By HENRY H. MCVEY Apr 04, 2014

While we believe that the current economic expansion will extend through late 2016 or early 2017, a variety of stresses are beginning to build up across the global capital markets arena. Beyond China slowing and tight credit spreads, we think notable “macro soft spots” include a more difficult profit margin story in the U.S. as well as complacency about the potential for any change in inflation and interest rate volatility. Meanwhile in Brazil, the real fundamental macroeconomic trajectory is notably more sluggish than what the recently published data would suggest. At the same time, Japan has the potential to remain a disappointment in 2014 for a number of reasons. So, in our view, now is likely a good time to start thinking about how these potential macro headwinds could start to affect overall portfolio performance in the quarters ahead.

As my close family, friends and work colleagues know, my expertise is certainly not in technology. In fact, I am still challenged by replacing toner cartridges, much less updating my iPhone (which I finally just bought). That said, through the years I have learned enough about technology – and general business and investing cycles – to believe that Andy Grove, former head of Intel, was on to something important when he articulated that, “success breeds complacency.”

In the world of global macro and asset allocation, we believe success in 2013 came from an unwavering commitment to owning risk assets in size. As for 2014, we are still sticking to our base call that risk assets could again outperform government bonds, albeit at a pace far less compelling than last year (see our Outlook for 2014: Stay the Course Insights note for further details).

But Grove also correctly points out that, “complacency breeds failure,” and 58 months into an economic recovery (and a 155% return in the S&P 500 since March 20091), we think it makes more than a little sense to assess whether we are beginning to see any noteworthy excesses or what Grove termed “complacencies” building up in the global capital markets. Importantly, beyond the recent concerns we highlighted in our China: Repositioning Now Required note or the concerns we highlighted around credit spread levels in our January outlook piece (see Outlook for 2014: Stay the Course), we also see a handful of other “macro soft spots” that we think are worthy of investor consideration at this point in the cycle. They are as follows:

U.S. Corporate Margins Potentially Extended; Yet We Have Seen Essentially No Acceleration in Capital Expenditures. See below for more details, but we believe current net margins in the United States—while likely sustainable in the near term—argue for flat to negative earnings growth in the not too distant future. Specifically, when economic momentum does slow, (which we think is the key variable, not the absolute level of margins), we believe earnings could fall much faster than GDP—the exact opposite of what has occurred thus far in this economic recovery. Longer term, we are even more concerned that U.S. companies appear to be overspending on buybacks and at the same time underspending significantly on capital expenditures. In our view, this approach to capital allocation could have negative long-term implications for sustainable growth—and ultimately value creation. Given these views, we recommend investors at least begin the process of thinking through potential hedging programs to guard against outsized long equity exposures.

Interest Rate and Inflation Outlook: The Market is Offering Attractive Hedging Opportunities. In the aftermath of the financial crisis, many of the assets held on the balance sheets of Fannie Mae and Freddie Mac have found their way onto the balance sheet of a much more benign owner, the U.S. Federal Reserve. All told, on-balance sheet holdings of mortgage-backed securities (MBS) held by the Federal Reserve now represent about 30% of the total MBS market, compared to a zero weighting in 20072. Over the same period, the portfolio holdings of the government-sponsored enterprise (GSE) market share has slipped to 5% from a peak of one-third a decade ago3. We think this “hand-off” is important because it has crushed expected volatility in the fixed income market. In fact, expected interest rate volatility is now in just the tenth percentile over the last decade4. However, with quantitative easing (QE) now reversing in the United States, we do wonder whether expectations for fixed income volatility have gotten too complacent, which we think provides investors with an attractive way to buy insurance protection at what we view as discounted prices. A similar story also holds true for inflation expectations, in our view. Details below.

History Suggests That Japanese Consumption Tax Hikes Are Negative for Both GDP and Risk Assets. With the Japanese consumption tax rising to 8% from 5% (Exhibit 25), its first increase since 1997, we thought it made sense to analyze what history might teach us about subsequent performance of the equity market, Japanese government bonds (JGBs) and the yen. See below for details, but the capital markets, equities in particular, have not typically been kind. So as we think about macro soft spots in 2014, Japan is certainly an important one on which to focus, as there is growing risk that Japanese Prime Minister Shinzo Abe’s “Third Arrow” structural reforms to position Japan’s economy to compete in the 21st century falls short of investor expectations.

Brazil Inflation Appears Understated at a Time When Growth Is Already Slowing; Risk to the Currency Is Still Significant. In our view, Brazil’s inflation problems may run deeper than what official numbers suggest. See below for details, but our base view is that the government is suppressing regulated prices to hold down overall consumer price index (CPI) trends, which are now breaching the upper bounds of the central bank’s targeted range. Moreover, higher inflation trends are occurring at a time when we expect GDP growth to surprise on the downside in 2014. Bottom line, we think Brazil could become an even more challenging macro story in the quarters ahead, and in doing so, it will underscore some of the secular challenges we think many EM countries now face. If we are right, then we think investors may want to consider investments that benefit from a weaker than expected currency trajectory in emerging markets, Brazil in particular.

To be sure, we do not think that any of the aforementioned issues are likely to immediately dent the trajectory of the global economic cycle that we are currently forecasting. To review, our base case is that the current economic expansion extends through late 2016 or early 2017. However, our macro dashboard is beginning to show that a variety of stresses, many of which we detail below, are beginning to build up across the global capital markets arena, and as such, now is likely a good time to start thinking about how they could affect overall portfolio performance in the quarters ahead.

Exhibit 1

Using Past Cycles as a Guide, Multiple Expansion Now Appears Ahead of Schedule

Past U.S. economic cycles analyzed: i) 3Q38-1Q45, ii) 2Q61-4Q69, iii) 2Q75-1Q80, iv) 1Q83-3Q90 [excluded here], v) 2Q91-1Q01, vi) 1Q02-4Q07. Data as at March 26, 2013. Source: KKR Global Macro & Asset Allocation analysis of S&P data.

Exhibit 2

The Illiquidity Premium Still Appears Attractive, in Our View

Weighted average yields of senior term debt and senior subordinated debt. Data as at December 31, 2013. Source: S&P LSTA, public company filings of Ares Capital Corporation.

Looking at the big picture, we continue to champion the same macro themes we laid out in our Outlook for 2014: Stay the Course note. Specifically, we continue to think multiples are now a little ahead of schedule relative to history. Indeed, as Exhibit 1 shows, this cycle has seen multiple expansion occur a little earlier than what history would suggest. In our view, this headwind likely means more volatility and less upside to equities than in 2013. Second, we continue to believe that the structural deleveraging across the global wholesale banking sector has created an attractive illiquidity premium. As one can see in Exhibit 2, this illiquidity premium still appears sizeable, particularly in today’s low rate environment. Finally, with central banks throughout the developed economies holding nominal interest rates well below nominal GDP, we think now is the time to own real assets that can provide growth, yield and inflation hedging. To be sure, we are not looking for near-term inflation, but we believe buying some optionality – and getting paid to wait along the way – makes a lot of sense in today’s low rate, low inflation environment, particularly relative to traditional commodity notes/swaps as well as Treasury inflation-protected securities (TIPS) (Exhibit 4).

Exhibit 3

History Shows That Pinning Fed Funds Below GDP Growth Leads to Rising Inflation Over Time

e = KKR Global Macro & Asset Allocation estimate. Our estimate assumes the Fed does not tighten until mid-2015 and that nominal GDP growth averages 4.5% annually between 2012 and 2014. Data as at March 20, 2014.

Exhibit 4

We Favor Inflation Hedging Vehicles With More Yield and More Growth Than TIPS

Data as of March 24, 2014. Source: Bloomberg.


U.S.: Storm Clouds on the Horizon?

When I stepped into my role as Chief U.S. Investment Strategist at Morgan Stanley in early 2004, I was young and green and made a lot of mistakes along the way up the learning curve. But one thing I did right in those early days was to ask my predecessor Steve Galbraith if he had any pearls of wisdom on how to approach the job. His view was pretty straight-forward: The best way to add value was to focus on anomalies where the potential for mean reversion was significant.

This approach has stayed with me in one form or the other during my career in macro, and as I look forward, our work shows that – at least statistically speaking – today’s margins in the U.S. likely mean little to no overall growth ahead if there is any form of mean reversion in the coming years. One can see this in Exhibits 5 and 6, which show that current margins not only look extended, but also imply a negative earnings growth rate over the 2013-2018 period.

Exhibit 5

Profits Margins Now at Peak Levels…

U.S. corporate profits = after-tax corporate profits with inventory valuation adjustment and capital consumption adjustment. Data as at February 28, 2014. Source: Bureau of Economic Analysis, Haver Analytics.

Exhibit 6

…Which Tends to Imply Challenging Corporate Profit Growth Ahead

U.S. Corporate Profits = After-tax Corporate Profits with Inventory Valuation Adjustment and Capital Consumption Adjustment. Data as at 3Q2013. Source: Bureau of Economic Analysis, Haver Analytics.

As Exhibit 7 illustrates, our work shows that with the exception of energy, telecommunications and materials, margins are at or near all-time highs. Importantly though, our analysis does not suggest that the current profit cycle is by any means over. In fact, the KKR Global Macro Asset Allocation (GMAA) base case is that the economic cycle continues to be positive through late 2016/early 2017. All told, we think the current recovery may reach 95 months or so in duration versus its current level of 58 months. While we admit that 95 months in duration might sound long, it actually would be only in-line with the average of the past three recoveries (albeit more volatile than past recoveries, due to the de-leveraging component).

Exhibit 7

S&P 500 Margins for Many Sectors Are Close to or Above Their Ten-Year Average

S&P 500 Sector Margins


Consumer Discretionary

Consumer Staples



Health Care


Info Tech


Teleco Services















































































Last as at February 28, 2014; Average = average for the last ten years; max = maximum for the last ten years; min = minimum for the last ten years. Data as at February 28, 2014. Source: Factset.

But make no mistake: We think the forward-looking macro environment for Corporate America will likely be more difficult for at least two simple reasons. First, with margins at the high end of their historical band, earnings growth during the 2014-2016 period will likely have to be driven primarily by revenue growth and/or more buybacks, which represents a notable change from the margin-driven, early phase of the recovery (e.g., 2009-2013). Second (and potentially underappreciated by the investment community), when the cycle does turn, margins and profits could likely fall substantially faster than GDP, which would be almost the exact opposite of what has occurred so far in the current cycle (Exhibit 8). Importantly, similar to past cycles, we think that both business executives and analysts could likely again miss the magnitude of the negative operating leverage (Exhibit 9).

Exhibit 8

Corporate Profit Growth Is Outpacing GDP Growth By Levels Not Seen Since the 1990s

Data as at March 3, 2014. Source: Bureau of Economic Analysis, Haver Analytics.

Exhibit 9

When Earnings Turn Down, Business Leaders and Analysts Typically Miss the Turn

Analyst estimates measured on bottom-up basis. Data as of March 21, 2014. Source: S&P, Thomson Financial, KKR Global Macro & Asset Allocation analysis.

Our bigger picture and longer-term conclusion though, is potentially more ominous. From our vantage point, it appears that companies have been underspending on fixed investment, and at the same time overspending on buybacks throughout much of the current cycle. In the near term, we fully acknowledge that this approach means higher margins, lower share count and likely better stock price performance.

However, over a longer period of time, we have two major reservations about this approach. First, as stock prices move up and the economy improves, the attractiveness of buybacks tends to deteriorate relative to other reinvestment options. Exhibit 10 provides a simple example of the degradation. It shows that from 2009-2012 the ROEs companies were realizing on their recent investments were near or at times even below the earnings yields of their own stocks (i.e., the inverse of the forward P/E), which peaked for the S&P 500 at 9.1% in September 2011. In such an environment, it made sense for many management teams to buy back stock rather than commit further capital to new projects.

Fast-forward to today however, and the earnings yield on stocks has fallen to a more modest 6.4% at the same time that companies are realizing 20%+ returns on incremental equity. As such, today we would strongly encourage more management teams to consider reinvesting in their businesses rather than buying back stock. Unfortunately, our message appears to be falling on deaf ears as buybacks could reach $527 billion in 2014e, compared to $458 billion last year and just $146 billion in 2009.5

Exhibit 10

Earnings Yields Have Fallen (i.e., P/Es Have Risen) at the Same Time That ROEs Have Increased, Making Buybacks Less Appealing Today

Return on incremental equity = 5yr change in EPS / 5yr change in book value. Data as at February 28, 2014. Source: S&P, Factset, KKR Global Macro & Asset Allocation analysis.

Exhibit 11

Capex-to-Sales Is Still Lagging, Which Seems Odd This Far Along Into an Economic Expansion

Data as at 3Q2013. Source: Thomson Financial, Morgan Stanley Research.

Meanwhile, companies have been spending a lot less on capital expenditures relative to prior cycles. Indeed, as Exhibit 11 shows, capital expenditures-to-sales have fallen to just 6.7% in 3Q13 from 8.6% in 2000 and 10.1% in 1982. In our view, lack of reinvestment in property, plant and equipment (PPE) means that—over time—the productivity of a franchise is likely to decline. It also means that executives would have fewer opportunities to “right-size”’ or improve efficiencies in their core businesses, as there would be few reinvestment levers to pull.

So as we look ahead, our longer-term concern is the trajectory for sustainable growth. Why? Because if companies have already squeezed a lot of operating efficiencies out of their businesses but are electing not to reinvest in productive assets at this point in the cycle, then there could theoretically be less structural growth for U.S. companies coming out of the next downturn, in our view. We believe, this potential macro issue should not affect near-term trend lines, but we are increasingly nervous the next recovery cycle could be even more disappointing than the current one.

Interest Rates: The Best Time to Buy an Umbrella Might Be When the Sun Is Shining

“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Ronald Reagan

This memorable Ronald Reagan quote regained popularity with portfolio managers and market prognosticators during November 2010, immediately after the Federal Reserve introduced QE2. At the time, fears were running rampant that all the money printing was going to lead to inflation levels not seen since the Carter presidency. Fast-forward to today, and the Fed’s balance sheet is now over four trillion dollars, which easily exceeds both the Great Depression and World War II on a percentage of GDP basis6. Outside the U.S., money printing has also been robust as the Bank of Japan committed to buying approximately ¥7 trillion of JGBs per month, which is the equivalent to 70% of new issuance7. Even the conservative European Central Bank (ECB) is now hinting it might do something more on the QE front to not only weaken its currency but also to improve private credit spreads in the periphery.

Yet despite all this central bank activity of late, investor anxiety in the fixed income market has actually diminished greatly. In particular, complacency seems to be running rampant in two areas. First, concerns around future inflation are again plummeting. One can see this change of heart in Exhibit 12, which shows the premium for out-of-the money payer swaptions (i.e., bets on much higher rates to hedge against future inflation) has collapsed dramatically since last summer. So whereas investors believed in 2011-2012 that there was a decent chance that outsized monetary policy might lead to inflation or even hyperinflation, down the road, that viewpoint today has now been all but disqualified by essentially everyone in the investment community.

Exhibit 12

The Premium for “Out-of-the-Money” Options Is Collapsing as Investors Have Given Up on the Prospect for Higher Inflation

The above line shows the difference in implied volatility for options struck 25 basis points higher than the forward and options struck 25 basis points lower than the forward (“the skew”). When this spread is elevated, investors are paying for protection against higher interest rates. Data as at March 7, 2014. Source: Bloomberg.

Second (and potentially more importantly, in our view), investor expectation about the potential for interest rate volatility has also collapsed. Without question, the introduction of quantitative easing as well as the perceived clarity around forward guidance by the Fed has helped to reassure investors, in our view. Moreover, we believe the transfer of the negative convexity risk embedded in mortgage-backed securities from the balance sheets of the GSEs (Fannie and Freddie) to the Federal Reserve through the Fed’s extensive QE program also appears to have significantly sapped volatility from the interest rate swap market. All told, on-balance sheet holdings of mortgage-backed securities (MBS) by the Federal Reserve now represent roughly 30% of the market, compared to a zero weighting in 20078. By contrast, the GSEs’ combined investment portfolio only represents about 5% of the total MBS market versus a peak of one third a decade ago9. This shift is important because the Federal Reserve does not hedge the convexity risk of its portfolio, while historically, the GSEs have. This active portfolio management by the GSEs intensified the normal movement of the interest rate market as hedging a negatively convex mortgage portfolio forces you to buy bonds when up and sell when down.

Exhibit 13

The Forward Rate Market Is Pricing In a High Degree of Uncertainty About the Future, But the Volatility Market Appears to Disagree

Data as at March 7, 2014. Source: Goldman Sachs Research, Bloomberg.

Exhibit 14

The Cost to Insure Against Higher Rates Is Now Extremely Cheap Relative to History

Data as at March 7, 2014. Source: Goldman Sachs Research, Bloomberg.

Interestingly though, this more benign outlook for inflation and rate volatility seems to be occurring at the exact same time that the spread between the short and long ends of the market has reached record levels. Put another way, at a time when investors have never been more uncertain about the relationship between short- and long-term rates, the investment community seems to have become confident that any change in the steepness of the curve would occur in a highly uneventful way.

To be sure, we are not arguing that rampant inflation is about occur, nor we do believe that rates are headed materially higher in the near term, as we are maintaining both our 1.75% inflation forecast and our 3.3% 10-year year-end target Treasury forecast for 2014. However, the cost to insure against these forecasts being wrong seems incredibly cheap in two areas, we believe. First, the market is now implying that there is a just an 18% chance that the 10-year yield will reach our target by year-end 2014 (our target is now 3.3%)10. By comparison, at the end of 2013, the options market was pricing approximately a 35% probability of a 3.3% yield on the 10-year Treasury by year-end 201411. Second, after years of worrying about higher inflation, the market now only expects about 1.4% headline inflation during calendar year 201412. By comparison, the Federal Reserve has that rate at 1.75%, consistent with our view. As such, it just strikes us as odd that investor expectations about future inflation have fallen materially versus the beginning of the cycle (when there is usually lots of slack in the economy) at a time that the Fed is suggesting a higher path (and we are now finally seeing less excess capacity in the system).

So our bottom line is that despite Federal Reserve Chair Janet Yellen’s most recent comments that rate hikes could occur as early mid-2015, we think the market still seems to be giving investors an attractive low-cost opportunity to hedge against the risk that the outlook for inflation and interest rate volatility does not stay totally benign. Moreover, given the spread between two- and 10-year rates is at record wide levels at the same time that volatility is so low, we think that this inconsistency may also present an opportunity for investors to arbitrage these potentially diverging views. Finally, these low cost hedges are being offered at a time when the Fed is about to dial back its outsized bond buying support after a record period of loose monetary policy. In the end, nothing may change in the fixed income markets, but as my colleague David McNellis often reminds me during our team’s hedging strategy sessions, the best time to buy an umbrella is often when the sun is shining.

Brazil Macro Outlook: More Challenges Ahead

While we feel confident that we have outlined many of our concerns surrounding the Asian region in our China: Repositioning Now Required piece, we do think now might be an appropriate time for investors to refocus some of their macro concerns towards Latin America, Brazil in particular. In our view, Brazil’s current economic trajectory is likely to run substantially below what many investors now think. Key to our viewpoint are the following macro data points. First, our research shows that the 2013 primary surplus (i.e., the fiscal outlook before interest expense) of 1.9% was significantly overstated, despite this figure still missing the government’s stated target of 2.1% (Exhibit 16). From what we can tell, a combination of one-time revenue supplements such as the sale of exploration rights of the Libra oil field and the tax recollection program known as the REFIS boosted the headline primary surplus by nearly 110 basis points13. Without these items, we think the surplus would have been just 0.8%, a far cry from both the reported level and the government’s original target level. One can see the magnitude of the divergences in Exhibits 15 and 16.

Exhibit 15

Brazil’s 2013 Fiscal Balances Appear In-Line…

Data as at February 28, 2014. Source: Haver Analytics, Ministry of Finance, Global Source Partners.

Exhibit 16

…But the Actual Surplus Was Much Smaller Once One-Off Items Were Excluded

One-off maneuvers included in the Central Government revenues: onerous assignment of oil exploration, anticipated dividends, revenue from Sovereign Fund, extraordinary income from National Development Fund and regularization of judicial deposits. One-off maneuvers included in the Central Government expenditure: Petrobras’ capitalization and transfers to Sovereign Fund. Recurring fiscal result excluded concessions revenues and income from Refis (a tax recovery program), and assumes that expenses without maneuvers equals recurring expenditure. Data as at December 31, 2013. Source: Haver Analytics, Ministry of Finance, Global Source Partners.

Second, we think that the government’s current economic assumptions for 2014 are just too optimistic. Explicit in the government’s forecast that it will achieve a primary surplus of 1.9% in 2014 is that the economy will grow 2.5% (Exhibit 18). As Exhibit 17 shows, we, by comparison, think GDP will reach only 1.5% in 2014. This viewpoint is significant because we think the government will have to again adjust downward its already revised spending budget (Exhibit 18). In addition, we do not think the rating agencies will tolerate another lackluster primary balance result, particularly as they come to fully appreciate that 2013 was accomplished solely through aggressive accounting maneuvers. Already, on March 24, 2014 Standard & Poor’s downgraded Brazil to BBB- from BBB, citing lack of fiscal discipline and weak policy credibility14.

Exhibit 17

Consensus Estimates Are Now Catching Up With Our More Conservative Outlook

Data as at March 7, 2014. Source: Bloomberg.

Exhibit 18

Brazil’s Revised Budget Will Also Likely Need to Be Revised Downward Again

Budget in BRL Billion


Original 2014 Budget

Revised 2014 Budget


% Change (2014 / 2013)

Gross Revenue
(tax + Social Security)






Transfers to State and Munis






Net Revenue






Social Security






Mandatory Spending






Discretionary Spending










Spending (incl. Social Security)






Primary Federal Surplus





Real GDP Assumption












Nominal GDP Growth





Data as February 28, 2014. Source: Banco Santander, Ministry of Finance.

Separately, we also think inflation projections for 2014 are understated, and even after making the proper adjustments, they are likely still headed even higher than the consensus now thinks. At year-end 2013, the government reported that inflation was 5.91%, but our analytical work shows that the real underlying number is likely north of 7.0%15. Here’s our thinking. First, as Exhibit 19 shows, the government has implemented a series of stopgap measures including tax changes in areas like gasoline, autos and electricity that have kept regulated price growth below market. For example, Petrobras is still being forced to sell gasoline at a 10% discount to international prices, which we believe is costing the government BRL 12 billion a year in forgone revenues (Exhibit 20). But this is just one example and as we look ahead, Exhibit 21 suggests that the government will again look to artificially suppress prices in many key areas of the economy, transportation in particular. Importantly, in doing so, we believe these subsidies will not only increase its fiscal burden but they will send false signals about accurate pricing trends in the marketplace.

Exhibit 19

Regulated Price Adjustments for 2014 Expected to Avoid Politically Sensitive Sectors Such as Transportation

Data as at February 28, 2014. Source: Santander Brasil.

Exhibit 20

Domestic Gasoline Prices in Brazil Are Being Priced 10% Under International Prices

Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia e Estatistica.

Exhibit 21

Regulated Prices, Which Are 23% of the IPCA Weight, Are Being Held Artificially Low, Leading to Lower “Official” Inflation

IPCA is the consumer price inflation measure used by the central bank for guiding monetary policy. Regulated prices, which are insensitive to supply and demand because they are determined by pre-established contract or set by public sector entity, weights 23.2% of IPCA, tradable 35.6% and non-tradable 41.2% (both market driven only). Data as at February 28, 2014. Source: Instituto Brasileiro de Geografia e Estatística, Haver Analytics.

Exhibit 22

The Central Bank of Brazil Must Now Raise Rates Higher, Despite Slower GDP Growth

The Selic rate is the Brazilian central bank’s overnight lending rate. Data as at February 28, 2014. Source: Instituto Brasileiro de Geografia e Estatística, Haver Analytics.

So our bottom line with Brazil is that the real fundamental macroeconomic trajectory is notably more sluggish than what the recently published data would suggest. As such, we continue to approach macro investments in this country with caution. In particular, we think that Brazil needs the combination of a weaker currency to improve exports at the same time it needs higher rates to quell greater than reported inflation and lack of slack in the labor force. If we are right, then the central bank’s current tightening cycle may go on for longer than many investors think, which likely means slower growth not only in 2014 but also 2015.

Japan: Will History Repeat Itself?

At a time when the Fed and some of its peers are beginning to moderate or even withdraw monetary liquidity, we remain struck by how committed the Bank of Japan is to providing substantial liquidity to the system. Indeed, as Exhibits 23 and 24 show, the growth in the monetary base in Japan has now accelerated to a point where its central bank balance sheet as a percentage of GDP now looks quite extreme relative to its peers in the developed market. Moreover, we believe there is more to come as the Bank of Japan remains committed to purchasing 70% of the available JGBs in the market each and every month16.

Exhibit 23

Japan Is Expanding Its Monetary Base at a Faster Rate Than the U.S., China and the U.K…

Data as at February 28, 2014. Source: Federal Reserve Board, European Central Bank, Bank of Japan, Cabinet Office of Japan, Bank of England, Haver Analytics.

Exhibit 24

…And That Pace Increased Meaningfully In 2013

Data as at February 28, 2014. Source: Bank of Japan, Bloomberg.

Prime Minister Abe is credited with the improvement in the Japanese economy through a policy of combining increased government spending with unprecedented monetary easing, an approach which has been labeled “Abenomics.” But even with this forceful monetary initiative and ongoing fiscal stimulus, we still think that there is a significant potential risk to the Abenomics turnaround story. In particular, we are cautious about consumption trends, as the Japanese government raised the consumption tax from 5% to 8% on April 1, 2014, with a further hike to 10% scheduled for October 2015 (Exhibit 25).

In our view, investors should not underestimate this tax hike, as our research surrounding prior consumption tax increases leads us to believe that not only could the consumption tax sap growth but also it could be a negative for risk assets if history repeats itself. What do we mean? Well, for those looking for what Chevy Chase termed a “refresher course” in his standout role in the comedy movie Fletch, we would start by reminding folks that the history of Japanese consumption taxes dates back to 1979 when the Liberal Democratic Party (LDP) first attempted to introduce one but failed. After a 10-year battle, a consumption tax of 3% was finally implemented by the LDP in 1989, rising to 5% in 1997. One can see the history of the trajectory in Exhibit 25.

Exhibit 25

Historical and Proposed Path of Japan’s Consumption Tax

Data as at April 1, 2014. Source: Ministry of Finance.

While the long-term effects of the tax hikes on consumption and nominal GDP are mixed, the short-term experience was quite similar in both 1989 and 1997. Specifically, in the quarter after Japan introduced the consumption tax on April 1, 1989, GDP contracted by 1.3%. Private consumption fell, accounting for 0.9 percentage points of the quarter-over-quarter GDP decline (Exhibit 26). Meanwhile, when the consumption tax increased to 5% from 3% in 1997, one can see in Exhibit 27 that GDP growth contracted 1.0% quarter-over-quarter, with consumption accounting for more than 100% of the decline.

Exhibit 26

Real GDP Contracted After the Introduction of the 1989 Consumption Tax, But Only in the Short-Term…

Qqsaar = quarter over quarter seasonally adjusted annual ratio. Data as at 2Q1990. Source: Cabinet Office of Japan, Haver Analytics.

Exhibit 27

…While the Same Story Played Out in 1997, But Longer Term, the Economy Fell into Recession

Qqsaar = quarter over quarter seasonally adjusted annual ratio. Data as at 2Q1998. Source: Cabinet Office of Japan, Haver Analytics.

Beyond affecting growth, the increases in the VAT also had a significant short-term impact on the Consumer Price Index. In 1989, Japanese CPI increased from 1.05% to 2.68% in the quarter following the introduction of the VAT while the hike in 1997 had a similar short-term impact as year-over-year CPI increased from 0.56% to 2.07% (Exhibits 28 and 29).

Longer term however, our research shows that it is more difficult to draw conclusions on the pace and level of inflation. Six quarters after the introduction of the VAT in 1989, inflation remained well above 2% (Exhibit 28). By comparison, six quarters after the hike in 1997, inflation actually reverted and declined for several quarters. As such, our bottom line is that the short-term story is evident – inflation will head higher, in our view. But longer term, we are more skeptical about the effects that the hikes will have on inflation expectations, which we think will likely have a significant impact on how Abenomics is viewed.

Exhibit 28

The Introduction of the Consumption Tax in 1989 Caused An Immediate Spike in CPI…

Data as at December 31, 1990. Source: Ministry of Internal Affairs and Communications.

Exhibit 29

…But in 1997 Inflation Headed in the Other Direction

Data as at December 31, 1998. Source: Ministry of Internal Affairs and Communications.

Beyond inflation and growth, we also looked at how the tax hikes impacted capital markets areas like the stock market on a longer-term basis. The simple answer is that the stock market was materially lower four quarters after the consumption tax increases. Specifically, as one can see in Exhibit 30, the market depreciated by 3.1% and 23.2% in 1989 and 1997, respectively, four quarters after the hike.

Exhibit 30

The 1989 and 1997 Tax Hikes Negatively Impacted Stocks, But Were More Mixed in Other Areas





Pre-Hike Tax Rate




Post-Hike Tax Rate








Pre-Hike NKY Level




1 Qtr. Post Hike NKY Return




4 Qtrs. Post Hike NKY Return








Pre-Hike JGB Yield




1 Qtr. Post Hike JGB Yield Change




4 Qtrs. Post Hike JGB Yield Change












1 Qtr. Post Hike USDJPY Return




4 Qtrs. Post Hike USDJPY Return




Pre-hike April 1989 data as at March 31, 1989; Pre-hike April 1997 data as at March 31, 1997; Post-hike 1 Qtr. April 1989 data as at June 30, 1989 and April 1997 data as at June 30, 1997; Post-hike 4 Qtrs. April 1989 data as at March 31, 1990 and April 1997 data as at March 31, 1997. Source: Ministry of Internal Affairs and Communications, Bloomberg.

So as we look ahead, the question for investors is whether history will repeat itself. To some degree, it already has as Bloomberg shows that the Nikkei has fallen 9.0% through March 31, 2014. But given that the consumption tax is estimated to remove ¥6 trillion from the economy, we think that there is risk that the current consensus consumption forecast for the next three to four quarters could still be too optimistic17. Specifically, we think that consumption could be closer to the estimates of Morgan Stanley’s Robert Feldman, who forecasts -2.4% in 2Q14 and 0.1% in both 3Q14 and 4Q14)18. As such, we think that the government will need to do more with either monetary policy (such as switching the allocation of the country’s pension savings towards more stocks) or introduce additional measures to stimulate structural growth. If there is good news on this latter issue, it is that the Japanese Finance Minister Taro Aso indicated on March 27, 2014, that the government would fast-track 40% of its total fiscal spending to occur during the April-June quarter.

We also think that Prime Minister Abe should do more to raise real wages. According to a recent Reuters survey, fewer than one in five Japanese companies plan to raise base wages in 2014. Moreover, only 11% of firms said that they plan to lift total remuneration (bonuses plus base pay increases) by an amount sufficient to cover the 3% rise in the consumption tax19. The recent increase in commodity prices is also an issue. According to our work, approximately 30% of the total year-over-year change in the increase in inflation since January 2013 has come from primarily higher fuel prices linked to a weak currency, not stronger growth driving better pricing for Japanese citizens as one might expect.

Exhibit 31

Gasoline, Electricity and Natural Gas Are Large Components of Headline Inflation

Data as at February 28, 2014. Source: Ministry of Internal Affairs and Communications.

Exhibit 32

Foreign Investors Have Bought Into the Japan Story

Data as at February 28, 2014. Source: Credit Suisse, Thomson Reuters.

Finally, Abe needs to implement his “Third Arrow” structural reforms. He has identified several important areas for change, including freer trade, deregulated energy and zoning, modernized healthcare and a more flexible workforce with higher female participation. While the government has been making incremental progress in these areas (e.g., it is creating deregulated “Strategic Economic Growth Areas” to promote foreign investment as well as introducing tax incentives for corporations that raise wages), we think to date the Third Arrow has been largely disappointing. Key events that we think could rekindle investor enthusiasm include progress on the Trans-Pacific Partnership (currently held back by concerns over agriculture) and/or the restarting of idled nuclear plants (currently held back by popular opposition and slow progress on the Fukushima cleanup).

Exhibit 33

Weaker JPY Has Not Led To an Improved Trade Balance

Data as at February 28, 2014. Source: Ministry of Finance/Japan Tariff Association.

Exhibit 34

Banks Have Underperformed the Topix By 12% Over the Last 12 Months

Data as at March 25, 2014. Source: Ministry of Finance/Japan Tariff Association.

Bottom line, we think that Japan has the potential to remain a disappointment in calendar 2014. In particular, weaker private consumption could mean that GDP falls short of the BOJ’s current 1.5% forecast for F201420. Moreover, investors are beginning to appreciate that a lower yen in isolation cannot fix many of Japan’s structural issues. As Exhibit 33 shows, Japan’s trade balance has not improved as higher oil prices in yen terms have offset much of the improvement in Japan’s export sector from a cheaper currency. Moreover, recent underperformance in the banking sector, as we show in Exhibit 34, seems to underscore our point that more supply-side, structural reform is really needed to convince both local and foreign investors that this time is now really different.


While it has certainly been an attractive environment for risk assets since the market bottomed in March 2009, the economic cycle now seems more seasoned. With this seasoning, we believe macro excesses are beginning to form. In the United States, the margin story is now more difficult, and when GDP does slow, we expect profits to fall much faster. Meanwhile, in the U.S. fixed income arena, investor sentiment appears to be somewhat complacent, particularly at a time when Federal Reserve policy is likely to be less accommodative.

In Japan, we see continued room for economic disappointment, particularly as it relates to consumption trends. As we detailed above, history shows that weak consumption trends are typically associated with weak equity market performance. As such, Japanese authorities will likely need to assess whether more stimulus is required. Our strong view is yes, but given current high government debt levels, we believe additional stimulus could create further instability in the country’s capital markets.

Finally, within emerging markets, we continue to view both China (which we detailed earlier in our report China in Transition) and Brazil (which we detailed in this report) as countries facing major structural issues. In the case of Brazil, our work shows that growth is likely to disappoint on the downside at the same time that inflation will surprise on the upside.

Overall though, we continue to believe that the current economic cycle runs through early 2017. Against this backdrop, we think risk assets, particularly in the developed markets, will continue to perform well. But as we discuss in this paper, we think now is not the time to get complacent. The cycle is maturing and with that maturation, we believe excesses are building, many of which will likely act as potential catalysts/headwinds when the next downturn inevitably occurs.

1 Data from February 28, 2009 thru March 31, 2014. Source: Bloomberg.

2 Data as at March 27, 2014. Source: Federal Reserve Board:

3 Data as at December 31, 2004. Source:

4 Data as at March 31, 2014. Source: Bloomberg.

5 Exhibit 23, Outlook for 2014: A Changing Playbook.

6 Data as at February 28, 2014. Source: Federal Reserve, Bureau of Economic Analysis, Morgan Stanley Research.

7 Data as at May 30, 2013. Source: Financial Markets Department, Bank of Japan.

8 Ibid. 2.

9 Ibid. 3.

10 For simplicity purposes, we are assuming the delta on an option on Treasury futures is a proxy for the implied probability. Data as at March 26, 2014. Source: Bloomberg.

11 Data as at December 31, 2013. Source: Bloomberg.

12 Data as at March 26, 2014. Source: Bloomberg.

13 See footnote Exhibit 16 for full details.

14 Data as at March 24, 2014. Source: Bloomberg.

15 Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia e Estatística, Haver Analytics.

16 Ibid.7.

17 February 2, 2014 Cornerstone Macro report dated March 3, 2014.

18 Data as at January 21, 2014. Source: The A, B, Cs of Abenomics: Philosophy A; Content B; Implementation C, Morgan Stanley Research.

19 Ibid. 17.

20 Forecast as of November 1, 2013. Source: Bank of Japan.