As Bad As It Gets
Our last comments on the sovereign-debt-ticking-time-bomb otherwise known as Japan came in June 2012, when we proclaimed, The Gig Is Up, based partly on the sound economic reasoning that adult diaper sales are a leading indicator of distress in government financing.
It appears that such talk is heating up once again. We’ve heard that a number of smart managers pitched “The Widow Maker” at a recent investor conference in Geneva. And at GIBI in Dallas last week, Kyle Bass reminded investors why he continues to press their widely publicized bet that the bill has come due in Japan. He believes that Japan will structurally fall apart within the next eighteen months as there is no chance of Japan ever repaying their debt and once the numbers are fully understood, confidence will evaporate. He believes this is the single most mispriced option that has ever existed in world history – an option on the government risk free rate, based on the level of the risk free rate itself (which is at all time lows) and the volatility of that rate (which is also at all time lows).
Kyle does not appear to be alone in his thinking given recent comments from John Hussman:
“On the subject of deficits, the situation in Japan seems increasingly strained. The gross debt/GDP ratio in Japan is now about 225%, and net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 130%. During the entire post-war period, Japan has enjoyed a significant trade surplus, which has allowed it to run growing government deficits. Meanwhile, household savings have declined from nearly 15% in the 1990’s to next-to-nothing today. Needless to say, that large and persistent trade surplus has enabled economic dynamics that normally would not be sustainable. But over the past year, Japan has fallen into a trade deficit, which has deepened recently due in part to tensions with China. We are now observing an ominous combination of a significant trade deficit, a deep government deficit, non-existent household savings, a steep debt/GDP ratio, and a contraction in both manufacturing and service sectors according to the latest purchasing manager’s surveys out of Japan. While Europe remains our primary source of concern, I am concerned that both China and Japan are likely to have a more destabilizing impact than is widely assumed.”
And FPA’s Steven Romick:
“As bad as the United States is or seems, Japan, it can be argued, is worse. When we’re asked when America’s problems will catch up with it, we plead the 5th. It’s inevitable, but impossible to time. Japan, however, is far enough along that we believe its fiscal problems will start making headlines sooner rather than later (Please don’t ask us to define “soon”).
“Despite a deteriorating balance sheet over the last five years, the Japanese Yen has appreciated almost 25% versus the USD, while interest rates, as measured by the 10-year government bond, have nearly been cut in half, to 0.8%. According to a recent IMF Country Report, Japan’s worsening fiscal condition has been a trend for the past two decades, during which the net public debt has increased nearly ten-fold. The same report further states, that “Japan’s net public debt is higher than in almost all other advanced countries, and unlike in many other advanced countries, is projected to rise further. Even a relatively small increase in the sovereign risk premium would make fiscal consolidation more difficult, pose challenges to financial institutions, harm growth prospects in Japan, and could spill over to global risk premia and growth.”
“With this in mind, we have recently begun purchasing over-the-counter derivative instruments that are intended to be profitable if the Japanese Yen weakens or Japanese interest rates rise. Since we have purchased options, our losses are limited to the purchase price of these contracts and are sized accordingly. The potential payoff could be substantial and quite asymmetric if either the exchange rate or interest rates revert to historical levels or something akin to five years ago, when the Yen traded at 115 to the U.S. Dollar and the 10-year Japanese Government Bond (JGB) was 1.7%.
“Considering that we have, at best, only a vague notion of when Japan will take over the headline baton from the PIIGS, each of the instruments we purchased has a multi-year life (including one as long as ten years). That allows us to structure the trade by placing greater emphasis on the “if” part of the thesis, rather than the”when.”