We can all pretend that debt doesn’t matter. We can pretend that demographics don’t matter. We can pretend that raising taxes aids rather than frustrates an economy, and we can pretend that citizens will continue to bend over and be sodomized by central bankers.
But we’ll only ever be pretending, because in the real world all of these things matter, and in the real world human beings will always look out for #1. Darwin was right.
This is universal, but today I”m talking about the land of the rising sun, the land of Toyota, Mitsubishi, Saki, Yakuza and glowing fish. Fukushima dealt a huge blow to Japan’s economy, not least because Japan is no longer energy independent, but what will really kill Japan’s economy is its state of finances.
We edge ever closer to a day when things in Japan go from manageable to, “Oh my God we’re all going to die…” unmanageable. Betting on such an event is not only intellectually sound it is financially appealing, since the amount of risk required to bet this way is heavily skewed in our favour.
Asymmetric trades which allow for substantial payoffs is exactly what my friend and partner Brad’s strategy has been for decades. Decades which have earned him tens of millions of dollars from applying methodical strategies based on his core thesis of finding global deep-value asymmetric trades.
Why do we think the day of reckoning is close? Well, financing debt requires capital inflows. Japan has managed to finance truly absurd debt levels due in no small part to its previous trade surplus and domestic savings pool. Both of these elements are being systematically eroded in rapid fashion, leaving Japan looking a lot like Wile E Coyote as he runs of the edge of a cliff, just prior to plummeting towards the earth.
Firstly lets deal with the domestic savings pool. This pool of capital is, as we’re all by now well aware mostly held in JGBs. It isn’t growing while the debt burden grows, and it cannot grow, as the demographic headwinds facing Japan are the most severe in the developed world. But don’t let such a dire situation get in the way of a solution. The government are funding so called “match making” parties in a desperate attempt to boost the birth rate. As if that was not absurd enough, they’ve turned to creating a robot baby… I kid you not. What, I hear you asking, is, “What is this meant to do?”
Well, it appears that the Japanese population is so devoid of emotion that they require these “bots” to “trigger the maternal/paternal instinct, causing people to “want” to have a baby. Trust me, I’ve had young babies and a crying baby, let alone a robot does nothing to stimulate anything in me, other than a headache. It is the last thing on earth likely to drive any rational human being to want to get horizontal!
Hopeless!
Now lets move on to a trade. I found this in the Wall Street Journal. It shows Japan’s waning trade. Put simply, the fundamentals for Japan are terrible.
According to this recent Bloomberg article, Japan have just reported a widening trade deficit with exports by volume falling the most since June last year.
The deficit quadrupled from a year earlier to $1.45 Trillion yen ($14.1 Billion), larger than a 1.08 Trillion yen projection by economists. On a seasonally adjusted basis, the deficit grew to 1.71 Trillion yen.
All the while JGBs hold steady, the yen remains supported in large part right now from the uncertainty in Europe, with Ukrainian headlines causing capital to run to “safety”. Volatility in the Yen is low and the pricing of it is nothing short of unbelievable. Once again ideal hunting grounds for Brad.
In an email exchange with Brad he provided me his thoughts on the above topic:
While much has been debated about the affect of “Abenomics” on the Japanese economy, the “kingpin” to the outcome in Japanese financial markets is the Yen. A material move to the upside in the USD/JPY will result in the Nikkei moving higher. There is absolutely no question about that. What is questionable is if there is a material rise in the USD/JPY, how much will Japanese equities rise in USD terms (if at all).
My suspicion is that a significant move to the upside in the USD/JPY will result in Japanese equities rising in USD terms and to a degree that surprises most.
Why? Well the answer rests in the JGB market.
A material depreciation in the JPY (rise in the USD/JPY) will cause inflationary pressures in Japan. Given that the 10yr JGB yield is trading at a mere 0.60% it should be obvious that the “Japan will continue to experience deflation for another generation” trade is one of the most crowded trades on the planet!
When this unwinds (probably due to inflation appearing) then the flow of capital out of the JGB market will be one of the biggest floods we have seen in a generation. Funds flowing out of JGBs have essentially two routes:
- to stay within Japan and the only viable home would be in equity markets (equities win) or
- out of Japan itself, which would result in further selling in the JPY which in turn would push the Nikkei higher (equities win again).
So a material depreciation in the JPY equals a win-win situation for Japanese equity markets. The real question is will we likely see material upside in USD terms?
Well put it this way – it wouldn’t be hard to achieve a material move to the upside due to two factors
- the volume of funds in JGBs (its one of the worlds most crowded trades) and
- the lack of liquidity in Japanese shares. So even a relatively small flow out of JGBs and into equities is likely to lead to material gains in Japanese equities in multiple currency terms.
That’s the “view” as attractive as it is, but what really makes this “trade” attractive is in the way that it can be applied to achieve an “anabolic” asymmetric payoff with relatively little capital outlay. If one looks at the cost of long term options (going out 1-2 years) on the Yen and equities you will observe that it is either at multi-year lows (in the case of equities) or very close (the Yen). So it won’t take much of a move in the JPY and or the Japanese equity market to translate into dramatic returns if one applies the view via long-term call options.
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If you have any questions, thoughts or comments related to trading, drop them here. Each Friday Brad shares his thoughts and answers questions on the markets, trading and anything in between. We promise to respond!
Have a wonderful weekend and see you next week!
– Chris, Brad, and the rest of the team
