Global Financial Crisis

Trust in Japan? Strangled by sontaku 忖度

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Trust and Japan used to go hand in hand. It was a hard earned reputation.  A mining executive once told me that “when you sign a contract with the Japanese, that is the contract. When you sign a contract with the Chinese that is the beginning of the negotiations.” Hardly a subtle difference. Yet here we are in the last few years where a plethora of scandals from Japanese companies have come to light. Houeshold names too – Olympus, Toshiba, Kobe Steel, Subaru, Toray, Nissan, Mitsubishi Motors, Takata, Mitsubishi Materials, Asahi Kasei, Obayashi, JR Central, Nomura etc etc. It is almost as if there is a coming-out of sorts so the crimes are somewhat diluted in the midst of others. Syndicated scandals? Expect more to come out. Perhaps the worst part about it is the limp wristed approach by the regulators. ‘Sontaku’ (忖度) in Japanese is a word meaning ‘glossing over’ which is exactly what the regulator is doing over scandals involving household names. Hear no evil, see no evil, speak no evil.

In October I was invited to give a lecture to 70 bureaucrats at the Ministry of Finance’s attack dogs – the Financial Services Agency (FSA) and the Securities and Exchange Surveillance Commission (SESC) on foreign perceptions of Japan’s handling of corporate  crime. In the interests of objectivity the first slide pointed to how no corporate governance system is perfect citing the minefield of foreign corporations caught up in bad behaviour – VW, Petrobras, Parmalat, HealthSouth, Lehman Brothers etc etc. I also highlighted the sentencing of executives who commit crimes – many received lengthy jail sentences, personal fines while the corporates faced eye-watering penalties.

Ironically much of the crime committed by corporates here is at a relatively pithy level. Instead of billions being massaged into or from the books, Japanese corporates tend to commit the equivalent of falsely submitting a $20 taxi receipt to your boss as a business related expense. One almost could conjure up a scenario that if Toshiba was ever able to make back the money to cover the accounting fraud they’d have broken into corporate HQ in the dead of night to put it back in the safe.

I touched on Kobe Steel which conveniently broke the news that it had falsified the true contents of its products to customers. While pointing out such behaviour was regrettable a chart which showed a heavy shorting of the stock on the day it announced it to its duped clients displayed the bigger problem. A question was asked directly to the regulator – “do you intend to investigate the heavy short selling of Kobe Steel stock 3 weeks before the company announced this to market?” No answer.  The following slide showed that a person that was able to short the stock 3 weeks before the announcement would have cleaned up a tidy 60% profit. Again no plans to investigate the insider trading. Why bother having the FSA if it is a toothless tiger?

The following slide showed the types of fines dealt to both the broker (Nomura was a regular feature in the leaks) and the investor (at the time Chuo Mitsui Asset). The fines were the equivalent of $500 and no suspension of license was pursued by the regulator, When the following slide that compared it to the types of fines meted out to foreign banks – lengthy jail terms, lifetime suspensions and monster fines in the the millions and billions jaws didn’t so much drop but celebrate the idea “thank God we live in Japan”. Truth be told the FSA did punish one dying asset manager $150mn but that is an exception. That is the problem. It is too conditional where convenient.

Rolling onto the next slide the discussion looked at how ‘sontaku’ was a problem. Whereas the FSA & SESC heavily pushed for license revocation of foreign investment companies that it found to break rules, it let off all the domestic companies that had ‘brand names’ to protect. What message is the regulator sending if local corporations know they can pretty much get away with anything. In what way is that a fair system? If foreigners will be turfed on a whim then why do the locals get special protection?

When looking at agency funding, the FSA was put up against the US SEC and Australia’s ASIC equivalents. The US was there for illustrative purposes. Yet Australia was the market that made the point clearest. Despite having a total market cap 5x the size of Australia and 30% more listed companies, Japan spends 20% less than the antoipodeans. Even worse it had fewer numbers of staff and its budget was shrinking.

When analyzing market surveillance, in 2014 the Aussie market issued 36,000 speeding tickets (alerts to potentially suspicious trading). The sophisticated systems are designed to catch any wrong doing. The Japanese issued around 180 speeding tickets. I suggested the FSA go cap in hand to ASIC and the ASX and ask if they can buy the software off the shelf. Safe markets attract capital because all actors feel adequate protections are in place to prevent crime. Higher liquidity attracts more liquidity. It is a win win.

Several years ago the fanfare of the Corporate Governance Code was thrust into the faces of the intenational investment community that Japan Inc was changing. After visiting multiple staff inside the FSA and the TSE there is absolutely no pulse of proactively to be seen anywhere. Even my slight nudge to get the FSA to tap the shoulder of the TSE to suggest listed corporates provide English language materials to encourage more transparency for foreign investment met with the response, “it might help if you spoke directly to the Deputy PM & Minister of Finance Taro Aso.”Not a word of a lie.

How can the Japanese authorities look to appropriately handle a slew of corporate scandals if the encouragement of English language documents requires someone (a gaijin no less) outside the agency to ask the Deputy PM to suggest it back down to them. It is an embarrassment.

In closing perhaps we can look to these corporate scandals breaking out as endemic of a greater underlying problem. While the knowledge that the regulator is likely to do next to nothing provides mild comfort, the reality is that Japanese companies have been strangling themselves for decades. The corporate fabric is fraying. The world is far more competitive than it was. For Japan to assert its ‘quality and/or engineering gap’ dominance now means profits likely suffer. In order to  get around that hurdle it seems that to maintain profit margins, corporates now lie about specifications hoping a history of ‘trust’ and ‘time honoured’ traditions can keep the bluff going. As mentioned earlier the scale of the ‘cheating’ is pitiful yet the shame it brings is multiples larger.

Japan’s cultural rigidities are on full display. Unfortunately they couldn’t arrive at a worse time. Clumps of companies confessing crimes to soften the collective blow is only the start of many more. I suggested in my speech that the authorities introduce a 3 month amnesty period for companies to fess up to any wrong doing. That way they can clear the decks and make it clear that any wrong doing after that date will be met with harsh repercussions. Of course it won’t happen but expect the list of companies above to have many join them at the table of shame.

Madoff wasn’t so long ago

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It was just over 9 years ago that Bernie Madoff pleaded guilty to a Ponzi scheme that cost investors over $65bn. While many happily point fingers at greedy banksters we tend to forget that despite Harry Markopolos, handing the SEC (the US regulator) the details of the case in 1999 on a platter it failed to act. His testimony points directly to the kind of problem that exists with government regulators – no track record in the fields they legislate. In the 9 years prior to Madoff pleading guilty, Markopolos caught him at the $6bn stage. The SEC after multiple investigations turned nothing even with a treasure map provided by Markopolos that someone with markets experience would have discovered in 30 minutes. Throw on all the other scandals (ratings agencies etc) that the SEC failed to capture and it cost taxpayers $700bn.

Willful negligence? I gave a speech at the Japanese financial regulator (FSA) on fraud and insider trading  at the time of the Kobe Steel data scandal. When presented with comparable data with other exchanges the blind eye is no less scandalous. So before hanging the financiers out to dry perhaps people ought to question the regulators whose incompetence and inaction is at fault. If you give a child a box of matches unsupervised then don’t be surprised if the whole house burns down.

This can’t wait

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John Mauldin has written an informative piece entitled “this can’t wait” which sums up a lot of pieces I’ve written on the sickening state of public pension unfunded liabilities and the debt super cycle that is facing us. While Mauldin is trying to sell his investment services on the back of this, I wasn’t when I wrote mine. Public service announcement? Maybe but the stats of the black holes we face in pensions and central bank QE which has failed to boost money velocity will bite. Hard. There will be no “I told you so” glory because almost everyone will lose big.

Even if people want to criticize me for being a perma-bear there is no harm in being aware of what is likely coming.

Bitcoin now on prime time Japanese variety TV

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The picture above is of Tetsuro Degawa, a Japanese comedian who does his best to show himself to have little intelligence. On prime time TV tonite he was talking about Bitcoin. The sign to the right partially says “can you understand Bitcoin in 5 minutes?” 

Japanese TV audiences generally gasp at new information so Bitcoin was a subject of great interest. Still one wonders if Degawa is presenting on the crypto currency that we’re one stage away from the taxi driver giving tips.

Today, Bitcoin is trading over $15,000 up another 13% today alone. Apparently Warren Buffett has disclosed Berkshire Hathaway has bought some too.

In 20 years in financial markets I cannot work out how something backed by nothing other than greed in a market that is not regulated and highly vulnerable to cyber terrorism continues to sucker more people in.

Tulip mania may be removed as the bubble yardstick before long. As one of my experienced private wealth managers likes to say, “I have difficulty fathoming the “no euphoria this time” view.”

Is this another sign of the top of the asset bubble?

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Is this sign of the top? Normally Japanese banks are more risk averse than a politician speaking after a scandal has leaked. So what is the connection of Rolls-Royce using the foyer of the HQ of one of Japan’s megabanks (SMBC)? To promote high net worth banking customers to take out negative interest car loans? To give a luxury element to their brand? Do we need to remind ourselves the last time Japanese corporates shunned conservative values and splashed out on Van Gogh and Monet artworks? It was before the bubble collapsed.

At least the expensive artworks can be theoretically smuggled out of the building in style! We shouldn’t worry about security either as the SMBC foyer has robot security.  They have a “game function” on the touch panels meaning that would be robbers need only distract the robots with video game junky children.

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The “bigger” point about the FANG sell off

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While the press is waxing lyrical about the unprecedented loss caused by a sell off in FANGs (Facebook, Amazon, Netflix & Google) we should note that it overlooks one factor. Before getting to that, to start with the sell off in gross dollar terms it is unsurprising given the already highly inflated value of the base stocks. So if A $500bn market cap Facebook loses 4% it is equivalent to $20bn. On one day FB lost a Fiat Chrysler. It’s math. Let’s not forget that Bitcoin is now worth $165bn but let’s not let that bubble spoil the party.

The problem that faces financial markets is the advent of ETFs. While stupefyingly simple to understand as an investor it is that same simplicity that breeds complacency. ETFs are simple products that enable investors to pay much lower fund management fees to buy easy to understand baskets- whether coal, gold, oil or FANGs. There are 106 ETF products that own Facebook as a Top 15 holding with that averaging between 5% and 10% of the entire fund.

Yet on the way up things are rosy. It is what happens on the downside that has yet to be fully tested. Around two years ago, CM wrote a report which warned of the risk of ETFs on the downside, especially levered ETFs (i.e. you buy a 2x levered FANG fund which means if FANG stocks go up 5% you theoretically get 2x the return for any given move up or down.

However in times of uncertainty (i.e. heightened risk) the options markets that price risk move magnitudes on the downside vs the upside. Meaning for an ETF to replicate what it proclaims on the brochure becomes much more difficult meaning the fund may under or overshoot the promises. Also in certain markets (e.g. US & Japan) where stocks on the exchange have limit up/down rules on the physical stock, should a market crash ensue, the ETF prices on the theoretical values of stocks that may not have opened for trading. What that means is that the ETF may reflect a market that is 10-15% below where it actually eventually opens. Meaning poor ETF buyers get gouged. However the computer algorithms in the ETF end up chasing, not leading the market which in and of itself creates more panic selling further reducing market confidence. Where a market might have traditionally fallen  3% on a given piece of bad news, ETFs tend to react in ways that might cause a market to retreat 6%. Indeed market volatility is amplified by ETFs.

At the moment market behavior is exceedingly complacent about risk. Before GFC highly complex products like CDOs and CDSs were the rage. 99% had next to no clue how they operated but they found their way into the local government investment portfolios of even small country towns in Australia.

ETFs on the other hand are strikingly simple to grasp but that also means we pay far less attention to the risk that goes with them. That is the bigger worry. People complacently thinking their portfolios are safe as houses may wake up one morning wondering why some flash crash has caused Joe and Joanne Public’s retirement nest egg to get decimated.

 

If everything is so great then why is our political scene so broken?

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Queensland’s state election said it all. Both the incumbent parties lost massively even though the incumbent Labor Party looks like holding on to power. While Pauline Hanson’s One Nation party looks like it fared poorly in terms of seats it still got 13.8% of the vote from 1% in 2015. Forget the headline results but think of what the political turmoil In local, state and federal levels is telling us more broadly.

Think logically about it all. If the economy is booming, jobs are abundant and prosperity is on the march then there is little need for governments to be running deep deficits let alone facing hung parliaments and acts of desperation. Surely the incumbent governments of the day can laud their own achievements and their constituents would happily keep returning the status quo. The majority should continue to be happy. More by rights should be winners in such a world of record housing prices, steady wage growth, low unemployment and 25 years of economic growth as experienced in Australia.

Yet PM Turnbull turned on many of the traditional supporters of the conservative wing of his Liberal National Party (LNP) coalition who turned their back on him to hand Labor the victory in Queensland. Not so fast Prime Minister. They didn’t leave the party. The party under your incompetent stewardship left them. At all levels the LNP is divided. There are some quarters suggesting that the Nats may split from the Coalition in the next election in Queensland to leave the stench of the Liberal Party to themselves. This is when personal ambition trumps wish to serve a nation.

While the LNP was handed the most valuable and recent lesson of the disaster that was the Rudd-Gillard-Rudd internal factional knifing during their time in power, it completely buried its judgement and started following a left leaning press, weak poll numbers and copied Labor’s folly. Now we have a hung parliament (not withstanding the dual citizenship fiasco) with chronically weak and misguided leadership. One that tells voters that they have no clue rather than introspection that the party may indeed be the problem.

It used to be said that Australia enjoyed the most stable politics in the Asia Pacific region. That encouraged foreign investment and gave Australia low interest rates, a superior credit rating and a regulatory platform that ensured trust (important for corporations), the envy of many nations. Yet inside a decade we have had 5 (soon to be 6) prime ministers which has thrown that ‘reputation’ in the toilet. In a world where international capital is more mobile than ever and asset prices are peaking, instability in government eventually carries severe financial market penalties.

For Aussie banks, levered up to the gills with inflated mortgage books on their balance sheets, such things have negative implications for the 40% reliance on global wholesale credit markets to fund themselves in the face of a tightening US interest rate cycle. Do not underestimate the negative connotations of a federal government that has lost its way, no matter which major party is in power. Where the average Aussie can’t bear anymore on the mortgage, a third admitting they can’t pay the home loan if they lose their job for 3 months or more. Almost 1,000,000 Aussie households would be in severe mortgage stress if rates moved 150bps(1.5%). Think of the spill-over effects on consumption which would only lead to a recession and lay offs, exacerbating a cycle, all the while bashing the currency making international funding even more biting. If only we had a stable government that had a decent fiscal position to weather that storm. Oh, that is right we squandered that in 2008.

One Nation in Australia, AfD in Germany, Party for Freedom in The Netherlands, Front National in France, 5 -Star Movement in Italy, Fidesz in Hungary, FPO in Austria, the Sweden Democrats, Vlaams Belang in Belgium,  Progress Party in Norway, Trump, Brexit…these patterns aren’t random. It isn’t just populism but protest votes to establishment parties that aren’t delivering. While we are constantly told how great our lot is, sadly the gap between haves and have nots is widening globally. Politicians who are ditching political correctness and making waves on publicly uncomfortable issues are thriving. Why could that be?

Donkey (informal) votes in Australia have seen numbers soar from 2.2% in the 1950s to over 5.0% in the 2016 election. Some electorates in NSW saw as high as 14% informal votes. These are powerful messages in a country that has compulsory voting, which has slid to 90.9%.

The sad reality is that the electorate is making louder noises every election that things are not pointing in the right direction yet the muppets are still being returned to their box seats on a dwindling majority. Why? Because not enough voters are heeding the warning signs that are sounding in front of them. Of course politicians still continue to sell comforting lies backed by ever more unaffordable promises to keep themselves in power for as long as possible when we all need to be facing the unpleasant truths that will happen whether we like it or not.

Indeed those deplorables who voted One Nation might have spurned the LNP but not without good reason. In time, they will be viewed as the wiser ones. Not because they necessarily believe in Pauline Hanson’s platform but because they believe in Turnbull and Shorten’s even less. It all rings like a Premier League football coach making a litany of excuses for his team’s woeful performance that ignores the fact that the collection of individuals have absolutely no cohesion as a team. All the fans can do is bury their heads in their hands until the point they can’t bear to watch another game until the coach is sacked.