It puzzles a lot of you I know from your emails and your posts on my sites. Frankly, it puzzles me. And I’d say that anyone who says this doesn’t puzzle them has more ego than sense.
The world’s central banks have flooded the global financial markets with cash—and they’re still hooking up more and bigger hoses. The Bank of Japan alone now promises to add $80 billion to the global money supply each month.
And yet there’s no inflation. There’s no sign of inflation. Investors aren’t afraid of inflation. And inflation hedges such as gold are sinking like a stone.
Does this make any sense?
You can find a potential key to unlocking this puzzle in The Vapors 1980 hit “I’m turning Japanese I really think so.”
Let’s start by trying to understand the logic of the Japanese market at the moment.
Last week the Bank of Japan announced that it would double its current stimulus effort and buy $80 billion a month in bonds. The effort will expand the Bank of Japan’s balance sheet by roughly 1% of GDP a month. And the overt goal is to increase Japan’s inflation rate to something like 2%.
That would be quite an achievement. Japan’s inflation rate was an annual -0.7% in February. That is the country showed falling prices instead of the rising prices that make up inflation. Deflation in January ran at a 0.3% rate and at 0.1% in December. In fact you have to go all the way back to May 2012 to find a month that actually showed an annual rate of inflation. And even then the annual rate was just 0.2%.
If you believe that the Bank of Japan will achieve its goal of 2% inflation any time soon—heck, even if you believe it will attain 1% inflation any time soon—you would not buy a Japanese government bond at anything like the current price.
If you bought a two-year Japanese government bond at the closing price on April 10, you’d be locking up a yield of a whopping 0.13%. That’s a losing bet if you believe inflation is headed to 1% or 2% over the next two years.
The five-year Japanese bond yields 0.26%, hardly a significant improvement. Go out to ten years? The yield is just 0.58%. Even at 1% inflation you lose money every year on these bonds.
Go out to the 30-year bond—30 years!—and the yield goes up to 1.46%. Over 30 years you would beat inflation if it rose to 1%. You’d lose money if the Bank of Japan hit its goal of driving inflation to 2%.
Let’s assume that the Japanese and foreign investors who buy these bonds—foreign investors held 8.7% of Japanese government bonds in December 2012, up from 7.4% in December 2011—haven’t been driven completely insane by a nearly lethal dose of fugu. In what belief scenario does buying a 10-year bond yielding 0.58% make sense?
It has to be built on three beliefs.
First, most investors in Japanese bonds have to think the Bank of Japan will fail. Perhaps not immediately or spectacularly. But eventually and fundamentally. No matter how much money the Bank of Japan pumps into the Japanese economy, it will not achieve, these investors believe, 1% inflation, let along 2%.
I think there’s a good chance that this belief is correct. It’s hard to see how Abenomics presents a solution to the effect of globalization on the still relatively closed Japanese economy, or to a lethal combination of a quickly aging population and disproportionate political power to the old and rural, or to Japanese corporate structures that are distinctly shareholder unfriendly, or to the inefficiencies of Japanese capital spending and labor practices. (As Martin Wolf pointed out in an April 10 piece in the Financial Times, Japan has invested more in fixed business assets as a portion of GDP than the United States over the last ten years (13.7% of GDP per year versus 10.5% in the United States) but has badly trailed the U.S. growth rate during that period.)
Second, most investors—and many people who think the Bank of Japan will fail also hold this view—believe that even if the central bank succeeds there will be plenty of time to see the turn coming and to reposition portfolios. Inflation won’t replace deflation overnight, this belief holds, so there will be plenty of time to organize an orderly exit. But there’s also no rush to head for the exits since turning Japanese deflation into inflation will take years.
It’s hard for me to tell how much of this group believes in the “orderly exit” versus the “plenty of time to exit” scenarios. My guess, from living through the market busts of the last decade, is that this belief group is probably dominated by the “orderly exit” folks. If we’ve learned anything from the busts of the last decade, it’s definitely NOT humility. The market is still dominated at the institutional level by folks who believe they can either build a derivative that will insure them against the bust or that they are smart enough to get out ahead of the rush.
The real problem in the current market is that it does look like there’s a big hunk of time between now and when the Japanese market and economy might turn toward inflation. Not going to happen tomorrow—if it happens at all. And with the EuroZone at the edge of recession, with Chinese growth unlikely to return to the heady days of 9% to 10% annual rates, and with the U.S. recovery much slower than the historical norm, it’s reasonable to think that any turn would be in 2014 or 2015 at the earliest. And who wants to lay in a supply of inflation hedges now (and take the punishment until they pay off) or give up a year or two of profits from their current positioning?
And third, most investors don’t believe the current scenario could blow up on them. Yes, the Bank of Japan might succeed—against the odds as they calculate them—but that won’t create a bust. And, of course, there will be plenty of time to find the exit. When you’re calculating the risk of your current positioning, therefore, you don’t need to factor in the possibility of another market bust.
Unfortunately, I think ignoring the possibility of a bust is wrong. A bust scenario is actually very easy to construct and very plausible. If the Bank of Japan were to succeed to creating inflation in Japan, there is the possibility that expectations for deflation might be rapidly followed by expectations of inflation. And that inflation expectations could then run out of control.
It wouldn’t take all that much in a country that’s not used to even 2% inflation. If enough Japanese came to believe that they were looking at a permanent inflationary attack on their wealth and a permanent depreciation of the yen that constituted an attack on their standard of living, they might, in significant numbers, decide to take their money out of the yen and out of Japan. That might be enough to create a self-sustaining crisis where Japanese investors didn’t put their money into Japanese government bonds and where the yen continued to fall at a panic-inducing speed. (I am old enough to remember visiting Japan when the exchange rate was 180 to the dollar. There’s nothing sacred about the recent dollar-yen exchange rate of less than 100 yen to the dollar.)
And then what would the Bank of Japan or the government of Japan be able to do? It could raise interest rates to stem the decline of the yen—but that would stun the Japanese economy, Japanese consumers, and Japanese bondholders. It could impose exchange controls—such as those just added by Cyprus.
Pretty wild stuff, right? And you can see why it would add up to a significant bust, one that isn’t priced into the Japanese market or market behavior at all right now.
Now take these same belief scenarios and apply then to the global financial markets.
First, just like Japanese investors, U.S. and other global investors are willing to accept a 0.73% yield on a 5-year U.S. Treasury because they don’t think the Federal Reserve will be able to generate enough growth in the U.S. economy to create significantly higher inflation. Or to make the U.S. central bank raise interest rates before 2015. In fact given all the clamor on Capital Hill to cut government spending NOW there’s even a chance that the U.S. economy will slow modestly from its current growth rate and that Treasury investors will see a gain on their holdings of 5-year Treasuries as their yields sink to, say, 0.6% or 0.5%.
Second, if the Fed’s policy does succeed and if its partner in growth, the People’s Bank of China, does succeed in pushing China’s growth rate above 8.5%, then investors will see inflationary pressures coming in plenty of time to move to the exits. Goldman Sachs just lowered its projection for the price of gold to $1270 an ounce—in 2014. Plenty of time, Goldman clearly thinks, before anybody gets worried about inflation. If you do a survey of price trends for other commodities that might start to move up with higher growth and higher inflation, most don’t call for any price recovery until 2014 at the earliest.
One reason, I think, that we’re seeing massive increases in the money supply from the world’s central banks and lower prices for oil, copper, iron ore, and gold is that the consensus is that any inflationary worry is well off into 2014 or beyond. There’s no point to buying these assets now and sitting on them while they go nowhere—or fall—until they’re needed in 2014 or 2015. That kind of hedge in advance, that far in advance, can be very expensive.
And, third, no one has factored the risk of another bust into prices in this market. Oh, sure there are bears warning that stocks are over-valued and must fall. But that call isn’t constructed around a specific and plausible scenario for a bust. And consequently, it’s not factored into share prices. The one scenario out there—that an increase in interest rates that follows when the Federal Reserve and other central banks have to sell down their balance sheets—is, again, so far into the future that it’s not worth worrying about now.
Don’t worry. Be happy.
And I’d adopt that position myself if I thought that was the only scenario for a bust. I can see other alternatives: the Japanese yen panic I outlined above; a truly chaotic breakup of the EuroZone or an only slightly less chaotic descent into a recession across the area that is deep enough to take a substantial bite out of U.S. and Chinese growth rates; a run of bad loans in China that forces the government to bail out its banking sector.
How likely are any of these? I don’t know but my best estimate is that the odds are relatively low. Do I get out of the market now to protect against these unlikely events? I don’t think so. Do I ignore them completely and give up on all my hedges—selling all my gold stocks, for example? Not quite although I have trimmed positions. (I’ll have more on how I’m thinking about using gold on a post on Friday afternoon.) Do I abandon all worries about risk and pile it on? No indeed, even if selling positions that by the numbers are fully valued in order to reduce risk stands a chance of leaving money on the table if the market continues upwards.
In other words I remain a reluctant and worried participant in the current market, trying to find positions that promise a solid gain but that don’t expose me to too much risk.
What else is new?
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own positions in any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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