CONFIDENTIAL

JAPANS ATTEMPTED REFLATION

JANUARY 2013

Prepared by: M. Cullen Thompson, CFA President & Chief Investment Officer cullen.thompson@bienvillecapital.com Blake Bennett Analyst blake.bennett@bienvillecapital.com

CONFIDENTIAL

Japans Attempted Reflation

Summary

Monetary policy in Japan is undergoing a monumental change. For the first time in Japans post-bubble era beginning in 1990, it appears policymakers intend to drive real interest rates into negative territory. As a result, we believe the yen could continue to weaken and that Japanese equities could be in the early stages of a powerful rally On October 30, 2012 the Bank of Japan and Ministry of Finance issued a joint statement entitled Measures Aimed at Overcoming Deflation,* setting the stage for powerful easing, including what seems to be an explicit attempt to weaken the yen. On December 16th, 2012, Shinzo Abe was elected Prime Minister with a mandate to end deflation (i.e. to reflate the Japanese economy) Although Japan has struggled with a deflating economy for nearly two decades, the timing of these actions is not random. For a variety of idiosyncratic, macro and geopolitical reasons, the Japanese economy is faltering. Partly as a result of a strong yen, industrial production and business surveys have deteriorated, and the revenues of several national export champions have collapsed Due to negligible growth and deflation, the level of nominal GDP in Japan remains well below previous highs (Slide 4), a dangerous circumstance for an economy carrying the worlds largest sovereign debt burden. As history has proven, debt and deflation cannot coexist In return for failing to reflate the Japanese economy, the Bank of Japan is on the verge of losing its independence. At the behest of Abe, it seems likely the BOJ will confirm a new 2.0% inflation target on January 22nd. In April 2013, the BOJs hawkish Governor, Masaaki Shirakawa, is set to retire, likely to be replaced with a far more dovish candidate (Slide 5) In implementing monetary policy, the Bank of Japan is authorized to buy domestic and foreign assets, including equities and REITs (Slide 6). Achieving the 2% inflation target will prove difficult as domestic deflationary pressures remain. Wages, specifically, are contracting (Slide 7). Hence policy will need to be highly aggressive In recent years, although the BOJ has expanded its balance sheet (Slide 8), it has risen far less than other central banks since the financial crisis began (Slide 9) Regardless of whether the BOJ proves successful in achieving their inflation target, the expectation of aggressive policy can have a meaningful impact on the yen and Japanese equities, which remain at low levels compared to previous highs (Slide 10 & 11). Recently, equities have rallied and the yen has begun to weaken (Slide 12). But on a real, trade-weighted basis, the yen could fall another 20% before reaching the levels of 2007 To be clear, the intention of the additional policy measures in Japan is to enlist the portfolio balance channelthat is, to drive real interest rates negative, forcing Japanese savers out of cash and bonds and into riskier assets (i.e. equities). The Federal Reserve has attempted this process twice recently: in 2003 and 2009 (Slide 13), both of which resulted in higher asset prices. By contrast, real interest rates in Japan have remained positive, benefitting bondholders (Slide 14). High real rates also encourages saving over consumption The 2003-2005 analog in Japan is interesting: monetary policy was aggressive, the BOJs balance sheet expanded by 25%, the yen weakened by 15% and Japanese equities rallied 125%. Of course this occurred during a period of global easing and reflation. In order to achieve todays stated goals, the BOJ will need to be far more aggressive. For instance, in order to peg and maintain the Swiss Franc to the Euro at 1.20, the Swiss National Bank has expanded its balance sheet by 100% since August 2011 * http://www.boj.or.jp/en/announcements/release_2012/k121030b.pdf

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CONFIDENTIAL

Japans Attempted Reflation

Summary

We believe the primary risk to this theme is lack of policy follow-throughthat is, policymakers fail to act to the degree they are currently suggesting, as has occurred in the past. We currently believe this risk is minimal given the determined and coordinated communications from policymakers, as well as key upcoming events (e.g. Upper House elections, etc.). However, lack of policy followthrough would invalidate the theme However, on a valuation basis, Japanese equities are relatively cheap (1.2x Price/Book versus 1.5x for other global indices) and yield 2.7%, more than 3x the yield from Japanese government bonds International mutual funds are also currently underweight Japanese equities. Goldman Sachs believes international mutual funds allocation to Japan is 4% below benchmark (MSCI EAFE). If portfolio managers feel pressure to get to benchmark, some $60 billion could flow into Japanese equities (in addition to the estimated $20 billion of recent inflows) Japans debt-to-GDP ratio is above 200%. Therefore, higher interest rates in Japan could be highly destabilizing. Today policymakers are undergoing a delicate balancing act: attempting to increase inflation and inflation expectations so that investors reallocate savings to riskier assets without causing nominal bond yields to rise. We are unsure of whether they can achieve this and continue to expect significant stress in the JGB market at some point. However, at the moment our focus has been to attempt to profit from a weakening yen and rising Japanese equities To be sure, these events have significant implications for the global economy. To weaken the yen, the BOJ needs to buy foreign assets, and given the size of the purchases required, the likely candidates would be US Dollar and Euro-denominated assets. Neither the US, nor Europe prefer to see a meaningful appreciation of their currencies A materially weaker yen also complicates the necessary global rebalancing process: the US and parts of Europei.e. current account deficit countriesneed to move towards trade balance to achieve sustainable growth (i.e. a weaker USD and euro relative to some peers). By contrast, the surplus countries, notably China, Japan and Germanythe worlds 2nd, 3rd, and 4th largest economiesneed to engineer more domestic demand, relying less on exports, or external demand, for growth. A policy-induced shift back towards export-led growth by the surplus countries would only rekindle the global imbalances that erupted in 2008 Having virtually exhausted its ability to grow through investment, China is unlikely to sit idle as Japan weakens the yen, stealing external demand in the process Recently, the yen has weakened by nearly 20% versus the Korean won, one of Japans primary competitors, threatening Korean exports, which represent 50% of its economy In sum, aggressive actions by the BOJ could escalate into a full-fledged currency war. Investors should be monitoring these events closely

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Japans Attempted Reflation

In nominal terms, economic activity in Japan is below the level of the mid-1990s, representing a potential disaster for a country with Japans growing debt burden and declining population
Japan Nominal GDP (in yen)
530,000

520,000

510,000

500,000

490,000

480,000

470,000

460,000

450,000 Mar-94

Mar-96

Mar-98

Mar-00

Mar-02

Mar-04

Mar-06

Mar-08

Mar-10

Mar-12

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

Therefore, the newly-elected Abe administration has embarked on a national mandate to generate inflation and higher nominal GDP growth. As a consequence, the Bank of Japans independence appears to be in jeopardy

The Japan Times, January 14, 2012 Prime Minister Shinzo Abe said Sunday that his government will set a medium-term 2 percent inflation target with the Bank of Japan in a joint statement expected later this month to help shore up the recession-hit economy. "What will be important is properly including the price goal of 2 percent," Abe said during a program on NHK in his latest move to pressure the central bank to be more aggressive in combatting the country's chronic deflation ahead of its next monetary policy meeting on Jan. 21 and 22. Abe said the BOJ's current goal of 1 percent inflation lacks "strong determination" and that the government and central bank will come up with "a definite goal and write that it will be 2 percent." Abe claimed the new target needs to be achieved under a medium-term scenario rather than a long-term one or financial markets "will not react." The prime minister said he believes the next BOJ governor, who will replace Masaaki Shirakawa when his tenure ends in April, should be someone who can take "bold monetary steps and is in line with our points."

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Japans Attempted Reflation

To generate higher inflation and a weaker yen, the Bank of Japan will have to be highly aggressive. Fortunately it has a lot of options at its disposal, more so than other central banks

Eligible Assets to Purchase

Government Bonds (Domestic) Government Bonds (International) Mortgage-Backed Securities (RMBS) Asset-Backed Securities (ABS)

Federal Reserve

European Central Bank

Bank of England

Bank of Japan

Corporate Bonds (Domestic)

Equities

Commercial Paper

REITs

Source: Bank of Japan; Federal Reserve; ECB; BOE; Jefferies; Bienville Capital Management, LLC

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Japans Attempted Reflation

Wages continue to deflate, depressing domestic inflation and suggesting the 2% inflation target will be difficult to achieve. To engineer both inflation and growth for its export-oriented economy, policymakers are focusing on the trade channel, i.e. a weaker yen. However imports represent less than 20% of Japans economy, meaning the inflation from imports, which includes natural resources, would have to overwhelm the entrenched domestic deflation without harming consumption
Japan Average Monthly Earnings (in %)
8.0

6.0

4.0

2.0

0.0 Mar-91 -2.0

Mar-94

Mar-97

Mar-00

Mar-03

Mar-06

Mar-09

Mar-12

-4.0

-6.0

-8.0

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

Although the Bank of Japans balance sheet has been expanding over the past few years

Bank of Japan - Total Assets (in billion yen)

170,000

160,000

150,000

140,000

130,000

120,000

110,000

100,000

90,000 Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

its aggressiveness pails in comparison to other central banks since the onset of the financial crisis.

Growth of Central Bank Balance Sheets (January 2008 = 100)

450

SNB: +326% BOE: +306%

400

350

FED: +214%
300

250

ECB: +134%

200

BOJ: +48%
150

100

50 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12

FED

BOJ

SNB

BOE

ECB

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

The Nikkei remains more than 70% below 1989s bubble highs

Nikkei 225 Index

45,000

40,000

35,000

30,000

25,000

20,000

15,000

10,000

5,000 Nov-86

Nov-91

Nov-96

Nov-01

Nov-06

Nov-11

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

and 40% below 2007s levels. By contrast, thanks to aggressive monetary stimulus which drove real rates negative, US equities are approaching all-time highs.
Nikkei 225 vs. S&P 500 (Index)
20,000

1600 1500

18,000

1400
16,000

1300 1200 1100

14,000

12,000

1000 900 800

10,000

8,000

700
6,000 Oct-00

Oct-01

Oct-02

Oct-03

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12

600

Nikkei 225
Source: Bloomberg, Bienville Capital Management, LLC

S&P 500

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Japans Attempted Reflation

The dollar-yen exchange rate has broken a long-term trend and appears to be moving towards 100, a level that would please both Japanese policymakers and export-oriented companies
Japanese Yen (Spot)
130

120

110

100

90

80

70 Jan-05

Jul-06

Jan-08

Jul-09

Jan-11

Jul-12

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

On a real, trade-weighted basis, which accounts for the deflation of wages in Japan, the yen could fall another 20% before reaching the lows of 2007
Japanese Yen (Real Effective Trade-Weighted Exchange Rate)
160

140

120

100

80

60 Dec-94

Jun-96

Dec-97

Jun-99

Dec-00

Jun-02

Dec-03

Jun-05

Dec-06

Jun-08

Dec-09

Jun-11

Dec-12

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

Negative real interest rates in the US have caused significant rallies in risk assets (i.e. the portfolio balance channel). In 2003, both equities and real estate rallied. In 2009, negative real interest rates and QE have caused equities to rally again
US Real Interest Rates vs. S&P 500 (2-Year Treasury - CPI)
4.00%

1600 +102% +117% 1500 1400

3.00%

2.00%

1300
1.00%

1200 1100 1000 900

0.00% Mar-00 -1.00%

Sep-01

Mar-03

Sep-04

Mar-06

Sep-07

Mar-09

Sep-10

Mar-12

-2.00%

800
-3.00%

700 600 US Real Rates (LS) S&P 500 (RS)

-4.00%

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

By contrast, real interest rates in Japan have remained largely positive, encouraging savers to place the vast savings in cash and Japanese government bonds (JGBs). If inflation rose, real rates would turn negative, inspiring savers to move out on the risk spectrum
Japan & US Real Interest Rates (2-Year Government Bond - CPI)
3.00%

2.00%

1.00%

Japanese real rates remain positive

Sep-01 Mar-03 Sep-04 Mar-06 Sep-07 Mar-09 Sep-10 Mar-12

0.00% Mar-00 -1.00%

-2.00%

whereas real rates in the US are negative

-3.00%

-4.00%

Japan Real Rates

US Real Rates

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

During the last material monetary easing (i.e. 2003 2005), which did coincide with a global reflation effort, the Bank of Japans assets expanded by 25%, which helped to weaken the yen by 15%
Bank of Japan - Total Assets (in billion yen)
160,000

+25%

150,000

140,000

130,000

120,000

110,000

100,000 Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

while the Nikkei rallied by over 100% (before declining 60% during the financial crisis).

Nikkei 225 (Index)

20,000

18,000

+130%

16,000

14,000

12,000

10,000

8,000

6,000 Oct-00

Oct-01

Oct-02

Oct-03

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12

Source: Bloomberg, Bienville Capital Management, LLC

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Japans Attempted Reflation

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