JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE

Takeaway: We now view the Japanese equity market as a short idea amid a likely acceleration in both domestic and globally interconnected risks.

Globally Interconnected Risks Are Rising

Consistent with our growing expectation that the US economy has entered into a multi-quarter Quad #4 setup, we think recent weakness in the Japanese yen is overdone. Specifically, our GIP model backtest results indicate that the JPY has historically performed best in this economic environment, which makes sense given that Quad #4 in the US implies a dour outlook for the prices of many financial assets globally and the yen’s status as a “safe haven” among them.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - JPY

Again, “risk off” usually means “risk on” (to the upside) for the Japanese yen. This is because of the yen’s status as both a global funding currency and Japan’s status as an international capital allocator. Its net international investment surplus of ~$3T is equivalent to 68% of the country’s GDP and compares to a -$5.5T deficit for the US.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - NIIP

Probable upside in the JPY should equate to probable downside in Japanese share prices given rising correlation risk in marketplace. Our multi-duration look at this relationship suggests the Japanese yen has become increasingly important as a directional driver of the Japanese equity market. In fact, the chart below would suggest that the USD/JPY breaking out of its 101-103 trading range to ~109 has been the primary driver of the latter ~half of the TOPIX’s +17% rally from the its mid-April lows.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - MULTI DURATION CORRELATION STUDY

Indeed, it would seem that if we get the currency right from here, we should be able to accurately forecast market beta for Japanese stocks. Again, we’re of the view that a Quad #4 outcome in the US is positive for the Japanese yen, which implies a bearish outlook for Japanese stocks.

Idiosyncratic Risks Are Rising As Well

Obviously we can’t just isolate the US in any attempt to predict the direction of the USD/JPY cross (or any exchange rate for that matter); what’s happening from GIP perspective in Japan is likely to play a key factor as well. And from the perspective of the Japanese economy, a bullish call on the JPY from these levels is actually a lot easier to make.

Our GIP model also has Japan entering into Quad #4 for the fourth quarter. While a second consecutive quarter of likely deceleration in reported inflation figures is sure to pull forward market expectations of BoJ easing as we traverse through the next few months, we do think the confluence of both growth and inflation slowing will weigh on sentiment in the interim in the context of Japan’s already muted post-tax hike recovery.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - JAPAN

Indeed, if our GIP model proves accurate in predicting the 2nd derivative of those metrics, we’d expect to see a growing loss of faith in the Abenomics agenda among investors, at the margins. To that tune, the following six signals give us confidence in our forecast for both Japanese growth and inflation to slow in the fourth quarter:

Tougher GDP compares on the margin:

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - GDP COMPS

A loss of sequential growth momentum:

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - Japan High Frequency GIP Data Monitor

*As the preceding table highlights, Japan’s Economy Watcher’s Survey, Small Business Confidence, Industrial Production, Machine Tool Orders, CapEx, Housing Starts, Bank Loans, Consumer Confidence, Overall Household Spending, Real Household Incomes, Exports and Imports are all sequentially decelerating as of July/August and/or negatively diverging from their respective trailing 3M trends. The conclusion: Japan’s post-tax hike recovery has lost a considerable amount of steam.

A demonstrable loss of purchasing power among Japanese consumers:

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - REAL WAGES

Demonstrably tougher CPI compares on the margin:

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - CPI COMPS

A loss of sequential inflation momentum:

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - CPI

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - PPI

Demonstrably reduced import price pressures:

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - FX

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - IMPORT PRICES

Currency Debasement Is Falling Out Of Favor With Japan Inc.

Going back to our point about the potential for steepening levels of pushback against the Abenomics agenda (i.e. using a confluence of monetary and fiscal easing to achieve “+5% monetary math” at seemingly all costs), we’re actually already starting to see increased pushback from Japan Inc. regarding the recent bout of yen depreciation, which clearly took many Japanese corporations by surprise given expectations embedded in the BoJ’s Tankan survey.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - 5  MM

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - TANKAN YEN

Moreover, an increasing number of key business lobbies are finding it increasingly difficult to pass through the costs of higher import prices, which is squeezing the outlook for corporate earnings growth, at the margins, and weighing on near-consensus expectations that Abenomics will help Japanese companies close the ROE gap between their DM counterparts.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - NTM EPS

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - ROE

Recall that amid secular yen appreciation, a large portion of Japan Inc.’s manufacturing capacity has been off-shored to places like China, Thailand and even Mexico. That Japanese exports have been slowing on a trending basis since the start of the year is very telling in the light of that.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - DIB 12M

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - EXPORTS

In summary, we think the hurdle for a meaningful expansion of the BoJ’s QQE program is much higher now than it has been at any point in its ~18M of existence.

This view is in line with both our existing expectations for a monetary policy vacuum in Japan and BoJ Governor Haruhiko Kuroda’s latest guidance that the Japanese economy remains on track to hit their inflation target in the appropriate timeframe.

Of course the BoJ will adjust monetary policy if and when it is deemed necessary (also in line with his latest guidance), but it’s important to remember that Kuroda is not a supporter of piecemeal easing; he prefers “shock and awe” when it comes to influencing inflation expectations in the marketplace. That means he’ll likely react to the aforementioned fundamentals on a lag (e.g. sometime in 1H15).

Investment Conclusions: Short the DXJ; Long the FXY

All told, we are increasingly of the view that the Japanese equity market is pinned up here on a rope based purely on hopeful expectations for a US economic recovery [and subsequent monetary policy tightening] that we continue to think are grossly misguided. 1,300 on the TOPIX or 16,000 on the Nikkei 225 is rather aggressive in light of that.

JAPAN: UP ON A ROPE, FULL OF [MISGUIDED] HOPE - Consensus GDP Estimates

As such, we now find it prudent for investors who have participated in the rally in Japanese shares to book gains. We had been comfortably watching the rally from the sidelines amid a lack of conviction in our fundamental view, which, in the context of holding ourselves to the highest analytical standards, is a miss. We don’t like missing things – especially not what could be next 10-plus percent correction the Japanese stock market.  

Have a great evening,

DD

Darius Dale

Associate: Macro Team