A comparison of bubbles and deflation in Japan and the US

- Lessons from Japan’s burst bubble and deflation
Concern over deflation in the US — There is growing concern that economic sluggishness and a declining inflation rate in the US will become protracted, just as happened in Japan. Compared with Japan, the damage caused by the bursting of the bubble in the US has been smaller as the bubble was far smaller. The response of the US government has also been more effective.
US housing bubble was small — In Japan, official residential land prices rose 88.0% during a five-year period from 1986 to 1991. In the US, land prices increased only 47.1% during the five years from 2001 to 2006, which is the reason why the aftereffects have been milder.
No stock bubble in the US — Between its low in October 1982 and its high in December 1989, TOPIX rose 5.5x, while the S&P500 increased only 2x between its low in March 2003 and high in October 2007.
Serious structural problems specific to Japan — The reasons behind Japan’s protracted low economic growth and deflation lie in the combined effect of two factors: (1) serious damage caused by the bursting of the bubble, and (2) a decline in Japan’s potential economic growth rate. The latter factor became a serious issue after Japan resolved its non-performing loans problem in 2004.
Factors exacerbating Japan’s bubble — A distorted shareholder composition and fragile corporate finances exacerbated Japan’s problems. The entrenched practice of cross-shareholdings magnified the impact of the bubble breakdown. The scale of the damage inflicted on corporate balance sheets resulted in excess debt becoming a long-term issue that dragged on until around 2004.
Differences in demographics and corporate sector competitiveness — We think the core scenario for the US will be a gentle decline in the economic growth rate and a low inflation rate. However, unlike in Japan, which has been hurt by an aging society and the weakening international competitiveness of the corporate sector, we see only a remote possibility of declining economic growth and excessively low inflation becoming a long-term problem in the US.
- Structural problems that prolonged Japan’s deflation
Macro factors — We think that demographics and fiscal deterioration had a large part to play as macro factors in the low growth rates Japan experienced in the wake of the collapse of the Bubble and in exacerbating and prolonging deflation. According to IMF forecasts, Japan’s government debt-to-GDP ratio is set to hit a lofty 222.3% in 2010, versus 92.6% for the US.
Large tax increases almost inescapable — We believe that big hikes in Japan’s consumption tax rate are all but inescapable because of the deterioration in the fiscal position. Consumer unease about social security and tax hikes is depressing consumption and keeping the savings of the elderly elevated. Homes where the head of household is over 60 have 60.7% of total savings.
Demographics — The US population has risen by 12.6% over the last decade, while Japan’s has risen by a mere 0.7%. Growth in the working-age population in the US is rapid and growth in the population under 15, the workforce of the future, is also firm.
Micro factors — The US overwhelms other countries in its international competitiveness in the craft of manufacturing. US corporations also boast impressive profit growth potential. Japanese corporations’ international competitiveness in manufacturing, growth potential, and profitability fell a long way after the collapse of the Bubble. Apple and Sony are good examples of this.
Japan’s manufacturing prowess on the wane — It used to be said that Japan was good at manufacturing but in contemporary high-tech fields such as computers, semiconductors, LCDs, telecom equipment, pharmaceuticals, and aerospace, Japanese firms cannot compete with giant overseas corporations.
US firms highly profitable — Of the world’s top 100 manufacturers (excluding energy firms) ranked by net profit in fiscal 2009, just five were Japanese. The top-ranked Japanese firm, Takeda Pharmaceutical, only placed 34th. There were 46 US firms in the top 100.
- Deflation in Japan and the US structurally different
Differences with Japan — The long-term downtrend in inflation rates is not a phenomenon peculiar to the US but something we have observed worldwide. We also note that cyclical factors specific to the US are pushing down the nearterm inflation rate. We do not believe that the US will experience long-term deflation, as its potential growth rate is higher than that of Japan.
Inflation rates falling globally — Inflation rates have been falling substantially in China—to an average of 1.9% in the first decade of the 21st century from 7.8% in the 1990s—and in India—to 5.6% from 9.5% over the same span. We think that global inflation rates have undergone a structural decline that has nothing to do with GDP growth rates.
Structural factors in common around the world — Growth in imports from emerging economies such as China and falling import prices have kept down the rate of goods price inflation in the US. Supply chain management has grown more sophisticated as IT costs have come down and technologies have spread. Falling prices for IT equipment have also had a considerable impact on inflation rates.
Cyclical factors unique to the US — In July 2010, the US core CPI was low, at 0.9% YoY. Rent, which accounts for 41.6% of the core index, fell 0.7% YoY. We expect rent to remain on a downtrend over the near term, depressing US interest rates.
No change in the uptrend for equities globally — Over the last year (as of August 17), the S&P Global Equity Index (ex Japan) has risen 10.6%, the US index 10.1%, the Europe index 8.9%, and the emerging index 19.0%. However, the Japan index has fallen 12.7%, battered by the strong yen.
Domestic-demand stocks may have the near-term edge — The S&P Global Equity Index PER (forward fiscal-year basis) has fallen to 9x, making us think that much of the concern has been priced in, as exemplified by the rapid decline in the US long-term interest rate. While yen strength and falling share prices may continue near term, we forecast a rally in Japanese equities from autumn.

Little room for error

- "The past month’s rally has left emerging market spreads priced nearly to perfection."
- "The environment is likely to remain supportive of EM assets, but the upside/downside is looking increasingly asymmetric."
- "EM bonds have been a top performer, mostly from the Treasury rally, but also from relatively strong spread performance compared to other risk assets."
- "With this outlook, we prefer relative value opportunities, especially in high yield names. We continue to like basis in Venezuela, and now believe the 23s are the most attractive bond on the curve. Poor handling of new issuance will continue to hinder the credit, but the bonds offer a lot of upside. We also still like Argentina EUR-denominated."
- "Bond spread curves should continue to flatten as the long end of most curves still offers more value than the short end."


Markets Eye China's US Treasury Investment Strategy

- "On February 22 we published our first note on China’s investment strategy in US Treasuries, prompted by the US Treasury Department’s February 16 release of its Treasury International Capital (TIC) report for December 2009. This showed that China’s holdings of US government bonds had declined by a sharp $34.2 billion. Since the latter half of 2009, China’s holdings of US treasuries have remained on a downtrend."
• "As we analyzed from the February 16 report, the decline of China’s Treasury holdings from 2H 2009 was, we thought, a correction following the surge of its holdings from the latter half of 2008. Figure 2 plots the YoY change in China’s forex reserves and the YoY change of its US Treasury holdings. As markets fell into turmoil following the Lehman shock, China arguably increased its allocation to Treasuries, a relatively safe asset. Then, as the financial crisis abated and the real economy began to recover, China sought to return the level of its Treasury holdings to the original trend (Figure 1). We concluded, therefore, that there was probably “no reason to overreact to China’s current short-term moves”."

JPMorgan Japan Equity Strategy 20100823

India Jun-Q review: Not a weak quarter after all

- After a weak start, Jun-quarter ended on a positive note for Sensex "While Jun-qtr earnings season began on a disappointing note it ended with strong positive surprises from few large cap companies. Initial earnings disappointments from NTPC (-21% vs. DB est), Hero Honda (-18%), Maruti (-19%) and Sterlite (-9%) were neutralized by positive surprises from large caps - Tata Motors (+43% vs. DB est), ITC (+18%), BHEL (+12%), Tata Steel and SBI (both +8%), leading to overall Sensex’ yoy EBITDA & PAT growth of 22% & 16% respectively. On free float basis, the corresponding growth numbers were 29% & 31% - largely driven by
strong growth and comparatively higher free float of Tata Steel. Sensex numbers (ex-Oil PSUs) were above our estimates at all levels i.e. Sales (+1.1% vs. DB est), EBITDA (+4.5%) and PAT (+0.6%). Tata Steel (strong turnaround at Corus) helped shore up yoy growth, while Oil PSUs posted negative surprise driven by under recoveries and volatility over subsidy sharing."
- Metals, Cap Goods, Financials lead, Telecom and Cement drag "Metals posted strongest PAT growth (+1.4% vs. of DB est) due to low base and robust turnaround at Corus. Capital Goods followed with 27% yoy PAT growth (+6% vs. DB est), as BHEL, despite a difficult environment, recorded strong numbers on the back of output improvement, indigenization and favorable RM/Sales ratio. Strong NII growth and lower than expected credit costs led to robust growth in Financials (+24% yoy and +4.6% vs. DB est). Unsurprisingly, Telecom witnessed weakest yoy PAT growth at -41% (-29% qoq) – although at revenue and EBITDA level, our Telecom analyst noticed improving competitive position for incumbents on qoq basis. Cement & construction followed with a -28% yoy PAT growth, which was 7% below our already lower estimates."
- We do not see any meaningful risk to our full year Sensex earnings estimate "We believe that street concerns over FY11 Sensex’ earnings growth are overdone. Despite a largely mixed quarter and soft growth (ex- Tata Steel), overall revision to FY11 Sensex EPS was marginal. During the earnings season, there were earning revision to 10 Sensex stocks with four upward and six downward revision - but the overall impact on Sensex PAT was only marginally negative at -1.6%. Earnings upgrade in Tata Motors (+57%) largely neutralized downgrades in Sterlite (-25%), NTPC (-13%) and DLF (-9%)."
- Better than expected monsoon to further stimulate aggregate demand, reiterate Sensex target of 22000 "We reiterate our year-end Sensex target of 22,000 driven by expectation of earning CAGR of ~25% over FY11-12, strong macro economic momentum and robust FII inflows - which have aggregated US$12bn YTD, and hold potential to exceed the annual peak levels of ~US$18bn. Besides, the ongoing monsoon season appears to be one of the best in almost five years and will help further stimulate - already elevated - aggregate domestic demand. We are therefore reiterating our overweight on the consumer discretionary sector."

DeutscheBank India Equity Strategy 20100822

Changes in the position of equities in the risk/return trade-off

- "The crisis has led to a fall in share prices and a rise in the variability of their return. We seek to ascertain to what extent this development has made equities less attractive for investors, relative to other assets. To this end, we look at changes in the positioning of equities relative to other assets (sovereign bonds, corporate bonds) in the risk/return trade-off."
- "We see that:
• if investors have a long-term horizon and a long memory (15 years for example), the relative appeal of equities is only barely reduced;
• if investors, however, have a short-term horizon and a short memory (8 years for example), they believe that investment in equities is completely dominated by investment in bonds."

Natixis Flash Economics 401 20100819

Strategy Forum

- "Markets are gripped by pessimism about a global slowdown and the risk of deflation. We think that pessimism is overdone, leading to our constructive view on risky assets. On today’s Strategy Forum we explore two aspects of that more constructive view."
- "First, we see cyclical and structural reasons why Asia will do well despite tepid developed-market growth. Chetan Ayha (Asia-Pacific economics) and Ridham Desai (India equity strategy) will discuss why they see the growth baton passing from China to India by 2013-15, highlighting the investment implications of that shift. Second, do you want to get paid for owning risky assets? Graham Secker (Europe equity strategy) offers a menu of stocks that exploit dividend yields exceeding bond yields. Rashique Rahman (EM macro strategy) outlines the case for EM debt, where yields are still high. And Hussein Allidina (commodities strategy) explores the allure of gold as a tailrisk hedge, based on low real rates."
- "As an aside, after meetings in Asia last week, I believe Asian investors are generally aligned with our views, especially on relative performance. Not surprisingly, they are upbeat on their region and on commodity prices. Big Asian investment funds are increasingly interested in EM

Morgan Stanley Strategy Forum 20100823

A Credit Crunch Ceases

- Bank lending standards continue to ease. "The most important news in the past 10 days has not been the Fed’s outlook or the corporate enterprise spending forecasts put out by a leading technology bellwether, but rather the latest data from the Fed’s quarterly bank lending standards survey. Indeed, the results showed a continued trend towards easing conditions and its track record with respect to forward business activity is hard to dispute given that the cost of capital and thereby credit is very instrumental to business investment decision making."
- Commercial & Industrial (C&I) loans generally lag conditions by six quarters. "While there is and has been great frustration expressed about the seeming lack of a pickup in bank loans, it is critical to understand that credit standards lead loan trends by six quarters in either direction (with respectable correlation), and the current lag is typical. Indeed, lending standards even lead credit markets by a few months, but it must be recognized that capital markets offer far better terms than banks do when the credit environment improves – plus, with record junk bond issuance, it is hard to suggest that risk-oriented credit is severely limited."
- Corporate balance sheet strength may limit the need for more loans. "The attempt to create so-called “bullet proof” balance sheets after the near collapse of the financial system in 1Q09 has led many corporate financial executives to build up huge cash reserves in a bid to prevent liquidity-driven internal crises. Yet, as money begins to flow towards business investment, management teams do not need to borrow more when they can tap their own respective cash hoards."
- Business investment activity has rebounded without a loan pickup. "One can see that business investment already has picked up based on GDP data. Furthermore, our studies of capital spending plans of more than 625 US nonfinancial publicly traded companies demonstrates planned actions that show increased activity. However, it is not well understood that capital spending moves in tandem with employment trends more so than consumer spending does and thus a turn in hiring plans is relatively important, too."
- Jobs should rebound modestly alongside the normal nine-month wait. "The angst over high and stubborn unemployment is both understandable and warranted, but the trends are shifting and the lending standard results show the likelihood for continued albeit modest jobs recovery over the next three quarters which should also benefit capex and industrial production trends. Thus, beneficiaries of better business activity in the next six to nine months should be able to report improved trends in the next several quarters, though commodities have spiked faster than in the past so that area may be less affected; thus, we prefer the Capital Goods and Energy industry groups."


Reform progress in the euro area periphery

- "Sovereign spreads have widened considerably during the past two weeks"
- "The market is concerned that countries will get caught in a vicious circle of budget cuts and faltering growth"
- "Our primary concern is that public support for necessary reforms may falter"
- "The rescue packages give the periphery countries time to get their houses in order"
- "But a positive outcome is dependent on the willingness of the countries to accept tough but necessary reforms"
- "We believe that the ECB will stand ready to purchase large amounts of government bonds if needed"

DenDanske Research Euroland 20100823

Japan: BOJ move to stem strong JPY is imminent

- "In our view, the Bank of Japan (BoJ) will soon step in and try to stem the recent appreciation of JPY. However, we do not expect direct intervention in the FX market, although this possibility should not be ruled out completely. Instead, we expect the BoJ to step up its quantitative easing."
- "A BoJ move should be able to create a much more solid platform below USD/JPY. However, unless it delivers aggressively, we are unlikely to see JPY weaken significantly until the financial markets regain confidence in global growth."

DenDanske Flash Comment 20100825

Hong Kong Property Sector: Hard or soft landing in 2012?

- Traces of 96/97 bubble? Home prices up 14% YTD and 47% from 2008 trough. Increasing call for some kind of housing subsidy?
- Public consultation already underway. Two key dates: Sep 17 and Oct 13
- Theory Vs. politics?
• The Hong Kong government theoretically favours a free market
• Subsidy will short circuit the market’s natural restraint
- Is it a bubble? Health check OK
• No excessive use of leverage
• Speculative demand in check
- Three new sources of demand
• Demolition displacement
• Return of mainland babies
• Negative real rates
- Valuations are still very supportive
- Landbank duration important in case of a hard landing?
• SHKP, Cheung Kong and HK Land are our top picks

Nomura HK Property Sector August 2010

Profiting in a Low Rate Environment

- Macro Trends — "The global economy seems to be entering an era of low interest rates and slow growth as the recovery loses steam. This will likely be positive for China’s equity market because: 1) China will also maintain its policy rates at historic low levels for longer; 2) weak dollar traditionally favors EM equities; and 3) capital inflows would rise when investors chase higher growth, a stronger currency and better returns."
- Policy and Market Update — "China’s tightening cycle has probably bottomed though policy overhangs remain a risk. Lower real interest rates in general indicate buying opportunities. Barring no double dip in the developed world, we continue to believe that downside risk in the market is rather limited."
- Sector Preference — "We upgrade the property and materials sectors to neutral from underweight to take advantage of an extended period of low interest rates. Meanwhile, we are still cautious about the banking sector as we see a lack of positive catalysts in the near term."
- Stock Picks — "High beta and high dividend yield are two key criteria for stock picks amid low interest rates. CNOOC and Maanshan Iron are two relatively high beta and high yield plays. In the category of high beta and low yield, we favor Nine Dragons, Dongfeng Motor; Agile Property; and PICC. On the other end, Jiangsu Exp, CCB and ACC Acoustic belong to the low beta and high yield league."
- Multi-Strategy: Add Risk — "Multi-Asset points toward continued stabilization. Slowing US economy points to weaker USD, which helps Chinese equities. 1) Buy Cyclicals Basket, 2) Futures Pair: Long HSCEI, Short SPX, 3) Long Outperformance Call Option (HSCEI – SPX), and 4) Buy HSCEI calls outright."


Is real estate a good hedge against inflation?

- "Many institutional investors have increased their (residential and commercial) property portfolios, partly because of the relatively high returns currently offered by real estate, but also because they think that real estate is a hedge against inflation, which could return in the long term. We examine the effectiveness of real estate as a hedge against inflation, and we ask several questions: • is protection provided by real estate prices or by rents?
• do residential and commercial real estate provide the same protection?
• is the situation identical in the case of domestic inflation and imported inflation?"
- "We find that investors should be very cautious, because:
1. residential real estate prices have been correlated to credit and no longer to inflation since the 1990s;
2. residential real estate prices are now correlated to inflation only in the United States and Germany; moreover, they are correlated to employment, and therefore provide no protection against inflation in an inflationary recession (e.g. an oil shock);
3. commercial rents are not at all correlated to inflation;
4. only rents paid by households are universally correlated to inflation;
5. there is no apparent difference between headline inflation and underlying inflation."

Natixis Flash Economics 400 20100819