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Conclusion: Japan’s economy continues to underperform its regional counterparts and the factors driving our Japan’s Jugular thesis remain supportive. We welcome the Nikkei 225’s recent strength as a shorting opportunity within the context of this bearish fundamental backdrop.

 

Position: We are not currently invested, but remain bearish on Japanese equities and bearish on the Japanese yen for the intermediate-term TREND.

Strategy Update

Regarding the title, the pun is most definitely intended, as Japanese equities have experienced a monster short squeeze since the dollar bottomed on November 4th. The Nikkei 225 has outperformed nearly every other major world equity market since then (with the exception of Ukraine and Bangladesh) to the tune of +6.2%, aided by a positive 0.72 correlation with the U.S. dollar in that time period.

Squeezing Japan’s Jugular - 1

Given that persistent yen strength was outlined as one of the key drivers in our bearish Japan’s Jugular thesis (email us if you need a copy of our 4Q10 Macro Themes presentation), it comes as no surprise that Japanese equities have rebounded off their lows alongside weakness in the yen (JPYUSD down -3.8% in the above time period).

Squeezing Japan’s Jugular - 2

With the dollar trading comfortably above its TREND line of support of $79.71, it appears the Bullish Buck Breakout has some legs and is supported by a confluence of supporting factors – American Austerity, Sovereign Debt Dichotomy, and Quantitative Guessing backlash.  Given this setup, we anticipate further weakness in the yen from here over the intermediate-term TREND.

So that must equate to a bullish outlook on Japanese equities over the same duration, right?

Wrong.

In a report published on 10/26 titled: Japan’s Jugular Continues… Don’t Buy the Hope, we outline three reasons why Japanese equities will continue to look attractive on the short side once we sift through near-term strength associated with yen weakness. Those reasons are: 

  1. The Consumption Cannonball looks to conquer an ailing U.S. consumer in 4Q10 and 1H11 (the U.S. is Japan’s second largest export market at 16.4% of total exports);
  2. Tightening in China and elsewhere in Asia as inflationary headwinds brought on by QG force economies throughout the region to rein in speculative growth via rate hikes, tax hikes and price controls (China, Korea, Taiwan and Hong Kong combine for ~39% of Japan’s export demand); and
  3. Rising tensions with Asian rivals China and Russia (note: this looks to have taken a back seat, but the damage to Prime Minister Naoto Kan’s approval rating has been done – 35% in November vs. 53% in October). 

In addition to those factors, the bulk of global economic data continues to be supportive of the Hedgeye Global Macro outlook, which suggests: 

  1. Growth is slowing;
  2. Inflation is accelerating; and
  3. Interconnected risk is compounding. 

Under this setup, we remain extremely cautious on equities as an asset class, in general, over the intermediate-term TREND.

While we’d certainly like to see an additional 2-3% short squeeze in the Nikkei 225 before we re-short it, the reality is that it just broke its TREND line overnight. Should it fail to close above 10,001 in the immediate-term, last night’s (-1.9%) decline is an explicitly bearish quantitative signal.

Squeezing Japan’s Jugular - 3

Macroeconomic Update

Overnight, Japan released its October economic data and, by and large, the slowdown continues.

Export and Industrial Production growth slowed again in October, coming in at +7.8% YoY and +6.1% YoY, respectively. The comps only get tougher from here…

Squeezing Japan’s Jugular - 4

As we show in our Japan’s Jugular slide deck, Japan is an economy that is highly levered to manufacturing and exports for growth and employment. Considering, it’s not a conceptual leap to see Japan’s Unemployment Rate tick up for the first time since June, as the economy shed 180,000 jobs – the most since May.

Squeezing Japan’s Jugular - 5

A second-derivative effect we outline is that the pain felt by the manufacturing sector would eventually reverberate throughout the rest of the Japanese economy, causing consumer confidence and spending to decline. In October, both Consumer Confidence and Retail Sales growth continued to slow, coming in at 40.9 and (-0.2%) YoY, respectively.

Squeezing Japan’s Jugular - 6

Going forward, it’s important to keep in mind that stimulus measures and policy changes helped buoy the Japanese consumer in 3Q10, including a subsidy for energy-efficient cars and a tobacco tax hike scheduled for October 1st. Both programs pulled forward consumer demand to the tune of a 0.7 point contribution to 3Q10 GDP, after having no contribution from private consumption in 2Q10. In addition, Japan’s hottest summer in over a century fueled demand for cooling products.

These tailwinds helped boost 3Q10 GDP growth to +3.9% QoQ SAAR and their absence will create a drag on growth in 4Q10 and potentially into 1Q11 – just around the time bearish 4Q10 economic data is being reported in globally. Japanese equities have nowhere to turn but to the hopeful promise of additional stimulus. As we have shown, stimulus won’t matter when it’s all said and done; it merely helps the Nikkei rally to lower highs as it has done for much of the past two decades.

Squeezing Japan’s Jugular - 7

FYI, Japanese equities haven’t always gone up during periods of yen strength historically. Throughout the past twenty years, the inverse relationship has waxed and waned over various durations.

Squeezing Japan’s Jugular - 8

Needless to say, Japan’s chin is exposed.

Darius Dale

Analyst