yen strength a minus for Abenomics

This time a year ago $1 bought about 120 yen.  That figure was 125+ last June.  The rate was 113, however, a week ago–and 108- today.

This amounts about a 10% year-on-year gain in the yen’s purchasing power against the dollar, half of that strength during the past week.

The rise is good for consumers for whom the cost of imported items like food has skyrocketed under the administration of Prime Minister Shinzo Abe.  Not so good, though, for Mr. Abe’s grand plan to resuscitate his country’s still moribund industrial sector through massive currency depreciation.

There’s no particular reason for the yen to strengthen that I can see.  Yes, Mr. Abe did recently observe that aggressive intervention in currency markets is an imprudent strategy.  And, yes, this is the time of year when corporate cash flows back into Japan causes mild currency strength.  But the Bank of Japan recently initiated a negative interest rate policy designed to weaken the yen.  And in my view there’s no sign yet that Mr. Abe’s bet-the-farm gamble on 1980s-era export industries is paying off.

Yet the currency is going up.

This may just be bad luck.

If we assume that the US dollar has peaked, then the question for short-term currency traders is which of the two remaining majors, the yen or the euro, is a better bet.  Given renewed uncertainty about Greece and the upcoming vote in the UK on a referendum to exit the EU, traders may think they have little choice other than to shift their holdings toward yen.

Still, the biggest economic problem for Japan–and the reason Japan is a cautionary tale for the US–is that the political power structure there is totally committed to defending the status quo and retarding structural change.  It’s subsidizing industries whose heyday was in the 1980s, and it’s allowing its workforce to shrink by its anti-immigration stance in the face of an aging domestic population.  A rising currency will only make the circle harder to square.

 

 

Foxconn and Sharp Corp (6753), an update

A month ago, I wrote about the merger proposal for Japanese video screen maker Sharp Corp (6753) made by Taiwan-based Foxconn (aka Hon Hai Precision).  Foxconn had offered to acquire control of Sharp for roughly US$6 billion, or about twice the price that Japanese government-owned Innovation Corporate Network of Japan (ICNJ) was willing to pay for the chronic money-loser.  Nevertheless, before a public uproar over the traditional Japanese solution of hiding a problem in a government-orchestrated bailout rather than fixing it, it appeared that Sharp would opt for the ICNJ offer.  So much for Abenomics.

Three developments since then:

–it is now clear that neither proposal involved buying Sharp shares from existing shareholders.  Both Foxconn and ICNJ intended to purchase new stock from Sharp itself.  On the positive side, that would mean that Sharp would receive all the funds.  On the negative, existing shareholders–meaning the investing public in Japan–would be severely diluted.

–apparently feeling significant public pressure from the disparity between the two offers, the board of directors–surprisingly, to me–chose Foxconn over the ICNJ!

–yesterday, on the eve of the change of control, Foxconn announced it was suspending its offer.  According to Reuters, this was because in the final, official disclosure of financial documents by Sharp, Foxconn learned the company had US$2.7 billion in liabilities it had not known about previously.  

Sharp says the liabilities were properly disclosed in its financial statements.  I interpret as meaning that, yes, Sharp didn’t bring the subject up in negotiations, despite its importance, but that there was a least an oblique hint in its publicly disclosed financial reports that these liabilities might exist.  It also sounds to me as if Sharp had a higher legal disclosure requirement in the case of takeover, which it fulfilled at the last minute, hoping no one would notice.

 

My thoughts:

–Welcome to Japan.

–One Reuters report says the liabilities are “contingent” ones, meaning that in some way future events will determine whether Sharp is on the hook for the $2.7 billion.  These might be guarantees for the borrowings of other companies, like suppliers or customers.  They might be warranties, or guarantees of minimum purchases from suppliers, or guarantees that Sharp products in the hands of merchants can be returned for full refunds if not sold.  In any event, however, there are a whole lot of them.  Foxconn’s action implies it believes the contingencies are pretty likely.

–Foxconn says it still wants to go through with the deal, but presumably at a lower price.

 

the yen and the unraveling of Abenomics

Last week the Tokyo stock market had two days in which the benchmark Topix index fell by more than 5%.  For the week as a whole, the market declined by 12.5% (the quirky Nikkei 225, the Japanese equivalent of the Dow, fell by 11%).

This has little to do with worries about the oil price or about a global economic slowdown, in my view.  This is all about Abenomics.

The three “arrows” rhetoric aside, the idea behind Abenomics has been to create extraordinary short-term economic stimulus in Japan through huge depreciation of the currency, large increases in government deficit spending and a big expansion of the money supply.

It has been clear from the outset that all three of these actions will leave deep permanent scars on the Japanese economic landscape.  However, their purpose has been to buy time and space for export-oriented Japanese industry to restructure and modernize.  That would, in turn, allow these firms to hire more workers and increase wages for all.  In the eyes of Abe boosters, the benefits brought by a revitalized industrial base would more than offset the body blows caused by depreciation, inflation and an increase in already gargantuan outstanding government debt.

It has also been clear that Abenomics can’t take infinite time to work. Shock-and-awe stimulus is temporary; waves of it are progressively less effective.  Theory and practical experience both say that without substantive changes an economy tends to revert to its previous torpid state after a few years   …except there’s higher inflation.

In Japan’s case, industry hasn’t voluntarily restructured.  Government continues to protect recalcitrant corporate managements from outsiders skillful enough, wealthy enough and willing enough to take on the modernizing task.  So far, then, Abenomics has all been jam tomorrow, as Lewis Carroll put it.

Since the beginning of this month, early in the fourth year since the launch of Abenomics, the yen has risen by about 7% against the US$, 8% against the renminbi and about half that against the €.

This strength is a bit surprising, since it comes immediately after further stimulus by the Bank of Japan in the form of negative interest rates.  Investors in Tokyo are reading the currency strength as the first sign that the window of opportunity for Abenomics to succeed is starting to close.

I’m not sure this interpretation is completely correct.  But, having been an Abenomics skeptic from day one, I won’t argue that it’s wrong, either.

For people like me, who continue to watch from the sidelines, Japan is important to the rest of the world as a tourist destination, but mostly as a cautionary tale about the limits of monetary policy and the dangers of special interest politics determined to defend the status quo.

 

 

Sharp Corp (6753) and Abenomics

Abenomics in brief

Prime Minister Shinzo Abe’s well-known plan for reinvigorating the Japanese economy has three “arrows.”  The first two are large government deficit spending and ultra-loose money policy, which were designed to buy time for structural reform of Japanese industry.   The two have had toxic side effects:  they have mortgaged Japan’s future with lots of new government debt and, through the currency depreciation they engendered, have reduced national wealth by a third.

Regular readers will know that from the outset I’ve believed that Japanese corporations won’t restructure voluntarily and that the Tokyo government had no interest in forcing corporate leaders to do so.  In other words, Abenomics a very expensive farce, that had no chance to succeed.

the Sharp case

The latest case in point is Sharp, a heavily indebted chronic money-loser which is in the process of being nationalized by state-owned Innovation Corporate Network of Japan (ICNJ).  ICNJ is offering shareholders a total of $2.5 billion for their shares and the company a continuing supply of the opium of state support.

Hon Hai Precision, a Taiwanese company best known in the US as Apple supplier Foxconn, has bid twice that figure.  It has pledged to keep all Japanese employees and to transfer its management and manufacturing technology into Sharp.  As I’m writing this, news is breaking that Hon Hai is about to sweeten its offer by pledging to invest a minimum of $850 million in Sharp operations after acquiring it.

the board decision…

So, which will the board of Sharp choose:

–twice the money for shareholders plus an infusion of new technology and world-class manufacturing management?, or

–what’s behind the curtain marked ICNJ?

Although no final decision has been made, all the press leaks indicate that Sharp is going to choose ICNJ–and that the Tokyo government is encouraging the company to do so.

a wake-up call?

The Financial Times seems to believe that the Sharp case will prove to be the ah-ha moment that will cause foreign investors to understand that Mr. Abe never intended to fire the crucial third arrow of Abenomics.  It thinks an outflow of foreign capital will follow this realization.  For the sake of Japanese citizens who are bearing the burden of the first two arrows, I hope the FT is wrong.  My private reaction is to ask why it’s taking foreigners so long to smell the coffee.

 

Japan as a possible future for the US

Japan, in my subjective view

As I wrote yesterday, the Japanese economy continues to limp along at about stall speed, hugging closely to the 0% line between growth and contraction.  There are several reasons for this, in my :

–an aging population

–strong social prejudice against accepting women as working professionals (meaning Japan wastes potentially half its workforce)

–strong aversion to foreigners that manifests itself as an unwillingness to allow immigration

–therefore, a shrinking workforce

–money-based politics that fiercely defends the status quo

–veneration of age as the source of wisdom, meaning that older managers can’t/won’t solicit/accept suggestions from younger, more technically competent, subordinates

–a docile electorate

the US is the same, in…

–an aging population

–lingering discrimination against women

–growing political (shoot-yourself-in-the-foot) pressure to limit immigration overall, and especially by high skilled professionals from Asia

–money-based politics that defends the status quo, seen, among other places, in failure to reform the federal tax code (Japan and the US have the highest rates in the OECD)

the US differs, in…

–having a younger population than Japan, meaning we have time to make changes–and the example of the fate of Japan to motivate us to do so

–a better record on hiring women (not a high bar, though)

–political and cultural embracing of youthful entrepreneurs and disruptive ideas

summing up

The US has younger population tan Japan and a more vigorous economy, but is carrying similar dead-weight in the forces of the status quo, typified by politics in Washington.

In the past 25 years, Japanese voters have voted on two occasions to toss the dominant Liberal Democratic  Party out of office and replace it with the Democrats (formerly the Social Democrats, and the Socialists before that).  Both occasions triggered bitter intra-party warfare about who should receive credit for the victory.  Nothing got done, so voters quickly reselected the LDP, as the lesser of two evils.

Hopefully, we can do better than that.

 

Japan in recession …again

Assuming we take the simple, but commonly accepted, definition of recession as two consecutive quarters of negative real GDP growth as our measure–and there’s no real reason not to, I think–Japan slipped back into recession during its last fiscal quarter.  The reason:  in Groundhog Day-like fashion, the Tokyo government tightened fiscal policy prematurely earlier in the year, producing the same negative result for the third time in recent memory.

Three observations:

–the Japan experience is the reason Janet Yellen is so wishy-washy about raising interest rates in the US

–in a certain sense, technical recession isn’t as bad a thing for Japan as it wold be for, say, the US or China.

How so?

GDP growth comes from two sources:  having more people working, or having existing workers perform their jobs more efficiently.  Unlike the view (often) expressed by one of my Depression-era former bosses, productivity increases don’t come from imposing sweat shop working conditions.  They come from investment in education, training and productivity-enhancing equipment.

In Japan’s case, the domestic working population peaked around 1995 and has been falling by about 0.5% per year since.  One obvious solution to this problem would be to allow foreign workers to immigrate.  But, although there has been some slight movement lately, Japan’s borders remain rigidly closed to outsiders.

Productivity?   From 1950 – 19980, Japan was a productivity wonder.  However, Japan has struggled to keep up with the more intensive pace of change since then.  Why?  I think the rigidly hierarchical nature of company social interaction in traditional Japanese companies stifles the voice of innovation from younger employees.

Let’s say, though, that somehow Japan achieves productivity increases of +1% annually despite the “no comments; just follow orders” attitude of top managements.  I think that’s too much, but let’s go with it.  If so, the overall economy needs half that figure to overcome the decline in the workforce.  Real GDP growth has a trend ceiling of +0.5%.

So, the maximum sustainable rate of GDP expansion in Japan is barely north of zero.  It shouldn’t be surprising, then, if that figure spends considerable time south of breakeven.  As long as the numbers don’t get too negative, Japan will continue to stumble along on its journey to economic insignificance.

–what makes Japan important, interesting …and scary for the US and the EU is that we’re seeing a possible future for us in the Japan of today.

More on this tomorrow.

will the poor performance of Energy, Materials and Industrial sectors derail the S&P 500?

In the course of doing a performance attribution for the S&P 500 year-to-date last week, I noted that the S&P 500 ex Energy, Materials and Industrials, is pretty close to flat so far this year on a total return basis.

But is it correct to conclude that the “healthy” sectors of the S&P will continue to be relatively immune to the economic illness caused by the price collapse of global mining commodities?   …or will they eventually be dragged down if, as I expect, commodity weakness continues for an extended period of time.

This isn’t as silly a question as it might seem at first.

In the early 1990s I was asked by the board of the company I worked for to present my views on the stock market in Japan at that time.  I created a presentation that divided the Topix index, which was trading at about 70x earnings, into three parts:

–highly speculative property-related companies that were trading at around 500x earnings and made up 10% of the market

–export-oriented industrials, such as the autos or tech companies like Canon, which were trading at 15-20x earnings and made up 30% of the market, and

–everything else, which made up 60% of the market and traded at around 25x.

I said what I believed:  that, while the index might do poorly as the speculatives came back to earth and the bulk of the market went sideways, the export-oriented stocks were cheap and would go up significantly in price–not only in yen but in dollars, too.  My model was the behavior of the US market throughout the second half of the 1970s, when former speculative favorites, the Nifty Fifty, were crushed while everything else went up.

An aside: a famous finance academic on the board, who made it clear he had not sought the opinion of a mere “practitioner” like me, objected that the low dividend yields of Japanese stock proved they remained wildly overvalued.  A little embarrassed (for him), I had to explain that Japanese tax laws did not provide the same preference for dividend income that the IRS did. In fact, dividend income was subject to income tax at an extremely high rate (up to 90%) in Japan.  Because of this, taxable investors (the majority at that time) had a very strong preference for (untaxed) capital gains.  Companies tended to make negligible cash payouts and to use stock dividends as a substitute.

Embarrassingly (for me), it turned out that my reasonable analysis was completely wrong.  Yes, the exporters were cheap, but for the next decade they significantly underperformed similar-quality companies elsewhere in the world.  In this case, the general economic funk that engulfed the Japanese economy hurt the stocks of all firms listed there.  There was no escape.

my thoughts

Thee aren’t a whole lot of relevant examples of this kind of situation to generalize from.  (Another might be the worldwide collapse in the price of mining commodities and of commodities stocks from 1982-86, which did not impede the upward progress of global stock markets from mid-1982 on.)

My hunch is that the contamination of “good” stocks in 1990s Japan is more a function of the continuing economic malaise in that country than of anything else.  What’s somewhat troubling is that the US today is very similar demographically to Japan back then, when lack of workforce growth was a significant contributor to Japan’s stagnation.  We have the same woes of extremely low interest rates and an impotent legislative arm tied to the status quo and unwilling to use fiscal policy to bolster the economy–another set of lead weights dragging Japan down.

 

At the end of the day, I’d argue that the US is inherently a much more dynamic country than others in the developed world.  Also, I see the commodities collapse as much more like an external shock than a sign of weakness in the domestic economy in the way the property collapse in Japan was.  So I see the chances that commodities/commodity stock softness will cripple the rest of the US stock market as low.  But there are enough similarities between us today and Japan 25 years ago to make me vaguely uneasy.