INSIGHTS

On January 27, 2011

The Boy Who Cried Wolf

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The domestic scene continues to be dominated by the replaying of the Armageddon card that has seen quite a bit of use over the last few years. We’ve seen the death of the consumer, death of housing, death of banking, death of governments and recently, death of municipalities dominate the headlines. If this continues, we  may see the “death of death” prognostications. Each Armageddon prediction does have a kernel or two of truth in their inherent argument which must be acknowledged to truly understand the scope if the fear is actually realized. Once the scare tactic has made its path, these pronouncements often create opportunities from the panicked herd. I can’t help but be reminded of the parable about the boy who cried wolf. The fable curiously is attributed to Aesop who lived some 2500 years ago and further affirms our unbelievable ability to repeat history while in the midst of progress. The municipal warnings have some merit, but for those willing to look under the hood a bit, you may find it is more of sheep in wolf’s clothing versus the other way around.

Overnight, Standard and Poor’s downgraded Japanese sovereign debt to AA- from AA. The downgrading of Japanese sovereign debt is one that has been anticipated for some time by institutional investors and political watch dogs. However, the downgrading was justified more from a political consultant’s viewpoint versus a condemnation of their fiscal management and demographic challenges….both of which could have been cited as reasons for the downgrade.

S&P cited a “lack of coherent strategy to address these negative aspects of the country’s debt dynamics”. It also cited the inability to build cohesion since the new ruling party took over last summer. The move has sent the Yen selling off by over 1% today while bond yields have remained mostly the same. This muted impact is a direct result of 90% ownership of Japanese government bonds being held domestically. The holders of those are not a panicky bunch and are not necessarily interested in the short term swings as they have been accustomed to this situation over the last 20 years.

This creates a scenario that may actually be the catalyst for breaking the strength of the Yen and allow a bit more economic growth from a declining currency. Consider the chart pattern in the Yen over the last five months and the flag pattern (space between the two trend line arrows) that is developing.

Yen Since Last September

Source: Bloomberg. See Charts/Graphs Disclosure.

A flag pattern has traditionally denoted a breakout to either the upside or downside; in this particular case with the background political information, we see this as potential confirmation of a rally in the Yen versus the U.S. dollar.

This is important to the Japanese economy as we have noted in the past because of the reliance on exports to drive economic growth versus domestic consumption rates that are near the world’s average.

Domestic Consumption as % of GDP

Source: CIA Worldfact Book, World Bank, McKinsley Quarterly. See Charts/Graphs Disclosure.

China and the United States are Japan’s top two trading partners totaling over 35% of total exports. With a declining Yen, and our view that Japan’s top two trading partners will see good growth in their GDP, we see this as being a positive long term trend even if the initial water is a bit rocky.

As many have called for the death of Japan due to their immense challenges, there is a beacon of hope. We have long cited the challenges that have been swept under the rug in Japan. What appears to us to be challenges to their debt side may actually be a positive to their economy and equity markets. We would see any pullback in the Japanese equity markets as an opportunity to those who are not fooled by the sheep in wolf’s clothing.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.