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The big news is a weaker yen

It's nice that the U.S. equity market is making new post-recession highs, but one of the biggest things happening on the margin is the decline of the Japanese yen. 


The chart above offers some long-term perspective on the yen/dollar exchange rate, by comparing the spot forex rate against my calculation of the yen's Purchasing Power Parity. The yen hit an all-time high of 76 vs. the dollar just over a year ago, a value that I calculate was about 50% above its PPP. The yen, in other words, was extremely strong. A very strong currency is symptomatic of tight monetary policy, an environment that has prevailed for almost three decades in Japan. It's not surprising, therefore, that Japanese inflation has been zero or negative for the past two decades.

In the past few months there have been some big changes in Japan, with powerful political pressures being brought to bear on the Bank of Japan to adopt an aggressively accommodative monetary policy. That this may turn out to be successful in turning chronic deflation into some form of positive inflation is reflected in the yen's 14% decline—from 78 to 91—against the dollar in the past four months, most of which has occurred since mid-November. As the chart also suggests, there is plenty of room for the yen to weaken further against the dollar.


This next chart shows how the value of the yen has been an important factor driving the Japanese equity market. Beginning in 2007, the yen surged from 123 to its all-time high against the dollar in late 2011—a staggering increase of 62%. This coincided quite closely to the 55% decline in the value of the Japanese stock market over the same period. Tight money not only gave Japan a case of deflation, it severely depressed the value of the Japanese equity market. Now, with the yen down 13% since mid-November, the Nikkei 225 is up 26% in dollar terms—a remarkable reversal of fortune.


It's probably not a coincidence that spot commodity prices, as measured here by the CRB Raw Industrials index, are up over 9% since November. The outlook for Japan's moribund economy is improving as the yen weakens, which in turn is likely whetting the Asian region's appetite for commodities. The weaker yen seems to be improving the outlook for the U.S. economy as well, with the S&P 500 up 11% since mid-November.


As the chart above shows, since peaking early last year, commodity prices have lagged significantly the rise in gold prices. It could be that commodities now have some catching up to do (they would need to rise by as much as 40% to reestablish their former relationship with gold), and the latest rise is just the first chapter in that story.

I don't pretend to fully understand all of this, but the relationship between the yen, equities, and commodity prices is too powerful to ignore. 

Economic fundamentals drive equities higher

High-frequency data continue to reflect slowly-improving economic fundamentals. But since interest rates are still priced to a recession, equity prices are likely to continue to rise as long as there is no sign of a new economic downturn.



The first two charts show seasonally adjusted unemployment claims on a weekly and 4-week moving average basis. However you look at the data, claims have reached a new low for the current business cycle. This is consistent with the pattern of every business cycle. This recovery has been miserably slow, but it is ongoing.


I first showed this chart is a post back in October 2011 (and many times since then). At the time, the market was beset by fears of a Eurozone crisis, and my point was that those fears were overblown because the fundamentals of the U.S. economy—as reflected in the ongoing decline in unemployment claims—were still improving. That's still the case today. As the above chart shows, equity prices have been tracking the improvement in claims throughout this recovery. Equities offer returns that are too attractive to resist as long as the economy fails to deteriorate, especially when compared to the extremely low yields on cash and Treasuries.

Apple postscript

In my post last week "Apple sure looks cheap" I argued that, at $486, lots of bad news was being priced into AAPL stock. With the stock now trading at less than $460 in after-hours trading in response to Apple's fourth-quarter earnings announcement, it looks like I was under-estimating the potential for a negative surprise.


Here's what the chart now looks like, including today's plunge of almost 11%. In the great scheme of things, the recent selloff still ranks as a minor disappointment.

In any event, I have to believe that today's after-market crash will come to be seen as an over-reaction in the fullness of time. Most companies would be thrilled to report record quarterly revenue, record quarterly net profit, a 29% gain in iPhone sales compared to last year's quarter, a 49% surge in sales of iPads compared to the year-ago quarter, and triple-digit growth in China. iPad sales would have been even stronger, but they couldn't make them fast enough. Evidently, however, expectations were inflated.

Does this mean that Apple's earnings are doomed to decline going forward? I have a hard time believing that. At the current trailing PE of 10.4, AAPL is very cheap for a stock that can post such an impressive list of accomplishments. There is every reason to believe that earnings growth will continue to be positive (as production catches up to demand and new markets continue to post growth), and new product releases will be well-received.

Full disclosure: I am still long AAPL at the time of this writing.

The amazing yield conundrum

Today's investment climate is unique, if only in one respect: the huge difference between the current yield on cash and on alternative investments.


In a time when cash is yielding almost nothing, investors are faced with alternatives that are much more attractive. Equities, for example, are yielding 700 bps more than cash. Emerging market debt is yielding 650 bps more; high-yield debt almost 580 bps more; BAA corporate bonds 460 bps more; and investment grade corporate debt 320 bps more.


Despite the huge yield advantage to be gained from alternative investments, bank savings deposits—which yield almost nothing—have surged by almost 70% in the past 4 years (13% per year annualized), and are up from $4 trillion to almost $7 trillion.

This can only mean one thing: the market is extremely risk-averse. To pass up equity yields of 7% in favor of cash yields of practically zero, you have to believe that equities are extremely risky, and might well decline at least 6-7% a year for the foreseeable future.


This pessimism is even more pronounced when you consider that on average, the S&P 500 index has increased about 7% per year for the past 60 years. Not only is the earnings yield on the S&P 500 over 7%, the above chart argues that it's expected price appreciation is about 7% a year. The market is passing over a possible equity return of 14% per year in favor of cash that yields nothing.


And it's not just U.S. equities that the market is trying to avoid, it's equity markets the world over. As the chart above shows, the market cap of global equity markets has risen by almost $30 trillion (more than double) even as interest rates on safe-haven assets have plunged and holdings of risk-free assets have soared.



Indeed, one might say that higher equity prices have encouraged a flight to safety. How else to explain that as equity prices return to their pre-recession highs, risk-free yields are approaching historical lows?

Pity the Chinese (update)

I'm happy to report that the Chinese are no longer accumulating foreign reserves, which means they are no longer running a trade deficit with the rest of the world. Markets have forced the adjustments that politicians were demanding. Perhaps this will put a stop, once and for all, to all the foolish China-bashing that has only served to increase global tensions.


After more than 15 years of steady gains, China's foreign exchange reserves have been effectively unchanged at about $3.3 trillion for the past 18 months. Moreover, for the past two years, China's holdings of Treasuries have also been effectively unchanged at about $1.2 trillion. China is no longer accumulating foreign exchange reserves because it no longer needs to keep its currency from appreciating. We're likely quite close to the end of the ever-appreciating yuan.


After appreciating by 68% in real terms against a broad basket of currencies (as shown in the chart above), the yuan apparently has no need to appreciate further. The huge effective appreciation of the yuan relative to other currencies has meant that the cost of making stuff in China is now much higher relative to other country's costs. Capital is thus no longer flooding into China, and in fact, jobs are starting to leave China for cheaper destinations. China has achieved a measure of foreign trade stability.

The money that China was spending on Treasuries and other hard-currency bonds is now available to spend on goods and services from around the world. Indeed, since China stopped accumulating Treasuries in mid-2010, U.S. exports to China have grown at a 13% annualized rate. So here's the answer to all those who worried for so many years: "What will happen if the Chinese stop buying our Treasury debt?" It's simple: when they stop buying our debt they will instead buy our goods and services. And if China should want to reduce its holdings of Treasuries, then it will perforce buy even more of our goods and services. This is simply international balance of payments math.

A little over two years ago I wrote a post titled "Pity the Chinese," in which I said "Contrary to what you read in the press—which mistakenly believes that our large trade deficit with China is something we need to worry about—China is the one that needs to worry, not us."

They sell us mountains of cheap goods, then turn around and invest most of the proceeds (equivalent to our trade deficit with China) in U.S. Treasury securities. We get the goods, and we get to keep the money.
For most of the past 10 years, the U.S. has been working hard to depreciate its currency, in the mistaken belief that easy money and a cheaper dollar would stimulate the economy. China, in contrast, has been forced by relentless capital inflows and political pressure to revalue its currency even as it bought up massive amounts of foreign currency in an attempt to slow the yuan's rise. The result has been very costly for the Chinese, since they have put trillions of dollars of wealth into bonds with very low interest rates, denominated in currencies that have lost value against the yuan. In this manner, the Chinese have effectively transferred a significant amount of their wealth to other countries.

It really has been a pity, but at least now it looks like things won't be getting any worse.