Not given to over-dramatising a phrase, my eye was drawn to a report issued by BCA Research entitled “The Widow Maker”. Was this referring to Scotland’s failure to qualify for Brazil in the World Cup (again)!? Apparently not. As it turns out, it is of course the name by which the trade goes of shorting Japanese Government Bonds (JGBs).
The act of shorting JGBs has been a fruitless one for 20 years and more, but it is a trade to which some hapless investors have been drawn on a regular basis as yields have fallen over this period from 3% to 2%, from 2% to 1% and all the way through to their 0.6% yield today. A similar fate has befallen shorters of Swiss Government bonds too, whether they chose to short when they were 3%, 2% or 1% all the way through to their 0.75% yield today.
What is the relevance? There could not be a wider difference between the fortunes of the Japanese and Swiss economies over the past 20 years. Switzerland has thrived about as much as Japan has suffered, yet their bonds mirror one another. Why is this?
The reason must lie in their shared experience of seeing low to no inflation in this time. And what is the fear underlying the calls to Mario Draghi to begin to do whatever it takes instead of simply saying he’ll do whatever it takes to save the Eurozone? It is the fear of deflation and the morphing of a European-style period of disinflation into a Japanese style period of disinflation.
In the same way that those who shorted JGBs and Swiss bonds were expecting a “normalisation” of yields, so we hear today numerous comments about European and UK bond yields being close to the tipping point at which “normal” yields will be seen again. But what is normal?
As a species we benchmark our expectations of normality against that which we recognise through our own experience, finding it hard to understand or grasp situations that we have had no knowledge of previously.
In most of our lifetimes, and particularly our professional lifetimes, “normal” has been a multi-decade period of inflation, consequential high interest rates and a credit boom the likes of which has never been seen before. BCA refer to the period as the Great Aberration. As we can’t think of a better name, that’s what we’ll refer to it by as well.
The 400 years preceding 1965 were typified by “credit growing broadly in line with the economy’s productive potential and (apart from during wars) structural inflation was non-existent. And the lesson from Japan and Switzerland – and other major economies now – is clear; if credit growth is not much higher than the growth in the economy’s productive potential, it is very difficult to get structural inflation, in which case, bond yields in the major economies are more likely to follow the Swiss template.”
All of which means that the Widow Maker lurks in the shadows waiting for all who think that shorting European bonds at these levels is a good looking trade. We maintain our overweight position towards European equities as we are fairly confident that Draghi will do something to appease the growing murmur of unrest as there have been a few signs of the impetus slowing on the Continent.
We believe in a continued recovery and retain our aggressive stance towards the periphery. Greece sold off sharply on political troubles but has recovered quite sharply and we like the BCA reminder that “stock markets in crisis-stricken countries usually go up somewhere in the neighbourhood of 400% from crisis lows to recovery highs over a four year period”.
The main problem everywhere is that markets have moved from being cheap to being no longer cheap, although they generally stop short of being over-valued. This leads us to the question that we are often asked about why we are out of emerging markets. True, emerging markets have rallied quite strongly this calendar year so, as we always do, we have questioned our stance. In short, we find it very hard to envisage a sustainable recovery in emerging markets, and in natural resources and mining stocks, against the backdrop of a slowing China.
The consensus is that China is an accident waiting to happen, yet emerging markets are still seen as the source of endless growth. Strangely, despite our view on emerging markets, we do not necessarily feel quite as bearish on China as others, so we await the right opportunities to take an interest once more. The soggy equity performance to which we alluded is nowhere more evident than in Japan.
Having been one of the top performers in the previous year, it has outperformed only Iran and Venezuela this year to date, yet we cautiously maintain our optimism towards it. Admittedly our patience is being tested, but the fact that Prime Minister Abe remains more popular at this stage of his mandate than any other Japanese Prime Minister in the last 15 years suggests that he has still got the backing to continue to bring Japan out of its ever-so-long slump and into the heady heights of inflation at 2%. This won’t happen unless the Yen weakens and remains weak, and this is one of the reasons why the market has disappointed as the Yen remains a safe haven in turbulent times.
We expect the Bank of Japan to turn on the QE taps again if recovery is threatened, while if the BoJ does not act it suggests that the 2% inflationary target is likely to be achieved without help. Both these scenarios are tentatively bullish for Japanese equities, although nothing is logical about the Japanese market, let alone predictable or reliable.