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Commodity Investing Shell Shocked
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Japan’s gravity-defying stock market rally just entered official correction territory last week, with another five percent drop, testing investors’ resolve. Since its May 22 nd peak, the Nikkei 225 stock average has fallen more than 13 percent—easily the worst performance among the world’s 94 major stock markets. The Nikkei’s plunge, coupled with a backup on government bond yields have led some to rethink their Japanese investments.

While investors debate the merits of Japan’s monetary shock and awe strategy, it seems clear that the weakness in the Nikkei over the last six trading days is Japan-centric and not indicative of broader concerns. If investors were truly concerned about slowing growth in China or the Fed taking their foot off the gas pedal of quantitative easing (QE), the S&P 500 would have sold off too.

For many, the Nikkei’s sell-off was long overdue. Japan sceptics point to the country’s deteriorating fundamentals to bolster their case. Tax revenues have been in retreat for two decades as the country has been mired in deflation, with prices falling across the board. With stagnant nominal GDP for more than 20 years and large and growing deficits, Japan’s debt-to-GDP ratio continues to grow and will surpass a stunning 245% later this year.

The excessive government debt levels, coupled with a falling working-age population leaves the country between a rock and a hard place. It costs the Japanese government 24% of revenues just to pay the interest on its debt and that's with interest rates below 1% for ten-year money. Should the country’s aging population start cashing in their government bonds, a troubling interest rate shock could set in. And if interest rates on Japanese government bonds move to a more reasonable 2.2% level, Japan would spend 80% of its revenue, just servicing the interest payments on its debt.

For years, countries in the developing world have obsessed over the threat of a widening “currency war,” where money-printing central banks in advanced countries would drive unwelcome funds into their appreciating currencies and undermine their economies’ competitiveness. Japan’s recent experience appears to be just another example of this persist worry for emerging market economies. The massive program by Japanese officials to double the monetary base has caused the yen to slump by 20% since last October, a boon for Japanese exporters.

But despite the concern over the U.S. and Japanese monetary experiments, the evidence of an escalating global currency war is scant. The Turkish lira and South African rand are in a full-blown rout with talk that the U.S. Federal Reserve might soon pull back its monetary stimulus. India and Brazil aren’t following suit with their own massive QE programs since both countries are experiencing stagnating growth and high inflation. The ECB is not likely to fire up the printing presses as even the most modest levels of inflation appear to strike terror in the hearts of ECB officials.

Brazil is faced with an ongoing slide in the real and a stubbornly high inflation rate. Despite a disappointing GDP report last week, the country’s central bank was forced to increase rates by a half-percentage point to support the currency. Yet despite those higher rates, the real opened sharply lower this past Friday, plummeting 1.6% to a new four-year low, forcing the central bank to intervene to stabilize the currency.

While the tumble in the Nikkei is concerning, the success of Abenomics will not be measured week-to-week by the returns in the stock market, but rather by its effect on the real economy. Fears of a full-blown currency war appear to be over-blown; however, Japan’s exporters are likely to gain at the expense of those in Germany, given the overlap between the two countries exports.

Given the increasing uncertainty and volatility in world stock markets, I continue to overweight U.S. equities in my global investment framework. The recent backup in the U.S. 10-year Treasuries suggests that we are in the very early stages of the “great rotation” out of bonds. In analyzing data from 1990, the S&P 500 returned 13.3% on average, during periods of rising 10-year Treasury yields, for stocks with a growing dividend stream. While rising rates and stock market volatility may present a challenge to high yield investments generally, stocks with modest payout ratios, rising dividends and defensive characteristics should be the place to be over the next few months.

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