Conclusion: Simply put, the broad slowdown within the Japanese economy continues. Don’t buy the hope associated with oncoming yen weakness or hopeful expectations of an economic recovery in the U.S.
Position: Short Japanese equities; Short the Japanese yen.
Per our 4Q10 Macro Themes presentation, the summary of our intermediate-term investment thesis on Japan reads: “Japan’s export-led recovery slows to a halt in 4Q10. GDP could potentially go negative in the next two quarters.”
With the inclusion of Japan’s latest trade data which was released over the weekend, we feel comfortable saying sufficient “progress” towards negative GDP growth in the island economy is being made. Japanese export growth slowed again sequentially in September to the slowest growth since December 2009, coming in at +14.4% YoY. That number was posted against a (-30.6%) “comp” and October 2009 represents the last of the easy “comps” at (-23.3%). The mathematical headwinds get increasingly difficult in November and December of 2009, at (-6.3%) and +12.1% YoY.
Sell-side analysts and the media alike have gotten the bear case to-date, which is largely driven by the strong yen – which has been trading at or around a 15-year high versus the dollar over the past several weeks. As we have shown in our presentation (email email@example.com if you need the replay materials) Japan’s economy is leveraged to manufacturing and exports, which are the key sources for employment and investment within Japan.
As we called out back in August, the strong yen is a major headwind for Japanese exporter’s competiveness and profit margins, which, in turn, are negative for the Japanese economy. Per Japan’s Cabinet Office latest annual survey, Japanese companies remain profitable as long as the yen trades at 92.90 per dollar or weaker in FY11, which began on April 1st for many companies. To date, it has averaged around 88 per dollar, despite recent Japanese Bureaucrat efforts to weaken the yen, which have included Comprehensive Monetary Easing and intervention in the FX market (the latter of which has been marginalized due to increasing global opposition to currency devaluation).
As we’ve said all along, the #1 factor driving yen appreciation is dollar depreciation, i.e. it isn’t that the yen is going up as much as it is the dollar is going down (down -13% since its June 7 high). What could cause the dollar to reverse its decline over the intermediate term and “alleviate” the stresses on the minds of many Japanese manufacturers? The three factors we see as most likely in our models are:
- Hawkish fiscal rhetoric from a more Republican Congress (see Boehner’s recent comments on spending cuts)
- Mean reversion
- Widespread reflexive declines in emerging market equities and commodities (triggered by tightening in China and the QE2 announcement “missing” lofty expectations); global loss aversion should increase demand for cash holdings
Of course, when the yen starts to go down, you’ll get your fair share of lemmings touting Japanese stocks because currency headwinds will shift on the margin to currency tailwinds. Don’t buy the hope. Growth in the U.S. (Japan’s second-largest export market) is setup to slow meaningfully over the next 2-3 quarters and I’m willing to bet the family business that anyone telling you to buy Japanese stocks in the next 3-6 months doesn’t see the Consumption Cannonball coming. Layer on tightening in China (Japan’s largest export market) coupled with rising tensions between the Asian rivals, and it looks increasingly like Japan is running out of bullets over the intermediate term.
Overnight, Japanese Prime Minister Naoto Kan’s Cabinet approved a 5.1 TRILLION yen ($63 billion) stimulus package on top of an additional 1.5 TRILLION yen special account available to the Japan Bank for International Cooperation for overseas investment and infrastructure projects. As the chart below clearly shows, this too won’t matter when it’s all said and done. Again, don’t buy the hope.