UnRisk 7

The Setting Sun – Japan’s Coming Debt Crisis

Japan’s Nikkei 225 stock average rose by around 23% in 2012 and has continued to rise in early 2013. Much of the increase was since the announcement of the election in late 2012, when the index rose by around 20%, outperforming 92 of 94 equity benchmarks around the world. Foreigners increased holding of Japanese equities by a net US$21 billion in the six weeks before Christmas.

The increase reflects faith in the reflation strategy of second time Prime Minster Shinzo Abe to increase growth through an additional US$120 billion of public spending and create inflation to reduce the debt to GDP ratio.

In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between1971 and 1990. Since the collapse of the Japanese debt bubble in 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the difference between actual and potential GDP being 5- 7%.

The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981. Short term interest rates are around zero, under the Bank of Japan’s (“BoJ”) Zero Interest Rate (“ZIRP”). 10 year Japanese government bonds yield around 1.00% per annum.

Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in government debt. Japan’s total tax revenue is at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan spends more than 200 Yen for every 100 Yen of tax revenue received.

Japanese government gross debt is now around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%. Total gross debt (government, non financial corporation and consumer) is over 450% of GDP.

Japan’s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of this large government debt.

Japan has a large pool of savings globally, estimated at around US$19 trillion. In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. Around 90% of all Japanese Government Bonds (“JGBs”) are held domestically. Low interest rates make servicing the high levels of debt manageable.

If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates.

Japanese household savings rates have declined from between 15% and 25% in the 1980s and 1990s to under 3%, reflecting decreasing income and the aging population. As more Japanese retire, inflows into JGBs will decrease making domestic funding of the deficit more difficult. Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits.

Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012 due to an appreciating Yen, slower global growth and higher cost of energy imports. But Japan’s large portfolio of foreign assets (US$4 trillion, including US Treasury bonds of US$1 trillion) will cushion the effects for a time. But even if net income from foreign assets stays constant, Japan’s overall current account may move into deficit as soon as 2015.

As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas. Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly.

Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.

Higher borrowing costs will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs.

To avoid the identified chain of events, Japan must address the core problems. Reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.

Japanese policy makers can maintain its zero rate policy and monetise debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a de facto domestic default or restructuring to reduce its debt levels.

Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. But the bet has failed each time, giving the strategy its name – the widow maker.

Economist Rudiger Dornbush once observed: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”. Japan’s toxic combination of weak economic performance, large budget deficits, high and increasing levels of government debt, declining household savings and looming current account deficits is increasingly unsustainable.

© 2013 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

Perceptions of Beauty & Stock Valuations

The American comedian Will Rogers provided sage advice about investing: "Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it".

Changes in the economic environment and a world of low growth make following Rogers' method more difficult than ever.

Stock spruikers argue that equities are “undervalued”. But changes in the economic environment may make quaint measures such as price-earning (“PE”) ratios misleading. In a world of low growth, the dynamics of corporate earnings, which ultimately underlie stock prices, have become more complex.

Profit margins and cash flow improve, perversely, in a period of low growth. Initially, companies cut costs improving profitability. As revenues are stagnant, companies have no need to invest in expanding capacity or working capital, releasing cash flow.

Reduction in depreciation charges and the ability to use cash flow to reduce debt reduces interest expenses. In the present cycle, sharp decreases in interest rates, though not necessarily interest margins, have also improved profit margins.

These effects are short term. In effect, they misstate earnings. As English Economist John Hicks argued true income must to allow for sustained productive capacity, which is the amount that can be withdrawn or paid out without diminishing the ability to produce the same next year.

Plant must eventually be replaced. Cost cutting, productivity improvements and restructuring cannot be repeated endlessly.

In the long run, increases in profitability require revenue growth. But lower growth translates into lower demand slowing revenue increases. Lower demand and also over capacity in many industries have reduced corporate pricing power decreasing profitability.

A striking feature of recent corporate history has been low and poor quality revenue growth. Earnings have increased more than revenues. Where companies or sectors experience revenue growth, the causes are interesting.

Beneficiaries of government spending targeted at increasing demand have benefitted.

Artificially low interest costs have encouraged substitution of technology and mechanised equipment for human resources boosting revenues of technology and industrial equipment manufacturers. Commodity producers’ revenues have benefitted from rises in volumes (driven by emerging market demand) and higher prices.

Banks and financial institutions’ earning have benefitted from central bank activity to create artificially low interest rates and provide near unlimited funding.

Policy measures have provided additional “carry” income, allowing banks to borrow at near zero rates to invest in government bonds or higher yielding assets. These investors have also profited from capital gains as central banks have intervened aggressively to bring down asset yields. Low rates have also reduced loan losses allowing weak borrowers to continue to service crippling debt. In the US, specific actions targeted at the housing market have boosted returns for mortgage lenders.

Unsurprisingly, bank earnings and stock prices have performed well.

Some firms have increased revenue by cannibalising competitors and adjacent industries. RIM and Nokia have lost market share to i-Phones. Sony’s Walkman and other makers of mobile entertainment devices have lost market share to i-Pods. Makers of personal digital assistants – Palm Pilots and Handsprings- were superseded by smart phones. Tablets have increased market share at the expense of desktop and notebook computers.

Picking the winners and losers in this game is difficult.

The build-up of cash on corporate balance sheets is frequently cited as a sign of corporate health.

In the US, since 2008 companies have been net lenders rather than borrowers and now hold around US$1 trillion in cash. Japanese companies hold liquid assets of US$2.8 trillion. European companies too hold large cash balances. Mark Carney, the newly appointed Bank of England governor, referred to the $300 billion of cash held by companies in his native Canada as “dead money”. He urged vainly for firms to “put money to work and if they can’t think of what to do with it, they should give it back to their shareholders”.

The high cash balances reflect uncertainty about future financing conditions and the willingness of banks to lend. But it primarily reflects the lack of investment opportunities.

The cash balances are a drag on corporate earnings, given the near zero interest rates in most developed markets. But cash surpluses have influenced stock prices and returns.

Following Mark Carney’s advice, many companies have returned capital, through stock buybacks and higher or special dividends. In late 2012, fear of US tax changes prompted such actions. But investors are now faced with the problem of where to deploy the cash.

Other companies have used surplus cash to purchase competitors, businesses or assets. Given the indifferent results of many mergers and acquisitions (many acquisitions by technology firms and resource companies come to mind), it is unclear that this will benefit anyone other than shareholders of the acquired company and investment bankers.

Equity valuations increasingly will reflect changes in the market environment.

Changing demographics affect stocks. Investors approaching retirement may switch to more defensive asset and seek steady income, favouring bonds and cash. Low and declining returns over time has also undermined demand for equities. The reduction is evident in outflows from equity funds into other assets.

But a major factor is increasing distrust of the market itself.

Government policies especially zero interest rate policies, quantitative easing and other forms of financial repression, now exert a significant effect on stocks. Low holding costs have driven stock prices. Dividend paying stocks have benefitted from the attention of investors seeking income.

With limited policy options and central bank desire to boost asset prices to protect financial institutions and increase consumption, further intervention, including direct purchases of stocks, cannot be ruled out. The Bank of Japan has purchased risky assets including corporate bonds and stocks. During the 1997/1998 Asian monetary crisis, the Hong Kong Monetary Authority purchased stocks.

Algorithmic trading now dominates stock markets, making up between 30% and 70% of all activity. While necessary to facilitate execution, computerised trading may increase volatility. Holding periods now average a few seconds. Computer generated market failures, such as the Flash Crash and the problems of Knight Capital, reduce confidence in the integrity of the market.

Average investment periods for traditional investors have fallen from 7 years in 1940, 5 years in 1960s, 2 years in the 1980s to 7 months currently. Short term trading feeds volatility and may distort values.

Responding to shorter investment holding periods, the European Union have proposed a quixotic investor loyalty plan (rather like a mileage scheme offered by airlines!). Under the plan (which faces significant opposition), loyal shareholders in European companies would benefit from extra voting rights and higher dividends. This would be a significant change to the “one-share one-vote” principle of corporate structures.

Despite the increase in computer driven trading, overall trading volumes have declined by 15-30%. The reduced liquidity affects stock valuations.

Revelations of insider trading reduce and expert networks designed to secure preferential access to tips has emerged. As Robert Khuzami, director of enforcement SEC put it in his successful prosecution of Galleon: “Raj Rajaratnam is not a master of the universe, but rather a master of the Rolodex”. Institutionalised wrong doing further undermines investment interest, especially from retail investors.

Equity market analyst Laszlo Birinyi may have been right when he observed that “the relationship between the stock market and the economy is tangential, not causal”. But in the longer term, the disjunction between fundamentals of real earnings or cash flow and stock prices as well as changes in the structure of the market undermines investor interest in and demand for stocks.

John Maynard Keynes famously likened the stock market to a beauty contest, where success depended on anticipating the views of the judges rather than an investor’s own perspectives on pulchritude. Stocks may or may not be undervalued. But fundamental changes in the drivers of stocks and trading in equities now make Keynes views on investing success more important than ever.

© 2013 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money