We Are All Global Economists Now

In April 2008, worries that a major Icelandic bank may default temporarily roiled global financial markets. Iceland's economy is minuscule and its population is smaller than that of Pittsburgh, but its banks were deeply involved in global markets, and their failure sent losses rippling through European economies and impacted financial markets around the world. It is generally recognized that the US treasury and Fed made a grave error in assuming that the failure of Lehman Brothers. Lehman was certainly not the largest player in the global financial system and had virtually no traditional banking operations. Yet its failure nearly caused a melt-down in the global financial system. In November 2009, Dubai shook investor confidence from the Persian Gulf to Tokyo after its proposal to delay debt payments risked triggering the biggest sovereign default since Argentina in 2001. Sudden shifts in China’s monetary policy have instigated sharp selloffs in the Shanghai stock market that have also reverberated around the world in a matter of hours. Last week, sovereign debt concerns in Western Europe again roiled global markets.

Welcome to the world of global finance. We are also global economists now. In Europe, the ECB is promoting research on approaching financial sector systemic risk from the standpoint of "too networked to fail" rather than "too big to fail"—or the butterfly effect, if you will. Researchers describe a global web of securities firms that are connected more intimately and extensively to the global financial system than was previously realized, especially by the regulators. To some, the "Butterfly Effect", or more technically the "sensitive dependence on initial conditions", is the essence of chaos. In the real world, an intensely interconnected global financial system that is only partially controllable by country, regional and international regulators can and often does have a dramatic effect on your savings and investments.

From out little perch in Tokyo Japan, it is easier to follow Tokyo and China’s machinations than Europe’s. When the new Obama Administration came to power, economists and strategists became extremely bearish on USD, given the inevitable and dramatic increase in debt that was inevitable given the Obama stimulus packages. Then attention turned to Japan’s dramatic increase in debt under the Hatoyama Administration. But while worrisome from a longer-term perspective, Japan’s debt looks more manageable that Western Europe’s in the short-term and the USD and US treasuries have again become the risk-avoidance choice of global investors.

The ECB's Liquidity Monster

In a blog dated September 7, 2009, Edward Hugh of the Fistful of Euros blog nailed the current sovereign debt crisis in Europe with a piece called, “There Is Another Shoe To Drop In The Global Economic and Financial Crisis - And The Focus Will Be On Europe’s Perifery”, in which he concluded that “.sometime in late 2010 or early 2011, all of this will, with a horrid and almost deterministic inevitability, all come to a head”.

In its updated World Economic Outlook published on January 26, in which the IMF again revised upward its forecasts for global GDP, the IMF continued to warn against removing extraordinary stimulus measures too early. In its September 2009 Outlook, the IMF had already stated that the policy challenge once recovery began was to map a middle course between unwinding public interventions too early, which would jeopardize the progress made in securing financial stability and recovery, and leaving these measures in place too long. With the January upward revision, IMF Managing Director Dominique Strauss-Kahn made it clear the IMF thought it was too early, again warning that countries risked a return to recession if anti-crisis measures are withdrawn too soon. His warning was ignored by the ECB, for whom we have to thank for the current European sovereign debt crisis.

To counter the global financial crisis, the US Fed monetized roughly $1 trillion of US government debt since 2007(Treasury and agency bond purchases). During a similar period, the ECB lent $1.5 trillion to Euro-area banks. These Euroland banks in turn lent most of this money to their governments. Without this funding, the governments of Ireland, Greece, Portugal, Spain and Austria would have long ago gone bust. Commercial banks in have been buying unlimited quantities of government bonds with money borrowed from the ECB, and these bond purchases in turn have been used as collateral for more ECB borrowings to buy more government bonds. Implicit support of
the ECB’s willingness to discount the government bonds first purchased by local banks and then discounted at the ECB was a major reason credit spreads tightened so visibly after the global financial crisis abated.

But like the virtually useless credit rating agency sovereign credit ratings, tightened bond spreads WERE NOT a reliable indicator of a commensurate recovery in credit quality—indeed, quite the opposite. In fact, the ECB created what UBS analysts called a “liquidity monster”; committed to providing ever-greater amounts of funding to the European banking system without any clear exit route.

Further, government securities account for less than half of the nominal value of the securities the ECB has accepted as collateral at its liquidity windows, which actually included all manner of unconventional collateral (mortgage-backed securities, etc.). As a consequence, the total value of these eligible securities is currently pegged at €12.2 trillion, or the equivalent of 130% of Euro area GDP. This large pool of eligible collateral considerably eased banks’ liquidity constraints during the crisis, but left them dependent on a steady stream of liquidity, and created a European central bank with what the FT called “rubbish” assets.

At the height of the global financial crisis, the ECB loosened the rules on what collateral banks could present to get central bank funds. This was initially presented as a “temporary” policy due to expire in late 2009. But the ECB extended the policy until the end of 2010, and many observers thought or hoped until recently that this policy would be extended again, perhaps until 2011 or beyond. This ECB funding grew to the equivalent of 2.3% of bank assets in Euroland, according to Deutsche Bank estimates, but was much higher for currently troubled sovereigns like Greece (8.8%) and Ireland (5.8%).

The Excess Liquidity Party is Over

In effect, the ECB committed to providing liquidity without the ability to regulate the banks. Thus bank reliance upon the ECB has continued to increase. The tricky part for the ECB was to withdraw this liquidity support without triggering a sizeable shock to the weaker sovereigns. It has not gone well so far. The trigger for the crisis is the ECB’s move to essentially force these banks to go “cold turkey” –i.e., the removal of between 400~500 billion Euro of ECB liquidity from July 2010. Given market movements in the first week of February, it looks like investors are trying to discount the possibility that sovereign risk contagion from Greece to the rest of Southern Europe, to five of the 16 Euro-adopting nations or more. If the contagion is not contained, it could place severe stress on potentially 20%~30% of Euro-zone GDP, say European analysts.

The Shanghai stock market has slid over 10% on China's efforts to reign in bank lending and cool off its property market. The ECB has triggered a sovereign debt crisis by trying to shut down its liquidity machine, and the Fed is scheduled to wind down its ABS purchases in March. In other words, the 2009 liquidity party is over.

All risk trades (global equities, Euro, commodities, emerging) markets have already dropped below 50-day moving averages and are now testing their 200-day moving averages. Once the immediate downside risk is confirmed, we could see an intermediate trading range develop that could continue for six months to a year. Generally this means,

1) Buy USD/Sell Euro/Pound Sterling
2) Sell Sovereign Risk/Buy US Treasuries
3) Avoid gold until downside is confirmed
4) Sell Euro equities now, buy emerging (including China) after downside is confirmed
5) Hold on Japanese equities until JPY turns again

Japan's Budget Deficits: Something Has to Give

The primary fiscal balance for Japan's national and prefectural government budget will set a new historical record deficit of JPY40.6 trillion in FY2009 (to March 31, 2010), or 2.5X higher than the JPY16.2 trillion seen in FY2008. This is also a new historical high as a percent of nominal GDP, at 8.6%, which is much higher than the previous high of 6.0% in FY1999. Going forward, the primary fiscal balance is seen being JPY33.5 trillion in FY2010 and JPY36.5 trillion in FY2011. In other words, some JPY111 trillion of debt will be added in just three years, ballooning Japan's gross government debt well past 200% and net debt well above 100%.

While JGB yields have been well-behaved despite an aborted short-JGB attempt by hedge funds and the Euro sovereign debt crisis, this belies growing concern among domestic JGB investors that something has to give, i.e., either a) Japan's economy sees a growth spurt (highly unlikely), b) inflation accelerates (again highly unlikely), or c) the DPJ-led government abandons promised expenditure plans and announces a credible fiscal reconstruction plan in June 2010, the bond vigilantes could very well push JGB yields noticeably higher despite the strong deflationary pressures pushing down Japanese domestic prices.

Massive Double Top From 2000 IT Bubble Peak. Similarities With the 1969 to 1974 Double Top

After hitting a major secular peak in 2000 with the bursting of the IT bubble, the S&P 500 went through a major correction in losing 47.6% peak-to-trough before bottoming at 800.58 on a weekly chart. The Fed's pumping monetary stimulus steroids into the financial markets reflated the bubble to a new high of 1,561.80, which was deflated by the 2008 crisis that deflated the S&P 500 to a new low of 62.34, or 56% lower than the second peak. This second low was nearly 15% lower than the post IT-bubble low. These double tops came after a 26-year bull market pushed the S&P 500 upward by 24.5-fold from 1974 lows.

On a weekly chart, this massive double top between 2000 and 2008 looks very similar to the double tops between 1969 and 1974. During these double tops, the S&P 500 lost 33% during the first selloff, and then lost another 48% in the selloff from the second peak.

Like the current recovery, the S&P 500 first recovered about 90% of the second selloff, but then consolidated for about four years from 1976 to 1980, before breaking up through the second top (1973) high. Since November of last year, we have been painting a scenario that,

a) Calls for an interim correction as stock prices shift from being driven by excess liquidity (excess monetary stimulus) to being driven by economic and earnings fundamentals as the recovery gains traction and the Fed (monetary authorities) move to normalize monetary policy.

b) Followed by a fairly-well defined trading range like was seen in Japan's Nikkei 225 from 2004~2005 coming off the April bottom in Japan's financial crisis in the 1990s. Like the first stage of recovery in Japan, the US market rebound in 2009 contained a good deal of "junk" stocks priced for bankruptcy during the height of the crisis being repriced as going concerns in the 2003~2004 recovery rally in Japan. Then, Japan's Nikkei 225 marked time in a fairly well defined trading range for about a year before breaking up through the rebound highs of the first recovery wave.

If the current recovery in the S&P 500 and US stocks follows the 2004~2005 pattern in Japan and the 1976~1980 pattern in the US, we could in the foreseeable future enter a well-defined trading range for the major US indices after this interim correction as stock prices shift gears to being driven by economic and earnings fundamentals instead of by liquidity, which was the primary driver of stock prices in the first phase.

Long-Term Weekly S&P 500














Source: Stock Charts.com

Can't Completely Ignore the January Indicator

Everyone knows the old market adage "as goes January, so goes the year", and every year there is a down January, there are a number of pundits that say the January indicator should be ignored for various reasons. Last year when January ended in the negative column, we also argued against assuming that 2009 would be a down year, simply because the market was in the process of bottoming.

Over time, however, there is good evidence that the probability is higher for a down year when January is down. Since the 1920s, the average index gain in years with a positive January close is 12.9%. In negative January years the index has averaged -2.8%. Over the past 81 years, US stocks have been up seven times when a minus January was recorded. Further, there were only three times (1928, 1935 and 2009) when two-digit returns were recorded after down January years. The other examples, (1956, 1968, 1978 and 1992), the US market recorded only tepid gains of between 1%~8%).
In other words, the historical averages support the January indicator.

China' Vice-Premier Promises to Boost Domestic Demand

Li Keqiang, the Vice-Premier of the State Council of China, told World Economic Forum participants in Davos that domestic demand contributed 12.6 points to China's GDP growth in 2009, completely offsetting the 3.9 point contraction of external demand. When the global crisis first erupted, foreign observers believed China would see a significant slowing of GDP growth, to 5%~6%. While recording one quarter of 4%~5% growth, China's early stimulus (4 trillion yuan) in November 2008 revved up domestic demand, to over 11% in the final quarter of the year.

While foreign investors now fear that China may lurch too soon and too far in tightening, the Vice-Premier promised that China would continue to stimulate domestic demand with "proactive fiscal policy", including public spending, tax cuts, subsidized purchases and incentives, while continuing to maintain a moderately easy monetary policy. Thus the sell-off in Shanghai stocks may be an over-reaction to news and rumours that the Chinese government is asking its major banks to reign in loan growth and even clamp down on property speculation.

Davos (Institutional Investor)

Toyota's "Minsky Moment"?

In economics, Hyman Minsky is known for his concept that long periods of stability cause people to take on even more debt and ever more risk, leading to a gigantic meltdown now referred to as the "Minsky Moment".

Many books have been written about the "Toyota way". US companies trying to re-invent themselves in the 1990s studied Japanese management techniques for hints how they could improve their techniques and processes. Given past fame with its world renowned "kanban hoshiki" (just-in-time) inventory management, complacency regarding its reputation for quality versus the lemons produced in Detroit, and its single-minded pursuit of becoming the world's largest car producer, this may be Toyota's corporate "Minsky Moment", which may have become too big to efficiently manage.

In 2002, Toyota set an ambitious goal of owning 15% of the global automobile market. To get there, it would have to grow by 50%, and would have to build new plants in the United States, China, and elsewhere in Asia, as well as introduce dozens of new models. Toyota managed to win bragging rights as the world’s biggest car company, but this appears to have come at a high cost.

In the past two years, Toyota's has lost a massive amount of money, totaling $7.1 billion, and recorded the first losses in its history as a public company as sales in 2009 slid 20% YoY.
Once referred to a "Toyota bank" for its solid balance sheet and cash balances, Toyota found itself having its financial unit (Toyota Financial Services Corp.) ask for JPY200 billion in loans from the Japanese government.

While aiming to return to profitability in the year that starts in April. There are signs that the company is now having some serious quality problems like those that once dogged its US competitors. Toyota now has recalled nearly 6 million vehicles for problems with the accelerators used across its lineup, a sweeping safety action that has tarnished its reputation for quality and emboldened its rivals, and this action came after reported prodding by the US Transportation Department. Toyota is halting production at six plants in the United States and Canada for the first week of February. of recalled models make up more than half of its annual sales in the United States. Major car rental agencies including Enterprise Holdings, Avis Budget Group Inc and Hertz said they were pulling Toyota vehicles from their rental fleets. There is even now a web side called Toyota Problems.com.

While undoubtedly not fatal, Toyota is experiencing the biggest crisis the company has ever faced, with Ford , Hyundai and even Chinese makers coming on strong. The company has taken on somewhat of a green image with the early success of its Prius hybrids. But Toyota's hybrid strategy has a serious flaw, i.e., full-fledged diffusion of hybrids is dependent on obtaining sufficient supplies of lithium and other rare earth metals that are a power of ten in shorter long-term supply than fossil fuels. Major current suppliers to world markets like China have already begun to restrict exports of rare earth metals, while trying to buy up as much of these global resources they can. Countries have enlisted industrial policy (for Japan it is METI) for help in obtaining sufficient supplies to avoid choking off future production.

Foreign investors have long wagged their collective fingers at Japanese companies for having poor corporate governance and a lack of outside directors to ensure proper checks and balances. Yet they have so far made an exception for Toyota, which has a bloated board consisting of corporate insiders and no outside directors.



Despite the recent spurt in performance for Japanese equities as a whole, Toyota's ADR has basically tracked the S&P 500. In the Tokyo market, it is still the largest company in terms of market capitlization, at around JPY13.98 trillion or 2X that of its nearest rival, Mitsubishi UFJ Financial Group, but only because other large-cap Japanese companies have been doing worse, not because Toyota has been doing better.



Nissan, once considered on the brink before Renault and Carlos Gohsn showed up to revive the company, is now hands-down outperforming its main Japanese rival, as can be seen in the following chart, in no small part due to the fact that Nissan is seeing the highest sales growth and market share in China, which by the way has become the world's largest car market.

Consequently, while Toyota may look attractive because it has lagged its domestic rivals and still has the best momentum in hybrid (green) cars, we suspect that merely installing the family heir and moving Japanese back into key overseas management positions won't immediately fix the company's problems. Basically, while Toyota is viewed within Japan as a "global" company, its top management is not, and it remains to be seen whether it can adopt a global view and new approaches that are commensurate with a rapidly shifting global automobile market.

Japan's GDP: No Double Dip, But Still Weak

As previously indicated by IMF officials, the IMF has raised its forecast for world GDP growth in 2010 by 0.8 percentage points to 3.9%, and its 2011 forecast by 0.1 point to 4.3%.

While US growth as well as growth in all of the BRICs nations saw upward revisions, Japan's growth forecast for 2010 was left unchanged and the 2011 forecast was actually trimmed by 0.2 percentage points. In 2010, Japan's economy is expected to recover only one-third as fast as the global economy, and half as fast as the world economy in 2011.

The BOJ's most recent medium-term outlook is even more cautious than the IMF's growth forecast. The BOJ is looking for 2010 Japan GDP growth of 1.3% (slightly revised up from a prior 1.2% forecast), and has expressed a willingness to use more of its balance sheet to provide liquidity and credit as it remains guarded about the risk of further JPY appreciation. While the BOJ does see some signs of slowing momentum in Japan's recovery, Governor Shirakawa does not see Japan's economy entering a double dip, despite the waning impact of government stimulus and other headwinds such as the strong JPY.

The recovery in Japan's economy so far has been driven entirely by exports, as July~September 2009 growth of 1.3% came from a 3.5 point boost from exports, primarily Asian market exports, which now account for some 54% of Japan's trade
versus a combined 29% for the US and the Euro regions. While recovering, Japanese industry is far from healthy, as production and exports are still only 80% of 2007 peaks, and corporate profits are only 40% of prior levels, because the business environment for domestic companies like cement, department stores and processed metals remains extremely adverse.

This is why China's tapping the monetary brakes, which has caused Shanghai stocks to consolidate, has also triggered profit-taking in Japanese stock China plays, like Hitachi Construction Equipment (6305), Komatsu (6301), Kawasaki K.K. (9107), Seven & I HD (3382) and Daikin (6367).

In addition, Standard & Poor's is not impressed with the DPJ-led Hatoyama Administrations strategy to restart Japan's growth, and has lowered the outlook for JGBs to "negative", because of delays in fiscal restructuring and the continued growth in general government debt, which S&P sees reaching 100% of GDP in the fiscal year to March 2010, and growing to 115% in the next several years. The Japanese government's net debt position is a deficit of JPY317 trillion, with total liabilities of JPY603.6 trillion (up JPY6.6 trillion from 2007) versus assets of JPY247 trillion, down JPY1.5 trillion from 2007.

Will Japan's Sleeping Pension Giant Shift More Funds Overseas?

Japan's government pension investment fund (GPIF) is the world's largest pension fund. With assets of some US1.37 trillion, it is 80% larger than the combined assets of Norway's Government Pension Fund and the Netherland's Stichting Pensioenfunds ABP.

The asset allocation of the approximate JPY90 trillion it has invested in markets. trillion it has invested in the markets as of September 2009 was 70% in domestic bonds, 11.1% in domestic stocks, 8.2% in foreign bonds and 9.6% in foreign stocks. This compares to portfolio benchmarks of 67% for domestic bonds, 11% for stocks, 8% for foreign bonds and 9% for foreign stocks.

There is now a lot of speculation regarding the GPIF's next moves as a Welfare and Labor Ministry committee is now considering how the management of the GPIF should be changed, regarding the strengthening of its investment management committee, the hiring of financial "experts" (outside managers), reducing management fees paid to outside managers and perhaps even splitting the fund into two parts--the aim being of course to achieve better investment returns.

As this committee first began its deliberations last November, and is expected to reach a conclusion by the middle part of this year (2010), while its basic asset allocation stance should be ready by the end of March in time for the new fiscal year. In the Japanese government bond market, many fund managers are concerned about the possibility that heavyweights like GPIF won't allocate fresh funds at a time when already hefty supply is rising to fund fiscal spending.

The foreign media is reporting that the GPIF is likely to cut back its purchases of domestic stocks and foreign bonds this year, removing a key source of support for JGBs just as the Hatoyama Administration's programs begin pushing up the amount of new JGB issuance needed to fund Japan's fiscal deficit. The GPIF reportedly needed about JPY4-5 trillion of funds to supply the national treasury to help repay benefits to pension recipients for 2009.

On the other hand, the GPIF was seen as one of the main drivers behind recent capital outflows from Japan that surprised the currency market with their size and persistence. The giant pension fund is estimated to have bought JPY2.2 trillion to JPY3.3 trillion (US$22-33 billion) in overseas equities between October and March, and is believed to have stepped up its buying as markets tumbled following the collapse of Lehman Brothers in September. The fund also probably bought another JPY2-4 trillion (US$20-40 billion) in domestic equities in the past six months. To us, this appears to be simple portfolio re-balancing by the fund. Despite losing some JPY9.3 trillion in 2008 during the global financial crisis, the fund moved to re-balance its allocations, moving new fund inflows from domestic bonds into equities and away from bonds, the weight of which had dropped below their benchmarks.

The fund will henceforth begin experiencing net outflows, by the amount of pension benefit payouts needed for a rapidly aging Japanese society that exceed inflows, which intitially will be fairly modest (i.e., several trillions of JPY), but as the fund is likely to make up this shortfal through maturing bonds held, there will be no equivalent rollover into new JGBs. To meet benefit payments, the GPIF will now have to begin selling down all assets, while trying to adhere to their benchmark asset allocations.

This is behind the reports that the GPIF would become a net seller of JGBs in 2010, and this news was enough for some overseas hedge funds was enough to renew their short positions in JGBs. The amount of funds directly managed by the public pension fund had been increasing because the government was repaying loans from the fund for off-budget public works and welfare projects. These loans were transferred back to the pension fund by the year ending March 2009, when the fund began managing all of its pension reserves by itself (of which 90% is hired out external fund managers).

While there are those on the committee would continue to push for a cautious stance and have all of the fund's assets allocated to Japanese Government Bonds, there is also a group pushing for higher allocations to foreign assets. The general expectation is that the new benchmark allocations will not be much different than existing benchmark allocations.