Monday 27 February 2017

Vacationing in Japan, and going long Yen

I took a break from blogging (and more than casual on-the-road research) last week by taking a quick vacation to Japan - a long overdue first-visit. The snowboarding in Niseko was excellent. Tokyo was the bustling and colourful metropolis I expected it would be; and the food was outstanding. These were all consensus views on Japan, and the consensus was right.

There is another consensus view on Japan I am less in agreement on, however: that the Yen is a sell. I think it's probably a buy.

For a start, on the ground, the Yen feels modestly cheap. In my view, the easiest way to tell if a currency is cheap or expensive is to intuit it from visiting the country. Are you more frequently surprised on the upside or the downside when the bill arrives? (Incidentally, the Malaysian Ringgit is a standout buy on this basis at present in my view). The Yen struck me as moderately - although not egregiously - cheap on this basis, confirming what one may have assumed from an examination of the country's external accounts & inflation-adjusted historical trading ranges.

The food in Japan is not only delicious, fresh, and healthy, but also remarkably cheap - even in premium downtown areas. Accommodation is also reasonably priced given the densely packed nature of the sprawling city - a small room in a modern hotel in downtown Shinjuku - heart of the entertainment district - can be had for as little as US$100 a night. Public transportation is excellent - highly efficient and cheap. Taxis are expensive, but that is to be expected in any advanced industrial nation. It is amply clear Japan is highly competitive.

Don't play with the BoJ?

Despite being cheap, the Yen is nevertheless a highly-consensus sell in the financial community. Most foreign investors are bullish Japanese equities but have fully hedged out their Yen exposure, or are outright short. The view is that the BoJ will do whatever it takes to debase the currency, because it said so. There are two implicit assumptions here: (1) that the BoJ has the ability to effectuate this ambition; and (2) that the BoJ's policy commitment will not waver.

I'm not sure those assumptions are as safe as many believe. QE has failed to generate inflation everywhere it has been tried to date, and there are very good reasons why (this is a complex subject which I'll save for a future blog post - however, it's hard to do better than Richard Koo's excellent work). In addition, with QE being a largely flawed and ineffectual policy experiment, in my view, it is bound to eventually go out of fashion globally and/or in Japan, which could trigger an unexpected policy re-think.

In addition, while most investors believe the BoJ's policies are a reason to sell the Yen, I'm inclined to view these policies as a reason to buy (the same is true of the ECB and the Euro). Why? Most investors believe the correct approach to investing is to figure out what you think is going to happen in the future, and then position yourself accordingly. I don't. I think you should figure out what other people think is going to happen, and then look for ways in which they may be wrong. This is because it is changes of opinion that drive financial market asset prices, not the future as it is currently envisaged. All the big money in markets is made and lost in the tails - things that people generally do not expect to occur that nevertheless end up occurring. You make money by being positioned to benefit from major changes in aggregate opinion. That is why (intelligently implemented) contrarianism pays.

Markets already expect continuing efforts by the BoJ to debase the currency, and that is already reflected in the Yen's current trading level. That is why the currency is cheap. However, this is also what makes a Yen short so risky. Indeed, short Yen is such a crowded trade that if there is even a whiff that the BoJ is wavering in its debasement commitment, the Yen will surge. Japanese equities will also tank if this happens, which is why I think the consensus long Japan equities/short Yen combo is a poorly considered one. For me, the Yen tail risk is skewed to the upside over the medium term for this reason, even if the bears end up being right long term.

What to do?

With the above being said, it is hard to have more than a hunch on currencies & big-picture macro trends in general. There are too many degrees of freedom. The above is an armchair opinion at best, and not a basis for a serious investment. I'm also a stock picker at heart, not a macro guy. I'm therefore not about to run out and put on a big Yen trade.

I did buy a small amount of spot Yen at 117 late last year, converting some of my cash holdings from USD, which I thought was likely peaking. I'm maintaining that position. If long term out-of-the-money calls on Yen are cheap, I might consider buying some, however (I haven't looked yet).

The most practical takeaway is likely that when looking at stocks in Japan, I will incline towards the view the Yen has a greater risk of unexpected strength, and so (1) avoid hedging out Yen exposure; (2) exercise extra caution when looking at exporters, which will be punished severely if the Yen surges; and (3) all else being constant, favour Japanese domestics.