The Great Wall Of China Hoax

| About: iShares China (FXI)

The secret of life is honesty and fair dealing. If you can fake that, you've got it made." - Groucho Marx

Looking at the Chinese currency falling against "Mack the Knife" aka King Dollar + positive real US interest rates, moving in sympathy with Bitcoin sailing through the 1000 threshold, with 2016 closing on arguably the epic failure of Mainstream Media (MSM) being the most prominent feature as pointed recently by Ray Dalio from Bridgewater Associates, we reminded ourselves for our title analogy of the Great Wall of China hoax faked newspaper story concocted on June 25, 1899, by four reporters in Denver, Colorado, about bids by American businesses on a contract to demolish the Great Wall of China and construct a road in its place. The story was reprinted by a number of newspapers. We found it interesting that this hoax was created at the height of imperialism during late 19th Century when Great Britain obtained its 99-year lease for the New Territories, extending the Hong Kong colony that had been ceded in 1841, while Germany seized the Chinese port of Kiaochow and used it as a military base, and French leased Kouang-Tchéou-Wan from China. Of course, this hoax coming at the very height of imperialism is reminiscent of our October 2016 musing "Empire Days" in which we pointed out that the "status quo" was failing:

It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "status quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

The hoax began with four Denver newspaper reporters, Al Stevens, Jack Tournay, John Lewis and Hal Wilshire, who represented the four Denver newspapers - the Post, the Republican, the Times and the Rocky Mountain News. They met by chance at Denver Union Station where each was waiting in hopes of spotting someone of prominence who could become a subject for a news story. Seeing no celebrities and frustrated with no story in sight and deadlines due, Stevens remarked:

I don't know what you guys are going to do, but I'm going to fake it. It won't hurt anybody, so what the Devil."

The other three men agreed to concoct a story and walked on 17th Street toward the Oxford Hotel to discuss possible ideas and came up with a story in which the Chinese planned to demolish the Great Wall, constructing a road in its place, and were taking bids from American companies for the project. Chicago engineer Frank C. Lewis was bidding for the job. The story described a group of engineers in a Denver stopover on their way to China. That's how the hoax began and spread like wildfire, even making a comeback in 1939 as an urban legend due to Denver songwriter Harry Lee Wilber claiming in a magazine article that the 1899 hoax had ignited the Boxer rebellion of 1900. The cultural historian Carlos Rojas comments that the original hoax being perpetuated by a second hoax, a "metahoax," illustrates the ability of the Great Wall to "mean radically different things in different contexts."
By now, you are probably asking yourselves where are we going with our analogy? Have we already lost the plot early on in 2017? Recent geopolitical events have clearly shown that in some instances MSM likes to fake it. This of course can have some unintended consequences leading to a hoax becoming a metahoax as pointed out by Ray Dalio from Bridgewater Associates in his latest missive:

If you have a society where people can't agree on the basic facts, how do you have a functioning democracy?" Distorted pictures lead us to make bad decisions. In my opinion, if people don't correct such inaccuracies and don't fight against this problem, continued distortions in the media will prevent the public's accurate understanding of what is happening, which will threaten our society's well-being. We in the financial community now openly talk about fake or distorted media being used to manipulate market prices to the harm of many, and similar conversations are taking place in most areas.

This is not just a fringe media problem; it is a mainstream media problem. And while it is widely recognized, there is no discussion underway about how to rectify it." - source LinkedIn Pulse, Ray Dalio, Bridgewater Associates

Fake news and fake prices, thanks to central banks meddling with interest rates for too long, can obviously lead to "unintended political" consequences as we have seen last year. Given 2017 is the 100th anniversary of the Russian revolution, we will not be surprised to see some more "sucker punches" being delivered in various asset classes and issuers (such as what we have seen with French issuer Vinci in 2016, Japanese Toshiba, UK retailer Next as of late). Both the MSM and central bankers are losing their aura, this will have some "unintended consequences" on asset prices rest assured.
Before we go into the nitty gritty of this year's musing, we would like to extend dear readers our best wishes for 2017 and we are looking forward to more discussions and comments. Moving to what we will cover in this conversation, we would like to turn our attention to the impact "Mack the Knife" is going to have on housing demand, and therefore gradually and most probably putting a dent into the much vaunted "Trumpflation" story. While the feel-good effect on the year might be lasting, some more thanks to better macro data from PMIs overall, it remains to be seen how long hope and complacency will trump reality...
Synopsis:
  • Macro and Credit - Japan as a base case - when low yield assets become nonperforming assets
  • Final chart - Chinese credit is currently under-pricing rising risks in CNH
  • Macro and Credit - Japan as a base case - when low yield assets become nonperforming assets
In numerous conversations we have pointed out about our difficulty in embracing the recovery mantra story playing out in the United States, thanks to lack of solid evidence in wage growth which would as well confirm the reflation story playing out, in a world awash in debt which, is no doubt weighing on growth prospect. As an illustration of political hope versus economic reality, no offense to ex-French Prime Minister Manuel Valls but his 1.9% GDP growth hypothesis in his just published political program for the presidential run of 2017, where he indicates that he will reduce the budget deficit while increasing public spending by 2.5% is hogwash. It just doesn't add up when public spending is already close to 58% of GDP (we are still laughing about this). No matter how ambitious a political program is, even with the benefit of the doubt, that market pundits seem willing to give, it seems to us that expectations are going to get at some point a reality check in 2017.
When it comes to fake prices and fake inflationary expectations, Japan comes to our mind, given its prolonged monetary easing stance and its consequences, leading to a vicious cycle of low growth where Europe seems to be heading thanks to a similar "Japanification" process, and unresolved nonperforming loan issues in large swath of the European banking system. Japan is as well of interest, not only due to poor demographics (as in Italy these days) but also from the perspective of low-yield assets becoming nonperforming. To that instance Japanese real estate is a good illustration of the process as highlighted by Deutsche Bank (NYSE:DB) in their Real estate sector note from the 4th of January entitled "Investment strategy for 2017: time to heed warnings of intellectuals":

"Heading for a world predicted 150 years ago

We believe the election of Donald Trump as US president and the UK's Brexit decision are outcomes of overly successful capitalism instead of heightened populism. These events expose the risks of capitalism that were predicted by Karl Marx, Adam Smith, and other intellectuals in the past. Japan has not recognized the trend changes, and we expect Japan’s real estate market to worsen in 2017.

Karl Marx, Adam Smith, and other intellectuals from the past predicted these risks 150 years ago. Continuing deregulation leading to a world dominated by "survival of the fittest" naturally breeds success for those with capital and intelligence. It fosters dominance by the elite. Capitalism is fundamentally aggressive. Various regulations have been enacted for dampening this aspect of it. However, continuous deregulation has created a "winner takes all" world and expanded disparities between rich and poor.

Several intellectuals understood the risks of capitalism. For example, Karl Marx warned that "successful capitalism means victory for those with capital and knowledge, and when left unaddressed, creates a society with large disparities and monopolies and leads to higher prices." Adam Smith, known for the "invisible hand," wrote "The Theory of Moral Sentiments" in 1759 prior to the "Wealth of Nations" (1776). In this book, he acknowledged that competition is important, but explained that the spirit of fair play and consideration for others is an essential premise. Even Max Weber, who argued that making money is good, noted that capitalism requires high moral sensitivity in order to succeed.

In Japan, Sontoku (Takanori) Ninomiya famously stated that "economic activity that ignores morality is a crime, and morality that forgets economic activity is nonsense." Japan also had the “Sanpo Yoshi” spirit exemplified by Omi merchants that calls for benefits to the buyer, seller, and local communities together. In other words, risks of capitalism were predicted in both the east and the west.

However, it is getting difficult to find a new frontier beyond extension of the frontier to the middle class through deregulation. Capitalism appears to be reaching its limits in its current form. Natural redistribution (trickle-down theory) has failed, and calls for redistribution are making headway among the middle class. We believe this sentiment is behind the results seen in the election of Trump as US president and the UK's Brexit decision. The world may be entering a chaotic age as it seeks new types of capitalism.

Important elections will take place in Europe in 2017, including legislative elections in the Netherlands in March, presidential votes in France in April and May, legislative elections in France in June, and a general election in Germany in September. Results in Italy's national referendum in December 2016 forced the resignation of Prime Minister Matteo Renzi. We believe people may follow the Italian case in quite a few countries and expect disruptions and crises to pick up momentum worldwide in 2017.

NIRP transforms low-yielding properties into non-performing assets

We believe that lowering nominal interest rates via the NIRP (negative interest rate policy) weakens the financial intermediary function and leads the Japanese economy to deflation. As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth. We see the risk of low-yielding assets becoming non-performing and triggering a significant setback to the NAV in Japan during 2017 in light of the approaching limits to monetary easing amid increased uncertainty in global political and economic conditions.

String of failures

Measures such as monetary easing that exceeded market expectations, a consumption tax hike amid a recovering economy to spur fiscal structural reform, and a strong ROE emphasis on shareholders have been adopted by the BoJ, the government, and the private industry, with each of them considered optimal. However, all have contributed to deterioration in Japan's economy and its real estate market. This is a classic example of the proverb, ‘the road to hell is paved with good intentions’. Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

To avoid the extreme ultimate decision

As countries worldwide reconsider their positions due to widened disparities driven by overly successful capitalism, Japan has yet to reflect on this. It remains one step behind, as it moves forward with minor government and deregulatory policies. Japan should realize that it needs to foster stronger ethics and morals and pursue policies that break away from excessive focus on ROE and encourage long-term investment and higher wages for employees. Unless these changes are adopted, we see increasing likelihood that Japan will be faced with the ultimate decision.

Bursting of "quiet bubble" to accelerate in 2017

In 2016, the real estate market started heading towards the end of the “quiet bubble”. We see this move picking up pace in 2017. We see hardly any factors supporting optimism. We determine our target prices for the real estate sector by using a residual income model. We also take NAV into account. Downside risks include: 1) a rise in risk premiums due to a decline in bank lending to the real estate sector; 2) the hasty implementation of a hike in consumption tax and/or income tax, or a decline in government spending due to a rush toward fiscal restructuring; and 3) deepening NIRP amid another monetary easing. Upside risks include: 1) significant salary increases in private sector companies, and 2) consumption tax and income tax cuts as well as large-scale fiscal spending." - source Deutsche Bank

As clearly highlighted by Ray Dalio in his latest missive, playing a hoax for too long, ultimately has unintended consequences and bring about political instability. The impact of globalization have been clearly leading to some political discontent given it has fostered dominance from the elites as highlighted by Deutsche Bank in its note. We touched on the impact of globalization back in February 2015 in our conversation "The Pigou effect" and we indicated Populism was bound to happen as predicted by the maverick Sir James Goldsmith and his 1993 insightful book The Trap which was followed by The Response:

We also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015:
1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey. “And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient.

He violently criticized the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.
In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided above):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

While MSM is still wondering why there is a global rise in populism and why Trump got elected, for us it fairly is very simple, the social contract between society and the economy has been truly broken.
So the poor "schmucks" or "deplorables" as some politicians were calling them that were initially sold the "greatness" of "globalization" are now realizing they have been fleeced and obviously they are not happy about it:

U.S. Wage Growth Since 1973* Upper / High Income: +52% Everyone Else: -4.6%

Distribution of U.S. Household Wealth to the Bottom 90%

2016: 22% 2005: 30% 2000: 31% 1995: 32% 1985: 37%

Young Americans living w Parents*

2016: 40%2000: 31%1990: 30%1980: 30%1970: 23%1960: 23%1950: 22%

*18-34 yr olds - H/T Lawrence McDonald

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

Clearly, the latest spat between president-elect Donald Trump and Ford (NYSE:F) might be an illustration of the US administration trying to counter the fundamental aggressiveness of US capitalism that strongly benefited from the Fed's generosity. Put it simply, it might look as an attempt (or a hoax) to favor Main Street against Wall Street. It remains to be seen what the new US administration will set in motion and to paraphrase Groucho Marx, maybe faking is making it after all and the deplorables might have once again been conned, we shall see.
But, moving back to low yields becoming nonperforming, we remain very wary of the destructive trail of "Mack the Knife".
While we continue to see pressure building up on China and capital outflows, we are eagerly waiting for the 7th of January when we will see the publication of the latest state of Chinese FX reserves. On that subject Bank of America Merrill Lynch in their Asia FX Strategy Watch note from the 4th of January anticipates that China FX reserves have fallen by $25 billion in December:

We forecast China’s FX reserves to fall by USD 25bn in December to USD 3,027bn. Our forecast is less than the Bloomberg consensus forecast for a fall of USD 42bn to USD 3,010bn in FX reserves.

We estimate an intervention effect of USD -15bn in December, which is less than the USD -40bn reading for November (Chart 1). Onshore FX volume rose from USD 670bn to USD 740bn in December; an increase in onshore FX volumes are associated with a larger estimated intervention effect. Some of that impact on the estimated intervention effect may have been offset by the narrower average CNH-CNY basis of -55bps in December, from -167bps in November, leading to our smaller than consensus forecast decline in China’s FX reserves.


Our estimate of the valuation effect in December is USD -10bn. While the USD continued to strengthen against the EUR, GBP and JPY, the rate of USD appreciation was less than the previous month.

As China’s FX reserves falls towards the USD 3trn level, we believe officials may act to contain RMB depreciation expectations because:

  1. The USD 3trn could be of psychological importance to investors and officials. We show in our year-ahead report that this will ultimately be crossed in 2017, though capital controls are being engaged to sure-up credibility.
  2. Capital outflows from China picked up to USD 205bn 3Q 2016, especially through trade credits and the use of CNH.
  3. Inflation has maintained its upward trend in 2016, especially according to the PPI measure, raising concerns over FX inflation pass-through.

Indeed, the USD/CNY fixing rate has been notably lower than that implied by the 16:30 closing rate and the basket implied change throughout December 2016. Furthermore, FX purchases by individuals are now under greater scrutiny than before as the annual USD 50,000 limit was reset on 1 January 2017." - source Bank of America Merrill Lynch

On top of the unabated outflows from China thanks to "Mack the Knife", US rate hikes envisaged by the Fed will no doubt have an impact not only on US housing but, on the US economy as a whole as pointed out in Deutsche Bank's aforementioned note:

Are there any adverse impacts from the US rate hike?

We view 2017 as the start of major changes in trends as we mentioned above. The FRB increased the interest rate in December 2016 despite the increased possibility of major changes in global tides. We agree that conditions are healthier in the US than in Japan and Europe, which have adopted negative interest rates. However, the US rate hike may weaken its economy.

We are particularly concerned about auto loans and student loans in the US, which are now at all-time highs, having increased to $1.1tr and $1.3tr, respectively. Home mortgage loans have not recovered to the level before the Lehman collapse but are substantial. We believe that the US rate hike holds the risk of causing a downturn in housing demand.

We expect the rate hikes to gradually have a negative impact on the US economy and thus force a rate reduction in 2017 rather than further increases in rates. Hence, we believe investors should consider the potential for a shift back to yen appreciation. The risk of the economies in the emerging countries needs to be closely monitored as well. Even if faced with such conditions, the BoJ lacks additional options as it is already approaching limits of monetary easing.

The only possible action by the BoJ is widening negative interests. However, this may further undermine financial intermediation in the economy and accelerate a deflationary trend. We believe widening the negative interest rate would be a critical failure that adversely affects not only the real estate and stock markets but also the entire economy.

We expect a new era of global disruption over the long-term horizon, while we believe it will become apparent in 2017 that the US rate hike will have an adverse effect on the global economy and that Japan will not be able to cope with the impact. The environment for the Japanese real estate market is likely to present even stronger headwinds, in our view." - source Deutsche Bank

Of course, if the reflationary story turns out to be a hoax in a world where growth is stifled by high levels of debt, it will materialize itself at some point in 2017 and one would expect, the bond bears to retrench and yields to resume their downward trajectory during the course of the year. While hope is the ongoing "winning" strategy," at some point reality could reassess itself. On a side note, we have turned slightly positive on gold and gold miners over the course of December.

But moving back to Japan being a case study for monetary experiments, the impact of monetary policies have clearly shown their effect on real estate as pointed out by Deutsche Bank in its long interesting note:

When expanded low-yield properties become nonperforming assets

As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth.

In fact, Mitsubishi Estate's yield on leased properties has slumped from over 9% (FY3/00) to the 5% range, and Sumitomo R&D’s yield has fallen below 5%. A flurry of designation of special economic zones led by deregulation has created incentives for investment in low-yield assets. Low-cost finance also enables it.

Cumulative free cash-flow deficits at Mitsui Fudosan, Mitsubishi Estate, and Sumitomo R&D totaled ¥1.9tr from FY3/00 to FY3/16, due to continuous excessive investments over a long period (free cash flow: operating cash flow -
capex).

As long as the current level of large investments continues, these companies cannot buy back shares or raise dividends significantly because they simply do not have the necessary funds.


Locations that previously did not have offices have suddenly transformed into cutting-edge office districts, further heightening supply. The office stock in Tokyo's 23 wards has increased 1.7x since 1991. Rents, meanwhile, are at all-time lows following repeated ups and downs over economic cycles because of flat demand.

Alongside excessive investment in rental assets, inventory assets have risen sharply and the turnover ratio has dropped to an all-time low. For example, Sumitomo R&D's inventory assets have increased by ¥720bn, from ¥128.3bn in FY3/00 to ¥846.7bn as of end-FY3/16.

Meanwhile, Sumitomo R&D's real estate sales rose modestly from ¥150.5bn in FY3/00 to ¥274.8bn in FY3/16, reducing the turnover rate from 1.17 to 0.32, an all-time low. Similarly, Mitsui Fudosan's turnover ratio dropped to an all-time low of 0.4.

Low-yielding assets have been accumulating in Japan due to the prolonged monetary easing climate. We believe the BoJ's negative interest rate policy, which lowers nominal rates, is worsening the situation, since the policy further undermines the function of financial intermediation and thereby encourages deflation.

Japan, which is approaching the limits of monetary easing, has limited response options and faces significant risk of low-yield assets becoming nonperforming assets if the yield upswing, yen strength, or other factors create headwinds for the economy amid heightened uncertainty in global political and economic conditions in 2017. We believe this implies the possibility of significant erosion in the NAV." - source Deutsche Bank

Clearly, the prolonged downturn of the Japanese economy in conjunction with the implementation of Negative Interest Rate Policies (NIRP) have led to excessive investment in rental assets and inventory assets have risen accordingly.

But, for us, the greater distortion coming out from NIRP is the distortion it is creating in terms of "credit allocation". As we pointed out in our conversation "Goodhart's law", back in June 2013, there is "good credit" (infrastructure and productive investments) and "bad credit" (real estate):

Credit is like cholesterol, there is bad cholesterol that can’t dissolve in the blood (Low-density lipoprotein) and good cholesterol (High-density lipoprotein).

When too much LDL (bad cholesterol) circulates in the blood, it can slowly build up in the inner walls of the arteries that feed the heart and brain. This condition is known as atherosclerosis, and heart attack or stroke can result.

In 2008, we came very close to a global heart failure. The world had a stroke.

But, what led to the bad cholesterol in the first place? Bad credit. So betting on a government making the right choice of allocation with "fiscal stimulus" is wishful thinking, we think.

Government policies favoring housing bubbles have led to mis-allocation of credit (bad cholesterol), like in the US, the UK, Hungary, Ireland and Spain. Bad cholesterol (the "credit stroke) has led to "Balance Sheet Recession" (Japan).

Government policies favoring infrastructure investment is good cholesterol:
One can posit that President Eisenhower when he signed the 1956 bill that authorized the Interstate Highway System in 1956 was of great benefit to the US. In his parting speech of the White House on the 17th of January 1961, he warned about the risk of bad cholesterol (military complex) but that's another story..." - source Macronomics, June 2013

In terms of Japan, there is clearly indication that NIRP is already leading to "bad credit" as per Deutsche Bank's report:

Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

The first problem is BoJ’s policy. We believe its monetary easing policy has been excessive. We are not negative about monetary easing, but we believe this has started doing more harm than good.

The worst setback has been the decline in demand for non-real estate loans since the adoption of the NIRP, creating tightening rather than easing effects. Recent data actually show a 7.2% increase in loans to the real estate industry versus a slowdown to 1.4% in other areas (Figure 11).

The NIRP has proved dysfunctional in Japan due to record-low loan-deposit ratios (demand for bank loans is low and has moved little in response to lower interest rates). In addition, the NIRP, which lowers nominal interest rates, promotes deflation by weakening financial intermediation. Slowing loan growth to industries other than real estate is evidence of this.

Furthermore, the BoJ has adopted yield-curve controls because the volume of JGB holdings at banks that can be sold to the BoJ has already reached a limit. This has raised the risk of investors pricing in the limitations of monetary easing. We believe this is a problem too.

The BoJ's introduction of measures to control the yield curve amid NIRP promotion of deflation negates any benefits from lower interest rates. Yield-curve controls that prevent yields from declining are contradictory to the NIRP's reduction of the nominal interest rate. We believe this presents a nightmare scenario for the real estate sector.

Put differently, we see expected revenues declining, risk premiums rising, and risk-free rates trending upward. This means the three key determinants for stock prices in the real estate sector should move into a direction that is detrimental for the sector.

Our worst-case risk scenario would be widening of the negative interest rate by the BoJ that prompts banks to impose account management charges on large deposits. We believe this would start triggering further deleveraging.

Many Japanese companies are effectively debt-free and take bank loans mainly to maintain friendly relations with banks. If they are charged management fees for those accounts, we suspect many of them would reduce their deposits as much as possible and work to repay their loans.

Banks would then suffer not only a narrowing lending spread but also a drop in the lending balance. Japan would experience credit contraction (deleveraging), and as a result, slip into deflation again, in our view.

It is also important to consider market risk. The BoJ's massive JGB purchases have lowered JGB liquidity. Therefore, we see the risk of a sudden steep rise in interest rates if some type of shock occurs.

Furthermore, dark clouds are gathering over upbeat lending in the real estate industry because restrictions may be imposed on loans to the industry (as reported by some media sources). In fact, banks’ outstanding loans to the real estate industry have climbed to a record high of 14.8% of total loan value. We believe this already exceeds the acceptable level.

Second culprit is excessive focus on ROE

We believe the second culprit is an excessive focus on ROE. The behavior of Japanese corporations changed considerably after the 1997 financial crisis, and companies have stopped increasing employee compensation even with profit growth.

Since then, their more shareholder-centric stance has resulted in a greater tendency to distribute profits to shareholders rather than use them to boost employee compensation. If we assign 1997 a base value of 100, dividends would now be 500 while employee compensation is still 100.

We believe the domestic demand economy cannot grow without corresponding growth in employee compensation. On the other hand, executive compensation has been increasing. This would be understandable if management generated strong results, but in one case, executive compensation increased by more than ¥200m YoY even when the firm made a loss due to failed M&A and other initiatives. This is the tragedy of Japan copying the negative aspects of a shareholder-centric stance.

Shareholders are not a company's only stakeholders. Other stakeholders include clients, employees, and the society to which the company belongs. Although shareholders can easily cut off their ties by selling their shares, clients and employees are unable to end their relationship so easily. From this point of view, shareholders are not even the most important stakeholders.

We are not suggesting that companies ignore shareholders. Rather, we believe that insufficient attention given to employees and other stakeholders could destabilize a society. This is already happening in other advanced nations. In our opinion, it is a big problem for Japanese companies when managements fail to consider the experiences of other nations as related to its own issues." - source Deutsche Bank

The Japanese story, to some extent is clearly indicative of the challenges faced by the new US administration. This is for us the biggest headwind for the Fed, given it has accentuated through its loose policies the rift between the have and the have not. We have reached the limit of what monetary policies can do and the toxicity it has brought in terms of mis-allocation. It remains to be seen how the new US administration can encourage real wage growth and the latest Ford episode, lack for us an essential part to ensure a real recovery taking place and not a hoax, namely that the new Donald Trump administration needs more than having companies investing "in America," because if the new elected president wants to "make America great again," it certainly needs to learn from the Japanese experience and ensure US companies invest "on Americans" we think.

Deutsche Bank's note also clearly makes some solid points relating to the Japanese tragedy:

Need to avoid ultimate decision

We see voters worldwide are calling into question the widening disparities caused by capitalism's overwhelming success, as evidenced by Trump's victory in the US presidential election, the UK's decision to exit the EU, and the resignation of Italian Prime Minister Renzi as a result of a national referendum in December.

However, the changing trend poses risks that were predicted long ago by intellectuals like Karl Marx and Adam Smith. Continuing deregulation funnels control to the elites, expanding disparities between rich and poor in a "winner takes all" scenario. Furthermore, it is difficult to find new frontiers because they have already been expanded to the middle class, raising the specter that capitalism in its current form will disappear. Natural redistribution (trickledown theory) has failed, and calls for redistribution are making headway among the middle class.

Even as the “quiet bubbles” approached their demise in 2016 and will likely accelerate in 2017, Japan remains mired in a dilemma. Instead, it seems to be standing still as a laggard, unaware of the growing chaos and crisis and the major changes taking place worldwide.

At this juncture, we believe Japan needs to foster a spirit of fair play that takes into account the interests of all parties and cultivates strong ethics and moral values, stop focusing too much on ROE, and enact policies that encourage long-term investment and higher wages for employees, as were outlined in the writings of Adam Smith, Karl Marx, and other intellectuals in the past. Without these changes, Japan may not be able to avoid the ultimate decision.

Specifically, companies are expanding shareholder returns to boost their share prices and increasing M&A because their own R&D reduces ROE. Innovation cannot be achieved this way. Companies should not refrain from long-term investments. Honda's ASIMO, linear-motor bullet trains, hydrogen engines, carbon fiber, and Japan's other impressive technologies obtained through long-term investment would not have been realized in a world focused on ROE.

We also believe that profits should be fairly allocated to employees, not just to shareholders and executives. Unless this happens, the cycle of "widening disparity → excess savings → low rates and low growth → asset price gains → bubble collapse → monetary easing" will continue unabated. Nevertheless, it seems that this cycle is at its limits.

We see need for tighter regulations, not just deregulation. This is particularly important in the real estate industry. Locations that did not have offices are suddenly being transformed into cutting-edge office districts, further heightening supply as a result of continuous deregulation. Therefore, rents are at all-time lows after repeated ups and downs during economic cycles.

We believe it is possible to achieve strong economic growth by ending sluggish consumption and increasing new products through innovation if Japan stops focusing excessively on ROE, and ends wage-curtailment for ordinary employment and restraints on capital investment. It is also time to halt deregulation and restore strong ethics and morality, along with more measured competition.

We believe the "quiet bubbles" started to collapse in 2016, and expect the downturn to accelerate in 2017. The economy and the real estate market will likely remain sluggish because of inadequate policies being pursued in the public and private sectors. We find almost no factors that support optimism. We believe Japan will likely face an ultimate decision unless the reforms we discussed above are enacted." - source Deutsche Bank

The wise words of Sir James Goldsmith from 1993 we mentioned back in June 2013 in our conversation "The Pigou effect" still resonate with the above and the risk for capitalism's demise:

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

The ongoing rise in populism thanks to globalization and aggressive capitalism, in search of maximizing ROE and shareholders return have had the desired effects in leading towards a surge in populism. It remains to be seen how the new US administration will ensure that the economy serves the US society, or put it simply, make sure Main Street gets its fair share of the pie which has been lacking in recent years, thanks to the Fed's bold monetary policies which were a boon to Wall Street.
In similar fashion, China is playing a difficult balancing act in trying to deflate its induced credit bubble while ensuring social stability which is illustrated in our final chart.
  • Final chart - Chinese credit is currently under-pricing rising risks in CNH
Our final chart illustrates the complacency between upwards pressure on the Chinese currency thanks to "Mack the Knife" and China credit risk and comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 4th of January entitled "Let's get technical." It displays the rise of USD/CNH 3 months ATM (At the Money) volatility versus China exposed names 5 year CDS index:

- source Bank of America Merrill Lynch

If "Mack the Knife" continues its unabated run, it remains to be seen how long China related credit is going to be able to hold the line. When it comes to Great Wall and hoaxes, it remains to be seen if indeed The Great Wall of Mexico will be one after all, but we ramble again...

This nation is notorious for its ability to make or fake anything cheaply. 'Made-in-China' goods now fill homes around the world. But our giant country has a small problem. We can't manufacture the happiness of our people." - Ai Weiwei, Chinese artist

Stay tuned!

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