The Outlook For Japanese Stocks

What will it take for Japanese equities to outperform next year?

T he underperformance of Japanese stocks since the mid-1990s has been largely driven by multiple contraction, rather than weak earnings-per-share growth. Japanese equities currently trade at book value, compared with 2.2 times book in the U.S. On a forward P/E basis, Japanese stocks trade at 12 times next year’s earnings, in line with the global average. That said, Japanese corporate profit margins are only half of what they are globally, suggesting some scope for efficiency gains among Japanese firms in the years ahead.

While valuations are compelling in the near term, Japanese stocks are likely to be driven by monetary policy. Although it is doubtful that Shinzo Abe – who is widely expected to be elected as the next Prime Minster on December 16 – will be able to compel the Bank of Japan (BoJ) to adopt a 3% inflation target, it is possible that he will be able to strike an accord with the BoJ that will lead to more aggressive quantitative easing.

This, together with the fact that after two painful decades, the corporate deleveraging cycle in Japan is drawing to a close and property prices have started to stabilize, suggests that the era of deflation may also be coming to an end. If so, real interest rates in Japan, which are the highest among the major developed economies, are likely to decline, giving Japanese assets a welcome boost.

Bottom Line: Although valuations are compelling, the big swing factor for Japanese equities will be the extent to which the BoJ pursues aggressive monetary policy. Stay tuned.

Copper: Which Way?

Copper prices are trading in a tight range, which cannot last forever. The combination of an improving global backdrop and a Chinese demand catalyst could soon result in an upside breakout.

E vidence continues to accumulate that the Chinese economy is on a recovery path that is bullish for copper. The November preliminary HSBC PMI release for China showed the first expansion in 13 months. Copper-specific end-use indicators corroborate these views. Output of freezers, electrical meters, air conditioners, power-generating equipment and power cables all appear to have stabilized. Together, these account for over 50% of copper consumption in China.

Meanwhile, bearish sentiment and net speculative short positions are bullish indicators from a contrarian perspective. The risk to our view is a dollar spike, higher uncertainty in Chinese policy or a relapse in Europe, but we assign these outcomes low odds of occurring.

Bottom Line: Our Commodity & Energy Strategy service expects an upside breakout in copper prices, stay tuned.

Meet The New Reserve Currencies

The IMF announced plans to add the Canadian and Australian dollars to the list of its reserve currencies.

Meet The New Reserve Currencies

C urrently the IMF reports FX reserve allocations for only five currencies: the U.S. dollar, euro, Japanese yen, British pound and Swiss franc. All remaining FX holdings are lumped together as “other currencies”. Historically, holdings of “other currencies” were fairly insignificant and did not warrant a detailed breakdown.

However, since the global financial crisis and the ongoing sovereign debt problems in the euro zone, reserve managers have been looking for alternatives to the major currencies. From about 2% of total reserves in 2009, the allocation to “other currencies” has risen to over 5%. The Canadian and Australian dollars probably account for the vast majority of this increase.

To be sure, the IMF’s announcement is only a recognition of what central banks have been doing. It does not make the Canadian and Australian dollars any more attractive. Nevertheless, the shift into alternative currencies is a trend that is likely to persist. Global FX reserves total over $11 trillion, so a 1% change in currency allocation during the span of a year amounts to more than $100 billion.

A large sum for relatively small economies like Canada and Australia to absorb.

Bottom Line: Zero bound short term interest rates, ballooning central bank balance sheets, large fiscal deficits and worrisome government debt levels are forcing investors, in both the public and private sectors, to seek out relatively sound alternatives to the major currencies.

CAD, AUD, NZD, NOK and SEK are the main beneficiaries of this trend.

How To Resolve The Greek Question, And When

Greece will only become solvent when another quarter of its sovereign debt is written off.

 How To Resolve The Greek Question, And When

A ssume optimistically that Greece’s nominal GDP can grow at a 3% rate over the next 5-10 years. Also assume annual primary surpluses average 1.5% of GDP, a little better than before Greece’s boom and bust. This means that to achieve long-term solvency, Greece’s debt servicing burden must decline to 4.5%, from today’s level of 6% of GDP.

In other words, Greece needs to write off another quarter of its debt. But in the case of the ECB, it is illegal to write down sovereign debt as this amounts to monetization of government financing. And in the case of the EU/IMF, a haircut effectively imposes losses on taxpayers including some from outside the euro area. Hence, the first port of call for sacrifices will once again be the private sector which still holds about 40% of Greek government bonds.

The main mechanism for the write-down would be the ESM lending funds to the Greek government to buy back its own debt at current distressed market values subjecting many private bond holders to capital losses.

When must policymakers answer the Greek question?

As bonds mature and are refinanced through official loans, the ownership of Greek debt is slowly but surely shifting out of the private sector and into the official sector. Hence, there will come a point when large official sector losses are unavoidable to make Greece credibly solvent.

Policymakers are surely aware of this and as we have previously covered in our research, the Troika is inching toward an answer to the Greek question.

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U.S. Housing: How Good Can It Get?

U.S. housing related data continue to surprise on the upside, but we caution against extrapolating current trends.

US Housing, How Good Can It Get?

T he NAHB home builder survey reported yesterday that home builders are becoming increasingly optimistic about the residential real estate market, based on “increasing demand for new homes as inventories of foreclosed and distressed properties begin to shrink in markets across the country”. Nonetheless, the NAHB index is still below 50, which means that there are still more builders that view conditions as “poor” rather than “good”.

Similarly, housing starts also beat expectations again in October, but construction is still weak relative to historic norms. While it is good news that the housing data is firming, investors should not expect more than a modest upside potential in this sector.

True, foreclosures are hitting the market at a slower pace than during the past few years, but the home-ownership rate continues to fall. New entrants will only trickle into the housing market because weak real income growth and credit constraints are ongoing headwinds.

Bottom Line: Residential real estate is likely to be “only” a modest positive contribution to GDP growth in 2013.