China’s Transitory Rare Earth Element (REE) Monopoly

Now that QE2 being announced at the next FOMC meeting is a given, we see potential for short-term position covering in short USD positions and profit-taking in surging emerging as well as commodity markets. While this is happening, JPY could pull back from 15-year highs and give Japanese equities some breathing room for a relief rally. However, a run back above 11,000 on the Nikkei by next February may be too much to expect, as we just don’t see any sustainable reversal in the race to the bottom for US treasury yields as well as the great shrinkage in US-Japan long bond yields that would support a sustained rally in Japanese equities. Consequently, the trade is buy more emerging market equities and commodities on this possible pullback, and take profits as Japan equities stage a brief relative performance rebound.

The sharp curtailment of rare earth elements (REE) by China has highlighted just how dependent technology-intensive western nations are on what is still a relatively tiny basic materials market of only around $1.2 billion. Be it for environmental considerations as China claims or the desire to save these materials for its own consumption, China’s sharp cutbacks in exports of rare earth elements has market prices of these materials soaring. The faster market prices rise, the sooner China loses is current monopoly on supply, as there is no shortage of potential supply of these “rare”elements.

The two names most mentioned as REE plays are Molycorp Minerals（MCP）, owner of the Mountain Pass mine in the U.S. and Lynas Corp. (LYSCF.PK), owner of the Mount Weld mine in Australia, which combined can supply 25%‾30% of global supply when fully operational. Investors however need to be aware that both stocks have tripled in price since June‾July of this year on the news that China has substantially cut back REE exports, while operations are still deeply in the red. As other REE plays essentially have no product to sell as yet and may not for many years, we view such stocks as speculative plays with little fundamental support at present. In Japan Showa Denko (4004) and Hitachi Chemical (4217) are key suppliers of ceria surry, but this business is too small to dramatically turn around total revenues or earnings even if prices of REE materials are jacked up as much as 300%. Consequently, stock prices have followed the general market for Japanese equities, i.e., steadily waffling lower since April 2010 highs.

Japanese Banks: High Inherent Risk from Bond Market Volatility

As US and European banking majors were sinking under the weight of on and off-balance sheet toxic assets from the US sub-prime debacle, Japan's megabanks found themselves in the glow of unaccustomed financial health. Ostensibly, Japan's major banks survived the crisis and are generally believed to have restructured their businesses. Yet the stock prices of Japan's big three megabanks continue to tank, in an ongoing bear market that has continued since Japan's excess credit bubble burst in 1990, and aggregate market cap of the big three megabanks is even lower than it was 13 years ago at the depth of the crisis.

Simply put, Japan's banking sector has destroyed trillions of yen of shareholder capital. In November 2007, the combined market cap of the big three was about JPY22 trillion, compared to the combined market value of nine predecessor banks of the three financial groups that totaled JPY27 trillion at the end of December 1997. Further, the recent market capitalization of the three megabanks is JPY11.2 trillion, which represents a total JPY16 trillion or so of destroyed shareholder value since December 1997.

Granted, stock prices of the big three have not gone straight down. As NPLs bottomed and the government stepped in to nationalize Resona Holdings in 2003, the big three megabanks staged a powerful rally. From a combined market capitalization of JPY4.7 trillion in April 2003 to a JPY39.7 trillion high in March 2006, the market capitalization of the big three surged 8.4-fold as Japan's economy staged a recovery and interest rates began to normalize. However, it has been downhill since, with total market capitalization shrinking back to JPY10.3 trillion and stock prices peaking well before the stock market as a whole peaked in mid-2007.

In addition to a shrinking profit base, megabank stock prices have been heavily weighed down by cross-holding unwinding as banks reduce their stock holdings and corporates reciprocate, and repeated "beggar-thy-neighbor" capital calls of between JPY500 and JPY800 to bring regulatory capital up to the levels required by the new Basel Accord. Until a recovery along the lines of that seen in 2004~2006 is apparent, we see minimal upside potential in the major bank stocks.

In their October global financial stability report, the IMF noted significant inherent risks to Japanese banks from a "shock" to the Japanese government bond (JGB) market that causes a spike in JGB yields. Japanese banks remain undercapitalized compared to their global competitors as equity investments are still 75% of tangible common equity for the money center banks, profitability is weak because of the BOJ's QE and net interest margins on loans are at ultralow levels.

Such a spike actually happened in June 2003, when a sharp rise in bond market volatility sparked by investor realization that Japan's banking crisis was under control and the economy was recovering caused banks to re-adjust their assumed risk in their Value at Risk (VaR) models that led them to temporarily dump JGBs, causing JGB yields to surge from an historical low 0.45% to 1.6% in just three months. The bank regulators have been running internal risk scenarios for the regional banks suggesting that such a move would cause bond losses in the trillions of yen for the banks.

A Deflation-Resistant Stock: Is There Such an Animal?

As the US recovery sputtered, the Fed first cut its forecast for growth and inflation, then Ben Bernnake told us the macro outlook was “unusually uncertain”, and now the Fed has reversed the course set in place to wind down a balance sheet already triple its normal size at $2.3 trillion; trumping the inflation scenario and sending investors scurrying into the deflation camp and fleeing “risk on” trades. Hattip to the deflationists. One could point out that deflationists have not had their prediction (i.e., real deflation) come true for the last 50 years, but rather than fight the tape (and the Fed), now-contrarian inflationists will just have to go with the flow for now i.e., reduce equity and commodity exposure and go long VIX volatility, bonds, gold and cash while waiting for the next turning point. With the S&P 500 failing to hold its 200-day moving average and now testing its 50-day moving average, we’ll have to see if support at 1,060, 1,010 or 900 holds.

For Japan, this means strong momentum for new highs on JPY/USD below JPY/USD80 despite an increasingly expected response by the Japanese government, and downside on the Nikkei 225 of about 11% to the 8,000 level i.e., the opposite of our “next 15 minutes of fame” scenario in which Japanese equities stage a meaningful rally. With Japanese JGB yields having historically been as low as 0.44% and JPY/USD still pushing historical highs, both foreign and domestic investors are likely to keep money parked in JGBs until the deflation hysteria passes. Our point remains however that once JPY/USD peaks, it won’t stay there long. When JPY peaked at JPY79/USD in 1995, it almost immediately began falling, and crashed to the JPY/USD140 level by 1998.

Investors now steeped in deflation psychology are beginning to look to Japan for guidance on what stocks could hold up during a major bout of deflation. We have identified 47 Nikkei 225-constituent stocks that have dramatically out-performed both the MSCI USA and EAFE indices since Q3 1998 during Japan’s deflation. Further paring this down by selecting those that, a) dramatically outperformed the US and EAFE indices, b) have ROCE (returns on capital employed) of over 8% and c) have lower (under 13X) EV/EBITDA ratios, gives us a compact list of 11 stocks that should continue to do well under Japan’s ongoing deflation.

Who Wants to Bet Again on a Cyclical Turn in JPY?

In November 2009, foreign investors had essentially given up on Japan as a hopeless basket case and JPY was peaking. Around that time, we began suggesting that Japanese stocks had a fighting chance for a decent rally in early 2010, predicated on a weakening trend in JPY to and below JPY100/USD. This “decent rally” lasted until April, when investors got a case of “double dip” and began again to take risk off the table, thereby sending JPY back toward historical highs.

Basically, the strong JPY is only adding salt to the wounds of Japanese equities. If growing concerns of a double dip in the US and slowing growth in Euroland and more importantly China weren’t enough, JPY surging back to JPY85/USD was well beyond what exporters had been assuming in their FY2010 budgets, meaning forex losses on top of the feared weakening export volumes. The strong JPY has been an albatross around the Japanese market’s neck since JPY was trading weaker than JPY120/USD in June 2007, and nearly JPY170/EUR in July 2007. Since then, JPY has surged 42% versus USD and nearly 50% versus EUR. That is a massive swing that even aggressive fiscal stimulus, let alone the anemic countermeasures implemented so far in Japan, could offset.

With JPY now again pushing the JPY85/USD, we are approaching the next fork in the road, i.e, when JPY will again peak out. Since the Nikkei 225 has a high negative correlation of 0.61 vis-à-vis JPY, cyclical peaks in JPY are an ideal time to establish medium-term (i.e., 6 months or so) trading positions in the export sectors, i.e., precisions, electronics and automobiles, as stock prices in these sectors discount currency movements real time. While the turn is contingent on a more relaxed attitude toward global growth and rising, not falling US bond yields, Japanese stocks will again have their brief 15 minutes of fame and outperform their global peers during the next JPY weakening phase. Meanwhile, the market forward P/E multiple is back to 2008 lows, or around 16X.

Conversely, the Nikkei 225 has an even higher positive correlation with JGB yields (0.74), meaning that any new down-leg in JGB yields (ostensibly on more serious concerns about the economic recovery) should be taken as a warning that stocks are also headed for another down-leg, sending investors into an even deeper “risk off” mode.

Strong Yen is Bad News for Japan Stocks

The financial market commentary recently sounds more like a commercial for Baskin Robbins, i.e., “ double dip!, double dip!”, and equity indices are now fighting historical odds in being able to show positive returns for 2010, while bond returns are outperforming stock gains by the widest margin in nine years as investors scramble to preserve capital from a double dip recession. In our view, however, the risk of a significant selloff from here is limited, despite further growing evidence of a slowdown.

What businesses and investors dislike most about the Euro sovereign issue, China’s tightening, the talk of a double dip, etc. is uncertainty. Take away the uncertainty, and stock prices react positively. A good example is British Petroleum (BP); cap the well, cap the uncertainty, and the stock soars. Another example is Goldman Sachs (GS).

Since China’s Shanghai Composite has taken the biggest hit this year (down 24% YTD), it could be an interesting contrarian play for the next 6‾12 months given the high growth potential China continues to offer. Since China is so important to the supply-demand balance for commodities like crude oil and copper, rallies here are also keyed to what happens with China stocks. Meanwhile, other Asian economies are doing quite well, thank you as are their stock markets, so much so that to a man they are having to tighten monetary policy to get ahead of inflationary tendencies.

On the other hand, while Japan’s Nikkei 225 has declined less than other major markets in 2010, this is merely because it lagged the 2009 equity rally so severely. Declining JGB yields are pointing to downside risk in Japanese stocks. The IMF has warned Japan that it needs to get its fiscal house in order. So what? It’s not as if Japan’s politicians don’t know this, it is a question of being able to execute. The DPJ and Naoto Kan tried to make good on their promise to the world that they would get their fiscal house in order, but look what happened. They were handed a sound thrashing in the upper house elections that is discouraging further talk of austerity, even though everyone, even voters, is very aware that Japan needs to come to terms with its mountain of government debt.

It's A Binary World Now: i.e., Risk On or Risk Off

Centering on U.S. stocks, equity markets managed a good rally last week from temporarily oversold levels, but it is still too early for an "all clear" sign. Some brave souls in the U.S. were confident enough to state that lows in the S&P 500 have been seen for the year, but we are not ready to bet the farm on such a call, and neither are the hedge funds, it appears. Trading has become binary, i.e., its either all risk trades on (developed market stocks, emerging markets, commodities, high yield debt and commodity currencies) or tin hat trades, i.e., USD, L-T U.S. Treasuries and gold?with JPY and Japanese equities drawing incremental amounts of haven money as well?China in JGBs and European investors in equities because of the good performance seen YTD as far as Euro-based investors are concerned.

While investors appeared more sanguine about Euro sovereign debt and disappointing US employment numbers last week, these and other issues such as the lack of demand in the U.S. housing market have not gone away. The IMF upgraded its global GDP outlook for 2010 GDP but downgraded their outlook for Euroland, emerging markets and Japan in the process while ironically upgrading the U.S. and China's outlook, two areas of more concern as regards the growth scare.

The media polls in Japan are showed another roller coater ride regarding voter support for the Naoto Kan Cabinet and the DPJ on the eve of upper house elections on Sunday. The expectations were that the DPJ would lose their majority, and that is exactly what happened. While the domestic and foreign media saw weaker bonds, a weaker yen and weaker stocks as the market reaction, stocks were actually a little higher mid-day on Monday (+7.2 points) and JGB yields were a little lower (-0.015 points to 1.140%)--i.e., market response was largely muted. While it will now be harder for the Kan Administration to get legislation through the Diet, economic policy was at best muddling through before the elections, and should continue to muddle through after them.

Foreigners over the past two weeks have again become slight net sellers, after a week of buying in the third week of June. Trading volumes for all investor types however are anemic and there is little conviction in either direction?implying that we could continue to waffle for the foreseeable future but not break down decisively below prior February lows, or in other words our "correction and a fairly narrow trading range thereafter" scenario.

Japan: Stock Prices Fall Despite Better Fundamentals

Equity indices are now fighting the historical odds. In other words, since 1900, when stock prices were lower at the end of January and the end of June, the market ended up having a bad year some 21 times out of a total 26 times. Last week, open speculation about a double dip recession in the U.S., essentially all developed economies and China had investors taking more risk off the table. Two-year U.S. treasury yields hit new lows as a "dark cross" emerged in the S&P 500 50-day and 200-day MAs, and the market index was also showing a bearish head-and-shoulders pattern. JPY back to JPY86/USD has Japanese investors flocking back into U.S. treasuries. Bond returns are exceeding stock gains by the widest margin in nine years as investors scramble to preserve capital.

The growth scare is coming from evidence that the global export-led global recovery is losing steam, as manufacturing growth from China, the euro region and the U.S. slowed in June for the second consecutive month. This just after the OECD revised its forecast in late May for GDP growth in the OECD economies from 1.9% to 2.7% percent this year.

Ironically, Japan's June Tankan reading of Japanese business sentiment was a positive surprise, showing the best positive reading in the sentiment index in two years for the larger manufactuers, with a reading of +1 versus expectations of -4 and compared to -14 in March. The reading represents the fifth consecutive quarter of improvement, and large Japanese manufacturers see further improvement to +3 over the next three months. Profits at these manufacturers are now expected to show a 43.8% rise in 2010 versus a 3.7% decline in 2009.

Unfortunately, foreign investors, who are so instrumental in Japanese stock price formation as they own some 26% of the market and account for 40%~60% of trading value on the Tokyo Stock Exchange, suspect the good news about Japan's economy is a lagging indicator to slowing global economic data, even though the ever-cautious BOJ is moving to revise up its forecast for Japan's GDP from 1.8% to 2.5% for FY2010.