Japan’s Jugular Update: Just Getting Started on the Short Side of Japanese Equities

Conclusion: Though we covered our oversold short position in Japanese equities today in the Hedgeye Virtual Portfolio, we remain outwardly bearish on Japan’s intermediate-term TREND and long-term TAIL.


This morning we covered our short position in the EWJ for a gain. We’ll look to re-short Japanese equities on a bounce back up to its immediate-term TRADE line of resistance at 10,909.


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Watching how US equities trade will be critical here, as both markets have been the beneficiaries of the “flows” into relative “safe havens”. If 1,307 in the S&P 500 doesn’t hold or if it can’t close above 1,330 in the immediate term, the probability of a meaningful bounce in Japanese equities dwindles. In an environment of Global Stagflation, these “safe havens” will wind up looking like relative value traps over the intermediate-term TREND.


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Regarding Global Stagflation specifically, Japan’s January trade data revealed more of the nasty tea leaves that we’ve been harping on since early November: 

  • YoY Export growth slowed sequentially by (-1,150bps) to +1.4%, driven primarily by a sharp reduction in Asian demand (China down sequentially: +1% YoY vs. +20.1% in Dec; Shipments to Asia down sequentially: +0.4% YoY vs. +14.8% in Dec);
  • YoY Import growth accelerated sequentially by +180bps to +12.4%, driven primarily by rising commodity prices, including Brent crude oil, which was up +29% YoY in Jan;
  • Japan's Trade Balance swung into a deficit for the first time in 22 months in Jan: (¥471.4B) vs. ¥727.7B in December. 

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Of course, any bull worth his shirt at a market top will find a way to massage this data into a less-bearish mosaic:


Seiji Adachi, Senior Economist at Deutsche Securities, argues that the timing of the Lunar New Year is distorting Japanese trade data a bit, as Japanese exporters started scaling back shipments to Asia in late January to accommodate for the early Feb start to the Lunar New Year (Feb 2-8 in 2011 vs. Feb 14-20 in 2010). He argues, “It’s hard to project how much the Lunar New Year holidays will affect trade as they change every year, so we need to look at the overall trend through March.”


In rebuttal to this view, the data shows that growth in the value of Japanese exports slowed on a global basis: 

  • YoY Export growth to the US slowed (-1,050bps) to +6% in Jan; and
  • YoY Export growth to the EU slowed (-900bps) to +0.7% in Jan. 

As we’ve been forecasting since October 5th via our Consumption Cannonball thesis, US consumption growth is slowing – a trend further highlighted by WMT’s sales/inventory problem. We knew that austerity and higher interest/tax rates would weigh heavily on consumption patterns in the EU, but it appears the US consumption dominoes are at the Tipping Point, and are currently being nudged by near $100 WTI crude oil prices.


Back to Japan specifically, Japanese stocks have indeed benefitted from the overwhelmingly bullish sentiment that is commonly associated with being at/near the top of a global economic cycle. Citing lagging 4Q global growth data points, Japanese Officials, CFOs, Economists, and PMs have all taken advantage of their chance(s) in the past few weeks to upgrade their assessment of the Japanese economy: 

  • Officials: Both the BOJ and the Japanese government upgraded economic outlooks, with the BOJ specifically raising their growth projections for the year ending in March to +3.3% vs. +2.1% prior;
  • Corporations: Toshiba, Cannon, and Toyota are among a handful of large Japanese exporters who recently guided higher on “strengthening Asian demand” and “robust US consumer demand”;
  • Sell-Side: Bloomberg consensus estimates for Japan’s 1Q11 GDP advanced from +0.5% QoQ SAAR in early Jan to +1.1% QoQ SAAR today; and
  • Buy-Side: “The worst of the economic conditions are behind us… If the global economy continues to recover, that should boost Japanese stocks.” – Junichi Misawa, Head of Equity Investment at STB Asset Management, which oversees $14B AUM. 

In stark contrast to such bullish sentiment, we continue to stick with the intermediate-term call embedded in our Japan’s Jugular thesis which shows just how vulnerable the Japanese economy is in a situation of Global Stagflation. In fact, Japan is among the least defensive economies in the world in such a scenario:


Hedgeye’s current global growth outlook (decidedly bearish) does not bode well for Japanese export and manufacturing growth, which, in turn, bodes poorly for Japanese employment and wage growth:


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The current global inflation trends bode exceptionally poorly for Japanese consumption growth, as rising food and energy prices tax Japanese consumers who have been accustomed to 10-plus years of flat-to-negative nominal wage growth and prices. In fact, four out of five Japanese citizens say higher prices would be “unfavorable” in a January BOJ survey – the common reason: lack of wage growth:


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The current global inflation trends are a headwind for Japanese corporate earnings, whose deflationary mindsets will continue to force them to Take it in the Margin as COGS increases fail to be met with offsetting sell-through price hikes:


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Last but certainly not least, the current global inflation trends are an unmitigated disaster for Japanese consumption growth on a combined government and private basis. It is without question that the Japanese economy is the least equipped to deal with rising interest rates, which is one of the many reasons it has kept rates near zero for such an “extended and exceptional” period of time.


Even the slightest backup in yields confounds the Japanese government budget, where debt service accounts for 44.8% of organic revenue (tax receipts + fee collections) – up +1,320bps from 31.6% in 2001, just ten years ago.


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To this point, the nominal yields on 10Y JGBs have backed up +41bps since bottoming out on October 6th (coincidentally one day after we published our Japan’s Jugular thesis). The more interest rates continue to back up, the more resolve Prime Minister Naoto Kan will have in his fight to hike the consumption tax. Should the current massive opposition to Kan’s proposal win out, Japan will be forced to issue additional debt to fund its burgeoning fixed social security expenditures, which currently consume 31.1% of total revenue – up +990bps from 21.2% in 2001, just ten years ago.


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We continue to maintain that sovereign debt buildup past the Rubicon of 90% Debt/GDP structurally impairs economic growth – a stance supported by eight centuries of empirical data. Japan is no exception here and Pavlovian investors who flock to Japanese equities, JGBs, and the yen as “safe havens” in times of heightened risk will be surprised to the downside on both an intermediate and long-term duration.


Darius Dale



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