BIAS Investments believes we are going through times when central banks are carrying the ball and politics matter. Investment opportunities exist among others in Japan, a country that is actively pursuing the devaluation of its currency.
At the latest quarterly market briefing by Bermuda Investment Advisory Services, BIAS CEO Robert Pires by his own admission “paddled back”, at least in part, on statements he made in the past that politics does not matter.
He maintained that it does not make a difference whether the Republicans or Democrats are elected in the US, because counter-intuitively the low tax and low spending agenda of the Republicans has historically not had a more positive effect on the financial markets.
But in certain circumstances it does matter, particularly when, as now, many governments have overspent, Pires said, speaking at a presentation that explained the context in which financial markets have to operate in 2013.
The gridlock in the US for instance means that no legislation can get passed. As a result of the inability to agree spending cuts or tax increases between both Houses and between Republicans and Democrats, a wave of automatic defence and domestic spending cuts, known as the sequester, took effect on 1 March.
The US has already seen the expiration of the Bush tax cuts, as well as the end of a 2 per cent break on payroll tax, which results in a $50 billion and $110 billion drag on the economy respectively. In addition to that come the costs of ObamaCare of about $20 billion, Pires said.
“The total drag on GDP of this sequestration is expected to be about $250 billion or 1.5 per cent.”
Pires also highlighted several economic initiatives in the US designed to help the economy grow despite the sequestration prospects. In his state of the union address President Obama mentioned the establishment of a Manufacturing Innovation Institute, intended to conduct research to innovate manufacturing and make it more competitive.
The US president also referred to an Energy Security Trust that would move cars and trucks off fossil fuels within in the next 10 years, as well as federal support to cut energy waste in homes and businesses in half over the next 20 years.
Moreover the Obama administration has called for a ‘fix it first programme’, that will put spending into the economy. “There are apparently about 7,000 bridges that need to be repaired in the US. And so this initiative is to repair ageing infrastructure, roads, bridges etc,” Pires noted.
Central bank carrying the ball
Like the central banks in Europe and Japan, the US Federal Reserve is doing much of the heavy lifting to get the economy going, said Mark Melvin, director with BIAS in Cayman. The Fed has for the first time set an absolute target for unemployment and inflation, stating that interest rates are going to remain low until unemployment falls to 6.5 per cent.
“That is expected to be in 2014 or 2015, so short-term rates are not going anywhere soon,” Melvin said.
“But as soon as the unemployment rate heads towards 6.5 per cent you will start seeing a rise in treasury rates.”
With an inflation target of 2.5 per cent, inflation remains comfortable at around 2 per cent, he added.
The Fed is pursuing these objectives with another round of quantitative easing, by buying every month $45 billion of longer dated T-bonds and $40 billion of mortgage backed securities, with the aim of keeping long-term interest rates depressed to boost the economy.
In the EU the European Central Bank has pumped €1.16 trillion into the central banking system. The ECB mandate is more narrowly focused on keeping inflation in check, so the initiatives in Europe are geared towards the liquidity of the banking system, Melvin said.
The ECB has created a Securities Market Programme, Outright Monetary Transactions and Long Term Refinancing Operations to achieve this objective. The LTRO, a programme by which banks can borrow money from the ECB at very low interest rates, provided they invest it, is now starting to wind down with banks repaying their obligations.
“In the UK the Bank of England is in perpetual QE it seems to me,” Melvin said, having paid £375 billion towards gilt purchases since 2009. Given that the UK economy is not showing signs of strength, the programme is likely to continue for some time under the new BoE governor Mark Carney, he added.
“The biggest news is that with the change of government has come a new change of policy by the Bank of Japan, which has instituted open-ended quantitative easing.”
With the measure Japan is trying to depress the value of the yen to make Japanese export products cheaper and more competitive.
The Bank of Japan is spending the equivalent of $106 billion on Japanese government bond purchases for as long as necessary. “This is a massive amount of money,” Melvin said and the yen has already depreciated quite sharply against the dollar.
While Japan is the only country that openly admits to attempting to devalue its currency, its policy is not different from that of the US or the ECB.
The competitive devaluation of one’s currency against those of major trading partners has many trade-related benefits in terms of cheaper production and export of national goods, improved employment, an improved trade balance and the ability to pay of national debt with cheaper currency.
Likewise the devaluation represents a tax on foreign goods making them more expensive than local products. This can ultimately lead to the erection of protective barriers by trading partners to protect pricing.
Moreover investors tend to prefer stronger currencies.
But all this has not resulted in a race to the bottom, nor are investors shunning Japan, said Melvin.
“Japan may have lit a fuse by explicitly stating that they want to weaken the yen, [while] the US, the UK and the ECB are doing it in a closet manner.”
After 20 years of depression, deflation and its decline as the pre-eminent exporting nation in Asia, Japan has decided to take advantage of a clear political mandate for Prime Minister Shinzo Abe to change its monetary policy. With the previous Bank of Japan governor resigning and three of the four members retiring Abe is in a powerful position to select members that follow a different agenda.
In all these years they were wrong, said Pires, and they now realised that they do need to follow the monetary policies that the US, the UK and the EU were employing to weaken their currencies and improving their competitive positions.
“Politics can drive economic direction, particularly if the party in charge has 61 per cent of the seats in the House of Representatives,” he added.
Abe has since he has been elected directed the BoJ to raise the inflation target to 2 per cent from 1 per cent. Pires said, “Inflation is not something that you are worried about when the global economy is contracting”.
BIAS has decided to overweight Japanese stock in its investment portfolio for the first time for a number of reasons. First Japan still is the third largest economy in the world, which leads to interesting opportunities during an economic turnaround. Japanese stocks also reduce risk in a portfolio because they are not correlated to the S&P 500 and other stock markets, performing in line only 30 per cent of the time, Pires said.
Another reason is that Japanese equities are cheap. 25 per cent of Japanese companies trade at multiples of less than 10 times earnings versus just 4 per cent in the US. So while there is currency risk, there is real opportunity, BIAS noted.