Time to Press?: Revisiting Japan from a Secular Perspective

Conclusion: The fierce grip of sovereign debt on Japan’s Jugular just got a little bit tighter. Below we explore the limited options Japan has to keep its government functioning and economy afloat in this fiscal year and beyond. Further, we use Japan's current situation as an example to highlight some of the many perils of ZIRP.

 

Position: Still bearish on Japanese equities for the intermediate-term TREND and long-term TAIL. Bullish on the Japanese yen for the intermediate-term TREND as our Q2 Macro Theme of Deflating the Inflation continues to percolate in the global marketplace.

Much like the US, Japan remains in a state of unmitigated disaster from a political leadership standpoint. Just two months following the greatest natural disasters in the country’s history Japanese bureaucrats have regressed to their longstanding ways of finger pointing and fear mongering on the job. Both opposition-led as well as internal calls for the resignation of current prime minister Naoto Kan have trumped the desire to pass financing legislation for the recently enacted ¥92.4T FY11 budget (which began on April 1st, 2011).

Net of the world’s second-finest political posturing (you know which country is in first place), the Diet essentially has two feasible options to finance the current budget: raise taxes or Pile [more] Debt Upon Debt – especially considering the recently enacted ¥4T supplementary relief budget is being financed in part by ¥1.5T in savings from just about all the cuts the DPJ was willing to stomach from the FY11 budget (additional packages summing ~¥21T will have to be financed with additional debt sales, however).

On the debt issue, the LDP continues to stand behind its refusal to approve legislation to sell the necessary amount of bonds which would stand to cover roughly 48% of the ¥92.4T FY11 budget. With GDP growth likely to come in quite soft for the first 1-2 quarters of FY11 due to the impact from the recent crises, it’s likely that Japan will be forced to issue additional deficit financing bonds along the way as tax receipts trail initial projections of ¥40.9T.

To this point, the BOJ has recently downgraded its domestic GDP forecast (-100bps) to 0.6% for the fiscal year ending March 31, 2012 due to the prolonged impact of supply constraints resulting from the disasters. Even without factoring in any mid-year supplementary JGB issuance, Japan is likely to finish FY11 with its Debt/GDP ratio at a whopping 212.4% – far and away the highest in the developed world and well past the Rubicon of 90% whereby sovereign debt burdens begin to structurally impair economic growth. As we have shown throughout our long-term work on Japan via our Japan’s Jugular thesis, the JGB market is setup to endure a major supply/demand imbalance as the population continues to age aggressively causing the Household Savings Rate to turn negative over the next decade or so. Furthermore, Japanese pension funds will have a hard time meeting the coming wall of payouts so long as they continue to devote a large percentage of their assets to low-yielding JGBs (another way ZIRP hurts economies in the long run).

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On increasing taxes, Kan is considering raising the national consumption tax from 5% to 8% for three years starting in 2012, though his party maintains a reluctant stance considering the last consumption tax hike back in 1997 sent the economy into a recession. The LDP along with both the Economy and Fiscal Policy Minister (Kaoru Yosano) and the Financial Services Minister (Hakuo Yanagisawa) don’t think a +300bps hike is enough, calling for an increase to beyond 10% (more than double the current rate).

 As recently as last month, 38% of Japanese voters approved of higher taxes to finance the rebuilding effort, according to the Nikkei newspaper. It remains to be seen whether or not they approve of structurally higher tax rates to finance deficits that now appear locked in above 10% of GDP in perpetuity (10.7% in FY11) as Japan’s ageing population commands more and more public spending on welfare in the coming years.

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We do, however, have clarity on the impact of higher taxes in Japan – depressed growth rates. With all the emphasis on Japan’s Export and Manufacturing numbers, it’s easy to forget that Private Consumption accounts for 57% of GDP on the island economy (vs. 5% for Net Exports). Given this setup, it isn’t a stretch to say that, over the long-term TAIL, as the Japanese consumer goes so goes Japan. With Overall Household Spending trending negative on a YoY basis since October (coincidentally when we introduced our Japan’s Jugular thesis), we remain skeptical of the ability of the Japanese consumer to absorb higher prices after ten-plus years of deflation and stagnant wage growth.

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As such, we remain bearish on the long-term TAIL of Japanese economic growth as the confluence of Japan’s suffocating sovereign debt burden or higher taxes depress consumption and limit investment for the foreseeable future. For this reason, we remain bearish on Japanese equities for the long-term TAIL. Reconstruction garbage aside, earnings forecasts for FY12 and beyond will prove much too high given Japan’s long-term growth potential (or lack thereof). To the former point, we remain disheartened by some of the actors within our industry when we come across data points like these: 

  • According to the latest Bloomberg Global Poll, 15% of Global Investors said Japan gave investor the best opportunity among global equity markets over the next 12 months in May, up from 8% in January. Incidentally, 15% was the highest reading in seven such polls dating back to October 2009.
  • Supporting this uptick in sentiment is the belief that Japan experiences an uptick in economic growth in the wake of the recent crises: “The Japanese equity market is largely discounting the reconstruction story… We expect the Japanese economy to have an uptick in activity within the next six to 12 months as reconstruction spending rises.” – Manoj Wanzare Senior PM at Plato Investment Management in Sydney, Australia. 

As we continue to maintain, REPLACING what was LOST due to EARTHQUAKES, TSUNAMIS, and a pending NUCLEAR MELTDOWN certainly doesn’t fall within our definition of ECONOMIC GROWTH. At the bare minimum, it’s not the kind of economic growth we think rational investors would be willing to pay for. The Japanese agree, with Consumer Confidence plunging 5.5 points in April to a two-year low of 33.1. We contend the current batch of bullish bets on Japanese equities are nothing more than another manifestation of The Bernank’s Dare to Chase Yield by marking the risk-free RoR to model via ZIRP. It’s amazing to see the kind of storytelling investors come up with when they are forced to chase returns due to their inability to earn a competitive yield on sensible investments.

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Perhaps they are bullish on Japanese stocks for another reason – additional easing out of the BOJ. As we have seen throughout Japan’s history and even with the US’s own recent history of QE1 and QE2, central bank easing has a powerful way of inflating asset prices, particularly those of the stock market. It would seem that international investors are positioning themselves to take advantage of any potential easing of financial conditions made possible by the BOJ reacting to what are likely to be incredibly depressed economic growth rates over the intermediate-term. In the two weeks following the initial temblor, the BOJ added ¥40T of additional liquidity to the financial system and it certainly wouldn’t be a stretch to see them go at it again, given their long history of being Indefinitely Dovish.

Not so fast, we contend. BOJ governor Masaaki Shirakawa has repeatedly rejected desperate pleas for additional easing from his own board members, Japanese bureaucrats, and Japanese investors alike. Citing academic doctrines taught to him by Milton Friedman himself, Shirakawa has become increasingly concerned with the propensity of Japan’s repeated monetary accommodation to spur rampant inflation and fuel asset bubbles (we are too). As such, he’s overseen a (-10%) reduction in the size of the BOJ’s balance sheet since the March 11 earthquake as well as rejecting political calls for outright JGB monetization, saying Japan’s current slowdown is attributable to supply-side pressures – something that Shirakawa contends cannot be remedied by additional easing.

In late March, the now marginally hawkish Shirakawa had this to say about embarking on a large scale effort to underwrite JGB issuance on the primary market:

“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.”

To his point, in the last round of outright JGB monetization which occurred during the Great Depression era, Japan’s CPI and PPI eventually peaked at YoY growth rates north of +40% and Real GDP growth slowed sequentially for nearly 15 years. We believe Shirakawa is correct in highlighting this risk to further dovishness out of the BOJ. The last thing the Japanese government wants to deal with is a structural re-pricing of JGB yields (higher). Currently, Debt Service eats up 44.8% of Japan’s combined Tax and Fee Revenue.

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As such, Shirakawa has been surprisingly hawkish on the margin in recent weeks, likely augmenting recent gains in the yen (up +5.9% since it bottomed on April 6). As the yen strengthens, we expect more carry trades to be forcefully unwound, potentially driving up the USD which would support additional weakness in the commodity complex. Obviously, we wouldn’t anoint the traditionally dovish BOJ as the key catalyst behind a bullish intermediate-term bet on the yen; as such, we’ll continue to rely on our call for Global Growth Slowing to continue to get priced into global bond markets and compress global interest rate differentials relative to short-term Japanese swap rates (bullish for the yen). Certainly intervention out of global Central Planners remains the predominant risk to being long here – a risk we very much welcome (better entry price).

Japandora’s Box

No matter how you slice it, Japan is in a box from both a political and economic perspective. It can’t organically grow fast enough to offset the growth of its sovereign debt burden, yet it can’t ease enough to artificially grow without risking a backup in JGB yields in the face of a structural decline in JGB demand. For years, investors have been predicting the fall of the Japanese economy, only to watch it resiliently tread water year after year. Could now, however, finally be the time long-term Japan bears start to get validated?

As we called out just days after the first quake hit, the most important take away from the recent string of disasters  wasn’t blindly going along for a brief, reconstruction-fueled relief rally; rather it was Japan’s fiscal and political ineptitude being exposed on a global scale for the first time in many years. As Japan is pushed closer to the Keynesian Endgame as a result of the associated costs with said reconstruction efforts, we expect the world to start paying attention. As we are finding out with Greece currently, earnings don’t matter when an economy is imploding. Japan will have its turn in the long-term cycle we’ve appropriately named the Sovereign Debt Dichotomy before this dance is over.

The fierce grip of sovereign debt on Japan’s Jugular just got a little bit tighter. Perhaps that explains why Japanese equities remain broken from a TRADE and TREND perspective.

Darius Dale

Analyst

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