15th December 2023
Dear Investor,
Back to reviewing our current investment themes to make sure the rationales are still intact.
Last time we discussed the US market and economy, while today we will discuss Japan.
We have been positive on Japanese equity markets all year and we wrote a detailed discussion on this topic in Commentary #2. Some excerpts below:
“In Japan, you now have a generation of investors and consumers, who have only lived through a deflationary slump with the prices of everything going down. These same people have seen the stock market collapse and the bond market continue to go up with a seeming back stop from the central bank (the BoJ).
You have had a massive outflow of capital into overseas assets as the corporate sector recycled the current account surplus and investors reached for yield outside Japan.
You have a government which has spent trillions of Yen in fiscal stimulus building proverbial bridges to nowhere resulting in a massive government debt to GDP ratio.
You have a non-functioning bond market where sometimes no trades happen because the BOJ owns so much of the market.
You have corporates and individuals who have been through the deflationary wringer. Corporates, once highly indebted, have cut costs and repaid debt giving Japanese businesses extremely healthy balance sheets. You have consumers with a healthy level of savings, who don’t spend because why spend today if it is cheaper tomorrow.
You also have quite a lot of zombie companies who are only staying afloat due to not having to pay much interest on their debt (although this has been coming down over the years).
You have a central bank and a government which wants to have extremely easy monetary and fiscal policy in order to counter deflation and aims to get the inflation rate up to 2%.
All of these factors contribute to why we thought of Japan when we thought inflation would start to pick up globally, and why it seemed to me that it would have the most impact there given Japan was so far ahead of the world in the deflationary spiral. With all that Japanese corporates have been through, any revenue growth should go straight to the bottom line.
Moreover, if we were shifting to an inflationary environment and bonds are not the place to be, then there is a massive pool of domestic capital waiting to shift from the bond market to the equity market.
Added to this, if we get inflation and workers start getting pay rises, then domestic consumption will pick up as well.
Finally, with interest rates rising, there will have to be consolidation in the corporate sector (this has been happening, but at a glacial pace, which is how things usually happen in Japan, but this COULD accelerate that trend).
The obvious trade is to sell/short Japanese bonds and to buy the stock market, front-running what Japanese institutional investors will eventually be forced to do.”
The year mostly played out as we expected and this together with the compelling narrative of better capital management and shareholder friendly governance, meant that Japanese equity markets were one of the best performers in Asia.
Japan had the winning combination of expansionary monetary policy, a weak Yen making the country both an attractive tourist destination post Covid and helping exporters out, and nominal wage increases supporting domestic consumption. But, after this run, we are becoming cautious on the Japanese equity market for at least the next 3 to 6 months as the economy is slowing and will continue to slow, especially as year over year comparisons become more difficult.
The domestic economy has weakened. Even though the lower yen has helped inbound tourism recover it has also contributed to inflation picking up, and as a result real wages have been falling which has impacted domestic consumption.
In addition, the export sector, whose earnings have been helped by the weak yen, hasn’t seen any real volume increases in exports (just translation gains). The strong US economy has meant exports to Japan’s biggest trading partner the US have held up well, while exports to China continue to decline.
The chart below shows how closely the JPY tracks the US 10-year yield. As the Japanese rate hasn’t moved that much for many years, it is primarily the US rate that impacts interest rate differentials between the two currencies and hence the exchange rate.
As we reiterated in Commentary #23, we believe the US is close to entering a recession and that there is a real possibility that JPY will continue to strengthen from here as US rates move down more. We added a long JPY position in the thematic portfolio to hedge that risk a few months ago.
The below 2-year chart of the JPY vs the USD shows there is ample upside risk for the JPY.
The move has the potential to be fast and strong as shorting the JPY against the USD has been a winning trade over the last couple of years, and many people have joined the party.
The chart below shows positioning in Yen Futures with data from the Chicago Mercantile Exchange. The key to focus on is the blue line which represents Non- Commercial Traders, which effectively is hedge funds and speculators. From a low of net 20,000 short positions in January 2023, the latest data on 7th December ended at a net 104,000 short position. This is a good proxy for what the market is thinking (and some types of traders will have forward positions as well) and shows how crowded the trade has become after having been so successful this year.
Source: Tradingster.com
While the trade has attracted many players, a few % move in the wrong direction can quickly wipe out any gains from this kind of carry trade, especially with the leverage usually involved in FX transactions.
A rapid unwinding of positioning could cause multiple problems not only in the FX and Japanese equity markets, but globally as money is repatriated to Japan.
There are also more voices raised against the weak Yen in Japan as it has increasingly reduced the purchasing power for the Japanese population. The Bank of Japan is in a tricky situation as the huge government debt levels means the government is happy to keep rates low, while the import dependency in key commodities means inflation is wiping out any wage increases for the working population. The generation of elderly savers would also love to see a real level of interest income.
The below article sums up the loss of purchasing power over time. When the article was written, the JPY was at 138, stronger than the recent low at 152 and the current 144.
Source: Nikkei Daily
Yen’s buying power sinks to 53-year low after decades of stagnation
Pricier imports squeeze Japan households while exports barely budge
TOKYO — A gauge of the yen’s strength against major currencies like the dollar and euro is nearing a 53-year low, forcing Japan to pay more for imported necessities like energy and food.
The real effective exchange rate — a measure that is weighted by trade value and accounts for inflation — came in at 74.31 in July, according to the Bank of Japan’s latest data.
This is not far off the most recent low of 73.7 last October, which was the lowest point since September 1970 — a time when the Japanese currency was pegged at 360 yen to the dollar.
All of this means the economy is slowing and will continue to slow. While the domestic economy will continue to be buttressed by tourism inflows, wages are likely to continue to lag inflation, which means falling real incomes will continue to hold back domestic consumption.
Japan’s Q3 GDP falls faster than first estimates as consumption sags
TOKYO, Dec 8 (Reuters) – Japan’s economy fell faster than first estimated in the third quarter, revised data showed on Friday, as the household sector faced growing headwinds, complicating the central bank’s efforts to phase out its accommodative monetary policy.
Consumer and business spending both shrank, driving down third-quarter gross domestic product (GDP). Separate data showed real wages and household spending kept falling in October, as prolonged inflation discouraged shoppers.
Although nominal salaries rose 1.5%, inflation of more than 3% wiped off the wage growth in real terms, which is seen as a gauge of consumers’ purchasing power. With income stagnant, household spending decreased 2.5% in October from a year earlier, falling for eight months in a row, internal affairs ministry data showed.
So, with a very cheap currency, a large net short JPY position, and the potential for interest rate differentials to move in the Yen’s favour, the Yen could well strengthen here causing disruption in not only the Japanese equity markets but also global ones. While a stronger Yen will help inflationary pressures down the line, it will impact the equity market negatively.
On the export side, we expect the US, Japan’s largest trading partner to be going into recession, hurting that part of corporate Japan as it is unlikely that other countries will take up the slack and with gains from Yen depreciation going into reverse, it is likely that corporate profits will decline from here, absent another large downward move in the Yen and a reacceleration of US growth.
Foreigners who are still the marginal investor will be sellers into this dynamic as monetary conditions get tighter and corporate earnings decline, especially as it becomes clearer that the economy is suffering. As one of the best performing markets in Asia, it will have attracted faster money which will be just as fast to exit as the inflection point of a weak economy hurting earnings becomes more apparent.
As per Reuters on November 16th
Year-to-date, Japanese stocks have attracted net inflows of 5.96 trillion yen from foreign investors, a stark contrast to 4.07 trillion yen of net outflows in the year-ago period.
Meanwhile, Japanese investors withdrew 73 billion yen from overseas stocks in the last week, becoming net sellers of foreign stocks for the first time in seven weeks.
We so expect some window dressing in December which should offer up decent prices to exit and keep the gains generated during 2023. Any news like the Bloomberg article below from yesterday, (which is essentially leaking that there is no increase in rates in Japan at the next BOJ meeting), causing a weakening of the JPY will provide other good entry points for currency positioning.
BOJ to See Little Need to End Negative Rate in December, Sources Say
- Yen extends losses, Nikkei futures pad gains after report
- Markets fully pricing in rate hike by the end of April
The Topix is only a few percent away from its recent (and multi-year) highs so we would expect any year-end action to be capped there.
These are the reasons we have been reducing Japanese exposure over the last few months and will likely fully exit in the coming weeks.
Longer term, any meaningful sell-off will provide an attractive entry point to the Japanese equity market.
Until next time,
