Returning from vacation, I couldn’t help my wide-eyed astonishment at the US equity market performance over the last week-and-a-half. In my view, Jon Hilsenrath’s comprehensive Wall Street Journal article released May 10, should have provoked a market reaction consistent with a modest reduction in the fuel which has driven risk markets to current all time highs. I hasten to add that I do not believe we have seen the highs/tights in risk markets for the year. One could argue that the WSJ article and more specific contemporaneous Bernanke commentary* in fact did not indicate a more hawkish acceleration of US Federal Reserve tapering than what financial markets already anticipated, except that other markets beyond US stocks (i.e. US interest rates, USD currency, and precious metals), did experience price action that would be expected in response to a delicate tapping of the quantitative easing (QE) brakes. Q1 2013 gave us compelling evidence that tail risks need not affect financial markets (e.g. Cyprus’ quasi-euro-exit) because by implication, global central banks stand ready to deploy all possible means to ensure price stability. Central banks’ liquidity injections and minimization of the tail risks have (perhaps rightly) dramatically decreased investor risk aversion, as evidenced by the S&P returns in the past seven quarters deriving almost exclusively from multiple expansion (chart), and credit spreads continuing tighter despite evidence that fundamental creditworthiness has already peaked. So I was puzzled by the S&P 500’s defiance of the little red flag.
S&P 500: Multiple Expansion (Data normalized to 3Q2011=100)
Source: Bloomberg, JPM
In my view, Japan was the wildcard last week adding this buoyancy to select risk markets. As Japanese equities continue to march higher, and the JPY continues to slide weaker, I believe it is forcing further introspection for worldwide investors witnessing/experiencing the “currency tensions” (read: competitive devaluation). In Japan’s case, the real risk of debasement (beyond merely devaluation) is becoming more broadly apparent. The sustainability of Japan’s chart-topping debt stock seemed to me to be prisoner to the delicate balance of miniscule nominal rates, modestly positive real rates, and strong domestic sponsorship of government borrowing (admittedly demographics were already weakening the third leg of the tripod as fresh retirees are shifting society from net savers to net spenders). I couldn’t understand why a government would attempt to create inflation that might derail any and perhaps all three of these contributors to their sustainability. Several high profile investors have long pointed out what is becoming a more broad based realization with Japanese Government Bonds (JGB) yields spiking last week**: higher interest rates make Japan’s debt service unsustainable as a percent of government revenue. Sure, we can envision combinations of inflation, real growth, and nominal rates which might indicate a declining debt stock, but obtaining that sweet spot could be, ahem, challenging. However, the reality facing Japan isn’t quite as grim. The country benefits from the composition of their debt stock, which can, on its own, dismiss some of the traditional notions of debt sustainability analysis adapted from EM and the eurozone. Japan’s debt is overwhelmingly fixed rate, non-inflation-linked, JPY-denominated local bonds. Setting aside questions of central bank independence, they can literally print any yen necessary to pay it. Isn’t this inflationary? You bet. Is it hyper-inflationary? Not necessarily. The Japanese government knows what their debt stock is, and in the extreme could print exactly that amount. But, this still constitutes debasement. One of the components of a credit-risk-free government interest rate in the traditional sense is the return an investor needs to be paid to take the risk that the currency is debased and purchasing power plummets. In the case of JGBs, yields are increasing as the risk of debasement becomes more apparent (though are still artificially low due to Bank of Japan purchases). Bottom line, JPY savers need an alternative to preserve their real asset value and, the world believes, they will look externally.
US corporate credit, US high yield credit, and US equities still look attractive to JPY investors against this backdrop. Non-Japanese investors are sensing this, and see no reason to sell. After all, as one of my colleagues is fond of pointing out, risk assets changing hands for cash at ever higher valuations looks a bit like a playground game of hot potato. Interestingly, for now, it’s the cash (not the risk assets) which seems to constitute the “potato.”
*http://www.federalreserve.gov/newsevents/speech/bernanke20130510a.htm (Asset Markets section)
**My personal opinion: you ain’t seen nothing yet (I think)