MPPI: August 2009

Friday 28 August 2009

Is the Sun finally rising?

The country of Japan has (in economic terms) been a write-off for a very long time. But a few things have happened over the past couple of years that are indicating that the Land of the Rising Sun may well be entering a new dawn. Before getting over-excited, it's worth noting what a very wise friend (who has had the unfortunate luck of being in the business of Japanese long/short equity) once told me - "Remember: the Japanese always disappoint". He is, of course, right: there have been false recoveries in 1992, 1995, 1999, and finally in 2005, all of which either petered out or were crushed by serious policy-mistakes.

There is no doubt that Japan has just experienced a very deep recession, but it was a very different recession to that experienced in the West - namely, it was export-led, and businesses were very quick to slash Industrial Production to levels not seen since the early-1980s. Since the dark depths of Q4/Q1, there has been something of a rebound, but it is highly unlikely that consumer demand from the US and other Anglo-Saxon economies will be anything like it has been over the past 25 years (I will cover this in detail in an upcoming post). And for all the noise about China, I find it hard to believe that the Chinese will import significant amounts of consumer goods from Japan in the medium-term - it is very much following a policy of "in-sourcing" - specifically, sending people abroad to acquire the expertise to produce high technology goods and then making its own cheaper versions. So China's rebalancing is good for China, but not really for anybody else (again, I'll do some work on this for a later post). So if Japan is to keep nominal GDP from falling, it is going to have to find an alternative to export-led growth.

The good news is that I think that Japanese policymakers "get it". Or at least some of them do to certain extents. The first example of this is that despite a relatively large (40%)and rapid (18months) appreciation of the Real Trade-Weighted Yen, the MoF/BoJ did not intervene in the the FX market. Since then, it has rebounded about 12%. Certainly, there were noises made when the moves in the JPY became disorderly, but I am reliably informed that the BoJ do not view the Yen as being overvalued, despite the many Investment Bank research departments that do. To see this, take a look at the below chart, showing the Yen as being at about the same levels it was in 2005 (or when USDJPY was hovering around 110). As can be seen from the chart, the real issue was the serious undervaluation of the Yen between 2003 and 2007.

Secondly, the Japanese have enacted an exceptionally large amount (nearly 100trn Yen) of fiscal stimulus over the past year in stark contrast to the half-hearted attempts of the 1990s. They are serious about trying to stimulate domestic demand. And this time, it looks as though the Japanese Consumer (who has been AWOL since 1990) actually wants to spend: opinion polls are predicting a landslide victory for the Democractic Party of Japan (DPJ) who basically have a single-policy platform to stimulate domestic demand.

Specifically, the DPJ have announced (i) that they do not object to a strong JPY, and have floated the idea of the US issuing JPY-denominated USTs, (ii) that they want banks to lend more both to businesses and to households, and (iii) that they wish to move away from the traditional strategy that has been followed by Japanese policymakers of exiting recession via an export-led recovery in favour of supporting consumption.

The first of these tenets has been discussed above, but it is also worth noting the advantages of a strong Yen. Firstly, it encourages Japanese to repatriate their overseas financial assets (although this seems counter-intuitive, there have been significant investment losses that will be cut, and with Japanese baby-boomers retiring, money needs to come back home to fund retirement). Secondly, it increases the purchasing power of the domestic consumer - it is often said that the Japanese regard foreign goods as inferior, but that misses the point: many of the constituent ingredients of Japanese goods come from abroad, and in fact, many of them are produced abroad, just having a SONY label put on them before they are sold. Thirdly, it forces the rebalancing of the economy as Japanese exports become less-competitive on global markets.

On the subject of bank lending, although the Japanese statistics have been revamped a few times over the past 20 years, it's possible to see from the below charts that credit outstanding (after shrinking post-1997, when the banking crisis became acute) began to grow again in 2005. Despite dipping down over the past year, it is still in a broad uptrend. As Richard Koo has pointed out, when the NPLs in the banking system had been cleaned up as part of the 2003 Koizumi reforms, both loan demand and supply returned and Japan was able to grow. This is important, because the banking crisis in the West has put Japanese banks in a competitive position, as they have both (relatively) clean balance sheets and political backing to expand. These is clearly a significant positive for domestically-orientated corporations looking to expand investment and also to consumers.

But what of domestic consumption? It has clearly been the case that consumption has collapsed in Japan on the back of the recession, but the effects of the fiscal stimulus already enacted, and the DPJ's pledge to enact another stimulus aimed at increasing spending should help. Indeed, it has also been floated a few times that a one-off generational tax-break might be enacted, allowing the asset-rich over-50s to pass a portion of those assets to their children. This is important, because many in their 20s & 30s have no recollection of the late-80s asset bubble that has so clearly affected consumer psyche and encouraged domestic saving. There is a corollary here related to the ability of banks to extend credit to households - with some form of financial assets behind them, these uncorrupted consumers will be less likely to be scared by borrowing and spending.

There is another, slightly unrelated, reason why I am getting enthusiastic about Japan. As a colleague's teenage daughter recently pointed out to him - Japan has all of a sudden become "cool", while America has become decidedly "uncool". As an example, how many people have noticed the relatively recent appearance on the High Street of affordable Sushi restaurants such as Yo Sushi, Itsu etc. and Japanese fashion brands such as Muji? It is also striking to see the closure of many branches of American-branded shops such as Starbucks, GAP and Borders. There are likely to be spill-over effects over the next few years as Westerners come to view Japan as a more regular tourist destination.

So how can we capitalise on this? There is the obvious Long Yen trade, but that is likely to be noisy and the levels are perhaps not as great as they have been. But what is interesting to note, is the extent to which the (exporter-dominated) Nikkei has outperformed the (domestic company-dominated) Topix - a striking 10% since March, and the ratio of the two is now at its highest since 2000. To a certain extent this is a result of the momentum-based nature of the risky asset rally since March, but given the strong history of mean reversion in Japanese equities and what appears like a real desire by the Japanese to change their ways, looking for Topix outperformance seems like a great way to play this rebalancing.

Then again... the Japanese always disappoint...

Friday 21 August 2009

Trust me, I don't Prefer you

Investors in Trust Preferred securities have had almost a rough a time as those that owned the Common Equity. As evidenced by the Citigroup conversion a few weeks ago, securities that looked like debt to the uninitiated have turned out to be equity-like. If you thought that was bad, spare a thought for the poor investors that bought Bradford & Bingley or Northern Rock subordinated debt who recently were defaulted on by the British Government.

Of course, at the back of their minds, the guys that bought sub-debt always *knew* that if they were being honest with themselves that they were taking equity-like risk. But when those banks were nationalised they thought they had a "get out of jail free" card.

But apparently not.

Fitch yesterday downgraded the subordinated debt of several UK and European banks, and the European Commission has already told Anglo Irish to defer payments on hybrid notes. The idea that subordinated debt & other low-placed elements of the capital structure will take losses has long been my opinion. As losses come through the system, the cack-handed way in which governments enacted their bail-out programs (especially the Americans) means that there is very little chance of them getting more money once the existing funds are drained, so creditors *will* take a hit.

The UK is way ahead of the pack on this one - guarantee the Senior Debt (which ensures that you can fund your Current Account deficit), but rightly hit those who took risk in trying to Arb you (as discussed above, those who bought sub-debt either knew the risks, or *should* have known the risks).

Obviously, the Trust Pfd conversion in Citi represented a large dilution - if a similar thing is going to happen in Europe, then there could be a rush for the door. Something of a shot across the bows (much like the rumours of a rights issue from Lloyds the other week).

But someone must be paying attention for ING's Preferreds to fall 26% yesterday...

Friday 14 August 2009

TLGP and tail-risk in the financial system

On October 31st 2009 one of the most important parts of the crisis measures - the TLGP (Temporary Liquidity Guarantee Program) - expires unless the FDIC chooses to extend it. In the autumn, the failure of Lehman Brothers and Washington Mutual resulted in a wholesale run on the banking system that threatened Mellon-esque liquidation. This program allowed the financial system to once again fund itself, with the backing of the government.

Since April, the amount of debt outstanding in the program has not really increased much, and since the (Un)stress(ful) Test results, very few institutions have issued debt with a guarantee as risk appetite and very large retail flows into bond funds have hoovered up debt across the financial and non-financial universe. Not only that, but political considerations around the fall-out from TARP and a V-shaped recovery in Banker-pay have strongly discouraged banks from accessing such programs (as well as extricating themselves from the TARP). Further, the FDIC (under the incompetent Sheila Bair: http://brontecapital.blogspot.com/2008/11/why-sheila-bair-must-resign.html) appears to be losing the battle for regulatory power - as evidenced by Geithner's use of several expletives in a recent meeting discussing financial sector reform. In a nutshell, it appears highly unlikely that the program will be extended beyond October.

This is interesting, because the presence of this program removed the roll-over risk for the financing of bank balance sheets. If one has the view that this summer's risk rally has mainly been on the back of strong liquidity and easing financial conditions (as well as the turn in the industrial cycle), then the removal of the TLGP opens up an interesting possibility - tail risk in the financial sector is back. If (or when) the risk rally falters, presumably as a result of the inevitable realisation that a production-driven rebound is unsustainable without a recovery in consumption (which, as yesterday's retail sales data showed is not on the cards), then this risk grows significantly. The large overhang of Commercial Real Estate on commercial bank balance sheets threatens the return of roll-over risks and associated solvency fears.

So why am I writing about this?

What is really interesting is the extent to which Libor-OIS spreads have collapsed to about their average level of the last 20yrs (~25bps - see below chart). There is a consensus in the money market that these spreads will be permanently wider than they have been over the last 10yrs, but the exact level, nobody is sure of. For the record, I'd argue that the range should be 15-25bps, but closer to the top-end of that range. The thing is, the Fed's QE (and other liquidity operations) have dramatically increased the amount of cash in the banking system, so these spreads are being held artificially low at the moment due to the excess liquidity (recall, there are several components that make up the spread - two of which are liquidity conditions and credit risk premia).

We know that the Fed is very reluctant to increase QE further, and appears to be preparing the market for no extension in the amount of purchases in October, although some have suggested that they might pool the MBS & UST purchases instead. Either way, base money is unlikely to be increased significantly in the near term unless there is another financial or deflationary shock. Thus, the downward pressure on cash rates due to liquidity in the system is likely to be muted.

To conclude, with the TLGP gone, tail-risk in the financial sector is back, and should the risk rally falter, it is likely that with the absence of this backstop that bank-related credit spreads should widen. The December 2009 forward-starting Libor-OIS spread is currently 29bps, with about 4bps of that pertaining to the year-turn effect, and represents a very high risk-reward to play this theme.