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June5,2013 Abenomics:LostinTranslation?

? After traveling through Japan for the past couple of weeks and with their economic experiment at the forefrontofthefinancialpress,itisanappropriatetimetogiveanupdateonHaymanscurrentthoughts regardingtheislandnation.MytravelstookmefromKyoto,theculturalheartofJapantoTokyo,Japans financialepicenter.Imetwithallkindsofthoughtfulandwonderfulpeoplethroughoutmytripfromtea servicewithZenpriestsinKyototothemetaphoricalZenpriestsoffinanceinTokyo.TheJapanesepeople are some of the most inviting, respectful, and thoughtful people with whom I have ever had the opportunity to spend time. There is no doubt that culturally and historically, Japan is one of the richest countriesintheworld. Unfortunately, I had this overriding feeling of sorrow and empathy for most of the people with whom I met because my conclusions regarding their potential financial fate were reinforced on this trip. Most large and complex problems do not have a single cause, and there are countless decisions and circumstancesthathaveledJapantoitscurrentsituation.Whilethereisnoformulaicdeterminationfor thesolvency ofasovereignbalancesheet (despite manyattemptsto developone),theinescapabilityof economic gravity remains constant. Japan and its leadership face an unsolvable equation in my opinion. The structural problems in Japan have existed for years and were evident during our original analysis of thesituationinlate2009,butitisfascinatingtoobservetheprogressionofthedeclineovertimeandthe recentbroadacknowledgementoftheirplight. TheRationalInvestorParadox Abe, Kuroda, Nakaso and their staffs are facing a fascinating paradox as they implement the three arrows of their new strategy: i) private sector investment inducing growth strategy ii) flexible fiscal policy,andiii)boldmonetarypolicy.OnApril4th,Kurodaannouncedplanstopurchase6070trillionyen of JGBs per year for the next two years which effectively doubles the monetary base for a country that wasalreadymovingM3atabriskpaceofover+3%peryear.TheBOJtemporarilyabandonedtheself imposed Bank Note Rule and told investors they will extend the duration of their purchases which effectivelymonetizesthecurveandallowslongerdatedpurchases.JGBinvestorsrespondedtotheBOJs

shockandaweplanbyimmediatelyreducingtheirexposuretoJGBs,thefirstrealcrackinthefacadeof investor confidence and panglossian beliefs. JGB futures locked limit down (i.e. Japanese government bond contracts tripped exchange circuit breakers) twice during the day on April 5th, which is technically counterintuitive to the central banking orthodoxy's expectations. This prompted the BOJ to revise the implementation of its asset purchases in order to provide more consistent support to the JGB marketplace,noweffectivelyparticipatingineveryotherdayoftradinggoingforward.Makenomistake, theresanewsheriffintown. They should be careful what they wish for. It is impossible for the Japanese Government to spin the recent volatility as anything but undesirable for JGB owners and the BOJ. As institutional investors explainedtomeinTokyo,theybelieveintheBOJ'snewplantogenerateCPIinflationandnominalgrowth inJapaneseGDP.Successfulachievementofthesepolicygoalswouldnormallyleadtoupwardpressure oninterestratesandlowerbondprices.Therefore,institutionalinvestoractions(sellingaportionofJGB holdings for example, according to the Japanese Securities Dealers Association, the major city banks soldover2.7trillionyenofJGBsinAprilalone,ontopofover4trillionyeninthefiscalyearendingMarch 31)shouldbeconsideredaperfectlyrationalresponsetothe new plansellJGBstopurchaseJapanese equitiesandforeignbondswithmuchhigher nominalandrealyields. Thisrationalbehaviorisexactly whatcomplicatesthingsforJGBinvestorsandtheBOJ. Wearegoingtoneedabiggerboat The financial communitys focus should be on the quadrillion (a thousand trillion) yen of debt. If the JapanesegovernmentisgoingtorunthelargestfiscaldeficitofanydevelopednationinFY2013atnorth of10%ofGDPorroughly50trillionyen,theBOJ'swarchestseemstobeinadequate.If5%ofJGBholdings (another 50 trillion yen) are sold due to rational responses to the new monetary plan, the sales will overwhelmtheBOJ'sabilitytopurchasethem.Iftheirplanistopurchase6070trillionyenofnewbonds eachyear(assumingallexistingdebtrollswithoutevent),thefiscaldeficitwillabsorb50trillionyen,and thecushion willbeapaltry10trillionyenofadditionalcapacity.Itlookstomeliketheyneedtodouble thenewcampaignattheveryleastiftheythinktheycaneffectivelykeepratesfromexplodinghigher.If thelargeholdersallowtheirshortdatedmaturitiesofbondstosimplyrolloff(somethingweexpectthem to do), the BOJ will be overwhelmed, and the plan that is in place will prove to be woefully inadequate. Effectively doubling the largest financial experiment the world has ever seen is not exactly riskfree, but itseemslikeanabsolutenecessityiftheBOJwouldliketomaintainanyoptionalityasidefromcheckmate.

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Surely,theBOJalsohassomefailsafeplansthattheyareworkingonifPlanAdoesnotmeetexpectations. IwouldassumethattheyhaveaplantopegratesbybeingthebuyeroflastresortofsubstantiallyallJGBs at certain yield ceilings on the curve. One argument I hear opposing our views on the JGB rates marketplaceisthatanycentralbankthatprintsitsownmoneycanpegratesindefinitelybysettingacap on rates analogous to the US rate cap of the late 1940s and 1950s. Unfortunately, we cannot compare thatappletothisorange.IftheBOJisforcedtoimplementratecaps,therewillbeavolatilityexplosion which will leave many casualties in the streets. I do not think a preemptive rate cap is in the cards. Incidentally,ifaratecapweretobeimplemented,itwouldputtheflooronthedollar/yenmove,andthe BOJ'sgameofwhackamolewouldbeinfullswing.

1yr/5yrSwaptionVolatility(last3months)

Source:Bloomberg.

1yr/5yrSwaptionVolatility(last3years)

SourceBloomberg.

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JPYvs.USDCurrencyVolatility1yrATMVolatility(Jan2012Current)

Source:Bloomberg.

Japan10yrBondFutureCurrentContractJBM3(February2013April2013)

Source:Bloomberg.

CoordinatedDiminishingMarginalUtility As central banks move to an unlimited expansion of their balance sheets, the marginal efficacy of these actions approach zero. In our opinion, the only reason the BOJ's new monetary policy actions have had such a positive effect is due to the unexpected size and scope of the announcement in relation to their economy and history (and in relation to other central bank plans). The bloom will fall off the proverbial rose,andtheywillberightbackwheretheystartedwithmountainsofdebtandanemicglobalgrowth. 4 HaymanCapitalManagement,L.P.2013

TotalAssetsofGlobalCentralBanks($inBillions)
$14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $ Jan02

BOJ FRB

ECB

PBOC

Jan03

Jan04

Jan05

Jan06 PBOC

Jan07 ECB

Jan08 FRB

Jan09 BOJ

Jan10

Jan11

Jan12

Jan13

Source:Bloomberg. Note:PBOC=PeoplesBankofChina;ECB=EuropeanCentralBank;FRB=FederalReserveBank;andBOJ=BankofJapan.

TheG7sconcurrentmonetaryeasinghasgeneratedtepidanddeclininggrowth.Whyshouldweexpect moreofthesametoachieveadifferentresult? GlobalIndustrialProductionYOYChange(Last3Years)


30%

20%

10%

0%

(10%)

(20%) Apr10 US
Source:Bloomberg.

Apr11 UK Eurozone

Apr12 Japan SouthKorea

Apr13

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Moving all rates closer to zero may save overlevered companies from bankruptcy, improve earnings as interestexpenseisreduced,forceP/Emultipleexpansioninequitiesasinvestorschasedividendyieldsfor income,andgeneratefitsandstartsofconfidenceandinflation.However,intheend,ifmonetarypolicy istheonlythingtheworldhastogenerategrowthgoingforward,thenweareallinforarudeawakening. Does anyone really think the U.S. Fed can ever willingly raise short rates again? At $150 billion per 100 basispointsinannualinterestexpense,wedonotthinkso.Outsideofaceremonial25or50bps,wedo not think Bernanke and the Fed will be able to move from the zero lower bound. In a 2004 paper, Bernanke, Reinhardt and Sack addressed the issue of leaving the zero lower bound and highlighted the uncertaintyaroundanexitstrategy: However,suchpoliciescannotensurethatthezeroboundwillneverbemet,sothat additionalrefiningofourunderstandingofthepotentialusefulnessofnonstandardpolicies forescapingthezeroboundshouldremainahighpriorityformacroeconomists1 The longer we are there, the harder it will be to ever move. When the U.S. rate complex does move, it willnotbeforagoodreason.Itwillbecostpushandnotdemandpullinflationatsomepointdownthe road.

TheLargestDivergenceEverSeen

Global equities are exhibiting one of the largest divergences between true economic growth and prices. In fact, it feels similar to July 2007. Equities march higher and higher as P/E multiples expand while industrial production numbers tank globally. We are concerned about the possibility for substantial furthercorrectioninsomeoverstretchedequitymarkets.

ISMManufacturingvs.StockIndexYOYChangeUnitedStates(Last3Years)
60% ISMManufacturing 40% 20% 0% (20%) Apr10
Source:Bloomberg.

S&P500

Apr11

Apr12

Apr13

MonetaryPolicyAlternativesattheZeroBound:AnEmpiricalAssessmentpageii (http://www.federalreserve.gov/pubs/feds/2004/200448/200448pap.pdf)
1

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IndustrialProductionvs.StockIndexYOYChangeJapan(Last3Years)
50% IndustrialProduction 25% 0% (25%) (50%) Apr10
Source:Bloomberg.

Nikkei

Apr11

Apr12

Apr13

BigTroubleinLittleChina We have become significantly more cautious regarding global growth and the potential for asset price appreciationinthesecondhalfofthisyear.Chinasgrowthappearstobestumblingdramatically.Thishas significantramificationsforindividualmarketsandtheworldeconomy. ThescaleandpaceofcreditexpansioninChinaoverthelast5yearsistrulystaggering.Thecompounded annualgrowthofbankassetsasmeasuredbytheChinaBankingRegulatoryCommissionhasbeen30.8%. More recently, the Chinese authorities started publishing data that includes nonbank credit growth to capture the way in which the credit creation machine has moved beyond traditional methods. Total Social Financing is now growing at 21.7% year over year as of April. The total size of the Chinese credit systemisnowapproximately256%oftotalChineseGDP.Togivesomeperspective,a30.8%compounded annualgrowthofcreditintheU.S.equivalentover5yearswouldbeanexpansionof$33trillion.Thisrate ofcreditgrowthis3timesthetotalcreditsystemgrowthexperiencedintheU.S.atthepeakofthebubble in2006. ThismassivecreditgrowthhasbeentheirresistibleforcethathasdrivengrowthandassetpricinginChina throughout the global financial crisis and maintained robust (and by world standards, incredible) GDP growthduringaperiodofglobaleconomiccrisisandanemicrecovery.TheChineseauthoritiessharethe faith of Bernanke and the Fed that liquidity and credit expansion are the ultimate curealls and that sufficientexpansionisthetidethatwillliftallboatsabovethethreateningrocksofstructuralinefficiencies and accumulated macroeconomic imbalances. They have relied time and time again on using reserve requirementsandtheirinfluenceoverthemajorbankstoencouragelendingandthentoslowitdownas

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theydeemnecessarytoavoidoverheating.TheresilienceintheChineseeconomyforthelast5yearsis atestamenttothismodel. Thestory,however,isneverthatsimpleandeventually,aswehaveseeninmajoreconomiesaroundthe world,theinescapablelawofdiminishingmarginalreturnspresentsitself.AsintheU.S.intheleadupto thecreditcrisis,themarginalutilityofanextraunitofcreditdroppeddramatically.Initiallysmallincreases innominaltermswereenoughtospurrealGDPgrowth,buttheneverincreasingamountswererequired to generate slowly shrinking amounts of growth. Eventually massive levels of credit expansion were required just to keep the economy on track. We believe an important limit has been reached in the capacityofChinesecreditexpansiontodeliverrealeconomicactivitygrowthandwealthcreation. FromthebeginningoftheyeartoMarch,ittookalmost18trillionRMBtogenerate5trillionRMBofGDP growth.Thisratioisthelowestithasbeensincethedepthoftheglobalcrisis.Sowherehasallthenew moneygone?ThedataavailablefromtheChinesecorporatesectorindicatesthatahugeproportionhas beenusedtofilloperationalshortfallsandtosupplyworkingcapital.ThedebttoequityratiosofChinese companies are exploding as they funnel new capital, not into yield returning investments, but into the black holes on their balance sheets that have been created by a slowing growth environment. In the industrialsector,thereisevenoutrightdeflationasovercapacityfinallytakesitstoll.

ChinaManufacturingPMI(Last3Years)
56 54 52 50 48 May10
Source:Bloomberg.

May11

May12

May13

ThespeedanddepthoftheChinesepolicyresponsewillhelpdeterminetheseverityanddurationofthis crisis.IftheChineseaddresstheissuequicklyandmovedecisivelytoreinincreditexpansionandaccept a period of much lower growth, they may be able to use the government and Peoples Bank of Chinas balancesheettocushiontheadjustmentintheeconomy.If,however,theycontinueonthecurrentpath

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andallowthisdeteriorationtoreachitsnaturalandlogicallimit,wewilllikelyseeafullscalerecessionas wellasacollapseinassetandrealestatepricessometimenextyear. Chinas direct contribution to global growth is enormous, but perhaps equally as important is its role in generatinggrowthindevelopedandemergingeconomies.Aslowdown,whethersignificantorextreme, intheChineseeconomyheraldsverybadnewsforassetpricesaroundtheworld.Agrowthcrisiscentered in Asia will further exacerbate the instability and volatility in Japan and have a devastating impact on secondderivativemarketplacessuchasAustralia,BrazilanddevelopingmarketsinSouth EastAsia.The combinationofrichvaluationsandfurtherthreatstogrowthhasledustodramaticallyreduceriskinthe portfolioandactivelypositionourselvestowithstandtheuncertaintyandinstabilityahead. Inexorable Despitetheabundantquantitativedataindicatingthefragilityofthefinancialsystemandtherisksposed by further indebtedness, very few individuals in Tokyo have expressed a willingness to embrace the difficult choices required to resolve this looming crisis. During my trip to Kyoto, I was introduced to a Japanese phrase that encapsulated the strangely fatalistic viewpoint that many local Japanese market participantshavetowardthetwinthreatsofdebtanddeflation.Thisconceptexplainsaresignationtothe unfoldingofeventsandawillingnesstosubmittothisunfortunaterealityratherthantofightaseemingly inevitableorimpossiblechallenge.Itseemsappositetoreprintithereaswewatchthebeginningofthis endgameintheJapanesedebtmarketsunfold: Shikataganai

Itcannotbehelped.

BestRegards,

J.KyleBass ManagingPartner
Theinformationsetforthhereindoesnotconstituteanoffer,solicitationorrecommendationtoselloranoffertobuyanysecurities,investmentproducts or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandumorothersimilarmaterialsthatcontainadescriptionofmaterialtermsrelatingtosuchinvestment.WhileHaymanCapitalManagement,L.P. (HCM) believes such thirdparty information to be reliable, it makes no representations or warranties as to the accuracy or completeness of such information.Theinformationcontainedhereiniscurrentasofthedatehereof,butmaybecomeoutdatedorsubsequentlychange.Theinformationand opinions expressed herein are provided for informational purposes only. This Presentation may not to be reproduced, distributed or used for any other purposewithouttheexpresswrittenconsentofHCM.

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