When Japan Falls, We Will Feel It

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Includes: EWJ, GLD, JGBS-OLD, YCS
by: Travis Christofferson

Take a quick gander at my neighbor's (family of 4) annual finances:

Household income: $40,000.00
Credit card debt: $800,000.00
Cost of debt service: $20,000.00 (they pay only 1% interest on all their credit cards)

Actually they aren't really a typical family of four. The wife left and the father's elderly mom moved in leaving the father as the soul source of income for the entire family.

I think we are probably all in agreement that my neighbor's finances look pretty grim to say the least.

Except these aren't actually my neighbor's finances. I lied. Rather, this is the balance sheet of Japan reduced as if it were a household.

If you're not already wondering who is the "credit card company" in this clearly irreconcilable situation, you should be. Turns out, the creditor lending to Japan at 1% - are the Japanese people themselves - who collectively own 94% of Japanese sovereign debt.

Anybody can see this situation is going to end badly. If the interest rates on Japan's debt rise by a mere 2% ALL the government tax revenue will be used up by debt service alone sending the country into bankruptcy.

The quantitative analysis of Japan's pending economic nightmare is simple - what is difficult is the qualitative aspect of timing. For Japanese interest rates to rise it will take a shift in the market participants (the Japanese people) perception. And that will be stubborn to change due to the fact that the Japanese, have for over twenty years, only seen their beloved bonds gain in value as everything else around them (stocks and real estate) has plummeted in value.

However this shift may be beginning to happen now.

I have lived in a neighborhood for over nine years without any major incidents - that is until last summer when a house burned down. Suddenly the whole neighborhood was aware of the potential danger and immediately became concerned about fires. New alarms were installed, flammable materials were thrown out - there was a sudden shift in perception simply due to new events dictating a new found awareness.

Decades have passed without incident, people became complacent, and then the subprime crises hit, which quickly morphed into a sovereign crisis in Europe, Japan, and the United States.

Slowly the world is becoming aware of the horrific situation most western governments have put themselves in. The world is realizing some debt can't, and won't be repaid

Sovereign debt is fine when treated like a corporation treats debt - every dollar borrowed should translate into at least a dollar earned. When governments do get it right they invest debt into things like the interstate highway system or the human genome project, things that have without a doubt increased GDP, and by extension tax revenue, allowing the debt to easily be paid back. Unfortunately the few good investments governments make are eclipsed by the myriad of bad investments - bridges to nowhere and over-promising entitlements - do this for too many years and suddenly a government finds itself in a situation like Japan. A situation that author John Mauldin calls, "a bug in search of a windshield." The graph below illustrates how inefficient the Japanese government has been with debt investment.

The creditors of western governments are waking up and becoming concerned about the ability of said governments to pay them back. Once the haircut is actually realized by private owners of Greek sovereign obligations, that awareness will be taken to a new level - it will no longer be a nebulous concept.

The Japanese are beginning to wake up to their own self-created nightmare. The banks are starting to prepare for a rise in interest rates.

One very good way to gauge the pulse of public consciousness is to see what people are searching for on Google. The search term "Japan debt" has gone from nonexistent before 2008 to marked activity over the last few years.

An interesting observation on the subprime crisis is that search for "housing bubble" peaked well in advance of the actual crisis apex.

For the housing crisis you can conclude that the public awareness created the tipping point and for Japan it will be no different. Keep your eyes and ears open to this shift in perception. If it follows the same path as the subprime crisis you will hear more and more news about Japanese debt while at the same time, politicians will be lying about the degree of danger and playing down the situation - they know the crisis will be precipitated by a decrease in confidence and they will do everything to stem the inevitable erosion of the creditor's confidence.

Once the Japanese house-of-cards begins to fall the government will have only two options: Default on their obligations or print money. Both way interest rates will rise and the value of the yen will decline. The way to protect yourself from this watershed event is by owning JGBS-OLD, YCS, and GLD. And be very careful, even though Japan is far away geographically, globalization has made it our neighbor. It is still the fourth largest economy in the world with indelible economic ties to the United States. When Japan falls, we will feel it.

Disclosure: I am long JGBS-OLD, YCS.