Tuesday / March 19.
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Macro ideas: The Japanese bull market is intact

|By Matein Khalid| Last week was a roller coaster and the Nikkei Dow closed at 19,800. Abenomics has had a seismic impact on Japan’s economy, financial markets and banking system. The yen has fallen from 76 on the eve of the election in 2012 to 122 against the US dollar. Corporate profits have exploded. Land price rises, job growth, bonuses, capex and consumer spending have lifted Japan from the spectral legacy of the two deflation haunted lost decades. The Trans Pacific Partnership (TPP) will be Japan’s NAFTA and arguably the most important trade pact in Asian history.
The fiscal and monetary arrows of Abenomics were both huge successes. The third arrow (structural reform) will now provide the ballast for Japan Inc. profits and Marunouchi, notably the Corporate Governance Code, labour reform, tax cuts and the government procurement/intellectual property changes mandated by TPP. The privatization of the Post Office, the 150% rise in the Nikkei Dow since 2012 and the Government Pension Fund’s (the world’s largest institutional investor) rise in equities allocation. Abenomics and the IPP will even reform Japan’s notoriously protectionist farmer and retail distributor lobbies in the LDP.
Corporate margins and returns on equity in Japan have begun to expand as companies embrace the concepts of shareholder value, alien even five years ago. This, prima facie, is an argument for a valuation rerating in the Japanese stock market. If the Fukushima tragedy and the Chinese riots in 2011 had traumatized Japan, Abenomics has led to a new pro-growth, pro-reform, pro-international trade political consensus, goosed by the “wealth effect” of tax cuts and higher share/property prices. The LDP has now given Japan its most successful postwar Prime Minister, whose legacy will be greater than those of Nakasone, Koizumi’s, or even Nobusuke Kishi, Abe san’s grandfather and admittedly a member of General Hideki Tojo’s wartime Cabinet when Imperial Japan overran Manchuria, attacked Pearl Harbour and vanquished the British, French and Dutch colonial empires in Southeast Asia.
Japanese equities trade at 15.6 times forward earnings on the Nikkei Dow. This does not surprise me since returns on equity (ROE) have doubled from 4% to 8% in the era of Abenomics. Unlike Europe or the US, Japan can credibly deliver 15-17% EPS growth in the next twelve months. While the dividend yield of the S&P 500 index is below the yield of Uncle Sam’s ten year US Treasury note, the Nikkei Dow’s dividend yield is 1.70% or four times of the yield on the ten year Japanese Government Bond (JGB).
I have made no secret about my strategic bullishness on Japanese megabanks Sumitomo Mitsui, Mitsubishi UFJ and Mizuho in 2015. This was a highly successful strategy call as the shares of the Japanese megabanks have risen 25-30% since the publication of my recommendation.
There are two global factors that could cause a near term correction in Japan’s bull market. One, China/Greece could cause global growth estimates to sag and hit export growth for Japan Inc. Two, carnage in global financial market could trigger safe haven flows in the Japanese yen, as happened during the post Lehman global banking crisis. These two scenarios will hit Japanese corporate profits and stock market performance. After all, Japanese equities lost 22% during the Bernanke Fed’s “taper tantrum” in June 2013.
Not even the most diehard Dia Nippon sceptic can deny that the Nikkei Dow and TOPIX have been in a secular bull market since Shinzo Abe’s election as Prime Minister in 2012. Yet the Japanese stock market has risen 40% since early 2014 and more than 150% since I first recommended yen hedged Nikkei Dow positions in November 2012.
Abenomics lifted the Nikkei Dow from 8000 to 20,800, a level last seen in 1996. The easy money in the Japanese bull market has been made but Abenomics, the GPIF, the promise of TPP capital flows and the “equity culture” all suggest that a “buy on dips” strategy is optimal.
Apart from soft Japanese exports and “endaka” (strong yen), the existence of cross-shareholdings and Diet opposition to Abe-san’s national security policy are sources of domestic risk to the stock market. Earnings guidance could also be more pessimistic by risk averse CEO’s as the Chinese economy unravels. Yet a stronger US economy could prove, as in the past, the economic locomotive for Japan Inc. Net net, I expect the Nikkei Dow to trade in a 17,600 – 22,000 range in 2015 – 16.
Currencies – The Canadian dollar continues to tank!
The collapse of the Canadian dollar from 1.06 to 1.27 in the past year was one of the most spectacular money making opportunities in the foreign exchange market. Canada was a victim of King Dollar, the crash in Crude oil/gold/base metals, anemic economic growth relative to the US and the shock Bank of Canada interest rate cut last January. As the Yellen Fed tightens US monetary policy this autumn, US/Canada interest rate spreads will only rise. While the 20% depreciation of the loonie since summer 2014 will boost Canadian exports to the US (particularly timber and auto parts), the financial distress in Alberta oilfields and Western mining states will keep the Ottawa central bank reluctant to tighten monetary policy, since Governor Poloz is also worried about speculative bubbles in the Toronto/Montreal condo and Vancouver housing markets.
Unlike the US, Canadian consumer spending, capex and business confidence is muted while the oil shock offsets export acceleration. In any case, the US economy has long recovered from its first quarter economic slump due to the Arctic weather, the California port strikes and the Texas shale drilling layoffs.
US housing starts are 1.1 million. Auto sales are 17 million units after seasonal adjustments, a post-crisis peak. Greece’s IMF default, capital controls, banking crisis and “OXI” (no) vote in Syriza’s referendum to the Troika’s austerity diktat are all a sword of Damocles on the Euro. It is no coincidence that oil prices plummeted 15% after the Greek crisis and the Shanghai/Shenzhen stock market collapse. The world’s positioning, sentiment, asset allocation and capital flows all suggest the King Dollar trade is not over. This means the Canadian dollar can well depreciate to 1.32 by Christmas. Like other global petrocurrencies (Russian rouble, Norwegian kroner, Malaysian ringgit, Mexican peso), the Canadian dollar is vulnerable to a fall in Brent crude to $40 this autumn.
Canada’s 1Q 2015 economic growth rate was 0.6%, the first six month contraction since 2011, a testament to the Dominion’s commodity price vulnerability. Canada will struggle to deliver 2% GDP growth in 2015, lagging the US by a full percentage point. While Ontario and Quebec’s factories and services businesses add 10 – 12,000 new jobs a month, layoffs in Alberta, Manitoba, Saskatchewan and British Columbia oil/mining sectors will continue. Sluggish wage growth will also hit consumer spending and an overvalued housing market at high ownership levels is yet another risk. Corporate capex will not provide economic ballast, as oil/mining woes deepen.
At 1.04 against the Euro, the Swiss franc is the world’s true safe haven currency, up 15% since the SNB under Dr. Thomas Jordan abandoned its failed 1.20 ceiling peg against the Euro. The Swiss franc has risen 6% against the dollar and is epically, even comically, overvalued at its current rate of 0.9380 against the dollar. The Swiss franc (with its negative interest rates) has devastated Switzerland’s export industries, from watchmakers in the Jura to the private banks of the Bahnhofstrasse and the ski resorts of Verbier, Montana, Courchavelsky and Gstaad! Its narrow range against the US dollar and the Euro despite the Greek debacle suggests SNB intervention in the money markets. Chicago futures data indicates the Swiss franc is the only major currency in the world where speculators are long against the US dollar, albeit the net long Swissie IMM position is only $0.8 billion, chump change in the $5 trillion global currency souk. I believe the safe haven bid in the Swiss franc has peaked as the Helvetica slips into recession. The Swiss franc is the world’s most overvalued currency.
Geneva is shockingly expensive and my friends who live there tell me about weekend shopping trips to France, maids demanding $3000 a month salaries, corporate profits fall and layoffs. The minus 0.75% SNB policy rate hits offshore hot money since the ECB began its QE program. A high carry cross trade that benefits from Swiss deflation and the oil price crash is long Indian rupee/short Swiss franc. The macro stars are aligned, dear Brutus.
Stock Pick – Ten reasons why I love Barclays PLC shares
So Antony Jenkins is out as Barclays CEO after three years in the hot seat. Jenkins took over in 2012 after Bob Diamond, the man who built Barclays Capital (Barcap) as Britain’s only bulge bracket investment bank, was ousted after epic losses in toxic credit derivatives, the LIBOR rate manipulation scandal and a public grilling in Westminster. “Mack the Knife” is the City nickname for Barclay’s executive chairman John McFarlane, now top honcho.
Jenkins tried to reinvent Barclays’s corporate culture. He pledged to boost the Group’s return on equity to 12% by 2016, though it was only 3.4% in 1Q 2015. He focused on the profitable “core” businesses of UK High Street banking, Barclaycard and Africa (Barclays owns Absa). Jenkins pledged to reduce the investment bank’s risk weighed assets from 50% to 30%. Jenkins axed 7000 Barcap jobs, including hundreds of managing directors and exited capital intensive trading and structured finance businesses. He gave the City’s enraged regulators the Barcap scalps they sought.
Jenkins inherited an investment bank that contributed 50% of Barclays profits but also dragged it into the morass of a SFO probe, the LIBOR rigging and foreign exchange settlements scandal. Jenkins hated the flamboyant, chest beating swagger of the trading room. A lifelong retail banker, he had a charisma deficit that doomed him.
Jenkins was ousted in a boardroom palace coup akin to the one orchestrated by the two Mikes at Citigroup against Vikram Pandit in November 2012. The Pandit coup was the signal for me to recommend buying Citi shares at 25 – 27. This was a strategic idea in banking that made more than 100% for investors who bought Citigroup at 25 – 27 since the shares peaked at 56 this summer. Will history repeat itself with Barclays at 254 pence?
Ten reasons why moi loves Barclays? One, like Deutsche and Credit Suisse, Barclay’s crown jewel in 2008 was its hugely profitable investment bank. I remember being mesmerized by Bob Diamond’s vision at a event in the Dorchester on Park Lane. He was unlike any of the Barclays retail banking Clem Attlees (“modest men with much to be modest about”!) I met in Dubai. Barclays later exited retail banking in UAE, sold its book to ADIB. Yet Jenkins’s strategy to axe the investment bank was just plain dumb. In 2014, Barclays generated £1.5 billion of the £2.3 billion of Group profits from the “core” Barcap.
Two, Barclay’s Achilles heel is its non-core, legacy Bad Bank (echoes of Citi Holdings), that lost £1.2 billion in 2014. Yet as Non-Core is run down, Barclays will release excess capital that will boost its Group ROE. This means a valuation rerating, exactly what happened with Citi in 2013-15.
Three, the recent rise in interest rate volatility and post Greece/China currency turmoil is hugely bullish for trading profits at Barcap. The board had to choose between profits and Saint Antony. The board chose profits.
Four, Barclays trades at 8 times forward earnings and 0.74 times tangible book value. These are similar valuation metrics that attracted me to Citi in 2012 and enabled readers of this column in KT to position for a 100% windfall in America’s third largest money centre bank.
Five, Barclays Basle Tier One capital is admittedly iffy at only 10.6%. Barclaycard, UK Retail and Business Banking, Absa and now core Barcap can all deliver 10% plus ROE. The City worries about a dilutive capital raise. I do not. Group ROE was only 5% in 2014. This will change.
Six, John McFarlane, like Bob Diamond, is a proven money maker. Jenkins was not. Aviva and ANZ shares rose 60 – 70% after Mac the Knife engineered their turnarounds. Why not in this ex Quaker goldsmith bank founded in 1690?
Seven, Jenkins created a bureaucratic nightmare at Barclays, with 375 management committees. Clunkiness, duckies!
Eight, sell side cognoscenti Barclays calculate end 2016 book value as 356 pence. So one of the world’s great banking empires trades in a fire sale on the London exchange. Yummy kins.
Nine, Barclays benefits from a steeper US Treasury/UK gilt yield curve and a peak in litigation risk.
Ten, the forward dividend yield is 4.6%. So investors who believe in Barclays get paid to wait while new management works its magic. Credere is the Latin word for belief – and, like Citi in 2012, Barclays is a Credere trade in international banking for me.