Exchange Rate Forecast - USDJPY Fundamental Drivers, Technicals & Dervatives

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Looking Back at 2016

At the beginning of 2016, Custom Products forecast USDJPY of between ¥109.0 (2 equation model) and ¥114.4 (3 equation model) by December 31, 2016 (Compared to ¥120.2 at the beginning of 2016).  Our forecast differed from actual year-end USDJPY  ¥116.96 due to: 1) we had expected 2 quarter-point hikes from the FRB instead of only one, 2) we had expected the BOJ to cut its policy rate on deposits further from -0.1% to   -0.3% by December, 3) the Brexit shock which caused the GBP to depreciate 16.5% against the dollar lead to a ¥3.8 appreciation (3.45%) of the yen and 4) oil prices closed the year at $53/bbl  (10% higher than our forecast adding 1.35% to yen appreciation). Having said this, based on our 2 and 3 equation models; we would have expected the USDJPY to end 2016 between 106.7 and 113.4 with perfect hindsight.

Why has the Dollar Strengthened Since the US Election?

Since the US election, the yen has weakened from ¥104.5 to ¥115 (overshooting to 118.6). This is best understood in terms of

  1. Short-term rates,
  2. Growth expectations, and
  3. Inflation expectations.

Clearly the path for US rates has been ratcheted up since the US election. This has come from higher long-term growth expectations and increased inflation expectations from oil and a tighter labour market, lifting US real rates vis-à-vis Japan. US-Japan 10-yr yield spread, which was recovering from a September low of 1.55%, rose from 1.85% on November 7 to 2.35% by January 24. Interestingly, Japan 5-yr forward inflation expectations (FWISJ55) have risen from 0.11% to 0.62%, greater than the US increase from 2.22% to 2.55%, making the Japanese yen less attractive with increasing negative real interest rates. Similarly US 2-yr treasury rates have nudged up from .82% to 1.15% while Japanese rates have held flat at -0.24%. Finally, the 10-yr ‘real’ interest rate differential has widened from 0.32% to 0.62%.

Net-net, Custom Products would have expected a ¥7.4 depreciation from the pre-election rate of ¥104.5 from inflation-expectation adjusted short-term yields, a Y2.8 depreciation based on the real long-term yield differential and a depreciation to ¥118.1 based on the relative money supply growth (otherwise known as the Soros Chart). Each equation has been weighted by the R2 bringing our current fair value USDJPY estimate to ¥112.65 (Chart 1 dark blue line).

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Central Bank Policy…2017 Outlook: Fed Still Behind the Curve

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By some measures, the Fed has been behind the curve since mid-2014, in not gradually raising its policy rate.1 Granted the Fed chose to delay initiating its hikes until unemployment fell below its 5% target in Q42015, while maintaining concerns over historically low core inflation. Despite a second quarter-point hike now after a one year pause, the Fed finds itself even further behind the curve than at this time last year. Even under an accommodative rules-based policy rate, December’s rate should be closer to 2-2 1/4 and not 0.75%. As it stands, real policy rates (minus core inflation) are -1%, when full employment and 2% GDP growth would imply a 0.6% neutral real rate as a minimum. If real GDP growth continues above 2.5% as Q4 is trending, then the neutral rate would approach 1%, still significantly below the 2.1% neutral rate average in the 20-yr period up until the GFC.

We think that neutral Fed real rates (FF rate minus PCE deflator) should hover between 0.6% and 1.2% (1stdev of 15 year trend where natural rate r =1.3x g and g has fallen 0.5% over last 10 years) over the next few years. If core inflation creeps up to 2.0% over the next year, from 1.65% now, then the Taylor-rule FF rate target would rise to 2.50%. In addition, CPI is likely to reach 2.3% next year from 1.7% currently, with crude oil alone adding 40bps at current prices. As CPI exceeds core inflation, neutral real rates would likely increase from 0.6% to 1.2% bringing the target FF rate to 3.1% by December 2018. Clearly the risk is on the upside!

Though long-term real rates were negative as recently as Q3CY16, they are now 80bps and should reach 110bps by the end of 2017.2 Should the CPI exceed core inflation by more than 50bps, then we expect term premia to rise from 22 bps now to 100bps+, pushing 10 year treasuries to as high as 4.2% by the end of 2018 (see Chart p.12). In fact, ‘Greenspan’s conundrum’ could very easily end up becoming ‘Yellen’s conundrum’ (if reappointed to a second term), as the market, being significantly ahead of the fed would likely push 10 yr yields to 4% long before the fed finishes ratcheting up its hike path through 2019, ending the current recovery.

Finally, if the Fed drains off $2trn in excess liquidity over the next 4 years (contrary to its current stated intention), real long term rates could rise an additional 60-120bps. However, attractive swap rates (Chart 6) should ensure that overseas demand limits the rise, while demographics will continue to favour strong demand.


  • The Fed has been leading the central banks’ rate cut race to the bottom and must begin to redress policy rate misalignment (Charts 12, 14)
  • Confusing and contradictory FOMC guidance may call for implementation of rules-based policy rates (p.10)
  • Inflation is likely to pick up faster than current Fed path indicates, leading to a ratcheting up in rate hike forecasts. Expect four quarter-point hikes in 2017 and 2018 (Charts 8, 9)
  • The Fed is likely to see significant intervention from Congress should it not begin draining excess liquidity over the next four years (p.3)
  • Though real long-term rates and term premia should rise over the next few years, demographics and overseas demand to limit the slope (Chart 7)
  • Chair Yellen’s allusions to a return to Greenspan’s ‘high pressure economy’ are misplaced (p.20)
  • Policy rates are like lighter fluid or kindle for a fire; they will help start the fire but this does not provide long-term growth. If anything, excessively low short-term rates
    encourage business to increase leverage and thus volatility as ROA peaks (Chart 15).

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Frightened Children - Analysts clinging onto the Mother of Guidance

“A mother understands what a child does not say” – Jewish proverb

 We looked at the growing consensus hugging nature of analysts in Japan who increasingly base their forecasts on a +/-5% range within company guidance.

Fig.1 below shows how the trend has climbed in the past 3 years. Whether one blames compliance or a lack of capability, consensus hugging now pervades over 50% of analysts from around 35% prior to 2013.

Fig.1 : % of Companies with Consensus Estimates less than +/-5% from company Guidance

The study gets worse when we look at it by sector. Since Lehman Shock, 75% of financial analysts in aggregate are within 5% of company guidance from 35% in late 2008. Unsurprisingly after the immediate crash, most analysts were way out of line with company guidance. 

When we broadened the study to +/-10% of guidance, nearly 70% of analysts are holding within that range. Has the hollowing out on the sell-side of more experienced analysts caused the trend? Naturally, the compression of commissions has forced many firms to cut overhead and the trend toward less experienced analysts has grown.

Fig. 11 % of All stocks estimates +/10% of company guidance

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The Public Pension Black Hole - Sucked in the vortex of an undiscovered universe

“It’s not what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so!” – Mark Twain

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The beauty of pension accounting is that slight tweaks can make a large unfunded liability seemingly disappear or at the very least shrink it to “she’ll be alright mate” levels. However if a pension fund plays the game of understating its risks for long enough then eventually it catches up, especially if performance is consistently poor. This is what we are starting to see in vivid colour among state and local (S&L) governments in America. Reality is biting. Let’s jump right in.

California Dreaming

To put this in perspective the California Public Employee Retirement System (CalPERS) lost around 2% of its funds in 2015/16. The fund assumes an aggressive 7.5% return. Dr. Joe Nation of Stanford Institute for Economic Policy Research thinks unfunded liabilities have surged to $150bn from $93bn in the last two years. Furthermore suggesting the use of a more realistic 4% rate of return. CalPERS has an unfunded liability of $412bn (or the equivalent of 3 years’ worth of state revenue).  California collects $138bn in taxes annually in a $2.3 trillion economy (around the size of Italy). With over-inflated asset markets and increasingly negative returns on highly rated paper, the growth in unfunded liabilities is even more concerning as any market correction (likely to be severe given such blatant manipulation to date). If the correction is huge it will push the unfunded portion to even more dizzying levels.

US Pension Tracker (USPT) defines its methodology to assess the true mark-to-market value of unfunded liabilities versus actuarial assumptions.

“[We] reflect market pension debt using a discount rate equal to 20-year Treasury yields rounded to the nearest one-quarter percentage point. The yield in 2014 was 3.00%. The use of this discount rate here is intended, as most financial economists agree, to more closely represent market realities and system liabilities.”

USPT assumes that public pension funds have a market based unfunded pension deficit of $4.833 trillion. The actuarial base (using a discount rate of 7.5%) of the pension deficit is approximately $1.041 trillion. This assumes an unfunded portion of $3.8 trillion. Using the 2016 20-year US Treasury bond yield of 1.71% the market based pension deficit explodes to over $8.8 trillion or a $7.5 trillion unfunded portion equating to around $74,000 per American household. For California alone this would push the pension debt per person above $135,000.

This study is a mere snapshot of the state of public pensions in the US. Once again we have a festering problem that is turning gangrenous yet not enough attention is being focused on solutions. The over reliance on authorities to get us out of this economic mess is concerning. Perhaps there is a wish that helicopter money (as B-52 might be more appropriate) will somehow kick off inflation and cut back into these unfunded liabilities. However, we should be careful what we wish for. The risk of duration on the negative yielding debt would wipe out large portions of pension assets making the journey highly challenging not to mention any hyper-inflation risks would reduce the purchasing power of any retirees who got paid their promised distributions. Quite simply there is no easy way out of this and whatever solution is found will involve pain. For all the kicking and screaming in the world, the problem has festered over the past decade and many administrators have chosen not to do anything serious about it. Brace yourselves.

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Methamphetamine Price, Purity & Economic Downturns - Drug pushers are economically rational

Methamphetamine prices and purity and the correlation to markets 

The US Justice Department (DoJ) and the Drug Enforcement Agency’s (DEA) latest report on the trends of methamphetamine prices and purity on the samples they buy from dealers shows some strong correlation. In the last 20 years, methamphetamine prices (US$/gram) have shown a 91% R-squared correlation (i.e. very high) to purity. 

Looking at Fig.1 we can see that the tech bubble collapse in 2000 and 2008 saw purity levels rise consistently several years before the crisis set in and the trend continues for a further 5-6 years. The latest data would suggest that the purity is heading back up, usually a sign that the economy is about to take a 'hit'.

While illicit drugs are no laughing matter there is a silver lining. Medicinova (4875 JP) is well advanced on a cure for drug addiction and is currently being funded by the US National Institute of Health to accelerate the commercialisation. The FDA is also fast tracking its approval.

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Yearning for Yield

The ‘yield’ plays are in the sectors vulnerable to downturn

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Brexit Schmexit. In the uncertain TINA (There Is No Alternative) world we find ourselves, traditional strategies looking for dividend yield security no longer carries the prudence moniker of years past. Especially as the sectors where you would expect to find a healthy cheque aren’t attractive anymore. Transports and pharmaceuticals are traditionally viewed as safe havens. However when Japan Airlines (9201) carries twice the yield of the JRs and the mainline drug companies float in the 2% range you tend to get the idea that these stocks are either fully priced or representative of market uncertainty. Even telecoms are in the mid 2% range. Japanese banks, brokers and auto companies are returning c.4~5%. The traditional defensives may still find a bit more relative gas in them before the market can’t stomach the levels.

Fig.1 highlights US unemployed persons. As America’s population has grown over the decades, naturally the number of unemployed even on a relatively steady state has climbed. What is striking is not so much that unemployment rises when the economy takes a hit but the 66 year linear pattern. We are approaching yet another inflection point and it corroborates the ‘Dire Straits for Central Bankers’ report of June 17th, 2016.

We analyse the relative unattractiveness of yield plays in Japan and conclude that while defensives might still have some gas left in the tank, there are few alternatives where one can really hide in the cyclicals world. Even looking at net cash and equity ratios TINA is not attractive in many cases.

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Dire Straits for central bankers - Money for nothing brothers in arms are out of ammunition

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Executive Summary

Better to sit down. We will be entering some pretty bleak conclusions in this report. The world’s central banks have hit stall speed. They have lost control and do not have enough altitude to recover. How bad can things get? There are two things at play here. One is economic (explicitly monetary) policy. The other is social reality (explicitly hardship). Both have become dysfunctional. Reckless central bank monetary expansion sold behind the banner of ‘nothing to see here’ has backfired. Money velocity (or the power of money) across the globe is plummeting to record lows. While the GFC was easily avoidable the post disaster mop up operation consists of printing our way out of the disastrous debt pile by inflating it away. Even negative interest rates leave inflation well below targets. Deflation still prevails. Poverty and post-GFC destitution has reached boiling point. When people feel robbed of their identity and increasingly their democracy we should not be surprised to see the rise of nationalism and non mainstream candidates and sadly violence, especially in Europe. This social disruption should not be ignored because the experimental financial engineering that was supposed to wiggle us from the bondage of moral hazard has had the complete opposite effect.

Here are 7 things to ponder;

  1. A recent US Federal Reserve survey found that 47% of Americans couldn’t raise $400 in emergency cash were the need to arise. 5% unemployment rate belies financial difficulties.
  2. A bank survey in Australia showed 50% of people wouldn’t be able to meet their financial obligations if unemployed for more than 3 months. Housing price to income ratio almost twice the level pre-GFC. Private debt: GDP ratio at 160%.Credit rating downgrade imminent.
  3. c.60% of ETF purchases in Japan and c. 100% of sovereign bond purchases are bought by the Bank of Japan which now owns 38% of outstanding government debt. 15 year Japanese government bonds now yield -0.004%. Japan’s move to negative rates  has caused a run on sales of mini-vaults as people look to store their own cash.
  4. M2/M3 money velocity has hit all time lows in the US, ECB, Australia, China & Japan.
  5. Italian banks non performing loans (NPLs) are approaching 20% and as high as 50% in the south of the country. The ECB is breaching their own covenants to hide the mess. Belgian Optima Bank has just been shut down for not being able to meet obligations. Many more?
  6. Over 25% of those in the EU live below the poverty line and youth unemployment is c.25% with long term unemployment now 50%. In Greece those numbers are 36%, 58% and 72%.
  7. China’s industrial sector among others shows clear signs of recording sales without much hope of being paid with receivables ballooning in some cases leaping to over 5 years of reported revenue pointing to a sharp uptick in corporate debt insolvency & NPLs to follow

I wish I could be optimistic about the future but I’m afraid there isn’t anything that shows much promise.

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Brexit: In and You’re Out, Out and You’re In

“There is one thing that you British will never understand: an idea. And there is one thing you are supremely good at grasping: a hard fact. We will have to make Europe without you –but then you will have to come in, on our terms”

Jean Monet, founding father of European Union (quoted in 1961)

As the Brexit Referendum Campaign draws to a close, Custom Products decided to present an analysis of some of the main themes in as a dispassionate but not disinterested way as possible. We have tried to examine the main reasons for ‘leaving’ and ‘remaining’, save the jingoism and hyperbole that has marked both campaigns.

Though we do not attempt to advocate either ‘leave’ or ‘remain’; it is rather evident, from a financial standpoint, that a vote for ‘Brexit’ would have long-lasting negative repercussions for UK incomes. It would also result in lower growth implying lower social mobility and possible higher public spending and taxes to bridge the gap. The title of our report, ‘Brexit: In and You’re Out, Out and You’re in’, however, reflects the reality that in this not a dry, cerebral issue, but rather an emotionally charged question.  As a disinterested third-party observer, one would likely examine the balance of evidence and say, “No the British populace has not always been duped by Delors, no the EU is not necessarily as undemocratic as the Eurosceptics would have you believe, and ‘yes’ the financial costs of leaving are not negligible”. In other words, if one was residing ‘outside’ of the UK, it would be easier to vote to stay ‘in’ based on a cost/benefit assessment devoid of nostalgia and emotion.

However, as recent polls have shown, ‘leavers’ are only half as likely as the ‘remain’ voters to be swayed by financial arguments, with words like ‘sovereignty’, ‘democracy’ and ‘immigration’ striking an emotional chord. This has successfully tapped in to the well of dissatisfaction ‘inside’ the UK. ‘Leavers’ can honestly claim, that Churchill was not a staunch advocate of a ‘United States of Europe’ but rather a pragmatist who saw Britain’s future ‘with Europe but not of it’, and even possibly more with the US. The ‘Leavers’ are also right to point out that, in some respects, they were duped in 1973 and then 1975, when both Heath and later Wilson sold the British people, what Helmut Schmidt called ‘cosmetic adjustments’, that disguised the fact that the 1972 UK Treaty of Accession to the EU was far more than a ‘Common Market’. As Mr. Heath put it, the agreement ‘will not threaten national sovereignty, but get us going again’. However, the treaty did in fact subjugate the UK parliaments and subordinate UK courts.

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FY2016 Earnings Summary and Company Specific Factors

Aggregate Earnings Summary
In this report we breakdown the just finished Earning Season by each sector and look at the new aggregate guidance for FY3/17. However, we are using two of our products that some of you may not be familiar with. So we want to give a brief explanation about them.

Specific Company Factor Analysis
Instead of looking across a universe of Companies to find which factor drive that universe, we use a time series for a specific company to see which factor drives that company. For example, if PBR is high, does the company underperform or does it not matter. Toho Gas is a great example. As you see in the chart below, PBR has a 29% IC, which means that when PBR is low, price rebounds, and when it is high it tends underperform.

Portfolio Analyser
The Portfolio Analyser breaks down the exposure to all the different factors. For this report we are using it to understand attributes of the different sectors. However, the main use is to verify that you have the desired exposures in your portfolio and do not have any unwanted exposures. For example you may have a Value strategy, but in fact the portfolio is more geared to growth. As an example, we screened for names with high Sales Growth and Low PBR. As you can see, this mock-portfolio has huge exposure to Sales yield growth and Book Yield. Happy to discuss the calculations, but this report is not the place to go into detail.

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Pinocchio Motors - Imagine if the sell-side had to recall every over-optimistic forecast

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It is clear that a 40% fall looks like the industry standard knee jerk reaction. Ford (F US) and Bridgestone (5108) shares reacted negatively to the Ford Explorer/Firestone rollover/tyre burst cases of 2000. 260 odd people died in the US. At the time many analysts tried to downplay the litigation aspect and consequent impact to Bridgestone. It was so under baked as to be unreal. The US loves a good class action and the shares took a while to take a beating. Ford also marked time in the initial phases until the matter became clearer. Takata (7312) has remained under pressure for its wilful misguidance of its customers. In Ford, Bridgestone & Takata’s case, lives were put at risk. For VW & MMC, this is not the case. However punishments seem to be over-inflated.

Here we go again. The story starved media gets its hooks into a has-been car maker with a mediocre presence and spinning it into the potential for multi-billion dollar fines. Mitsubishi Motors Corporation (MMC) admitted the falsification of fuel economy records. It is never good that a corporate admits to telling porky pies. To April 25, MMC has shed nearly ¥370bn from its market cap since the scandal broke.

In MMC’s defence, quoted fuel economy stats in any automakers brochures are always overly optimistic. The officially sanctioned tests are run on smooth tarmac in ideal conditions. So inflating already inflated numbers in the real world effectively makes no difference. However is this form of advertising any different to the Flab-blaster 1000 helping you lose belly fat or a shampoo that will make your hair silky smooth? Should research analysts be held accountable for every single earnings mistake found to be made through a lack of rigour and due process? One might even argue that in the dating game, interested parties inflate their qualities to such a degree that should the other party fall for it they could be sold goods that might not live up to expectations.

Class actions in Japan will be promulgated in December 2016. There are no cases now. The Consumer Court Special Procedure Act (“The Act”) will only allow qualified consumer organisations (not consumers) to sue against businesses. In many cases such consumer bodies have limited financial resources. Under the current Act certified (by the Prime Minister no less) consumer organisations can file for injunctive relief not damages. From the end of that year it might change but since 2007, 15 lawsuits for injunctive relief have been filed. Interestingly, the 2007 law says that consumer associations must notify any offender corporations to provide a window to fix the problem before engaging in any legal action. 

As it is the Japanese domestic market that is under fire we can only suspect the MMC fine will be paltry compared to the 500,000 car buyback that VW is embarking upon. Let us not forget that one can be an insider trader in Japan and pay a fine of only $700. Pretty light on.

Nissan will expect to be compensated somehow but if the production arrangements via MMC are viewed as long term beneficial to Nissan then perhaps MMC will be forced to accept even tougher terms on outsourced production in place of a fine. The juxtaposition of MMC is simple. Accept slimmer margins on future outsourced production or risk having to close plants and face the prospect of further restructuring. It is unlikely the government wants to see another round of layoffs. MMC employs around 30,000.  Nissan can choose to bury MMC if it so chooses and indeed if it has the will to go to Osamu Suzuki and ask for similar terms which are probably unlikely it could but I suspect it won’t.

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