Japan – Politics, Central Banking and the Nikkei 225

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Macro Letter – No 84 – 29-09-2017

Japan – Politics, Central Banking and the Nikkei 225

  • PM Abe called a snap general election for October, amid rising geopolitical tensions
  • The BoJ maintain QQE despite Federal Reserve plans to reduce its balance sheet
  • Japanese stocks will benefit if the ‘Three Arrows’ of Abenomics continue
  • Japanese wages are rising whilst inflation is stuck at zero

On Monday Japanese Prime Minister, Shinzo Abe, called a snap general election. During the press conference in which he made the announcement he said:-

It is my mission as prime minister to exert strong leadership abilities at a time when Japan faces national crises stemming from the shrinking demographic and North Korea’s escalating tensions…

He went on to outline a JPY 2trln stimulus package, to be implemented before year end. This will be financed by raising the consumption tax rate from 8% to 10% in October 2019. The tax increase is expected to generate JPY 5trln/annum and, if any revenue remains after the stimulus, it will be used to reduce government debt. With a further JPY 2trln earmarked for education and social programmes it seems unlikely the maths will add up.

Meanwhile, despite the Federal Reserve’s announcement, last week, that they will begin balance sheet reduction, the Bank of Japan (BoJ) continue their policy of quantitative and qualitative easing (QQE) involving the unorthodox ‘yield curve control’ measures. From more on this please see Macro Letter – No 65 – Yield Curve Control – the road to infinite QE which I published in November 2016. I stand by my conclusion, although my prediction about the JPY (I thought it would continue to weaken) has yet to come to pass:-

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

In the long run demographic forces may halt Abenomic attempts to debase the Yen. This 2015 paper from the Federal Reserve Bank of St Louis – Aging and the Economy: The Japanese Experience – makes fascinating reading. Here is a snippet, but I urge you to read the whole article for an overview of the impact of an ageing population on economies in general, Japan exhibits some unique characteristics in this respect:-

In a third study, economists Derek Anderson, Dennis Botman and Ben Hunt found that the increased number of pensioners in Japan led to a sell-off of financial assets by retirees, who needed the money to cover expenses. The assets were mostly invested in foreign bonds and stocks. The sell-off, in turn, fueled appreciation of the yen, lowering costs of imports and leading to deflation.

Returning to the current environment, on Monday, in a speech to business leaders in Osaka entitled – Japan’s Economy and Monetary PolicyBoJ Governor Haruhiko Kuroda made several observations about the economy, labour market and inflation:-

The economy is expanding moderately, and the real GDP growth rate for the April-June quarter registered a firm increase of 2.5 percent on an annualized basis. It is the first time in eleven years, since 2006, that it has continued to mark positive growth for six consecutive quarters…

The year-on-year rate of increase in hourly wages of part-time employees, which are particularly sensitive to the tightening of the labor market, has registered about 2.5 percent. This is higher than that of full-time employees, implying that the difference in wage levels between part-time and full-time employees has become smaller…

In the labor market as a whole, the unemployment rate has declined to around 3 percent, which is equivalent to virtually full employment, and the active job openings-to-applicants ratio stands at 1.52, exceeding the highest figure during the bubble period and reaching a level last seen as far back as in 1974…

The year-on-year rate of change in the consumer price index (CPI) excluding fresh food has increased to around 0.5 percent recently, but that which also excludes the effects of a rise in energy prices has been relatively weak, remaining at around 0 percent…

Kuroda-san went on to defend the BoJ 2% inflation target and explain the logic behind their ‘QQE with Yield Curve Control’ mechanism. I am struck by the improving affluence of the average worker in Japan. Inflation is zero whilst wage growth, except for the dip in July to -0.3%, has been positive for most of this decade. Real Japanese wages have been rising which is in stark contrast to many of its G7 peers. See Pew Research – For most workers, real wages have barely budged for decades for more on this subject.

The minutes of the July 19th/20th BoJ – Monetary Policy Meeting – were released on Tuesday.  They left policy unchanged. The short-term interest rate target at -0.10% and the long-term rate (10yr JGB yield) at around zero. Commenting on the economy they noted continued solid investment, especially by larger firms and the sustained improvement in private consumption. The consumption activity index (CAI) for Q1 2017 showed a fourth consecutive quarterly increase. I was interested in the statement highlighted below (the emphasis is mine):-

…members shared the view that, with corporate profits improving, which mainly reflected the growth in overseas economies, business fixed investment plans were becoming solid on the whole. They also shared the recognition that the employment and income situation had improved steadily and private consumption had increased its resilience. Members then concurred that a positive output gap had taken hold, given the recent tightening of labor market conditions and the increase in capacity utilization rates, with the latter reflecting a rise in production. Based on this discussion, they agreed to revise the Bank’s economic assessment upward to one stating that Japan’s economy “is expanding moderately, with a virtuous cycle from income to spending operating” from the previous one stating that the economy “has been turning toward a moderate expansion.” One member pointed out that Japan’s economy was shifting from a recovery dependent on external demand to a more self-sustaining expansion brought about by an improvement in domestic demand. This member continued that it was also becoming evident that improvements in economic activity had been spreading across a wider range of areas, urban to regional.

The current QQE policies were reconfirmed (emphasis mine):-

With regard to the amount of JGBs to be purchased, it would conduct purchases at more or less the current pace — an annual pace of increase in the amount outstanding of its JGB holdings of about 80 trillion yen — aiming to achieve the target level of the long-term interest rate specified by the guideline.

With regard to asset purchases other than JGB purchases, many members shared the recognition that it was appropriate for the Bank to implement the following guideline for the intermeeting period. First, it would purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding would increase at annual paces of about 6 trillion yen and about 90 billion yen, respectively. Second, as for CP and corporate bonds, it would maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

An independent summation of the current environment and the prospects for the Japanese economy comes from an article by Kazumasa Iwata – President of the Japan Center for Economic Research – AJISS – The Future of the Japanese Economy: The Great Convergence and Two Great Unwindings:-

Since bottoming out in November 2012, the Japanese economy has been in an expansionary phase that reached its 58th month in September of this year. Although not yet as long as the economic expansion achieved during the Koizumi reforms (73 months), the current phase exceeded the mark set by the Izanagi boom of the late 1960s (57 months). While this phase is technically termed expansionary, it lacks strength. In contrast to the average growth rate of 1.8% seen during the Koizumi reforms, the average rate in the ongoing expansion has only been about 1%.

The economic strategy underlying Abenomics is to put the Japanese economy on the road to 2% growth. The experiences of the Koizumi reforms demonstrate that it is quite possible to realize 2% growth by implementing an effective growth strategy. This is evidenced by the theory of convergence through technology diffusion. The catch-up attained by China, India and other emerging countries since the 1990s through offshoring and the construction of global value chains has been astounding. Professor Richard Baldwin argues that the start of the Industrial Revolution ushered in an era of Great Divergence for the global economy via technological innovation and capital accumulation in the developed countries and elsewhere, and that from the 1990s we have been in an age of Great Convergence due to rapid drops in information and telecommunications costs.

In contrast to the brisk development enjoyed by emerging countries, Japan has found itself in a two-decade-long period of stagnation, its economy falling far below the convergence line predicted by Convergence Theory…

Japan already failed to boost its productivity during the 1st IT Revolution of the mid-1990s, and it is now in the 2nd IT Revolution, otherwise known as the 4th Industrial Revolution, centered on IoT, AI, and Big Data. OECD research shows that the top 5% frontier companies have not seen a decline in productivity growth since the financial crisis. Other companies lag behind these frontier companies in globalizing and using digital technology (digitalization), which has only widened the productivity gap between them. Were all companies in Japan able to boost their performance on par with the top ten companies utilizing AI and IoT, Japan’s growth rate could be accelerated by 4% (JCER 2017).

It is interesting to note that Iwata-san sees the greatest risk coming from the unwinding of QE by the Federal Reserve and the ECB, combined with the increasingly protectionist stance of US trade policy. He does not appear to expect the BoJ to reverse QQE, nor Abenomics to falter.

Market Impact

What does the forthcoming election and continuation of infinite QQE mean for Japanese financial markets? Firstly here are three 10 year charts, of the USDJPY, 10yr JGBs and the Nikkei 225:-

USDJPY 10yr - monthly - Tradingeconomics

Source: Trading Economics

!0yr JGB - 10yr monthly - Tradingeconomics

Source: Trading Economics

Nikkei 225 - 10yr monthly - Tradingeconomics

Source: Trading Economics

The Yen has been trading a range this year; it has strengthened against a generally weakening US$, whilst weakening against a resurgent Euro. 10yr JGBs have been held in an effective straightjacket by ‘Yield curve control’. Meanwhile the Nikkei 225 has followed the lead of other equity markets, both in Asia and the US, and marched steadily higher. A break above the highs of August 2015 would see the index trading at its highest since 1997. A dividend yield of 2% (source: Star Capital – as at 30/6/2017) looks attractive compared to JGBs or inflation, although a P/E ratio of more than 17 times and a CAPE ratio above 26 may be cause for caution.

An assessment of financial markets would not be complete without a review of real estate. The BoJ mentioned that house prices have been fairly flat this year. Below is a r chart of the Japan Housing Index and the CPI Index since the financial crisis of 2008:-

Japan Housing Price Index and CPI 10yr Trading Economics

Source: Trading Economics, Japan Ministry of Internal Affairs

Real Estate rental yields are currently around 2.5% making property an alternative to stocks for the long term investor. Personally, with dividend yields around 2%, I would want more than 50 basis points to invest in such an illiquid asset: chacun a son gout.

The Geopolitics of North Korea makes Japan vulnerable: Japan’s currency will bear the brunt of this. Given that much of the recent economic growth has been export led, this Yen weakness is unlikely to damage the prospects for the stock market, except perhaps in the short-term.

If Abe wins a convincing mandate on 22nd October, military spending may be added to the mix of public sector stimulus. Pervious consumption tax increases have proved damaging to the nascent economic recovery, this time, dare I say it, might be different. With wages increasing and domestic demand finally beginning to rise, a moderate tax hike maybe achievable, although I still think it more likely that implementation will be deferred.

The table below, which shows the top 10 best value stocks in the Nikkei, was calculated on 28th April. It is produced by Obermatt – click on the name to find out more about Obermatt’s excellent range of services and their valuation methodologies:-

Nikkei_225_-_Top_10_-_Obermatt_-_28-4-2017

Source: Obermatt 

To be clear, being a top-down macro investor, I have not personally delved into the relative merits of the stocks above, but I am comforted to note that most of them are household names, even outside Japan. A testament to the quality of many Japanese corporations.

From a technical perspective one should have bought the chart breakout back in November 2016. The market is close to resistance at 21,000 and I would like to see a monthly close above this level before risking additional capital, however, after nearly three decades of deflationary adjustment, the Japanese economy may be beginning to find sustainable growth. I believe this is despite, rather than as a result of, government and central bank policy: but that’s a topic for another time.

 

 

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Why did Japanese NIRP cause such surprise in the currency market and is it more dangerous?

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Macro Letter – No 49 – 12-02-2016

Why did Japanese NIRP cause such surprise in the currency market and is it more dangerous?

  • The Bank of Japan announcement of NIRP sent shock waves through currency markets
  • The Yen has strengthened on capital repatriation since the BoJ move
  • JGB 10 year yields turned negative this week
  • Longer-term the Yen will weaken

At the end of January the Bank of Japan (BoJ) shocked the financial markets by announcing that they would allow Japanese interest rates to become negative for the first time. USDJYP reacted with an abrupt rise from 118 to 121 which was completely reversed a global stock markets declined USDJYP is currently at 112.06 (11-02-2016). The three year chart below shows the extent of the move:-

USDJPY_-_3yr

Source: Big Charts

Here is an extract from the BOJ Announcement:-

The Introduction of “Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate” 

The Bank will apply a negative interest rate of minus 0.1 percent to current accounts that financial institutions hold at the Bank. It will cut the interest rate further into negative territory if judged as necessary.

The Bank will introduce a multiple-tier system which some central banks in Europe (e.g. the Swiss National Bank) have put in place. Specifically, it will adopt a three-tier system in which the outstanding balance of each financial institution’s current account at the Bank will be divided into three tiers, to each of which a positive interest rate, a zero interest rate, or a negative interest rate will be applied, respectively.

“QQE with a Negative Interest Rate” is designed to enable the Bank to pursue additional monetary easing in terms of three dimensions, combining a negative interest rate with quantity and quality.

The Bank will lower the short end of the yield curve and will exert further downward pressure on interest rates across the entire yield curve through a combination of a negative interest rate and large-scale purchases of JGBs.

The Bank will achieve the price stability target of 2 percent at the earliest possible time by making full use of possible measures in terms of the three dimensions.

In answer to the title question, part of the surprise was due to BoJ Governor Kuroda-san’s volte face. Prior to his departure for Davos, he had ruled out the adoption of negative interest rate policy (NIRP) upon his return the BoJ announced the NIRP “out of the blue”.

I was also surprised, not that the BoJ had adopted NIRP, but that it had taken so long for them to “fall on their sword”. After all, they have been struggling with deflation and low bond yields for more than a decade and embarked on QQE ahead of their collaborators at the ECB, SNB, Riksbank and Danmarks Bank. The Economist – Negative Creep – makes some important observations:-

Almost a quarter of the world’s GDP now comes from countries with negative rates.

Not so long ago it was widely thought that, if interest rates went below zero, banks and their depositors would simply switch to cash, which pays no interest but doesn’t charge any either. Yet deposits in Europe, where rates have been negative for well over a year, have been stable. For commercial banks, a small interest charge on electronic deposits has proved to be bearable compared with the costs of safely storing stacks of cash—and not yet onerous enough to try to pass on to individual depositors.

That has resulted in an unavoidable squeeze on profits of banks, particularly in the euro area, where an interest rate of -0.3% applies to almost all commercial-bank reserves. (As in Switzerland and Denmark, Japan’s central bank has shielded banks from the full effect by setting up a system of tiered interest rates, in which the negative rate applies only to new reserves.) If interest rates go deeper into negative territory, profit margins will be squeezed harder—even in places where central banks have tried to protect banks. And if banks are not profitable, they are less able to add to the capital buffers that let them operate safely.

Perhaps the answer lies in the transient influence NIRP had on the value of the JPY. The Yen had risen quite sharply amid repatriation of risk assets during the first weeks of January, the BoJ announcement stemmed the tide briefly, until the flood resumed. The move beyond Qualitative easing – which provides “permanent” capital but does not make its presence felt to the same extent – should have caused the Yen to recommence its secular decline. With the liquidation of asset flows dominating the foreign exchanges the BoJ’s action was like a straw in the wind. Negative rates may be instantly recognizable whilst the purchase of common stock is masked by the daily ebb and flow of the stock market, but when investors are exiting “pursued by Bear” central bankers need to act with greater resolution – in time I expect the BoJ will adopt a more negative stance.

In the longer run NIRP will reduce the attractiveness of the Yen, which brings me to a second question – is NIRP is more or less damaging, to the economy, than the QQE which has gone before? I am assuming here, that QQE, like all the forms of quantitative easing to emanate from the coffers of the major central banks, is inherently damaging to the economy because these policies artificially lower the rate of interest, leading to malinvestment. This destroys long run demand by reducing the return on savings – especially important in a country where the population is rapidly aging. More pensioners with less income from their savings, more workers with inadequate pension provisions due to low interest rates and more defined benefit pension funds at risk of default due to insufficient funding of their liabilities. An added twist to this sorry situation is the propensity for unprofitable businesses to continue to operate, inexorably dragging down productivity. These are just a few of the unintended consequences of engineering interest rates below their natural level.

Investment Opportunities

In the past I have been bullish for the Nikkei on a currency hedged basis. The five year chart below shows the relative performance versus the Eurostoxx 50 over the last five years:-

Nikkei 225 vs Eurostoxx 50 - 5yr

Source: Yahoo Finance

Long Nikkei 225 hedged may still prove a positive strategy, although the up-trend appears to have failed in the near term, but I believe, in the long run, under the BoJ – “QQE with NIRP” regime, the best trade will be to short the Yen. Again, the near term the trend is unfavourable – repatriating capital flows may be the driving force – when the capital flows subside, the “Emperor” will be seen to have “less than zero” clothes. The Yen should run into resistance around 110 and again at 105 – keep your powder dry.

10yr JGBs yields nudged into negative territory this week, whilst the 40yr maturity has backed up from 1.12% to 1.23% over the past seven sessions. That may not seem much of a return, but longer dated maturities are likely to offer increasingly attractive carry potential as market participants attempt to establish the “limit of NIRP”. JGB futures offer a reasonably clean way of participating in any upside whilst hedging the majority of your currency exposure in either direction. You may be late to the trade, however, as the eight year, monthly yield chart below reveals:-

japan-government-bond-yield 2008-2016 Monthly

Source: Trading Economics

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.

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.