Museum Piece: Japan at Macro Vision
January 21, 2008
By Robert Alan Feldman | Tokyo
Investor attitudes
During client visits in the US last week and at the formal session of Macro Vision (Morgan Stanley’s annual conference in New York on the global macroeconomic outlook), the word ‘Japan’ was virtually absent. When discussed at all, Japan was mentioned as a museum piece, i.e., an example from history, relevant to the current world only as a lesson about what happens when there are severe and prolonged policy failures. Indeed, the most common question was whether the US is repeating Japan’s errors that led to the lost decade. The similarities between the US subprime problem and Japan’s financial meltdown are eerie, but there are many differences too. In both cases, there were imprudent borrowers, imprudent lenders and unprepared regulators. Disclosure was inadequate, and financial innovations worsened the problems – since neither markets nor regulators fully understood the implications of the new instruments. The differences are important as well. In the US (and in Europe), institutions have been relatively quick to admit problems and to raise new capital. Broad and deep capital markets, clear standards on capital adequacy and regulator scrutiny have been contributors to this swifter response. Hence, most investors concluded that it will not take the US a decade to correct the subprime/credit problem. For investors in Japanese assets, however, this news only dulls the pain of the impending US economic slowdown on Japanese firms. Thus, the bulk of foreign investors are unlikely to trigger a surge of Japanese equities. This attitude stems not only from adverse macroeconomic developments in Japan (such as consumer sentiment collapse), but also from the atmosphere in the US and the global economy. So long as subprime problems, credit problems, the global slowdown and high energy/agricultural price problems remain, it will be hard to convince investment committees in the US to raise weightings in Japan. In the hallways The hallway chatter about Japan at MacroVision was somewhat different. The many seasoned international investors at the conference are quite aware that Japan can change quickly. Many were among the beneficiaries of the sharp surge of Japanese equity prices in May 2003. They see extremely low valuations for many Japanese companies, even after considering the potential for far worse-than-expected earnings. Indeed, there were several mentions of technical indicators, such as the low P/B ratios and high dividend yields relative to JGB yields (both of which are cited by my colleague Naoki Kamiyama in his bullish arguments). However, while seeing value, US investors are not ready to buy Japan, because they are afraid of a value trap. A catalyst is needed to release the value. With macro policy going back toward old-style pork barrel and with old-guard boardrooms feeling protected by recent court rulings, there is no catalyst in sight. The essence of this attitude was summarized perfectly by a seasoned, Japan-savvy client at the end of the conference: “Call me when something interesting happens.” At least he is willing to take the call. What’s the trade? For investors, Japan is a particularly sticky problem. Neither the direction nor the timing of any turnaround in the economy or corporate performance is clear. One simple response is to avoid Japan altogether. However, this response has an opportunity cost, in case there is a sudden move in markets. For investors worried about that opportunity cost, the response depends on investment style. When investment philosophy allows, options strategies are another possible response. The pessimist’s strategy is a Japanese securities strangle. Even the pessimists acknowledge that low valuations in Japan imply a potential upside. They also acknowledge that Japan can turn on a dime. So, even for pessimists, upside protection is needed. However, if Japan remains on its current path, share prices could fall even more. Thus, one might want to buy both calls and puts, in amounts and with strike prices that suit one’s portfolio and opinions. Such a position would cost money to maintain, but would allow one to sleep at night while concentrating on other markets. The optimist’s strategy is a costless collar. The logic here is that the downside may be limited. After all, even though earnings may fall, valuations are already very low. Moreover, Japan has underperformed other global markets recently. The upside, although uncertain in timing and extent, is large, in light of the huge hidden value on Japanese balance sheets and the potential impact from a return to the reform agenda. Hence, an investor may write puts and use the premiums to buy calls, in amounts and with strike prices that suit one’s portfolio and opinions. Such a position would be costless in terms of money, but not sleep. For long-only investors, another possible response is to prepare buy-lists, and then to start buying when clear signs of an upswing emerge. Depending on the orientation of a portfolio, there are likely to be highly undervalued stocks in Japan that will rise sharply if sentiment turns positive. Even though such a strategy may not be able to call the bottom perfectly, significant increases of value are possible. A final caution comes from recent experience. In September last year, my trip to Europe revealed uniform pessimism. I described this pessimism in Love’s Labor Lost (September 24, 2007). The response was immediate and overwhelming. Investors bought the market in droves, on the view that, when pessimism is so universal, the market must be a buy. Since then, TOPIX has fallen by 14%.
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On Economic and Financial De-Coupling
January 21, 2008
By Stephen Jen, Luca Bindelli & Charles St-Arnaud | London
Summary and conclusions The dollar’s general weakness in the first trading days of the year suggests that investors, collectively, are not yet fearful enough for the ‘Dollar Smile’ to work. Specifically, this descent in the dollar implies a general presumption that the US – being the epicentre of the current global slowdown – will suffer the most and that the rest of the world (RoW) will be relatively unhurt from such a slowdown in the US. In addition to this geographical dichotomy, risky assets may need to fall much more for fear to become the main driver of investment. We believe that the ‘Dollar Smile’ will eventually start to work, when the RoW starts to slow, with a delay. In this note, we take another look at the issue of economic and financial de-coupling, for selected countries. From yield differentials to the ‘Dollar Smile’ The dollar has been weak in the first two weeks of the year. This implies several opinions among investors. First, investors must have the view that the collateral damage from a US slowdown will be ring-fenced and the US will likely suffer the worst of the consequences while the RoW will largely be spared the downdraft in demand. Second, investors may be increasingly discouraged by the low yield premium on USD assets. Our measure of ‘hedging costs’ for USD-based real money portfolio investors have changed drastically, providing less of a support for the dollar. However, we believe that both of these opinions will change, allowing the dollar to rally this year against the EUR and the GBP. In turn, the JPY and CHF could rally against the strengthening dollar, for as long as the US is in a recession, which we believe will likely persist through 1H08. One by one, various parts of the RoW will start to show signs of a slowdown/deceleration. Even though we are of the view that this ‘economic re-coupling’ will be tentative and partial, financial coupling will likely push investors back into ‘fear mode’ and bond rather than equity flows will, perversely, support the dollar – consistent with our ‘Dollar Smile’ framework. Back in September 2001, our proxy of hedging costs also breached the 0% threshold. Yet the dollar remained strong until the Bush administration imposed temporary tariffs on steel in February 2002. In our view, this episode in 2001/02 was a demonstration of the safe haven status of the USD. This is related, but distinct, from the discussion on whether the dollar is still the top reserve currency. The fact that three-quarters of all hedge funds worldwide, no matter where they are located, are ‘dollar-based’ is important, as it suggests that when risk-taking is curtailed in general, the dollar will be bought. We remain comfortable with this view. On economic and financial de-coupling A key part of this discussion about the reliability of the ‘Dollar Smile’ framework is whether the RoW can remain de-coupled from the US, both in economic and financial terms. We have written on this matter and have taken the position that the RoW is less coupled to the US than in the past, though a recession in the US would have meaningful consequences. In other words, while in the past, when the US caught a cold, the RoW got pneumonia, these days, if the US economy catches pneumonia, the RoW’s economy will catch a cold. At the same time, however, financial coupling is likely to have remained quite high, we have warned, and an outright bear market in the US would likely lead to a bear equity market elsewhere – which is precisely what our equity strategists believe will be the case in 2008, at least in 1H. We make these observations: - Observation 1. A wide disparity. On measures of economic and financial coupling, countries span over a wide range. Economies outside the US are coupled or de-coupled from the US, with Latam and Canada being the most highly coupled and China, Japan, Brazil, Korea and India being the least coupled . Some countries such as EMU and the UK have demonstrated high financial coupling but relatively low economic coupling.
- Observation 2. A possible change over time, we suspect. We suspect that there has been a general drift for many of these economies over the past few years away from being so tightly coupled with the US, reflecting regionalisation and the positive ‘alphas’ that we have discussed in our previous writing. The US economy still matters for the RoW’s economies, but it matters less than before.
- Observation 3. A variable degree of financial coupling. There is a presumption – made both by ourselves and by others – that financial correlation has almost always been high around the world, that when the US equity markets move, every other equity market also moves. However, since 1990, while ‘in peace time’, equity market correlation seemed high between the US and the RoW, in times of shocks this has really not been the case at all. For example, during the Tequila and the ERM crises, equity correlation between the US and the RoW dropped to zero. Further, the bursting of the IT bubble in 2000 and the current credit crisis were actually accompanied by a sharp collapse in cross-market correlation.
- Observation 4. Causality. During the ERM crisis, the RoW’s markets were falling (led by Europe and ahead of the US market), yet the US market relatively outperformed, therefore lowering the correlation (average performance of ROW and US during September 1992-September 1993 was 5.6% and 11.5%, respectively). On the other hand, the IT bubble episode shows that when the US equity market started to drop (in 1Q02) the ROW followed, but only with a lag, thereby also lowering the observed correlation. This suggests that when US equities underperform, so does the ROW.
Bottom line
Whether the ‘Dollar Smile’ would help to keep the dollar supported during a US recession is a function of the tightness of the financial and/or economic coupling. While we are of the view that the degree of economic coupling has declined substantially in recent years, financial coupling is likely to have remained high – high enough to preserve the left side of the ‘Dollar Smile’. If we are right, the dollar’s weakness in the first two weeks of the year will be reversed, as investors become more fearful and more risk-averse.
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