“Sell in May and Walk Away” didn’t work this year. Through May 30, the Dow Jones Industrial Average and S&P 500 are basically up 3%.
Now investors are wondering whether the recent volatility in Japanese markets is foretelling the future of U.S. markets.
After last October’s initiation of “Abenomics”, the quantitative easing-like monetary policy championed by Japanese Prime Minister Shinzo Abe, the Nikkei has rallied some 50%.
However, after pushing the Bank of Japan to raise its inflation target to 2%, the Abe plan is meeting market resistance, and the faults are becoming visible.
The problem with the 2% inflation target is that Japanese banks, which hold an enormous amount of Japanese government bonds, likely will come under severe capital pressures as this occurs.
The thesis is that as inflation rises, interest rates will as well; meaning bond values will drop, causing balance-sheet issues for the banks.
Although this thesis is sound, I believe it is incomplete and ignores several key facts:
Japan is still stuck in a deflationary cycle, and the May 30 Japanese CPI and PPI data showed this very clearly.
Although comparisons are plentiful, U.S. monetary policy in its totality is very different than that of Japan.
And perhaps most significantly, U.S. banks don’t own a lot of U.S. Treasuries or TIPS.
Unlike U.S. banks, Japanese bank holdings in longer-dated JGBs have swelled to astronomical levels and thereby have created a significant problem for the central bank, unnerving markets.
Notwithstanding, even a relatively mild rise in interest rates could have a dramatic impact on bank and insurance company balance sheets, especially once mark-to-market rules (part of the Basel III and Simpson-Bowles reforms) come into effect in 2014.
As a result of having a zero interest rate policy for more than a decade, regional Japanese banks and insurers already mark to market, and are therefore very susceptible to a rise in interest rates.
Investors do not need to panic and should not view this as a broad-market sell signal. Rather, this is a real-time case study of how equity markets react to a rising interest rate environment.
Based on this, we will be monitoring the reaction of various market segments within the Japanese equity markets in an attempt to provide us with better insights as to how U.S. markets may react if or when the Federal Reserve begins to exit its current easing strategy.
Will small-cap value stocks, which tend to have very little debt exposure, dominate in this market cycle? Or will large-cap stocks with fortress-like balance sheets be a safe haven?
History tells us that companies with stretched valuations tend to fare worst in a market decline, a cycle we are sure will repeat itself. The good news for investors is that we believe there will be a meaningful shift in domestic monetary policy this year.
In spite of the banter and worrying, there are no signs (unfortunately) that our economy is strong enough to continue its expansion course without help from the Fed. Moreover, Europe and Australia are still in monetary easing mode, making a turn in our policy less likely.