Download A Distressed Nation on the Brink of Collapse

Japan’s End Game
Dear Strategic Investor,
I hope everyone had a fantastic New Years and holiday celebration.
I spent New Year’s Eve in Seattle with my wife, watching the fireworks shooting out from
under the Space Needle.
This trip to Seattle has turned into a tradition. We’ve spent New Year’s there for the last
three years. And every time we go it gets better.
There wasn’t a worry on my mind. I don’t think about the markets when I’m there. It’s a
needed break. But it never lasts long.
The fact is there are a lot of things to think about in 2013, including…

Another debt ceiling debate in the U.S…

The sovereign debt crisis in the EU…

Whether the U.S. will wage war against Iran…
And on top of these things, there’s something else: Japan.
A Distressed Nation on the Brink of Collapse
Japan is the poster child for economic outcomes such as deflation… out of control
government spending… and more than two lost decades.
But how did Japan get into such a precarious situation?
It all started with a bubble that burst. And when it all came apart, it took stock and real
estate prices down with it.
In order to fight off the deflationary effects of this busted bubble, the Bank of Japan (BOJ)
lowered interest rates and started printing money to create inflation.
Not only has the BOJ completely failed to create inflation, but it’s put Japan in the worst
economic situation of all the developed economies.
Today, Japan has a debt-to-GDP of 230%... still holds ultra-low interest rates… and has
experienced deflation since June 2012 (and nine out of 12 months in 2011, plus all of 2009
and 2010).
For a long time, analysts have tried to pinpoint when Japan’s end game would come. They
figured this printed money would lead to hyperinflation. At the very least, they imagined
that Japan would eventually have a sovereign debt crisis of its own.
Yet, more than two decades have gone by without either occurring. And everyone who bet
against Japan would have lost money.
The Most Hated Trade in the World
If you bring up the idea of betting against Japan to most seasoned investors, they’ll look at
you like you’re crazy. More than 20 years have conditioned the markets to expect the
Japanese economy to continue chugging along.
Betting against Japan has become one of the most hated trades in the world.
And that’s exactly why I’m warming up to it.
The world is very different today than it was just seven years ago. What used to be
unthinkable to investors – sovereign debt defaults – is now being accepted as a potential
outcome, even for a developed nation like Japan.
You can thank the European Union for that.
Before the financial crisis, there were economists calling for the euro to become the next
great reserve currency. That’s how much faith people had in the euro.
Today, people are genuinely debating whether the euro will survive another five years. Not
only has Greece entered default, but countries like Spain and Italy look like they’re headed
for the same fate.
So what was considered impossible a couple years ago is now a believable, and even likely,
possibility.
That’s bad news for Japan.
Out of all the developed economies, Japan is in the worst shape.
It has a rapidly aging population. It relies too heavily on exports. It has trade problems with
China. It had two horrible disasters shake the nation. And it’s economically impotent.
All it needs to fully realize its decline is a catalyst. And we may be seeing that now…
The End of Japan as We Know it?
Japan has a new Prime Minister, Shinzo Abe.
And he’s sick of watching Japan stagnate for the past two decades. So he has a plan to get
the country out of the doldrums.
First, he wants the Bank of Japan to increase the 1% inflation limit to 2%. Second, he wants
to ignore the debt cap for the year. And third, he’s called for the BOJ to carry out “unlimited”
easing.
He wants to create inflation. But he should be careful what he wishes for.
Remember, Japan has a debt-to GDP ratio of 230%. The country has been fortunate enough
to acquire all of this debt at very low interest rates. But inflation, if it occurred, would push
interest rates higher. As the country rolls over its bonds at a higher interest rate, its debt
payments would increase.
Eventually, interest payments would take up a huge chunk of Japan’s budget requirements.
The country would have to either cut spending or increase taxes. Most likely it would do
both. But there is no guarantee that Japan could balance its budget or grow fast enough to
reduce its debt-to-GDP.
When Japan’s leaders recognize the problem in a few years, they will likely print more
money to make up the shortfall. This would eventually erode confidence in the yen, and put
the currency on the path to a hyperinflation problem in the future.
And what if they don’t print more money? Well, then Japan would have to default. That
would be the biggest sovereign debt default the world has ever seen.
This leads us to several implications.
1) The yen will probably lose value in the years to come.
2) Inflation in Japan will spill over to the rest of the world by 2016.
3) The dollar will grow stronger if the yen should collapse (and lead to a delay in any
potential U.S. sovereign debt crisis).
These are all things we can capitalize on. But first, we want to see if Shinzo Abe can actually
get traction with his plan to inflate Japan’s economy. If we see him progressing towards his
end goal, then we’ll feel a lot better about betting against Japan.
For now, the Strategic Investment portfolio has done extremely well.
And over the coming months we’ll keep giving you plays to capitalize on the macro-level
events we see heading our way.
Until next week,
Charles Del Valle
P.S. Your Davidson Unplugged transcript from December 23 isn’t ready yet. But we’ll let you
know when it is.