Geopolitical Developments: Japanese Bankers And Main Street USA/China/Russia

Putin’s malevolence may well cause Japanese bankers to retrench and lead the global economy down to recession. We’re in the early innings not just of the war but the economic ramifications of Putin’s irrationality. Eventually this will catch up with the US equity market and plunge indices to bear market levels. The volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), but my technical reading of key stocks in the S&P 500 is neutral. Yesterday there were several negative factors across global asset classes. The US yield curve is rising and in the current context that is bearish. Inflation expectations are rising based on measures of Treasuries and TIPS. Expect the S&P 500 to be range-bound over the next few days before beginning a steep decline.

The tentacles of the Ukraine crisis manifest throughout Asia and reveal financial linkages that are rarely covered in the public discourse. A particularly flamboyant example is the nickel market, which broke down as sanctions multiplied upon Russia and convinced traders that supplies would be choked off. This straightforward consequence of the war ramifies profoundly to Japan and China and shows how culturally-driven imbalances in these two nations put the commodities market and in turn global confidence at risk.

Japan has suffered from lost decades since the go-go 1980s, and once consequence has been the unusual role Japanese banks play in the commodities market and other esoteric financial markets. The volume of assets Japanese banks hold abroad means they are affected by US interest rates set by the Federal Reserve, but also the orderly functioning of various financial markets. When disorder comes, and when this is amplified by uncertainty about Fed policy, Japanese banks get caught and put businesses that depend on them at risk. This is the essence of contagion.

Nikkei Asia notes “With the financing of much of Asia's trade and the flows in and out of its various financial centers still heavily dependent on Japan, Japan's bankers, squeezed between an overheating U.S. and an increasingly troubled China, have a difficult balancing act to perform…Since the 1990s, Japan's big banks have had a very large and growing deposit base but limited domestic demand for credit, forcing them to look overseas for profits in international capital markets, which are dominated by dollars. To grow overseas, Japanese banks needed vast amounts of dollars. Fortunately, there was a solution in the Eurodollar market, and this is where things get more complicated…

“The first step of this chain often starts in London. Bankers in Tokyo will pledge yen as security for loans and receive Eurodollars in return, enabling them to make loans or buy assets in dollars. In turn, Japanese banks will usually demand some sort of security or collateral for these loans. This can vary from U.S. securities to real estate to the commodities that underlie trade finance…Because borrowing in Eurodollars is more expensive than borrowing onshore in America, Japanese banks must find higher-yielding returns to offset this cost. This naturally forces them toward higher-risk lending. A good example of this is the failure of Archegos Capital Management, a family office that managed the personal assets of South Korean-born U.S. investor Bill Hwang, which caused outsized losses for Japanese banks…Another cost relates to complexity and with it, most importantly, fragility. At every stage, there are moving parts such as the value of the collateral backing the loans or the creditworthiness of the banks involved. If all parts of this chain remain stable, then all is well. But sudden changes can cause things to quickly fall apart and dollar liquidity to evaporate. Witness the problems China Construction Bank is having finding dollars to pay for a nickel financing.”

The volatility in commodities markets following the invasion helped raise volatility in the US equity market, and that heightened volatility means the US economy will slow down significantly. The link between global financial markets and the American corporations who dominate the US economy is equity volatility, because American CEOs look to the volatility narrative to determine what strategic decisions to make regarding growing or cutting back operations. The complexity of the US economy and in turn the global economy make it too costly and difficult for CEOs to run independent forecasting teams, and so in making sales forecasts they look to volatility to give them a positive or negative read. So the dislocations caused by the war impact US firms regardless of whether they pay attention or care about geopolitics. And the problem is that these dislocations are combining with uncertainty about the Fed to drive the Japanese banks to make tough decisions about cutting back on lending, which could lead to more volatility and in turn wreck the global economy. Nikkei Asia further notes:

“Fortunately, if markets get tough, Japan does have an insurance policy: as a close ally of the U.S., the Bank of Japan can borrow dollars directly from the Federal Reserve to provide a temporary overdraft to its banks. This is an advantage not available to the People's Bank of China or even the Hong Kong Monetary Authority, which must rely on a finite amount of U.S. currency reserves. Again, as Russia is discovering, the ability to access these reserves depends on the goodwill of G-7 nations…With the Fed now worried about inflation, likely to lead to a tightening of global liquidity, Japanese banks must now make some tough decisions over what to do with the more than $5 trillion worth of overseas claims they have amassed. Do they cut back on risk and reduce their Eurodollar borrowing, charge a higher interest rate to borrowers, or become more selective in their lending? Our guess is that they will do a mixture of all three…With $166 billion of direct exposure to mainland China and Hong Kong, and with huge problems beginning to surface in Chinese real estate, this sector will be a prime candidate for risk reduction. It will be a difficult balancing act and, if Tokyo's bankers do not pull it off, it may add to China's own problems at an already difficult time.“

So Japanese banks that have been affected by commodity volatility and Fed policy are at risk of cutting down on China’s beleaguered property market, which has contagion effects because global investors have exposure to Chinese property and China is one of the few bright growth spots for the world. A falling China would further dent US exports and raise the trade deficit, likely plunging the US into recession just as the Fed is taking the punch bowl away because of panic over inflation.

The heart of the matter are the cultural-economic imbalances in Japan, China and the US. Japan has too much savings finding too little domestic investment, because this historically cohesive, conservative and stable nation went through cultural convulsions as its economic miracle unfolded. China has too much government-directed growth that results in property speculation, because its leaders cannot shed their Maoist beliefs in elite leadership and paternalism toward the “mass line” of Chinese workers. And the US has too little savings chasing a lot of investment because it’s an individualistic society that doesn’t define individualism, and so caters to the lowest common denominator of self-interest, namely materialism and consumption.. The net result is American workers are significantly dependent on the decisions of Japanese bankers, which is anathema to the history’s most benevolent superpower.

Yesterday I sold a small portion of my market exposure via the levered ETF UPRO. My current positions include a now larger and signifiiant cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.