Japan: A Fiat Fool’s Game

Conclusion: Buying the dip in advance of the recovery story in Japan is as consensus as buying the top in Japanese equities was in February. Don’t be pulled into this value trap. Further, we use historical data to show how current Japanese monetary and fiscal policy may have Japan en route to 1930’s-40’s-style stagflation.

This morning, it was confirmed that foreign investors bought a net ¥955B ($11.8B) worth of Japanese equities last week – the most since 2004 – as “buy the dip” took on a whole new meaning. In comparing the week ended March 18th to similar weekly data, Japan’s Ministry of Finance confirmed that this is “substantially the most on record”.

In conjunction with the report, we also received more confirmation that the “flows” indeed drove the Nikkei 225 to its latest lower-high on February 21st, as foreign institutional investors were weekly net buyers of Japanese equities from Oct. 29 through Mar. 18 – the longest streak since the 26 weeks through Dec. 9, 2005. That’s not at all insignificant, as roughly 70% of the trading volume in Japan is the result of foreign institutional transactions – likely because most Japanese aren’t gullible enough to buy their own equities after two decades of lower-highs and lower-lows.

The comments provided by Richland Capital Management’s Alex Au to bloomberg.com support our view that foreign  investors have been and continue to plow money into Japanese equities because they are “cheap”:

“Foreigners are probably not necessarily bullish, but are thinking they can buy some cheap stocks at that moment.”

Given that foreign investors have been net buyers since October, the phrase “doubling-down” certainly comes to mind.

Switching gears, our bearish thesis on the Japanese economy hasn’t changed since early October. If anything, the accompanying sovereign debt issuance acceleration resulting from the reconstruction costs (upwards of ¥25 TRILLION or $308.6B) further depresses Japan’s long-term growth prospects. Empirical studies have shown sovereign debt buildup past the Rubicon of 90% Debt/GDP structurally impairs an economy’s long-term growth prospects, and Japan, with its ~210% ratio, has been no exception.

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Given the last eight centuries of history’s lessons, the following questions should be considered: 

  • If you’re buying Japanese equities because they are “cheap”, what earnings forecast are you using?
  • What’s your duration?
  • What GDP forecast are you using and have you modeled in a potential 3-6 month slowdown?
  • What’s your inflation forecast? 

Regarding duration, anyone who’s in it for the long haul needs a refresher on history’s lessons, which indeed show us that buying and holding Japanese equities has been arguably the worst trade of the last twenty years.

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Regarding growth, we’re almost certain the Keynesian Kingdom will find a way to pull-forward future demand to help finance this earthquake. We caution, however, that merely REPLACING what has been LOST due to the recent tragedy with unprecedented levels of government leverage is NOT growth. Using earthquakes, tsunamis, and nuclear meltdowns as catalysts on the long side are not investment processes we subscribe to at Hedgeye.

Regarding inflation, we got some positive news this morning that Bank of Japan Governor Masaaki Shirakawa is opposed to monetizing the aforementioned recovery-related sovereign debt issuance, out of fear it may stoke inflationary pressures. This is in stark contrast to the recent proposals out of the DPJ and LDP calling for the BOJ to monetize the incremental debt issuance, out of fear the additional supply wouldn’t be adequately absorbed by the market – i.e. the bureaucrats fear a higher cost of capital looms in Japan’s near future if more and more JGB supply hits the open market (exactly what the long-term component of our Japan’s Jugular thesis forecasts).

Currently, the BOJ limits itself to purchasing long-term JGB debt on the secondary market consistent with the amount of banknotes in circulation, meaning that the BOJ has "spare capacity" to purchase around ¥20 TRILLION yen to purchase long-term JGBs – on top of its current purchases of ¥21.6 TRILLION annually and its current Asset Purchase Facility, in which it is buying ¥5 TRILLION of short-term JGBs.  The issue with the current political proposals lies in the fact that the BOJ is reluctant to outright monetize the government’s debt by funding it on the primary market.

In spite of Shirakawa’s warnings about the inflationary impact of debt monetization, as well as the potential blow to Japan’s international credibility, Japanese legislators have pushed on, invoking parallels to the Great Depression – the last time the Japanese government used a special circumstance to justify funding a substantial increase in debt and deficit spending via BOJ debt monetization:

“Bank of Japan bond underwriting is a policy that is evaluated highly worldwide because it helped Japan recover from the Great Depression before others.” – DPJ member Yoichi Kaneko

“If this isn’t a special situation, what is?” – LDP member Kozo Yamamoto

Shirakawa aptly responded:

“If a central bank starts to underwrite government bonds, there may be no problems at first, but it would lead to a limitless expansion of currency issuance, spur sharp inflation and yield a big blow to people’s lives and the economy, as has happened in the past.”

As a recap, in 1932, Japanese Finance Minister Korekiyo Takahashi boosted spending by 34% with the aid of BOJ monetization, which peaked a year later at 89.6% of JGB issuance and continued for the next 14 years until the end of WWII. Takahashi was later assassinated in 1936 when tried to rein in these expansionary policies to fight inflation. It appears that even 80 years ago, those that get paid by The Inflation don’t like it when the government pulls the plug any more than they do today…

All told, if Japan is to avoid the structural stagflationary problems that persisted throughout the 1930’s and 1940’s whereby consumer and producer prices eventually grew at YoY growth rates north of +40% and real GDP growth slowed sequentially for nearly 15 years, the bureaucrats would be well-served to heed Shirakawa’s warning. Unfortunately, with the yen trading down on the day in spite of the BOJ’s sobering comments, we, alongside the global currency market doubt they will.

Darius Dale

Analyst

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