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.

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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.

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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

Analyst

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