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The fiscal cliff is on everybody's mind and rightly so. The economic future of the country is at stake, probably more so than most people realize. A look at Japan's economic history provides a very sobering look at what could happen if we do go over our fiscal cliff.

The fear being cited by the politicians and the media is that if we do not get our fiscal house in order we could go the way of Greece. From an economic perspective, the U.S. monetary system is different from Greece's. Greece does not issue its own currency while we do, so the issue for us is not one of solvency, but a weakening currency and potential imported inflation.

The real danger arising from going over the fiscal cliff is that we could very easily go the way of Japan, which has seen 2 decades of lost economic growth and counting.

This is a chart of Japan's money supply growth which shrank severely between 1990 and 1992 when Japan went off their fiscal cliff. Japan's money supply was growing at an average rate of 9% in the 80's and then dropped to a 2% growth rate. You could say that Japan brought their fiscal house in order.


(Click to enlarge)

But look what happened to their GDP growth over the same time. Japanese GDP was growing at an average rate of 6% in 1990 and dropped to 0% in 1991 and has averaged 0% in the last 20 years.


(Click to enlarge)

A massive cut in government spending led to a fall-off in the GDP. The hope was that the private sector would make up for the lost government stimulus.

This failed to materialize and the same could very easily happen in the US as well!

Investment Implications

Let us take a look at some of the investment implications from the Japanese history and draw parallels with our own markets.

1. Currency Stronger:

Over the last 20 years Japanese yen has strengthened from Y250 / $1 to Y82 / $1. This is no surprise. As Japan reduced its money supply, supply and demand logic dictated that the currency should strengthen, and it did.

If we do go over the fiscal cliff and see a massive reduction in our own money supply growth, I would expect the U.S. dollar to strengthen, especially against the G7 currencies. PowerShares DB US Dollar Index Bullish ETF, (UUP) or ProShares UltraShort Euro ETF, (EUO) would be good ways to play this. Both these ETFs are bullish U.S. dollar.

2. Interest Rates Lower:

As Japan's economy continued slowing through the 90s and beyond, interest rates in Japan kept collapsing and the Bank of Japan kept instituting quantitative easing all through the 90s. The 10 year Japanese government bond went from yielding 8% in 1991 to 0.69% at present.

Our 10 year Treasury note has mirrored this move as the Fed has cut rates and embarked on quantitative easing since 2008. Our 10 year Treasury yield has dropped from 4.25% in 2008 to 1.61% at present. If the parallel between Japan and the U.S. is true and our GDP growth suffers, the 10 year Treasury note could very easily go down to 1%. iShares Barclays 20+ Year Treasury Bond ETF, (TLT) which is a bullish U.S. Treasury bond ETF would be a good way to play this.

3. Equity Market Correction and Stall:

As for the equity market, Japan's Nikkei dropped like a brick from 1990 to 1992 as it went from 40,000 down to 15,000 and then traded sideways in a very choppy fashion between 1990 and 2000, ranging between 15,000 and 20,000. It then took another dive down in 2000 and is currently trading at 9400.

Our equity market would suffer not just from a drop in economic growth, but also from taxes on dividends. The rally in the S&P 500 from 2009 to now, of nearly 100%, has been engineered by the fiscal and monetary stimulus by the government and the Fed respectively. A massive reversal in this stimulus as a result of the fiscal cliff could see the US equity market give back most of those gains. Technical analysts have been calling for a retest of the 700 level for a long time as well. ProShares Short S&P500 ETF (SH) or ProShares Short QQQ ETF (PSQ) are good ways of positioning for a drop in our equity markets.

4. Buy High Alpha Markets:

But there are other market opportunities as well to consider beyond the U.S. The relatively better assets to invest in 2013 could be the high alpha markets. The so called frontier markets did extremely well in 2012 as they are being buoyed by good fundamentals like cheap valuations, good risk-return metrics, steadily increasing foreign capital flows and strong commodity exports to China.

As an example, African Composite mutual fund, NAFCX is up 30% and Asian countries beyond BRICs are also up in 2012 (Philippines+30%, Thailand+30%).

As a final word, we always advise our clients to adopt a dynamic rebalancing and a risk managed approach to portfolio management rather than a buy, hold and pray approach. Markets these days are affected by a lot of non-economic factors and asset classes can go in and out of favor quite rapidly.

Source: Fiscal Cliff - A Lesson From Japan