Conclusion: Growth in Japan is setup to slow meaningfully in 2H as a result of regulatory uncertainty, anti-growth legislation, and a good ol’ fashioned lack of enough demand to surmount increasingly tough comparisons. Moreover, we expect the BoJ to intervene in the FX market not too far beyond current growth-negative levels in the JPY/USD exchange rate.
Position: Short Japanese equities (EWJ); Short the Japanese yen (FXY).
Amid an unsurprising bout of legislative gridlock and proactively predictable, broad-based sequential accelerations in economic growth data, we’ve been quiet on Japan in recent weeks. Now, with a growing spate of “uncertainty” enveloping the global economy, we find it appropriate to revisit the secular trends we have identified within the context of our Japan’s Jugular thesis. Moreover, the research and risk management setups support being short Japanese equities and Japan’s currency, the yen. We identify levels and a few key catalysts below.
Regulatory Uncertainty is Depressing Growth
The hullabaloo around Prime Minister Naoto Kan’s eventual resignation continues to prevent the Japanese government from functioning at full speed; so much so that the Diet has yet to ratify legislation authorizing the issuance of ¥44.3 trillion ($575B) more JGBs to finance the FY11 budget – which began back at the start of April! The Ministry of Finance warns that they’ll have to begin restricting implementation of the budget as early as late September without a resolution of Japan’s own debt ceiling debacle. Much like in the U.S., we expect legislation to eventually be passed in time to avoid default; we also expect continued brinksmanship to weigh on consumer and corporate sentiment that has otherwise been steadily accelerating off the March/April lows. Barring a second extension, Japanese lawmakers have until the end of this month to figure it out (the current Diet session adjourns on September 1st).
Regarding the reconstruction effort, DPJ lawmakers have confirmed that the Japanese government plans to spend a total of ¥19 trillion ($246B) over the next five years to fund public disaster recovery efforts. Via two recent bills totaling ¥4 and ¥2 trillion apiece, as well as an additional ¥3 trillion in savings, ¥9 trillion of the total requirement has already been secured. This leaves an additional ¥10 trillion which is likely to be financed with higher taxes, according to official sources. A panel of the prime minister’s top economic advisors has suggested doubling the consumption tax to 10%, though the party remains reluctant to proceed with their suggestion, given that the last increase in 1997 sent the permanently-fragile economy into a recession. Raising the income tax and/or corporate taxes also remain viable outcomes.
Regardless of avenue, we see any moves by the Diet to raise taxes to this magnitude as incrementally bearish for Japanese growth over long-term tail, as the ever large government (deficit = 10.7% of GDP in FY11; debt = 212.4%) continues to swallow the economy whole. Nevermind the reconstruction story, even prior to the earthquake/tsunami, the Finance Ministry had already officially proposed that the consumption tax be doubled by “at least the middle of the decade” to cope with fast-rising social security costs (~30% of total expenditures). Public rebuilding efforts only speed up the timeline and increase the magnitude by which anti-growth fiscal policy must be implemented over the long term.
Uncertainty surrounding future energy policy is also slowing Japanese economic growth on the margin. Energy reform, which is the second of the two remaining pieces of legislation that Naoto Kan must see passed prior to resigning (the deficit-financing bond bill is the other), remains a key topic of contention in Japan and supports our view that Kan might remain in charge well into 2012 – despite his lowly 17.1% approval rating. Kan seeks to have Japan procure 20% of its energy needs from renewable energy by 2020 – up from around 1% currently. No details have been given surrounding how the world’s most heavily indebted sovereign entity plans to pay for such a broad-sweeping initiative.
The uncertainty here is a negative near-to-intermediate-term catalyst because it: a) potentially delays the timeline by which Japan’s nuclear plants come back online (currently 38 of Japan’s 54 reactors are either idle or offline); and b) it casts uncertainty amid Japanese manufacturers on whether or not Japan will have enough power supply to meet their production plans over the long term. Such ambiguity is already weighing on corporate decisions to invest in Japan, as a recent Cabinet Office survey shows the percentage of goods Japanese manufacturers plan to produce outside of the Japan by 2015 jumped +340bps YoY to 21.4%.
This secular shift would be incrementally exacerbated if Japan has any hiccups meeting its energy needs over the next 6-12 months as planned blackouts force consumers and corporations to slow energy use. According to Bloomberg calculations, 40 of Japan’s 54 reactors will be offline undergoing scheduled maintenance in August and it remains to be seen if the political will is there to quickly bring them back online. We’ve already seen Japan’s unemployment rate tick up +10bps in June to 4.6% - a noticeable and meaningful increase, given that Japan’s ever-dwindling working age population keeps an artificial and deceptive lid on Japanese unemployment statistics.
All told, the combination of fiscal and energy policy uncertainty and the likelihood that any resolutions are likely to take the shape of anti-growth policy have us bearish on Japan’s economic growth over the intermediate-term TREND and long-term TAIL. Broken from a TRADE perspective, we think that Japanese equities are starting to reflect this reality while the incredibly consensus storytelling about “cheap valuations” and “reconstruction” falls to wayside of underperformance.
Our models point to a measured deceleration in Japanese YoY GDP growth in 2H and the fundamental setup supports that conclusion. Moreover, we expect the recent trend of accelerating sequential growth (MoM; QoQ) to come to an abrupt end shortly, as nearly 2/3rds of the lost manufacturing capacity resulting from the March/April disasters has come back online already in just three short months. The current risk management setup suggests investors are giving the Japanese equities the benefit of the doubt – at least for now.
Bank of Japan Intervention
At the current 77.09 per U.S. dollar and recently as low as 76.76 on a closing basis, the Japanese yen is once again in crisis territory for Bank of Japan (BoJ) officials. In fact, their latest Tankan Survey of 1,472 exporters show that Japanese corporations are, on balance, forecasting the yen to average 82.59 per dollar this fiscal year, which ends on March 31st2012. Since the fiscal year began back on April 1st, the JPY/USD exchange rate has averaged 80.96 – a full 2% above corporate expectations. As further strength in the yen begins to depress corporate confidence and profit growth, we expect the BoJ to take matters into their own hands by unilaterally selling yen in the FX market, just as they did late last summer (¥2.12 trillion from Aug. 28ththrough Sept. 28th).
As such, we have elected to front-run the BoJ by shorting the FXY this morning. Recent policymaker commentary supports our view here: Governor Masaaki Shirakawa said last week that, “[the strong yen] could have adverse effects on the economy as a whole through a decline in exports and corporate profits, as well as a deterioration in business sentiment when appreciation is caused by uncertainties about overseas economies”. To the latter point on sentiment, recent data shows that the cash holdings of Japanese corporations hit yet another high in 1Q (up +7.1% to ¥211.1 trillion) and we would expect to see further upside here as the strong yen weighs on intermediate-term profit forecasts. Additionally, Shirakawa affirmed comments made by deputy governor Hirohide Yamaguchi the week prior in saying that the BoJ would take “appropriate actions as necessary”.
All told, we don’t ever find Big Government Intervention necessary and would prefer to let free markets reflect their fundamentals. Given that free markets have all but gone extinct, however, we’ve chosen to front-run the BoJ by shorting the yen in our Virtual Portfolio for a TRADE. Game Policy or be gamed yourself.