Conclusion: Yoshihiko Noda’s ascent to prime minister of Japan may be just what Japan needs to reverse the deterioration of its sovereign balance sheet. Though purely speculation at this point, it does create a major TAIL risk that needs to be managed by the long-term Japan bear community – us included.
Position: Bullish on JGBs (TREND); Bullish on the Japanese yen (TREND).
First thing’s first: The Japanese economy remains a slow-motion train wreck. As we have thoroughly outlined in our Japan’s Jugular slide deck, Japan’s fiscal laxity, ageing population and Indefinitely Dovish monetary policy are all preventing the country from experiencing sustained healthy levels of economic growth. In fact, without deflation providing an illusory boost to real GDP growth, the Japanese economy has literally gone nowhere over the last 20 years, with the most recent nominal GDP report (2Q) back at 1991 levels of ~460 trillion yen.
Along with a couple of notable names in the hedge fund community, we remain long-term bears on Japan’s economy. What separates our process from theirs, however, is a distinct emphasis on timing. And from a timing perspective, we see catalysts lining up for being long of long-maturity JGBs and the Japanese yen, as well as removing Japanese equities from our list of top short ideas. No we are not getting outright bullish on Japanese equities, but we are affirmatively signaling that the conditions for shorting them are eroding on the margin.
This marginal shift in our intermediate-term outlook for Japanese asset classes comes amid a noteworthy shift in Japan’s political situation. Yesterday, it was confirmed that Finance Minister Yoshihiko Noda will succeed the now-departed Naoto Kan as Japan’s next prime minister – the country’s sixth in five years and the third since the ruling DPJ party took control of the lower house in 2009.
Noda, who is among Japan’s most fiscally conservative officials, has upheld rhetoric suggesting that he won’t back away from Kan’s desire to rein in Japan’s fiscal deficit (currently at 8.1% of GDP) and produce a balanced budget in ten years. In fact, he flat out said that the DPJ had let the country down in this regard and called for raising the 5% consumption tax by “the middle of the decade” in order to secure funding for accelerating social security expenditures and a third reconstruction stimulus package totaling around ¥10 trillion.
It remains to be seen whether or not he can galvanize the fractured Japanese leadership and rally the Keynesian bureaucracy around the idea of deficit cutting any better than his predecessor. If history has taught us anything, it pays to take a wait-and-see approach with regards to Japanese policy, given the astonishing turnover in leadership we’ve seen in recent years. That said, however, Noda appears to have enough internal support to at least begin to have a healthy debate about balancing Japan’s budget without letting politics get in the way of progress.
In this light of this development, we maintain our favorable view of the Japanese yen and are now outright bullish on long-term JGBs as Noda’s agenda proves bond market friendly: higher taxes should beget slower growth and more cash flow for the sovereign to begin paying down its massive debt burden (~220% of GDP). Regarding the yen specifically, Noda appears to be backing off his interventionist tilt (three record interventions in the last year alone) with the latest $100 billion FX reserve scheme; additionally, Japan’s Cabinet Office is currently embarking on a campaign to educate the public on the “merits of a strong yen” – suggesting policymakers are perhaps coming to grips with the futility of their interventionist efforts.
Time will ultimately tell whether or not these TREND-duration ideas become TAIL-duration turnaround stories. That conversation is much better served for a later time and date, however. For now, we remain long-term bears of the Japanese economy and we need to see a great deal more fiscal and monetary policy adjustment before changing our view here. On the margin, however, Noda’s victory should ultimately prove positive for Japan’s balance sheet and we’d be remiss to present it as otherwise.