Welcome to our Unhedged newsletter! We appreciate the feedback from our readers who have been longing for a discussion on the role of loose fiscal policy in fueling inflation. Well, you’re in luck because the Bank for International Settlements (BIS), also known as the central bankers’ bank, agrees with you. In their recently published annual report, the BIS emphasized the need for higher taxes or lower spending to complement the efforts of central banks. This is a refreshing acknowledgment, but the question remains, is anyone listening? We’d love to hear your thoughts at [email protected] and [email protected].
The optimism surrounding Japanese equities, which we have been bullish on for quite some time now, seems to be contagious. Let’s recap the bull case:
1. Japan is experiencing a potential sea change in corporate governance, with pressure on companies to return cash to shareholders.
2. The country’s economic cycle is out of sync with other nations, and its economy is heating up.
3. Global investors are underweight Japan, so any outperformance could attract inflows.
4. Japan provides an interesting investment opportunity for those seeking exposure to Chinese growth without the political baggage.
5. Japan has successfully defeated deflation, and core inflation is now above 3%.
6. Warren Buffett has given his personal endorsement to the Japanese market.
However, skepticism about the Japan rally and doubts about the depth of corporate reform are spreading. Many believe that Japanese stocks have experienced a rapid rise and may be due for a correction. Technical indicators suggest the market is overextended, dampening near-term optimism.
The rally also appears disconnected from the expected benefits of corporate governance reform, as the stocks with the lowest price-to-book ratios have lagged behind. This may be due to the fact that these stocks are mainly small caps, and global fund flows tend to favor larger, more liquid stocks. So, while the rally looks stretched and uneven, it’s important to consider the long-term Japan story.
Now, let’s turn our attention to the yield curve. Unhedged firmly believes that inverted yield curves cause recessions. However, some argue that the yield curve’s predictive power is a matter of information rather than causation. They suggest that the bond market anticipates the decline in short-term rates associated with a recession and adjusts long bond prices accordingly. This informational view is based on the bond market’s ability to accurately forecast future inflation and growth.
While equity markets, credit spreads, and other indicators also consider future inflation and growth, they tend to be more noisy and less precise in their predictions compared to the Treasury market. This is because these factors have a greater impact on Treasury investors than equity investors. While we understand the reasoning behind this view, we believe that the yield curve’s track record in calling recessions is remarkable and suggests a possible causal relationship.
In summary, the yield curve’s ability to consistently predict recessions over the past half-century demonstrates the collective intelligence of the bond market. While markets can often get things wrong, the yield curve’s accuracy in this regard is much higher than usual. Therefore, we lean towards the notion that there may be a causal relationship at play, rather than attributing it to coincidences or the bond market’s superior knowledge. We welcome other possible explanations and would love to hear your thoughts.
That’s all for today’s newsletter. Thank you for reading, and we hope you found it enlightening.
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