Shinzo Abe and Haruhiko Kuroda Blow up the Yen

Hutchinson Lilley Investments LLP [email protected]

Shinzo Abe and Haruhiko Kuroda blow up the Yen

On 31st October the Japanese prime minister and the head of the Bank of Japan (BoJ) decided to blow up the Yen. They unexpectedly announced that they would step up the rate and degree of quantitative easing (QE – or money printing) to levels seen nowhere else since Gideon Gono blew up the Zimbabwean Dollar in 2006. The Bank of Japan’s existing measures were already of a different dimension from past efforts but under the renewed initiative the Japanese monetary base will grow at an even faster pace. 80 trillion Yen will be created every year (on an existing monetary base of 262 trillion Yen) and will be used to buy government bonds and also some equities. Japanese GDP is running at about 480 trillion Yen. The total value of Japanese government bonds outstanding is 980 trillion Yen which is 200% of GDP. It is difficult to imagine that these bonds will ever be repaid for value, just as the debts in Zimbabwe were not repaid for value either.

Japan Monetary Base (Currently 262 Trillion Yen)

The currency markets immediately reflected the recklessness of BoJ’s monetary policy (combined with the profligacy of the treasury department of the Japanese government) and decided to mark the Yen lower. HLI was short of the Yen so this worked our way.

Japan Yen per Dollar (the higher the number, the weaker the Yen)

During the month we added a handful of Japanese companies to the portfolio which have a significant proportion of their earnings arising outside of the country. We would expect them to benefit from a material boost in earnings as a result of the translation effects of the cheap yen (ie their foreign sales expressed in Yen will be worth a lot more). We would expect the share prices to rise in response to this boost in earnings. We have added Toyota (autos), Fanuc (factory automation), Asahi Kasei (chemicals), Shionogi (pharmaceuticals), Canon (photographic) and Denso (auto components). These companies

were not unreasonably valued before the collapse of the Yen and will certainly now be helped along by the weak currency.

We have hedged out the exposure to the Yen which comes with owning the above Japanese stocks. We are considering putting some money where our mouth is and taking a short position in Japanese Government Bonds. This would have been a disastrous decision in the past because Japanese bonds have gone from strength to strength ie yields are at record lows. Here, as in the US, the market is heavily distorted by Central Bank activity but eventually the market must wake up to the default risk we refer to above. In fact, on the 1st December Moody’s cut the credit rating for Japanese Government bonds from A1 to Aa3 which would confirm that there is substance to our fears, although the bond market did not drop on the news.

This Oil Price fall is not normal. OPEC has changed its aims.

Oil Price since 2003

During 2014 the oil price has fallen by 32% from $100 to $67 per barrel. With the exception of the wild oscillations which occurred at the time of the financial crash, this movement looks abnormal. It suggests to us that OPEC has changed its objectives.

OPEC has so far existed in order to manipulate the oil price so as to maximize returns for its members. At the moment it is failing in this aim, in fact its recent decision to keep production output at current high levels is more about keeping market share than maximizing profits. In the past OPEC would have decided to cut production in order to keep the nominal price high. OPEC has 12 members, 6 from the Middle East (Saudi Arabia, UAE, Iran, Iraq, Qatar and Kuwait), 4 from Africa (Nigeria, Angola, Algeria and Libya) and 2 from S. America (Venezuela and Ecuador). Saudi Arabia is by far the dominant

producer with its daily output of 8.8m barrels being twice as big as the next biggest producer of Iran and 3.5 times bigger than number 3, Kuwait. Accordingly, Saudi Arabia’s is the dominant voice in negotiations

OPEC’s hand seems to have been forced in its decision because the energy world has changed in the last 6 or 7 years, in many ways the seeds for this change were sewn by OPEC itself. By keeping oil at around $100 in this period, demand for oil has been depressed. Furthermore, non OPEC oil producing countries have been incentivised to pump more oil than they otherwise might have done. Also, high cost producers have been able to get a toe in the door. Much of the Canadian Tar Sands sector for example exists only because the oil price has been in the $100 per barrel area. And new technologies have been worthwhile investing into. The most spectacular example has been the US shale industry which would probably not have been expanded if the oil price had been lower.

Oil and geopolitics have always been bedfellows. The low oil price is dealing a knockout blow to Russia which some people say is just deserts for their policy of occupation in the Ukraine. Together with the trade embargo, the low oil price is causing a fall in trade volumes and a collapsing currency.

Russian Rouble v GB Pound

The high oil price contributed to the weak economic growth we have seen globally. High prices of crude have encouraged lower usage of oil while incentivizing climate change targets and alternative energy sources such as solar and wind. So in summary, OPEC now finds itself in the position where demand is weak, rival producers are increasing their output and substitutes for oil are becoming more entrenched.

OPEC’s new market share seeking policy is intended to reverse some of these factors, at least in the short term. The lower price should stimulate demand and it will knock out the least marginally

profitable companies in rival industries and technologies. In the long term of course this is damaging because worldwide the overall use of oil will continue to rise and we need the new technologies to work for our future prosperity. But right now, the low oil price is a positive.

Good news for the Economy here?

While the fall in the oil price is clearly bad news for the producing countries (and would have been a disaster for an independent Scotland), it should be very positive for the rest of us, at least until the price heads back up again – which it will certainly do at some stage. More than quantitative easing (QE) or ZIRP (zero interest rates), low energy prices really can help to stimulate an economy. Throughout history, high energy prices have been synonymous with low economic growth and conversely, economic booms have always coincided with cheap energy.

Furthermore, although median incomes have been falling since 2007, low energy prices are felt as a benefit by consumers everywhere. There is some evidence that confidence has risen recently in the UK and US.

This good news story has not really received the attention it deserves in the papers, in my view. I think it could have something to do with the accepted wisdom among conventionally trained economists (who are usually Keynesian in their leaning), that deflation is a terrible thing which must be avoided at all cost. Low oil prices are bound to pull down the already low official RPI inflation indices in the western hemisphere economies. Keynesians hate falling prices, although consumers seem to love them - viz Black Friday. Conventional economic thinking pervades the media and all of our public institutions but these people tend only to speak on behalf of people who have borrowed too much money (and not on the lenders). For borrowers high inflation enables the debt to be paid off more easily at a cost to the lenders whereas under deflation the reverse is true. As I have written before, the biggest borrowers are governments so they and their spokesmen hate deflation. But for the rest of us, our lower heating bills and motoring costs are a welcome fillip under otherwise difficult economic times.

Germany Appeals for Swedish help to avert looming electricity shortages (FT November, 2014)

Someone else who should welcome falling energy prices is the German government. Following the Japanese Tsunami of March 2011 the German government decided to close its nuclear power stations. This was more of a political environmental gesture than something borne out of a genuine fear of a tidal wave hitting Nordrhein Westfalen. Now of course, there is an energy shortage. The windmills

can’t cope and Germany has to import more than it used to (from the French grid – powered by nuclear, by the way). But worst of all, it has to restart power generation from its filthy lignite coal burning power stations in former East Germany. And in the greatest indignity of all it has to plead with the Swedes – who own 2 lignite plants on German soil and who had intended to close them down, to ask them to keep the plants running. So Germany now has a greater dependence on foreigners and dirtier power generation than before when they had energy independence and cleaner power. A book I enjoy is called “Why Government doesn’t Work” by Harry Browne. It speaks of the unintended consequences of most government initiatives. It also lists a set of laws, 2 of which seem to apply to this story.

Rule 4 “Every government programme will be more expensive than originally thought” Rule 6 “No government program has ever achieved its stated aim”