Japanese Equities Break Out, Despite No Structural Reform ‘Third Arrow’ Yet

20th November 2013

The tactical asset allocation stance since Q3 has been long USD and Japanese equities for a breakout to the 17-18k level on the Nikkei by end Q1 and a move toward my productivity adjusted 110 target on the JPY. While I’ve been on the road in Asia, those bets have been paying off, while China has surprised the skeptics by announcing a broadly coherent if as ever gradualist set of pro-market reforms to reduce some of the most glaring economic perverse incentives which have undermined productivity growth and the capital-output ratio. Japanese equities trade on a 14.5x forward PER with scope for a pick-up in ROE as well as renewed JPY weakness, but above all the much heralded domestic asset reallocation into inflation hedges. Not to mention real estate; I noted on my travels prominent ads in papers from HK to Singapore and even Bangkok for prime Tokyo condo developments, which would have been unthinkable a year ago but which the yen move and ultra-low JGB rates have turned into a compelling arbitrage versus overheated (and increasingly tightly regulated) local markets. But could domestic household formation also begin to drive real estate demand?

I got talking at an airport lounge to a very senior Japanese banker who is convinced that the Abe government will soon allow joint bank accounts, joint mortgages, and joint title to property for married couples, who for the first time would be treated as a single unit for tax purposes, all of which would boost the female workforce participation rate and potential growth. That wouldn’t be so much a ‘third arrow’ as an economic Scud missile, because the anachronistic social contract for educated women in Japan has been driving many adverse trends from a low marriage and fertility rate to the moribund real estate market. A surge in dual income, reproducing and mortgage borrowing households is one key to boosting real growth to anything like the 2% a year through 2020 forecast by the government, when underlying potential growth is estimated by the BOJ at only about 50bps.

Japan trades on a P/B of 1.3x but trailing ROE is only 7% – just a little over half the return from global equities as a whole. There has been some modest improvement in in the last few quarters, in part as the weaker yen has helped boost EPS. The consensus currently expects substantial improvement to about 9.5% over the next year. Japanese ROE is so far below other markets in part due to lower asset turn but above all because of lower margins. Structural reforms that work to improve the level of net income margins remain key to a sustained rerating of Japanese equities.

Have Markets Underestimated Japanese Resolve to Weaken the Yen?

The Japanese have a history of proving inventive faced with desperate circumstances, and in fact rarely move forward without their backs to the wall, given inherent cultural inertia. The exceptional factors which have allowed endless deficits, notably the recycling of corporate retained earnings into JGBs to offset falling household savings, and a surprisingly resilient current account surplus despite a long-term deterioration in the country’s comparative advantage in manufacturing, are now coming to an end.  Near term, the BOJ slashed its economic growth forecast for fiscal year 2012-13 to 1.5% from 2.2% and decided to raise its asset buying and lending program. It was the first time since 2003 that the conservative BOJ has eased policy for two months in a row.

In another radical shift, the central bank issued a joint statement with the government pledging their combined efforts to pull Japan out of deflation. In an unorthodox move (although not dissimilar to a recent BOE bank lending initiative), the BOJ also unveiled a plan to supply banks with unlimited amount of cheap, long-term funds under a new scheme initially set at around 15 trillion yen. Markets reacted with a sense of déjà vu to the latest asset buying plans but this has the potential to be far more significant both in its direct impact on the yen and in the combined determination of the bank and government to stave off another deflationary episode than the consensus thinks. The yen carry trade is back on, backstopped by the BOJ balance sheet…

The near term macro outlook is deteriorating rapidly, bringing the currency headwind into stark focus. Japan’s coincident composite index, which consists of 11 key indicators, including industrial output and retail sales, dropped 2.3 points m/m to 91.2 in September. Excluding quake impacted March 2011, September’s fall was the biggest since February 2009 and marked the sixth straight month of decline. Factors from the persistently strong yen to the on-going territorial dispute with China disrupting the auto sector in particular have undercut economic activity. Output fell an unexpectedly large 4.1% from August, while seasonally adjusted retail sales fell 3.6% on month. The government said that 9 of its 11 main economic indicators deteriorated in September amid a sharp slowdown in industrial production, signaling a “possible turning point” into contraction, the seventh time the government has used such language since 1986, announcements which were indeed followed by four subsequent recessions. Core machinery orders, which measure the change in the total value of new orders placed with machine manufacturers, excluding ships and utilities, declined 4.3% in September, worsening from a 3.3% pace of decline in August. Core machinery orders dropped 7.8 % on a y/y basis in September, from a 6.1% decline in August.

The Cabinet Office defines “turning point” as indicating that there is a high possibility the economy will be acknowledged retrospectively to have peaked several months ago. The risk of a renewed recession has clearly risen in recent months. The October coincident CI will likely show a further drop and lead to another downgrade of the assessment to “worsening,” which is defined as a possible recessionary phase. The index was greatly affected by industrial production, which posted the biggest drop in September in recent years with the exception of the March 2011 earthquake and the global financial crisis of 2008-2009. A survey of manufacturers released by the Ministry of Economy, Trade and Industry on Oct. 30th showed that companies expect output to fall 1.5% in October m/m.

The jointly issued document says that the BOJ will continue with “powerful monetary easing” until its goal of 1% inflation is achieved, and the government will tackle structural reform and carry out appropriate macroeconomic policy. The BOJ decision to expand asset purchases by 11trn yen came after the government announced a 422.6bn yen stimulus package. The newly appointed Economy minister Seiji Maehara appeared at the latest BOJ policy board meeting for the second month in a row. While the DPJ is headed for the exit, the LDP is headed by Shinzo Abe, an outspoken advocate of more aggressive monetary easing measures, such as a higher and binding inflation target (of 2% plus). The BOJ is vulnerable to political pressure as the end of Gov. Shirakawa’s term in April approaches. However, the BOJ’s view that deflation can’t be overcome by monetary policy without deep structural reforms given a huge and persistent output gap and the declining comparative advantage of Japanese industry has apparently been accepted by the government. For investors, the key conclusion is that Japan is approaching a comprehensive attempt to slay deflation.

If PM Noda dissolves the lower chamber while the yen is still painfully strong, it will hurt the DPJ’s already ominous electoral prospects as national consumer electronics champions like Sharp enter their death throes. If the economy slows sharply, it will be difficult to go ahead with the politically expensive consumption tax increase which is the DPJ’s key policy achievement (from the current 5% to 8% in fiscal 2014) as scheduled. State Minister for Economic and Fiscal Policy Seiji Maehara, who played an important role in having the consumption tax hike bill clear the Diet, was also active in pressuring the BOJ to further ease its monetary grip. Having demanded that the BOJ be strictly independent when in opposition, the DPJ in power is aggressively pressuring the central bank to be more interventionist. LDP leader Abe has also suggested that the party will seek to revise the 1998 BOJ Act if it regains power.

 

Despite Investor Cynicism, This Time Really Might Be Different…

Essentially, if the BOJ stands by as another deflationary episode develops, both parties stand ready to lobotomize it. I noted back in the March 1st  Weekly on Japan that: ‘Japan’s experience of low deposit rates has driven a global search for yield which has turned millions of unassuming housewives into frenzied traders of Australian and Brazilian currency and bond markets. As investors respond to incentive signals, the displacement into EM debt and currencies inevitably drains liquidity from low-yielding domestic markets, ultimately creating a need for more QE or other liquidity operations, like endless blood transfusions to sustain a slowly hemorrhaging patient.’ It’s notable in that context that the yield differential between Japanese equities and JGBs has surged this year, and it can only be a matter of time before investment banks offer leveraged structured products harvesting that arbitrage opportunity rather than ones focused on ever more exotic EM debt.

Under the new program, the BOJ will provide funding for banks to expand their lending. The problem is not the ability or even willingness of banks to lend, with loan-to-deposit ratios now in line with US and Asian peers, but a lack of demand for credit due to deflation and the high exchange rate. The impact of Europe’s debt crisis has combined with the slowing Chinese economic growth, the latter trend exacerbated by the territorial row with China and consequent consumer boycotts of Japanese cars. Ultimately, much of the new open-ended BOJ lending is likely to leak overseas. Governor Shirakawa stressed that “Supporting activities by financial institutions and companies, whether domestic or overseas, will eventually lead to growth in Japan.” The BOJ is often criticized for being too conservative, but its balance sheet has swollen to over 30% of GDP; the problem is that it took them 20 years to get there, compared to less than five in the euro zone.

Relative to GDP, ongoing BOJ securities purchases will be significantly larger than the Fed’s QE3+ activity and are likely to be unsterilized. As of the end of October, the BOJ had bought 34.4trn yen of securities under the APP, introduced in October 2010. The new plan is to raise securities holdings to 66trn yen by the end of 2013, implying monthly purchases of about $28bn at the current USD exchange rate, compared with the Fed’s current QE3 run-rate of $40bn per month. The planned purchases by the end of 2013 amount to almost 7% of projected 2013 GDP or more than twice the comparable US figure (assuming that the Fed doesn’t have second thought by H2 2013, which is perfectly feasible).  The scale of the latest initiatives may well be combined with a lengthening the maturity of securities purchases (as longer-term bonds are more likely to be held outside the banking sector, so buying by the central bank results in a direct boost to the broad money supply in addition to a rise in bank reserves). The BOJ currently limits buying of government securities, which account for 58.5trn yen of the 66trn APP target, to bills and JGBs with a remaining maturity of less than three years.

Japanese companies, for their part, are shifting capital investment abroad and snapping up overseas firms. The new lending scheme may thus help Japanese companies that are looking to globalize to survive. How will the unlimited provision of funds by the BOJ affect portfolio capital flows into and out of Japan? On the face of it, the global carry trade based on yen funding has just had a steroid injection. Foreign financial institutions with branches in Japan will be able to receive loans of up to 4 years at an annual interest rate of 0.1%, which they will then be able to lend overseas. While banks themselves are not eligible to receive loans themselves under the program, nonbank financial institutions will be. The carry trade refers to a strategy in which investors borrow funds in yen at a low interest rate and invest in currencies or other instruments in countries with higher interest rates. The carry trade exploded over the past decade as the BOJ’s QE easing effort proceeded erratically.

As the new program will provide funds to banks that boost lending not only in Japan but also overseas, Japanese monetary authorities will implicitly be encouraging that carry trade flow. The BOJ now expects prices (excluding fresh food) to rise by 0.8% in FY 2014. The bank’s Outlook for Economic Activity and Prices report, cut earlier predictions of prices in FY 2012 and 2013 (the median rates of estimates made by nine members of the bank’s Policy Board) to minus 0.1% and 0.4%, respectively. The latest report said that: “In fiscal 2014, it appears likely that it will move steadily closer toward the bank’s price stability goal in the medium to long term of 1%” but it’s notable that two board members recruited from the private sector apparently disagreed.

Ironically, after a decade wrongly calling the tipping point for JGBs, foreign investors have been increasing their exposure to Japan’s bond market since mid-2011, lured by high inflation- adjusted yields. The 3.5% climb in the USD/yen since the beginning of October reflects a growing disparity between high frequency data coming out of the US and Japanese economies. Calling an end to the endaka that has wrecked the terms of trade for exporters, particularly versus Korean rivals, is an even bigger forecasting graveyard than calling the top on JGBs. The key driver historically for the USD/yen rate is still the gap between yields on 2-yr Treasuries and 2-yr JGBs which at sub 20bps is little changed from the average over the past year.

However, if we see a resolution to fiscal uncertainty in the US, the pace of deleveraging and pent up consumer demand in housing and autos suggest that by mid-2013 that differential will probably have widened significantly. Meantime, there have been only three occasions in the past 13 years when investors been more underweight than the current reading of -1.4 standard deviations. On each occasion, Japan has outperformed the MSCI World Index over the following quarter, by an average of 7%. Indeed, of the 26 occasions when investors have been more than one standard deviation underweight, Japan has outperformed the world on 70% of occasions over the following three months.  While I’m no fan of data mining, that offers food for thought. Japan is now about as unfashionable among asset allocators as European assets were back In June, when global investors dismissed the possibility of a radical policy breakthrough. In typically ambiguous Japanese fashion, we’re probably seeing one…