Big in Japan

The Blind Squirrel's Monday Morning Notes, 18th March 2024.

• Rampant speculation ahead of Tuesday’s Bank of Japan meeting has most macro eyes trained eastwards. If meaningful yields are coming to Japanese government bonds as a result of a shift in BOJ policy, we have plenty to think about.

• The results of last week’s ‘shunto’ spring wage negotiations surprised markets to the upside. One of the employers that did not even counter the RENGO union’s ask on wage hikes was Toyota. We look into the recent meteoric share price rise of the Japanese auto giant.

• In Section Two (for paid subscribers), we expand on the auto theme and consider some portfolio changes in the sector. There is also plenty to discuss on FOMO hedges, bond risks, coherent optics and the energy complex in this week’s Acorn Review.

Welcome! I'm Rupert Mitchell aka The Blind Squirrel and this is my weekly newsletter on markets and investment ideas. If you've received it, then you either subscribed or someone forwarded it to you (add yourself to the list via the button below). Please also consider becoming a paid subscriber or gifting to a friend!

The audio companion to this week’s note will be uploaded to Substack on Tuesday to allow me to incorporate comments and feedback from this note. It will also be available as a podcast on Apple, Spotify and the other usual podcast apps.

Big in Japan

Rampant speculation ahead of Tuesday’s Bank of Japan meeting has most macro eyes trained eastwards. If meaningful yields are coming to Japanese government bonds as a result of a shift in BOJ policy, we have plenty to think about.

1. If shorting Japanese Government Bonds therefore suddenly becomes a profitable endeavor, do Natural Gas futures trading and shorting Australian Bank stocks (on a ‘propadee’ bubble thesis) get left as the last remaining ‘widow-maker’ trades in global macro?

2. Does an unwind of the carry trade complex finally upset the best trend-following trades of the past few years?

It is hard to argue that there was a superior risk-adjusted investment strategy anywhere on earth that compared to the simple carry trade of borrowing Japanese Yen to buy short-term local currency money market instruments in Brazil and Mexico since January 2021. Source: Augur Infinity Analytics.

We have seen this ‘high expectation’ movie before. Last summer, we covered some of the bigger implications of such a change in policy.

Waiting for the Big One

We revisited the topic again in December.

Now, Sid James and Ueda-San walk into that bar. Carry On?

Back in July, fever pitch expectations were met with some minor monetary ‘tweaking’ by the BOJ. The ‘defining macro event of 2023’ turned out to be a damp squib rather than fireworks for global asset markets. In December, it was positioning (aka gamma) squeeze in JPY futures options that set the hares running. This time is different is of course a dangerous expression in markets, but here we are again!

The results of last week’s ‘shunto’ spring wage negotiations surprised markets to the upside. Large employers like Toyota (more on them later) apparently did not even ‘put up a fight’ as collective bargaining by the RENGO union saw average wages boosted by 5.28% (a 33-year high).

This came only days after a 2% drop in Japanese equity prices was not met with customary ETF buying from the central bank. A signal that a ‘new sheriff was in town’ and that Japan is finally starting to favor labor (as opposed to capital) friendly economic policies or just a recognition that buying stocks at new all-time highs was perhaps excessive stimulus? 🤷‍♂️

Perhaps it is time for foreign investors (apart from Warren Buffett!) to do some of the heavy lifting in Japanese stocks!

Impressive looking chart but the absolute AUM numbers are still tiny.

These moves even inspired the excellent ‘FX Poet’

Andy Fately

to deviate from his standard rhyming couplets and compose an authentic(ish) Japanese haiku on the topic!

Click the haiku to link to Andy’s full piece: ‘Offsides’

However, in the context of rising US treasury yields driven by yet more ‘hot’ CPI and PPI inflation data, the Japanese Yen chose to move with yield differentials rather than try and front-run revolutionary developments on the domestic policy front. For now, US interest rates would appear to matter more for the Yen.

US and Japanese 30-Year yield differentials are almost identical to where they were last July, yet the Yen is nearly 6% weaker. For now, the probability of US rate cuts in June appears to be more important.

The shunto developments were certainly eye-catching but must be viewed with a dose of pragmatism. Wage bargains at the large cap employers do not necessarily mean that SMEs (that employ 70% of Japan’s workforce) have the pricing power to be able to follow suit (especially with local PPI also rising more than expected last week). Real wages in Japan have actually now fallen for 22 months straight!

I think that we find ourselves in a position that markets are now not expecting fireworks from the BOJ this week. Having said that, Japan continues to be the swing liquidity provider to the world’s risk assets - at the cost of the value of its currency and the relative wealth of its workers. The implications of a shift in policy remain significant and probably underpriced.

Especially when the ruling LDP’s polling numbers continue to test new lows.

The tin foil hat question is whether the BOJ cares more about the LDP’s poll numbers or President Biden’s. Never forget that central banking is a global club. The reference to ‘Rupert’ has nothing to do with squirrels (see The Murdoch Effect).

I mentioned Toyota earlier. On Thursday evening, ‘Team 🐿️’ went to the MCG to support our beloved Carlton (‘The Blues’) against the Richmond Tigers at our first live ‘footy’ game of the AFL (‘Aussie Rules’) season.

83,881 fans were at the Melbourne Cricket Ground for Carlton’s match vs local rivals Richmond (TBH AFL games are pretty much all ‘Local Derbys’ as nearly all the clubs have links with Melbourne). Taylor Swift’s crowd at ‘The G’ was slightly bigger a few weeks ago but she was allowed to have fans watching from on the hallowed turf!

We (Carlton) won the game in our traditional ‘by the seats of our pants’ fashion (aka less than 1 goal). But let’s zoom in on the title sponsor for the AFL, the 🐿️’s new favorite winter sport (and his second favorite sport played at ‘The G’ after cricket🏏):

Toyota: Good for ‘Footy’ - same applies for ‘Gridiron’

In a country which ceased to have a domestic automotive industry with the shuttering of (GM-owned) Holden in 2017, Toyota’s much loved Hilux pickup trucks (or ‘Utes’ as they are called here) are almost viewed as a trusted Aussie ‘domestic brand’ as much as a ‘Maccas’ (McDonalds to most 🐿️ readers) ‘Royale Quarter-Pounder with Cheese’. Note that the same Japanese auto giant also happens to be the principal automotive partner of America’s NFL (just ask Americans about their Tacoma trucks - it’s the same thing!).

I know that The Oscars ceremony was last Sunday (the 🐿️’s Oppenheimer predictions crushed it btw) but MotorTrend came out with its annual ‘Power List’ of ‘Movers and Shakers’ of Global Auto at the beginning of March.

‘False prophet’ Elon slipping down the ranks to 50 will wind up a few of the Musk ‘fan boys’; Jensen Huang’s there because… ‘AI’ of course, stupid! Akio Toyoda’s rise from #30 to #13 is more understandable but still way too low in the 🐿️’s opinion. Toyota’s ‘gaijin’ designer/ branding guy, Simon Humphries, appearing above Toyoda at #4 tells a different story… (link to full story and list via image above).

The rise to ‘top of the hit parade’ of a US auto union boss (UAW’s Shawn Fain) is another macro topic in its own right which the 🐿️ is going to save for a later date! As a child of the 1970s, I remember a time when union bosses were household names. Is history about to rhyme? An analysis of the pack behind him is even more interesting.

From (insanely!) ‘unranked’ in 2023 you have BYD’s founder and president moving into the #3 spot. The rise of BYD is also another macro story in its own right. I highly recommend

Kevin Xu

’s excellent article on the topic: “Wang Chuanfu, a Name Everyone in the West Should Know”.

Part of Wang’s ‘superhero origin story’ revolves around his admiration for (and emulation of) Toyota:

As regular readers will know, your 🐿️ had a post-investment banking ‘recovery spell’ in the automotive industry, working for a Chinese electric car startup. During my time there, I was constantly mystified by the Japanese auto sector’s apparent ‘slow walk’ on passenger vehicle ‘BEV’ electrification.

Toyota had led the world with ‘Phase 1’ of vehicle electrification with hybrids (HEVs). The Toyota Research Institute (‘TRI’) was the world leader in terms of the understanding of lithium battery and hydrogen fuel cell technology. Part of me was (lazily) thinking that Toyota’s reluctance to champion battery-electric vehicles (BEVs) was simply a function of their (highly commercial) HEV dominance with the Prius.

I even went as far as to thinking that their attendance at car shows profiling their hydrogen-fueled cars (the Mirai) was some kind of gaslighting or attempt at distracting the market from their disinterested stance when it came to lithium-based BEV solutions!

For a (definitely) older and (marginally) wiser rodent, it all now makes complete sense. Toyota has figured out the math on EROEI earlier than anyone else and was brave enough to stand its ground as it faced the torrents of abuse from the (very shouty) ‘it’s not a real EV if it does not have a plug’ crowd.

Toyota does not attempt to hide the advantage it has obtained from its dogged focus on HEVs while the rest of the industry embarked on a massive BEV malinvestment frenzy. Source: Toyota Integrated Report (with 🐿️ annotations).

2023 Toyota Integrated Report

20.4MB ∙ PDF file

Download

Toyota's integrated report is a long (107 pages) but really excellent read. It is a very transparent window in the group's history, product roadmap and strategy.

Download

They also understood that it is naive to ‘assume away’ sourcing and supply chain issues in the arena of battery metals and compounds essential to a pure BEV solution to passenger vehicle electrification.

Am going to forgive TRI’s Dr. Gill and his mildly completely outrageous ‘chart crime’ (with the scale adjustment of his g/km emissions bar on the right-hand side) but his point about the accelerated advantage of hybrids vs. BEVs in terms of Co2 emissions is well taken. It did, however, make certain folk very angry indeed! Judge for yourselves (link to full presentation from Davos).

Intriguing pastel shades but a world of toxic consequences that cannot be discounted. What should also make sane people angry is the assumption that lithium production is ‘environmental consequence’ free! Perhaps Toyota’s views on lithium-lite solutions really should be given a proper hearing?

Guess what, Toyota’s focus on HEVs has certainly paid off financially and the market has started to cotton on. And let’s not forget that the company actually has a very solid BEV offering if turns out that ‘Barry’ wants one after all:

“Because it’s a Toyota”. You HAVE to watch this! (click above). Hat tip to Mrs. 🐿️ for spotting this new ad release on Sunday afternoon - I did not think she paid attention when I tell her what I am writing about at the weekend)!

Toyota shares performed well in 2023 but only really in line with the broad market for Japanese large caps. It was February’s announcement of a big earnings beat that triggered the recent significant outperformance. Toyota Motor Corp (7203: TSE, candles) Nikkei 225 futures (turquoise line).

The almost doubling of its share price in 15 months now makes Toyota the best rated among diversified (i.e. not pure luxury or EV-only) auto OEMs globally.

Source: Koyfin.

I have written before about the multiple ‘trap’ that traditionally faces the auto sector. As you can imagine, raising money for a car company forced the 🐿️ to study a lot of ‘trading comps’ tables. Pretty quickly you realize that typical, mature automotive OEMs consistently trade in an EV/Sales multiple range of 1x to 1.3x over time. A status quo that has prevailed for decades.

Toyota is no different and on that metric is definitely showing signs of over extension, especially with returns on invested capital currently only marginally above its own long-term average.

Russell Clark

wrote an excellent piece last month called “Commodities, Buffett and the BOJ” in which he commented on how Uncle Warren’s investment in the Japanese ‘sogo shosha’ trading houses had managed to nail one of the very few commodity bets that have worked over the past couple of years. I know that the 🐿️ has certainly been in many ‘hard asset’ plays that have not done the same!

In a statement that am sure will be viewed as blasphemous in certain quarters, Russell attributes the ‘turbo charge’ behind the success of these investments to canny policy watching. He concludes that a combination of share repurchases by the trading houses and the BOJ’s ETF purchases (as part of its QQE program) - as well as the yen-denominated funding - have been the biggest drivers of Berkshire’s returns on the trade. Is that possibly what we are looking at with Toyota’s current valuation premium?

Toyota’s share repurchases have been more modest than those of the likes of Mitsui, but it stands to reason that the shares would have been a major beneficiary of any market-cap weighted index ETF buying! Source: 2023 Integrated Report.

In the context of a Nikkei 225 being up 60% in the past 12 months, the correlation between market capitalization and returns among the auto stocks seems significant!

I can assemble multiple narratives to support Toyota’s premium valuation among the diversified OEMs, but what if the truth behind the most recent performance is more prosaic (i.e., that it is benefitting from the same tailwind supporting as Buffett’s ‘sogo shosha’ bet - a stimulus punch bowl that may be in the process of being partially removed)?

And because you know the 🐿️ cannot resist a 1980s German synth-pop cultural reference, it certainly helps these days to be ‘Big in Japan’! I will let myself out.

That’s it for the front section this week. In Section Two (for paid subscribers), we expand on the auto theme and consider some portfolio changes in the sector. There is also plenty to discuss on FOMO hedges, bond risks, coherent optics and the energy complex in this week’s Acorn Review.