Japan

From A Dog To A Darling: 5 Ways To Profit From Japan That Most Have Missed

From a dog to a darling, Japanese stocks have finally found favour. After returning 52% for investors last year, there are still 5 reasons this market has further to go, with opportunities most have missed. There is the potential for a catch up within the stock market, mispricing, earning growth, restructuring and increased buying. Sectors to benefit from reflation and growing domestic demand within a still unloved part of the market may profit.

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The EU ‘Rescue Fund’ – Part of The Problem Not The Solution

There is still much to be decided before EU leaders can claim to have provided a comprehensive and credible plan to end the sovereign debt crisis. The rescue fund itself has met with significant obstacles, with demand in doubt and delays to capital raising leading to question marks over its ability to borrow on behalf of those that can’t. Instead of improving sentiment, it may cause it to deteriorate. Details, commitment, growth, structural reforms and greater consolidation of governance, fiscal policy and politics are needed. This has become a global issue.

Deutsche Bank, Germany’s biggest bank, and Credit Agricole, the largest retail banking group in France, rallied more than 19% over the last week in October after certain ‘positive’ news was announced at EU Summit. Measures included the leveraging of the rescue fund to €1tn, a voluntary default of Greek debt and bank recapitalisation. However, this may involve a dangerous derivative structure with insurance coverage not guaranteed and demands not going far enough.

Delays could hit sentiment, deadline looming

The European Financial Stability Fund (a.k.a. the ‘rescue fund’) was created to borrow on behalf of those countries that found themselves unable to borrow (read Greece, Ireland, Portugal etc). However, Wednesday’s attempt to raise capital met a substantial obstacle – limited demand, leaving the fund itself unable to borrow. The €3bn 10-year bond offering had to be postponed, in the hope conditions would improve but a ‘red flag’ has been raised. If this fund is already having issues, at its current size with a lending capacity of €440bn, how will it manage with demands up to €1tn? Inadequate demand could cause sentiment to deteriorate, worsening the very situation it was meant to improve.

Demand from the East now in doubt

Plans to leverage the current fund to enable this €1tn of firepower seem to be heavily reliant on demand from the likes of China and Japan. This makes their apparent lack of interest in this recent bond offering most worrying. Investors have maintained the situation is too opaque and the risk/reward potential too skewed to the downside.

Dangerous derivative structure

The ‘Special Purpose Investment Vehicle’ which would allow this leveraging to occur has been likened to a CDO – collateralised debt obligation and the instrument that was at the heart of the subprime crisis, by insuring investors against loss. The bonds act as collateral so investors effectively buy junk sovereign debt with a certain level of guarantee from the fund.

The Greek ‘haircut’ has highlighted some of the risks. The ‘writedown’ of debt was structured as ‘voluntary’. It was agreed that private bond holders should offer to write off half of the amount Greece owed them versus a formal, official, enforced default. The latter would be classified as a credit event and trigger any insurers to pay up. However, the former doesn’t. Therefore investors who insured against losses paid a premium for cover but won’t get paid out to offset the losses suffered. The risk of a debt ‘default’ may not always be mitigated.

 Doesn’t cover all that is needed

More details are needed to understand how bailout facilities will be implemented and hopes for the first signs of commitment from the IMF, China and Japan were dashed at the G20 Meeting last Thursday and Friday. Moreover, the recapitalisation of the banks, which was set at €140bn will need to be increased dramatically. The IMF already put the level at €200bn, with analysts advising a number nearer €275bn.

Finally, the fund does not compensate for what the EU really needs: growth, structural reforms and greater consolidation of governance, fiscal policy and politics. The EU’s jobless figures are the highest they’ve been since the launch of the euro. Draghi may have put the focus back on growth by cutting interest rates, in a move that surprised the markets, from 1.5% to 1.25% but admitted growth forecasts are likely to be downgraded so the EU economy will remain fragile for some time. Accounting for approximately 24% of global GDP and with lower demand hitting export-oriented Asian countries, as for example Taiwan expands at its slowest rate for 2 years.

This is a global issue.

Gold may Glitter but can it Deliver?

The classic “safe-haven” investment has seen a strong uptrend in its value since the autumn of 2008. Risk aversion, inflation fears, falls in the dollar and demand from the east have all been credited as drivers of this move. But just how supportive are these factors going forward — what is the risk gold could lose its lustre?

A Hedge against Inflation

The fear of inflation is heating up as on Wednesday the Bank of England suggested that “there is a good chance” inflation will hit 5% later in the year, far above the target rate of 2%. Elsewhere, on the same day, Chinese inflation figures surprised on the upside. However, is gold an adequate hedge? It can be shown graphically that it is not. Charting the inflation rate (CPI change year on year) against the gold price, we can see that over the past decade the relationship breaks down. Indeed, if the gold price kept up with increases in general price levels, it would be valued at $2,600 an ounce instead of around the $1,500 level. How about if instead of actual inflation, we look at the market’s expectation of inflation? Even in this case, the relationship does not hold. Instead, there are other factors at play. As previously discussed, investors may be more focused on the sustainability of the economic growth rate and allow for some inflation. Inflation alone may not provide sufficient support.

The Gold Price (white) vs. CPI change year-on-year (orange). Source: Bloomberg

A Beneficiary of Risk Aversion

So — could upcoming economic, fiscal or political disappointments sufficiently boost the gold price? Here the case looks stronger. From sovereign debt crises in Europe, to the tragic tsunami in Japan and the turmoil in the Middle East, there has been enough newsflow to stoke fears and flows into gold (a “whopping” $679m of capital was invested in precious metals in one week alone at the beginning of April). Furthermore, a lack of confidence in the dollar further boosted investment for those looking for a more reliable base.

Demand from the East and Central Banks

In addition to jewellery demand, central bank purchases may provide much support for gold as we move forward. Russia needs to acquire more than 1,000 tons and China 3,000 tons to have a gold reserve ratio to outstanding currency on parity with the U.S. This is even likely to be an understatement with China stating publicly they would like to acquire at least 6,000 tons and there are unofficial rumors that this may go as high as 10,000 tons.

A bubble with no clear end

George Soros described gold as the “ultimate asset bubble” and with sentiment driving the price as much as fundamentals, it’s unclear when the trend will reverse. An increasing monetary base is looking for a home. As Marcus Grubb, MD of Investment at the World Gold Council was quoted as saying at a ‘WealthBriefing’ Breakfast on Thursday: “In the next 10 minutes the world’s gold producers will mine $3m of gold, while the US prints $15m.” However, an often-overlooked drawback in investing in gold is its lack of yield. With some stock offering attractive dividend yields and investors wanting their investments to provide attractive returns during the life of their investment, capital flows may wander.

The Investment Insight

Remain wary of relying on one driver of returns; it can often be overshadowed by another. Instead build a complete picture and continuously question your base case scenario. Gold is a more complex asset than many give it credit for and as always, it pays to be well diversified.


The ‘Surprises’ of the Japanese Crisis and the Investment Lessons to Learn

Success is not final, failure is not fatal: it is the courage to continue that counts – Sir Winston Churchill

The human suffering of the earthquake and following tsunami in Japan is well documented. Exceeding the magnitude of Kobe both in strength and structural damage, the final cost is unknown and the aftershock which occurred yesterday did nothing to abate the concern. Surprise consequences have revealed significant weaknesses in both the word of politics and business and from an investment point of view, there are lessons we can learn…

A Political Surprise – Germany

The ruling party in Germany was voted out of office in one of its most prosperous states after almost 58 unbroken years in power. If they lose one more state election in September, Merkel could face a “blocking majority”. Despite voter concerns over the EU rescue fund (which they see as a potential ‘bottomless pit’) and claims leaders are out of touch with business, the surprise came as instead the loss was blames on Japan. After extending the life of 17 nuclear power stations and then calling a 3 month ‘thinking period’, politicians claimed the nuclear crisis swayed voters towards a Green anti-nuclear coalition.

 

A Business Surprise – Car Makers

The other surprise came to the heads of car making companies. Reliant on tight inventory management and a high proportion of electrical components, the supply chain interruptions from suffering Japanese suppliers hit these firms hard. What surprised them the most was the fact that a lot of these electrical components came from a single source. Since these were often parts sold to previous firms to be built into other parts then sold onto car makers, this concentration risk was not identified. In reaction Peugeot, Europe’s second largest auto maker by volume was forced to slow production at 7 plants in France and Spain. Japan’s Nissan saw the affects lasting for at least a month and started importing engines from their US plants – a reversal of a trend.

 

Source: Bloomberg – Since March 11 2011, the date of the earthquake, Peugeot (white) has caught up with the MSCI Wold Index (yellow) whereas Nissan (orange) is still struggling at a 13% lower level – all performance normalised.

The ‘Crisis Effect’– Luxury Goods

In reaction to the devastation, many in Japan are spurning conspicuous spending. Tiffany lowered their earnings expectations and expects Japanese sales (a fifth of their total) to fall by 15% in Q1 against retail demand rising 11% on average across the rest of the globe. Bulgari has now re-opened all but one of their 40 stores but, as one of their biggest markets, sees sales remaining weak for at least 6 months. This 6 month figure may have been derived from a comparison with the Great Hanshin earthquake, Kobe, back in 1995 where the after-effects were felt for approximately this length of time. However, this time around there have power cuts affecting populous areas, supporting concerns this is over-optimistic.

 

Source: Bloomberg – Bulgari (orange) hardly moved post-earthquake despite earnings concerns whereas Tiffany (yellow) was hit hard (-11%) but has also staged an impressive recovery (+11%)

The Bottom Line – Heightened Uncertainty

What this all highlights is the heightened level of uncertainty we are dealing with. There remains the potential for events few of us could predict, with consequences which come as a surprise and, those that are temporary, with a hard-to-forecast end date.

 

Investment Insight: The Lessons we can Learn

There are clear lessons we can learn. With a global recovery still open to macro shocks, it is prudent to remain active with an ability to protect your portfolio, whether through managers that can reduce their net exposure to markets or otherwise. And from a more stock specific point of view, know companies in which you invest well, including the full length of their supply chain and the true resilience of their client base. It’s true that crucial, often overlooked details are often only realised during times of stress, and this is by far one of the most tragic. Never stop learning.