Japan: The Sun Also Rises?

QuintStuart P. Quint, CFA, Brinker Capital

This is part two of a two-part blog series. Click here to view part one.

What are the signposts?

Japan also might be recognizing its opportunity for major change out of years of frustration with both voters and the political establishment.  Current Prime Minister Shinzo Abe assumed office in December 2012 on a platform of promoting economic growth with the use of “three arrows”: monetary, fiscal, and structural economic reform.  So far, he has won positive reviews on the “first arrow”.   Naming a new head of the Bank of Japan with support from both ruling and opposition parties has resulted in an aggressive acceleration of quantitative easing in Japan.  The goal is to change price expectations from deflation to inflation, and thus improve prospects for savings, investment, and economic growth.  Major companies also gave employees small positive wage increases for the first time in many years.  Consumer sentiment and financial markets thus far have responded positively.

Monetary policy is not enough to solve Japan’s woes.  Structural reform must be tackled, though it will not be easy and could take more time.  On the political front, the government must undertake electoral reform in accordance with a ruling from the Supreme Court that could potentially rebalance voting power to younger, urban voters who benefit from more reform.  The question is whether leaders on both sides have the political will to implement a real reform.  If not, Prime Minister Abe could lose approval and momentum to reform.

shutterstock_17785696Additional structural reforms include trade, energy, tax, health care, and agriculture.  Agriculture is key not only to the economy, but also to national security.  As an example, the average age of the Japanese farmer is around the mid-sixties.  Very few large farms with economies of scale exist.  The acreage of farmland in Japan is also declining.  Japan is vulnerable to rising food prices, particularly if other countries restrict exports, such as what occurred several years ago when rice prices spiked.

Trouble in the Mediterranean

Joe PreisserJoe Preisser, Investment Strategist, Brinker Capital

Blue-chip stocks listed in the United States stumbled on their quest to reclaim the historic heights they recently attained, as a renewal of concerns from the European continent served to unsettle investors. Proverbial wisdom contends that markets will climb a, “wall of worry”, and this statement has rung particularly true this year as the Dow Jones Industrial Average has marched steadily higher amid a torrent of potential pitfalls. Up until this week, market participants have largely disregarded the political gridlock ensnaring Washington, D.C. and the possibility of a resurgence of the European sovereign debt crisis, instead clamoring for risk assets, and in so doing, have driven stocks into record territory. The current rally has, however, paused for the moment with the increased possibility that Cyprus may become the first member of the Eurozone to exit the currency union, once again casting the shadow of doubt across the Mediterranean Sea and onto the sustainability of this collection of countries.

A decision rendered by leaders of the European Union last weekend—to attempt to impose a tax on bank deposits within the nation of Cyprus in exchange for the release of rescue funds the country desperately needs—sent tremors through global financial markets. Although the Cypriot population stands at slightly more than one million citizens, making it one of the smallest countries in the Eurozone, the repercussions of this decision were felt across continents. Policy makers representing the nations of their monetary union hastily gathered to decide what conditions would need to be met in order to disperse the necessary financial aid to Cyprus, totaling ten billion euros, and in so doing, made a significant policy error. According to The New York Times on March 19, “Under the terms of Cyprus’ bailout, the government must raise 5.8 billion euros by levying a one-time tax of 9.9 percent on depositors with balances of more than 100,000 euros. Those with balances below that threshold would pay 6.75 percent, an asset tax that would still hit pensioners and the lowest -income earners hard.” Although the intentions of the European leaders making this decision were to target large foreign depositors, who have historically used the country’s banks as a tax haven, the proposed inclusion of those on the lower end of the spectrum has created widespread uncertainty.

EurosThe imposition of a tax on deposits that would include those of 100,000 euros and less, which had been guaranteed by insurance provided by the European Union, has created concerns over the stability of the banking system in Cyprus and by extension, that of the Eurozone in its entirety. By negating the very guarantee that had been put in place to strengthen this vital portion of the Eurozone’s financial system, policy makers have increased the risk that large scale withdrawals will be taken across Cyprus, which is exactly the type of situation they had hoped to avoid. The New York Times quoted Andreas Andreou, a 26-year-old employee of a Cypriot trading company, who gave voice to the feelings of the populace when he said, “How can I trust any bank in the Eurozone after this decision? I’m lifting all my deposits as soon as the banks open. I’d rather put the money in my mattress.” In order to forestall such an event, and protect against the possibility of contagion to the other heavily indebted members of the currency union, the country’s banks have been shuttered and are scheduled to remain so until Tuesday.

Uncertainty continues to swirl in the warm Mediterranean air as the Cypriot Parliament on Wednesday rejected the original terms of the bailout, casting the nation’s leaders into direct conflict with those of the European Union. With the deadline for
the country to propose a viable plan to raise the requisite 5.8 billion euros,
set by the Continent’s Central Bank for Monday, fast approaching, the stakes of
this game of brinksmanship have been raised, as the possibility of the country
leaving the euro zone has been broached. Eric Dor, a French economist who is the head of research at the Iéseg School of Management in Lille, France offered his opinion on the rationale of Europe’s leaders in The New York Times on Thursday, “They are saying we can take the risk of pushing Cyprus out of the Eurozone, and that Europe can take the losses without going broke.” Although the raising of the possibility of Cyprus being expelled from the monetary union, is most likely a negotiating tactic designed to goad Cypriot leaders into adopting the reforms the E.U. has deemed necessary, with the more likely outcome of a compromise being reached, the current impasse serves as a reminder of the difficulties facing the Continent as it continues its unprecedented experiment in democracy.

Fed Likely to Remain Accommodative in the Near Term

Magnotta@AmyLMagnotta, CFA, Brinker Capital

Equity market investors expressed concern last week after the release of the minutes from the latest FOMC meeting suggested that the Federal Reserve is considering slowing down the pace of the current quantitative easing (QE) program. The Fed is currently purchasing $85 billion of U.S. Treasury and Agency mortgage-backed securities per month.

The Fed has changed its stance on when policy would potentially move to a tightening bias, from emphasizing a calendar date to basing it on economic data. The Fed has stated that it would not raise short-term rates until the unemployment rate fell to 6.5% as long as inflation is not expected to rise above 2.5%. With inflation currently running well below their threshold and with the unemployment rate elevated at 7.9%, it is likely the Fed is more focused on bringing down the employment rate, potentially at the expense of higher inflation.

With short-term interest rates already at the zero bound, the asset purchases are attempting to promote the same result as additional cuts to the fed funds rate. Even if the Fed tapers off their asset purchases in the next few months, any QE is still easing. They would just be taking their foot off of the accelerator. We feel that economic growth should remain tepid in the first half of the year and not strong enough to bring down the unemployment rate significantly, so the Fed is likely to keep their accommodative stance. In addition, the key members of the FOMC – Bernanke, Yellen and Dudley – all lean to the dovish side with respect to monetary policy.

Before actual tightening occurs, the Fed will first have to end QE. When the Fed stops asset purchases, it would be in the context of an improving economy. An improving economy is typically a positive for asset prices. As ISI Group shows in the following charts, equity prices have eventually increased in past episodes of policy tightening.

The Fed raised interest rates from 1.00% to 5.25% from June 2004 to June 2006. After a modest correction, equity prices moved up substantially.

The Fed raised interest rates from 1.00% to 5.25% from June 2004 to June 2006. After a modest correction, equity prices moved up substantially.

The Fed tightened in more aggressive increments during the 1994-1995 period. The equity markets moves sideways for a period of time, and then ultimately moved higher.

The Fed tightened in more aggressive increments during the 1994-1995 period. The equity markets moves sideways for a period of time, and then ultimately moved higher.

Balancing Act

Joe PreisserJoe Preisser, Brinker Capital

Concern lurched back into the market place last week, as the specter of an eventual withdrawal of the extraordinary measures the U.S. Central Bank has employed since the financial crisis, served to temporarily rattle markets around the globe. Although stocks rebounded smartly as the week drew to a close, from what had been the largest two-day selloff seen since November, the increase in volatility is noteworthy as it spread quickly across asset classes, highlighting the uncertainty that lingers below the surface.

Equities listed in the United States retreated from the five-year highs they had reached early last week following the release of the minutes of the most recent Federal Open Market Committee (FOMC) meeting as the voices of those expressing reservations about continuing the unprecedented efforts of the Central Bank to stimulate the U.S. economy grew louder. The concern of these members of the Committee stems from a fear that the current accommodative monetary policy may lead to “asset bubbles” (Bloomberg News) that would serve to undermine these programs. “A number of participants stated that an ongoing evaluation of the efficacy, costs and risks of asset purchases might well lead the committee to taper, or end, its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. The minutes stated.” (Wall Street Journal).

Tangible evidence of the unease these words created in the marketplace could be found in the Chicago Board Options Exchange Volatility Index, or VIX, which measures expected market volatility, as it leapt 19% in the aftermath of this statement representing its largest single-day gain since November 2011 (Bloomberg News). The reaction of investors to the mere possibility of the Fed pulling back its historic efforts illustrates the continued dependence of the marketplace on this intervention and highlights the difficulties facing the Central Bank in not derailing the current rally in equities when it eventually pares back its involvement.

A measure of the uncertainty surrounding the timing of the Federal Reserve’s withdrawal of its unprecedented efforts to support the U.S. economy was dispelled by St. Louis Fed President, James Bullard, in an interview he gave late last week. Mr. Bullard, currently a voting member of the FOMC, was quoted by CNBC, “I think policy is much easier than it was last year because the outright purchases are a more potent tool than the ‘Twist’ program was…Fed policy is very easy and is going to stay easy for a long time.”

Reports of statements made by The Chairman of the Federal Reserve, Ben Bernanke, earlier this month, which downplayed the potential creation of dangerous asset bubbles through the Central Bank’s actions, released Friday, helped to further assuage the market’s concerns. “The Fed Chairman brushed off the risks of asset bubbles in response to a presentation on the subject…Among the concerns raised, according to this person, were rising farmland prices, and the growth of mortgage real estate investment trusts. Falling yields on speculative-grade bonds also were mentioned as a potential concern” (Bloomberg News). Although the rhetoric offered by these members of the Federal Reserve in the wake of the release of the minutes of the FOMC was offered to alleviate fears, the text of the meeting has served as a reminder to the marketplace that the asset purchases currently underway, which total $85 billion per month, will be reduced at some point in the future, and as such, has served as a de facto tightening of policy.

Though investors appeared to be appeased by the words of Mr. Bullard as well as those of Mr. Bernanke, the steep selloff that accompanied the mention of a pull back of the Central Bank’s efforts is a reminder of the high-wire act the Fed is facing when it does in fact need to extricate itself from the bond market.

Economic Outlook and Monetary Policy

Andy Rosenberger, Brinker Capital

Recently, I had the pleasure of attending a speech by Charles Plosser, the President of the Federal Reserve Bank of Philadelphia.  Mr. Plosser’s remarks were credited by many in the press as the reason for that afternoon’s sell-off in the markets, which resulted in a -1.04% decline on the S&P 500.  Although not currently a voting member of the FOMC, as President of a regional Federal Reserve branch, his opinions and influence are important to monetary policy decisions.

While Mr. Plosser still believes that growth will be 2% in 2012 and 3% in 2013 and 2014, the financial press was principally focused on his comments that quantitative easing is not effective at helping the broader economy.  His belief is that too little focus is placed on the potential future costs of printing money and that the Fed actions carry with them ‘significant risks’ with ‘meager’ benefits.  Honestly, I was somewhat surprised by the frank comments from Mr. Plosser.  After all, it’s not all that often Federal Reserve officials are completely candid with their outlook (can you remember the last time the Fed called for a recession?).  Nonetheless, the straightforward opinion was a nice change from the normally overoptimistic Federal Reserve comments.

During the Q&A session, I was able to sneak a question in for the President.  Specifically, I asked if Mr. Plosser could comment on the channels in which Quantitative Easing (QE) is effective (through lowering rates, depreciating the dollar, and increasing asset prices).  Covertly though, my intention was to get his view on QEs ability to increase equity prices.  Similar to his comments regarding the cost and benefits of QE, his frank answer was that quantitative easing should not increase the value of asset prices.  Mr. Plosser’s explanation was that asset prices are simply a discounted value of future cash flows.  Although QE lowers the rates at which equities are discounted, he had a strong view that “quantitative easing does not create wealth.”  My guess is that Mr. Bernanke and Wall Street would disagree with Mr. Plosser here.  Time will tell who is ultimately correct.

Source: Brinker Capital and FactSet

To read Mr. Plosser’s speech, please click here.

Economic Headwinds and Tailwinds

Amy Magnotta, CFA, Brinker Capital

We continue to approach our macro view as a balance between
cyclical tailwinds and more structural headwinds. While we have
seen some cyclical improvement in the economy, helped by easy
monetary policy, we continue to face global macro risks and
uncertainties. The unresolved macro risks could result in bouts of
market volatility and as a result portfolios have a modest defensive
bias, and are focused on high conviction opportunities within asset classes.

Tailwinds
Accommodative monetary policy: The Fed has become even more accommodative with the announcement of further quantitative easing, an open-ended mortgage-backed securities purchase program, and they seem determined to continue until growth picks up. In addition, the Fed has pledged to keep interest rates low into 2015. The European Central Bank has also pledged support to defend the Euro and has committed to sovereign bond purchases of countries who apply for aid. Emerging economies have room to ease further if growth slows to an unacceptable level. There is the expectation that China will ease further to attempt to engineer a soft landing.

U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be put to work through M&A, capital expenditures or hiring, or returned to shareholders in the form of dividends or share buybacks. While estimates are coming down, profits are still at high levels.

Housing market improvement: There is evidence that the housing market has bottomed and could soon be in a position to contribute to economic growth. Prices have stabilized and sales have increased over last year. Homebuilder confidence is at levels last seen in 2007. Housing inventories have fallen. Low mortgage rates and rising rents have driven affordability to record levels; however, credit remains tight.

Headwinds
U.S. fiscal cliff / U.S. election / U.S. fiscal situation: The current U.S. political environment does not inspire confidence. We face a significant fiscal cliff in 2013 due to expiring tax cuts and spending measures. With economic growth in the U.S. at stall speed, the size of the fiscal cliff could tip us into recession territory. There will be no resolution of the fiscal cliff until after the election is decided, which will result in greater uncertainty. We hope for a short-term extension of some of the measures, setting up for a larger tax and entitlement reform package to be debated in 2013. Fiscal policy uncertainty has led U.S. companies to put plans for additional hires and/or capital expenditures on hold until it is clear what the rules are.

European sovereign debt crisis and recession: While the ECB and EU leaders have pledged support to the Euro, actions need to follow words. Bond purchases by the ECB will not solve the problems in Europe, but it can buy policymakers time to make real reforms. However, growth will continue to weaken in the region. High unemployment combined with planned austerity measures have led to more social unrest.

Global growth slowdown: There is evidence of a slowdown in growth not only in developed markets, but also in emerging markets. Growth in the U.S. continues to be sluggish, leaving the economy susceptible to shocks. Europe is in recession territory. Growth in China has slowed and continues to show signs of further weakening.

Tensions in the Middle East: Geopolitical risks in the Middle East are cause for concern. A sharp rise in oil prices will be a negative shock to the global economy.

This commentary is intended to provide opinions and analysis of the market and economy, but is not intended to provide personalized investment advice. Statements referring to future actions or events, such as the future financial performance of certain asset classes, market segments, economic trends, or the market as a whole are based on the current expectations and projections about future events provided by various sources, including Brinker Capital’s Investment Management Group. These statements are not guarantees of future performance, and actual events may differ materially from those discussed. Diversification does not ensure a profit or protect against a loss in a declining market, including possible loss of principal. This commentary includes information obtained from third-party sources. Brinker Capital believes those sources to be accurate and reliable; however, we are not responsible for errors by third party sources on which we reasonably rely.