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Unsubstantiated claims

In my recent article Japan the end of the beginning I said most of the foreign security holdings via

insurance companies and pension funds are currency hedged back into the Yen and this needs to be

taken into account when evaluating exposure to a weaker Yen and higher inflation. The following table

showed a drilled down exposure of Japanese Household Financial Assets as at December 2012 (BoJ

data):

With only 16.4% of assets invested in equities or off shore securities, I concluded that Japanese

households are overwhelmingly positioned for the deflationary environment to continue. Should the

BoJs target of 2% inflation within 2 years start gaining credibility, they would be very inappropriately

positioned. When you consider that purchasing additional equities and offshore securities would not

only lower risks of real capital loss, but also enhance yield, I expect reallocation within the $15trillion of

Japanese household financial assets to be a major driver of Japanese equities and to have a significant

impact on the Yen.

Currency hedging in Japanese Life Insurance portfolios

However an article carried by Reuters (As Japan insurers flirt with foreign bonds, yields may move morethan yen 25Apr13) gives some fascinating insights as to the extent of currency hedging in institutional

portfolios. This is important as in the table above I assume that foreign security holdings would provide

capital protection in a weak Yen/higher inflation scenario. It appears that for the vast majority of these

holdings, that is not the case.

Nippon Life (the largest private sector life company with Y50tr = $500bn of assets) has Y6.64tr in hedged

foreign bonds and Y2.11tr in unhedged (March 31 2013), so only 24% of foreign bond holdings are

%age of Total

Financial Assets

Japan

Total

Bonds Cash Equities Off

shore

Sec

Infn

Proof

Total

USA Equities

Equities 6.8 6.8 6.8 32.8 32.8

Investment Trusts 4.0 0.8 0.6 2.3 2.9 11.8 5.5

Insurance 21.1 15.3 0.2 1.3 3.1 4.4 10.8 2.9

Pension Funds 6.6 2.2 0.3 0.7 1.6 2.3 17.3 8.5

Bonds/loans 2.1 2.1 9.5

Cash on deposit 55.2 55.2 14.6

Other 4.2 3.2

Total 100.0 20.4 55.7 9.4 7.0 16.4 100.0 49.7

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Japan follow up Institutional Exposures Macro Economic Research May 2013

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providing protection against Yen weakness. Another example, Asashi Mutual Life Insurance, the 6th

largest, has just moved from fully hedged to 90% hedged as at March 31st.

If we assume that foreign security holdings in the Life Assurance portfolios are 80% hedged back into

Yen, the 16.4% of Household Assets protected from inflation and Yen weakness drops to under 14%.

Similar hedging policies by Pension Fund managers would lower this even further to around 12.5%.

The authors of the Reuters article referenced above draw the conclusion that because of the extensive

hedging of foreign bond holdings, we should not expect significant Yen selling as demand grows for

offshore bond holdings. My take on this is actually the reverse as the Yen weakens there will be

increasing pressure to reduce the hedging on both the existing pool of assets and new flows and this

could in fact be a larger number than the flow itself. As quoted in the article, Hiroshi Ozeki, GM of

Finance and Investment Planning for Nippon Life says: If there is appropriate timing, we would like to

boost our allocations to unhedged foreign bonds. Takahiro Ono, Asahi Mtual Life chief portfolio

manager concurs: If there are clear prospects for the yen to fall further, we may consider lowering the

ratio of hedged foreign bond buying a bit.

I believe the past two decades of deflation and the strong Yen have also entrenched corporate attitudesand policies generally. The structure of balance sheets in the corporate sector (many companies carry

massive net cash balances) and the foreign exchange hedging policies of exporters and multi-nationals

will be slow to reflect the new reality, and the impact of changes here still have to impact the Yen in

years to come.

Conclusion

Given the extent of currency hedges within institutionally managed portfolios, Japanese Household

financial assets may be even more exposed to Yen weakness and inflation than I thought, with the

hedging reducing inflation-robust assets from 16.4% to as low as 12.5% of total financial assets at

December 31 2012.

A change in hedging policy by institutional investors as existing hedge losses mount up could result in

significant Yen selling.

Kevin Cousins is a portfolio manager at Brait Capital Management Limited. ("BraitCM"). This article isprepared by Kevin as an outside business activity. As such, BraitCM does not review or approve materialspresented herein. The opinions and any recommendations expressed in this article are those of the

author and do not reflect the opinions or recommendations of BraitCM.

None of the information or opinions expressed in this article constitutes a solicitation for the purchase orsale of any security or other instrument. Nothing in this article constitutes investment advice and anyrecommendations that may be contained herein have not been based upon a consideration of theinvestment objectives, financial situation or particular needs of any specific recipient. Any purchase orsale activity in any securities or other instrument should be based upon your own analysis andconclusions. Either BraitCM or Kevin Cousins may hold or control long or short positions in the securitiesor instruments mentioned.