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Asia Pacific Intelligence

Debt levels worse than Greece and political change drive breakthrough in moribund Japanese markets

Thursday, February 07, 2013

Chris Rigg

Chris Rigg is the manager of the multi-strategy Audley Japan Opportunities Fund which was launched in September 2011. The fund has achieved performance of 5% since launch. Rigg has some 30 years of experience in the Japanese markets. The inspiration behind the fund was that while mainstream investors have steered clear of Japan for years, the firm had the view in late 2010 that the Japanese fiscal situation was getting precarious to the degree that Japan would be forced to make difficult decisions that would lead to a seismic shift in the financial markets. "Specifically, we launched the fund to take advantage of the changes that we believed would unfold in due course: a rebounding equity market, a weaker JGB and yen and developed a proprietary trade structure that yields asymmetric returns from these views" Rigg says in an interview with Asia Pacific Intelligence.

"At present, the equity market and yen have moved as we had anticipated and we have profited from these movements. However, the bonds have gone against us since the fund launched but we still have the view that bonds are grossly overvalued" he says. Rigg reports that Japanese bonds are trading at levels that have only reached once before in 2003. "The bond market has been strong because investors still have an expectation that the Bank of Japan will be more aggressive in their monetary policy, buying more domestic debt." Rigg thinks it is more likely that they will also buy foreign debt, thereby weakening the yen.

"The level of debt Japan is running, which by some measures is far worse than in Greece, is unsustainable," said Rigg. "With net debt at 140% even if Japan were to run a budget where revenue and expenditure were balanced before interest costs, the economy would have to grow by 1.8% in nominal terms just to stabilize the debt/GDP ratio. The reality is that the Japanese government spends twice as much as tax revenue and debt servicing costs consume half of tax revenue."

Japan has some of the lowest borrowing rates in the world, Rigg says, principally because of its current account surplus but this is now shrinking fast with Japan running its first seasonally adjusted deficit since 1981.

Against this scenario, the Japanese stock market is buoyant because the new Prime Minister, Shinzo Abe, has indicated that he is growth orientated and wants to get the Japanese economy up and running again. "He's compiled a supplementary budget of 10-12 tln yen ($11-13bn) in size and is asking the central bank to adopt a 2% inflation target."

Abe has declared that he believes that the Bank of Japan should be aggressive in the conduct of their monetary policy and because of that the yen has weakened from a high of 78/79 to the US dollar to 89, effectively moving about 10% across nearly all currencies.

Rigg started covering Japan in 1984 when the Nikkei was at 13,000, by December 1989 it had gone up to 39,000 and in 2013 it was at 10,000 - "30% below where it was when I started" Rigg says. "It's been an abysmal stock market for the last 22 years. It became very overvalued and what happened is that Japanese companies have slowly been devalued. The Japanese economy has become deflationary and when that happens everything goes down in price - everything is cheaper than it was 20 years ago. For instance, people's salaries have gone down 1% per annum on average in the last 10 years."

Deflation is incredibly bad because the effect is that if you know things are going to be cheaper then why buy them now? In addition, companies and consumers reduce debt because debt doesn't go down in price whilst incomes and assets do in a deflationary environment. The consequence of deflation is that economic growth and asset prices are very weak" Rigg says.

The Japanese government has not succeeded in turning this situation around for 20 years but the reason behind the recent Japanese stockmarket rally is that investors believe Abe will have an opportunity to turn it around. "There are a number of reasons for this" Rigg says. "He has control of the legislative agenda because he has a two thirds majority in the lower house. He's been saying good things pre and post election to the Bank of Japan that it must be more aggressive." Abe's strength will increase with the March/April replacement of the governor and deputy governor of the Bank of Japan, Rigg believes.

Beyond deflation, Japan is also suffering with an ageing population which means that social security spending has increased as revenue has gone down. "The reason why government bonds don't reflect this is because, unlike Greece where it is dependent upon foreigners to finance itself, Japan can fund itself domestically - they don't need our money because they have a current account surplus" Rigg explains. "In addition, because of deflation, people are attracted to the bond market because the real return on government debt is high because everything else is going down in price."

Rigg feels that Japan is now at a tipping point where the country has realised that the government debt situation is not sustainable. "They need to get growth back and end deflation. If that happens the last thing you want to hold is government debt." Rigg predicts this will happen in 2014 but that markets will realise this way before the event and price this in before that date.

Opalesque has featured video interviews on Japan here and here and held a Roundtable in Japan in 2012. You can download the Roundtable, here.

 
This article was published in Opalesque's Asia Pacific Intelligence our monthly research update on alternative investments in the Asia-Pacific region.
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