Complacency breeds a yen for yen

The financial world works in mysterious ways. Decisions by policymakers can have unintended consequences that defy what investors might reasonably expect to be their logical outcomes.

Take quantitative easing (QE). Central banks around the world have created more than $11 trillion (£7.56 trillion) in new money to counter the potentially devastating outcomes of the 2007-09 financial crisis.

The aim was to create liquidity in the global financial system, stimulate economic demand and, as a consequence, boost inflation and interest rates. But only the first of these aims has worked, and only asset prices, rather than real prices (except property) have meaningfully risen.

Why are foreign investors dumping Japanese stocks?


Some commentators have been worrying for some time that the disparities between strong asset price growth and anaemic economic and corporate profit growth can only have two outcomes.

Either asset prices deflate, or economies and profits catch up. Recent economic and corporate profitability outcomes and forecasts suggest that asset prices are getting closer to the line of fire.

Markets have been volatile over the past 18 months, with losses triggered by suggestions of an increase in interest rates in the US or collapsing energy prices, but stocks have managed to regain their poise and losses have largely been capped in the low digits.

But I am starting to see more commentaries from investment strategists and fund managers who smell more than a whiff of complacency about.

One of them is John Hussman, a US-based economist and fund manager writing on the website, who says that, based on historically reliable measures, present extreme valuations suggest that investors have 'over-adapted' to suppressed short-term interest rates.

Essentially, this means that during this long period of relatively low rates, investors hunting for yield have continued to buy riskier assets. But such periods are typically associated with the most extreme valuations.

Hussman warns that since 1926, the deepest losses in stock markets have actually occurred when short-term interest rates are relatively low and in an absence of any material hike in interest rates as the collapse unfolds.

'It's that overvaluation that really drives the subsequent losses,' he says. 'As soon as any underlying economic vulnerability is actually realised, investors quickly recognise that they've driven risk premiums too low.'

Perhaps we are approaching that point, with the US Federal Reserve holding fire on raising rates as it worries about the global implications of Brexit and the underlying durability of the US economic recovery.

Investors who share concerns about complacency in the markets need to ensure they have a decent slug of cash and lower-risk assets in their portfolios.

Two months ago I mentioned three funds that could fit the bill - the global equities fund Fundsmith Equity, the sterling corporate bond fund GAM Star Credit Opportunities £ and the mixed asset trust Capital Gearing. However it should be pointed out that none of these would be immune to a major market crash.


This month I'm suggesting a more offbeat asset class to add to the 'safe-haven' mix: Japan.

Rated Funds: Japanese Equities

On the face of it, it's a somewhat perverse suggestion. Despite massive QE stimulus over the past three years the country has failed to shrug off the economically debilitating effects of its late 1980s property and stock market bubble.

The population and the workforce is rapidly ageing due to a low birth rate and a lack of immigration (Brexiteers take note); and all those older people are preferring to save rather than spend.

The introduction of negative interest rates in February by the Bank of Japan is hitting the country's financial sector hard.

In response prime minister Shinzo Abe postponed a much-trailed rise in consumption tax to 2017 at the earliest. It all looks pretty grim and over the past year the stock market is down 19 per cent, as the chart below shows.

nikkei-performance-in-yen-and-poundsNone of which seems to be much of a 'safe haven' endorsement. But what is interesting is that the 19 per cent fall in the Nikkei 225 index, expressed in Japanese yen, translates into no change in value for a sterling investor. The strength of the yen against sterling has negated the weak stock market.

(This currency fillip also explains why one Japan-oriented investment in my Sipp - Baillie Gifford Shin Nippon - has risen by 38 per cent over the past year.)

Since the EU referendum was announced in February, sterling has been weakening against other major global currencies and is forecast to plummet by up to 20 per cent should voters opt to leave.

But even a vote to remain will not necessarily lead to a sustained sterling rebound. Within the Conservative party, hitherto clandestine infighting has erupted into open warfare, which raises the question of whether David Cameron can continue to lead the Tories.

Markets won't like that. Nor will they appreciate any statistical confirmation of fears that the UK economy has stalled since the referendum was announced in February.

Either way the risks are highly skewed to the downside for sterling, which is a sound reason for investors to increase their exposure to overseas assets, and hopefully benefit from foreign currency-enhanced gains.


Despite its own internal problems, Japan's currency looks a good bet to benefit from its safe-haven status, which will likely persist beyond the EU referendum.

The US election and the now-not-so-remote prospect of Donald Trump as president will increasingly weigh on markets; nobody seems to have much of an idea of what is really going on in China's bloated financial and real estate sectors; but more crucially traders continue to be obsessed with the price of oil (and US interest rates) as a valuation proxy for global equities, rather than traditional measures such as balance sheets, cash flow and profits.

The simplest way to sell sterling and buy yen is via an exchange-traded product (ETP). ETF Securities offers dozens of currency products, including ETFS Long JPY Short GBP (LSE: GBJP).

As the name suggests, this ETP buys yen and sells sterling, and it has gained 20 per cent in six months. A leveraged version gives three times the underlying exposure. A global bond fund could also provide a buffer against volatility.

When the economist John Maynard Keynes observed that 'the market can stay irrational for longer than you can remain solvent', he was referring to his own poorly timed currency trades.

Developed stock market valuations are certainly irrational, and some fingers have recently been burnt by betting against them staying that way. However, some overseas currency exposure - particularly to yen - should offer UK investors protection against Brexit and overvalued stock markets.

Where the US leads, the world tends to follow, so I'll give the last word on US market valuations to Hussman. Apologies if it gives you sleepless nights.

'A decline of 40 to 55 per cent would presently be required to bring prospective 10-year S&P 500 total returns into the 8-10 per cent range that has always been reached or surpassed during the completion of every other market cycle across history.'


The Japanese yen, like the Swiss franc, has safe haven status mainly because it has a decades-long record of current account surpluses. Because it consistently exports more than it imports, it is the world's largest creditor nation.

Coupled with this is the fact that the value of overseas assets held by Japan is very high - and far higher than the value of Japanese assets held by foreign investors. Statistics from the World Bank (to end 2014) show that Japan held ¥113.9 trillion (£738 billion) in net foreign assets.

In times of risk aversion or crisis some of that money, along with foreign assets held by private Japanese investors, is repatriated.

That boosts the value of the yen, which in turn is further boosted by global investors buying yen. But it also reduces valuations for export-oriented sectors of Japan's stock market.

Andrew Pitts was editor of Money Observer 1998-2015.

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