When Around the Bend the Yen Descends...

In May of 2007, when almost everything seemed Hunky-Dory, the sober-minded BCA forecast EURJPY of >180. In a note of reply to this extrapolation of this prevailing trend into the future, I took a stab as to which side of the distribution the fat-tail might be hiding. With certainty, we now know where it was (Cass-1, BCA-Nil). Since The Reckoning began in earnest [and risk-off] pushed USDJPY below par, many have tried their hand shorting JPY. Armageddonist Kyle Bass (somewhat wrongly one might point out) forecast its demise several years ago in a lengthy piece arguing that JPY is essentially guano (my word not his though upon reflection I realize I've erred in my wordchoice as guano IS extremely valauble). And swaggering big-picture dudes talking their books at Drobny's pow-wows, have featured short JPY trades more or less continuously since 2009, with each episode leading to the formation of a nascent trend, though each subsequently ending with a head-on into the electronic herd and other mysterious flow.

JPY now sits at 76 and some bits versus USD, and circa 103 basis the European unit. This is NOT a post forecasting the imminent demise of the Yen. My hide too lies besides Friends of Drobny, reckoning that the end of Q1 was the denoument, though I still think it will pay sufficiently in the next 12mo, despite being egg-faced on the timing. But that is not the point of this post.

What I encourage you to do is put your imagination caps on for a few minutes. Not that you need them to inspect the collateral damage of a currency appreciating up towards 50% vs. the worlds other two largest units. Of course during the past two decades Japan has followed the US and Europe in hollowing its base, setting up shop first abroad in its largest market, then all over southeast asia and subsequently in China and beyond. The global manufacturing enterprises thus created can absorb some of the shock. And they do hedge their FX too, providing additional triage. But as in the mid-1990s squeeze, Japanese enterprises' product prices abroad have not moved with the currency, as manufacturers have chosen to stomach lower margins in order to retain markets, customers and volumes rather than cede them to competitors. This is one of the primary reasons trade gaps are sticky. And it is not necessarily irrational, particularly if one believes the curse of an over-valued exchange rate to be temporary.

Investors have observed the carnage and voted with their feet. Many large exporters have dived beneath their 2008 crisis-lows, plumbing price and valuation depths not seen for a deacde (or more). Their brethren that haven't sunk so low are chasing their coat-tails. It is, to use a technical term, ugly. And as usual, there is circularity since banks remain large shareholders, and despite their clean-er balance sheets (clean meaning not laden with US Housing, and peripheral Euro sovereign exposure), experience stress upon capital ratios with each new lurch down in the broader indices.

The pessimist (and the quant, and the fundamental screener) looks and sees uncompetitive enterprises, and all the red flags associated with declining sales and margin erosion. Five-year histo sales growth of MINUS 15 to 20%. Same in operating profits (or worse). Some reflects reality for zombie co's remain and continue to produce in comical Shaun Of The Dead fashion. However, under the circumstances, the numbers of these JPY-sensitives actually demonstrate some superhuman adaptive skills. They have managed (so far) to avoid being fatally torpedoed by the currency, and in the main, keeping the declines in operating profits to almost-tenable levels. Their income statements, when viewed in dollars or Euros, of course tell another picture. In this imaginary land, historical top-line growth for companies this size and breadth have been respectable - even ignoring The New Normal. One must imagine the sensitivity of their OPs to fanatasize about what lies below, though any of the brokers will share their forecasts as will the companies themselves (if you chance the latter). But a USDJPY at par would unarguably bring a polished lustre (and apparent top-line revenue growth) to what are presently tarnished in diminished local currency value translations. The circularity works through the system. Bank capital re-inflates, reducing stress, and encouraging an expansion of lending. The Government's balance sheet, too smartens as currency losses on the trillion or so of their US T-Bonds diminish and their USD coupon receipts contributes to government coffers. Worker bonuses rise, consumption edges higher and consequentially, suicides drop. Maybe even whaling might finally be abandoned!! (I exaggerate on this last point.)

Rose-tinted glasses...yes, perhaps. But the grimmest view of JPY-sensitives by investors are also seeing a distorted view of the world (Stevie Wonder's Sunglasses?!!?) since the JPY is no SGD CHF NOK SEK or CAD. It is JPY and it is, irresepctive of its levitation, Bat-Shit. The current prevailing view is one that myopically assumes the status quo remains, and makes no judgement upon where the fat-tail is NOW, and what those impacts (whenever the fat-tail shows itself) will be.

Japanese companies are already some of the cheapest in the world. Admittedly, sometimes for good reason (hostile to shareholders, poor governance, truly dismal prospects). When regressed against peers along value and growth axes, they are the cheapest, but also with the lowest growth. It is, I submit, worth more closely examining the idea that the apparent lame-duck growth (shrinkage, more accurately, in local JPY terms) has more to do with the extemes of the JPY rather than the ossification one encounters in the type of value traps enroute to ignominy. In precisely the same way fair-weather friends make themselves scarce at the first signs of trouble, or the young, beautiful gold-digger abandons her balding sugar-daddy when SEC investigation bankruptcy is on the horizon, so have investors fled from otherwise sound (and cheap!!) enterprises, in the process driving them to multiples of diminished cash-flow expectations or, even better, free cash-flow expectations that would have made Graham or Dodd or both salivate. And these enterprises are not shells of their former selves, hollowed-out by predators and asset-strippers, but companies that continue to invest robust proportions of revenues in R&D, and remain on the leading-edge of their respective markets.

It is true that many Japanese companies remain hostile to foreign investors, pay hommage to a wider constituency than that narrow-defined by shareholders, and are undoubtedly poor communicators. To their credit, their corporate GINI's would make American executive management blush; they can, and are willing and able to make longer-run ivnestment decisions that American mgmt can only dream of; and they have spent the last two decades relentlessly (and deftly) avoided being cast upon the Scylla of vaulting energy prices and the Charybdis of an elephantizing exchange rate. What doesn't kill you makes you stronger - not in the proverbial sense, but, as my youngest too-often exclaims "For Real!". One needn't recount here, after two deacdes of being squeezed vise-like, the output unit of GDP per input barrel of oil and labour which by comparison will only conjure images of profligate lard-ass Yanks driving Lincoln Continentals, and Cadillacs of the type that causes Jeremy Clarkson to spit venom and derision. Yes, maybe the Japanese don't do finance like GS or MS, nor do they do activism like Warren Lichtenstein or Nelson Peltz, having had their near-death brush with Zaitech. But then again, maybe NOT emulating US IBs and their financial shenannigans is not such a bad thing, all considered. At the corporate level, they are, at this stage, more likely to be financially STD-free, despite their less-than-salubrious past.

I find myself getting bulled-up as I write this, but THAT is not the point, nor my conclusion. The allure may merely be in relation to the rest of the trolls, who are not as far along in their metastases. The point is that when the world is driving by looking out the rear window and extrapolating the recent past ad infinitum into the future, discounting or ignoring causes, at the expense of reasonably weighing the probabilities of alternate future realities, one can ascertain on which side of the distribution the fat-tail resides. And that, to me, seems where we are at the moment. And I have put my imagination-hat on and think the visions neither far-fetched, nor even that far off.