Japan Watch

Today: Japan’s laboratory experiment; earnings.

Stocks Rally Across Globe Japan’s stimulus plans rippled across global markets, pushing the Dow Jones Industrial Average to a record, sending the dollar near a seven-year high against the Japanese yen and pulling U.S. government bond prices lower.

By boosting annual asset purchases by as much as a third, to ¥80 trillion ($732 billion), the Bank of Japan stands to bolster global demand for stocks by driving down bond yields, making shares relatively more attractive. The European Central Bank in October kicked off its own round of bond buying in a bid to jolt low inflation on the Continent, while the Federal Reserve on Wednesday ended its bond-buying program amid steady improvement in job growth.

The expanding gap between the U.S. and European and Japanese central-bank policies has sent money flooding into the U.S. in anticipation of higher returns.

“The world has grown addicted to easing,” said Savita Subramanian, chief U.S. stock strategist at Bank of America Merrill Lynch. In a further boost, the Japanese government’s pension fund said Friday that it would raise its allocation in Japanese and foreign stocks. (…)

On Friday, the dollar climbed 2.9% against the yen. A weaker yen could undergird a halting recovery in Japan, as it makes exports more competitive overseas. Japan has been long beset by weak growth and a damaging cycle of falling prices and lower spending known as deflation. (…)

Gold, seen as a haven, tumbled 2.3% on Friday to a four-year low. Oil prices slid 0.7%, to $80.54 a barrel, extending a decline that has reduced crude prices by a quarter since the spring. Both figures point to expectations of soft global growth, traders said. (…)

The dollar has risen 46% against the yen since the start of 2012, when Japan began adopting policies aimed at reviving growth and boosting inflation. (…)

• “Whatever it takes” in Japanese:  Bank of Japan: crazy wisdom

(…) Only three out of 32 Bloomberg-polled analysts expected easier policy; four of nine BoJ board members cast their votes against it. Mr Kuroda, therefore, looks all the more determined to hit 2 per cent, and to rove over asset markets until he has done so. Contrast the Fed: it marries collegiality with long-term guidance through “dot plots” of when members think rates will rise. The goal is to move asset prices gradually. Mr Kuroda’s willingness to shock has a certain order, too, if the market now believes he will stop at nothing.

• Demand From Japan Pension’s Fund Could Cap Treasury Yields The world’s largest public pension fund is going to join yield-hungry Asian investors into Treasurys.

Japan’s $1.2 trillion public pension fund — the Government Pension Investment Fund — said Friday it plans to slash how much money it puts in domestic bonds and ramp up its investments in stocks and foreign bonds. Under the new allocation guidelines, the ratio for overseas bonds will rise to 15% from 11%.

• Japan Fires Another Shot in Global Currency War A currency war looms – not a 1930s-style scorched-earth conflict, but a damaging stealth war that will exacerbate the global economy’s woes and distort domestic political agendas.

(…) The BOJ describes its actions in terms of boosting domestic growth and pricing power, but the real way it works is to export deflation to the rest of the world – it has been doing this ever since the yen began an 30% decline versus the dollar once “Abenomics” stimulus were first floated in the fall of 2012.

Despite ceding its status as the world’s second-largest economy to China, Japan still accounts for a whopping 8% of global GDP. And it is an even more important contributor to the world’s supply of manufactured merchandise. As a weakening exchange rate drives down the price of its cars and electronic goods overseas, Japan creates competitive challenges for other countries’ producers, putting jobs at risk and policymakers in those places under political pressure to respond.

Those responses are already evident: in the Bank of Korea cutting rates this month and coming under pressure in parliament for more; in the Reserve Bank of New Zealand making uncharacteristically overt warnings about the strength of the “kiwi;” in the central banks of the Czech Republic, Sweden and Israel hitting the same “zero bound” limit for interest rates at which the U.S., eurozone, Japan, U.K and Switzerland have been stuck for years.

The biggest players in the global monetary system have mostly resisted direct tit-for-tat responses to Japan’s yen-weakening moves over the past two years. But it’s only a matter of time before their policymakers use words or actions to combat its effect. The upshot: even more global deflation and sluggish growth.

Consider China, which arguably has the most to lose from competition with Japan and, even more so from a weakening South Korean won. Since the start of summer, the Chinese yuan’s exchange rate, which is managed against the dollar, has risen steadily versus the greenback virtually every other currency has fallen. As such, the yuan is up 12.5% against the yen since late June and 11% versus the dollar.

For an economy whose manufacturing exports are its lifeblood and that’s going through a challenging slowdown, this is untenable. “Riding on the dollar’s coattails has put enormous pressure on China in terms of its export competitiveness,” says Cornell University and former International Monetary Fund economist Eswar Prasad. He expects to soon see “a fair amount of intervention by the People’s Bank of China to keep the [yuan] from rising on a trade-weighted basis.” That, in turn, will induce other Asian governments into heavy intervention, he says.

It will also play out in the fractious politics of the eurozone. Already, deflation risks have led European Central Bank President Mario Draghi to open the door to bond purchases, driving the euro lower. But he faces stiff opposition from the Deutsche Bundesbank’s hard-money diehards, especially over the more controversial option of buying sovereign bonds. France, by contrast, would desperately love a monetary boost to help it meet its EU-mandated fiscal targets. And Greece, whose bonds are now returning to crisis prices, is dying for the same. These strugglers are on a collision course with Germany and other healthier northern European nations – as well, perhaps, with Spain, which resents the idea of Frances freeloading on ECB support when it has had to make painful economic adjustments. More imported Japanese and/or Chinese deflation will merely exacerbate these tensions.

Then there are economies that are really in trouble: places like Russia, Venezuela and Brazil, for whom a falling oil price is leaving their finances exposed even as they are forced by stubbornly high inflation and currency outflows to hike rates rather than cut them. In this environment, global competitive depreciation could trigger outright crises.

The wild card is the U.S. As a mostly domestically driven economy, America can bear the pain of a stronger dollar for a while – but that’s not boundless. Strikingly, Federal Reserve Vice Chairman Stanley Fischer has already voiced concern about the depressing economic impact of a stronger dollar.

For now, the U.S. continues to grow and add jobs, but it can’t be the world’s only engine of growth indefinitely. So, while the Fed is still likely to go through with a first rate hike in the spring or summer next year, this global game of passing the deflation hot potato will inevitably slow or even halt the process of U.S. monetary tightening.

Thus the stealth currency war will become complete. And the world economy will be no better for it.

Barron’s did some practical basic math:

Friday’s 2.5% drop in the yen is equivalent to a $1,500 price cut on a $60,000 Lexus, the luxury brand of Toyota Motor (ticker: TM), or on an Acura, Honda Motor ’s (HMC) high-end marque. That would exert competition for BMW, Daimler ’s (DDAIF) Mercedes-Benz, Volkswagen ’s (VOW.Germany) Audi, Tata Motors ’ (TTM) Jaguar, General Motors ’ (GM) Cadillac, and even Hyundai Motors (005380.Korea), which is trying to break into that league with its Equus sedan.

Consider now that the yen has lost 38% in the last 2 years…

This next piece is the best analysis I have seen so far:

• Gavyn Davies Bank of Japan opens the floodgates

(…) It shocked the markets with a gigantic increase in its QE activities, ensuring that the total central bank injection of liquidity into the global economy in 2015 will be much larger than it has been in the last year.

The BoJ will now increase its balance sheet by 15 percent of GDP per annum, and will extend the average duration of its bond purchases from 7 years to 10 years. This is an open ended programme of bond purchases that in dollar terms is about 70 percent as large as the peak rate of bond purchases under QE3 in the US.

In a parallel announcement, the government pension fund (GPIF) said it would reduce its domestic bond holdings from 60 percent of its portfolio to 35 percent, while increasing its overall equity holdings from 24 per cent to 50 percent.

Some of this has happened already, but this change will increase the purchase of Japanese equities by a further $90 billion, and the purchase of non Japanese equities by $110 billion, all effectively financed by sales of $240 billion of bonds to the BoJ, and therefore ultimately financed by central bank creation of reserves. Although Governor Kuroda said that these decisions are not directly connected, the combined effect is to introduce a new type of QE on an enormous scale.

The Japanese injection, relative to the size of the economy, is far larger than anything attempted by the other major central banks.

It is also large enough to ensure that the overall supply of central bank liquidity to the world markets will rise by 1.3 percent of global GDP next year, compared to a rise of only 0.3 percent this year. Reports of the death of QE have, it appears been greatly exaggerated.

Clearly, BoJ Governor Kuroda has now doubled down on the QE bet he made jointly with Prime Minister Abe almost two years ago. Faced with a slowing economy after the sales tax increase in April, and falling oil price inflation, the choice was either to abandon Abenomics, with no very obvious alternative to put in its place, or to prescribe a much larger dose of the same medicine. (…)

Japan is now conducting a laboratory experiment in whether monetary policy can break an economy free of a severe deflationary trap with interest rates stuck at the zero lower bound. Governor Kuroda’s monetary experiment has in effect morphed into a strategy involving devaluation plus financial repression.

The yen is 32 percent lower than it was three years ago. And real bond yields have been depressed well into negative territory. If this does not work in stimulating nominal demand, then nothing the central bank can do on its own will work. “Helicopter money” would be the last throw of the dice, but that involves monetizing a budgetary easing, so it is probably more correctly viewed as a fiscal measure.

So will this rather desperate second phase of Abenomics “work” for Japan? Success would involve a restoration of inflation and inflation expectations permanently to 2 per cent, while holding bond yields at close to zero. The devaluation and monetary easing would compensate for the second leg of the sales tax increase from 8 to 10 per cent due next autumn, so nominal GDP would grow at least at a 3 per cent rate and the public debt to GDP ratio would start to decline.

This is a tall order, but it is not impossible. A sufficiently determined central bank ought to be able to restore inflation to an economy, and that is the key ingredient of what is needed. But there are huge risks. If inflation expectations were unexpectedly to rise too rapidly, the strategy could end in uncomfortably high inflation. However unlikely that looks today, it presumably worried four members of the policy board sufficiently to vote against the strategy on Friday.

(…)  If it fails to restore inflation to Japan, this will be taken as a sign that monetary policy everywhere is powerless in the face of the deflationary forces that appear to be gathering momentum in the world economy.

The lessons will of course be particularly salient for the euro area. In many ways, Japanese thinking on monetary policy has now become the inverse of the ECB’s.

Under Mr Kuroda, the BoJ has deliberately sought to take the markets by surprise, maximizing the announcement effects of QE by shocking the markets. The ECB, in contrast, seems always to raise market expectations ahead of each of its monthly meeting, only to disappoint consistently when the decisions are finally reached.

The BoJ has also relied deliberately on buying sovereign debt, while the ECB has eschewed this (…). On top of all this, the BoJ has forced the yen down by a third against the euro, which will add to deflationary pressures in the euro area.

If this shows any signs of succeeding in Japan, surely there will be irresistible pressure on the ECB to follow suit. If however the BoJ experiment fails, markets may become very sceptical whether there is any escape route from deflation in the euro area.

One final point will be of interest in global markets. If QE works at all, it seems to work mainly by changing expectations about asset prices in the financial markets. In the past, the Fed has always been assumed to be the dominant actor in changing market expectations. Now, the Fed is contemplating tightening policy while other central banks are stepping up QE.

The bullish response of global markets to the opposing Fed/BoJ announcements last week suggests that investors are no longer just slavishly following the Fed.

There is now a new feature in Bearnobull: JAPAN WATCH (Click on “ON WATCH” tab, “ECONOMY”.

ECB’s Bond Conundrum  The Federal Reserve just closed the book on its government-bond purchases. The Bank of Japan on Friday vastly expanded its program. Now attention turns to whether the European Central Bank will start buying sovereign debt.

(…) The ECB meets Thursday, but it isn’t expected to unveil new measures. At issue is whether any ECB purchases of government debt would lift inflation toward the bank’s target of near 2%. Annual eurozone inflation was just 0.4% last month.

ECB interest rates can’t go lower. That leaves purchases of public and private debt as the main lever to keep borrowing costs down, boost asset prices, weaken the euro and goose inflation.

The ECB is buying some private securities and is open to adding corporate bonds. Officials have flagged government-bond buying as possible, but reached no decision amid doubts such purchases would help the economy without supportive government measures. (…)

Austria’s central banker is hesitant, saying more government investment is a better idea. Germany’s Bundesbank firmly opposes buying government bonds. And no one at the ECB is publicly making a forceful case for buying them. The reasons are twofold. The policy is deeply unpopular in Germany, where it stirs fears of central banks printing money to finance runaway public spending. Opponents also say there is little evidence it would help the weak eurozone economy.

Fed bond buying nudged long-term U.S. interest rates lower, in part because so much borrowing in the country is financed through capital markets. Europe’s financial system is bank-based and therefore would be less responsive to quantitative easing, skeptics say. (…)

Europe has already had a dry run of sorts with quantitative easing. Mr. Draghi’s pledge in July 2012 to do “whatever it takes” to save the euro, backed by a bond-buying plan that hasn’t been used, led to lower bond yields across the eurozone.

In other words, the ECB got quantitative easing-like effects on bond markets without spending money. But the economy saw little benefit. (…)

Refining Saudi Arabia’s Oil Strategy A collapse in refining margins suggests oil prices have further to fall.

(…) Since Oct. 1, the Gulf Coast “crack spread,” a proxy for the margins U.S. refiners make on each barrel of oil they process, has plummeted to about $5.50 from almost $16. That is despite the fact that the price of their biggest cost, crude oil, has fallen by about $10.

That paradox points to further pressure on oil prices.

Two things have the market spooked: Fears around global economic growth, centered on Europe and China, have led to cuts in forecasts for oil-demand growth. On the supply side, Saudi Arabia has confounded expectations by not cutting its output to restore balance to the market.

Instead, Saudi Arabia has cut its prices. This encourages refiners to buy its crude oil and process it into products like gasoline. But with the outlook for demand softer, all that product starts to build up and weigh on refining margins. Refiners, aghast at lower margins, will in turn press oil suppliers to reduce prices further.

(…) As long as Riyadh prioritizes market share over price—which it can do for a while as a low-cost producer with large financial reserves—refiners will take its barrels or demand that rival producers cut prices to stay competitive.

If a price war has started, investors should treat refining margins as news from the front line.

Can U.S. Stocks Hit Sweet Spot? U.S. stocks are entering what normally is their strongest period for gains. But some investors worry that this year, current events could outweigh history.

Over the past 100 years, the best three-month stretch for stocks has been November through January. On average, the Dow Jones Industrial Average records strong gains in all three months, jumping 1.5% in December alone, according to Bespoke Investment Group.

The S&P 500 shows a similar trend since 1928, the period for which data are available. It has risen an average 3.4% over the three months, nearly double its 1.86% average gain for three-month periods in general. (…)

EARNINGS WATCH

Three-quarters of the way in the season, the best account continues to come from Factset:

Overall, 362 companies have reported earnings to date for the third quarter. Of these 362 companies, 78% have reported actual EPS above the mean EPS estimate and 22% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above both the 1-year (73%) average and the 5-year (73%) average. If 78% is the final percentage for the quarter, it will mark the highest percentage of companies reporting actual EPS above estimates since Q2 2010 (79%).

In aggregate, companies are reporting earnings that are 4.7% above expectations. This surprisepercentage is above the 1-year (+3.6%) average, but below the 5- year (+5.9%) average.

As a result of the upside earnings surprises, the year-over-year blended (combines actual results and estimated results) earnings growth rate for Q3 2014 has improved to 7.3% today relative to an expectation of 4.5% at the end of the quarter (September 30).

The year-over-year blended sales growth rate for Q3 2014 of 3.8% is equal to the estimate of 3.8% at the end of the quarter, as the upside earnings surprises in the index overall have been offset by downward revisions to revenue estimates for companies in the Energy sector during the month of October.

In aggregate, companies are reporting sales that are 0.5% above expectations. This surprise percentage is below the 1-year (+0.7%) average and the 5-year (+0.6%) average.

In their earnings releases and conference calls, a number of companies have cited the negative impact of the stronger dollar on both results for the third quarter and expected results for the fourth quarter. Comments from companies regarding Europe have generally been mixed, while comments regarding China have generally been positive.

Companies have also begun to lower expectations for the fourth quarter, as 46 companies in the index have issued negative EPS guidance for Q4, while 18 companies have issued positive EPS guidance.

Last year at the same time, 66 companies had warned for Q4 and 13 had positively pre-announced. So more companies have changed guidance this year and 72% for the worse compared with 84% last year. Yet,

(…) analysts have cut estimates for Q4 2014, Q1 2015, and Q2 2015. The estimated earnings and revenue growth rates for all three of these quarters are lower today compared to expectations on September 30.

The Q4 bottom-up EPS estimate (which is an aggregation of the estimates for all the companies in the index) dropped by 2.7% (to $30.96 from $31.82) during the month. (…) the decline in the bottom-up EPS estimate recorded during the course of the first month (October) of the fourth quarter was higher than the 1-year (-1.3%), 5-year (-0.6%), and 10-year (-1.8%) averages.

However, most of the reductions to earnings estimates have occurred in the commodity-based sectors. As noted in last week’s report, the Energy sector (-10.8%) has recorded the largest decline of all ten sectors in terms of bottom-up EPS, followed by the Materials sector (-7.5%). No other sector has recorded a decrease in bottom-up EPS of greater than 3.3% through the first month of the quarter.

For Q4 2014, Q1 2015, and Q2 2015, analysts are currently predicting revenue growth rates of 2.6%, 3.2%, and 2.6%. These revenue growth rates are also well below the estimated growth rates of 3.8%, 4.5%, and 3.6% for these same three quarters back on September 30.

S&P’s own tally shows the beat rate at 75.5% so far. In effect, 81% of the 155 companies that reported last week beat estimates. But S&P’s compilation of bottom-up estimates also declined for both Q3 (-0.6%) and Q4 (-1.9%) from 2 weeks ago.

The bulk of remaining companies to report are in the consumer sectors. It will be very interesting to hear from them. In the meantime, October turned out to be a non-event on monthly charts. The Rule of 20 “fair value” (really full value, see THREE-STARRED EQUITIES) now stands at 2121, 5.2% higher than Friday’s close. “Fair value” rose 3.6% from September’s 2048, thanks to the 2.4% advance in trailing EPS and to inflation edging down from 1.7% to 1.5%.

What Bubble? Silicon Valley’s Younger Set Opts for Optimism Is there a tech bubble? The question exposes a generation gap in Silicon Valley. The psychological dividing line is whether you were in the game the last time it all came crashing down.

He [Sam Altman, president of Y-Combinator] allows that “there is too much capital available right now, and there are too many startups. It’s a little crazy right now.” But he also says that “I believe in the future, and to be a good investor you have to believe in the future.”

Thus, the 10,000 applications that Y-Combinator received for its last class of startups, in the summer of 2014, represent for Mr. Altman not the cresting of a great wave of entrepreneurial hype, but the logical result of Y-Combinator’s ability to concentrate power and influence in the valley through its alumni network, in which companies that graduate are made available to advise new recruits.

Also fueling record interest in Y-Combinator and other startup incubators is the increasingly global nature of tech. Forty percent of this year’s Y-Combinator applicant pool came from outside the U.S., says Mr. Altman. (…)

Voters Favor GOP by Slim Margin for Control of Congress Republicans hold a narrow edge on the question of which party likely voters want to control Congress, a new Wall Street Journal/NBC News poll finds.

It has been a while since we last had political stuff here. Nobody complained!