JAPAN POLICY VACUUM PART II?

Takeaway: We lack conviction on the intermediate-term direction of the Abenomics Trade and we think investors should remain on the sidelines for now.

I know. The only thing worse than an offensive lineman who can’t block is a sell-side strategy note that lacks conviction. But don’t take our lack of conviction as the absence of conviction altogether; rather, we have conviction in the view that it makes little sense for investors to have conviction in either direction of the Abenomics Trade (SHORT Japanese yen + LONG Japanese equities) with respect to the intermediate term.

 

Consider the following arguments that are in favor of this investment strategy:

 

  1. A likely transition from Quad #3 (i.e. growth slowing as inflation accelerates) in 2Q14 to Quad #1 (i.e. growth accelerating as inflation decelerates) in 3Q14: Not exactly the hardest call to make. Japanese growth has certainly stabilized here in the back half of 2Q and that is very supportive in the context of an easier GDP compare and tougher CPI compares.
  2. A re-risking of the GPIF portfolio: Per Japanese Prime Minster Shinzo Abe, a review of GPIF’s target allocation is due anytime in the next 1-3M. He has gone on record to suggest that the portfolio rebalancing will “benefit the insured and also bring investments that foster growth”. The general consensus among the investment community is that GIPF will likely reduce its JGB holdings from 60% of its $1.2T in assets to 40% and increase its allocation to Japanese equities to 20% from 12% currently.
  3. Favorable micro tailwinds: Japanese companies have announced a record $25B in share repurchases as of the last week of JUN and are sitting on a record $3T in cash to the extent they will look to continue engineering an optical improvement in ROE over the intermediate term. Per Bloomberg, TOPIX companies posted an 8.6% ROE in the year through 1Q14, the most since the 12M ended 1Q08. That’s well in advance of the trailing 10Y average of 6.2%  – which is the 2nd lowest reading of the 24 developed markets tracked by Bloomberg and less than half that of the S&P 500.

 

 

JAPAN POLICY VACUUM PART II? - JAPAN

 

JAPAN POLICY VACUUM PART II? - Japan High Frequency GIP Data Monitor

 

JAPAN POLICY VACUUM PART II? - GDP COMPS

 

JAPAN POLICY VACUUM PART II? - CPI COMPS

 

Now, consider the following two arguments that are particularly unsupportive of the aforementioned investment strategy:

 

  1. Abe’s “Third Arrow” is more talk; less walk: In an op-ed this weekend, Abe defended the “Third Arrow” of his economic reform agenda, claiming that it will “fell Japan’s economic demons”. While time will ultimately tell on that front, we do not share Abe’s bullish conviction with respect to the current plan.
    • We like that he remains committed to lowering Japan’s corporate tax rate to sub-30% “over the next several years” (after a -240bps reduction in the effective rate in FY14), but we do not think it’s particularly helpful to ensure that the measure will be “revenue neutral” in the context of long-term fiscal consolidation targets. That likely equates to even more pressure on Japanese households from a tax perspective. Moreover, it’s unclear how promoting marginal growth in corporate profits will benefit Japan; if the US experience is any indication, the only growth Japan will see from rising corporate profits is growth in socioeconomic inequality.
      • The Third Arrow is woefully short on ameliorating Japan’s core economic issue: woeful demographics. Specifically, a policy to promote mass immigration is conspicuously absent from the Third Arrow as it stands currently. Per StreetAccount:
        • Kyodo cited government data that indicated Japan's population fell 243,684 YoY to 126,434,964 as of 1-Jan. 
        • Deaths hit a record high of 1,267,838 last year while births were up modestly YoY to 1,030,388.
        • Those 65 or older increased to 31,582,754, and those under 15 hit 16,489,385, a twenty-year low.
        • 39 of 47 prefectures experienced a fall in population, with Hokkaido seeing the largest decline.
        • Elderly people accounted for 24.98% of the population, and the number of foreign residents declined 2,347 YoY to 2,003,384.
  2. Easier Fed + Japanese monetary policy vacuum = stronger JPY: We continue to be the bears on the USD because we continue to be the bears on domestic economic growth and the latter supports our contrarian view that the Fed will continue to ease monetary policy, at the margins, as we progress throughout the year. We put out a deep-dive on this topic last week; CLICK HERE to access that report. While down from the trailing 3Y reading of +0.98, the Japanese equity market remains tightly correlated to the USD/JPY cross (+0.73 over the TTM). We expect that correlation to tighten (in a manner that is negative for Japanese stocks) as consensus is forced to review its lazy expectations for US monetary policy, at the margins.

 

Net-net, we do not think it’s appropriate for investors to gross up their exposures here in either direction. Our call for investors to cover Abenomics shorts ~1M ago was highly appropriate, but the outlook from here is less than clear.

 

As such, we think it makes sense to hold tight through 3Q so that we can finally be 1-2M striking distance of a likely expansion of the BoJ’s QQE program. Again, that is the approximate timing of the next major pro-Abenomics Trade catalyst according to our Hedgeyes, as the resiliency of the Japanese economy post the consumption tax hike should continue to keep Kuroda and Co. at bay for at least the next 3-4M.

 

Specifically, given the large amount of “hay” that the LDP has promised to bale on the growth and inflation front, we continue to see no reason why long-term investors should bail on the Abenomics Trade (i.e. they should remain involved on the long side of Japanese equities). Policies to Inflate out of Tokyo aren’t going anywhere anytime soon; that’s more than we can say for the Japanese consumer, however.

 

JAPAN POLICY VACUUM PART II? - 5

 

JAPAN POLICY VACUUM PART II? - 6

 

Email us if you have any further questions and we’d be more than happy to follow up. Best of luck out there!

 

DD

 

Darius Dale

Associate: Macro Team


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