Kyle Bass's counterargument to bullish talk on Japan...
KUDOS to those who bought Japanese stocks, writes Chris Mayer for the Daily Reckoning.
The Tokyo Stock Price Index, or Topix, is up 37% for the year and a blistering 60% since November.
It was in December that Shinzo Abe came to power in Japan. He promised easy money. And the Bank of Japan delivered by promising to double the money supply. It was like waving a red cape in front of a bull. Olé!
The idea behind this spectacular rally in the one of the world's largest stock markets is as simple as it is absurd. The impetus for the bullish charge is that printing lots of money is good for stocks.
Well, so far, it seems to be... but I wouldn't bet on it lasting long.
I was at Grant's Spring Investment Conference in Manhattan a couple of weeks ago. Mark Yusko, the CEO of Morgan Creek Capital Management, was there. He said Japanese stocks are a buy. Emphatically so. The argument was that a weaker Yen would bring profits for exporters. And that inflation (or currency devaluation) is good for stocks.
He particularly liked the financial companies in Japan. "These stocks are going to go up," he said. "It's not a question of whether they might go up, it's not a question of whether they might do well and make profits. They're going to go up..."
Kyle Bass, chief of Hayman Capital Management, was also there and presented right after Yusko. If Yusko was a guy waving a red cape in front of the bulls, Bass was a guy brandishing a sword.
Bass, if you know anything about him, was one of those who made a fortune by predicting the subprime mortgage crisis. You may also know that he's been predicting disaster in Japan for a few years now. Nonetheless, on quality of the arguments, I give the nod to Bass. He dispatched the Japan bull with a few thrusts of his sword.
The first thrust was to bring up Mexico in 1994 during the so-called Tequila Crisis. The Mexican government, much like Japan today, told the world what it was going to do. It was going to print a lot of money and devalue the peso.
"In theory," Bass said, "Mexican equities should have taken off with that 60-70% currency devaluation. But what happened? In 40 days, they dropped 70%. You lost 60-70% on the currency, plus 70% on the equity... And look at how fast it happened. It happened very, very quickly. In a month's time, things literally fell apart. You couldn't act fast enough."
The Japan bull thesis, already dealt a mortal blow, staggered... but Bass wasn't finished. Next, he took the sword to Japan's sorry fiscal condition. Japan is insolvent, he said. Everyone knows it. The only question is how long they can hold on. He walked through some back-of-the-envelope math on what this means for Japanese bonds. On reasonable assumptions, he arrived at an 83% haircut. Ouch.
The bull was bleeding now, breathing heavily. Bass kept at him...
Yusko, and others, say a weak Yen will be great for Japanese exporters. What they miss, Bass said, is that about 16% of the Japanese economy is imports. So imported goods immediately become more expensive as the Yen weakens. Exports take longer to adjust. "Your terms of trade actually worsen at first," Bass said. "I think that's going to be a shock to people who own equities." (He also used a great term I've not heard before — "macro tourists" — to derisively refer to those who buy stocks for flimsy macro reasons but have no expertise in global markets.)
The bull was nearly spent. Bass moved in to deliver the final cut...
"I think the average Japanese person will lose maybe a third or 40% of their purchasing power," he said, getting more apocalyptic as the minutes ticked away. He talked about the social risks in Japan. "You don't want to be the only man standing in a place where everyone is losing 70% of their purchasing power," he said. The crisis in Japan would destabilize the whole region, he said, and lead to social unrest. I had visions of mobs, firebombs, tear gas, spilled miso soup...
The beginning of the end is already here, Bass said. It started three Fridays ago, on April 5. Japanese bond prices began to move in odd ways not seen by any living traders. The Japanese "swaption" market, used to manage interest rate risks, blew out 50-100% overnight. "The brokers were calling us asking, 'What's going on?'
"The move that we saw that Friday was the holy crap moment," Bass said. "The mindset of investors changed, ever so slightly."
He mocked those who rely on what governments say: "I've never been in a meeting with a finance minister or prime minister where a guy says to me, 'Yeah, you know, you're absolutely right, we're screwed.' I've never been in one of those meetings. Period."
In the Q&A, attendees peppered him with questions about what the world would look like after a Japanese crackup. One Bass observation that stood out for me: "On that day, US yields go negative." If Japan implodes, it could bring a flight to the Dollar — just as in 2008. US interest rates would fall.
Continuing this line of thought, I would add that commodities, too, would get hit hard in Dollar terms. It would probably mean gold would fall in US Dollar terms, at least in the short term. Perhaps the sell-off in gold we see now is the market anticipating the day of a denouement for Japan.
Anyway, when Bass was through, our host Jim Grant ambled up to the stage to drag off the carcass of the Japan bull. Intellectually, at least, the bullish argument on Japan was dead. It can take a while for markets to catch up to a real disaster in the making, though — which was the main subject of Bass's talk, titled 'The Difficulty With the Psychology of Negative Outcome's. But it gets there eventually.