Where We’ve Been
On October 31st, the day of the BoJ’s surprise easing, we wrote a note titled, “WEEKEND MUST-READ: DOES THE DEATH OF JAPAN = THE DEATH OF ACTIVE MANAGEMENT?”. The key investment takeaway from that note was as follows:
”We’re inclined to maintain our SHORT bias on the DXJ and our LONG bias on the FXY for now. We think recent moves are exaggerated in both directions in the context of a highly likely dearth of incremental Policies to Inflate over at least the next few months.
That being said, however, we are actively looking for a rise in cross-asset volatility as an opportunity to exit this position in the coming weeks. In short, we are now wrong on this trade and are seeking to minimize the damage by not covering high (DXJ) and selling low (FXY).”
It’s worth noting that the Japanese yen tends to be positively correlated with cross-asset volatility due to the country’s status as the world’s largest supplier of capital. Japan’s 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.
With the obvious lack of cross-asset volatility since 10/31, we have been made incrementally wrong on this recommendation and are now content to just get the heck out of the way. For what it’s worth, the DXJ and FXY have moved -487bps and -787bps, respectively, against us since we introduced the thesis on September 22nd.
That was obviously the right call to have made by mid-October (e.g. the DXJ and FXY moved +1045bps and +253bps, respectively, in our favor from 9/22 to 10/15), but we have clearly overstayed our welcome on the short side of the “Abenomics Trade”.
Unlike our competitors – the vast majority of whom lack a buyside practitioner’s approach to global macro risk management – we actually get things wrong here at Hedgeye. With no banking, trading or asset management revenues to help “keep the lights on”, we don’t tend to stay wrong for long, however. Moreover, we’d like to think our customers appreciate our conviction on the LONG and SHORT side of global macro risk management.
The alternative would be opining with no view…
Where We’re Headed
In the next three sections, we attempt to coagulate all of the moving parts across Japan’s macro and political economy. Hopefully we’ll adequately distill that into an investment conclusion, but as the title of the note implies, we’ll let you be the judge of that!
The Snap Election: Tricky At Best
Today Prime Minster Shinzo Abe officially announced a November 21st dissolution of the Diet, effectively paving the way for snap elections on December 21st. To the extent that he secures a second mandate, it is likely that he attempts to push through a series of potentially unpopular reforms over the next four years, including but not limited to:
- Lowering corporate taxes from an effective rate of ~35% to the mid-20s
- A reduction in agriculture tariffs as part of entry into the U.S.-led Trans-Pacific Partnership
- Deregulating the health care industry
- Promoting women advancement in the workforce; Abe aims to have women account for 30% of management positions at Japanese companies by 2020, up from ~6% now
- A broad restoration of Japan’s nuclear power plants
- Potential constitutional reform to expand Japan’s military
Currently the LDP (Abe’s party) has 294 of 480 seats (61%) in the House of Representatives (i.e. lower house) and 114 of 242 seats (47%) in the House of Councilors (i.e. upper house). Together with partner NKP, Abe’s coalition has a 68% mandate in the lower house and a 55% mandate in the upper house.
Conclusion: there’s really nowhere to go but down from these levels. In fact, we consider it a highly risky proposition for Abe to pursue a snap election at the current juncture in light of recent Japanese economic data:
- Overall Household Spending (i.e. “Real PCE”) crashing, down -5.6% YoY
- Real Household Income crashing, down -6% YoY
- Consumer Confidence on the lows
- Small Business Confidence on the lows
- General economic confidence (per the widely-followed Economy Watcher’s Survey) on the lows
FYI, it’s worth mentioning that Japan entered its fourth recession in six years with the advent of the 3Q GDP release:
- 3Q Real GDP: -1.2% YoY from -0.2% in 2Q
- QoQ SAAR: -1.6% from -7.3%
- Real Private Demand: -2.3% YoY from -0.3%
- Household Consumption: -2.8% YoY from -2.7%
- Private Residential Investment: -12.3% YoY from -2%
- Private Nonresidential Investment: 2.8% YoY from 3.8%
- Real Public Demand: 0.8% YoY from 0.6%
- Government Final Consumption Expenditure: 0.3% YoY from flat
- Public Investment: 2.9% YoY from 5.2%
- 3Q Nominal GDP: 0.8% YoY from 1.9% in 2Q
- 3Q GDP Deflator: 2.1% YoY from 2% in 2Q
Further, the Japanese economy continues to contract here in 4Q:
To top it all off:
- The approval rating for Abe’s Cabinet has fallen to 48.1%, down -6.8ppts. from the previous poll conducted in early September;
- Abe’s economic policies were the top reason cited by respondents who did not support the Cabinet at 40.2%;
- 84.8% of all respondents said they did not feel the economy has recovered;
- 63.8% of the respondents expressed opposition to legalizing casinos, while only 30.3% expressed support;
- 60.2% oppose allowing the nation’s nuclear reactors to resume operation, while only 31.9% support their reactivation;
- 55.9% said measures to encourage the promotion of women at corporations are not effective, while a much smaller 40.8% said they are effective; and
- Per broadcaster NTV, approximately 2/3rds of voters are against an election next month.
Good luck next month, Mr. Abe; you’re going to need it!
In fact, the only saving grace we can find in support of a positive election surprise is the fact that:
- 65.9% of respondents were opposed to raising the consumption tax rate to 10% in October 2015 (recall that Abe has just announced delaying the planned +200bps hike by 18M to April 2017); and
- The NTV survey highlighted above found that support for Abe's LDP was at 40%, which compared to a lowly 10% approval rating for the main opposition DPJ party.
Abe has hinted at resigning if the election results point to an overwhelming majority of voters rise up against his Abenomics agenda. In that light, the “Abenomics Trade” will be facing a critical level of tail risk in the coming ~month.
Fiscal Policy: Getting Easier
With respect to Japanese fiscal policy, prepare the anchor for more stimulus. The government is currently considering a supplementary budget worth ¥2-3T full of measures aimed at “helping people cope with rising energy prices, local revitalization and reconstruction in disaster-hit areas”.
With unspent funds from FY13 and above-target fiscal revenues from FY14, the government should be able to secure about ~¥4T in funds for a supplementary budget. In terms of the anticipated economic impact, this figure compares to supplementary budgets of ¥10T and ¥5.5T in FY12 and FY13, respectively.
In the context of Abe delaying next fall’s consumption tax hike and pledging to proceed with the first iteration of cooperate tax cuts next year, Japanese fiscal policy will remain very favorable for equity investors over the next 12-18M.
On the flip side, much of the late-2013/early-2014 acceleration in real GDP growth was pull-forward ahead of April’s +300bps VAT hike. Without a similar need for consumers and businesses to accelerate expenditures, we anticipate Japan’s economic contraction will continue for at least the next two quarters as the country laps extremely difficult GDP compares.
In fact, the broad balance of Japan’s high-frequency economic data continues to lose sequential momentum on a trending basis. In the context of how we model Real GDP, this all but ensures a continued deceleration in the growth rate of the headline figure(s).
Monetary Policy: Getting Crazier
Japanese consumption be damned, we now know that the BoJ is completely comfortable with going “full Weimar [Republic]” with Japanese monetary policy, as most recently highlighted by today’s 8-1 vote in leaving monetary policy unchanged; recall that the board was split 5-4 when Governor Haruhiko Kuroda opted for additional easing last month.
What we found even more surprising is the fact that Kuroda reiterated his “upbeat” assessment of the economy. Yes, the same Japanese economy that is mired in recession and contracting -1.2% on a YoY basis!
What this tells us is that he is likely leaving room for a downside surprise to his targets, which would afford him scope to expand QQE sooner, rather than later. Per Bloomberg, sellside consensus expects a further expansion of QQE by June. Kuroda surprised us once; he won’t catch us off guard again!
Reasons for QQE expansion over the next 2-3M:
- The BoJ has to increasingly provide liquidity to the JGB market in the context of the GPIF portfolio reallocation and Japan’s deteriorating BoP dynamics (CLICK HERE for more details);
- The BoJ is seemingly hell-bent on perpetuating Japanese stock market inflation (there is speculation that the BoJ buys ETFs whenever the 1st section of the Tokyo Stock Exchange drops more than -1% in the morning session); and
- A potentially reflexive loop of decelerating inflation and a lower-highs in Japanese inflation expectations as JPY weakness perpetuates USD strength, which continues to be a material headwind for the prices of key commodities.
All told, the BoJ can and will “do more” to pursue the “5% Monetary Math” agenda as originally stated with the introduction of Abenomics.
It seems crazy to us allocating capital to the “Abenomics Trade” (i.e. LONG the DXJ and SHORT the FXY) at current price levels in Japan’s equity and currency markets, but perhaps that’s precisely the point: Japanese central planners are forcefully compelling us to join in on the craziness.
Investment Conclusions: Doing Nothing, For Now
If there’s anything investors should glean from the U.S. midterm elections is that the state of the economy matters big time at the ballot box. We don’t want to be in the way of a potential election surprise that could potentially render the entire Abenomics agenda a thing of the past.
While we’re likely to miss out on further upside by not joining in on the craziness of it all, we think this is the most prudent risk management decision for an investor to make at the current juncture. At a bare minimum, those that have risk managed this trade appropriately should look to book gains in the coming days/weeks.
For those of you who have a desire or mandate to keep “riding the bull”, you should take some solace in the fact that with a Z-Score of +0.2x (TTM), the JPY isn’t nearly as crowded of a short now as it has been in recent months. Perhaps there’s another leg down to ~125 vs. the USD right around the corner!
All told, if Abe strengthens his mandate to pursue his crazy economic agenda, we will happily go “all-in” on the long side of Japanese equities (DXJ) and on the SHORT side of the Japanese yen (FXY), while anticipating further economic deterioration in the process! We just find doing so ahead of the elections to be a risky proposition.
Imagine if you were forced to buy Germany’s DAX equivalent in the early 1920s?
SOURCE: The Economics of Inflation by Costantino Bresciani-Turroni, published 1937
Crazy stuff indeed…
Feel free to ping us with any follow-up questions. Have a wonderful evening,
Associate: Macro Team