Shaw Capital Management Investment Deadlock for Japan

The Democratic Party of Japan’s (DPJ) landslide victory

in the Lower House election a year ago ushered in

euphoric predictions of bold new policies, and even a

transformation of the Japanese political system.

There were widespread hopes that the DPJ would end

the run of short-lived leaders. Instead, Prime Minister

Yukio Hatoyama’s tenure proved to be a slow-motion

train wreck. Indeed, the DPJ quickly showed itself to

be no more competent in governing Japan than its

much-derided opponent, the Liberal Democratic Party

(LDP).

After shedding its two albatrosses of Hatoyama and

general secretary Ichiro Ozawa, and many of its earlier

campaign pledges, the DPJ hoped for a respectable

showing in the last Upper House election. Instead, the

ruling DPJ suffered a stunning defeat, when voters had

the opportunity to show whether they were confident

in Prime Minister Naoto Kan’s just over 1-month-old

administration.

The party ended with only 106 seats, far short of the

122 needed for an outright majority. The gap is too

large to be filled by creating a coalition, because the

most likely potential partners also lost seats.

As a result, the DPJ coalition can no longer ensure

approval of its legislative initiatives.

A twisted parliament portends even greater legislative

stalemate and political gridlock. Gerald Curtis, a

professor at Columbia University in New York and a

long-time expert on Japanese politics, said the election

had returned Japan to the paralysis and gridlock of the

past few years. “You cannot pass a budget now in this

political environment. You’ll have weak and unstable

government. While the world changes fast, the Japanese

government will change very slowly”.

Trying to put a good face on the results, Kan said he

viewed the election as a “starting point” for his push

for a more responsible government ...

The policy implications of the election outcome do not

suggest an aggressive approach to monetary, fiscal or

structural policy over the next few months.

Indeed, the attention of the large parties will most

likely be focused on internal matters, leaving less time

for focus on the economy.

Gridlock is bad for the economy and for investor

sentiment if policy drift continues for a prolonged

period.

According to Alan Feldman, managing director at

Morgan Stanley in Tokyo, there are so many pressing

problems in the Japanese economy that the costs of

gridlock could be very high.

In particular, pressure on the Bank of Japan for more

aggressive monetary policy will likely be minimal, at

least until political disarray ends.

Without strong political leadership little progress is

likely on budget priorities.

The same goes for tax decisions.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.

Shaw Capital Management Investment Equity Markets 2010 Part 2

For the moment attention is focused on the strength

of the German economy, and the beneficial effects that

will be felt elsewhere in the zone; and there has also

been a relaxation of tension about debt defaults, after

the rescue package agreed by the member countries,

and the intervention by the ECB to support the weaker

bond markets.

The German export performance depends of the

maintenance of strong growth in the global economy

that may not be sustained; and the odds still suggest

that one or more of the weaker countries will at least

be forced to defer interest payments on its sovereign

debt, and may even default. The latest improvement

in the markets therefore seems likely to need further

support from Wall Street if it is to be sustained.

The best performance amongst the major markets over

the past month had occurred in the UK market. The

measures announced by the new Coalition government

to reduce the size of the fiscal deficit have been well

received by the market, despite the fact that they will

slow down the pace of the economic recovery over the

coming months; and the latest estimate of a 1.1% growth

rate in the second quarter of the year suggests that the

effects of the fiscal retrenchment might even be less

than had been expected, and has removed most of the

fears about the possibility of a move into a “double-

dip” recession.

The improvement in sentiment amongst investors is

therefore easy to understand.

Even before the announcement of the estimate of

growth in the second quarter of the year, there had

been further evidence of an improving economic

situation.

The unemployment rate fell; retail sales volumes rose

by 1%, the strongest monthly increase in almost a year;

and the latest quarterly survey from the CBI reported

that manufacturing output increased at its strongest

rate since 1995.

The 1.1% estimated rate was well above most forecasts.

It was the result of expansion in both the manufacturing

and services sectors of the economy.

But the most surprising figure was the estimated 6.6%

rate of growth in the construction sector that accounted

for around one third of the overall growth in the period.

It has also produced considerable interest regarding

the reaction of the Bank of England to these figures.

The bank has previously been mainly concerned about

the risk of slower growth, and had even considered at

the last meeting of its Monetary Policy Committee

“arguments in favour of a modest easing in monetary

policy” because “prospects for gross domestic product

growth had probably deteriorated a little over the

month”.

The mood will have changed now; but the governor,

Mervyn King, has recently indicated that there will be

no early changes in policy as a result of one set of

figures.

The background factors affecting the market therefore

remain. Short-term interest rates will remain low, and

the economy is performing better than expected; but

the austerity measures that are to be introduced, and

especially the increase in VAT in January, will depress

demand over the coming months.

It therefore seems likely that the UK market, like the

markets in mainland Europe, will need further support

from Wall Street if the recent strength is to be sustained.

The Japanese market is lower over the past month.

There has been further evidence that the pace of the

recovery in the Japanese economy is weakening; and

the poor performance by the ruling Democratic Party

in the recent election seems likely to lead to a period

of political uncertainty that will make it difficult for

action to be taken to reverse the trend.

The earlier decision to introduce measures to reduce

the massive fiscal deficit was a major reason for the

government’s poor election performance in the

election, and may well be reversed; and the Bank of

Japan’s action to try to increase the rate of bank lending,

especially to smaller companies, also seems unlikely

to have much of an effect on the economic situation.

The background situation in Japan is therefore very

disappointing, and this is reflected in the performance

of the equity market. It seems unlikely that there will

be any early improvement in the situation, and so the

Japanese market weakness looks set to continue.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.

Shaw Capital Management Investment Deadlock for Japan

The Democratic Party of Japan’s (DPJ) landslide victory

in the Lower House election a year ago ushered in

euphoric predictions of bold new policies, and even a

transformation of the Japanese political system.

There were widespread hopes that the DPJ would end

the run of short-lived leaders. Instead, Prime Minister

Yukio Hatoyama’s tenure proved to be a slow-motion

train wreck. Indeed, the DPJ quickly showed itself to

be no more competent in governing Japan than its

much-derided opponent, the Liberal Democratic Party

(LDP).

After shedding its two albatrosses of Hatoyama and

general secretary Ichiro Ozawa, and many of its earlier

campaign pledges, the DPJ hoped for a respectable

showing in the last Upper House election. Instead, the

ruling DPJ suffered a stunning defeat, when voters had

the opportunity to show whether they were confident

in Prime Minister Naoto Kan’s just over 1-month-old

administration.

The party ended with only 106 seats, far short of the

122 needed for an outright majority. The gap is too

large to be filled by creating a coalition, because the

most likely potential partners also lost seats.

As a result, the DPJ coalition can no longer ensure

approval of its legislative initiatives.

A twisted parliament portends even greater legislative

stalemate and political gridlock. Gerald Curtis, a

professor at Columbia University in New York and a

long-time expert on Japanese politics, said the election

had returned Japan to the paralysis and gridlock of the

past few years. “You cannot pass a budget now in this

political environment. You’ll have weak and unstable

government. While the world changes fast, the Japanese

government will change very slowly”.

Trying to put a good face on the results, Kan said he

viewed the election as a “starting point” for his push

for a more responsible government ...

The policy implications of the election outcome do not

suggest an aggressive approach to monetary, fiscal or

structural policy over the next few months.

Indeed, the attention of the large parties will most

likely be focused on internal matters, leaving less time

for focus on the economy.

Gridlock is bad for the economy and for investor

sentiment if policy drift continues for a prolonged

period.

According to Alan Feldman, managing director at

Morgan Stanley in Tokyo, there are so many pressing

problems in the Japanese economy that the costs of

gridlock could be very high.

In particular, pressure on the Bank of Japan for more

aggressive monetary policy will likely be minimal, at

least until political disarray ends.

Without strong political leadership little progress is

likely on budget priorities.

The same goes for tax decisions.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.

Shaw Capital Management Investment Financial Market Summary 2010

Financial Markets: Sentiment in the financial markets

improved considerably over the past month. There was

less concern about the possibility of a move into a

“double-dip” recession; and fears about sovereign debt

defaults also eased.

The improvement in conditions intensified the debate

about the relative merits of austerity measures and

further stimulus in the current situation, and revealed

a significant difference in the approach of the Fed and

the European Central Bank.

Equity Markets: Most of the equity markets recovered

strongly from the falls that had occurred at the end of

June, helped by some encouraging corporate results in

the US, and the relaxation of tension about debt defaults

in Europe.

Wall Street led the rally, and markets in Europe were

able to follow the upward trend, with the strength of

the German economy providing significant support.

The best performance amongst the major markets

occurred in the UK, as investors continued to react

favourably to the proposed measures announced by

the new UK government to reduce the huge fiscal

deficit. The worst performance amongst the majors

occurred in the Japanese market as economic and

financial conditions in Japan continued to deteriorate.

Government bond markets received some support

during the past month from the easing of tensions in

the sovereign debt markets in Europe. The recent

“shock and awe” support operation agreed by member

of the euro-zone, and the decision by the European

Central Bank to buy the bonds of some of the weaker

countries, has provided some reassurance for investors;

but considerable uncertainties remain about prospects

for the bond market.

The Fed is suggesting that further stimulatory measures

might be necessary, whilst at the same time the ECB is

warning that reductions in spending programmes and

increases in taxes were now necessary, in Europe, but

also elsewhere in the industrialised world. Movements

in bond markets have therefore been fairly limited

over the month.

Currency Markets: The feature of the currency markets

has been the swing in sentiment. This has allowed the

euro to rally strongly, helped also by the improving

sentiment about sovereign debt defaults; and sterling

has also moved higher after the announcement of

measures to reduce the fiscal deficit in the UK and the

more favourable economic news on the UK economy.

The best performance; has been achieved by the yen,

as its “safe haven” status has been further enhanced

by the more serious problems elsewhere in the currency

markets.

Short-Term Interest Rates: There have been no changes

in short-term interest rates in the major financial

markets over the past month.

Commodity markets have benefited from the general

improvement in financial markets over the past month.

Significant gains have occurred in base metal prices,

and in the prices of wheat and coffee amongst the soft

commodities.

Precious metal prices have fallen back, and oil prices

are basically unchanged over the month after rallying

strongly from recent lows.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.

Shaw Capital Management Investment Portfolio Performance 2010

We have made no changes in our portfolios this month. The swing in sentiment towards a more favourable view of prospects for the global economy is encouraging, and has been reflected in the recovery in equity prices.

We have therefore decided to maintain our holdings in Euro & US equities. We continue to retain our 10% holding in cash deposits as a contingency measure. The sovereign debt crisis remains a very serious threat, thus we have zero exposure to bonds. World Growth There has been much talk in recent weeks of a ‘double- dip’ recession, as some weak figures have come out. However wobbles of this type are fairly typical in a recovery from a severe recession. In our view the recovery remains in line with the path we have laid out before. This was for a world recovery that would be restrained by raw material shortages, which would put constant upward pressure on their prices. So we see world growth this year at around the 4.5% rate, well below the 5.5% figure being registered at the height of the boom; notice that the world is not ‘catching up’ the lost output of 2009, rather it is reverting to a slower growth path from the lower output base. Even with this pattern raw material prices have been very strong, with oil for example near the $80 a barrel mark.

The rises in these prices forced China and India to tighten policy and restrain their fast recoveries to prevent inflation. Even now in India inflation is not yet under control, having reached 13.9% in May, and policy will need to tighten further. On a lesser scale inflation has become threatening in a number of emerging market countries. So what we are seeing is that the fast-recovering countries mainly in East Asia are having to restrain their growth. Meanwhile in the OECD countries where inflation remains muted … or in the case of Japan deflation remains entrenched; growth is much weaker than in East Asia. The reason for the disparity of growth lies

in the disparity of productivity growth.

In East Asia the movement of people out of low- productivity agriculture into high-productivity manufacturing using the technology imported from advanced countries implies huge productivity growth. In advanced OECD countries productivity growth is dependent on innovation, a much slower process. So we observe a world in which productivity and so GDP growth is restrained generally by tight raw material supplies and in which the OECD countries growth relatively more slowly also. This adds up to a weak recovery in OECD countries, which is what we observe. The picture is not likely to change. It will take time for new technologies and discoveries to shift the shortage of raw materials; there are parallels here with the 1970s and 1980s when it took until the end of the 1980s to ease the acute shortages built up in the earlier decades. By 1990 for example oil per unit of real world GDP had

roughly halved from the mid-1970s and oil prices fell to low levels. Nevertheless this does not mean that employment growth need be weak or unemployment remains high.

Labour market flexibility … i.e. real wages falling relative to general productivity and willingness to adopt new practices … can encourage substitution of more labour for capital and raw materials. This is most obvious in service industries where there is plenty of scope for higher labour-intensiveness. Furthermore, service industries themselves can grow faster when labour is more flexible. So could this weakness turn into a double-dip recession in the OECD? It might seem so if growth there is restrained by tight raw materials and if also

governments are pursuing fiscal tightening; the only way might seem to be downward pressure on growth. But this is to leave out the role of monetary policy. In the OECD inflation targeting has been the unsung hero of macro policy; inflation has stayed down in the recovery and deflation kept at bay during the 2009 recession.

The reason lies in the effectiveness of inflation targeting in anchoring expectations. Surprisingly also, many inflation expectations mirrored in wage settlements and bond yields have remained around the 2% mark, reflecting the inflation targets set by most OECD central banks or governments. But it should not be a surprise; the targets have reflected a popular change in overall policy, towards outlawing

high and variable inflation. We had it, people did not like it, and policy changed to stop it during the 1980s or at latest by the early 1990s. In the debate over recession and public debt the idea

that inflation should be used to tackle either problem has barely been discussed, let alone advocated in any serious way.

What this has meant is that monetary policy has been quite unhampered by the fear of inflation in its aim to keep recovery on track. With OECD banking systems mostly in difficulties credit growth has been held down — in most countries it is hardly positive. So monetary policy has had to use unconventional

means to encourage investment and consumption. Interest rates on official lending have been kept close to zero and central banks have aggressively bought financial assets from the public, with the effect that the yields on these assets have been reduced.

These purchase programmes have now been stopped. But if recovery looks threatened they can be restarted and will again have a powerful effect through these asset markets.

Two decades ago such programmes would have raised inflation expectations. Today they are given the benefit of the doubt. Some people argue that they are quite safe because bank credit and broad money therefore are hardly growing; however, one cannot be sure that other financial channels are not replacing banks while they are so weak.

The truth seems to be that firms and people who need finance are mostly able to obtain it on quite cheap terms, so banks are being bypassed to a substantial degree. But inflation is not expected to result because it is widely (and correctly) believed that if inflation were to start rising monetary policy would be tightened. This belief does free central banks to take aggressive action to prop up the economy if it falters.

In short we think that the recovery will continue much along the current lines because from above it is held down by raw material shortages while from below it is held up by potentially aggressive monetary policy, with the power to more than offset the dampening from fiscal retrenchment.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.

Shaw Capital Management Investment Equity Markets 2010 Part 1

 Equity markets have rallied over the past month, sentiment has swung once again towards a more

optimistic view of the prospects for the global economy, and concerns about sovereign debt defaults in Europe have eased. Wall Street has recovered from the sharp sell-off in late-June, helped by some encouraging second quarter earnings reports; and markets in Europe have responded, with the UK market providing the best performance over the month. The worst performance amongst the major markets has occurred in the Japanese market because of disappointing economic news and increased political uncertainty after the setback for the government in the recent election. The general improvement in the markets over the month is a welcome development. The gloom in April and May about economic prospects was clearly overdone. The US economy is performing as expected, and the Chinese authorities are clearly intent on preventing their economy from overheating.

The global economic recovery will therefore proceed at a slow pace. The sovereign debt crisis in Europe remains unresolved and defaults remain a real possibility. The risks have therefore increased in the bond markets, and this has provided support for the equity markets. So long as monetary policy remains supportive, the global recovery should eventually produce a sustainable improvement in bond prices; but some of the current uncertainties in the bond markets must be resolved before this can occur.

The performance of the US economy remains the key factor is assessing the prospects for the equity markets. There has already been a request to Congress for additional spending programmes “to keep the economic recovery on track”, and although there has been no response so far, some action may become necessary. The excess gloom has disappeared, fears about sovereign debt defaults in Europe have eased, and there have been encouraging corporate results from a number of major companies, including Microsoft, Caterpillar, UPS, and Intel. Problems still remain in the banking sector, and have been reflected in the fall in earnings from investment banking at Goldman Sachs, Citigroup, Bank of America, and JPMorgan; but overall investors have been reassured that corporations are coping fairly

well with the present situation. Mainland European markets have also recovered from the sharp falls. There has been encouraging news about the economic background in the euro-zone; fears about

sovereign debt defaults have eased; and the latest “stress tests” have only revealed weaknesses in seven of the ninety-one banks that were included in the survey. Euro Markets have therefore been able to follow the upward trend on Wall Street, and regain recent losses, despite the uncertainties that have still to be resolved.

Conditions are clearly continuing to improve in many areas of the euro-zone economy, and especially in

Germany, helped by the big fall in the value of the euro in the first half of the year, and the strong growth in many of the export markets in the developing world. German companies have taken full advantage of the competitive currency and the available export opportunities, and so, even though domestic demand has remained relatively weak, the German economy is now expected to grow by around 2% this year. The situation is very different in Greece, Spain, Portugal, Ireland, and even in Italy, and these weaker economies are obviously acting as a drag on the overall performance of the area. The latest purchasing managers indices for both the manufacturing and services sectors of the area are higher, and argue against a pessimistic view of growth prospects; but for the moment we have left unchanged our modest forecasts of overall growth around 1.5% this year. The European Central Bank is clearly more optimistic about prospects. So far it has not raised its growth forecasts; but based presumably on the assumption that the recovery from recession is soundly based and self-sustaining, its reaction to the present situation contrasts sharply with the cautious view of the Fed.

The president, Jean Claude Trichet, is arguing that further public spending cuts and tax increases should be introduced immediately, especially in Europe, but also elsewhere in the industrialised world. “Without the swift and appropriate action of central banks” he recently argued, “and a very significant contribution from fiscal policies, we would have experienced a major recession. But now is the time to restore fiscal sustainability”.It is not clear what the consequences of this view might be; but the central bank might even be encouraged to tighten monetary policy as the present programme of fiscal retrenchment develops.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.