Brief Loss of Confidence

April 2008 Dr. Hans Black

In an eerie week just before mid-March, global stocks were plummeting and most participants in the global investment business were trying to figure out just where the rotten apple lay. By Friday, March 14th, the finger-pointing began in earnest as shares of Bear Stearns were plummeting. During the subsequent weekend, events played out that had not been seen for over seventy years. Indeed, just before the opening of the Asian markets on Sunday, March 16th, global central banks stepped in and took over the operation of the Bear Stearns, handing it to J.P. Morgan in the process. I will spare my friends and readers all the gory details. I would like to reiteratate that this is not in our opinion a bailout as shareholders in prominent global international institutions lost a lot of money quickly. Furthermore, despite the necessary guarantees by the US central bank we are nowhere near out of the woods. Markets may rally short-term but we in no way endorse the view that we have been given the all clear to rush back into financial instruments and particularly financial companies. Indeed, we believe that the events of March 2008 will be long remembered as the month the game changed in earnest. Many stocks will continue lower, especially those linked to the consumer and credit. We prefer selected technology companies, commu-nication companies and particularly health-care companies. Gold will go lower short-term but then head substantially higher, perhaps starting next year.

Void at the Bank of Japan

April 2008 Stan T. Schmidt

For the last thirteen months, financial markets in the developed world have struggled to gauge the extent of the minefield in which financial institutions and investors found themselves in the aftermath of the bursting of the U.S. housing bubble. Ever since HSBC, one of the world’s leading banking institutions, announced in March 2007 that it was taking a USD $10.5 billion write-off against 2006 earnings as a result of growing defaults in the sub-prime markets, the toxic waste has continued to bubble up to the surface around the globe giving rise to the growing realization that credit market problems were now in everyone’s back yards. The resultant fallout has been a crucible for G7 central banks. The ECB has at times moved at more than its usual glacial speed to provide liquidity to the markets, although it continues to be our view that interest rate cuts are greatly needed to address a slowdown in the Euro zone. At the same time, Ben Bernanke, Chairman of the Fed since February 2006, has had to prove exceptionally resourceful in his baptismal fire. Desperate times call for desperate measures and politics, and crises, make for strange bedfellows, but the cooperation of the U.S. and European central banks has, at least to date, along with the Bank of England (BOE) and the Bank of Canada, brought the markets back from the brink of meltdown on at least a few occasions over the last thirteen months, although we believe the final chapter of this saga is yet to be written and is still a ways off.

It is somewhat disquieting then, at a time when central banks are being tested as rarely before, to cast an eye toward the Bank of Japan. Since March 19, when Toshihiko Fukui’s five year term as Governor expired, along with the terms of his two deputies, Kazumasa Iwata and Toshiro Muto, the world's second largest central bank (after China) with over $1.0 trillion of reserves, a G7 country, has been without a leader, a position that a struggling Japanese economy can ill afford.

To understand how such a situation could occur, it is important to appreciate that Japan is in somewhat uncharted territory in its own right, experiencing a rare case of paralysis through political gridlock. In a country where the ruling Liberal Democratic Party (LDP) has held power for all but one year since 1955, the art of political compromise is not always what it should be. The opposition Democratic Party of Japan (DPJ) last year won control of the Upper House of the Diet, giving it the power to block appointments made by the LDP led Lower House.

The political problems of former Prime Minister Shinzo Abe, were highlighted in an article we wrote in August 2007. After a scandal over missing pension records eroded the party's popularity last year, the upper house fell under the DPJ control for the first time last July, leading to Abe’s resignation in September. Yasuo Fukuda, tapped by the LDP to succeed as Prime Minister, has been haunted by a continuing slide in his approval ratings due to the fact that, as of mid-March, owners for only about 20 percent of more than 50 million unidentified pension accounts have been found, falling far short of the LDP’s promise to identify all the records by March.

With public sentiment rapidly deteriorating, political immobility has set in, and the BOJ has become an unfortunate casualty. Last month, the DPJ walked out on budget talks and has now flexed its new found muscle again by holding up the appointment of the nation's top central banker.

Thus far, Prime Minister Fukuda has proven unequal to the test which is being seen as a referendum on his leadership. With current disapproval ratings hovering around 54%, and an approval rating of only 31%, Fukuda made the mistake of nominating Toshiro Muto for the top BOJ job, in spite of the fact that the DPJ had opposed the appointment of Muto as Deputy Governor five years ago. Not surprisingly, Muto’s nomination was voted down, as was that of Koji Tanami who was named by Fukuda after the rejection of his first candidate. Both houses approved Kiyohiko Nishimura and Masaaki Shirikawa as deputy governors. The tide of public opinion has continued to turn against Prime Minister Fukuda in the face of rising doubts about his ability to provide leadership and his tenure is now increasingly shaky. In recent public opinion polls, 41 percent of respondents thought the government and the ruling coalition were to blame for the standstill, versus 27 percent who thought the opposition parties were at fault. Should Fukuda’s popularity fall further, it is likely that members of his own LDP party may soon begin calling for his resignation. Either way, it appears that the price of securing confirmation of a new BOJ governor is likely to be promulgating a candidate likely to be more independent of the Finance Ministry and consequently more acceptable to the DPJ.

In the interim, the BOJ is without a Governor and a clear direction, but not totally without leadership. The Bank of Japan Law stipulates that in the absence of a Governor, one of the Deputy Governors will become acting governor. That position has been assumed by Masaaki Shirikawa who has over 34 years of central bank experience, including working in the BOJ's monetary policy planning division. It appears that he will also represent the BOJ in international gatherings including the Group of Seven meeting of finance ministers and central bankers in Washington this month.

What will meet the new governor, when one is finally agreed upon, is an economy which is rapidly losing steam and threatening Japan's longest recovery since World War II. Hammered by the slowdown in the U.S. and by the over 20% appreciation of the Yen since the summer of 2007, the BOJ will have to focus on avoiding a recession with limited tools at its disposal. There are not a lot of policy options with the key bank rate at 0.5%, considering that over the last seven months the Fed has cut rates from 5.25% to 2.25%. Faced with the world's largest public debt, negligible interest rates, a stronger yen, and the prospect of slowing markets in the West, the key would appear to be to stimulate domestic spending by getting households to save less and spend more.

This has not proven to be an easy challenge over the last few decades. The attempt has seen the BOJ create its own credibility problems, chief of which was cutting rates to zero in the late 1990s. Under Governor Fukui's leadership, the bank reversed a five-year policy of trying to pump up the economy with cash and maintaining interest rates near zero by raising its key overnight lending rate for the first time since 2000, first to 0.25 percent, and then to 0.5% in February 2007. Now is the time to reassess that direction.

The world is much too volatile a place right now for Japan to lack economic leadership. Domestically, a tightening of fiscal conditions has resulted in a drop of almost 18% in equity prices this year and appreciation of over 12% in the yen versus the dollar. Confidence among Japanese manufacturers fell to a four year low in the latest Tankan index, released April 1, signaling the impact of slowing export sales in the U.S., Japan’s largest export market. With the Fed perhaps poised to cut rates again at its April 30 meeting and with the scheduled release of the BOJ’s annual report on the economy and prices due this month, the pressure is likely to mount on acting Governor Shirikawa to cut rates once again, even in the absence of a new governor. In the interim, the political logjam in Japan spells trouble, not only for the domestic economy and the LDP leadership, but for the delicate balance of the world financial community as a whole.