Sunday, January 12, 2014

2014 Outlook: Rogue Wave 1: Japan Is A Powder Keg Searching For A Match

2014 Outlook: The Greatest Illusion The World Has Ever Seen
2014 Outlook: The Danger & Opportunity The Illusion Creates
2014 Outlook: U.S. Stock Market
2014 Outlook: U.S. Residential Real Estate
2014 Outlook: U.S. Municipal Bond Market
2014 Outlook: Rogue Wave 1: Japan Is A Powder Keg Searching For A Match
2014 Outlook: Rogue Wave 2: Europe Calmly Sits In The Eye Of The Storm
2014 Outlook: Rogue Wave 3: The Global Housing Bubble Is Back
2014 Outlook: Investment Opportunities In The Year Ahead

"More than any other time in history, mankind faces crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly."

- Woody Allen

As we begin to move around the world and look for danger beyond the complacency and over pricing of asset prices, the first stop has to be Japan. Unfortunately, for this once mighty economy, the quote above sums up what their choices will feel like over the remainder of this decade.

I believe Japan will be the first major Lehman-like moment in next stage of the sovereign debt crisis. People that do not follow the financial markets will turn on the news to find out that what is taking place is serious.


Japan is implementing the Illusion on a far grander scale than any other country in the world. We are in the early stages of a global currency war and Japan fired the first shot in late 2012, continued the assault through 2013 (and promised to continue firing years into the future). All the other major countries, which are focused on devaluing their own currency to boost exports and lower the burden of smothering debt payments, will have to "react" to Japan as we move forward.

It is important to understand that when we talk about a sovereign debt crisis in Greece and a debt/currency crisis in Japan, it is not the same. Greece is a tiny spec of dust within the global economy. Japan is the third largest economy in the world. It has banks similar in size to the United States and it holds two of the six largest corporations in the world (and 71 of the largest 500). To compare debt problems with Japan and Greece would be like comparing the debt problems of Lehman Brothers with Toll Brothers.


Japan on paper is a powder keg waiting for a match. John Mauldin, author of the book Code Red, refers to Japan as a bug in search of a windshield. Their debt to GDP ratio has risen from 67 percent in 1990 (when their asset bubble burst), to a mind boggling 245% (and rising fast) today. Greece was at 130% debt to GDP when it imploded. No country has ever come close to where Japan's debt to GDP stands today without triggering a major currency crisis or debt default.

In late 2012, Prime Minister Abe told the Bank of Japan (their central bank) that they had a new mandatory inflation target of 2 percent. Haruhiko Kuroda was nominated as the leader of this bold new assignment.

Kuroda's first step was to begin a quantitative easing program that was the same size as the one the United States was running. The difference? The Japanese economy is one third the size of the United States. It would be the equivalent of the Federal Reserve tripling the size of the current QE program in the U.S. The Bank of Japan is not only purchasing government bonds and mortgages like the Fed, but private sector assets as well. They are buying everything in  sight with printed dollars.


The goal of a money printing program of this size is simple - they wish to put a cap on interest rates while severely devaluing their currency against others around the world. This raises the cost of imports such as energy and food, which (they hope) will raise inflation to the magical 2 percent level. Then (they hope) inflation will just magically stop at the 2 percent level. More on that in a moment.

Beginning in late 2012 and moving into early 2013, the yen fell 35 percent against the dollar. It has hovered just over 100 on the index throughout most of 2013. You can see the moment in late 2012 when the "Abenomics" Illusion began:


Many forecasters believe that the yen has the ability to fall to 250 or well beyond if the market begins to panic. Does this sound impossible? The yen traded at over 350 yen to the dollar just four decades ago.

Every drop of 1 yen against the dollar translates into $2.7 billion additional profits for Japan's largest exporters. Countries that compete for those exports such as Korea, Hong Kong and Taiwan are seeing their sales plunge due to the recent yen decline. Germany, which experienced a rising euro through most of 2013, is losing market share to Japan around the world.


It seems like a good plan doesn't it? Japan has little regard for how fall their currency falls in the open market and plans to continue Abenomics indefinitely. The program mirrors the Fed's QE-ternity program.

What are the problems?

The first is that other countries will eventually respond. As the pain continues to mount for exporters around the world, there will be calls for currency weakening within those countries in order to stay competitive. Currencies are only pegged against each other; so any decline in price from the euro, dollar or British pound is a rise in the Japanese yen. The market's reaction will be important to watch in 2014.


The second and more important problem is what happens if the steady fall in the Japanese yen turn into panic selling. I think this is the most likely scenario. The currency will enter trouble first and the bond market will then begin to crack.

To sum it up, if Japan succeeds in moving inflation to 2 percent then investors will request a 2 percent return on government bonds just to keep pace with inflation. If the yield on government debt rises to 2.2 percent, 80 percent of the tax receipts collected will be used just to cover interest expenses on the debt. Game over. This is the paradox waiting for Japan which the markets have not yet figured out. When they do, it will be a rush to the exits.


In addition to bond sales, there will be the issue of inflation within Japan. Both the consumer and the economy are already struggling. If they move forward with raising taxes while inflation is rising, it will severely cut off domestic consumption and growth. The nightmare waiting for Japan's citizens will be horrific.

Japan's population declined by a record 244,000 in 2013. The previous record was a decline of 219,000 in 2012. It has continually declined since 2007 (deaths minus births). Its citizens are aging rapidly. Most of the Japanese government debt is held by savers within the country. As the country continues to age and retire, these citizens will begin selling these bonds into the market to cover living expenses.


Something is going to break in the year or years ahead. Keep a close eye on the yen, the yields on Japanese bonds and the response from other countries around the world.

While the United States and Japan have used the exact same Illusion on the markets, Europe has created a slight variation:

Up Next: Rogue Wave 2: Europe Calmly Sits In The Eye Of The Storm



2014 Outlook: Rogue Wave 2: Europe Calmly Sits In The Eye Of The Storm

2014 Outlook: The Greatest Illusion The World Has Ever Seen
2014 Outlook: The Danger & Opportunity The Illusion Creates
2014 Outlook: U.S. Stock Market
2014 Outlook: U.S. Residential Real Estate
2014 Outlook: U.S. Municipal Bond Market
2014 Outlook: Rogue Wave 1: Japan Is A Powder Keg Searching For A Match
2014 Outlook: Rogue Wave 2: Europe Calmly Sits In The Eye Of The Storm
2014 Outlook: Rogue Wave 3: The Global Housing Bubble Is Back
2014 Outlook: Investment Opportunities In The Year Ahead

"The banking system in the Eurzone periphery is under water, with a non-performing loan pile of $1.5 trillion to $2 trillion euros. Eastern Europe could become the epicenter of funding risk in 2014 due to big refinancings." 

-Blackrock

Europe has been a fascinating situation to watch over the last 18 months. In the late summer of 2012, the head of the European Central Bank (ECB) gave his now famous "We Will Do Whatever It Takes" speech. His objective was to imply to the market that the ECB stood ready to print an unlimited amount of euros to calm any sovereign bond market that began to lose control.

Up until that moment, the market was unsure where exactly the central bank stood. They continuously tested the ECB by loading up on credit default swaps and shorting the toxic debt of Portugal, Ireland, Italy, Greece and Spain. Hedge funds had the ability to drive markets into chaos and make a tidy profit doing so.

When the markets heard "whatever it takes," all previous bets were off. The interesting part is that we do not know if the ECB was actually willing to carry through on this promise. They brought a bazooka to the negotiating table and no one questioned whether it was loaded. Investors around the world immediately began piling into toxic high yielding sovereign bonds, believing that the ECB now stood behind them, just as the central banks have them covered in the U.S., Japan and the U.K.

Yields have fallen steadily from that moment in late 2013 through today. As we will discuss, many of the most toxic sovereign bonds are now at a spread less than 100 basis points from the U.S. risk free rate. The first part of the ECB's Illusion was built on a bluff. The trick itself never even had to be performed. You can see in the chart below that while the balance sheets of the Bank of Japan and the Federal Reserve have been growing at an incredible pace, the ECB balance actually decreased in size over the last year.


The ECB cut rates in November, but this move is pittance compared to the QE engines firing in the U.S. and Japan. Bernanke and Kuroda laugh at rate cuts, which are "so" 2007.

Due in large part to the ECB's balance sheet reduction, the core inflation rate has stayed low. A lower inflation (or even deflationary) environment makes it far more difficult for governments to service their debts. While the rest of the developed world has implemented financial repression successfully, Europe has yet to put the process in motion. For an understanding of this important concept see: What Is Financial Repression.



Many market participants see sovereign rates falling and believe the Eurozone's trouble are now in the past. Unfortunately, nothing has been structurally fixed within the Eurozone. The debts are building under the surface, creating a larger crisis in the years ahead. How have the debts been hidden? That brings us to the second part of Europe's Illusion, the sleight of hand.

The sleight of hand trick is simple - the governments continue to issue more debt than they can afford and the banks within that country purchase the bulk of the issuance.


It may seem silly for the banks to participate in such a scheme, but when you walk through the entire thought process it actually makes sense. Most of the banks within these bankrupt countries already hold a tremendous amount of toxic debt on their balance sheet. The only thing keeping a run from occurring is the implicit government guarantee in place should the banks run into trouble.

With this understanding in mind, you can see the banks have no choice. They are purchasing high yielding government bonds (and over the last year they have made great profits on these purchases) with the hope that the governments will stay solvent or the debt will be purchased by the ECB when the time comes.

The name of the game in today's global debt ponzi scheme is to do everything you can to push the day of reckoning back one more day, or one more hour. In the meantime, you can pretend that everything is okay on the surface. This is how the Illusion is performed and Europe has finally learned its secret.

As we will show in a moment, this process has helped lower interest rates on government bonds which has temporarily eased the funding needs of the governments. Unfortunately, while credit is being diverted toward the government sector, the private sector (which generates real growth and tax income) has been ignored. Lending to businesses in Europe requires a large reserve requirement. The ECB has provided money to lend to businesses, but the capital has been used to purchase government debt because the reserve (capital) requirements to make a government loan is almost non-existent. This allows the banks to leverage up at the highest possible rates of return.

Under the surface, the Eurozone grows more fundamentally flawed by the day. Germany began to make structural changes, such as re-working their labor policies, before the crisis hit. The remainder of Europe did not take these actions, and they have been blindsided by a freight train.


Germany has seen their exports rise and unemployment fall. The rest of Europe has experienced the opposite.


Yet all is not roses, even in the beloved Germany. Their largest bank, Deutsche, now has the largest derivatives portfolio in the world at $70 trillion. The are the most highly leverage bank in Europe at 60 to 1 (Lehman reached a peak of about 40 to 1). If something goes just slightly wrong with their portfolio, they will be far too big to save.

At some point the divergence between Germany and "the rest" will come to a head and the system will snap. Either the ECB will come in and blanket the Eurozone with printed currency, or the bankrupt countries will need to leave Europe (and the euro) and devalue their own currency.

We will cover the PIIGS names you know in a moment, but before we do I want to introduce you to the newest member of the crisis club in Europe, France. While they have gone mostly unnoticed by the media thus far, their problems will begin to enter the spotlight in 2014.

France had two successive months of economic contraction, which may translate into another quarterly decline in GDP. This would put the country back into technical recession. Unemployment in France has risen for 9 consecutive quarters and recently hit a new 16 year high.


The rising euro in 2013 has been crushing for France. Their industry minister, Arnaud Montebourg, claims that every 10% rise in the euro costs France another 150,000 (remember our discussion on how the world would respond to Japan?). French debt to GDP rose to over 90 percent in 2013.


Despite this troublesome outlook, the Illusion has taken hold for investors wanting more the French dream. The CAC 40, which is an index containing the largest 40 French companies, has been on a tear. Daily Sentiment Reading hit 97% bullish on December 30, even higher than the bullish reading just before the 2008 crash (93% bullish). The 10 year government bond in France sits at only 2.50%, lower than the risk free U.S. treasury bond of the same duration.

Moving throughout the PIIGS we find a similar story. In Italy, the unemployment rate has crossed above 12% with youth unemployment at 41.6%. Poverty levels are at all time highs, while the debt to GDP crossed 127% in 2013.


Meanwhile, the interest expense on Italian government debt has calmly declined. The 10 year yield has fallen to only 3.91%, less than 100 basis points of the 10 year US treasury yield.

In Spain, unemployment has reached 26.7% with youth unemployment at 57.7 percent. Spanish bad loans have hit 13% while the debt to GDP has risen to 86%.

In spite of this, the same "magic" is occurring in Spain. While Spanish bad loans soar, investors become more excited about purchasing toxic government debt as seen in the chart below.


Investors used to worry about Spain's ability to pay its bills but that has long since subsided. The Illusion has become belief. Bankrupt Spain is now treated almost as well as Germany by the financial markets.


In Ireland economic growth is flat, unemployment is in double digits and their sovereign debt to GDP is exploding higher.


These former worries for investors have been brushed aside. As seen in the collapsing yields below, Irish bond investors are now "Happy To Lend Again."


No European story would be complete without Greece. Greece now owes 320 billion euros in sovereign debt and its debt to GDP stands at 174% after two restructurings. The following shows the incredible rise from 1999 to 2013.


With no hope of ever repaying this debt, the Greek 10 year yield has fallen to only 7.53%. The Greek stock market was one of the best performing assets on the planet in 2013 as liquidity drunk and momentum chasing investors piled in with force. Citigroup projects Greek debt to GDP to cross 200% by 2016 with unemployment at 32 percent. None of this matters in today's world. The Illusion has become belief.

Which country within Europe may hit the headlines first in 2014? Remarkably, it may not be any of the above. The most likely bet is tiny Slovenia, which saw its GDP shrink by 2.7% in 2013. The GDP has declined by 11% since 2008 and their SBI stock index has collapsed 75% from the September 2007 peak. While the government recently injected 3 billion euros into their financial system, EU stress tests have found another 4.8 billion of potential losses. Based on the speed of Slovenia's decline, bailout talks may have already begun.

Does this summary provide a rosy picture for the future of the European Union? Looking at the financial markets one could be confused. Yields on PIIGS government bonds have fallen to levels that are now close with the United States. Stock markets throughout Europe are exploding higher, and they have continued their relentless tear upward into early 2014. Sentiment has reached the euphoria stage on the expectation that asset prices will continue to move higher in the future.

For those who thought this was just a United States Illusion, I hope you have seen how deep this rabbit hole goes. Investors around the world have moved full force into European risk assets on a central bank's "promise."

Up Next: Rogue Wave 3: The Global Housing Bubble Is Back

h/t Mauldin Economics, Zero Hedge, Trading Economics

2014 Outlook: Investment Opportunities In The Year Ahead

2014 Outlook: The Greatest Illusion The World Has Ever Seen
2014 Outlook: The Danger & Opportunity The Illusion Creates
2014 Outlook: U.S. Stock Market
2014 Outlook: U.S. Residential Real Estate
2014 Outlook: U.S. Municipal Bond Market
2014 Outlook: Rogue Wave 1: Japan Is A Powder Keg Searching For A Match
2014 Outlook: Rogue Wave 2: Europe Calmly Sits In The Eye Of The Storm
2014 Outlook: Rogue Wave 3: The Global Housing Bubble Is Back
2014 Outlook: Investment Opportunities In The Year Ahead

As we enter 2014, the focus for almost every investor is centered around the search for "yield." In a low interest rate environment, at the latter stages of a cyclical advance in asset prices, investors feel more comfortable moving out on the risk spectrum in order to achieve what they consider the proper return for their portfolio. If junk bonds are in the mid 5% level and they feel they need that return on their money, then they will purchase junk bonds. 

Your thought process should be the exact opposite. When investors are willing to stretch this far for yield, by purchasing stocks at nose bleed prices and high risk bonds at incredibly low yields, your goal should be to find assets that will be protected when these yielding assets reverse course.

The most hated asset on the planet right now by far is cash. It should be your largest position. By cash, I mean safe cash. I would locate funds that carry exclusively short term U.S. treasury bonds (duration of 6 months or less). The monthly yield will be close to 0%. That's okay. You want to have dry powder available to purchase assets as they go on sale, and you can consider this your large storage facility of dry powder waiting to be deployed.

The next thing you want to do is make a list of assets that you believe are in long term secular bull markets based on how the future will unfold over the next five years or beyond (not how it will unfold over the next six months). When those assets go on sale, you can then begin to make purchases and build your portfolio.

My personal list looks something like this:

Gold
Silver
Mining Shares
Agriculture 
Energy Companies
Water Companies
Rare Earth Companies
Emerging Market Stocks
Canadian Dollar (& Bonds)
Australian Dollar ( & Bonds)
Brazilian Real (& Bonds)
New Zealand Dollar (& Bonds)
South African Rand (& Bonds)
Swedish Krona (& Bonds)

I am currently making purchases from my list more actively than at any point since early 2010. Why? Many of the assets on my list have been sold off heavily, and they are hated by the market. This is the scenario that triggers buying under my guidelines, low price combined with low sentiment. The two items on my list I am most actively buying today are silver and agriculture. Many of the currencies on my list are very close to buying levels (I was buying the Brazilian real over the summer), even though I would like their bond markets to sell off further so I can purchase the sovereign bonds simultaneously. Chinese shares are almost back within a buying range. Same with a few specific Russian companies.

Please understand that I am not trying to provide you a list to say "do this" (I am NOT currently buying MOST of the assets on the list above). I am only trying to show you the thought process behind how I invest. Most of my investment time is spent sitting and watching and raising cash. It is like a fisherman sitting out on the open water all day - a very boring process. When the market provides an opportunity through both a price and sentiment decline, I begin accumulating until either the price or sentiment reverses course.

Looking at price and sentiment, precious metals experienced a massive price decline over the past year and they have been completely given up on as an investment class. Sentiment levels have plunged to record lows over the past few months. I have not been as active as I am today in the silver market since 2006. Back then it felt the same as it does today, no one is paying attention. I never imagined there would be another opportunity like what we are experiencing today in the precious metal's secular bull market. Prices will (hopefully) fall lower in the short term. I will accumulate more.

I am buying wheat, corn, sugar and other specific baskets of agriculture. The prices are in the toilet. Sentiment is worse. Prices will (hopefully) fall lower in the short term. I will accumulate more.

If oil prices were to plunge over the next few months, I would begin accumulating stocks in that sector. By plunge, I mean fall back under $75 a barrel (currently at $92). If the Canadian dollar were to fall sharply, I would begin making an investment. By sharply, I mean fall below 80 vs. the U.S. dollar (currently at 91). 

If every asset on my list were to move higher in price and become loved (this occurred from early 2010 to about mid 2011), then I would step aside and raise cash. I hate to buy an asset when people are talking about it on CNBC or Bloomberg. 

What I suggest you do first is take as much time as possible to invest in your understanding of the global economy and financial system. Then close your eyes and imagine how you expect the world to look five years into the future. With that vision in place, begin to decide which countries may have capital moving toward them at that future date. Then decide which assets classes within that country may perform best (stocks, bonds, real estate) and begin to compile a list of attractive assets within that sector. This is how you work backwards to determine the best way to structure a portfolio.

You want to do the opposite for markets if you feel there is a potential danger. As I discussed throughout this entire Outlook, I believe there is danger lurking in many areas of the world today. If you can move safely out of the way when that danger arrives, you will be far ahead of almost everyone around you. In addition, by investing time in your personal education it will give you the conviction to make purchases when a selling panic begins.

I appreciate you reading this Outlook and I look forward to an exciting year ahead. For further discussion on how I am personally preparing for the world I see in the future, see:


I am not a financial advisor. You should speak with one before making any investment decisions.