Change A’Cometh In Japan

Conclusion: The Japanese economy is set to undergo some meaningful political and regulatory changes. None of them are positive for Japan’s long-term economic growth.


Position: Bearish on Japanese equities (TREND; EWJ); Bullish on the Japanese yen (TREND; FXY).


Japan, the world’s third-largest single-country economy, had a busy day today. First it was announced that Moody’s downgraded Japanese sovereign debt one notch to Aa3 with a stable outlook. The JGB market hardly flinched (10yr yield up +1bps, while 2yr and 30yr yields declined), as reasons for the downgrade (“weak economic growth prospects”; “frequent changes in government that prevent long-term budget planning”; and “a build-up of debt since the 2009 global recession”) are known-knowns to market practitioners. It will be interesting to see if Moody’s follows through with a shred of intellectual honesty and downgrades the U.S., as our situation is quite similar to Japan’s: 

  1. Weak economic growth prospects – CHECK;
  2. Unstable government preventing long-term budget planning – CHECK; and
  3. A build-up of debt since the 2009 global recession – double CHECK. 

At least Japanese investors own 95% of publicly-held JGBs. That dwarfs the U.S.’s ~69% domestic investor ratio… But rather than waste time attempting to hold the lagging ratings agencies accountable, let us shift our focus back to Japan.


More Intervention; Less Growth

The second announcement came in the form of more Big Government Intervention out of the Japanese Finance Ministry via their decision to release $100 billion of Japan’s $1.07 trillion in international FX reserves into the hands of Japan’s state-run Bank for International Cooperation (JBIC). The funds will be distributed to exporters and small-to-medium-sized enterprises with the intent on spurring overseas purchases. Key potential areas for procurement are energy resources and overseas manufacturing capacity to counter the strengthening yen (more on this later).


The implications for this as it relates to the Japanese economy are large – potentially regarding future economic growth and capex spending by large Japanese corporations. Japanese officials, which are seeking to dramatically reduce the country’s reliance on nuclear energy over the next decade (by at least 20%), are contributing to major uncertainty in the boardrooms of Japanese enterprises as a result of their lack of consensus on long-term energy policy. As we wrote earlier in the month in a note titled, “THINGS ARE ABOUT TO GET A LOT WORSE IN JAPAN”:


“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%.”


The secular shift in developing manufacturing capacity away from Japan being headed by major corporations (i.e. very large employers), like Toyota, Sony, and Nissan Motor – all of whom get royally squeezed when the yen appreciates beyond their forecasts: 

  • The stronger yen cut Toyota’s EBIT by -¥50B (-$650M) in the most recent quarter;
  • The yen’s rapid ascent recently forced Sony to cut its earnings guidance by -25%; and
  • Nissan Vice President Joji Tagawa officially warned of the stronger yen’s impact on job growth in Japan, citing the -¥55B ($715M) hit to their 2Q EBIT. 

As we alluded to earlier, the shift away from nuclear power only exacerbates the shift away from the Japanese economy of productive economic capacity. As we outlined in our Japan’s Jugular presentation in 4Q10, Japan’s economy is highly leveraged to manufacturing and exports; as the producers go, so goes Japan’s economy (think: job growth). It will be interesting to see how the government plans to fund the country’s shift away from nuclear power over the long term with its debt/GDP ratio officially at 219% – prior to the earthquake/tsunami (OECD). Interestingly, a Japanese government report shows that a kilowatt hour of electricity is +26.4% more expensive to produce with LNG (vs. atomic power) and +101.9% more expensive to produce with crude oil. Given the current underdeveloped stage of renewable energy resources, we’d estimate the government’s official goal to grow the country’s reliance on this particular source of fuel by roughly 20x over the next decade will be incredibly costly.


Change A’Cometh In Japan - 1


If rising energy costs are indeed passed on to Japanese corporations, it will be an incremental headwind to economic growth on the island economy – in addition to negative population growth, an ageing population, eclipsing sovereign debt feeding into fiscal policy and regulatory instability, and, our personal favorite, ZIRP. Simply put, marking the risk free rate of return at ZERO percent indefinitely does five things (all of which are negative): 

  1. DARES investors to chase yield (like forcing Japanese savers to seek higher returns off-shore in riskier securities, like emerging market high-yield corporate credit for example);
  2. DISGUISES financial risk (like the Japanese government seemingly being OK with a sovereign debt burden 2.2x the size of the economy);
  3. DELAYS balance sheet restructuring (see above);
  4. DEPRIVES elderly savers who rely on fixed income to fuel their consumption the means of doing so (Japan has a lot of elderly savers, FYI); and
  5. DOOMS the economy by frightening corporations and consumers away from either levering up or investing their “record cash pile” in productive capacity (cash on Japanese corporate balance sheets has grown to yet another record high in the most recent reporting period). 

Something to keep in mind as Wall St. continues to beg the Fed for another round of Keynesian Elixir.


All told, we remain bearish on Japanese equities as economic growth is setup to slow meaningfully over the intermediate term, while long-term growth prospects are becoming dimmer on the margin.


Change A’Cometh In Japan - 2


Who’s Next?

Even beyond the intervention scheme, perhaps the most meaningful announcement of the day that current prime minister Naoto Kan is likely to step down by Friday, pending the likely passage of legislation to subsidize renewable energy and legislation to authorize the sale of deficit financing bonds that will procure funds for roughly 40% of central government expenditures for the current fiscal year, which began back on April 1st. Both bills were cleared by the more important lower house over the last few days and are expected to be ratified by the upper chamber.


The eventual passage of these bills, the final two prerequisites to the prime minister’s eventual resignation, means that Kan and his record-low 18% approval rating are finally out the door. The implications for this are great, considering that the Diet has been operating just above stall speed for quite some time now – well before the March earthquake/tsunami really put a lid their legislative productivity. We are of the view that having a less contentious leader in charge of the Japanese bureaucracy would allow the country to move forward with key policy initiatives ahead what is likely to be an meaningful FY12 (starting in April 1, 2012), specifically as it relates to Japan’s long-term fiscal health.


Currently, there are three candidates vying to replace Kan in what will be Japan’s SIXTH prime minister in the last five years. The field of potential replacements is shaping up as follows: Japan’s current finance minister Yoshihiko Noda (a deficit hawk and avid FX interventionist); the populist Seiji Maehara, former foreign minister who resigned earlier in the year over a campaign violation (a proponent of big spending and central bank stimulus); and the lesser known Banri Kaieda, who’s current post as trade minister leads us to believe that he’s also in heavy into FX intervention and monetary easing (the Toyotas, Sonys, and Nissans of the world have his ear).


The key takeaway here is that Japan is likely to have a shift, on the margin, in fiscal policy goals in the coming weeks. How that translates directly into the country’s P&L and balance sheet over a longer duration is something we will keep a close eye out for in the coming weeks. For now, let us shift to the current investment implications of this political change.


In the absence of a non-Keynesian, the marginally hawkish Noda is our preferred candidate of the three and a Noda victory would be incrementally supportive of our current bullish bias for the Japanese yen – a position supported by compressing interest rate differentials on the short end of the curve as our calls for Growth Slowing, Deflating the Inflation, Sovereign Debt Dichotomy, and Housing Headwinds force more Indefinitely Dovish policy out of the Fed. For those capable of executing directly within the forex market, we remain particularly bearish on the Aussie dollar over the intermediate-term TREND and see perhaps a bit more risk/reward to being long the JPY/AUD exchange rate (-8.2% YoY) over the JPY/USD currency pair (+9% YoY).


Darius Dale



Change A’Cometh In Japan - 3


Change A’Cometh In Japan - 4

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Italy Update: Austerity in the Balance

Positions in Europe: Short Italy (EWI); Short EUR-USD (FXE); Short UK (EWU)

Keep September 6th front and center on your European calendar.  On this day, CGIL, the largest of Italy’s three main trade unions, is expected to strike against the budget cuts proposed in PM Silvio Berlusconi’s €45.5 Billion austerity package. We flag this date due to the associated volatility in European markets around the event, including follow-through implications for the package as Italy’s sovereign and banking health risks remain front and center.


We added Italy (via the eft EWI) to the short side in the Hedgeye Virtual Portfolio on 8/22.


Italy’s real issue is one of growth; critically, the terms of the austerity package could add further downside risks to growth as political risk under Mr. Bunga Bunga remains a clear and present danger.


The proposed terms of the austerity bill announced on August 12th include:

  • Harmonized tax on financial income at 20%
  • “Solidarity tax” of 5% on income earners over €90,000 and 10% above €150,000
  • Spending by ministries cut by €6 Billion
  • Requirement that towns of less than 1,000 inhabitants merge
  • Scrap of 36 provincial authorities with fewer than 300K inhabitants

€20 Billion of the budget cuts are expected for 2012, with the remaining €25 Billion coming in 2013, to meet a promise Berlusconi made early in the month that Italy would have a balanced budget by the end of 2013. [Note: Italy’s budget deficit could shrink to 3.2% of GDP this year].  


The new measures must be approved by Parliament within 60 days (from 8/12). Commentators suggest the package fails to address state-pension program reform, tax cheats, or labor reform, all of which may or may not be revised when it reaches Parliament next month. And Berlusconi is seemingly getting pushback on the package from all sides:  his own center-right colleagues, the Northern League, the opposition and at least one main union, all of which bodes poorly for compromise on its terms, and ultimately its passage.


Based on structural constraints we believe that the country’s growth, and therefore revenue estimates, may be too lofty, which will undermine its ability to meet deficit reduction targets.  In August, Finance Minister Giulio Tremonti said it’s sticking to government GDP forecasts of +1.3% and +1.5% in 2012 and 2013. But given the current economic environment across the region, and the fact that annual Italian GDP has averaged only +0.2% in the last 10 years, with a high of +2.7% in 2006, we think a GDP revision to the downside in 2012 and 2013 is highly probable.  


And while one can argue that Italy is near the deficit limit of -3% (of GDP) set by the EU’s Growth and Stability Pact, we don’t see any country in the region immune to sovereign debt contagion risk. In particular, we’ve flagged the negative divergence in German equities and its slowing high-frequency data over the last 4+ months.  And as we’ve seen over the last 18 month, countries that don’t meet their debt and deficit reduction targets have been punished severely by the market. 


Another headwind that we’ve been vocal on is that the Italian Treasury faces €69 Billion in maturing debt (principal and interest) in September.  This will create additional pressure on Italian issuance in the coming months. Since the ECB resumed its SMP bond purchasing program in early August to include Italian and Spanish paper, yields have come in, however Trichet has indicated that he has no desire for the program to either be large or take on a long duration. Instead, he promotes the EFSF as Europe’s debt “elixir”. 


While Europe’s sovereign debt crisis has proven that policy change and market sentiment can shift with the wind, both the push back on the austerity and ultimately the terms of the program will be important to monitor to gauge capital market performance in Italy and across the region. Should Italy not be able to convince the market that it has its house in order, contagion, including into the heart of Europe, is going to get a lot louder, and swiftly.  


Matthew Hedrick

Senior Analyst


Italy Update: Austerity in the Balance - 1. piig

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