Will the Nikkei breakout or fail and follow the Yen lower?

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Macro Letter – No 25 – 05-12-2014

Will the Nikkei breakout or fail and follow the Yen lower?

  • The Japanese Yen has declined further against its main trading partners
  • The Nikkei Index has trended higher on hopes of structural reform and QQE
  • JGBs remain supported by BoJ buying

The Nikkei 225 index is making new highs for the year as the JPY trends lower following a further round of aggressive quantitative and qualitative easing (QQE) from the Bank of Japan (BoJ). The Japanese Effective Exchange Rate has fallen further which should help to improve Japan’s export competitiveness whilst import price inflation should help the BoJ achieve its inflation target.

Net Assets

For several decades Japan has been a major international investor, buying US Treasury bonds, German bunds, UK Gilts as well as a plethora of other securities around the globe.  Japan has also been a source of substantial direct investment, especially throughout the Asian region.  May 2014 saw the release of a research paper by the BoJ -Japan’s International Investment Position at Year-End 2013 – the authors observed:-

Direct investment (assets: 117.7 trillion yen; liabilities: 18.0 trillion yen)

Outward direct investment (assets) increased by 27.9 trillion yen or 31.1 percent. Inward direct investment (liabilities) remained more or less unchanged.

Portfolio investment (assets: 359.2 trillion yen; liabilities: 251.9 trillion yen)

Outward portfolio investment (assets) increased by 54.1 trillion yen or 17.7 percent. Inward portfolio investment (liabilities) increased by 71.4 trillion yen or 39.5 percent.

Financial derivatives (assets: 8.2 trillion yen; liabilities: 8.7 trillion yen)

Financial derivatives assets increased by 3.6 trillion yen or 77.5 percent. Financial derivatives liabilities increased by 3.3 trillion yen or 62.5 percent.

Other investment (assets: 178.4 trillion yen; liabilities: 193.6 trillion yen)

Other investment assets increased by 25.5 trillion yen or 16.7 percent. Other investment liabilities increased by 31.6 trillion yen or 19.5 percent.

Reserve assets (assets: 133.5 trillion yen)

Reserve assets increased by 24.1 trillion yen or 22.0 percent.

The chart below shows how Japan continues to accumulate foreign assets despite their balance of payments moving from surplus to deficit:-

Japanese_assets_vs_liabilities_-_IMF_-_BoJ

Source:BoJ

From the mid 1980’s until the aftermath of the bursting of the 1990’s technology bubble, international investment was one of the principle methods by which Japanese firms attempted to remain competitive in the international market whilst the JPY appreciated against its main trading partners.

The Japanese Effective Exchange Rate chart below shows how the JPY has weakened since the initial flight to safety after the bursting of the “Tech Bubble” and again after the flight to quality during the “Great Recession”. This currency weakness was accelerated by the introduction of Prime Minister Abe’s “Three Arrows” economic policy:-

JPY Real Effective Exchange Rate 1970- 2014 BIS

Source: BIS

We are now back to levels last seen before the Plaza Accord of 1985 – after which the JPYUSD rate rose from 250 to 130.

Whilst Japan’s foreign investments returns should remain positive – especially due to the falling value of the JPY – Japanese saving rates continue to decline, just as negative demographic forces are pushing at the door. The stock-market bubble, which burst in 1990, was most excessive in the Real-Estate and Finance sectors. With housing demand expected to decline, for demographic reasons, and financial firms now representing less than 4% of the Nikkei 225 these sectors of the domestic economy are likely to remain moribund. The chart below shows the evolution of Japanese house prices from 1980 to 2008:-

Japanese Home Prices - 1980 - 2008 Market Oracle

Source: Market Oracle

After the slight up-tick between 2005 and 2008 house prices have resumed their downward course despite increasingly lower interest rates.

What Third Arrow?

In order to get the Japanese economy back on track, fiscal stimulus has been the government solution since 1999, if not before.  Shinzo Abe won a second term as Prime Minister with a set of economic policies known as “The Three Arrows” – a cocktail of QQE from the BoJ, JPY devaluation and structural reform. The Third Arrow of “Abenomics” is structural reform. This type of reform is always politically difficult. With this in mind Abe has called an election for the 14th December – perhaps prompted by the release of Q3 GDP data (-1.6%) confirming that, after two consecutive negative numbers, Japan is officially back in recession. He hopes to win a third term and fulfil his mandate to make the sweeping changes he believes are required to turn Japan around.

Energy reform is high on Abe’s agenda. Reopening nuclear reactors is a short term fix but he plans to make the industry more dynamic and spur innovation. In a recent interview with CFR – A Conversation With Shinzo Abethe Prime Minister elaborated on his plan:-

…On the other hand, we wish to be the front-runner in the energy revolution, ahead of others in the world. I would like to implement the hydrogen-based society in Japan.

The development of fuel cells started something like 30 years ago as a national project. Last year, I have reformed the regulations that inhibited the commercialization of the fuel cell vehicle. And at last, a first ever in the world, we have implemented the commercialization of hydrogen station and fuel cell vehicles.

Early next year, in the store windows of automotive dealers, you’ll be able to see the line up of fuel cell cars.

In the power sector, we shall put an end to the local monopoly of power, which continued for 60 years after the war. We will be creating a dynamic and free energy market where innovation blossoms.

He then went on to discuss his ideas for reform of corporate governance:-

Companies will have to change as well. I will create an environment where you will find it easy to invest in Japanese companies. Corporate governance is the top agenda of my reform list. This summer, I have revised the company law on the question of establishment of outside directors. I have introduced the rule called “comply or explain.”

Amongst listed companies in the last one year, the number of companies which opted to have outside directors increased by 12 percent. Now, 74 percent.

Tax reform is another aspect of Abe’s package. In the past year, corporate tax rates have been cut by 2.4%. Another term in office might give Abe time to make a difference, but his ill-conceived decision to increase the sales tax earlier this year had a disastrous impact on GDP – Q2 GDP was -7.1%. A further increase from 5% to 8% was scheduled for October 2015 but has now been postponed until April 2017 – as a palliative to the “deficit hawks” the increase will be from 5% to 10%. Whilst this was a relief for the stock market it led to a further weakening of the JPY. Last week, Moody’s downgraded Japanese debt due to their concerns about the government’s ability to control the size of its deficit.

The Association of Japanese Institutes of Strategic Studies – Tax System Reform Compatible with Fiscal Soundness – makes some interesting suggestions in response to the looming problem of lower tax receipts: –

Given Japan’s challenging fiscal circumstances, broadening the tax base while lowering corporate tax rates seems a realistic compromise to head off a decline in corporate tax revenues. However, simply lowering corporate tax rates on the condition that corporate tax revenues be maintained is of limited effectiveness in stimulating the economy. If the emphasis is to be placed on the benefits of this approach for economic revitalization, then corporate tax rates will need to be drastically lowered and the rates for consumption tax and other taxes raised. Steps will also need to be taken to reform the tax system overall rather than just to secure revenues by increasing consumption taxes. Although the weight of the tax burden will inevitably shift toward consumption tax, the tax base must also be expanded through income tax reform to secure tax revenues. An obvious choice is reconsidering the spousal deduction that gives tax benefits to full-time housewives so that the tax system can be made neutral vis-a-vis the social advancement of women. A major premise in tax increases is ensuring efficiency and fairness in fiscal matters. If the public can be persuaded that tax money is being put to good use, high consumption tax rates such as those in Scandinavia will enjoy public support. A taxpayer number system should be promptly introduced and an efficient and fair tax collection environment put into place.

Japan’s government debt to GPD is currently the highest among developed nations at 227%, however, according to Forbes – Forget Debt As A Percent Of GDP, It’s Really Much Worse – as a percentage of tax revenue debt  is running around 900%, far ahead of any other developed nation.

Labour market reform is high on Abe’s wish list, in particular, the roll-out of incentives to encourage Japanese women to enter the labour market. This would go a long way towards offsetting the demographic impact of an ageing population. It has the added attraction of not relying on immigration; an perennial issue for Japan for cultural and linguistic reasons:-

Japan - Female participation in Labour market OECD

Source: OECD Bruegal

Agricultural reform is also an agenda item. It could significantly improve Japan’s competitiveness and forms a substantial part of the Trans-Pacific Partnership (TPP) negotiations which have been taking place between Japan, USA and 11 other Asian countries during the past two years. Sadly the free-trade agreement has stalled, principally, due to Japanese reluctance to embrace agricultural reform. The Peterson Institute – Will Japan Bet the Farm on Agricultural Protectionism? – takes up the story: –

What is at stake? The gains for Japan from entry into the TPP are substantial, more than what nearly any other member of the agreement would reap. Peter A. Petri, visiting fellow at the Peterson Institute for International Economics, estimates that the agreement would add 2 percent to Japan’s GDP by 2025. More broadly, the TPP represents an opportunity for Japan to reinvigorate its unproductive domestic industries (agriculture included) by permitting greater foreign competition. It would also enable Japan to reassert itself as a leader and a model in the Asia Pacific. Facing an uncertain future with China gaining influence in the region, Japan needs to remain strong and dynamic at home, economically enabling it to leverage its technical and market-size advantages to secure its position in the region. These gains are now in jeopardy largely because of Japan’s agricultural protectionism.

How protectionist is Japan? To be fair, Japan has made progress on lowering support for agriculture since the 1980s. The United States—the primary objector to the protection afforded to Japan’s agricultural sector—also still provides support for its own agriculture sector. However, the magnitudes are starkly different. For every dollar of agriculture production, Japan provides 56 cents of subsidies to farmers. The United States and European Union provide just 7 cents and 20 cents for every dollar, respectively. Additionally, Japan spends nearly 1.25 percent of its GDP on agriculture subsidies (which includes support for producers, as well as consumers). The United States and European Union spend 1 percent and 0.7 percent, respectively. There are also many internal barriers, such as restrictions on the sale and use of farm land and preferential tax structures for farmers, which discourage older generations from leaving or corporate farms from entering the farming sector in many areas.

The political importance of the rural vote may have caused Abe to backtrack on his timetable for reform. This is another example of how important the forthcoming election will be both for the Japanese economy and its stock market.

Kuroda and GPIF to the rescue (again)

On October 31st the BoJ announced an increase in its stimulus package from JPY60trln per month to JPY80trln. On the same day the Government Pension Investment Fund (GPIF) which, with $1.2 trln in assets, is the world’s largest, announced that it planned to reduce its holding of government bonds to 35% from the current 60%, this money will be reallocated equally between domestic and international equity markets. That’s $150bln waiting to be allocated to Japanese equities. The BoJ also announced an increase in their ETF purchase programme, but this pales into insignificance beside the GPIF action.

Writing back in January 2013, Adam Posen of the Peterson Institute – Japan should rethink its stimulus – gave four main reasons why Japan has been able to continue with its expansionary fiscal policy: –

Japan was able to get away with such unremittingly high deficits without an overt crisis for four reasons. First, Japan’s banks were induced to buy huge amounts of government bonds on a recurrent basis. Second, Japan’s households accepted the persistently low returns on their savings caused by such bank purchases. Third, market pressures were limited by the combination of few foreign holders of JGBs (less than 8 percent of the total) and the threat that the Bank of Japan (BoJ) could purchase unwanted bonds. Fourth, the share of taxation and government spending in total Japanese income was low.

Last month saw the release of a working paper from Peterson – Sustainability of Public Debt in the United States and Japanwhich contemplates where current policy in the US and Japan may lead, it concludes:-

The implication of these projections is that even for just a 10-year horizon, somewhat more effort will be required to keep the debt-to-GDP ratio from escalating in the United States, and much more will need to be done in Japan. Using the probability-weighted ratio of net debt to GDP (federal debt held by the public for the United States), holding the ratio flat at its 2013 level would require cutting the 2024 debt ratio by 8 percentage points of GDP for the United States and by 32 percentage points of GDP for Japan. In broad terms achieving this outcome would involve reducing the average primary deficit by about 0.75 percent of GDP from the baseline in the United States and by about 3 percent of GDP in Japan.

The Japanese economy is now entirely addicted to government fiscal stimulus, reducing the primary deficit by 3% and maintaining that discipline for a decade is unrealistic.

I’m indebted to Gavyn Davies of Fulcrum Asset Management for this chart which puts the BoJ current QQE policy in perspective: –

Total CB assets vs GDP - Fulcrum

Source: Fulcrum

Whither the Nikkei 225?

With the JPY continuing to fall in response to QQE and the other government policy decisions of the last two months, the Nikkei has rallied strongly; here is a 10 year chart:-

Nikkei 225 - 10yr - source Nikkei

Source: Nikkei

The long-term chart below, which ends just after the 2009 low, shows a rather different picture:-

nikkei-225 - 1970 - 2009 - The Big Picture - The Chart Store

Source: The Big Picture and The Chart Store

From a technical perspective, recent stock market strength has taken the Nikkei above long-term downtrend. Confirmation will be seen if the market can break above 18,300 – the level last reached in July 2007. A break above 22,750 – the June 1996 high – would suggest a new bull market was commencing. I am doubtful about the ability of the market to sustain this momentum without a recovery in the underlying economy – which I believe can only be achieved by way of government debt reduction. Without real reform this will be another false dawn.

The chart below shows the Real Effective Exchange Rate for a number of economies. The JPY on this basis still looks expensive however the impact of a falling JPY vs KRW or RMB will be felt in rising political tension and potentially a currency war:-

Real_Effective_exchange_rates_-_1980_-_2012_BIS_-_

Source: BIS

Japan can play the “devaluation game” for a while longer, after all, a number of its Asian trading partners devalued last year, but the long-run implications of a weaker JPY will be seen in protectionist policies which undermine the principles of free trade.

Conclusions and investment opportunities

JPYUSD

The Japanese currency will continue to weaken versus the US$. This chart from the St Louis Fed, which only goes up to 2012, shows how far the JPY has appreciated since the breakdown of the Bretton Woods agreement:-

usdjpy1971 - 2010 Federal Reserve

Source: Federal Reserve

I think, in the next two to three years,  JPYUSD 160 is to be expected and maybe even a return to JPYUSD 240.

JGBs

The BoJ currently owns around 24% of outstanding JGBs but this is growing by the month. Assuming government spending remains at its current level the BoJ will hold an additional 7% of outstanding supply by the end of next year. By 2018 they could own more than 50% of the market. In order to encourage longer-term investment – or, perhaps, merely in search of better yields – the BoJ has extended the duration of their purchases out to 40 year maturities. The latest BoJ data is here.

Central bank buying will support the JGB market as the GPIF switch their holdings into domestic and international stocks. . International ownership remains extremely low so adverse currency movements will have little impact on this decidedly domestic market. With 10 year yields around 0.45%, I see little long-term value in holding these bonds when the BoJ inflation target is at 2% – they are strictly for trading.

Nikkei 225

The Nikkei is heavily weighted towards Technology stocks (43%) and on this basis the market still appears relatively cheap, it also looks cheap on the basis of the P/E ratio, the chart below shows the P/E over the past five years:-

Nikkei 225 - PE - Source TSE

Source: TSE and vectorgrader.com

Here for comparison is the Price to Book ratio, this time over 10 years:-

Nikkei 225 Price to Book 10 yr

Source: TSE and vectorgrader.com

Neither metric indicates that the current valuation of the Nikkei is excessive, but, given the frail state of the economy, I suspect Japanese stocks are inherently vulnerable.

Over the next year the Nikkei will probably push higher, helped by buying from the GPIF and international investors, many of whom are still under-weight Japan. A break above 18,300 would suggest a move to test the April 2000 high at 20,833, but a break above the June 1996 high at 22,757 is required to confirm the beginning of a new bull market. In the current economic environment I think this will be difficult to achieve. There are trading opportunities but from a longer-term investment perspective I remain neutral.

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The Fourth Arrow Option – how Japan may side-step structural reform

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Macro Letter – No 16 – 18-07-2014

The Fourth Arrow Option – how Japan may side-step structural reform

  • The Third Arrow is hard to deliver but the Fourth Arrow has already been unleashed
  • State and private investments will switch to equities and real-estate
  • The “monetary extortion” of negative real interest rates is here to stay

The First Three Arrows

Mori Motonari (1497 – 1571) was the ruler of the Chugoku area of Western Japan. His land was on the brink of war so he summoned his three eldest sons and gave the first an arrow, asking him to break it. Of course, his son easily broke the arrow in two. Then, Mori gathered three arrows together, gave them again to one of his sons, and asked him to break these three arrows, all together. His son tried with all his strength to break the arrows but it was impossible. Mori explained to his sons, “Just like one arrow, the power of just one person can easily be overcome. However, three arrows together cannot be destroyed. Human strength is the same as these arrows; we cannot be defeated if we work together.”

Abenomics

Today the Three Arrows describe Shinzo Abe’s economic policy:-

Arrow one –        Monetary stimulus by the Bank of Japan (BoJ)

Arrow two –        Tax cuts by the LDP government

Arrow three –    Structural reform

The first arrow has been unleashed with vigour by the BoJ as they target 2% inflation. The most recent CPI was +3.7% in May up from 3.4% in April. Job done? Probably not – prior to April the CPI had struggled to manage 1.5% and even the BoJ acknowledge that the recent rise is due to the consumption tax increase being largely passed on to consumers.

The second arrow has been enfeebled by the imposition of a sales tax increase in April 2014, although the June 25th announcement of corporate tax cuts from April 2015 should lend it some renewed strength. Japanese companies held a record JPY222 trn in cash at the end of 2013. A cut in corporate tax to below the rate of Germany (<30%) will be an incentive to invest at home rather than overseas. In Q4 2013 Japanese corporate invested JPY69 trn abroad – up 40% on the same period in 2012.

The third arrow is “structural reform” but, as any democratically elected politician will tell you, that is a job best left to ones successor. So far there have been tentative attempts to reform agriculture and healthcare.  Policies to encourage immigration and to promote female participation in the labour force are still awaited. As are the signing of free trade agreements with the EU, US and Japan’s Asian neighbours. To check on the glacial progress of the TTP the Office of the US trade Representative is a good starting point.

With only one well honed arrow, the quiver looks bereft. But a Fourth Arrow – asset reallocation to domestic stocks – has been unleashed with stealth. Whether or not it hits its intended target, it will benefit a couple of asset classes in particular.

Before examining the Fourth Arrow Option, however, I want to review the recent price action in the JPY, JGB and Nikkei.

The Yen that will not fall

 USDJPY 3yr weekly - Barchart.com

Source: Barchart.com

When the JPY broke out of its range to the downside at the end of 2013 I thought we might see another wave of depreciation, but during the first half of 2014 the currency has been range-bound despite continued BoJ quantitative and qualitative easing (QQE). The relative magnitude of this QQE is demonstrated by the chart below:-

Total central bank assets as percentage of GDP - BIS

Source:BIS- Bloomberg- Datastream – National Data

Like other major central banks, the BoJ is wrestling with the vexing issue of “transmission” – QQE has improved the fiscal position of Japanese banks but it has done little to stimulate credit demand in the wider economy. A significant portion of economic activity was front-loaded into the first quarter of 2014 to avoid the sales tax increase in April. Since then economic data has been weak. This was anticipated, and articulated, by the BoJ so it has largely been discounted by the markets – except, perhaps, JGBs which are toying with all-time low yields again this week (currently 0.54%).

The corporate tax cuts next April are estimated to lead to an increased stock market valuation of around 0.60%. This is hardly going to transform private sector investment decisions. The chart below from the Federal Reserve shows the anaemic expansion of credit despite the well heralded “Abenomics” package:-

Japan Credit - Federal Reserve

Source: Federal Reserve

Some economists have argued that the absence of private credit growth is due to a lack of demand for credit. This absence, is thought to stem from entrenched deflationary expectations. I believe this is only part of the story; of much greater importance is the lack of private sector opportunity due to the increasing scale of the public sector. The chart below shows the divergence between private investment and government consumption.

Japan Real GDP and Expenditure - David Andolfatto

Source: David Andolfatto

For those who wish to investigate this concept more closely, Federal Reserve Bank of St Louis head of research, David Andolfatto’s post, on his private blog site, What’s up with Japan? (G , evidently) makes interesting reading.

Meanwhile the fall in value of the JPY from October 2012 to April 2013 has not delivered a significant increase in export activity. This puzzle is examined in an interesting post by the New York Federal Reserve from July 7thWhy Hasn’t the Yen Depreciation Spurred Japanese Exports?:-

… we show that a key to understanding why there is low pass-through from exchange rates into export prices is that large exporters are also large importers, so they face offsetting exchange rate effects on their marginal costs. In the case of Japan, the connection between the yen and production costs has been made stronger since the country replaced nuclear power with imported fuels in the aftermath of the 2011 earthquake.

Developed country manufacturers are significant importers of semi-manufactured goods. A fall in the exchange rate makes these imports more expensive so the comparative advantage for exporters of finished goods is diminished by the increase in production input costs. Japanese import prices have stabilised along with the currency but higher import prices should support the BoJ in their attempts to meet the 2% inflation target for a while at least.

BoJ Guidance

The BoJ are decidedly more optimistic about the prospects for the Japanese economy. In a speech given on 19th June, entitled Economic Activity and Prices in Japan and Monetary Policy – BoJ policy board member Morimotomade the following remarks: –

On the effect of the consumption tax:-

Since the start of fiscal 2014, a subsequent decline in demand following the front-loaded increase prior to the consumption tax hike has been observed, mainly in private consumption, such as of durable goods, but domestic demand including business fixed investment has remained firm as a trend. Therefore, a virtuous cycle of economic activity has been operating firmly, accompanied by steady improvements in supply and demand conditions in the labor market. In this situation, the economy has continued to recover moderately as a trend.

On consumption and investment:-

Looking at domestic demand, private consumption and housing investment have remained resilient as a trend with improvement in the employment and income situation, although a subsequent decline in demand following the front-loaded increase has recently been observed. Business fixed investment has increased moderately as corporate profits have improved; for example, on a GDP basis, it increased in the January-March quarter of 2014 for the fourth consecutive quarter, and thus is growing at an accelerated pace. Public investment continues to increase, due in part to the effects of various economic measures, and has more or less leveled off recently at a high level.

On inflation:-

The rate of increase for April 2014 registered 3.2 percent, and on a basis excluding the direct effects of the consumption tax hike, it marked 1.5 percent, which is somewhat higher than the rate for March. Given this, the tax increase appears to have been passed on to prices on the whole, on the back of resilient private consumption. As for the outlook, although the effects of the upward pressure from energy-related goods that are directly affected by foreign exchange rates are likely to subside through this summer, the year-on-year rate of increase in the CPI (all items less fresh food), excluding the direct effects of the consumption tax hike, is likely to be around 1¼ percent for some time.

However on wages he makes these observations:-

The tightening of supply and demand conditions in the labor market is starting to influence wages. Hourly cash earnings of overall employees have started to increase moderately, albeit with fluctuations. According to the currently available aggregate results of wage negotiations compiled by the Japanese Trade Union Confederation (Rengo), wage negotiations this spring are expected to result in a rise by firms, including small firms, of around 0.5 percent in base pay, and about 2.1 percent in overall wages.

He is sanguine about business investment:-

In order to achieve sustainable growth of the economy, it is important that improvements in corporate profits and increases in demand lead to firms’ active investment. Corporate profits for fiscal 2013 rose significantly. As for fiscal 2014, firms have relatively conservative fixed investment plans at present. However, supported by a moderate increase in exports and developments in the foreign exchange market, in addition to firm domestic demand, corporate profits are expected to continue their improving trend.

Morimoto concludes with forward guidance about monetary policy and loan facilities going forward:-

First, with a view to pursuing quantitative monetary easing, the Bank decided to increase the monetary base — which is the total amount of currency it directly supplies to the economy (the sum of banknotes in circulation, coins in circulation, and current account deposits held by financial institutions at the Bank) — at an annual pace of about 60-70 trillion yen, thus doubling it in two years. Second, to achieve this, the Bank has been purchasing Japanese government bonds (JGBs) so that their amount outstanding increases at an annual pace of about 50 trillion yen. In doing so, the Bank has been working on interest rates across the yield curve — including longer-term ones — setting the average remaining maturity of its JGB purchases at about seven years. And third, the Bank has been purchasing exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding increase at an annual pace of about 1 trillion yen and about 30 billion yen, respectively.

… To support full use of the accommodative financial conditions by firms and households, the Bank — in addition to implementing aggressive monetary easing measures — has established the Loan Support Program through which it provides long-term funds at a low interest rate to financial institutions. Specifically, the Bank has been providing funds through two measures that constitute the program: the fund-provisioning measure to stimulate bank lending (hereafter the Stimulating Bank Lending Facility) and the fund-provisioning measure to support strengthening the foundations for economic growth (hereafter the Growth-Supporting Funding Facility). At the Monetary Policy Meeting held in February 2014, the Bank decided to enhance the two facilities.

A more recent speech by Deputy Governor Nakaso – Japan’s Economy and Monetary Policy – given on the 8th July, to an international audience, examines some of the criticisms of QQE: –

The first criticism is that the year-on-year rate of increase in the CPI is unlikely to reach about 2 percent — the price stability target — in or around fiscal 2015 as forecasted by the Bank. In fact, although many private sector economists have recently revised their inflation forecasts upward, these forecasts continue to be conservative compared to that of the Bank. Since QQE is an unprecedented policy, we understand that there remains skepticism regarding the policy’s effectiveness.

However, looking at price developments over the course of the past year, the inflation rate has no doubt been much higher than many had forecasted at the time of the introduction of QQE in April last year. That is, inflation over the past year has been above levels suggested by the relationship between the output gap and inflation data for recent years. This implies that inflation expectations have been edging up. The Bank will therefore continue with QQE, aiming to achieve the price stability target, as long as it is necessary for maintaining that target in a stable manner. Of course, if the outlook changes and if it is judged necessary for achieving the price stability target of 2 percent, the Bank will make adjustments without hesitation.

The second criticism focuses on potential difficulties related to exiting from QQE. In particular, there are concerns that, even after achieving the price stability target of 2 percent, the Bank might be obliged to continue its massive purchases of government bonds due to considerations of the fiscal situation. On the issue of exit, let me mention just two points.

First, the Bank is pursuing QQE and purchasing government bonds solely to achieve the price stability target of 2 percent. The Bank has no intention to go beyond this objective and monetize government debt. Second, the Bank of Japan is the only central bank which has hands-on experience in exiting from unconventional monetary policy. At the time when the Bank exited from QE, which lasted from 2001 to 2006, I was responsible for market operations as the head of the Financial Markets Department of the Bank. While of course QE and QQE are different, in my view, the Bank already has an extensive range of operational instruments to exit from QQE. That being said, what I would like to emphasize is that the Bank is still in the midst of striving to achieve the price stability target of 2 percent at the earliest possible time, and exit policies should be designed depending on the then prevailing economic and inflation situation. Therefore, it would be premature to discuss the specifics of an exit at this stage.

Nakaso concludes by examining the challenges facing the Japanese economy: –

I pointed out that one of the factors behind the rise in the year-on-year rate of change in the CPI is that the output gap has been narrowing and recently has reached around 0 percent, that is, the long-term average. This is mainly due to the increase in demand accompanying the moderate economic recovery. But from a somewhat longer-term perspective, it is also due to a decline in supply capacity in the economy. In fact, Japan’s potential growth rate has been on a downtrend since the 1990s.

The potential growth rate is determined by the growth in labor input, capital input, and improvements in productivity through innovation and the like. Let me review the trends in these three sources of growth — labor input, capital input, and productivity — that underlie the downtrend in the potential growth rate.

First, labor input has been substantially affected by demographic changes. While demographic changes due to aging can be seen in many advanced economies, such changes have been much more pronounced in Japan than elsewhere (Chart 14). These demographic changes have been one factor putting downward pressure on the potential growth rate through the decline in labor supply.

Second, capital accumulation has slowed because Japanese firms were weighed down by the need to resolve the problem of excess capital stock during the process of adjusting their balance sheets following the burst of the bubble. In addition, protracted deflation reduced firms’ investment appetite and resulted in the deferral of business fixed investment.

Third, productivity growth has also declined. One reason is that while concentrating on dealing with the aftermath of the bubble, Japanese firms were unable to adapt fully to major changes in the global economy such as advances in information and communication technology and intensified global competition. In addition, in the aforementioned deflationary equilibrium, innovation by firms was stifled and productivity growth thus subdued for a protracted period.

 The Fourth Arrow and the stock market

In its broadest terms the “Fourth Arrow” is “government sponsored” provision of permanent capital to the private sector with the intention of stimulating private sector investment. This could take the form of private equity and infrastructure allocations but will be more substantial, and visible, in the domestic equity market. In fact the process is already well underway both by government fiat and by the “monetary extortion” of negative real interest rates.

TheGovernment Pension Investment Fund (GPIF), rather conveniently, raised it target equity allocation from 18% to 26% at the end of 2013. At the end of 2013 fiscal year the fund allocation to domestic equities was 16.47% (JPY20 trn) and 15.59% to international stocks. Domestic bonds still represented more than 55% of the portfolio. Assuming they allocate evenly between domestic and international stocks, the new capital allocation to Japanese stocks will be of the order of JPY6 trn – but I suspect their will be pressure to invest domestically and the figure will be nearer twice that amount.

The latest World Bank estimate for the total market capitalisation of the Japanese Stock market from December 2012 was US$3.7trn (JPY370 trn) but the Nikkei 225 is around 50% higher since then. A much larger source of domestic equity investment may emanate from retail savings accounts due to the negative real interest rate policies of the BoJ. The recent increase in CPI means that the real yield on 10 yr JGBs is now -3.16%. After 2008 JGB yields fell in tandem with CPI but since 2010 this correlation has broken down.

The economic theories of Hyman Minsky and Charles Kindleberger suggest that higher levels of debt will slow economic growth if it is skewed towards borrowing that doesn’t create an income stream sufficient to repay principal and interest. This is why I think JGB yields are likely to remain at these low yield levels for some time to come.  The Japanese Personal Savings Rate remains at extremely low levels (currently 0.6% vs a pre-1989 level of more than 20%) and outstanding Government debt continues to grow the current ratio of debt to GDP is 227% up from 167% in 2008. From an investment perspective I see little value in JGBs but that doesn’t mean I am bearish – I expect the market to move sideways.

JGB 10 yr yield - monthly 2008 - 2014

Source: Trading Economics

Returning to the prospects for the Japanese stock market, another, even larger, pool of capital is likely to be redirected into Japanese stocks.  Research by Nomura suggests that retail investors in Nippon Individual Savings Accounts (NISA) could switch up to JPY70trn (around 12% of total stock market capitalisation) of their holdings to equities as a result of negative real JGB yields. Japanese household have historically maintained a low exposure to equities – there is now a real incentive for these investors to increase their exposure to risky assets.

On certain measures Japanese stocks look undervalued. The chart below shows (with some gaps in the data) the P/E ratio for the Nikkei 225 over the past 20 yrs. The current ratio is at the lower end of its range despite a substantial rise in the index between 2012 and 2013:-

Nikkei 255 - PE Ratio - 20yr

Source: Tokyo Stock Exchange

Analysis of the cyclically adjusted P/E by Capital Economics late last year prompted them to conclude that the market was already slightly overvalued by recent standards. They went on to point out that the late 1980’s boom substantially distorted the average P/E ratios. In other words, stocks aren’t as cheap as the might at first appear. An analysis of the ROE of the MSCI Japan index supports this view – at 8.46% it is ranked 28th out of 32 MSCI country indices.

The recent release of Machinery Orders for May at -30.5% shocked economic commentators – it was the sharpest decline since 2005. The stock market took the datum in its stride.

The Fourth Arrow and real-estate

In May 2013 the OECD – Focus on house prices – paper analysed the disparity between house price valuations in different developed countries. Here is a table from their report: –

House Prices - OECD

Source: OECD

Partly as a result of BoJ buying of REITs Japanese real-estate turnover increased by 70% between 2012 and 2013. Land prices in the Tokyo, Yokohama and Osaka have risen this year for the first time since 2008. With other central banks actively seeking to temper the overvaluation of their own housing stock I expect to see international as well as domestic capital flows targeting real-estate.

Conclusion

Domestic and international capital will flow into Japanese stocks and real-estate following the lead of the BoJ. The QQE policy of the BoJ will continue to target 2% inflation but the JPY will be subject to a tug-of-war. The BoJ’s attempts to weaken the JPY are likely to be undermined by inward international capital flows. The Japanese government may use geopolitical tensions with China to undermine confidence in the JPY. This article from the AIJSS – The Role of Japan’s National Security Council – may appear benign but I encourage you to read between the lines.  JGBs will remain range-bound, real interest rates, negative and growth, anaemic. The beneficiary of the dismal anodyne will be the Japanese stock market which will outperform several of its low growth peers over the next few years.

 

 

Japan: The Coming Rise?

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Macro Letter – No 1 – 6-12-2013

Welcome to my first blog. Those of you who have followed my commentary previously will be used to the eclectic mix of subjects I tend to write about. In my new blog I aim to expand on that reportage service by adding my own, more market centric, opinions.

Japan – The Coming Rise?

On the 4th December Bank of Japan (BoJ) board member Takehiro Sato gave an interesting speech on the prospects for the Japanese economy: –

http://www.boj.or.jp/en/announcements/press/koen_2013/data/ko131204a1.pdf

Japan’s economy has been recovering moderately. While it will be affected by the two scheduled consumption tax hikes, the economy is likely to continue growing at a pace above its potential, as a trend, on the assumption that the global economy will follow a moderate growth path…

… The growth rate for fiscal 2014 is likely to dip temporarily in the April-June quarter due to a decline in demand subsequent to the front-loaded increase in the previous quarters. However, I do not expect an economic downturn such as what we experienced at the time of the previous consumption tax hike in 1997. This is because the current economic situation differs in some aspects from that of the previous tax hike. Specifically, (1) the government is preparing an economic package with a total size of about 5 trillion yen; (2) emerging economies, some of which suffered from simultaneous declines in stock prices, bond prices, and in the value of their currencies this year, are becoming resilient to negative shocks compared to 1997, when the Asian currency crisis occurred, due to the establishment of backstops such as the accumulation of foreign reserves; and (3) Japan’s financial system has been stable as a whole.

Sato went on to predict above trend growth in 2014 H2. I think the majority of this information is priced into the market already.

BARCHART.COM - USD-JPY Weekly - December 2013.

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Source: Barchart.com

Bigcharts - Nikkei 225 - December 2013.

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Source: Big Charts

Despite the sharp correction since Tuesday,during the last few weeks the Japanese Yen (JPY) has begun a renewed decline (see weekly chart above). Earlier this year short JPY and long Nikkei futures (see daily chart above) proved to be an excellent trading opportunity. The election of Shinzo Abe (LDP) as the 90th Prime Minister in December 2012, with his “Three Arrows” policy, spelt hope for an economy which had been moribund, in GDP growth terms, for more than a decade. However, the present Japan story really begins on 25th April 1949 when the JPY was fixed against the US$ at a rate of JPY360 – this fixed rate remained in tact until the collapse of the Bretton Woods agreement in 1971. In the aftermath of WWII Japan, like Germany, took advantage of, what proved to be, a relatively low rate of exchange to rebuild their shattered economy. In the case of Japan one of the societal responses to the end of WWII was to encourage a nation of savers and investors.

As the US withdrew from Japan the political landscape became dominated by the LDP who were elected in 1955 and remained in power until 1993; they remain the incumbent and most powerful party in the Diet to this day. Under the LDP a virtuous triangle emerged between the Kieretsu (big business) the bureaucracy and the LDP. Brian Reading (Lombard Street Research) wrote an excellent, and impeccably timed, book entitled Japan: The Coming Collapse in 1989. By this time the virtuous triangle had become, what he coined the “Iron Triangle”.

Nearly twenty five years after the publication of Brian’s book, the” Iron Triangle” is weaker but alas unbroken. However, the election of Shinzo Abe, with his plan for competitive devaluation, fiscal stimulus and structural reform has given the electorate hope.  Abe’s “Three Arrows” policy takes its name from a 16th century Japanese legend which gives his proposal a cultural attraction, but he will need more than elegant words to overcome the difficulties of implementing the third arrow:-

Mori Motonari(1497 – 1571)ruler of the Chugoku area of Western Japan, found his land on the brink of war. He called his three eldest sons to his castle and gave the first an arrow, asking him to break it. Of course, his son easily broke the arrow in two. Then, Mori gathered three arrows together, gave them again to one of his sons, and asked him to break these three arrows, all together. His son tried with all his strength to break the arrows but it was impossible. Mori explained to his sons, “Just like one arrow, the power of just one person can easily be overcome. However, three arrows together cannot be destroyed. Human strength is the same as these arrows; we cannot be defeated if we work together.”

The BoJ’s 2% inflation target and policy of “quantitative and qualitative easing” (QQE) have been effective in managing market expectations – the JPY is lower and the Nikkei higher without too dramatic a backing up of Japanese Government Bond (JGB) yields. However, doubts about Abe’s ability to deliver the essential third arrow heralded a reversal of both JPY and the Nikkei during the summer. Now the JPY is declining once more and the Nikkei, rising – although other major stock markets have also performed strongly of late.

Is this the beginning of the next stage of the “Japan Trade” or are we merely witnessing year end rebalancing of portfolios?

Emerging Markets

To answer this question I believe we also need to consider the position of China, South Korea and other emerging markets. China is the growing regional hegemon within South East Asia and its territorial disputes with its neighbours around the South and East China Sea are likely to escalate – its announcement last month of the Air Defense Identification Zone (ADIZ) in the East China Sea is likely to sour relations with South Korea. This article from The Diplomat provides more information: –

http://thediplomat.com/2013/11/is-the-china-south-korea-honeymoon-over

Yet, at the same time China is an essential export market for these neighbours; according to a recent article from China Daily, Japan’s exports to China hit a four year low as a result of the rising military tensions surrounding the Senkaku/Diaoyu Islands : –

http://usa.chinadaily.com.cn/business/2013-08/15/content_16897913.htm

This year the US resumed its place as Japan’s largest export market, a position it had lost to China in 2009, however China is still a close second – although it also remains Japan’s largest import market.

For a broader review of the current geopolitical situation within the region, this week’s China-US Focus newsletter from the China – United States Exchange Foundation –  Japan and China: Courting Confrontation – is a useful resume:-

http://www.chinausfocus.com/foreign-policy/japan-and-china-courting-confrontation/

South Korea’s exports to China are also lower this year due to a slowing of Chinese growth, but, helped by stronger exports to Europe and the US, they have been able to support higher GDP growth – together with higher inflation – than Japan. The ending of the Iranian Oil embargo, easing upward geopolitical pressure on energy prices, will help South Korea maintain growth. Its exports to Japan have been strong throughout 2013. Nonetheless, the South Korean administration is extremely sensitive to a weakening JPY, notwithstanding the world class quality of a number of its exporters. Of course, lower oil prices will also benefit Japan but its energy consumption per capita is roughly 20% lower than that of South Korea.

The US has been leading the way with structural reform and parts of Europe have followed suit, however, a number of commentators have voiced concern about the need for emerging markets to embrace structural reform. Anders Aslund of the Peterson Institute had this to say: –

http://www.piie.com/publications/wp/wp13-10.pdf

The hypothesis of this paper is that the emerging market growth from 2000 to 2012 was atypically high and we might be back in a situation that is more reminiscent of the early 1980s. The growth of the last 12 years was neither sustainable nor likely to last. Several cycles that are much longer than the business cycle exist. One is the credit cycle, which Claudio Borio (2012) assesses at 15 to 20 years.

Another is the commodity cycle, which last peaked in 1980 and might last 30 to 40 years (Jacks 2013, Hendrix and Noland forthcoming). A third is the investment or Simon Kuznets cycle, which appears related to both the credit and commodity cycles (Kuznets 1958). A fourth cycle is the reform cycle, which might also coincide with the Kondratieff cycle (Rostow 1978).

The author goes on to highlight seven reasons why high emerging market growth will not continue at the pace of the past decade:-

1. One of the biggest credit booms of all time has peaked out. Extremely low interest rates cannot

continue forever. A normalization is inevitable. Many emerging economies are financially vulnerable

with large fiscal deficits, public debts, current account deficits, and somewhat high inflation. 

2. A great commodity boom has peaked out, as high prices and low growth depress demand, while the

high prices have stimulated a great supply shock. 

3. The investment or Simon Kuznets cycle has peaked out, as the very high Chinese investment ratio is

bound to fall and real interest rates to rise.

4. Because of many years of high economic growth, the catch-up potential of emerging economies has

been reduced and growth rates are set to fall ceteris paribus.

5. Many emerging economies carried out impressive reforms from 1980 to 2000, but much fewer

reforms have taken place from 2000 to 2012. The remaining governance potential for growth has

been reduced. Characteristically, reforms evolve in cycles that are usually initiated by a serious crisis,

and after 12 good years complacency has set in in the emerging economies.

6. Worse, the governments of many emerging economies are drawing the wrong conclusion from

developments during the Great Recession. Many think that state capitalism and industrial policy have

proven superior to free markets and private enterprise. Therefore, they feel no need to improve their

economic policies but are inclined to aggravate them further.

7. Finally, the emerging economies have benefited greatly from the ever more open markets of the

developed countries, while not fully reciprocating. The West is likely to proceed with selective,

regional trade agreements rather than with general liberalization.

I am more optimistic about EM growth than Peterson because of the underlying economic renaissance I believe is happening in the USA, combined with the benefits which will accrue from harnessing Big Data and the improving “health-span” (the upside of extended Life-span) over the next ten to twenty years.

Free Trade

A further factor to consider is the progress, or otherwise, of the Trans Pacific Partnership (TPP) and other agreements.  The European Centre for International Political Economy (ECIPE) has produced a timely up-date here: –

http://www.ecipe.org/media/publication_pdfs/ECIPE_bulletin_TPP_Nov_2013_final.pdf

The TPP is not the only Free Trade Agreement (FTA) on the agenda but the negotiations, even of bi-lateral FTAs, is so protracted that the financial markets are unlikely to afford them any credence until they are signed and sealed.

Demographics

As I mentioned earlier, historically Japan has been a nation of savers and investors. As JGB yields trended towards zero, investors looked for higher yields abroad. Today, in a world of near zero interest rates in the major economies, the “carry trade” is no longer the attraction it once was. More significantly, going forward, demographics will also change the direction of capital flows. Savers are retiring and become consumers. Foreign assets, which have gradually been repatriated during the last decade, will be eclipsed by consumption of foreign goods – the Japanese have been running a trade deficit since the beginning of 2012 – see the link below from Trading Economics:-

http://www.tradingeconomics.com/japan/balance-of-trade

Derivatives

The “carry trade” is discussed extensively in a recent working paper from the IMF – The Curious Case of the Yen – they make an impressive empirical case for a non-domestic cause of JPY “safe-haven” behaviour: –

http://www.imf.org/external/pubs/ft/wp/2013/wp13228.pdf

During risk-off episodes, the yen is a safe haven currency and on average appreciates against the U.S. dollar. We investigate the proximate causes of yen risk-off appreciations. We find that neither capital inflows nor expectations of the future monetary policy stance can explain the yen’s safe haven behavior. In contrast, we find evidence that changes in market participants’ risk perceptions trigger derivatives trading, which in turn lead to changes in the spot exchange rate without capital flows. Specifically, we find that risk-off episodes coincide with forward hedging and reduced net short positions or a buildup of net long positions in yen. These empirical findings suggest that offshore and complex financial transactions should be part of spillover analyses and that the effectiveness of capital flow management measures or monetary policy coordination to address excessive exchange rate volatility might be limited in certain cases.

The IMF concludes that the derivative “carry trade” is largely responsible for the safe-haven behaviour of the last few years:-

The evidence presented in this paper supports the interpretation of the yen as a currency with safe haven status. But safe haven effects work differently for the yen than for other safe haven currencies. Surprisingly and in contrast to the experience of the Swiss Franc, yen risk-off appreciations appears unrelated to capital inflows (cross-border transactions) and do not seem supported by expectations about the relative stance of monetary policies. Instead, we presented evidence that portfolio rebalancing through offshore derivative transactions occur contemporaneously to yen risk-off appreciations. This could reflect either a causal effect of portfolio rebalancing through derivative transactions or the workings of self-fulfilling expectations causing both currency appreciation and portfolio rebalancing.

Conclusion

In an unreformed developed economy like Japan the downside risks to growth remain and these risks temper my enthusiasm for Japanese stocks. Protracted fiscal stimulus by the Japanese government has been crowding out productive private investment for many years.  Japan and South Korea may have similar deflated GDP growth rates since 1997 but I would prefer to invest in a country where private domestic product is the engine of growth. Japanese stocks may rise as the JPY trends lower but the initial windfall to Japanese corporate profits is likely to be tempered by regulatory or tariff style retaliation from their neighbours and the need to repay Japanese government debt via taxation in the longer-term.

The JPY, however, is a different matter. Regulatory reforms such as the introduction of central counterparty, increasing margin requirements for OTC derivatives and the introduction of swap execution facilities (SEFs) are factors which should reduce the nominal size of the JPY “carry trade”.  The lower yield differential between the major currencies has also reduced the attraction of trade.  Demographic headwinds are now beginning to favour consumption over saving and Japanese government debt will need to be repaid in the fullness of time. Japanese corporations may defy gravity by overseas expansion but domestic firms will have to accept a protracted period of slow growth as the economy rebalances away from government spending towards private sector investment.

At the beginning of 2013, whilst I liked both trades, I advocated being long Nikkei futures rather than short JPY. Going into 2014 my preferences are reversed.