In Japan, The Bigger They Are, The Bigger the Losses

Some of Japan's biggest and most well-known companies are producing the biggest profit losses in FY08 to March, 2009 and have surprised analysts by predicting further losses in FY09, to March, 2010.

Toyota (7203.T) now sees a JPY437 billion net loss in FY09 following a JPY550 billion net loss in FY08 to March, 2009. The company plans to slash global vehicle production by 28% and the lowest level in seven years, to 6.68 million units from 9.24 million, and compared to total production capacity of 10 million units.

Panasonic (6752.T) now sees a net loss of JPY100 billion in FY09 versus a JPY380 billion net loss in FY08. In the fiscal year to March 2010, the company will be restructuring as well as digesting losses from the expected acquisition of Sanyo Electric (6764.T) as they move to buy Sanyo from this July.

Sony (6758.T) now sees a net loss of JPY98 billion in FY09 versus a net loss of JPY120 billion in FY08, the first back-to-back losses since listing in 1958.

Toyota, Panasonic and Sony's stock prices have rallied 43%, 46% and 78% respectively on expectations of a recovery in earnings in FY09 from a horrible second-half FY08 from October 2008 to March 2009. These gains will be hard to maintain if these companies' earnings are as bad as management themselves are now forecasting, because the gains were predicated on earnings recovery in FY09.

Bond Yields Nip Equity Bounce-Back: Look for a Re-Test of March Lows

As global equities rallied from March lows, professional investors have lifted their short positions, lifted their hedges and lowered their cash positions 30%~40% to increase equity exposure. The March lows were discounting, a) the global financial crisis, b) the worst economic contraction in the postwar period. The rally from these lows on the other hand is discounting the second derivative improvement, i.e., the fact that an increasing number of economic indicators are not declining as fast as they were.

But global economies are still shrinking year-on-year, and the S&P 500's failure to retake its 200-day MA around 949, its December rebound high of 943.85 or even to maintain the psychological 900 level means that March lows will now be retested.

The Sovereign Debt Digestion Problem

While everyone (including me) is uncertain as to how long the rebound will last before an interim correction, or a resumption of the bear market. I have realized that the answer lies in L-T bond yields. April data on US federal government revenues and outlays show the US deficit in the past 12 months not totals $1.25 trillion, and collapsing revenues versus soaring expenditures. US government spending is now on track to reach $4 trillion next year, and the amount of US debt that will need to be sold over the next few years is staggering.

So far, this hasn’t completely blown up in the US bond market’s face because there is still a lot of fear of the future, meaning bond investors are willing to accept meager Treasury yields in favor of questionable corporate bond default rates with a weak economy. But the US projected funding requirements just keep getting uglier.

Basically, the negative catalyst for a serious test of March lows could come from more failed government bond auctions. There have already been failed bond auctions in Germany and the U.K., and there is concern about failed bond auctions in Japan. Could it happen in the U.S.? The last auction of 30-year TBs was very tepid and the US treasury had to offer 10~15bps more than expected to sell the issue, so it may be just a matter of time before a US bond auction fails as well. Because of the Obama Administration expansive deficits, which according to CBO estimates will still be well over $1tn in 2019, there is a not-insignificant concern that the U.S. will have to either default on its debt or inflate it away.

Direct purchases of US treasuries by the Fed have had only a temporary dampening effect. The 30-year treasury bond's price has already broken down under its 200-day MA ($124) and is now substantially below that level. The 30-year TB price index ($USB) is now down 14.5% from a December 2008 high and looks headed much lower. 10-year TB yields (the flip side of bond prices) have broken up through their 200-day MA. By the same token, the US dollar index has fallen below its 200-day MA and the 50-day MA is heading for a dead cross. The USD index is being weighed down by a) reduced risk aversion, b) reduced “distressed” demand for USD, and c) aversion to the heavy calendar of Treasury debt issues.

As everyone knows, real stock prices tend to drop when long-term rates rise, and stocks tend to overreact to changes in long-term interest rates. Increasing bond yields imply a large discount factor and lower stock prices, given an unchanged level of earnings. To offset shrinking valuations, earnings have to improve above and beyond the shrinkage in valuations due to rising interest rates. Thus at some point the rise in long-bond yields will kill the rebound in stocks.

Conclusions

As for how to trade this, investors should first short US treasuries, which can be done at a retail level by purchasing the ProShares Ultrashort 7~10 year Lehman Brothers Treasuries Index (PST), or the ProShares Ultrashort 20 year plus Lehman Brothers Treasuries Index (TBT), or buying the Barclays short treasury ETF (SHV). They should also short the USD index through the PowerShares USD index Bearish Fund (UDN).

As for stocks, we put on some tight trailing stops on stock and ETF holdings last week as insurance to protect what had been nice two-digit gains, and have already been stopped out of positions in banks (WFC) and emerging markets (EEM), while China (FXI ETF) has so far held. As commodities like copper are also looking toppy short-term, we also expect to get stopped out here soon.

While we expect the March lows to hold, it doesn't hurt to have cash available to rebuy at lower prices once March lows are confirmed.

The Budding Global Recovery and A Revisionist Look at Japanese Stocks

V-Shaped or Square Root Shaped?

It is clearer and clearer that financial and economic Armageddon has been avoided. While there is still much to do in repairing bank balance sheets, the global financial system is clearly stabilizing.

There are also clearer signs of the second derivative--i.e., a slowing or bottoming-out of declines. Some are even suggesting a "v-shaped" recovery in the early stages to correct the implosion in economic activity and global trade while the global financial crisis was raging, then a flattening out as the longer term balance sheet recovery process sets in.

While it still sounds like blasphemy to the Nouriel Roubinis and Marc Fabers of the world, deep recessions are almost always followed by rapid rebounds, according to an economic law named after Victor Zarnowitz, a late expert on business cycles.

In the U.S., April consumer confidence has rebounded the most in more than two years on surging stock prices and falling mortgage rates. Guages of U.S. manufacturing activity have seen their biggest bounce since 2005 as companies eased up on inventory slashing. Even the crippled housing market has shown signs of stabilizing, according to Alan Greenspan and others.

In Japan, the March CI index of leading indicators improved 2.1 points to 76.6 for the first mo-mo improvement in six months, even as the coincidental index recorded its eighth month of declines. Contributing to the improvement in Japan's leading index was better consumer confidence, producer inventories, finished product inventories, the small and medium-sized company outlook for sales, stock prices, the spread between s-t and l-t rates and consumer durable shipments. March industrial production in Japan inched up 1.6% mo-mo, while the mo-mo improvement is expected to accelerate to 4.3% in April and 6.1% in March, even as production was still declining YoY by some 34% in March.

OECD leading indicators for the U.K., France and Italy are also showing mo-mo improvement.

Merrill Lynch economic research has dubbed the emergent recovery as a "square root shaped recovery", i.e, a sharp rebound to a point then a flattening. While not using square root, this is a similar scenario recently described by George Soros.

Increased Risk of Being Out of the Market

To a large institution whose performance is measured against peers as much as the market indices, the rapid recovery is making fund managers who are still cash heavy and largely out of stocks increasingly nervous. Bank of America research shows that US institutions parked a record $3.55 trillion in money market funds as the S&P 500 fell to a 12-year low in March, but since have deployed about $1 trillion in stocks, leaving some $2.51 trillion still on the side-lines in money-market funds as of April 27.

Reappraisal of Japan

In Japan, foreign investors became net buyers of Japanese stocks in April (by JPY410 billion) for the first month in eight months, and net buying by brokers for proprietary trading positions has returned following these foreign fund inflows.

A significant amount of selling pressure in Japanese stocks was triggered by the forced unwinding of the yen carry trade as well as a dash for cash by hedge funds following the failure of Lehman Brothers in September 2008. The global hedge fund industry shrank $136 billion in the first three months of this year to $1.34 trillion, following record losses last year, says Eurekahedge Pte., and the industry has shrunk 32% from a peak of $1.95 trillion at the end of June 2008.

In particular, 32 Japan-focused equity hedge funds, which represented the greatest number of hedge fund closures in the Asia Pacific region last year, says AsiaHedge magazine. Another five such funds closed in the first quarter. This trend is now beginning to reverse, however, as newer hedge funds like London based Samena Capital (Samena Japan Absolute Return Fund, $25 million AUM) are starting new Japan-focused hedge funds on the bet that nation’s stock prices will continue to rebound in the wake of the global credit crisis. Hong Kong lawyers say at least a dozen new Caymen Island-based funds that focus in Japan are starting up.

In the US, investors have been leery of the 100%-plus rebound in the bank stocks, and decry the "dash for trash" in lower quality smaller stocks, but that is exactly what happened in Japan as the stock market was coming out of the Heisei Malaise and a secular bottom of 7,600 or so in the Nikkei 225 in April 2003. Then, a massive rally in bank stocks (which bounded 2- and 3-fold from lows) led the market for about 12 months, as did massive rebounds in "trash", i.e., stocks once priced for bankruptcy but rapidly repriced as going concerns, including the bank stocks.

Japan Government Bond Issues Could Fail, As Bond Vigilantes Balk At Heavy Issue Calendars

(Bloomberg)
Fukuoka Mutual Life Insurance and other institutional investors fear that Japan's heavy calendar of JGB auctions may fail to attract enough bidders, meaning Japan's finance ministry could see its first bond auction failure since 2002. 10-Yr JGB's continued to fall on Monday as investors fear that the market will be unable to absorb a record JPY130.2 trillion of new bond issues. This would put the Japanese Treasury in a "very difficult position".

In September 2002, market yields on 10-yr TBs surged 12 basis points when an auction failed then. JGB yields recently bottomed just below 1.25% in January 2008 when Japanese exports and the economy was in free-fall from the global financial crisis that erupted in Q4 2008. 10Yr JGB yields have backed up to 1.50% since, but are still noticeably lower than at the 2.00% "normal" peak in May 2007. A 12 bps pop would put the JGB yield at 1.72%--still below the May 2007 level.

Heavy Issue Calendar of Sovereign Bond Issues Could Mean Other Auction Failures

Japan is not the only country facing possible sovereign bond auction failures. On March 25 the U.K. government failed to find enough buyers for 1.75 billion pounds of bonds for the first time in seven years. U.K. gilt (bond) traders said they U.K. market may not be able to absorb a record 220 billion pounds of bonds planned for the year to March 31.

Germany has also seen a couple of Bund auction failures since the onset of 2009, while U.S. treasury prices have fallen for seven straight weeks, the longest stretch since 204. Australian bonds may also post their first annual loss in a decade with the Australian government likely to announce a record budget deficit tomorrow.

The heavy issue calendars of sovereign bonds in the developed nations is increasingly contrasting with a rising risk appetite (demand for equities, not bonds) by investors with growing expectations for economic recovery. However, the economic recovery itself could be threatened if bond vigilantes go on strike for higher yields.

(Reuters)
Central banks throughout the world are turning to, or contemplating non-conventional measures such as asset purchases to keep credit flowing as they run out of scope to lower benchmark interest rates any further, and long-term rates react to the heavy calendar of sovereign debt auctions. The Fed said on Mar. 18 it would buy up to $300 billion in longer-term government bonds in the next six months, the first time it has bought Treasuries since the 1960s. But the recent rise in bond yields could be a signal that the U.S. central bank may need to continue to intervene to offset massive government debt issuance. Investors apparently viewed the the $300 billion Fed commitment to Treasuries as a starting point, not as an ending point. At 3.29%, U.S. 10-year Treasury yields are now 30% higher than where they stood when the Fed first made its Treasury purchase announcementin March.

By the same token, the Bank of Japan is under increasing pressure from the government to expand the amount of JGBs it directly purchases. A failure of any auction would up the pressure on the BOJ significantly.