Japan is trapped by a chronic fiscal deficit, perverse Yen appreciation, price and wage deflation and low nominal (but high real) interest rates. Sustained economic decay seems inevitable, and in many ways the fact that Japan avoided a depression in the 1990’s given the scale of the asset bubble is remarkable. However, the ‘value trap’ that Japanese equities have offered investors for many years may finally prove to be simply remarkable value. The 60% book value discount to the MSCI emerging market universe is particularly bizarre when you consider the huge exposure of many leading Japanese exporters to the Emerging Asia growth story. Companies like Suzuki (46%), Komatsu (39%), Hitachi (52%), Daikin (40%) and Kawasaki (24%) all have between a quarter and half of their revenue growth generated in China and the rest of emerging Asia. 

We’ve come full circle from the bubble days 20 years ago when brokers forecast 50,000 on the Nikkei as a foregone conclusion. As the global liquidity cycle peaks by early Q2 in the context of a synchronized and broadening economic recovery, it’s likely that the current consensus that developing markets will continue to outperform developed will prove misplaced. In that context, the developed market with the greatest upside potential against current expectations is Japan. I say this as a long-time Japan bear, for demographic and cultural reasons as much as economic.

In April 2008 for instance, I wrote that: ‘There has been one of those periodic outbreaks of bullishness on Japanese equities by several market commentators recently who posit that an inflation breakout leading to higher rates will be positive for stocks, and particularly banks. I would also, if that inflation were generated by domestic demand conditions rather than surging import costs…unfortunately, like China, Japan is suffering a rapid deterioration in its terms of trade.’ That supposedly bullish inflation ‘break-out’ didn’t last long as the world economy subsequently crumbled. Any investor in Japan should have no illusions. 

Japanese industrial stocks offer the cheapest revenue exposure anywhere to emerging growth infrastructure and consumption growth. For the export dominated Nikkei, a sustained dollar rally against the Yen through the remainder of 2010 would be a key driver for a re-rating, and is likely if a solid US recovery forces an earlier Fed policy tightening than the consensus expects in H2. Japanese banks look equally attractive, as the balance sheet recession that began almost 20 years ago is finally coming to an end (while just beginning in Europe and the US).  

Growing investor concerns regarding the sustainability of fiscal deficits across the developed world are even more justified when the impact of demographic decline, both in terms of exploding unfunded social and healthcare costs, and in depressing trend GDP growth, is taken into account. Europe, Canada, the United States, Japan, South Korea, and even China are aging at unprecedented rates. Today, the proportion of people aged 60 or older in China and South Korea is 12-15%. It is 15-22% in the European Union, Canada, and the United States and 30% in Japan. With life expectancy increasing (and typically a 65 year old can today expect to enjoy almost 20 years of retirement in Europe, the US and Japan), these numbers will increase dramatically. In 2050, approximately 30% of Americans, Canadians, Chinese, and Europeans will be over 60, as will more than 40% of Japanese and South Koreans.

Industrialized countries are experiencing a drop in their working-age populations that is even more severe than the overall slowdown in their population growth. South Korea represents the most extreme example. Even as its total population is projected to decline by almost 9 percent by 2050 (from 48.3 million to 44.1 million), the population of working-age South Koreans is expected to drop by 36 percent (from 32.9 million to 21.1 million), and the number of South Koreans aged 60 and older will increase by almost 150 percent (from 7.3 million to 18 million). By 2050, in other words, the entire working-age population will barely exceed the 60-and-older population. Although South Korea's case is extreme, it represents an increasingly common fate for developed countries. In 2002, the US population was adding ten people of working age for every single new potential retiree (those aged over 65). By 2023, there will be 10 retirees for each new working age person.

Sometimes a picture really is worth a thousand words, and several thousand words a day are wasted on trying to deconstruct incoming bullish data to fit the popular thesis that we are going to relapse into recession or at least stagnation later in 2010. Economists and investors are often like generals fighting the last war, and their outlook is coloured by their most recent searing experience. Right now, they're bogged down in trench warfare and ignoring the rumble of inflationary tanks on the horizon.  The fact is that the vast scale of global stimulus last year could not have failed to generate a decent cyclical recovery, and it is being supported in the US by strong corporate balance sheets and underinvestment in inventory and productivity enhancing and another $450bn in stimulus spending. We'll get something like a 4% real GDP year in the US, on which basis current monetary policy is unsustainable, despite Wall Street's wishful thinking to the contrary. The ’double dippers’, most of whom completely missed the warning signs in 2008, now spend their days unpicking every positive number to make it fit their thesis of sustained low interest rates and sluggish global growth at best. Meanwhile, a brutal reversal of the dollar carry trade, with an 11% move versus the Euro since early December, is sucking more liquidity away from the leveraged momentum trade in risk assets.

The reality is that central banks, particularly in the emerging markets, are falling behind the growth curve as the unprecedented scale of monetary and fiscal stimulus applied in 2009 finds traction in the real economy. Emerging Asia will be the first region to see policy normalization, and it’s beginning in China and India. Chinese lending data confirms a sharp slowdown in recent weeks; 90% of January's lending was made in the first two weeks before banks slammed on the brakes after a midnight phone call from Beijing while M1 money supply is now declining for the first time since late 2008. However, momentum is so strong that an 11-12% Q1 GDP number is likely, although that will mark the peak.

I warned coming into 2010 that the withdrawal of monetary stimulus by global central banks and rising bond yields would create turbulence in asset markets in H1, particularly in emerging market equities, high-yield debt and commodities. Where China has led in tightening policy, to the surprise of the overwhelming consensus, the Fed will now likely follow. Current US monetary stimulus is almost certainly inflationary over the next 3-5 years, by providing excess liquidity above that required by underlying growth prospects. The steep US yield curve reflects market expectations of Fed normalization, although to still modest levels historically. Imputed 10-year Treasury yields imply that the Fed funds rate will average 3.5% over the next 10 years. The steep curve, aside from being a useful way to re-liquefy bank balance sheets also implies that the only real uncertainty is precisely when the Fed begins to raise rates. Implied 10 year US CPI inflation as embodied in the TIPS market has risen from zero to over 2% in a year, still low by historical standards but incompatible with a sustained zero rate policy.

The stunning rally in US corporate bonds over the last year reflects not only panic default assumptions last spring exceeding the 1930’s experience, but also Fed policy since, which by buying ‘safe’ assets like Treasuries and MBS from institutions has displaced their cash into risky ones, taking IG spreads back to late 2007 levels at the tail-end of an historic credit bubble. The $1 trillion expansion of the Federal Reserve's Balance Sheet that occurred from Sept. '08 through end 2009 is probably the biggest monetary gamble the history of the U.S.  Prior to this crisis, commercial bank reserves totaled sub $100bn and hadn't grown since 2003; now they stand at $1.2 trn. The Fed, responding to a flight to safety in the dollar and Treasuries post the implosion of Lehman  bought over a trillion dollars worth of securities (mostly Treasuries and MBS) from banks. The Fed paid for these purchases by electronically crediting the accounts of its member banks with reserves, which is the type of 'virtual' money only the Fed can create. Buying and selling securities is the traditional way that the Fed increases or reduces the supply of money to the banking system, but never before on this scale.  This radical action was appropriate, since the alternative would have resulted in a monetary deflation of the sort that exacerbated the 1930's depression. 

Banks as of yet haven't used any of their extra reserves to expand their lending. The reserves are sitting idle at the Fed in the form of "excess reserves," which currently total $1.1 trillion. The Fed has massively increased the lending capacity of banks , but this hasn't created a flood of extra liquidity or a burst of inflation as that lending capacity is 'trapped'. The demand for loans is still weak. In aggregate, bank lending is weak in part because many consumers and corporates are still trying to deleverage. At the same time, banks aren't particularly anxious to lend either. After throwing credit standards out the window in the boom, they have been relentlessly raising their lending standards since. Banks have gone from being recklessly hungry for risk to being risk averse as they nurse their balance sheet wounds. But if they were to resume lending as economic confidence grew, that $1 trillion of excess reserves could potentially support about $10 trn of new credit creation, which is clearly inflationary. In principle, the Fed would just  sell Treasuries and MBS in exchange for taking back the trillion dollars of excess reserves, but that could push interest rates sky-high and undermine the recovery. 

China has been suffering inflationary pressure from loose US monetary policy via the pegged exchange rate, and the country is now taking the steps I've been predicting to tighten domestic policy such as hiking the bank reserve ratio and restricting capital raising in the sectors with the greatest overinvestment, such as cement. As of yet, interest rates haven't been raised, as has been the case across the region from Australia to India. The problem is that if China raises rates well in advance of the US, it risks attracting further ‘hot money’ capital inflows, exacerbating the asset price risks. One answer is to revalue the RMB substantially and the issue is whether it takes the form of a gradual or one-off appreciation; circumstances increasingly suggest the latter.

A rise in imported commodity prices in 2010, particularly of food, will likely force the issue (see inflation chart below). Chinese M1 money supply growth was growing at 35% y/y at the end of 2009, but has turned negative in January; it's the single most important driver of CPI inflation, boosting prices with a lag of six to nine months, and has exceeded broader M2 since mid 2009. Proxy measures of inflation expectations, such as the difference between demand and time deposits, look to be rising as local asset prices have boomed. Acceleration in Chinese CPI inflation to around 5% by mid-2010 is likely and 6-7% by year-end if excess liquidity hasn’t been drained by then. While tightening moves, in addition to current administrative measures limiting credit growth/investment, will probably take the form of further rises in reserve requirements and interest rate hike, an attractive alternative means of curtailing the nascent asset bubbles and at the same time rebalance the economy, is to revalue.

The 'double dip' scenario touted by many market bears is becoming increasingly untenable, for 2010 at least. We’re coming out of a decade that has seen the lowest contribution of corporate investment to GDP growth since the 1930’s, which has informed my view in recent months that business investment by cash rich US companies rather than consumers which will help fuel a robust US recovery in 2010 to about 4% real GDP growth. That cyclical rebound will be supported by strong net exports and another $450bn in stimulus spending. The just released Q4 data supports that bullish view on the strength of a US cyclical rebound. In particular, the inventory cycle is showing clear signs of reversing with inventory liquidation slowing sharply during Q4, as private business shed $33.5bn compared with $139.2bn in the preceding quarter, adding 3.4% to overall output.

Given the unusually deep and rapid inventory cuts during H1 2009 as a function of the 'one click' nature of the global supply chain in the Internet age, the upside as production simply catches up to sales will be proportionately larger in this recovery than in previous recessions. Consumer spending, which in the boom years accounted for about 70% of economic activity, grew by just 2% and was weaker than in Q3. GDP was also boosted by a rise in non-residential fixed investment, which grew by 2.9% after falling by almost 6% in Q3, and I'm expecting this recovery to be boosted by a surge in business investment. One of the most remarkable things about this data is that government spending rose just 0.1%, so the recovery was driven entirely by the private sector and net exports, which is a very healthy balance.

My expectation in recent months has been that economic strength, not the much expected weakness, would be the problem for investors in 2010 insofar as it meant a faster monetary tightening cycle and ebbing liquidity across markets. In particular, I've been predicting an aggressive reversal of Chinese policy, as credit growth at over 30% of GDP last year was clearly unsustainable. The Chinese recovery is now pretty clearly a 'V' with Q4 GDP just reported rising 10.7% y/y, and inflation is suddenly a real issue for the first time since Summer 2008, when it almost hit double digits. Food price inflation in China is now 5.3% y/y and as food accounts for over a third of rural household budgets, the PBoC will be under political pressure to restrain the liquidity surge unleashed in 2009. Secular demographic trends are already pushing up nominal wage inflation across the coastal regions to levels not seen in 24 mths, as companies compete for a limited supply of female school-leavers in particular. This combination of a front-loaded cyclical recovery worldwide (and I'd expect an imminent IMF forecast upgrade) with rising inflationary pressures and ultra-loose policy falling behind the economic curve, is a potentiall toxic mixture for investors.

Sentiment towards equities globally is certainly extended on every institutional survey. Emerging markets (particularly Brazil) are too popular, and  strong EM balance sheets and earnings outlook are in the price. Fast building inflationary pressures,  the unsustainable path of monetary policy that is set to reverse, and a heavy schedule of new equity supply will all weight on the asset class. Emerging markets ceased outperforming last Autumn, but are still every strategist's favorite asset class. As I said a few weeks back, I'm expecting developed world stocks (and quality in general) to outperform this year. 

Aggregate US oil inventory rose by 8.9m barrels last week, amongst the largest weekly aggregate increases ever. Gasoline stocks are now at levels not seen in two years, some 10m barrels higher than they were last year. Until now the product overhang has mostly focused on distillates which made sense since they’re a key feedstock for industry, and demand has slumped because of the US recession. Gasoline demand by comparison had remained stable, but not any longer. Crude refined in the US through November and December averaged 637m barrels or 4.4% below a year earlier on DOE data. In total, upwards of 1.7m b/d of demand for crude oil disappeared in Q4 2009 because refiners could not pass on the cost of crude oil to consumers in Europe and North America and had to mothball plants. Meantime, there is no more space for crude to move into the Strategic Reserve (remember George Bush frantically filling those SPR tanks at $130 in mid 2008?)  The SPR is out of the market and the implications are bearish of crude as long as OECD demand remains depressed (and those full tanks should also cushion any Iran related price spike).

Chevron's recent profit warning was instructive on the scale of the crisis in the downstream oil business. The second largest US oil company could not make money refining oil averaging $70. If Chevron can't pass on the cost of $70 oil to struggling US consumers via profitable crack spreads, then why do Goldman Sachs think  that a $90 average this year is rational? Their bull case is based on emerging market demand, but a significant portion of China's record 5m b/d December imports will be re-exported in Q1 as refined products, but to whom exactly?  Over the next 6 months, either crude oil has to correct back towards $60 or US average gasoline prices have to surge well over $3 (from a current $2.75) assuming crude oil stays around current levels. If crude oil heads to $90 or beyond, gasoline has to rise pro-rata. Is that credible with an unprecedented supply glut? Speculators currently own more than twice the storage capacity at the NYMEX Cushing delivery hub for WTI crude. What are they going to do with all this oil, which at some point needs to be physically delivered?

A major investment theme in 2010 will be growing tightness in agriculture and soft commodity markets as secular demand growth driven by rising per-capita incomes and Westernizing diets in Asian  markets meets relatively inelastic global supply. Globally, grain consumption was estimated to have increased 1.7% in 2009 despite the economic shock, according to the U.S. Department of Agriculture. In many ways, food looks like energy a few years ago, with a widespread assumption that after a prolonged period of real annual price declines we can look forward to sustaining this trend. However, just as with oil, those decades of low and negative returns have led to chronic underinvestment in everything from seed research to supply infrastructure. The rapidly aging profile of the current generation of farmers in the US and Europe is another factor likely to detrimentally affect medium-term productivity.  A rebound in global growth to the 3-4% range in 2010 will likely result in substantial price increases unless growing conditions prove exceptionally benign.

The Goldman Sachs Agricultural Commodity Index has lagged the wider commodity rally in 2009, despite record highs in several markets from sugar to cocoa. Food consumption is generally less sensitive to economic conditions than energy and metals, but a series of abnormal weather events around the world upended supply and demand fundamentals for corn, soybeans and sugar. An unusually late planting season in the U.S. due to excess rainfall led corn prices to rally more than 30% in the spring; a serious drought in South America curtailed soybean plantings and yields and sent soybeans prices soaring 50% in the first half. Prices came down through the summer as weather patterns normalized and eased supply worries. Overall, there is far more sensitivity to weather factors than a few years ago, making the agricultural commodities particularly volatile. While corn prices edged up just 2% in 2009, and wheat was down 11%, sugar prices soared to a 28 year high (up 129%) and cocoa at a 30 year high (up 23%) on supply disruptions in India, Brazil and West Africa, combined with tight global inventories. Livestock prices suffered losses as cost-conscious US consumers ate less meat. In the U.S., average red-meat and poultry consumption was estimated to have decreased by 2.6% to 210.6 pounds per person in 2009, according to the USDA. As a result, prices for lean hogs and live cattle rose by 8% and 2%, respectively, last year and that's likely to accelerate this year as the livestock herd has shrunk to a 3 year low.

I know many investment managers and they're universally competent, conscientious people. However, it's harder to claim that they add much value to the investment process, as they're hamstrung both by the failings of the intellectual framework that defines portfolio theory, as well as a career structure than offers perverse incentives to hug indices for the sake of job security. The way that most industry professionals look at markets is tantamount to doctors looking at disease without an understanding of pathogens. Much of the orthodoxy underpinning industry asset allocation principles is utterly misconceived. Take portfolio diversification; that derives from the CAPM approach that an asset's expected return premium is proportional to its market sensitivity, or beta. Beta is critical, because it decomposes the ratio of the asset standard deviation to the SD of the market, multiplied by the correlation coefficient between them.

The bedrock of conventional asset allocation for retail investors drilled into to every CFP is that they should seek 'uncorrelated returns' across a spectrum of non-equity assets to obtain superior risk-adjusted returns.If we've learned anything in 2008/9, it's that correlations are far higher than that theory ever assumed. For instance, on a 3 year rolling total return basis to end Q3 2009, US real estate correlated 81% with the S&P, hedge funds 66% (HFRI Composite Index), and private equity 84%. If anything those figures are an understatement, given stale pricing via NAV calculations for non-market traded assets, which would lag the return comparatives. We've seen cross-asset correlations hit 75-85% across equity indices (US and global), commodities and corporate bonds in 2008 on the downside and in 2009 on the upside.