investment recommendation for japanese bonds/equities

7/29/2019 Investment Recommendation for Japanese Bonds/Equities

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GlobalDebtCrisis:GreeceEuropeJapan?Frommypreviousarticle:GreeceandPortugalarestuckinaveryviciouscycle.GreekandPortuguesesovereignbondyieldshaverisensubstantiallymakingitnearlyimpossibleforthesenationstorolloverthedebtwithyieldstheycanpay.ForGreece,risingyieldshavebrought it to the edge of default several times. To prevent a Greek default, the Troika(European Commission, InternationalMonetaryFund, EuropeanCentralBank) hasbeen

sending large tranches of money to Greece to keep Greek bonds afloat and the Greekgovernmentsolvent.LastyearPortugalbecamethethirdEUcountrytoaskforaidfromtheEU and IMF. In June, Portugal will need to rollover 10 BillionEuros of debt and it is adubiousnotionthatPortugalcandothiswithoutpayingextremelyhighyields,unlessthetroikaagainbecomesthelenderoflastresort.WhenGreecewentthisroutetwoyearsago,massiveamountsofmoneywereneededinaidandbondbuyingtokeepitscountryfromdefault. When I see headlines fearing the end oftheworld for Greekbondowners andpossibly Portuguese Bond owners, I have to think, Whose head will roll next? In myprevious article examining the future of Japans equities, I came to the conclusion thatJapanese debt isnot a safehaven, but issailing intoa tsunami. Inthis article, I hope todevelopanevenstrongerargumentforwhyJapanssovereigndebtisanunsafeinvestment

and why I suspect Japanesesovereign debtwill soon bebludgeoned bya tide of risingyields,whichwehave seenwreak havoconbothGreekandPortugalbondprices, theireconomiesandpoliticalstability.The key toprofiting in the future on JGBswill beunderstanding the rapid social moodchangesthatoccurwhenatippingpointisreached.Atippingpointisthecriticalthresholdwhereaslightchangecangreatlychangetheenvironmentofthesystem.Thiscurvilinearchange in social mood and thought, often occurs in the popping of bubbles like themillenniumdotcombubbleinUSequities.Oftenbecauseoftheinnatehumanbiastoviewtheworldinalinearfashion,tippingpointsareunforeseenbythemassesbecauseoftheirnon-linearelementsandcomplexform.

Japanstippingpointwillneedtobecatalyzedbyatriggerwhichcouldbeapsychologicalcontagioneffectfromaglobalcreditevent,aJGBdowngrade,orothersIwillexaminelaterinthispost.Triggerswillcauseanincreaseinyields,whichwehaveseenforceGreecetonearlydefaultonitsbonds.Forexample,abigenoughcrediteventoriginatinginEuropewilltriggeratippingpointintheworldssovereignbondmarket.BondsthatareatrisklikeJapanswillexperiencealeapinyieldsbecausethemarketsopinionshaverapidlychanged.Investorswilldesiremuchhigher riskpremiums(yields)after beingburnedbythe riskassociatedwith sovereign bonds likeGreeces. Japanhasbeenkicking the can down theroadforsometimeandariseinyieldswillbethetippingpointforJGBs.

My top indicators that Japan Government Bonds (JGBs) are over-valued and could bereachingatippingpointare:

TheJapanesesovereignDebttoGDPratioiscreepingcloseto230%.IncomparisontoGreeces sovereignDebt toGDP ratio of150%andPortugals sovereignDebt toGDPratioof180%,Japans230%ismorethanworrying.InUSdollars,eachJapanesecitizen(child, worker, and retiree) owes about $86,200 each to Japanese Sovereignbondholders.(Source:theEconomist).


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GraphicSource:YoucanseehowJapanhasearnedthenickname,landoftherisingdebt.Rightnow,JapanhastheworldshighestsovereignDebttoGDPratioat230%,eventhoughJapanalsoistheworldsthirdlargesteconomy!

Japans sovereign debt maturity timeline is very frontloaded and has an averagematurityofabout6yearswhichisshorterthanItaly,France,Greece,Ireland,Spain,and

Portugal. A short average maturity means that more debt will become due earlier,puttingmorerolloverriskonJGBs,if interestrates increaseevenslightly. The graphbelowshouldscareinvestors.


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GraphicSource:

Duringthenextfiveyearsmorethan60%ofcurrentJGBswillneedtoberolledover.Thisisascaryprospectgivenwhatcouldhappenifborrowingcostsrise.Ifatanypointbond market investors no longer believe Japanese debt is as safe as it once was, avicious cycle of ever increasing interestpayments will begin just like inGreece andPortugal.ThisisthetippingpointthatisrealityforJapanesedebt.

InAprilof2012,theJapanesegovernmentexpectstomarketanother$566BillionUSor(44.2TrillionYen) tosimply pay for the budgetary spendingin2012 that theycantfundwith tax revenue.Thisbondoutlaywill raise Japansbudgetary dependenceondebttonearly50%;incomparisontheUSin2012onlyhasa29.6%dependence.


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GraphicSource:

IbelieveJapansdebtdependencesendsaverystrongsignaltothebondmarketsthatthisdebtmightnotbeasAA3rated(accordingtoMoodys)asmanyinvestorsbelieve.AnotherwaytoperceivethisproblemisbycalculatingthepercentageoftheJapaneseGovernmentsrevenuerequiredtopayonlythedebtserviceonitsdebt,(justincase

Japansuddenlycannotborrowmoredebttopayitscurrentdebtsinterestatcurrentextraordinarylowyields)


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GraphicSource:

Asyoucanseefromthisgraph,42.5%ofallofJapanstaxrevenuewouldhavetobespentpayingitsdebtservice(bondcouponpayments).IftheslightestthinggoeswrongforJapan,thescaleofthecrisisthatensueswillbealmostunmanageable.Asyoucanalsoseefromthisgraph,totaldebtservicepaymentsaresteadilygrowing(blueline)andgovernmentrevenuesaresteadilydecreasing(redline),fortwodecades

Japanspopulationisrapidlyaging.


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Overthenext50yearsJapanstotalpopulationwilldwindlewhiletheproductiveagepopulationwillalsobecomeasmallerandsmallerpartofthetotalpopulation.Anagingpopulation will put stress on the welfare system that Japan has in place and willcontributemorestresstotheJapanesebondsinthefuture.

OtherkeymoneymanagersarestartingtosuspectsomethingisamissintheJGBmarketas well. Kyle Bass, who made a fortune on the housing bubble crash and manages

HaymanCapital,recentlycomparedJapaneseBondstotheMadoffPonzischeme. TheMadoffPonzischemewasprofitableandviableuptothepointwhenmoremoneywasgoingoutthanin.WiththeagingpopulationinJapananditselderlycitizensnolongerbuyinglotsofbonds,itisstartingtofeelliketherearemorebondsellersthantherearebondbuyersinJapan.WhentheJapanesegovernmentisforcedtogototheglobalfixed-incomemarketsto sellbonds, the statusquoofextremely lowstableyieldsmightbereachingatippingpoint.

IhaveshownalloftheimportantpiecesareinpositiontosetJGBsupforatippingpoint,butitisalsousefultounderstandatwhatpointinvestorscannolongerdenyJapanisintrouble.Currently, Japanscost ofdebt isonly .97%on10yrbondsand0.12%on1 yr

bonds. So the Japanese government is managing to float by paying extraordinary lowinterest rates and manageable interest payments. Now imagine what these interestpaymentswouldlooklikeiftheinterestratewas1.92%like10yrUSbondsor1.86%on10yrGermanbonds.Toputtheselowratesincontext,Portuguese10yrbondyieldshitanewhightodayat15.22%.ThegraphbelowshowsthepointatwhichtheseinterestpaymentswouldoutstriptherevenuetheJapaneseGovernmentcouldrakeinviataxesbasedon2011figures.


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Currently interest rates are about1%. If yields rise even apercent or two, the interestpaymentsonJGBswouldbecomemassive,andtheJapanesegovernmentwouldhavealotofdifficultyinrollingoverthedebt,muchlessaddingtoitliketheyplantoin2012.AtthepointwheninterestpaymentsexceedtherevenuestheJapaneseGovernmentcantakeinviataxes,itissafeforinvestorstosayJapanesedebtismoreriskyandworthless.KeepinmindthatPortugalhasacostofdebtof15%onits10yrbonds.Assoonasthetippingpointisreached,Japaneseyieldswillbeinforaverylongrideup,whichwillcauseenormousdisruptioninJapan.

HoweveratippingpointforJGBswontnaturallyoccuronitsownandthepanicwillneedtobetriggered.ThenextsetoftriggersIbelievewillstartthefleefromJapanesedebtandfacilitatetheriseinyieldsandtheviciouscycle.

AglobalcrediteventwouldtriggeracontagioneffectandriseinJGByields.TheloomingGreekdefaultmakesacrediteventoriginatinginEuropehighlylikely.WhenbankshavetoadmitthatmanybondsinEuropearenotworthwhattheyarecurrentlypriced,theywillhavetomarktomarkettheirbondholdings.Asaresult,manybankswillfail.InvestorswilllookatJapanwithuncertaintyandyieldswillriseforJGBs.TheIMFhasalreadystatedthatthelargestrisktoJGByieldsisaglobalspilloverofcreditstress.AcorrelationofJGByieldswithotheradvancedcountriescanshowhowinter-relatedglobalcreditstressandJGByieldsare.


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GraphicSource:IMF

After the first large-scale credit event inrecent years, Lehman brothers collapse inSeptember of 2008, the yields correlation among advanced countries has becomestronger. In2011, the trend continued and the correlationbetween JGB yields andyieldsinGermany,France,andtheUSbecameevenstronger.IbelievethisshowsthedramaticcontagionrisktoJGByields.

Anotherpossibletriggerwouldbeachangeofsentimentinbondmarkets.Ifglobal

investorsbecomefrustratedwiththeincreasingriskanddecreasingyieldinJGBsthenwecouldseeariseinyieldsduetoareductioninthedemandofbuyersforJGBs.TheJapanesegovernmentsrateofborrowingisincreasingandinvestorscouldbegintodemandlargeryields,creatingatippingpointthemselves.IbelieveagoodbondsentimentindicatoristheCDSrateandincomparisontopotentialcatastrophecountriesandadvancedcountries.JapansJGBshaveaverylowCDSratecomparedtototalamountofsovereigndebt,butisveryabnormal.


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GraphicSource:IMF

JapanislocatedwaytothebottomrightonthegraphwherenoothercountryhasbeenabletosustainhighsovereigndebtandlowCDSrates.Japanmaybetheexception,butthisobviously showsinvestorsareverytrustingrightnow inJapanandonlyaslightchangeinthatsentimentisneededtosetthesystemonitshead.Aregressiontothe

mean will cause depression, desolation and default. Personally, when I look at thisgraph,IcannotimaginehowJGBsarenotmispricedespeciallygiventhedifficultyJapanwillhavepayingitsdebtsbackifyieldsrise1%percent.AtsomepointthemarketsaregoingtorealizethisisfollyandinvestorsbettingagainstJGBsaregoingtoprofitfromit.

An aging population will lead to an increase in social security payments and adecreasingnumberofinvestorstheJapanesegovernmentcanmarketitsbondsto.Asthey enter the dis-saving stage of life, one can see how important these comingchangesindemographicsarewhenJapanesecitizens,banks,andfundsownmorethan94%ofJGBs.


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GraphicSource:IMF

Comparedtootherwesterndevelopedeconomiesintheworld,Japanstandsaloneinfundingalmostallofitsdebtthroughitselfanditscitizens.Asaconsequenceofarapidlyagingpopulation,pensionfundsaresellinglargeamountsof JGBs topay for the increasing number ofpensioners.Pension funds typically buyriskfreegovernmentbondstoobtainthematuritiesneededtomatchtheirpayments

as workers retire. Unfortunately for the Japanese government, pension funds havealreadypurchasedasmanygovernmentbondsastheyareevergoingto.

GraphicSource:ZeroHedgePension funds including the National Pension Fund that owns 10% of all JGBs havebecomenetsellersofJGBs,whichmeansthatanynewbondstheJapanesegovernmentplanstomarketaregoingtobeevenhardertosell.Intherightpanel,youcanseetheJapanesegovernmentincreasinglyrelyingonshort-termbillstofunditsdebt,whichisnotahealthysign.

Unfortunately,debtservicewillnotbetheonlythingtheJapanesegovernmenthastopay for in the future. The graph below shows how much non-discretionaryexpenditures Japan can be currently paid for with tax revenue. Non-discretionaryexpenditures include debtservice, education andthequicklygrowing social securitypayments.


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GraphicSource:ZeroHedge

AdecreaseintheamountofmoneysavedbyJapanesehouseholdsandinvestedinJGBs

couldtriggerthetippingpointaswell.Whiletherearefeweryoungpeopletoinvestinbonds, the household saving rate has been steadilydecreasing over the past twentyyears.Japanesecitizensarenotlookingliketheywillbepickingupanyfutureslackin

outlaysofJGBs.


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GraphicSource:

ThemostpopularsavingvehicleforJapanesehouseholdshasbeenJGBssincethestockmarketpeakin1990,butifhouseholdsaresavinglessandless,thatdoesntbodewellforfutureoutlaysforJGBs.For twenty yearsand untilrecently, equitieswereone ofthemostvolatileand poorinvestmentsinJapan.ThusJGBsdidnthavetocompetewithequitiesforinvestors,butnowthedividendyieldofJapaneseequitiesmorethandoublesthe10yrBondyield.ItisbecomingharderandharderforJapanese(banksandcitizens)tojustifyinvestinginbondswhen stockand dividendyield appear tohave broken the disastrous 20-yeardowntrend.

GraphicSource:The divergence of dividendyields and bond yields hurts the future marketability ofJGBstoJapanesecitizens.IfenoughJGBbondholdersbegintosellJGBsandbuyequities,itcouldtriggerthetippingpointforJGBsaswell.IndisclosureIamlongbothJOFand

JEQwhichareclosedendmutualfundsthatspecificallyownbothlargeandsmallcapJapaneseequitiesaswellasmutualfundswithequityexposuretotheJapanese/Asianregion.

AdowngradewouldtriggeradrasticriseinyieldslikewesawinGreeceandinPortugalrecentlywhenPortugalsbondratingwasdowngradedtoJunk.Portugalnowisinthesame junky category as Greece, and as expected, the market reacted and yields onPortuguese debtdramaticallyroseafterthedowngrade.Itseemsverylikelythatthe


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viciouscycleofrisingyieldsandrisingdebtriskinesshastriggeredtheendgameforPortugal.

The same effect of a downgrade would be expected for JGBs. Even though JapansovereigndebtwasnotaspoorlyratedasPortugalstobeginwith,wehaveseenhowslightofachangeininterestratescanstarttheavalanche.Adowngradeseemsmoreand more likely especially given Standard and Poors director of sovereign ratings,

Ogawa,admittingthatitmightbe rightin saying thatwerecloser toa downgrade.Keepinmindthisisnotthefirsttimetheratingsagencieshavewarnedofadowngradeandthenfollowedthroughcausingextremerepercussions.

AnyspendingincreasesinareasotherthandebtservicingwouldincreasetheamountofborrowingneededtofundJapansexpendituresanddebtrollover.IncreasedborrowingwouldincreasetheriskofJGBsandincreasetheriskofrisingyields.In2010Japanspentroughly1%ofitsGDPonitsnationaldefense(4.8trillionyen).Thisissmall incomparison toother developedcountrieslike theUSwhichspentroughly4.8%(yes,theUSwasatwaratthetime),Germanywhichspent1.4%,andChinawhich

spent2%reportedly(very likely 2-3 timesthatestimate isactually spent).At1%ofGDP,defense spendinginJapanmeasuresataboutofall debt service spending. Ifdefensespendingweretorise infutureyearsthiswouldputalotofpressureonthedebtservicespendingandincreasetheriskinessofJGBssignificantly.IthinkitisreasonabletoexpectJapanesedefensespendingtoriseinthecomingyearsbecauseoftherecentincreaseofterritorialconflictsbetweenJapananditsfastgrowingneighbor,China.ChinahasbeenpushingtheboundsofmilitaryrelationswithJapanbyfrequentlyusingwatersnearJapanformilitaryexercises.NorthKoreatensionsintheregionhavealsobeenrisingasNorthKoreasnuclearprogramisgainingstrength.ItisnotimpossiblethatdefensespendinginJapanwillneedtoriseinthecomingyearsand

thiswouldputmorestressonfutureJapanesegovernmentborrowingandJGBs.2011alsomarked the firsttradedeficit Japan hashad in30years.This isimportantbecausethemaindriverofthissuddenchangewasthe33%increaseinoilimportsduetoadecreaseinnuclearenergybeingproducedinJapan.Whilethedecreaseinnuclearenergyresultedinthewakeof theFukushimanucleardisaster,itseemsreasonabletoexpect Japanese oil imports to increase in the coming years. It seems a full-scaledisaster in theFukushimanuclearcomplexwascloselyaverted,butrecentchecksofothernuclearfacilitieswere foundtobeinsufficient,whichcouldeasilyleadtoamorethoroughexaminationof thenuclearpowerplant facilities in Japanandstoppages innuclearpowerproduction.Thequestionstillremains,whetherthetradedeficitsignals

a new trend or if the Japanese trade surplus can bounce back despite an increaseddependenceonoilimports.IftradedeficitsarereallythenewtrendthenitcaneasilybeextrapolatedthatJGBswillbeundergoingmorestressasborrowingincreasestopayformoreoilimports.

Japanknowsitiskickingthecandowntheroadandofficialsaregettingdesperate.Indesperationtoreelinexpendituresanddecreaserelianceondebt,theJapanesePrimeMinisterrecentlyannouncedintentionstohiketheconsumptiontaxfrom5%currentlyto10%by2015andmaybeto25%infutureyears.BankofJapanGovernorMasaaki


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Shirakawaalsoadmittedthata100%raiseintaxesmightbethesolutioninhisJanuaryLSElecture.WhileatfirstthisseemslikeapositivedirectionchangeandasoundwaytobringthesovereigndebttotaldowntomoremanageablelevelsforJapan,IbelievethisisgoingtodecreaseconfidenceintheJapanesegovernmentandJGBs.Whencitizensarehit by 100% tax increase and its commensurate expected austerity economiccontraction, I dont think they are immediately going to save more to give to theirbelovedgovernmentfordebtservicepurposes.Ialsowonderhowlongthesechanges

aregoingtostayinplace,becauseasweknowJapanisonitssixthprimeministerinfiveyears,whichleadsintooneofmyfavoritequotes,Youdon'tholdofficeinthistown.Yourunitbecausepeoplethinkyoudo.Theystopthinkingit,youstoprunningit.-MillersCrossing(1990)

Japanskeytokeepingthesovereigndebtsustainablewillbekeepingconfidencehighandstable.Assoonasconfidenceslips,thetorrentofsellingwillsnowballintoanavalanche.Investorscrowdpsychologywilltakeoveroncetheslightestdoubtaboutdefaulthasbeenraisedandyieldswillinevitablyrise.

Afterall this doomand gloom, the remaining question is how to take advantage of thesituation?Iamcurrentlypickingentrancepointsin(JGBS)InverseJapaneseGovernmentBondFuturesETNand(JGBD)3xInverseJapaneseGovernmentBondFuturesETN.OnethingIamkeepinginthebackofmymindisthepossibilityofaflighttosafetyafteracrediteventinEurope,whichmaytemporarilycauseaninflowofcapitalintosupposedlysafebondslikeJGBs.Idontwishtoexperiencethepainoffailingtounderstandthebasicruleofashort,marketscanremainirrationallongerthanyouaresolvent.Butafterthissmallcapitalinflow,Iexpecttheseaofcapitaltorecedeinpreparationfortheimminenttsunamiofpanic.

AshistoryshowedinboththeGreekandPortuguesedowngrades,themarketactionperiodwhen the biggest profits on these shorts aremade is limited, thus investors have tobereadywhenthepanicstarts.Onlywhenconfidencehasbecomeitsstrongestwillrealitysetin.Japan has leveraged its economy substantially enjoying extremely low yields on itssovereign debt and unwaveringpublic confidence in its ability topay the debt back.Assoonasthetippingpointisreached,Japaneseyieldswillbeinforaverylongrideup.


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GraphicSource:IMF

Thegreatesttrickthedevileverpulledwasconvincingtheworldhedidnotexist-CharlesBaudelaireInvestorsmaybeconvincedJapanwillpaybackallitsdebtswithnon-inflatedmoneyfornow,butIamnotconvincedandampositioningmyselfaccordinglyforRevelations.

investment recommendation for japanese bonds/equities

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