The Next Country To Collapse Isn't In Europe

By (Joseph Hogue),

Shutterstock photo

Despite the recentmarket correction threatening the four-yearbull market , investors should be partying like it's 2006.

Easy-money programs from the world's central banks and a recovering globaleconomy could pushstocks 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 greatmarket crash.

So whatwill 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 thoseissues , there is a bigger threat that could pull down world markets and change the way we measure safetyinvestments .

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'sdebt situation, especially relative to the United States, is truly amazing.

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

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

The recenteasy 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) inbonds 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 ChairmanBen Bernanke andthe 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 increaseinflation to 2% from its current negative rate of 1%deflation . If they are even partially successful, interest rates on thegovernment bonds could jump. If inflation increases to 1% and the rate on the 10-yearbond increased to just 1.5%, the government would need to pay out 65% ofrevenues just to service the interest.

Kyle Bass of HaymanAdvisors 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 stockmarket is up more than 50% since November with thecurrency depreciating 25% since government officials started pushing their monetary plans. Just like 2006, everyone is talking about themoney 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% ofGDP , 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 tofund its massive deficits with the skyrocketing interest burden.

Why should investors care about a country that represents less than 10% of global growth? Toput 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-yearTreasury note , Japan'sgovernment bond has been used by the market to evaluate risk for more than 30 years. A collapse in this market could send shockwaves 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 JapanIndex ( 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 trailingearnings and may have a tough time adding togains .

U.S. automakers like General Motors ( GM ) and Ford ( 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 ( 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 ( FXY ) , down almost 20% since November, could eventually implode as a debt crisis ruins the currency's status as a safe haven and massivedepreciation follows. Investors may be able to use the fund as ahedge against market losses in their portfolio if a collapse does happen.

Risks to Consider: As the greateconomist 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 arecession . 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 Japaneseequities and keep the situation on your radar.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.

This article appears in: Investing International
Referenced Stocks: EWJ , F , FXY , GM , TM

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