The policies that Japan has embraced in an effort to revive its flagging economy are indeed desperate measures. To be clear, I believe that they will work in at least boosting asset prices and reviving the economy for a period of time. The long run prognosis is not so good.

Abenomics is like a swimmer trapped under water who must get to air quickly enough before he passes out. Unfortunately, to do that, he has to swim faster and burn more oxygen thus quickening his drowning. His fate rests on reaching the surface before his lungs give out.

Much of Japan’s fortunes and ills have come from its demographics. Given its current aging and shrinking population, economic growth will be hard to sustain and government budgets will be difficult if not impossible to finance.

The current spurt of asset purchasing by the BoJ coupled with fiscal expansion will only hasten the process of cash flow insolvency. The BoJ’s policy has already become hostage to game theoretic paradox, a curious manifestation of the Lucas Critique. If successful, the BOJ’s 2% inflation goal must make JGBs less attractive and so investors must shed JGBs wholesale. To be successful, therefore, the BOJ must become the sole bidder of JGBs, accelerating a demographical eventuality.

This is a vast acceleration of a dynamic that I had described in my last comment about Japan and it has surprised me. Be that as it may, I expect the BOJ to be able to control the term structure at least for the near future, and thus for the equity market rally to continue at least for about a year as animal spirits are revived. We can already see some optimism among domestic investors and corporates which is a very good sign in an economy which has this far been skeptical about all previous efforts to resuscitate the economy.

The longer term prospects are poor as savings dwindles with the population. Japan needs to reach oxygen before its lungs burst.

10 Year JGB Yields. Source Bloomberg.

The credit infused growth of the last twenty years has allowed many an inefficiency to persist undetected or un-addressed. The EUR is one such inefficiency. Unless national factor prices are flexible or factor productivities converge between countries in the Eurozone, a single currency must impede market clearing leading to inefficient allocation of resources leading to underemployment or unemployment. Only the acute dearth of credit has exposed this systemic weakness, at least to some. Many economists and central bankers continue to focus on the financial markets effects of the EUR without addressing its impact on the real economy. A point will be reached when the real economy issues will demand resolution.

The area most likely to demand attention is the labour market. As long as national level wages do not adjust to reflect differing levels of labour productivity, and without national currencies to effect that adjustment, unemployment must result in some markets, and shortages in others. Productive capacity may be shifted to reflect total factor productivity. This may hollow out manufacturing in some parts of the Eurozone to the advantage of others.

How does this micro structural inefficiency impact he UK and Switzerland? The answer is not simple. It is not clear if the EUR is over valued or under valued and thus if the Eurozone is beggaring its non EUR neighbours. Strictly, any distortion to relative prices is suboptimal for market clearing, so the region as a whole suffers. That said, there can be localized winners and losers. Many companies in Europe, both within the Eurozone and without, are global companies. Europe has a very open economy and so a weak currency helps Europe’s terms of trade and improves its balance of trade. Unfortunately, the weak currency strategy is not unique to Europe, Japan has recently begun to depreciate the JPY in an effort to get its exports going, and trade partners and competitors may not countenance more currency weakness as they too try to boost exports. Also, the common currency impedes price adjustments within the region creating intra European trade imbalances. Were intra European trade less significant the problem might be less troublesome but Europe does considerable trade with itself.

Even if The Eurozone does manage to boost exports, the distribution of profits will be unbalanced, precisely because of the internal misallocation of resources. Based on current observations, the owners and generators of intellectual property and brands will continue to thrive and the rest of the region will continue to struggle. For a more precise analysis of the fortunes of the Eurozone’s economies one would have to ask more specifically what each part of the world wants that The Eurozone can supply.

What must be apparent to observers who are not too close to sovereign bond and currency markets is that the cost of the EUR is not just financial sector stress and banking crises but more importantly a failure of the market in goods and services as well as factor markets. Yet it is the financial markets which have drawn the most attention and policy response. The recent actions of the ECB have removed much of the default risk from the banking system. Calls for closer banking union are misguided because they treat a tangential symptom. At he heart of Europe’s problems is that a common currency cannot serve a region with inflexible labour markets. The realization and the call to action will likely come from a chronic inability of the labour markets to clear.

The trouble with gold is that it has long derived its value as an alternative  to fiat currencies and paper assets whose values are derived from collective trust or faith and little else.  Gold has very little use except as a supply constrained store of value. As trust and faith are restored in paper assets, it is reasonable not to be surprised that gold should lose its value as an alternative. It is ironic that gold, by being an alternative to fantasy, should find its value hostage to the whims of fantasy.

Not everyone has time to read the lengthy, boring letters that I write, so I thought I’d summarize and simplify.

Current economic data is indicative of a global synchronized slowdown. Looking behind the numbers we find a more healthy US economy, a recovering UK economy, a chronically ailing Eurozone, and slowing emerging markets. The US economy has seen some short term weakness, most of it coming from a slowdown in government expenditures; the private sector economy continues to grow at not 2.5% but closer to 4% YOY. The UK economy is emerging from recession after taking austerity earlier rather than later, and lower corporate tax rates. The Eurozone has a chronic structural problem with the EUR which is failing to allow for price discovery in factor markets. Emerging markets struggle with capacity constraints, productivity limitations, mostly as a result of technological limits. Japan’s QE is the latest in the world and the first in a long time domestically, hence it is reaping economies of scale and is likely to ignite a self sustaining recovery. China’s economy I have discussed in previous posts, the latest export data is not only highly dubious but corrected for FX arbitrage volumes is quite poor.

I like US and UK equities. I like US housing even after it has risen as strongly as it has in the past year. I don’t like China and the Germans are levered to China.

Bonds look overvalued, especially investment grade. High yield trades more like equity and so is preferred. Given the volume of issuance, defaults will be postponed for some time. Companies are paying dividends and buying back stock releasing cash to investors who are seeking returns and who therefore are likely to redeploy to to equities, and given the resulting reduction in float, is likely to push equities higher. In fixed income I like bank loans for their seniority and floating rate coupon. I also like US RMBS for the housing exposure and security of good collateral.

Industrial metals are likely to suffer as growth redistributes to more efficient producers. Agricultural commodities are likely to do well on current dietary and demographic trends. Technicals are also supportive.

Gold remains a conundrum but which now reveals much about other asset markets. Gold is a hedge against QE but not any kind of QE, it is a hedge against unsuccessful QE. If QE is successful, gold is a less useful hedge as risky assets begin to react to improved fundamentals. The great rotation, may be out of gold.