The IMF, Japan and the failure of Abenomics

July 31, 2015

The IMF, after playing a major role in the complete collapse of Greek activity and the exploding Greek debt burden with its insistence that fiscal austerity solves every problem from Ghana to Greece, has now turned its attention back to Japan.

“The Bank of Japan needs to stand ready to ease further, provide stronger guidance to markets through enhanced communication, and put greater emphasis on achieving the 2 percent inflation target in a stable manner”  – IMF 2015 Article IV consultation with Japan

The failure of “Abenomics” to deliver a steady and sustained 2% plus inflation rate can easily be explained by the chart below. It shows the Output Gap i.e. the gap between actual output and potential output in the economy and the inflation rate. The recent spike in inflation was a one-off impact from tax increases that is fading away. Inflation has now slipped back to where it should be.


Japanese inflation is highly correlated with the economic cycle; when activity accelerates and the Output Gap closes we see inflation follow (and vice versa).

So, what is needed to get inflation sustainably higher in Japan is sustainably higher economic growth that removes the Output Gap and turns it positive i.e. gets the economy running above its potential.

The answer from the IMF/Bank of Japan to that challenge? Quantitative Easing (QE), of course… lots of it.

  • The Bank of Japan now owns 22% of outstanding Japanese government debt versus just 7% two years ago.
  • The Bank of Japan’s balance sheet is now 60% of GDP, almost double the size two years ago.

The chart below shows the growth in Bank of Japan Assets (QE purchases of assets) dwarfing the net issuance of equity in the Non-Financial Corporates sector and net issuance of government debt. An increase in QE and Bank of Japan asset purchases would give a further significant boost to asset price inflation (stay long Japanese equities), but we very much doubt it will boost activity and shrink their Output Gap.



Well, take a look at the assets of Households and Liabilities of the corporate sector:

  1. Japanese Households hold very little of their assets in equities and bonds and so the economy gets very little benefit from any wealth effect arising from an increase in the value of these securities. They own lots and lots of cash primarily.


  1. Japanese Non-Financial Corporates have less than half their financial liabilities in equity, with almost 30% in loans and bonds where yields are near the zero level already.



  • Expect the Bank of Japan to expand QE further (from 80 trillion yen, 16% of GDP a year at present) – keep pushing that string until it budges…
  • More QE = more local asset inflation = weaker Yen (until such time as the US market heads south, at least).



Gold… it’s not the US Dollar!

July 27, 2015

With Gold hitting its lowest level since late 2009, we are reading more and more commentary attempting to determine the cause of its recent weakness. Many have labelled its decline as a consequence of a stronger US Dollar, which itself is a consequence of expectations of forthcoming US Fed rate hikes. Once again the words of Thomas Huxley spring to mind: “The great tragedy of science – the slaying of a beautiful hypothesis by an ugly fact

For the sake of argument, for a UK-based investor, the following simple equation describes the relationship between the price of Gold and the US Dollar/Pound Sterling (USD/GBP) exchange rate:

  • USD/Ounce of Gold = USD/GBP   x  GBP/Ounce of Gold

So, the price of Gold goes down when

  1. USD goes up


  1. GBP price of Gold goes down

Clearly, it is, in principle, not the case that the US Dollar going up necessarily implies that the price of Gold goes down.

In fact, if we look at the spot price of Gold (in US Dollars) versus the USD/GBP exchange rate (monthly % changes) we see that there is no relationship at all over the last 20 years (the same is true looking further back).


And using the same chart but showing instead the spot price of Gold (in US Dollars) versus the change in the USD/Euro exchange rate (Gold from the perspective of a Euro investor)… again, no relationship (R2=zero).


Our hypothesis remains the following:

  • Gold has been an effective systemic and catastrophic credit risk hedge – you hold it when you fear for the very survival of the system. To that end, the Gold price has been highly correlated with credit default swap spreads (think of credit default swaps as insurance policies, the price aka “spread” rises/falls as perceived credit risk rises/falls).

The following chart shows a GDP-weighted average of the Credit Default Swap (CDS) spread for Italy and Spain versus the price of Gold during the recent boom and bust period for Gold. You can see the price of Gold surged higher as CDS spreads widened (systemic risk rising) from 2008 – 2011 and then fell from 2011 onwards as CDS spreads narrowed (systemic risk eased). The CDS spread narrowed sharply in the period after 2011 when central banks went “all-in” on QE and effectively “guaranteed” the liquidity (and solvency) of the financial system. The full scale shift to QE by the ECB this year explains the move in Gold, in our opinion, not the US Dollar.

The Gold price is now pretty much where CDS spreads suggest it should be.


What would cause Gold to surge higher again? The (unlikely) abandonment of QE and a decision by central banks to leave the massively debt-laden system to fend for itself.



Gold Miners: The day of reckoning approaches

July 23, 2015

Involvement in less regulated markets comes with its own risks. Markets participants were reminded of that when in the early hours of Monday, the 20th of July, the price of Gold plummeted by just over $45 an ounce (-3.9%) in less than a minute just before the market opened in China. This price action, caused by a massive sell order of $2.7 billion in Gold futures, looks an awful lot like market manipulation since no one in their right mind would try and sell such a large amount so quickly at the lowest liquidity point of the day. If a short-seller with deep pockets wanted to re-price Gold significantly lower, he would follow exactly the same modus operandi.


For Gold miners, this is of course bad news. After a golden decade (2001-2011) – no pun intended – when the market rewarded aggressive growth over cash flow generation and financial discipline, their fortune has changed dramatically. As the market for Gold peaked just below $2000 per ounce, investors came to the realisation that despite the yellow metal being in excess of 6x higher than 10 years before, Gold miners’ cash flow generation in aggregate was flat.

Fast forward 3 years and the situation has deteriorated quite dramatically. The chart below (courtesy of Goldman Sachs) shows the all-in cost of production (including net debt and interest due as well as operational expenses) for the major players of the industry. In effect, this shows that prices per ounce below $1050 would mean that an overwhelming proportion of Gold miners would be making a loss. The top 10 global miners also show leverage ratios (debt: equity) in the region of 100% on average. As the odds of higher interest rates in the US increase, access to financing and interest payment should worsen, adding financial stress to an already challenging operational situation.


Unsurprisingly, investors have started voting with their feet as the price of Gold approaches the $1050 – $1100 territory. Between August 2011 and June 2015, Gold miners showed a Beta of 1.6x to the price of Gold. In practice, this means that when Gold sold off by $1, Gold miners sold off by an average $1.6.

Since the beginning of the month however, this sensitivity has doubled, as Gold miners now sell off by an average $3.1 for each dollar lower in the price of Gold. This makes sense, since each dollar lower in the price of Gold exponentially increases the risk of insolvency, and ultimately bankruptcy, of these companies.


In due course, distressed investors with the nerves to get involved will be able to acquire Gold-related assets at a significant discount to fair value. The day of reckoning approaches, but things will probably get worse before they get better. Especially since the recent price action will in all likelihood spur the deep-pocketed trend-following community to increase their short positions, adding incremental pressure for lower prices to an already very weak market.



Industrial Metals Anyone…?

July 20, 2015

There is an interesting picture developing between Emerging Market Equity Performance and the Performance of Industrial Metals Prices.

The chart below shows the % Drawdown from the trailing peak level of the GSCI Industrial Metals Index (Aluminium, Copper, Zinc, Nickel and Lead) and the MSCI Emerging Equity Index.


There is an extremely high correlation until 2012… then there is a marked divergence. Why is this?

Look at the aggregate level of the inventory of Industrial Metals in the LME (London Metal Exchange) warehouses (metric tonnes).

Aggregate inventory is 73% Aluminium – Aluminium stocks have fallen 30% from their peak in late 2013 and are down 29% year/year.


Short Emerging Equity/Long Industrial Metals anyone? …Inventories of Industrial Metals are falling fast!



Why Greece cannot be Japan… or why Japan is not Greece (yet!)

July 16, 2015


  • Greek Debt/GDP Ratio is currently around 180% and, more importantly, the Greek Government Debt/Government Tax Receipts Ratio is 600% (6 x). These debt ratios will, of course, rise further after the bailout.
  • Greece is close to primary budget balance (it was 1% in primary surplus late last year and has a cyclically adjusted primary surplus of approximately 6% of GDP). The Greek 10 Year Yield is around the 12% level.
  • Greece has a current account surplus.


  • Japanese Debt/GDP Ratio is currently 230% and, more importantly, the Japanese Government Debt/Government Tax Receipts Ratio is 2200% (22 x).
  • Japan has a primary budget deficit of 7% of GDP and a cyclically adjusted primary deficit of 6% of GDP. The Japanese 10 Year Yield is 0.44%
  • Japan has a current account surplus.

Japanese Debt is approximately 22 x government tax receipts while in Greece it is 6 x government tax receipts. Japan also runs substantial structural deficits. This raises the question, why is Greece in crisis and Japan, with yields near zero, not?

Simple, monetary autonomy – having your own central bank.  The chart below shows the benefit of this.

2015.16.07 BoJ Debt

The Bank of Japan is accumulating vast amounts of bonds, it has gone from owning 7% of the outstanding stock two years ago to almost one quarter today.

So much for monetary autonomy, you truly can pretend there is no problem when you have a friendly central bank to buy your debt…



Is Austerity to blame? …We think so

July 7, 2015

“Why can’t Greece be more like Ireland?” has been cried over and over again in recent days. After all, they went through imposed austerity and yet have grown 1.9% annualised since the end of 2009 (in real terms) while Greece has contracted at a 4.9% annualised rate.

The following charts offer an explanation and illustrate why more austerity – in the form of the demand for large structural budget surpluses in Greece – may not be the answer.

Chart 1 shows the change in the Cyclically Adjusted Primary Budget Balance (this is the part of the budget that is structural and thus cannot be explained by strong/weak growth – it cannot be grown out of) and excludes debt interest repayments versus Annualised Real GDO growth over the last 5 years.

The line runs right through the data the correct way – a strong correlation between the degree of fiscal tightening (approaching 20% points of GDP in Greece) and realised Growth.

Austerity policies do appear to depress growth rates.


It is import to note that Ireland sits a little off the line. It has done slightly better than one would have expected given an 8% points of GDP swing in the primary structural balance.

If we exclude Ireland, the relationship is much stronger; austerity and growth are exceptionally linked.


Then what is so special about Ireland?

Take a look at Exports of Goods and Services as a % of GDP for those countries above. At the end of 2009 Greek Exports were just 18% of GDP, the lowest in the bloc. Going forward to today, exports now account for 33% of GDP (GDP has dropped by 25% and exports have held up with a weaker Euro).

But… look at Ireland. Irish Exports at the end of 2009 were almost 100% of GDP.


With the Euro declining (20% in broad, real, trade weighted terms from the end of 2009) and Unit Labour costs also declining, it is little surprise that Ireland has fared better. Especially when it has also experienced less than half the cumulative austerity that Greece has been subjected to. Austerity has been smoothly/steadily applied most everywhere, with Greece given a more front-loaded and larger dose than anyone else.


There is a message in this for the UK as well. Austerity, to date, has been comparatively modest, with virtually no tightening in the structural budget balance since 2011. A more aggressive stance would suggest that the much lauded performance of the UK economy could look a lot less exciting without some Sterling weakness to offset the impact.



Greek Default priced in

July 3, 2015

If you assume that the German Benchmark Yield Curve represents the Eurozone Risk Free comparison, then the spread of Greek versus German Bond Yields can be used to calculate the “Implied Probability of Default” already discounted by Greek Bonds at various assumptions for the Recovery Rate (the amount of money you expect to recover after default).


The 5 year Greek Bond fully discounts default with a 50% recovery rate, as do the 10 and 30 year Greek Government Bonds.

The 10 year Greek Bond fully discounts default with a 25% recovery rate, as does the 30 year Greek Government Bond.

Easy to see why some Hedge Funds have taken a position… default pretty much fully priced at these levels across the curve with half recovery; not an unrealistic expectation.

A 2009 Moody’s publication “Sovereign Default and Recovery Rates, 1983-2008” found for 13 defaults a value weighted recover rate of 30-40% (depending on method). Either way, with that type of recovery rate in Greece, default is fully priced in…



UK Current Account Statistics explains UK growth profile

July 3, 2015

Currently, there is an interesting picture in the UK Current Account Statistics and one which explains the comparatively better UK growth profile

The Current Account Balance = Government Balance + Private Sector Balance (where Private Sector Balance = Household Sector Balance + Business Sector Balance). The Current Account Balance measures the difference between Gross Investment and Gross Savings in the economy (and that difference can be allocated between sectors).

The 4-Quarter Moving Average of the UK Current Account Balance as a % of GDP is at its worst ever – a deficit of 6.2% of GDP. The UK has a Current Account Deficit on an alarming scale. The deficit says that the UK needs to attract a capital inflow, from foreigners, of just over £110 billion.

Large current account deficits have been shown, repeatedly, to lie at the heart of many a financial crisis. With a large, external financing requirement, you are very vulnerable to rising risk premia and sharply diminishing market sentiment. (Many excuses can be wheeled out including incorrect accounting for foreign property investment, poor returns on UK overseas assets, etc. The simple fact is, the UK is accumulating Net Foreign Liabilities at an alarming rate).


If we break the Current Account Deficit down and look at the Private Sector Balance (as a % of GDP), the Private Sector in the UK is back to accumulating Net Liabilities (Debt) – a deficit of 1.5% of GDP.

The late 1980s boom and the late 1990s boom were the last time we saw this (we skirted the deficit line in the 2006/7 period). No wonder the UK is doing comparatively well, the growth is underpinned by Private Sector liability accumulation and a record current account deficit – not a good structural sign.

The other side of the sharp deterioration in the UK deficit is the sharp improvement in the Eurozone deficit.


In conclusion, currently we have a record current account deficit and a private sector deficit again (alongside a sizeable public sector deficit). The UK does it again – builds a recovery on debt and asset inflation and not productivity.