The Next Country To Collapse Isn’t In Europe

Despite the recent market correction threatening the four-year bull market, investors should be partying like it’s 2006.

Easy-money programs from the world’s central banks and a recovering global economy could push stocks and other assets higher. So why is the comparison to 2006 relevant?

September 2006 was two years before the collapse of Lehman Brothers and a 28% drop in the markets in the span of less than a month. And two years is about the amount of time we may have until the next great market crash.#-ad_banner-#

So what will be the proverbial straw that breaks the market’s back? Europe? China? Market contagion from a collapse in commodities prices?

None of the above. While the rest of the market worries about those issues, there is a bigger threat that could pull down world markets and change the way we measure safety investments.

The next great collapse is unlikely to come from any of these problems. It is more likely to come from a country that has been a haven for investors for more than 30 years and accounts for nearly 10% of world growth.

A look at this country’s debt situation, especially relative to the United States, is truly amazing.

This country is paying 21% of government revenue on interest payments to support a 236% debt-to-GDP ratio. With annual spending twice as high as its revenue, the government is running a deficit of $455 billion a year and adding to its $11.2 trillion debt. This is all before the monetary stimulus programs announced recently by its central bank.

If you thought the United States government was a financial basket case, Japan is exponentially worse. A collapse in the yen and the stock market is all but certain — the only question is when.

The recent easy money program by the Bank of Japan gives us a good idea of the timetable.

The announcement by the Bank of Japan to buy 7.5 trillion yen (about $75 billion) in bonds per month and double the monetary base during the next two years is exponentially higher than anything the country has tried in the past two decades. If you think U.S. Federal Reserve Chairman Ben Bernanke and the Fed‘s $85 billion monthly purchases is extreme, consider that Japan’s economy is a third the size of the United States’ and that its growth has stalled in the past decade.

So the bank wants to increase inflation to 2% from its current negative rate of 1% deflation. If they are even partially successful, interest rates on the government bonds could jump. If inflation increases to 1% and the rate on the 10-year bond increased to just 1.5%, the government would need to pay out 65% of revenues just to service the interest.

Kyle Bass of Hayman Advisors recently told Barron’s that a debt crisis that will rival Argentina’s 2001 collapse is “the most obvious scenario of my adult life. The question is when.”

Japan’s stock market is up more than 50% since November with the currency depreciating 25% since government officials started pushing their monetary plans. Just like 2006, everyone is talking about the money to be made in the Japanese stock market.

Japan Monetary Base

(trillions of yen)

After two years, the assets held by the Bank of Japan may be as much as 60% of GDP, compared with just 25% for the Federal Reserve. The bank won’t be able to sell these assets without driving up rates, and the government will no longer be able to fund its massive deficits with the skyrocketing interest burden.

Why should investors care about a country that represents less than 10% of global growth? To put Japan’s importance in perspective, Greece’s economy is less than one-twentieth of Japan’s — and brought the market to its knees last year.

Like the 10-year Treasury note, Japan’s government bond has been used by the market to evaluate risk for more than 30 years. A collapse in this market could send shock waves across markets worldwide.

Why do I think the scenario could play out over two years?

The Bank of Japan’s monetary program will involve buying most of the government’s bond issuance for the next two years, which should help keep rates down. As the program winds down, the bond issues are unlikely to attract many buyers, sending rates higher. The government won’t be able to pay the high interest burden, and the Bank of Japan will not be able to sell its bonds to fight inflation.

The analogy to 2006 almost certainly will not play out along the same two-year timetable, however. The Bank of Japan’s monetary program covers two years. The stock market is fairly reliable as a six-month predictor of the economy, so investors could start running for the exits in as little as a year and a half.

Of course, anyone jumping out of the market in 2006 would have missed out on the remainder of the bull market. The trick is to ride the market further — while gradually rotating into safer names and assets.

The iShares MSCI Japan Index (NYSE: EWJ) is up 30% since its November 2012 low, but it has underperformed the S&P 500 by 74% since its launch in 1996, with a 31% loss in that time. The fund is extremely expensive at 21.5 times trailing earnings and may have a tough time adding to gains.

U.S. automakers like General Motors (NYSE: GM) and Ford (NYSE: F) have more to lose than most other domestic companies. The yen could collapse along with the financial system, which could make Japanese exports cheap compared with those of international competitors.

While Japanese automakers like Toyota (NYSE: TM) have factories set up internationally, the country still exports about 1.5 million cars a year to the United States. As the yen weakens, these companies may shift more production back to the mainland, driving the cost of Japanese vehicles down further.

The CurrencyShares Japanese Yen Trust (NYSE: FXY), down almost 20% since November, could eventually implode as a debt crisis ruins the currency’s status as a safe haven and massive depreciation follows. Investors may be able to use the fund as a hedge against market losses in their portfolio if a collapse does happen.

Risks to Consider: As the great economist John Maynard Keynes said, “Markets can stay irrational longer than you can stay solvent” — so shorting the Japanese market may not be recommended as the bubble inflates. Japan is still the third-largest global economic power, and it could stave off the inevitable for a couple of years.

Action to Take –> I firmly believe this event could send the world into a recession. Japanese stocks and the yen could be the hardest-hit, and shorting them may provide a good hedge against drops in other markets. Take your profits on Japanese equities and keep the situation on your radar.