US goven’t rather than businesses).

The theme that I’ve been most inclined towards is some sort of biflation. To the same extent as “stagflation” was unthinkable until the 1970′s, biflation right now is unthinkable. Biflation will occur when we have deflationary pressures through a stronger dollar and lower asset (equities, bonds, real estate), coupled with increasing rates (contrary to any policy the Fed will implement). It means that cheap dollars won’t be recycled into risky assets and government securities. It is a new paradigm, and one which the Fed is not equipped to handle with its current set of tools.

Let’s start with the dollar. What would cause it to go up? The dollar will go up when investors realize two equally important things: the euro is flawed and eventually doomed and the yen is doomed.

How soon can the flight from the euro and yen begin? I think the turning point is upon us. Greece was a wakeup call that no one heeded and investors pressed the snooze button. Ireland is the next one. And if we fail to wake up, more calls will come. Already, German’s are starting to grumble about having to bailout their profligate brethren.

Taking one step back, the role of a currency is 4 fold:

• as a medium of exchange
• as a measure of value
• as a unit of account, and
• as a store of value

Each currency has some advantages and disadvantages in each category (for example, it’s really tough to use gold units in an accounting ledger, but it is bettter as a storage mechanism than a piece of paper that can be printed at will).

That digression brings us to why the USD and gold can go up together in this scenario. As flight from the euro and yen becomes a reality, US deflationary pressures will heighten with a stronger currency. At the same time, fear will drive assets towards gold. As one trader never fails to mention to me, “Gold will peak on fear, not greed”. He speaks truth. Perhaps its my own cognitive dissonance that allows me to think that gold and the USD can go up together, but the key is relative to what. I’m not making a call on which one will outperform on a relative basis (to each other). Rather, relative to all other assets or stores of value, both will benefit.

Which brings us to the ineffectiveness of the Fed. With a steep yield curve, banks have less and less motivation to lend to businesses – why should they if they can earn NIM by lending to the Fed? They shouldn’t. The translation mechanism from Fed to consumer is broken and QE is going to increasingly be seen as a pro-establishment, pro-Wall Street bonuses measure and the average US citizen will retaliate. First, let’s recognize that a steepening yield curve is not beneficial to anyone but the banks, and maybe that’s important as they try to fix their balance sheets, but maybe they should just take the charges and move on instead of putting taxpayers on the hook. Second, the money rushing around now looking for yield and return in risky assets is much like the money sloshing around in 1999 – misappropriated and bound for disappointment.

I have been discussing some of these themes for a long time, and have only been partially right (for example, metals have rallied since we spoke about them 2 years ago, but the yen is up significantly since last year when we went short). What makes me think now is any different? Even a broken clock is right twice a day. True. Yet, I will push back by saying that I was also early in advising clients to play it safe in 1998 and 1999 – 2 years early, in fact. However, the eventual collapse that clients avoided was not worth the potential upside. The same is here. The yen might go up from here, but the significant risk is to the downside. Same with equities. They might rally more, hit new temporary highs for a few days or weeks or months, but they will falter and it’s not worth the risk.

So, as we go into a weekend, after a huge run-up, QEII, elections, massive moves in currencies and gold at record highs, energy rallies (I like energy long term), unemployment numbers that are mixed at best, etc. I am wary and believe the fingers of instability are large and worrisome. We are indeed in a new normal, but it will not be a black swan when the corrections come.

Is anything down today? Oh yeah, our sanity.

If the Fed was targeting stock prices, which seems to be the case, then at least for the time being he was successful. So let’s review, in a situation where money is already dirt cheap but not lending is happening, the Federal Reserve decided to target stock prices (call it, asset prices in general to give it the benefit of the doubt) that are held by relatively few people. Hmmm.

Gold is close to an all time high and certainly at a 20 year high:

Meanwhile, the dollar is down, although not at it’s lowest point:

But it doesn’t matter where you look today, it seems like the reflation trade is back on, deflationists be damned. Except, the yield on the 10 year is going down. What gives?

This is the result of investors front-running the Fed purchases.

I hate sounding like a downer, and I hate that I keep beating the negativity drum, and I’m certainly not any perma-bear. But this is not sustainable, valuations are not where you’d expect for any long term decent return on investment, and any quantitatively driven excess returns will be met with a more serious downside impact that will show up in future returns, but more importantly show up in future standards of living. We will look back at this period with astonished incredulity at our own lack of foresight.

In 1999, a relatively few advisors and analysts were pointing out that valuations were unsustainable. Then we pointed out that accounting gimmicks, such as recognition of revenues, channel stuffing, etc. were unsustainable and only represented “borrowing” sales from the future. We now have the same two factors in play. In terms of the latter, we are borrowing from future consumption and GDP growth, but eventually we will need to pay it back. We see it on the macro and the micro level. Financial institutions are “borrowing” earnings from reserves, while on the macro front we are literally borrowing some GDP growth.

Could it be my own bias that is keeping me from fully participating in this rally? I’ve been examining whether my own stance has led me to a position that is difficult to back down from, and therefore all the analysis is skewed to confirm my hypothesis. The answer is – maybe. I say maybe because maybe we are in a new world, but I seriously doubt it. ZIRP might mean that stocks are undervalued, but I don’t think so. $600 Billion might stimulate job growth that will compensate for the cost of the program, but I doubt it. The Fed might be effective in reaching their goal of a weaker dollar, but I don’t have any faith that they can be effective in anything other than causing uncertainty. Japan’s currency might continuously get stronger, but I doubt it. China might grow endlessly and not have a real estate bubble, but, again, I don’t think so. No matter where I look at the underlying fundamentals and money flows, there are disconnects that will need to correct. Certainly, some big investors disagree with me, so it is not without hesitation that I take the other side of their trades. However, as a disciplined fact-based investor, I can’t allow myself to be dissuaded from the research – and for now, all signs point to trouble.

If I had $600 Billion, I’d be rich

The Fed cam out with QEII and the essence is that there will be $600B pumped into the market for the next 8 months in the hopes of stimulating economic growth. I won’t go into the differing opinions of whether QEII will actually work, but simply state mine: if QEI didn’t work, why would QEII? We don’t have a liquidity problem that can be solved with more POMO activities. We have credit/faith problem, which isn’t solved with free money; quite the contrary, something that is free isn’t worth anything.

When the dust settles, I don’t think this round of QE will make much of any difference. The focus now is the turning point in the yen, the turning of Chinese growth numbers which I believe will come in over the next few months, and the breakdown of the euro (Ireland and Greece are only the beginning). The dollar will look like a superstar compared to the alternative, and will squeeze nay-sayers.

Japanese Yen Strength – the best explanation I’ve found

In one of the most cogent reviews of the Japanese yen’s strength, Kieran Osborne shows why the yen might be at a turning point.

For many, the strength of the Japanese yen is a conundrum. How can the currency of a country with such a weak economy, such a high level of debt, weak leadership, poor demographics, combined with an ever deteriorating economic outlook be so strong? Many market participants did not anticipate that the yen would demonstrate such strength 24 months ago. Now, many commentators focus on Japan’s “safe haven” status as a key reason why the currency has appreciated. True, at the onset of the financial crisis the Japanese banking system was viewed as being amongst the soundest globally, but as risk came back into the markets in March 2009 through most of that year, the yen continued to appreciate. In a period where we witnessed a substantial reversal in risk aversion (the S&P 500 returned over 50% from the end of February 2009 through December 31, 2009), the Japanese yen’s safe haven status does little to explain its strength.

So what has driven the strength of the yen? While the reasoning behind currency price movements is inherently multi-faceted, we believe some of the more relevant drivers of Japanese yen strength have been: 1) weak leadership; 2) low reliance on foreign investment; and 3) relative attractiveness of Japanese yields.

For the full article, click here.

This is a must read.

China – The Mother of All Grey Swans

New post from Vitaliy Katsenelson on China and Japan. The short version is that China is COMMUNIST! and the numbers can’t be trusted, while Japan is past the point of no return.

On China: I already mentioned that Russia used to do the same thing with numbers and ghost towns that looked great to observers, but were shams.

On Japan: The government won’t have an internal market due to demographics, and as the savings rate decreases, the international community will not continue funding JGB’s at 0% rates.

http://contrarianedge.com/2010/10/30/china-the-mother-of-all-grey-swans/

Look at the presentation. Understand the dynamics of overcapacity in China. Understand that demographics doom Japan’s currency.

Invest accordingly.

What I’m watching

It’s Friday evening and the markets are closed.

“Bombs on UPS plane” barely registered, but I have to think that the terrorists have an awful sense of timing. Next weeks elections already look set to place more Republicans in power, and whether you agree with the different parties or not, as a terrorist, I have to assume you like the Democrats on the margin. Which begs the question – why would you put national security back at the top of the agenda? Same goes for North Korea, where there are reports of some shots being exchanged on in the DMZ. Why now?

In my little corner of the world, I’m reviewing. Let’s start with the yen. It’s at new highs…again! This is a 20 year chart of the yen index:

Why? There are things in this  world, Horatio…

I continue to maintain my short exposure, without much fear. I’m not levered, it’s a small position, and I’m confident that the long term prospects of the yen are even worse than the USD, even with the QEII that might be announced next week. The risk is still to the downside for the yen.

Back here in the US, I’m reviewing both the 10 year yield and the 10-30 spread.

Bill Gross came out and said two words about the end of the bull market and everybody suddenly listens. The Fed can announce QEII and commit to purchasing bonds ad nauseum; however, this market doesn’t need easing, it needs jobs and confidence, neither of which will be accomplished by Bernanke if they continue on their current path.

Take a look at the 10-30 yield spread. This is a monthly chart of the past 20 years:

It has spent most of its time in the 0.9 range, but hit all-time lows earlier this month of under 0.6. Now, where do you think the risk lies? For spread to continue getting weaker? No. The 30 is leading the way, but the 10 will follow.

Which brings me to Dr. Copper. I can’t tell you how many people bring up metals and commodities, with a view that there is no end to the upside potential. Maybe. Probably not.

Take a look at the S&P to the commodity equity index:

It doesn’t matter which representation you look at. Look at SPX to gold if you prefer:

What does it mean? It might mean that Dr. Copper is telling us that the recovery is full-steam ahead and that equities will start to outperform on the upside. I doubt that. The other option is that commodities are going to pull back and lead equities down with them, albeit not at the same rate. Considering that GLD is one of the most widely held securities in Merrills retail brokerage accounts, guess which way I think we’re going.

Meanwhile, financials are weak and facing continued weak real estate conditions, limited visibility on their portfolios, and weakening consumer lending conditions. Real estate and jobs continue to be the big macro hurdles. The elections are already done and the incumbents are screwed, even the ones that will stay in power will do so only through extremely difficult conditions – this is a non-story and already discounted.

Japan – I just can’t look away and I think there’s an opportunity

I’ve written often about the challenges facing Japan in the next few years, from an aging population and the resulting transformation from savers to spender to the unsustainable debt that can only be financed with printing, all leading to an eventual devaluation if not complete collapse of the yen. I have been premature, but I am not wrong. Today, I actually want to point out a different opportunity in Japan – equities.

While the yen will top out (see chart below) if it hasn’t already, Japanese equities are looking relatively cheap. Trading at single digit P/E’s with an export focus that will only be helped by a declining yen, many Japanese companies will be poised for higher earnings going forward. The current yield on the Japanese market is hovering around 2%, but with potential for expansion with a declining yen.

Dylan Grice just put out a research piece highlighting how the Nikkei could rally significantly as a result of the coming devaluation of the yen. So the question is how to play it?

There are multiple ways from taking a currency position (we have been short the yen as we’ve written about endlessly) to going long the equity and hedging out the currency. This is not easily done by individual investors – or so I thought. When I started looking for different options, I came across a WisdomTree ETF that does just that – DXJ.

EWJ is the popular Japanese ETF. Most investors believe that because it is bought in domestic accounts on US exchanges with dollars, that it is dollar based; however, EWJ is NOT currency hedged. Meaning that if the index went up 1% and the yen went down 1%, USD based investors would not see any return.

DXJ on the otherhand, uses futures and forwards to hedge out the yen currency fluctuations for USD-based investors. Amongst some of the drawbacks it has: it’s small, has little daily volume, and the currency hedge can (and has) worked against it as the yen has strengthened. That being said it looks like a viable alternative for investors looking to get exposure to Japanese equity without the yen risk. For the record, this is in no way a recommendation to buy or sell any security, and at the time of this writing I do not have any position in EWJ nor DXJ, but do have a short yen position.

How long?

How long does Bernanke think he can hold his finger in the dam? As I write this, euro is over 1.4, yen is at 81.55. At some point, they won’t want to keep holding their treasuries, and that point, I fear is sooner rather than later. So why am I long the USD?

Here’s how it plays out: the USD carry trade is rampant, that is, short USD buy up the rest of the world. It’s driven the prices of every no-name asset up in terms of USD. The problem is that it’s now stretched and needs to get unwound. That will provide support for the USD; not support for treasuries, but support for USD against our trading partners. The alternative is bad for everyone – all fiat currencies lose and the system of trade and production and day-to-day operations breaks. And no one wants it. But it will come to the brink. For now, capital controls, monetary wars, and theoreticians playing with our futures.