US Still the Best Horse in the Glue Factory, While Japan Consolidates

Source: 4-Traders.com

Even the most entrenched uber bears have to admit that the US equity market, for whatever reason, i.e., be it singularly the Fed punch bowl or a combination of a repairing housing market, financial system and Fed punch bowl, the US equity market in terms of relative performance remains the best horse in the glue factory, especially when viewed in USD terms, which is what some 60% of funds invested globally cross border view their investments from.

The MSCI USA index is up over 26% in the past year and over 5% in the past three months. Not surprising, sovereign debt-challenged southern Eurozone countries like Spain and Italy are still down YTD, but so are Asia Pacific markets like Australia, and the emerging BRICs markets as well as once-hot markets like Brazil. 

 

Source: MSCI

<!–[if !mso]>st1\:*{behavior:url(#ieooui) } <![endif]–>Healthcare, Consumer Discretionary are the Driving Sectors 

Source: http://www.sectorspdr.com, to end June 2013

Most of the financial media is focused on discussing popular tech names (Apple, Google, Facebook, etc.), but the real driver of S&P performance to date has been the healthcare sector, while technology has been a major laggard. Healthcare in the U.S. at least is of course another major high technology sector where the US enjoys a significant technological advantage. Consumer discretionary is a close second, where even once left-for-dead auto stocks like Ford (F) has surged over 60%.
 
US Stock Prices Exceed IT and Housing Bubble Highs Despite Tapering Fears

US equities have continued to climb a wall of worry, with the SP500 now solidly above 2000 and 2007 “bubble” peaks. In other words, the “secular bear market is not over” Cassandras, and anyone who took their dire warnings to heart, have seriously missed the boat. In terms of risk sensitivity, the CNN Fear and Greed index (below) is indicating investors are still more worried about missing the upside than they are of downside risk, but the “irrational exuberance” is still well below 2011, 2012 and 2013 peaks. 

Source: CNN Note: Cocktail of junk bond demand, market momentum, safe haven demand, put and call options, market volatility, market breadth and stock price strength

Unmistakable Signs of Recovery

Sites like Zero Hedge revel in cynical, generally bearish commentary about just about any market, basically because such apocalyptic commentary draws more clicks. It may be the weakest recovery in 80 years, but there are unmistakable signs of recovery nonetheless. The July U.S. Manufacturing Purchasing Managers’ Index (PMI) report was encouraging, with the headline number jumping to 53.2 from 51.9 in June, a better number than expected. New home sales rose more than forecast in June to a five-year high. The July manufacturing upturn bodes well for Q3 GDP growth, after a likely easing in Q2, where some are suggesting “0” growth.

Ostensibly, the US is beginning to get strong enough for the Fed to begin talking about scaling back its ultra-easy monetary policies.  But Chairman Bernanke and other Fed officials need to continue stressing for the time being that any decision to raise short term interest rates is still a long way off, and moreover independent from decisions about asset purchases, as there is still a lot that can go wrong about the US economy.

As we have seen in each of the past three years, the Fed’s prediction of stronger economic growth by the end of 2013 could well again be revised lower from the current level of 2.5%. Historically, when industrial production has fallen below 0% growth the U.S. economy has been near, or in, a recession. Thus it is certainly prudent to continue monitoring the gap between the “real economy” and the Fed-goosed financial economy. 

Source: StreetValue.com, Hat Tip: Zero Hedge

Underlying Recovery in Confidence in the US Economy Behind the USD Perception Shift

For a long period after the crash of global financial markets, a USD rally was the sign of a “risk off” shift. Not any more. USD (UUP) has broken up out of the downward flag that was in place since USD peaked as stock prices were hitting the trough of the 2008 financial crisis. Now, USD is being driven by improving confidence in the ability of the US economy to recover, despite the fact that the man on the street has seen little, if any, of this recovery.

As the chart of UUP shows, the USD index has been steadily recovering since late 2011, but has yet to break convincingly to the upside, given the lack of a clear, slam dunk strong recovery case.

Source: Yahoo.com

 Pain in Bond Land

On the other hand, being a bond-concentrated fixed income investor has been painful, with the TLT (20yr+ TB ETF) losing about 15% YTD, despite assurances from the uber economic bears that the all-time lows in bond yields are yet to be seen because Japan-style structural deflation is inevitable. We believe their precept is false, i.e., that the US economy is destined, like Japan, to enter a decade (s) long malaise.

Not surprisingly, US data indicate that commercial banks have slashed their exposure to Treasuries by $40 billion to a 13-month low. While some claim this is “classic capitulation” if investors re-focus on the gap between the weak global economy, waning profits and risk assets, the great bond exodus appears to be gaining steam both among financial institutions and individual investors.

Source: BigCharts.com

Loss of Faith in All that Glitters

Paper gold “investors” have also seen the value of gold holdings evaporate over 30% YTD despite assurances from gold bugs that the drop-off was a ploy by the bullion banks (who are bleeding gold inventories) to temporarily crash paper gold prices so they could restock depleted inventories. We believe it is much more simple than the convoluted conspiracy theories claim, i.e., its all about real interest rates rising above the level where it no longer makes any sense for an “investor” to hold any more (physical) gold than needed for Armageddon hedges.

Source: BigCharts.com

“Teflon” Harry Browne Permanent Portfolio is Down Over 4% YTD

What this means is that the asset mix known as Harry Browne’s permanent portfolio which for some 40 years (according to the American Association of Individual Investors) has returned 9.5% per annum, boasts its worst single year drawdown being only 5% in 1981 and fell only 2% in one of the worst financial crises in history (2008), is down 4.4% year-to-date, as its 25% position in gold is down over 33% and its 25% position in cash (TIPS) is down nearly 8%, which has not been offset by the 18%-plus gain in stocks (SPY) and the 5%-plus gain in long-term bonds (TLT). Further, at the current juncture, the asset allocation rule of the portfolio would have you reduce the weight (31%) of stocks to top up the gold weigh (17%) to rebalance all holdings to the benchmark 25%–which is probably psychologically a hard call to make.

Source: Yahoo.com

Globally, Top-Down Picture Not as Favorable

Globally, however, recovery momentum is mixed at best, and in aggregate, actually slowing by some measures. Goldman’s economic momentum indicator is pointing to more, not less loss of momentum.

Source: Goldman. Hat Tip: Zero Hedge

This “recovery still a work in progress” picture of the global recovery is of course the main reason behind the wide dispersion of YTD returns among global equity markets, as first mentioned.

 
<!–[if !mso]>st1\:*{behavior:url(#ieooui) } <![endif]–>China, Once the Engine of Global Growth, Is Sputtering

In Q2, China’s economy grew 7.5%, continuing a slowing growth trend, and a disappointing Flash PMI worsened concerns of a further growth slowdown, to below 6% per annum growth, which would be considered a hard landing. China’s manufacturing weakened more than estimated in July, with a reading of 47.7 for HSBC/Markit’s purchasing managers index, est. 48.2. What’s the word for austerity in Chinese? China industry ministry said it will increase controls over industries with overcapacity. The ministry is to push restructuring and mergers in steel, aluminium, cement and other sectors. There were also reports that China banned the construction of government buildings for 5 years as part of an ongoing frugality campaign.

<!–[if !mso]>st1\:*{behavior:url(#ieooui) } <![endif]–>The Shanghai Composite fell 1% after HSBC China flash PMI hit an 11-month low, and while Premier Li Keqiang tried to calm markets by saying that 7.5% is the growth floor for 2013. The PMI reports just add to concerns about the nation’s economic slowdown. Many China watchers believe the new regime is willing to stomach short term pain for more stable long-term economic growth. To some, this reads: A painful credit burst is inevitable. 

China: Toward a More Sustainable Growth Path or Prelude to Crash and Burn?

A telling comment by China’s finance minister;  real GDP growth rate of 6.5% was now acceptable, as China’s new leadership has shifted its focus more to restructuring and redressing the darker side of high growth. Despite repeated attempts to gently deflate a housing/real estate bubble, Chinese home prices have now risen year-over-year for the sixth month in a row and June (at +6.8%) is the fastest rate since January 2011. The incessant rise in China property prices across 70 major cities ostensibly reflects apparently unstoppable exogenous hot money (credit) flows that the developed world’s major central bankers are pumping into the markets.

Still, the pressure to ease up from the various vested remains immense, leaving the door open for a potential move back to stimulus, which the government has begun hinting of. Chinese Premier Li Keqiang said the nation will speed railway construction, especially in central and western regions, adding support for an economy that’s set to expand at the slowest pace in 23 years.

Source: Trading Economics

The Shanghai Composite has broken down through a flag pattern that contained a 20-year support line. China’s stock market is beginning to look like a classic domineering tech company that has gone ex-growth, in this case, Blackberry, because of a major re-appraisal of long-term growth expectations.

Source: BigCharts.com

The wringing out of essentially all growth expectations from stock prices was of course a big factor in Japan’s 20-year “mother of all” bear markets. If China is on the verge of a hard landing, all the expectations for 8%+ growth to infinity will continue to be wrung from stock prices.

Source: BigCharts.com

A hard landing (defined as 6% growth, not an actual decline) of course would not be just China’s problem. Just how bad would the above-defined hard landing be for the global economy? GDP growth in Taiwan would be trimmed around 4.5pp, South Korea and Malaysia GDP would see a 2.5pp hit, Australia a 1.2pp hit and Japan a 0.6pp hit; while the Eurozone would see a 0.2pp and the US a 0.1pp hit. Globally, trade channel effects from the China hard landing would reduce GDP around 0.6pp, based on data from the OECD and IMF.  Needless to mention, China’s sputtering economic growth engine is a major reason for the poor performance of the Asian emerging markets.

Industrial Commodities

Copper prices of course have been responding to the China slowdown and loss of global economic momentum for some time, and its chart looks like there could be quite a lot more downside if China’s and the global economy continues to sputter. In other words, copper is another example of a broken chart. 

Source: 4-Traders.com

The Abenomics Trade

As expected, Japan’s Liberal Democratic Party trashed opposition parties in the recent Upper House elections, ostensibly giving Shinzo Abe and his cabinet a green light for full-scale Abenomics. The Ministry of Finance, through cabinet minister Aso, is now pushing for an early commitment to raising the consumption tax, before the ink is even dry on the latest quarterly GDP numbers. 

 

To offset what is expected to be a significant drag from higher consumption taxes, the street says the Abe Cabinet needs to provide some JPY5 trillion of additional stimulus.  A Bloomberg survey indicates a 30% chance of tipping into the fourth recession since 2008 should Abe bump the consumption levy to 8 percent in April from 5 percent, according to the median of 23 estimates in a Bloomberg News survey. FM Aso apaprently wants to make the call in August, so he can look good at the next G7 FM meeting. 

Aside from looking good at the next G7 meeting, we see no reason for Japan not to wait to ensure that Abenomics is really taking root, i.e., ensure the recovery is really underway, before implementing the next tax hike. Better would be to see a clear enough recovery in business sentiment that begins to stimulate hiring,better wages, capital expenditure plans,etc., i.e., visible benefits for the man on the street, whose consumption after all accounts for the majority of Japan’s economy. As it stands now, corporations get tax breaks and public works goodies, while workers will be saddled with significantly higher gasoline, electricity, living expense costs and more taxes on consumption, but no offsetting bonus or wage increases–i.e., more savings going into the corporate sector and away from consumption.

 

The Abe Administration also needs to keep an eye on JPY/USD. While stock prices are expected to continue rising, one major assumption is that JPY/USD will continue depreciating, whereas JPY/USD is recently stuck around JPY100/USD, and every dip below the 100 level triggers profit taking. 

Source: 4-Traders.com

 As a result, the Nikkei 225 continues to consolidate well below its May 2013 high despite the landslide LDP election victory. Profit taking continues in some of the early riser sectors, such as real estate. broker dealers, and trading companies.

Source: BigCharts.com

Sources: Tokyo Stock Exchange, Japan Investor

Indeed, the top 10 performing sectors have taken a noticeable shift to the dogs and cats category, notably, the electric and gas utilities, even though TEPCO (9501) remains mired in a Fukushima nuclear plant facility cleanup that is not going well at all. What surprises us is that there are no lawyers in Japan willing to take on the utility by representing fishermen, displaced residents who have a ligitimate case, in our view, to sue TEPCO for everything they are worth. such as Erin Brockovich versus Pacific Gas & Electric in the US.  The major shippers have also revived from the dead to become the second best-performing sector in the Topix.

Sources: Tokyo Stock Exchange, Japan Investor

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Amidst Global Central Bank Policy Jitters, Can the BoJ Handle It?

Our April 19, 2013 blog titled “Time to Bail on the Hottest Trade (Short Yen, Long Nikkei) This Year?”proved prescient, as JPY/USD has rapidly reversed and the red-hot Nikkei 225 has plunged since. Initially dismissed as a mere reaction to extremely over-extended rallies, investors/traders are now re-assessing the assumptions that triggered the “short JPY, long Nikkei 225” trade.

The Growth Disconnect Between US Macro (Economic) Expectations and Stock Prices

Zero Hedge has been highlighting for some time the growth divergence between US macro trends and the stock market. Although the S&P 500 has clearly seen a short-term top, US bond yields are still rising, onstensibly on the concern that an “tapering” by the Fed is premature within at least 2013, because the perceived US economic data do not support the Fed’s insinuation. 

Bottom line, the US market appears susceptible to both further S&P 500 correction as well as a “mark to reality” for 10yr bond yields—unless of course the spurt in bond yields is not due to rising growth expectations but instead growing doubts about the efficacy of the Fed’s QE—which has much more ominous implications than a mere interim correction in stock prices.

Hat Tip: Zero Hedge

Charles Gave of GaveKal has outlined the darker side of loss of confidence in QE. Basically, should the Fed (or any other major central bank now heavily intervening) lose control of asset prices, the downside move in financial markets may well be terrifying, because extraordinary monetary policy has been the backstop and support for financial markets since the 2008 financial crisis amidst the obvious failure (to anyone except Paul Krugman) of the “Keynesian Multiplier”.

Hat Tip: BigPicture

Has Abenomics Already Fizzled?

After 20 years of unfulfilled political promises and long marooned in a sea of macroeconomic despair and “unloved, unwanted and under-owned” by foreign investors, foreign investor interest in Japan suddenly revived with the bursting of “Abenomics” on the scene. Shinzo Abe’s “Abenomics” package of three arrows, i.e., 

a) Unprecedented (for Japan as well as the developed economies) aggressive BoJ monetary policy. 

b) Traditional fiscal stimulus

c) Promised wide-spread reforms, growth initiatives

At least on paper, Abenomics represented a rapidly implemented and unheard of coordinated “Rooseveltian Resolve” (bold, persistent experimentation) to address Japan’s two-decades long “Heisei Malaise”. Surprised foreign investors scrambled to restore positions in Japanese equities as JPY plunged from a new historical high of JPY75.74/USD to JPY102.49/USD on May 27, 2013. The plunging JPY triggering a massive 84% rally (in JPY terms) in the Nikkei 225 to the week of May 20, 2013 as foreign investors (beginning with the macro hedge funds) piled into the “short JPY, long Nikkei 225” trade. Even with the recent sharp selloff, this trade made the Nikkei 225 the hottest stock market in 2013 YTD.

Hat Tip: dshort.com

The following chart of major world stock market indices since 2000 shows that the Nikkei 225, even after the recent surge, still has some serious catching up to do.

Hat Tip: dshort.com

The lemming-like piling into the short JPY, long Nikkei 225 did not mean that foreign investors bought Abenomics lock, stock and barrel. To the monetary hard-liners (such as John Mauldin), Japan has embarked on what may be simultaneously the most outrageous, intriguing, and desperate monetary policy experiment by a major economic power in history. The sudden subsequent reversal of JPY weakness and plunging Nikkei 225 was apparently triggered by JGBs yields temporarily “surging” to 1% after hitting a new historical low on April 4, even though the BoJ was heavily interventing to buy JGBs across the maturity spectrum. Some had, and continue to have, their reservations about the BoJ’s ability to control the JGB market. 

High Stakes for Long-Only Domestic JGB Holders

For domestic financial institutions who have portfolios chock full of JGBs, the unprecedented volatility in JGBs was a high stakes gamble particularly for Japan’s banks, which own more than 40% of the JGB market. The last time there was a volatility flare-up in JGBs in 2003, domestic financial institutions were forced to dump JGBs as the volatility surge was playing havoc with their VAR (value-at-risk) models, and this selling caused 10yr JGB yields to triple in three months from 0.5% in June 2003 to 1.5%. The BoJ calculates that a marginal rise in short-term rates accompanied by a very significant rise in long-term yields (about 300bps, taking 10Y yields to their highest levels since 1996) would generate unrealized capital losses of up to ¥3.6trn for the internationally active banks. But the BoJ also calculates that the small number of very large internationally-active banks could also comfortably withstand an upward shift of about 100bps in JGB yields right across the curve – four times the recent rise at five-year maturities where the move has recently been most marked – with capital losses on bond-holdings of about ¥3.2trn offset by other factors to leave their Tier 1 capital ratios little changed.

It’s a different story however for the regional and shinkin banks, where the average maturity of JGB holdings is between 4 and 5 years. The impact of a marked steepening of the curve would, on paper at least, be more significant than for the major banks. But the BoJ nevertheless insists that the potential for larger unrealised losses on these banks’ bond-holdings would not necessarily hit Tier 1 capital ratios as these institutions typically house the bulk of their JGBs in banking book portfolios, meaning that they would not have an immediate impact on capital ratios.

Hat Tip: Zero Hedge

That’s not all. The back-up in JGB yields would lead to higher government debt service costs that could absorb half of the extra revenues the government expects from the 3 percentage point increase in the consumption tax due next April. 

Further, an extreme shift in the yield curve would provide a major hit to economic growth due to the impact on interest rates charged by the banks, which will restrain lending. According to the BoJ’s arithmetic, a 200bps upward shift in the curve might knock about 1.7 percentage points off nominal GDP growth and leave Japanese output broadly flat over the coming couple of years, thereby nulling the major policy stimulus and leaving achievement of the BoJ’s 2% inflation target well out of reach. 

But perhaps the bigger implication of the JGB market volatility to foreign investors is that the BoJ may not be in control, which is an even scarier proposition. There is evidence that Japan’s banks have been dumping their JGB holdings, as BoJ data for April showed the balance of government bonds held by the country’s major banks falling below JPY100 trillion for the first time since June 2011, and down 10.8% from March. 

JPY/USD Selloff Fizzles at JPY100

According to the OECD, the yen is 24% overvalued in terms of purchasing power. The Economist Intelligence Unit identifies Tokyo as the world’s second most expensive city, behind Zurich. That said, fortunes have been lost shorting the yen; that is, before Abenomics came along. Shorting JPY has also been one of the best trades of 2013. Between January and mid May, JPY dropped more than 16% against USD, 13% against EUR and 9% against the British pound. George Soros reportedly made a cool USD 1 billion shorting JPY. 

But USD/JPY peaked at 103.74 and again dropped to 95, causing traders to wonder if the best currency trade of 2013 was now over. 

Some FX strategists are now saying the biggest risk to the “widespread expectation of lower yen over the next several quarters” is a global slowdown in economic growth, as the external environment ostensibly matters greatly to the success or failure of BOJ’s super-QE policy. This not withstanding, speculative short JPY positions as measured by the CFTC’s commitment of traders have never been higher, meaning that many of these traders are convinced JPY is going to get a lot weaker regardless of the success or failure of Abenomics and the BoJ’s aggressive QE.

Source: Oanda

The long-term chart of JPY/USD suggests there is a significant degree of resistance below JPY100/USD, and even more resistance between JPY100~120/USD, that did not exist in 1995~1998. Thus the initial selloff in JPY/USD is well short of the last huge reversal seen in in 1995 (when JPY first breached JPY80/USD) and an eventual selloff to just below JPY150/USD three years later in 1998. Consequently, it is still too early to say that JPY/USD is now in a free-fall, as opposed to merely correcting the severe overshoot to a new historical high following the 2008 financial crisis and Japan’s Great East Japan Earthquake/disaster. 

Thus many hedge funds are reportedly playing the t 80-120-100 trade in USDJPY, with the scenario being that a US recovery and overshooting moves USDJPY to 120, while the eventual exit from “Abenomics” will help the yen come back to 100/USD.

JPY/USD: Source: Trading Economics

The radical economic policies of Abenomics (which some domestic wags term Ahonomics, meaning “this is crazy” economics) were expected to lead to outflows from Japan and underpin weakness in the yen that would in turn support a recovery in the Japanese economy, but that expectation has yet to become a reality. Prime Minister Shinzo Abe failed to impress investors/speculators with his “third arrow” of prescriptions to stimulate growth in his latest policy speech, and the BoJ also disappointed by staying pat at its latest monetary policy meeting. Suddenly, a lot of investors/speculators are rethinking the real implications of Abenomics. 

The Plunge in Real Effective Exchange Rates Should be More than Enough to Rejuvenate Japan’s Exports 

Since many Japanese exporters have managed to neutralize the impact of JPY/USD fluctuations amidst the soaring JPY over the past few years, the real impact on Japan’s export competitiveness is ostensibly not nominal JPY/USD, but real effective exchange rates. 

Despite two significant counter-rallies in 1996-2000 and 2006-2007, JPY real effective exchange rate has dropped some 38% since 2004, and some 47% since 1995, clearly indicating the real reason for Japan’s waning exports is not merely exchange rates.

Source: Bank of Japan

The drop already seen in JPY real effective exchange rate brings JPY’s value back to 1960 levels (i.e., below 80), which should be more than enough to restore profitability and competitiveness to Japan’s exports. 

As for JPY/USD, where the pair trade goes from here depends on the spread between US and Japan bond yields, i.e., the Fed allowing US long-bond yields to rise along with improving economic and inflation expectations, while the BoJ continues to keep its boot firmly on the JGB market, allowing the US-Japan bond yield spread to expand to a historically comfortable 300 bps or more. Such a scenario however would probably however entail a significant interim correction for US stock prices, which are already getting antsy about a possible Fed “tapering”. 

JPY/USD Could See Another Test of the 95 Handle Before Breaking Through 100 Again 

JPY/USD has already seen a bearish head & shoulders formation and has broken down through support just below JPY96/USD. To us, this implies that JPY/USD could well see another test of 95~96 support before attempting another break through JPY/USD 100 again.

Source: 4-Traders.com

Goldman Sachs: JGBi Expected Inflation is a Leading Indicator of Abenomics Success 

According to Goldman Sachs, the JGBi expected inflation is a symbolic leading indicator of the policy success of Abenomics. The fact that this indicator is now suddenly moving counter to its previous extended trend could possibly indicate the markets’ early signal questioning the credibility of the BOJ policy, which is beyond the issue of how effective Kuroda’s communication with the markets is. While Goldman and other BoJ observers raised the expectation that the BoJ would extend fund-supplying operations against pooled collateral to two years from the current one year limit to help contain immediate market instability, the BoJ instead decided to stand pat for the time being.

Source: Goldman Sachs, Hat Tip: Zero Hedge

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Decisive LDP Victory Heralds “Big Changes” for Japan?

The Liberal Democratic Party (LDP) and its junior partner, New Komeito, won more than two-thirds of the 480 seats in Sunday’s lower house election, taking back the reins of government in a landslide victory, and trashing the hetetofore ruling but rapidly unraveling Democratic Party of Japan (DPJ). The LDP-New Komeito coalition will have 325 seats, surpassing the two-thirds threshold that allows the budget-controlling Lower House of Japan’s Diet to pass bills voted down in the upper house.

The newly re-installed LDP Prime Minister Shintaro Abe is already talking about an supplementary budget for FY2012 to March 2013 of JPY5~JPY10 trillion, ostensibly to fill the gap created by a delay in the FY2013 budget creation and passage caused by the snap election, the first such delay in 19 years. Instead of talking hawkishly about “forcing” the BoJ to adopt a 2%~3% price target and purchasing government-issued construction bonds, new PM Shintaro Abe is “seeking closer collaboration” with the BoJ, and there is discussion about establishing a fund to purchase foreign bonds, including European Financial Stability Fund bonds, as promoted by the BoJ OB Kazumasa Iwata, president of the Japan Center for Economic Research, ostensibly to put more teeth in the government’s efforts to weaken the JPY/USD rate to “at least” JPY85/USD. Big manufacturers like Toyota (ADR:TM,TSE: 7203) have warned PM Abe that hundreds of thousands of domestic jobs would be lost if particularly the big Japanese auto producers are forced by a continued strong JPY to move more production capacity offshore.

Stimulating JapanOut of Renewed Recession

Japan’s economy is again in recession despite the implementation of DPJ stimulus package to rebuild the northern Tohoku region after the March 11, 2011 earthquake disaster that a) was seriously delayed in passage and b) had about 1/4th of the total funds allocation siphoned off by bureaucrats to their own pork projects. 

Japan’s trade balance has fallen into structural deficit after the earthquake disaster, more because of falling exports to a recessionary Eurozone and a slowing Chinese economy, as well as political friction with China over an island dispute. The recent December BoJ Tankan showed a worse than expected DI (diffusion index) reading for large manufacturers of minus 12 (a 9 point deterioration), and a 6.4 percentage point downgrade in large manufacturer current profits, to minus 3.5% YoY growth in FY2012. 

Thus Japan has another hole to dig itself out of economically, while the stimulus of a weaker JPY will take time. Further, fiscal stimulus of between JPY5 to JPY10 trillion is seen as a mere drop in the bucket it terms of kick starting Japan’s stalled economy. 

Bad Economic and Corporate Profit News Already Baked in Bond and Stock Prices, But Upside Potential Will be Limited by More Domestic Institutional Selling

Both the renewed recession and the deterioration in corporate profits are already discounted in both bond yields and corporate profits. Stock prices have followed JGB bond yields downward after a weak bounce-back in 2011 following the earthquake disaster, that is, until recently, when stocks began to discount expectations of an LDP led government and a more aggressive BoJ stance as well as a weakening JPY.

On the other hand, bond yields remain depressed. Does the growing gap between a Nikkei 225 that is trying to rally and still-low JGB yields mean stocks are seeing something that the bond market is not? Historically the bond market has been more adept at reading the real trend, which makes the attempted recovery in the Nikkei 225 suspect until JGB yields also begin to discount what stocks are trying to discount, i.e., an improving economic and corporate profit environment ostensibly fostered by an LDP determined to eradicate deflation and get JPY low enough to restore Japanese export competitiveness.

Thus the degree of recovery in Japanese stock prices is predicated on,

a)     How far the new government can push JPY exchange rates weaker.

b)     How far growth expectations as reflected in JGB bond yields can improve.

c)      How much the weaker JPY stimulates Japan’s exports.

Three Big Impediments to a Significant Rally in Japanese Stocks

However, there appear to be three big impediments to a significant rally in Japanese stocks.

1) Until March 2013 books are closed for the FY2012 fiscal year, any significant rally in the Nikkei 225 will be met by increased profit taking from domestic financial institutions, which will offset any thing but aggressive levels of net foreign buyings.

2) While the weak JPY is a stimulate for higher Japanese stock prices, the Nikkei 225 and JGB markets, heretofore moving in tandem, now disagree, with bond yields remaining near historical lows while the Nikkei is trying to rally. Historically, the bond market has been right more than the stock market. 

3) All traders have jumped on the same short JPY bandwagon, leaving a lot of room for Mr. Market to cause maximum pain. The following graph of the CFTC commitments of non-commercial trader short JPY positions shows a huge spike in both open positions and net positions, indicating all the hedgies have jumped on the same “short JPY” bus, leaving a lot of room for Mr. Market to cause the most pain as possible for those betting for a significant weakening of JPY.

Source: Nikkei Astra

Source: Oanda

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Development Economics 101 Could Break the Negative Spiral of Japan’s Growing Rust Bowls

Once the built-up coastal region around Amagasaki Japan was called Panel Bay and was a symbol of Japan’s high tech competitiveness because of the many factors making high-end flat panel displays

Now the area has become a grim reminder of Japan’s industrial decline that is creating growing rust bowls of factories and infrastructure. Given deep deficits at companies like Sony (6758.T, SNE), Panasonic (6752.T, PC) and Sharp (6753.T, SHCAY.PK),  Panel Bay too is becoming a rust bowl as many of these plants are closed or partially sold off.  Panasonic alone shut down two of its three factories here in March while Sharp, desperate to cover losses from its state-of-the-art flat-panel plant in nearby Sakai, accepted a bailout from a Taiwanese technology company. 

The fear, supported by growing evidence, is that the hollowing-out of Japan’s manufacturing capacity was accelerated by last year’s nuclear accident in Fukushima, which severely disrupted global electronic and automobile supply chains but presents a longer term problem of insufficient power supply as Japan shuts down the last of its nuclear power reactors. Basically Japan has outgrown its manufacturing/exports-based “Asian Miracle” template and desperately needs a new economic strategy. Just what this new template should be however is mired in intense and growing debate.  

The decline of Japan’s manufacturing base is particularly painful because there is little that Japan has come up with so far to offset the whole created in industrial production, GDP contribution, employment, wages and at the end of the daisy chain, government tax revenues. The following tables show the growth in GDP by industrial sector from 2005 to 2010.

Source: Cabinet Office

The upper half of the table shows which industry sectors were growing over the past several years. These sectors are a combination of “old Japan” and heretofore domestic-only industries, as well as community & service activities and producers of private non-profit services for households, which are not exactly the stuff of growing government tax revenues. On the other hand, the bottom half used to be the main pillars of Japan’s GDP growth, construction and finance/insurance in the domestic economy, and electronics, transport equipment and machinery in terms of external trade. 

The sectors in the bottom of the table also tended to be the biggest employers and the most lucrative sources of government tax revenues, since they traditionally accounted for the bulk of listed company corporate profits. 

Source: Statistics Bureau

The decline in manufacturing hits government tax revenues, and one of the first areas to go as Japanese government fiscal budgets became tighter and tighter was public works expenditures, which directly hit the construction industry, especially those companies deeply involved in regional infrastructure construction projects. Japan’s finance and insurance industry on the other hand has undergone massive consolidation following Japan’s home-grown financial crisis following the bursting of the excess credit bubble in the 1980s, and is but a shadow of its former self. 

With these leading industries providing knock-on effects to domestic service (and retail) company sales and employment, the hollowing-out of Japan’s manufacturing has resulted in reduced employment and wages in domestic sectors such as real estate as well. As a result, aggregate earned wages, disposable income and therefore family expenditures are in a clear declining trend. 

The loop-back into government tax revenues is obvious, but comes at a time (such as the Tohoku disaster) when large government expenditures would go a long way in re-starting the economy in the badly damaged Tohoku region. As it stands, the government is not only constrained by already massive government debt, but is hopelessly bogged down in political gridlock. Add a historically high yen into the mix, and you have the formula for a collapse in government tax revenues, particularly from the very sources that used to provide the bulk of corporate tax revenues.

How does Japan get out of this negative Catch 22? Everyone talks about economic growth, but virtually no one in the Japanese government even mentions specific actions that could be taken to restore this growth. Instead, the knee-jerk reaction is to significantly raise the consumption tax. Instead, a set of “Developmental Economics 101” could be used to revive corporate activity, which is the other pillar of any government’s tax revenues. Squeezing more blood out of the long-suffering Japanese salaryman is only a stop-gap measure.

When the Southern states in the United States were depressed in the 1980s, they began competing aggressively with each other and with overseas sites for investment dollars, with individual states setting up investment promotion offices in Japan, for example, and offering packages of attractive incentives to get companies to locate their plants or operations in their state. 

A “can do” willingness to cut through the red tape and endless bureaucracy would also be a very welcome development. Rapidly growing emerging companies in India, Taiwan, China and South Korea would be very open to locating factories in Japan given the right incentives, and the chance to access the large Japanese domestic market through acquisitions or strategic alliances with Japanese companies, where the entrenched prejudice against imports in favor of “made in Japan” products is beginning to break down, especially in sectors like consumer electronics, automobiles and fashion.

New York Times

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Sumitomo Realty’s Big Bet on Tokyo Commercial Real Estate

Sumitomo Realty & Development (8830.T) is embarking on a bullish JPY20 billion bet demand in central Tokyo for disaster-ready office space will be strong over the next five to six years, with five major projects in central Tokyo with floor space in the range of 100,000 to 200,000 square meters. Quake-resistant buildings already account for about 60% of all Sumitomo Realty’s properties.

Construction on the first project in the Nihonbashi district will begin this summer with a 35-story tower complex due for completion as early as FY2014. The tower will feature earthquake-damping equipment and a hall that doubles as a disaster shelter for stranded workers. A project for offices and residential buildings in the Roppongi entertainment district will begin as soon as this fall, with completion scheduled for FY2015, in the area once the Japan HQ of IBM Japan Ltd. Other projects are on the table for buildings in Osaki, Takadanobaba and Mita for FY2013 and beyond. In total these projects will create some 900,000 square meters of new floor space

In Roppongi, work on a block of office and residential buildings will begin as soon as fall. Sumitomo Realty aims to complete this project in fiscal 2015. The area was once home to the headquarters of IBM Japan Ltd. The developer is also planning to start projects in Osaki, Takadanobaba and Mita in fiscal 2013 and beyond.

This despite stubbornly high central Tokyo office vacancies that is creating fierce competition for tenants. Miki Shoji reckons the office vacancy rate at the end of February was 9.15% and is expected to worsen with the new buildings set to open this year.  Sumitomo Realty’s bet of course is that good, centrally located office space will remain attractive over the longer term. New buildings with entire floors available to a single tenant are still popular with companies looking for more efficient workspace. Since the March 11 Tohoku disaster, corporate tenants are also looking for buildings with better earthquake countermeasures. 

Sumitomo Realty’s stock has already surged over 50% this year on an improved outlook for Tokyo property, and as investor money returns to Japan real estate on the view it is now undervalued vis-a-vis other countries in Asia.  The stock could see some short-term consolidation given the sharp gains YTD.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Is Japan Back? An Increasing Number of Global Investors are Betting So

Bill Witherell, Chief Economist at Cumberland, now sees indications Japan’s economy is turning around. Industrial production advanced 3.8% in December, followed by a further 2% increase in January. The Japanese Ministry of Economy, Trade, and Industry (MITI) is projecting 1.7% increases in February and March. Over the 2012 calendar year the advance in GDP could well fall in the +2-3% range.

The most significant factor going forward, is the recent shift to an expansionary monetary policy by the central bank, the Bank of Japan (BOJ). The BOJ announced its intention to pursue a policy of quantitative easing through a major program of direct purchases of government bonds, and will be purchasing nearly all of the Japanese government bonds to be issued thru the remainder of this year. The Japanese central bank also announced its determination to overcome the current deflation and set a “goal” of a 1% rate of inflation, and further has the objective to achieve a depreciation of the US$/JPY exchange rate.

A report by Benderly Economics of Japanese corporate profits and equity-market returns suggests that if the economy is indeed turning around and the global recovery continues, Japanese corporate earnings will be strong, making Japanese equity valuations very attractive. Cumberland Advisors, like an increasing number of other foreign investors, has added to Japan positions in their International and Global Multi-Asset Class portfolios.

The Big Picture: Cumberland Advisors on Japan

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Japanese Small Caps Having the Longest Run Since 1975

Japan’s TSE second section index of smaller capitalized companies that usually trades at a discount to both the TSE 1 and the JASDAQ has risen for 26 consecutive days, the longest streak of consecutive gains since May 13, 1975, according to Bloomberg.  The TSE2 index still trades at an average of 0.68 nominal book value compared with about 1.24X for the Nikkei 225 index.

Behind this move are domestic institutional investors, who got burned badly by their traditional preference for the large-cap stocks, as the Topix Core 30 index of Japan’s largest capitalized stocks swooned last year, prompting the typically trend-following and slow-moving domestic institutions (managing public pension funds) to break away from their traditional large cap preference and move into smaller capital stocks….but not too small as for these institutions to be trapped in illiquid names.

Whether this shift is enduring enough to cause a permanent re-rating of the TSE2 remains to be seen. There is a reason for the TSE2 discount, and that is the fact that many stocks listed on the TSE2 were tightly held stocks with limited floats because of large holders, more often than not their parent company.

Bloomberg

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Hard Landing Necessary for China?

Smead Capital Management sees a hard landing for China as a necessary evil to clean up the financial system, as their debt problems are just beginning. Agricultural Bank of China is China’s Washington Mutual?

CNBC Video

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Despite Trade Deficit, Japan’s Foreign Exchange Reserves Hit a New High

Japan’s foreign exchange reserves hit a new record of USD1.307 trillion at the end of January, versus a November 2011 record of USD1.305. Japan is the only country with foreign reserves of more than USD1 trillion besides China, with USD3.18 trillion at the end of December 2011.

Helping to boost forex reserves was the JPY8.07 trillion (USD 105.2 billion) on forex intervention on October 31, the biggest ever single-day intervention, and  “stealth” yen-selling interventions from November 1 to November 4 worth a total of JPY1.02 trillion (USD 143.3 billion).

Japan’s merchandise trade moved into the red in 2011—its first annual deficit since 1963. This notwithstanding, Japan remains the world’s biggest net foreign creditor, as income from its overseas investments more than offset the trade gap, keeping its current account in surplus to the tune of about 2% of GDP.

Economists however fear that the income surplus could also disappear within a five years. Investment income in Japan’s current account (interest on foreign bond and stock holdings as well as corporate dividends) rose sharply until 2007, but is now falling because of low interest rates and the global economic downturn. If Japanese firms continue to reinvest more of the overseas profits in local markets, continue what has become active in-out M&A and the trade deficit continues to widen, Japan’s current account deficit including investment income could fall into deficit by 2015.

Offsetting the large forex reserves are Japan’s household-saving rate that has fallen from 14% of disposable income in the early 1990s to only 2% in the past couple of years. As the population continues to age, households’ saving rate is likely to turn negative. The government’s budget deficit (10% of GDP in 2011) also counts as negative saving.

With a net debt-to-GDP ratio—more than 130% in 2011 (IMF estimates) or second only to Greece, everyone is aware that Japan has a serious debt problem that so far has been kept at bay cash-rich domestic institutions and companies parking their excess cash in JGBs.  Thus the Japanese government cannot afford even a modest back-up in JGB rates, even to over 2%, as a mere one-percentage-point increase in yields would cause the interest service cost to double requiring a bigger reduction in the rest of the budget deficit simply to stabilize the debt-to-GDP ratio. Higher yields also imply big losses for Japanese banks and pension funds.

If banks are forced to cut their lending, this would depress growth and lead to a withdrawal of liquidity from global capital markets. Major Japanese banks like Mitsubishi UFJ Financial Group have recently drawn up risk scenarios and action plans for just such a scenario.

Foreign observers insist the Japanese government has ample room to increase taxes, particularly the consumption tax, to 15% or more from 5% currently, as Japan’s debt mountain ostensibly reflects low taxation, and that increasing taxes and trimming government spending (i.e., austerity) could brake the potential rise in bond yields to a modest level.

We disagree, and point to what’s happening in the GIIPS at present as evidence. What is desperately needed is structural reforms and a big “open for business” sign in Tokyo Bay, i.e., tax incentives, free trade zones, etc., or developmental economics as well as freer immigration policies. Here, Japan has a lot to learn from their “developing” Asian neighbors.

Kuwait News Agency

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

The Age of Austerity

“We are in a period of transformation. We are exiting the Age of Entitlement that was characterized by leverage, lax lending standards and the general belief that trees and home prices grew to the sky. The Age of Austerity that is now unfolding is consequential for investors of all types. Balance sheet strength and fiscal responsibility will be emphasized. As we traverse this secular journey, the process will not be easy. There will be winners and losers, and the risk of unintended consequences will be high.”

Pensions and Investments

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com