Is Japan the Canary in the Coal Mine?

This article was written with Oliver Pursche, co-portfolio manager of the GMG Defensive Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

Last week’s action in the Nikkei, coupled with the increase in downside volatility of commodity currencies, might be flashing a warning sign for US and European equity markets.

After last October’s initiation of “Abenomics,” the QE-like monetary policy initiated by Japanese Prime Minister Shinzo Abe, the Nikkei (INDEXNIKKEI:NI225) has rallied some 50%. However, after pushing the Bank of Japan to raise its inflation target to 2%, the Abe plan is meeting market resistance and the faults are becoming visible.

The problem with the 2% inflation target lies with Japanese banks, which hold an enormous amount of Japanese government bonds (JGBs), and would likely come under severe capital pressures as this occurs. The thesis is that as inflation rises, interest rates will as well; this means that bond values will drop, causing balance sheet issues for the banks. Bank holdings in longer-dated government bonds, whether Japanese, US Treasury, Italian bond or otherwise, have swelled to astronomical levels and have created a significant problem for central banks; this consequently unnerves markets.

Last week’s market action in the Nikkei, coupled with the increase in downside volatility of commodity currencies, might be flashing an early warning sign for US and European equity markets. Even a relatively mild rise in interest rates could have a dramatic impact on bank and insurance company balance sheets, especially once mark-to-market rules (part of the Basel III and Simpson-Bowles reforms) come into effect in 2014. As a result of having a zero interest rate policy (ZIRP) for over a decade, regional Japanese banks and Insurance companies already mark to market, and are therefore very susceptible to a rise in interest rates.

Investors do not need to panic and should not view this as a broad market sell signal. Rather, this is a real-time case study of how equity markets react to a rising interest rate environment. Based on this, my firm will be monitoring the reaction of various market segments within the Japanese equity markets in an attempt to provide us with better insights as to how US markets may react if or when the Federal Reserve begins to exit its current easing strategy. Will small-cap value stocks, which tend to have very little debt exposure, dominate in this market cycle? Or will large-cap stocks with fortress-like balance sheets became safe havens?

History tells us that companies with stretched valuations tend to fare worst in a market decline, a cycle we are sure will repeat itself. The good news for investors is that we do not believe that there will be a meaningful shift in domestic monetary policy this year. In spite of the banter and worrying, there are no signs (unfortunately) that our economy is strong enough to continue its expansion course without help from the Fed. Moreover, Europe and Australia are still in monetary easing mode, making a turn in our policy less likely.

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