“Our price target for the Yen is infinity, meaning it is going to be worthless.” – Axel Merk
One of the best performing stock markets this year in US Dollar terms has been Japan’s Nikkei 225, which is up over 35% year to date. The dramatic rise hasn’t been driven by fundamentals but rather by unprecedented levels of policy intervention which investors hope will eventually lead to improved fundamentals. As a brief history, the Japanese economy has been mired in deflation for the past two decades after massive real estate and stock market bubbles burst in the late 1980s and early 1990s. The Bank of Japan cut interest rates and was the first central bank to embark in quantitative easing (“QE”) in an attempt to reignite their economy - but to no avail. The post-bubble decades have been marked by a prolonged period of deleveraging leading to every central banks worst nightmare…deflation.
The problem with deflation, from an economics perspective, is that it disincentives spending and commerce since the value of the currency appreciates with time. In other words, consumers are incentivized to delay purchases because goods and services will become cheaper in inflation adjusted terms the longer they wait. Compounding the problem has been Japan’s culture and demographics. Japan has one of the strictest immigration policies in the world due in part to a fairly xenophobic society. Lack of immigration means the expansion of the work force and economic growth falls squarely on citizens of Japan, but Japanese citizens are having less children today than in generations past. This has led to a society that is heavily skewed toward the older generation. In fact, more adult diapers are sold in Japan today than baby diapers. An aging population and dwindling work force has been a drain on economic growth which has only aided the deflationary spiral.
As the economy slowed down due to the lack of job growth and consumer spending, the Japanese government stepped up their spending to “fill the gap” and jump start the economy. Two decades of this loose fiscal policy without the needed growth from the Japanese economy reaching “escape velocity” has created a mountain of public debt larger than any other developed nation.
The debt burden combined with a deflationary economy and unfavorable demographic trends is why John Mauldin has called Japan “a bug in search of a windshield.” His theory is that it isn’t a matter of if Japan will ever default on their debt but more a question of when and how.
This is the problem that Prime Minister Shinzo Abe (pronounce “Ah-Bay” not “Abe” as in Lincoln) inherited when he took office late last year. But unlike his predecessors who have held to the belief that the Bank of Japan should be truly independent, Abe has taken a much more active role in Japan’s monetary policy. He campaigned on a platform of loose fiscal and monetary policy as well as structural reform to incentivize domestic business investment. He promised that he would appoint a new BoJ Governor (akin to Ben Bernanke’s position as Chairman of the Federal Reserve here in the US) who believed in manufacturing inflation.
In March of this year he did just that when Haruhiko Kuroda was appointed the new BoJ Governor. Shortly afterward, Kuroda announced that the BoJ would increase its bond buying program through QE purchases and target an inflation rate of 2%. Then in April of this year Kuroda announced that the BoJ would double the monetary base over the next two years by increasing their asset purchases through QE to the tune of 1.4 trillion Yen. To put this in perspective, this level of QE equates to about 70 billion US Dollars a month which is only slightly less than the Federal Reserve’s $85 billion monthly target for an economy roughly one third the size of the US. This announcement was truly unprecedented and Kuroda went on record saying that it was “monetary easing in an entirely new dimension.”
This radical shift in policy is why investors have become so bullish on Japanese stocks while simultaneously getting very bearish on the Japanese Yen. Thus far, the policies haven’t created inflation as measured by the Japanese Consumer Price Index, but they have increased inflation expectations, which was the primary goal of the new policy.
The hope is that expectation of future inflation will get people to spend and companies to invest more today rather than putting those decisions off for a later date. It remains to be seen whether expectations will line up with reality but some big name investors are betting that Japan’s economic policies will lead to severely weaker Yen. Famed hedge fund manager Kyle Bass and outspoken entrepreneur Mark Cuban both have mortgages denominated in Yen betting that their debt burden will decrease with time as the Yen weakens against the Dollar. Kyle Bass has also gone on record to say his single best investment idea if you had to make one play today and leave it for 10 years would be to go long gold and short the Yen.
We have been following the saga in Japan for quite a while since their success or failure would have major macro implications for the global economy. When we first wrote about the Yen back in March of 2012, it was to make the bullish argument for why the Yen was a good risk-off currency that would strengthen against the dollar. This thesis was predicated on the fact that the BoJ had a long history of being week handed and Japan’s balance of trade was a natural tailwind for the currency. Our second update on the Yen talked about how winds of change were blowing through Japan, which led us to close out our long Yen position. Fast forward to today and those winds of change are more like hurricane regime shifts. The central bank is not only not weak handed but they have quickly swung the pendulum to the other extreme of being heavy handed. In addition, Japan’s balance of trade is now firmly negative, acting as a headwind for the currency.
The case to be short the Yen is an easy one to make and one that we are strongly considering for our portfolio. Fundamentally, Japan is in trouble and their only way out is to steal from their citizenry by inflating away the value of their mountain of debt through currency debasement. This is why shorting the Yen has very much been a consensus trade over the past year. The one thing that could definitely put a halt to the Yen’s slide would be other countries realizing Japan’s “beggar thy neighbor” policies were nothing more than a currency war. The line between a currency war and simulative economic policy is blurred to say the least. A recent meeting of G-20 finance ministers decided that Japan’s aggressive monetary policies were not an overt “currency war” giving the green light to BoJ. The weaker the Yen gets, the cheaper Japanese goods become to American and European consumers and other exporting nations like South Korea, Indonesia, and China will begin to feel the pinch. These countries will become more vocal in their objection if their economies start to suffer. Given all this, the path of the Yen will most likely be bumpy and volatile, but we still think it stands a good chance to weaken considerably against the Dollar, which is why we are strongly considering it for our portfolio.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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