Good morning. A standard complaint among Unhedged readers is that the role of loose fiscal policy in stoking inflation gets lost in the interminable discussions of monetary policy. Well, good news, complainers: the Bank for International Settlements (“the central bankers’ bank”) agrees with you. In its annual report, published yesterday, the bank said that higher taxes or lower spending are needed to supplement central banks’ efforts. It is good that the BIS is saying what individual countries’ central bankers cannot or will not. But is anyone listening? Email us: [email protected] and [email protected].
Japan jitters spread
Unhedged has been bullish on Japanese equities for the better part of a year, and in the intervening months Japan optimism has gotten contagious:
To recap the bull case:
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Japan may be undergoing a sea change in corporate governance. Companies are facing all-around pressure to return cash to shareholders, including from the Tokyo Stock Exchange. The focus is on companies with a price/book ratio below 1, about half the market. Buybacks hit a record last year, and are on track to do it again this year.
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Japan’s economic cycle is nicely de-synced from other countries. While US growth is slowing and Europe is flirting with recession again, Japan’s economy is by some measures heating up. GDP has been lifted by strong capex. Tourism has roared back. Nick Nelson of Absolute Strategy Research points out that Japanese PMIs have surged recently, to 55, a level he figures is consistent with 5 per cent annualised growth.
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Global investors are underweight Japan, so outperformance could invite inflows. The dark blue line below shows the weight Japan gets in global funds’ portfolios, relative to Japan’s share of global equity value. Exposure remains low (chart from Goldman Sachs):
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Japan is not China. That makes it an interesting market for investors who want exposure to Chinese growth — by way of companies active there — without the political baggage Chinese companies have to carry.
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Japan has slain deflation. Core inflation is north of 3 per cent.
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Warren Buffett has personally blessed the market. The Japan investors who cite this often do so with a chuckle, but they aren’t kidding.
There have always been doubters of the Japan rally, as we discussed last month. Sceptics pointed to cyclical risks to Japan’s economy, as well as pessimism about how deep corporate reform would run. Those doubts, and new ones, are spreading. The simplest reason is that Japanese stocks have gone up a lot very quickly. Many suspect a correction is coming.
Jitania Kandhari, portfolio manager at Morgan Stanley Investment Management, is bullish on Japan. Among her European clients, Japan has become an unavoidable topic, and she thinks “it’s become a consensus trade”. But Kandhari told us her near-term optimism is tempered by how overextended the market looks across technical indicators. One such gauge is how far Japanese stocks trade above their one-year moving average, compared to the ex-US all-country world index. On that measure, Kandhari calculates that Japan’s relative strength is at the 86th percentile, not extreme but suggestive of a pullback.
The rally also looks disconnected from the corporate governance reform narrative, argues Nick Schmitz, Japan portfolio manager at Verdad Capital. He notes that the stocks you’d expect to benefit the most from corporate governance reform, those with the lowest p/bs, have trailed behind. One reason is that the lowest p/b stocks tend to be small caps. But because Japan value funds skew towards bigger, more liquid stocks, the very cheapest companies do not benefit from global fund flows. As he put it to us, “prices have gone up where it’s easiest to hit ‘buy’”.
Schmitz makes the point in two charts. The first shows the share of stocks with a p/b below 1, in blue, and below 0.7, in orange. The left-hand side (“Academic”) looks at the total universe of Japanese stocks, the middle (“Commercial Index”) approximates index construction methods by excluding smaller stocks, and the right side shows the iShares Japan Value ETF, a popular fund. The holdings of the popular funds are more expensive:
Second, Schmitz looks at multiple expansion by stock size. Though small caps are cheaper and have better expected revenues, it is large caps that have risen most this year:
So the rally looks both stretched and uneven. Does that matter? A buy-and-hold investor who believes the long-term Japan story may not mind if there’s a temporary snapback. But equally, it’s probably less urgent to buy in right now. The Fomo phase is ending, in other words. If Japan is indeed facing a corporate governance and inflation transformation (we’re optimistic) it will take time to develop. No harm entering the market gradually. (Ethan Wu)
Yield curve: causation vs information
Unhedged thinks that inverted yield curves cause recessions. As we put it last week:
A curve inversion is nothing else but the Federal Reserve increasing short-term interest rates above the economy’s neutral interest rate (the rate that neither stokes inflation nor increases unemployment). No one knows precisely what the neutral rate is — but long-term interest rates are something like a market approximation of it (adjusted for inflation). Short rates well above the neutral rate slow the economy. Indeed, they slow it until recession occurs, in part because the impact of rate policy on the economy is unpredictable and lagged, so policymakers tend to stay tight for too long.
Some people disagree. They think that the yield curve’s predictive power is a matter of information, not causation. The bond market, they say, anticipates the rapid decline in short-term rates that is associated with recession, and it bids up long bonds accordingly. Bond investors also price in the lower inflation risk that recession brings (at least in recent years), pushing long bonds up further. Higher long bond prices mean long yields fall below short ones, which are kept high by the Fed, creating the inversion.
Edward Finley of Arrow Wealth Advisory summed up the informational view nicely when he wrote to take issue with our causal reading:
When there is a yield curve inversion, we are witnessing the bond market expressing its views about future inflation and growth. I would argue that it’s not the result of the Fed raising short term rates above the neutral rate . . . but merely reflects the bond market’s views about the neutral rate . . . we are talking about the bond market’s ability to accurately forecast recession.
All of which helps us make sense of the seeming dichotomy between equity markets, credit spreads, etc and the yield curve. Those markets also care about future inflation and future growth. So we are prone to read them as signals of future economic growth. The problem with that logic . . . is that they are exceedingly noisy . . . if I’m right about the dynamics of yield curve inversion, it’s less likely that it’s “right” or “wrong” but more likely that bond markets have a better sense [than equity markets] for future economic growth and inflation.
It makes sense that the Treasury market should forecast growth and inflation more accurately than equity markets, for exactly the reason that Finley points out. These things are more important to the returns of Treasury investors than of equity investors. And generally, I have some sympathy with the view of equity markets taken by many bond traders: that it’s just a bunch of meth-smoking risk monkeys who are bad at maths.
But I can only give so much credit to the wisdom and prudence of bond nerds. All markets get things wrong a lot of the time. The valuation of all assets rotate around their fundamental value as euphoria and panic wax and wane. Yet the 3-month/10-year curve is eight for eight in calling recessions back to 1968. That’s a lot smarter than markets usually are!
To put it slightly differently, the yield curve could have called every recession in a half century because the collective intelligence of the bond market is very high; or it could be a coincidence; or it could be a causal relationship. I like the last explanation, because markets ain’t that smart and believing in coincidences doesn’t get me anywhere.
There is a fourth possible explanation, or perhaps a subspecies of the third, that bears mentioning. It was suggested to me by Campbell Harvey last week. The idea is that the inverted curve is a self-fulfilling prophecy. Now that everyone thinks it predicts inflation, companies see an inverted curve and become more cautious about purchasing, investing, and hiring, making a recession more likely. Connoisseurs of unintended consequences such as myself love this sort of explanation, but I have no idea how true it is.
Does it matter which explanation we prefer? I suppose you could argue that the informational view is more optimistic. On that view, all the yield curve is telling you is that, according to bond investors collectively, short term rates will fall quite a bit before too long, and there is little long-term inflation risk. This is consistent with a rapid fall in inflation that does not bring recession along with it. Or bonds investors could just be wrong this time: a sample size of eight recessions is not that big, after all.
The causal view, on the other hand, comes close to saying that if you tighten policy hard enough and fast enough to invert the curve, you must get a recession. So, while I believe the causal theory, I hope it’s wrong.
One good read
After the Wagner rebellion, Russia can never go back.
Read the full article here