Japan: Setting Up to Collapse?
Conclusion: In the report below, we contextualize how recent economic data combined with price and policy action have Japanese equities looking like an incredible short opportunity over the intermediate-term. Moreover, we detail the cyclical and structural risks to both Japanese and US growth in 2011 – a must read regardless of industry focus. Lastly, we detail how near-term catalysts accelerate Japan’s long-term march toward the Keynesian endgame and how the credit and currency markets could start to significantly price this in over the intermediate term.
Position: Bearish on Japanese Equities for the intermediate-term TREND. Bearish on the Japanese yen and bullish on Japanese CDS for the long-term TAIL.
Pulling up the top-ten YTD performers among world’s equity markets, we see that it’s littered with countries with bad balance sheets and even worse political leadership:
- #2: Greece up +16.2%
- #3: Ukraine up +14.7%
- #4: Italy up +12.2%
- #5: Hungary up +9.5%
- #6: Spain up +9.3%
- #8: Romania up +7.4%
- #9: Iceland up +7.4%
Not surprisingly, we see that Japan too has benefited from the global mean reversion junk rally, though to a lesser extent (lower beta): +4.9% YTD. In fact, since the dollar bottomed on November 4, the Nikkei 225 is up +14.6% - second only in Asia to the hyper-beta Sri Lanka Colombo All Shares (up +17.3%).
The (-3.1%) decline in the Japanese yen drove the strength and recent outperformance of Japanese equities. While there is a great deal of merit to a weaker yen benefitting this manufacturing and export-heavy economy, we continue to urge severe caution to investors looking to “buy the cyclical bottom” in Japanese growth.
As we outlined in our Japan’s Jugular presentation on October 5th (email us for an updated copy), the benefits of a weak yen for Japanese exporters are VASTLY overplayed by the manic media. Consider the following breakdown of Japanese GDP (CY10):
- Private Consumption: 56.9%
- Gross Fixed Capital Formation: 19.4%
- Government Consumption: 18.9%
- Net Exports: 4.9%
While 4.9% on $5.39 trillion dollars is nothing to scoff at (~$265B), the lion’s share of the economy is leveraged to consumer spending, and consumers don’t welcome rising prices perpetuated by a weak currency when their wages are falling:
Backtracking a bit, it’s important to understand that Japan imports ~60% of its domestic food needs and over 100% of its crude oil needs. The YoY growth in global food prices and Brent crude oil will continue to act as a tax on Japanese consumers and corporations over the intermediate term.
In addition, analysis of producer prices on both the input and output level suggest the weak yen is doing significantly more damage than perceived by the media. Recent trends in the Bank of Japan’s Corporate Goods Producer Price Indexes underscore this reality.
Costs are going up and selling prices are on the decline for Japanese exporters – a margin squeeze that can only be remedied by growing unit demand. To some extent, we’re seeing that with recent positive revisions in earnings guidance by Toyota, Nissan, and Honda, all of which cited strong demand from Asia and upward surprises of sales in North America.
While it would certainly be easy to take corporations’ word for it, it wouldn’t be prudent risk management to assume steady state or an acceleration of Asian growth – or global growth for that matter. In fact, rising inflation and tighter monetary policy are two key reasons why we expect growth to slow in the region over the intermediate term. Other key emerging markets, particularly in Latin America, are tightening as well, so we continue to be outwardly bearish on the slope of global growth in 1H11.
Going Forward: The Outlook for US and Japanese Growth in 2011
For Japanese equities to continue work, global growth has to accelerate from here. The Nikkei’s fantastic run-up into and through today’s reported economic contraction (-1.1% QoQ SAAR) suggests Japan is getting the benefit of the “accelerating US growth” story. As we’ve mentioned in our previous work, US growth is setup to slow from here (though the gov’t is likely to continue fudging the numbers):
- Corporations will find it hard to pass through rising COGS inflation to US consumers (70% of the economy) who have been used to 20-plus years of merchandise deflation;
- Rising COGS inflation will make it tough for companies to increase their labor expenses and add any meaningful dent to the government’s currently understated unemployment rate of 9% (do you think SYY, F, or PEP plan to go on a hiring spree after their recent margin guidance?);
- Spending cuts at the Federal, State, and local level of government will further depress Non-Farm Payroll growth;
- Housing Headwinds Part II (yes, housing still exists, and yes, it’s mired in a secular decline) will further crimp consumer spending and have a negative wealth effect significantly greater than the positive effect felt by the recent paper-thin run-up in US equities (housing is more broadly owned);
- Rising interest rates will weigh on capital investment and the budgets at every level of the economy from the Federal budget to corporations to households across the country; and
- The five-quarter streak of positive inventory adjustments contributing to US GDP growth came crashing to a halt in 4Q10, detracting (-5.3%) from the sequential change in growth. The question all US management teams need to answer: do you load up on inventory here with many commodity prices at/near all-time highs, or do you delay those purchases and HOPE for lower input prices and a strengthening recovery? If the answer is the latter, inventory adjustments will continue to weigh on US GDP growth over the intermediate term, as we see no structural reason for commodities to retreat meaningfully absent a significantly stronger US dollar. US “S&P 500 earnings” bulls better hope and pray The Ber-nank doesn’t load his global monetary policy gun with QE3 bullets…
Moving back to Japan specifically, we don’t buy the bullish commentary offered recently by a few economists:
- “The economy’s pretty much past its temporary slump.” – Noriaki Matsuoka, Daiwa Asset Management
- “Japan bottomed out in the fourth quarter.” – Yuichi Kodama, Meiji Yasuda Life Insurance Co.
- “This was just a temporary contraction and growth may accelerate more than investors anticipate this quarter and next.” – Kyohei Morita, Barclays Capital
As mentioned before, the Nikkei 225 is up nearly 15% in just over three months, so it would be reckless to assume it hasn’t already been pricing in a bottoming of Japanese growth. To some extent, much of the economic data appears to have put in a bottom: Japan’s Export growth, Consumer Confidence, and PMI all appear to have inflected in Dec/Jan. Japan’s Unemployment Rate continues to trend down, albeit on a shrinking base (the Labor Force Participation Rate is contracted for the third straight month in December and is down -110bps from peaking in September at 60.2%).
One of the keys to getting the big trades right in global macro is determining whether or not inflection points are the start of new trends or whether or not they are temporary headfakes for Rookie Traders to succumb to. As mentioned before, we don’t see global growth accelerating enough for Japanese exporters to grow unit demand fast enough to overcome their rising input costs.
Domestically speaking, a combination of waning consumer demand and an exporting of investment abroad will weight on Japanese growth over both the near and long term. After contributing 2 percentage points to GDP in 3Q10 ahead of expiring stimulus and a tobacco tax hike, Consumer Spending subtracted (1.7) points from growth in 4Q10 (SAAR). Gross Fixed Capital Formation subtracted (0.1) points after contributing 0.6 points in 3Q10.
As mentioned before, declining wage growth and higher prices will squeeze Japanese consumer spending over the intermediate term. Moreover, we continue to see major Japanese corporations detail and execute on plans to export production abroad to partially escape the negative impact of a stronger yen on profits. Late last week, Japan Tobacco (the world’s third-largest publicly traded cigarette maker) joined Honda, Nissan, and Toyota as the latest major Japanese employer to unveil plans to export jobs and increase production overseas.
Accelerating Towards the Keynesian Endgame
Of course, the chaos theorists in us can’t resist pointing to the rapidly-deteriorating regulatory environment and an accelerated erosion of public finances as additional reasons for declining domestic investment. Japan’s Diet risks dissolution as early as June as a result legislative gridlock surrounding Prime Minister Naoto Kan’s record ¥92.4 TRILLION budget proposal and his refusal to force Ichiro Ozawa to testify regarding his recent indictment of violating campaign finance laws.
Kan’s budget, which is seeking to increase the consumption tax beyond the current 5% is being met with major contention from the Liberal Democratic Party opposition, who cite the 1997 recession as a reason to refrain from increasing the levy. Currently the DPJ does not have enough voting support to pass the legislation (required: approval of the LDP-controlled Upper House or 2/3rds majority in the Lower House), which suggests Kan will be forced to seek a public mandate in order to potentially ratify the bill.
Recent polls and election trends suggest the DPJ will perform unfavorably in the event of dissolution: Kan’s approval rating dropped to a low of 27% in February and DPJ candidates lost races for mayorships of Nagoya, Japan’s fourth-largest city, and Aichi on February 6th. The Japanese fiscal year starts on April 1st, which suggests Kan could be headed for a major political showdown as late as March whereby Kan could potentially be forced to resign as Prime Minister.
Should Kan resign and become the fifth consecutive Japanese premier to last less than one year, it would further destabilize Japan’s already unstable political situation, making its sovereign debt ripe for more ratings downgrades. Both Moody’s and the S&P have recently stated that Japan’s lack of a credible solution to reign in its public debt and deficit spending put the country at risk for further downgrades.
While we could care less about the warnings of analytically incompetent US rating agencies, we do recognize the impact that further downgrades will have on Japanese interest rates and public perception of the island economy going forward. A couple of steps down the rating scale could potentially erode any marginal global demand for Japanese government bonds due to persistent deflation. As our earlier work shows, domestic demand for JGBs is currently coming unglued as well and that looks to accelerate substantially in the latter half of this decade.
Perhaps the credit market is starting to bake all this into the cake (see chart below). Recent CDS moves in the face of bullish global growth storytelling suggests Japan is indeed accelerating its pace toward the Keynesian endgame of bankrupt pensions, hyperinflation, negative investment, declining consumer and business confidence and structurally impaired growth.