Japan's Pivot

By?Patrick Donley,?Matthew Gutierrez,?and?Shawn O'Malley, edited by?Robert Leonard?· December 19, 2022

*LinkedIn newsletter is posted at a one-day delay.

?????Congratulations to Argentina on their incredible World Cup victory over France yesterday, in a match that some are calling the greatest World Cup finale in history.?

The countdown begins until the tournament starts again in four years, but this time it'll be played across North America.?

Elsewhere, after Disney (DIS) spent $600 million to produce and market "Avatar: The Way of Water" the company's stock slipped almost 5% on reports that its opening-weekend domestic box office?missed expectations?for generating $150 million???

Here's the market rundown:

MARKETS

*All prices as of market close at 4pm EST

Today, we'll discuss two items in the news: Japan's potential pivot away from ultra-loose monetary policy, and a historic nature preservation deal, plus our main story on the global inflation outlook, expectations in investing, and the "All Asset" strategy.

All this, and more, in just?5?minutes to read.

IN THE NEWS

?? Sweeping Deal to Protect Nature?(NYT)?

Explained:?

• About 200 countries have agreed to preserve 30 percent of the planet's land and seas by 2030 to halt a dangerous decline in biodiversity.?
• The agreement, reached Monday in Montreal, comes at the 2022 United Nations Biodiversity Conference amid the rapid, global decline in biodiversity.
• The deal lays out a suite of 23 conservation targets. The most prominent, 30x30, would place 30 percent of land and sea under protection. Currently, only about 17 percent of the planet's land and roughly 8 percent of its oceans are protected.?

Why it matters:?

• The deal would roughly double biodiversity financing to $200 billion annually from all sources: governments, the private sector, and philanthropy.?
• "This is a huge moment for nature," Brian O'Donnell, a director of the Campaign for Nature, said. "This is a scale of conservation that we haven't seen ever attempted before."
• Researchers have projected that a million plants and animals are at risk of extinction, many within the next couple of decades.?

?? Japan Could Revise Central Bank's Deflation Fighting Mandate?(Reuters)?

Explained:?

• Next year, Japan will consider revising its decade-old plan for fighting deflation as a weak yen and rising import prices force the central bank to drop its ultra-loose monetary policy.?
• The government could initiate the revision after a new Bank of Japan (BOJ) governor is appointed in April.?
• While other central banks tighten monetary policy to combat high inflation worldwide, the BOJ has swam against the tide. The central bank kept interest rates artificially low, hoping that global inflationary pressures would free the country from its past deflationary troubles.?

Why it matters:?

• Inflation in Japan has exceeded the country's 2% target for seven straight months. However, the incumbent governor of the BOJ, Haruhiko Kuroda, has called for maintaining easy monetary policy until wages rise more.?
• Nearly half of economists polled by Reuters in December said they expected the BOJ to unwind its ultra-loose policy between March and October next year.?
• This news comes amid growing public anger over the rising cost of living, a problem that's?infamously unfamiliar?to the Japanese.?

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THE MAIN STORY: "ALL ASSET" STRATEGY INVESTING

Overview

What are the investment implications of the current global inflation outlook?

And how do professional investors use expectations to invest?

For insights into these questions, we turned to Jim Masturzo, the chief investment officer of multi-asset strategies at Research Affiliates.

The background

He first adds some historical context: "For more than a decade, following the end of the Global Financial Crisis, many observers have been concerned about the potential long-term inflationary impact from the large amount of stimulus injected into the system by global governments...

Coupled with explicit stimulus, there have been more tax cuts and extended periods of zero and negative interest rates. The result was a decade of inflation, but since that inflation was restricted to asset prices, rather than goods and services affecting consumers and businesses, few complained."

In other words, the Covid-19 pandemic helped push the financial asset inflation that started after 2008 into the real economy.

Where we are

Unsurprisingly, supply chains are unfathomably complicated, and our fragile system wasn't prepared for those disruptions.

Masturzo notes, "Central banks are actively raising rates in an effort to put the lid back on the pot, but massive sovereign debt levels challenge this effort."

While higher interest rates ripple through the economy to slow spending by making any borrowed spending more expensive, this doesn't only affect consumers.

A challenge for both consumers and governments

Governments also must borrow money to fund deficits (spending plans that exceed tax receipts).?

When interest rates rise, this has two troubling implications: debt issued at higher interest rates is more costly (greater interest payments), while government revenue is falling at the same time as the economy slows down (less income/sales/capital gains taxes).

Masturzo and his team believe inflation will not return to pre-pandemic norms any time soon, either, even with higher interest rates.

He explains, "Our research into inflationary episodes in developed market economies since 1970 finds that when inflation surged above a 6% annualized rate, it took a median of more than seven years for inflation to dial down to a 3% rate or lower."

His firm expects a lower, but still comparatively high, inflation rate over the next decade of 3.9% in the U.S.

Using expectations to invest

For investors, what matters are surprises to inflation expectations.?

Commodities historically outperformed when inflation surprised to the upside relative to consensus forecasts, whereas stocks tended to react negatively. We saw this dynamic unfold in the early months of 2022.

One takeaway is to consider the current expectations for inflation and position yourself according to which direction you believe inflation surprises will come from.?

At least, that's how institutional investors using so-called "All Asset" strategies tend to think about things.?

Research Affiliates sees inflation surprises as an opportunity to either overweight or underweight assets based on how they've historically responded to such surprises.?

They, of course, also consider things such as valuation, diversification, price trends (AKA momentum), the global business cycle, and the income-earning potential of their investments.

While this short-term trading and positioning across many asset classes and economic variables is too much for the average everyday investor to keep up with, the thinking reveals useful insights for everyone, especially value investors.?

Takeaways

See, value investing, at its essence, is determining what the consensus expectations are for a business, and when those views are excessively in one direction, making a bet that the company's valuation will 'mean revert' and eventually reflect more moderate outlooks.

If, for example, a company's current price-to-earnings ratio is historically cheap compared to its long-term average, expectations may imply scepticism about the underlying business's ability to continue earning profits at the same rate.?

Should you find reason to believe, though, that the market's price for this stock overly discounts the business's profit-earning capabilities, then you've effectively used expectations to find a profitable bet skewed in your favor.?

Macro-focused "All Asset" investors use expectations similarly, just at the asset class level, to try and make profitable bets.?

Dive deeper

To learn more about All Asset investing, you can check out?Research Affiliates' website.?

In the same vein, check out Rebecca Hotsko's?factor investing 101?podcast episode on?Millennial Investing.?

SEE YOU NEXT TIME!

That's it for today on?We Study Markets!?

See you later!

All the best,

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