Conclusion: Japanese equities are looking good on the short side once again. We think market expectations regarding the yen-weakness tailwind have become substantially overblown, as global fundamentals don’t support a meaningful rebound in Japanese export growth. Further, both economic fundamentals and earnings need to surprise to the upside in Japan in order to sustain this rally in a meaningful way from here.
Since the start of November, long Japanese equities have definitely been one of the top ways to play increasing global demand for US Dollars as US Treasury yields backed up. To the tune of +14.8%, the Nikkei 225 has been the fifth-best performing global equity market since 11/1, showing only marginal abatement in the face of:
- Global growth slowing;
- Inflation accelerating globally; and
- Interconnected Risk compounding
Essentially, we have an overrun equity market propped up on the hopes of accelerating US growth and yen weakness aiding Japanese export growth (JPYUSD down -3.5% since 11/1).
Since we unveiled our Japan’s Jugular 4Q10 Macro Theme on October 5th, we’ve been managing risk around our yen and Nikkei short positions, oscillating between the two. While we remain bullish on the USD over the intermediate-term TREND, we think market expectations regarding accompanying yen-weakness as a tailwind to Japanese exporters have become substantially overblown. Moreover, global economic fundamentals don’t support a meaningful rebound in Japanese export growth:
- We don’t see US economic growth accelerating meaningfully from these levels, with decelerating US consumer demand and a slowing inventory cycle becoming headwinds to US growth in 1H11 (US = 16.4% of Japanese export demand); and
- We are seeing explicit signs of slowdowns across Asia with several key countries on deck to tighten monetary policy meaningfully throughout 1H11 (China, Hong Kong, Korea and Taiwan = 39% of Japanese export demand).
One area a weaker yen can “help” Japan with is choking off domestic consumption. Japan is an island economy that imports roughly ~60% of its food needs and roughly ~107% of its crude oil needs. With world food prices at all-time highs and crude oil prices poised to remain comfortably elevated on a YoY basis, we find bullish hope surrounding a weak(er) yen to be misguided at best.
Consensus estimates for Japanese 4Q10 GDP growth are closer now to where our expectations were back in October (-0.75% QoQ SAAR). Forecasts for 1Q11 and 2Q11 are +0.50% QoQ SAAR and +1.25% QoQ SAAR, respectively. After a +14.8% equity market move in less than 2.5 months, the Japanese economy likely has to blow-out these low expectations to keep equity investors from getting nervous. It is in our expectation they won’t. Japan, an economy overleveraged to manufacturing and exports, will disproportionately feel the three-factor pain outlined at the onset of this report.
Of course we could be wrong on global growth and the Nikkei’s recent run could be pricing in stronger growth both domestically and abroad. Even still, given the overwhelmingly bullish bias in Japanese and US equity markets, earnings from 1Q11 and 2Q11 (in both markets) need to be phenomenal if this rally is to be sustained meaningfully from here.