Japan follow up – Institutional Exposures

Unsubstantiated claims

Macro Economic Research May 2013

In my recent article “Japan – the end of the beginning” I said “most of the foreign security holdings via insurance companies and pension funds are currency hedged back into the Yen” and this needs to be taken into account when evaluating exposure to a weaker Yen and higher inflation. The following table showed a drilled down exposure of Japanese Household Financial Assets as at December 2012 (BoJ data):

%age of Total Financial Assets Equities Investment Trusts Insurance Pension Funds Bonds/loans Cash on deposit Other Total

Japan Total 6.8 4.0 21.1 6.6 2.1 55.2 4.2 100.0

Bonds

Cash

Equities

Off shore Sec

Infn Proof Total 6.8

USA

Equities

6.8 0.8 15.3 2.2 2.1 55.2 0.2 0.3 0.6 1.3 0.7 2.3 3.1 1.6

32.8 11.8 10.8 17.3 9.5 14.6 3.2

32.8 5.5 2.9 8.5

2.9 4.4 2.3

20.4

55.7

9.4

7.0

16.4

100.0

49.7

With only 16.4% of assets invested in equities or “off shore securities”, I concluded that Japanese households are overwhelmingly positioned for the deflationary environment to continue. Should the BoJ’s target of 2% inflation within 2 years start gaining credibility, they would be very inappropriately positioned. When you consider that purchasing additional equities and offshore securities would not only lower risks of real capital loss, but also enhance yield, I expect reallocation within the $15trillion of Japanese household financial assets to be a major driver of Japanese equities and to have a significant impact on the Yen. Currency hedging in Japanese Life Insurance portfolios However an article carried by Reuters (“As Japan insurers flirt with foreign bonds, yields may move more than yen” 25Apr13) gives some fascinating insights as to the extent of currency hedging in institutional portfolios. This is important as in the table above I assume that foreign security holdings would provide capital protection in a weak Yen/higher inflation scenario. It appears that for the vast majority of these holdings, that is not the case. Nippon Life (the largest private sector life company with Y50tr = $500bn of assets) has Y6.64tr in hedged foreign bonds and Y2.11tr in unhedged (March 31 2013), so only 24% of foreign bond holdings are

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Japan follow up – Institutional Exposures

Macro Economic Research May 2013

providing protection against Yen weakness. Another example, Asashi Mutual Life Insurance, the 6th largest, has just moved from fully hedged to 90% hedged as at March 31st. If we assume that foreign security holdings in the Life Assurance portfolios are 80% hedged back into Yen, the 16.4% of Household Assets protected from inflation and Yen weakness drops to under 14%. Similar hedging policies by Pension Fund managers would lower this even further to around 12.5%. The authors of the Reuters article referenced above draw the conclusion that because of the extensive hedging of foreign bond holdings, we should not expect significant Yen selling as demand grows for offshore bond holdings. My take on this is actually the reverse – as the Yen weakens there will be increasing pressure to reduce the hedging on both the existing pool of assets and new flows – and this could in fact be a larger number than the flow itself. As quoted in the article, Hiroshi Ozeki, GM of Finance and Investment Planning for Nippon Life says: “If there is appropriate timing, we would like to boost our allocations to unhedged foreign bonds”. Takahiro Ono, Asahi Mtual Life chief portfolio manager concurs: ”If there are clear prospects for the yen to fall further, we may consider lowering the ratio of hedged foreign bond buying a bit.” I believe the past two decades of deflation and the strong Yen have also entrenched corporate attitudes and policies generally. The structure of balance sheets in the corporate sector (many companies carry massive net cash balances) and the foreign exchange hedging policies of exporters and multi-nationals will be slow to reflect the new reality, and the impact of changes here still have to impact the Yen in years to come. Conclusion Given the extent of currency hedges within institutionally managed portfolios, Japanese Household financial assets may be even more exposed to Yen weakness and inflation than I thought, with the hedging reducing inflation-robust assets from 16.4% to as low as 12.5% of total financial assets at December 31 2012. A change in hedging policy by institutional investors as existing hedge losses mount up could result in significant Yen selling.

Kevin Cousins is a portfolio manager at Brait Capital Management Limited. ("BraitCM"). This article is prepared by Kevin as an outside business activity. As such, BraitCM does not review or approve materials presented herein. The opinions and any recommendations expressed in this article are those of the author and do not reflect the opinions or recommendations of BraitCM. None of the information or opinions expressed in this article constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Either BraitCM or Kevin Cousins may hold or control long or short positions in the securities or instruments mentioned.

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