The Week That Matters (19-23 Feb, 2024)
Make Japan Great Again: Lessons for America, lessons for the world (Part 3)
It’s not just Nvidia…….
Fund managers make more money playing for a recovery, rather than trying to be well positioned ahead of a crisis. David Tepper and George Soros returned a lot more for their clients than Michael Burry ever did in 2008 by being constructive on markets from February 2009. There is a reason that perma-bear Jeremy Grantham’s AUM has collapsed over the last 20 years. He has missed out on many opportunities by always calling the top!
History does rhyme but outperformance comes from knowing which era in the past rhymes with the current one. Far too often, the talking heads of financial journalism focus on the wrong one. This era is nothing like the 1970s or 2000. It is much more like 2010, or perhaps even 2016, the last time China got serious about its share market. That means a full blown earnings recovery or at least multiple expansion as was the case in 2016.
We are seeing an example of a major market “head fake”. The media has been obsessed with a recession but just like Godot in the famous play by Samuel Becket, it’s becoming clear that one might not come. Let us briefly look at the evidence:
Inflation
Inflation tends to be seasonally elevated in January and February and the Red Sea disruptions have meant shipping costs have surged. As JP Morgan highlighted this week, however, it pays to have perspective. Shipping costs are 70% lower from their peaks during COVID. And then there’s this chart:
Part of the issue with the Fed is it relies on old data. Greenspan talked about this in the 1990s but nothing seems to have been done about it. Owner Equivalent Rent (OER), which the Fed uses for its CPI inputs, is outdated and has serious lags. According to the Fed, OER is still up 6% year over year.
The above chart has been produced by BLS, the Bureau of Labor Statistics. It shows where market rents are at the moment. As rent is fixed for 12 months usually, it’s vital to know what’s actually happening in the moment. Somehow, that’s lost on the Fed. But as you can see, rent seems to be dropping like a rock! What does that do to CPI?
Jobs
We should all spend more time examining the job report from January 2024. It was sensational. The media focused only on what it might mean for the interest rate cycle. Instead, they should have paused and put the whole thing into context.
We sat on a deflationary cliff in March 2020. Due to proactive policies by Trump’s Treasury Secretary, Steve Mnuchin, we avoided it - not being partisan here but Mnuchin was good! Despite Jerome Powell’s best efforts to hurt the working poor and the middle class with his excessive, Volcker-esque rate hikes, the US economy has an unemployment rate of just 3.7%! That’s simply amazing less than five years after a potential catastrophe. It’s also a testimony to what good government policy such as onshoring can accomplish.
Understanding how consumer and corporate balance sheets are different from what they were in 2008 will play a pivotal role in making sure your portfolio hums for the rest of the decade. Debt and debt service levels are close to all time lows. Boomers are passing on their money to their kids and more people than is commonly understood do not have a mortgage or at least have a small one on their primary residence. Separately, corporate balance sheets in aggregate are better than households when it comes to debt - they have been paying down debt since the GFC. If jobs remain plentiful, what does that all do to consumer spending?
Interestingly, Michael Burry increased his holdings in consumer related stocks recently. And the chart below produced by Chart Master seems to be supportive for consumer related stocks, especially as optimism will likely grow that China might be turning a corner short term. LVMH?
Earnings
Q4 earnings season has been great. Out of 396 companies in the S&P 500 that had reported by mid last week, 78% of companies beat estimates by an average of 7.5%, according to Fidelity. What stood out, however, was the 600 bps bounce in the expected growth rate, which is well above normal. Also the sequential improvement from each quarter to the next is exactly what this early cycle bull requires, according to their Global Macro Department.
We need an earnings recovery as the market has been anticipating an earnings inflection for over a year now. The forward P/E multiple went from 15x in October 2022 to 21x now. Those valuation gains now need earnings to fulfil their side of the bargain. If earnings come through (as they are doing), the P/E ratio can at least stop going up from here, and eventually come down, as typically happens during this phase of the market cycle. Don’t be too bearish?
JAPAN: The history of the world is but the biography of great men (and women!)
Warren Buffet’s investment into five trading companies was newsworthy in 2020. First, he had always shied away from investing in the Land of the Rising Sun throughout his career. And second, his investment didn’t come with strings attached. Most US financial titans (T Boone Pickens, Daniel Loeb or Paul Singer) always had an activist bent, when they announced a big investment there. Buffet merely remarked that the stocks were cheap.
Buffet’s investments do not explain the move in the Japanese equity market over the last few years, however. For that, you have to go back to the early 2010s. You need to go back to former Prime Minister, Shinzo Abe (now deceased).
The Great Man Theory is an approach to the study of history popularized in the 19th Century. Great leaders come forward when they're most needed, in order to become the foundation upon which history is built. Think Abraham Lincoln. Think Thomas Jefferson. Think Napoleon. The author believes Shinzo Abe should be on the list.
Some commentators have called him the Ronald Reagan of Japan. The author thinks that’s a disservice. He was much more significant. Ronald Reagan had a wonderful turn of phrase and definitely looked the part but he had been manufactured by families who lost out in the New Deal from the 1960s. For Shinzo Abe, he was not playing a part. His desire to make his country great again was much more visceral.
The Three Arrows: Brave and inspired policy
Life was grim in Japan in the immediate years after the Second World War. People were exhausted, homeless and hungry. They had put everything into the war effort, rightly or wrongly, and had nothing to show for it. This mass anxious-depressive order was called The Kyodatsu Condition.
Such levels of despair were not present of course in Japan in say 2010. Life was actually relatively good if you had money and were old. Your lunch box cost the same as it did 10 years earlier and your ski ticket might have even gone down in price. Thanks to deflation, it was a wonderful place to retire in many ways.
It sucked if you were young, ambitious or had debt. The young especially had lost their joie de vivre. Some were downright depressed and suicide rates were very high amongst the 20-something cohort. Deflation was slowly sucking the life out of the nation. And there was a feeling amongst certain leaders in Kasumigaseki (where the government bureaucrats work) and Nagatachou (where the politicians work) that without intervention, Japan would slowly die.
It was against this backdrop that Shinzo Abe along with the Bank of Japan’s Haruhiko Kuroda came up with the Three Arrow policy - massive QE, massive government spending and extensive structural reform. The usual Chicken Littles like Kyle Bass of the Japan Macro Opportunities Fund said it was a mistake and that the bond market would collapse. Just over 10 years later, the bond market is fine and Japan is back! Last week, the equity market made a 39 year high. Kyle Bass’s hair recedes every year but his confidence in himself never does. Is that his super power? It’s definitely not his alpha in Japanese fixed income markets.
Shinzo Abe: The Liberal Nationalist
What fascinates the author is how Shinzo Abe was allowed to do what he did. Shinzo Abe’s family were part of the Imperial Army. Nationalism runs in their veins. They do not believe in the common narrative about Japan’s role in the Second World War.
Imagine if one of Hitler’s Generals had a grandson, who emerged on the political scene and said, “let’s make Germany great again!” It would be major news. The media tried to destroy Giorgia Meloni for saying she believed in the family unit and wanted to make her country, Italy, great again. Imagine what would happen to a German, who was vaguely nationalist, especially if he had wanted to revise Second World War history the way Abe wanted.
Curiously, the American elite overlooked Abe san’s form of liberal nationalism. It didn’t get much attention at all. There were probably two factors behind this.
First, a strong Japan benefited the US. Japan is the natural ally for the US in the Far East, especially as it pursues its China containment policy. There is a reason why Japan was chosen for the Quadrilateral Security Dialogue (QSD) between India, Japan, Australia and the US. For Japan’s part, it’s not been in a better diplomatic situation since the Korean War in the 1950s! This is another reason to be bullish the Japanese equity market.
Second, powerful people in the US administration know full well that inflation isn’t the problem the global economy is facing. Deflation is a much bigger potential issue and it’s not clear that we won’t see huge deflationary forces at some point this decade. Things were looking very bad before COVID - low growth, low inflation amidst low interest rates. We could get back there quickly, especially as global growth is below trend as it has been since 2008.
Leaders from Bernanke to Krugman have paid special attention to Japan. For them, the deflation Japan saw could easily have become a broad based issue in the West. The US was therefore incentivized to support Japan in its efforts to get back on its feet, at least to see what policies might work.
Now that Japan has seemingly been successful at breaking out of deflation, it represents a blue print for the whole world as to how to fight deflation. Labor representation (unions) and infrastructure spend are part of the mix and it is this author’s opinion that the US administration will push for those in due course.
European Credit Crisis in 2024?
The Kyodatsu Condition cannot be applied to modern day Germans either but there is clearly an increasing sense of despondency amongst the public. For many, the European experiment has not worked and Germany’s role in the world, like Japan’s in 2010, is not where it should be.
This might explain the rise of the AfD in Germany over the last few years. It is seemingly doing very well in local elections and could even take a seat in the coalition government in November this year. If you closed your eyes, and listened to what they are saying, it’s similar to what Shinzo Abe said about getting Japan back on its feet. It could be an appealing message to the Germans come November.
Isn’t it about time therefore we started thinking though what an anti-Europe party being in the coalition government of Germany might mean for European credit markets? We worry too much about US and Japanese bond markets. The author thinks the real crisis might be in Europe this year. Didn’t Bismark once say Germany was too big for Europe? Someone, please let Kyle Bass know that the action might be in Europe, not Japan!
As always, thanks for reading. It was wonderful to see Japan hit new highs. I had the fortune of seeing the low print of the Nikkei in 2003 when I was on a trading desk there. And no, I didn’t buy the Nikkei at the lows! Most people either went home and polished up their resume or got drunk - a missed opportunity perhaps.
Best regards
Mateen