Valuation Analysis In Global Macro

My Thoughts On Valuations.

Valuation analysis is one of the most important tools in investing, particularly over the long term. The axiom is simple, as most are: buy low, sell high.

Valuation metrics provide signals on when investors should “buy cheap”, and when they should “sell high”. But this exercise is far from easy in the real world.

Assets might look expensive relative to their historic price or relative to the price of other assets. Yet some valuation indicators might look excessive, while others look fairly valued.

Comparing your asset of choice with other assets can also be difficult. At times, the relative valuation of one asset might provide a sell signal, while another asset points toward a buy decision.

Fundamentals can also change, attenuating the value of valuation analysis.

The yen provides a good example of this.

For many years now, the Japanese yen has looked very cheap according to currency valuation metrics. For instance, the chart below shows that Japan’s “real effective exchange rate” (REER) has been very low relative to its historical levels for years now. (REER is one of the best FX valuation tools in global macro).

In response to a cheap yen, exports as a share of GDP have increased in Japan; rising from about 13% before JPY collapsed in 2011, to 18.5% in 2018. Yet Japanese growth has been weak over the same period.

So what? The yen clearly looks cheap when using the real-effective-exchange metric. Therefore, based on what I outlined above, the message would be that investors should buy the yen. Yet this trade has failed for almost a decade now. Why?

In my opinion, this argument that the yen is cheap is too simple. It’s too easy. If forecasting currencies or any asset, as a matter of fact, was as easy as: hey, go check the valuation indicator, we would all be macro strategists.

I believe that yen bulls have missed that the broader macro environment has changed and that valuations have become less important.

Enter fundamentals and policy. In global macro, fundamental analysis basically considers the economic situation in any country and around the world. This is important because trends in fundamental growth impact all asset classes: currencies, stocks, bonds.

And a certain points in time, countries can go through structural economic shifts. As Japan did during its 1970s to 1980s boom, and then during its 1990s to 2000s deflationary period. (While Japan remained in a deflationary trap through the 2010s, its transition to deflation started in the 1990s).

Importantly, a structural shift in fundamentals, often produces a structural shift in policy. The time lag between the emergence of a new growth environment and a new policy environment, however, is long and variable. This a new economic regime might be followed by a new policy regime in ten years. Or in Japan’s case, 20 years. 

The Bank of Japan was known for decades to be tight-fisted hawks. In other words, they were always reluctant to pursue audaciously easy monetary policy. This pushed the yen higher.

Enter Shinzo Abe in 2012. After his election, which represented a paradigm shift, the Bank of Japan reversed course on two decades of obstinacy and embraced a very long and credible commitment to conspicuously easy monetary policy. This has kept the yen cheap for almost a decade.

Bringing this back to valuation analysis, if there has been a structural shift in Japanese growth and BoJ monetary policy, using REER or other valuation tools to forecast the yen is misguided. In short, JPY might not be cheap, and yen bulls might continue to have their horns clipped.

(As a germane aside, I would argue Japan’s new monetary-policy strategy has been underpinned by a long-term shift in its political regime; for more on that, read my April 2012 piece on why Abe’s election was a game changer).

I will close here by mentioning that this article was intended to be instructive rather than predictive. I am not making the argument that the yen will either appreciate or depreciate in the near-, medium-, or long-term future. That’s not what this piece was about. It was about showing that while valuation analysis can be very helpful in global macro forecasting, it should always be looked at in conjunction with other analytical tools – such as fundamentals and policy.

Hope you have enjoyed this article.

Carpe diem, YOLO. 

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