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Successful investors live by a golden rule: what the mainstream financial media talks about is not important. They focus on what they don't hear instead. So forget about Yellen for a second. Let go of Draghi, oil, the South African rand and Syria. That's all in the now. But investing is about the future.
We are convinced there is one proverbial elephant in the room in particular that will shape our future. And that elephant is Japan. The 'widowmaker' trade has been claiming financial lives for multiple decades now. That is, short JGBs, or Japanese Government Bonds, was so obvious a trade that it never worked. The 10-year yield currently trades at 0.3%, which is close to the all-time low. We're still waiting for the shoe to drop.
Will it ever drop? We believe it will. 'Drop' might not be the appropriate word. The accumulation of imbalances might trigger a cascade of events that will shake the world at its core. Let's investigate some data.
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Japan's debt-to-GDP ratio has hit a unprecedented 230%. You probably knew that. But it doesn't keep you awake at night. We are genetically wired to focus on acute danger. If a tiger approaches us, we focus. But if stands still and doesn't move for years, we turn around in search for other dangers. Wise investors remind themselves constantly of the tiger though. They never let their guard down.
What about the pace at which debt-to-GDP is ramping up? The budget deficit tells us all we need to know.
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For six years in a row already, Japan scored around minus 8%. And given the flattish GDP, these annual percentages head straight to the public debt pile. Japan's long term potential real GDP-growth rate is simply close to zero, given the demographics. The latest quarterly print was [12] a minus 0.3%. This makes the debt grow even faster.
The GDP leads us to the approach that governments used time and again in history to reduce debt loads: nominal GDP-targeting. Also known as inflation-targeting, financial repression, money printing, and monetary stimulus. The Bank of Japan (BoJ) is working hard in that respect. It already owns over 30% of the total JGB market. In a few years, Japan Macro Advisors (JMA) projects the BoJ might be holding over 60% of the total market given its current policies.
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What does that look like from a total balance sheet-perspective? With the BoJ also buying all kinds of non-JGB assets, the other central banks' balance sheets just pale in comparison. We are witnessing a truly historic experiment.
[11]It doesn't take an Einstein to figure out that this is totally unsustainable. The BoJ-policies will have consequences. The most likely scenario is that inflation slowly develops at first. Commodity prices could turn. The yen could take another beating. And then suddenly, inflation accelerates.
Now, there has always been a lack of 'demand' for stuff in Japan. It has always been lucrative to hold cash. Yens were safe. Every year, you could buy more stuff. But as inflation develops, the growing flock of elderly will realize their government benefits are just paper promises. When the price of everything rises, as already happened in the Japanse stock market, they will realize their savings are losing value. Money will then become the hot potato. The velocity of money will rise. Suddenly, 'demand' will appear. Inflation accelerates.
Hyperinflation is a possibility. It is not yet well-understood how this develops. There are multiple theories on the process. But historically, nearly all hyperinflations have been caused [13] by government budget deficits financed by money creation. And that condition for sure is present in Japan.
Once the bond market realizes what is happening, the game is over. The JGB market will crash. The 'widowmaker' will make millionaires of the ones still hanging on. There will be a fiscal crisis. Panic develops. A banking crisis ensues, as yen denominated asset prices and the yen itself both crash.
Japan leads the way
The most scary prospect is that Japan is our leading indicator. Remember what we heard after the financial crisis. The US was not Japan. Europe was not Japan. There was not going to be deflation here. We were smarter. We learned Japan's lessons. Well, as we're heading into 2016 you would be hard-pressed to find anyone who would deny that the US, and especially Europe, both struggle with anemic growth and deflation. Despite all the extraordinary efforts of the Fed and ECB.
Japan does lead our way. One morning, Japan's experiment will reach its logical conclusion. The sun will rise in the East and the world will be a different place. That morning might arrive sooner than you think.
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