Japanese Rally Pinned On Election Hopes

Includes: EWJ
by: Nicholas Pardini

Since the Japanese government called for an election on November 15th, the Japanese stock market (NYSEARCA:EWJ) has risen 12.5% (7.2% in dollar terms). Prime Minister candidate Shinzo Abe of the Liberal Democratic Party has made bold claims of reducing the Bank of Japan's independence in favor of stimulating 3% inflation. Since he is the favorite to win Sunday's election, markets are growing hopeful that this next expected round of easing will finally boost Japan out of its lost decades.

Unfortunately, reality does not reflect this optimism. I do not expect Japanese equities to rise any further in dollar terms because Japan's structural problems cannot be solved by more easing. Currency devaluation on its own merit is a flimsy catalyst for market rallies. In addition to this fact, Japan's demographic problems and high debt levels have made the economy fundamentally uncompetitive.

The first anchor to any sustainable Japanese recovery is debt. Japan's debt to GDP ratio is currently over 211% and is expected to reach 230% by the end of 2013. Over 23% of the Japanese government budget goes to interest payments on the debt. After factoring social security obligations, Japan's annual fixed liabilities consist of half of the Japanese government budget. This is especially scary with interest rates on ten year JGB's near all time low rates at 0.72%. Therefore, a rise in rates above 2% will bankrupt the Japanese government. That's where Abe's promise of inflation becomes a double edged sword. If Japan reaches its 3% inflation target, then interest rates will climb with inflation. Rates rising above 2.5% will be enough to trigger a Japanese debt crisis.

Deteriorating fundamentals of the Japanese economy do not help matters. Increased energy imports and Chinese boycotts triggered by the Diaoyu/Senkaku island controversy have caused Japanese net exports to plummet in 2012. Since Japan has to import nearly all of its food and energy needs, a commodity price shock can send the country into a perennial trade deficit. The strong Yen and the improvement of products of foreign competition from the US, China, and South Korea have made Japanese manufactured goods such as electronics and automobiles uncompetitive. Apple and Samsung's negative effects on the businesses of Japanese national champions such as Nintendo (OTCPK:NTDOF), Panasonic (PC), and Sony (NYSE:SNE) is the most glaring example of this. Weakening the yen may improve price competitiveness for some Japanese products, but higher costs of food and energy imports will outweigh some of these gains. In addition, Japan lacks an edge in product quality that they have had in the past.

The aging of Japan's society has also had drastic implications on the country's competitiveness. Demographic factors will drive the debt crisis in spite of the Bank of Japan's effort to contain it. I went into more details about this in a previous column I wrote last year, but the simple matter is that there are not enough young people buying bonds to the replace the retirees who are net sellers of bonds. What makes this worse is that retirees' lower demand for professional services has made it harder for younger, educated Japanese citizens to find high paying jobs needed to build savings to invest. A large portion of the Japanese youth known as NEETs are also apathetic to the concept of a career and therefore will not be future JGB investors. The lack of demand for JGBs has gotten to the point where the government has resorted to hiring pop singers and making desperate, nonsencial ad campaigns to sell bonds. Foreigners will not accept below 1% interest rates on bonds for much longer, so demographics without inflation may be enough to trigger a JGB sell off.

The conclusion that investors should draw is the Japanese government and economy is on the brink of a major breakdown. Devaluing the Yen does very little to solve the country's structural problems and may trigger the debt crisis instead of solving it. For those who believe risk assets will do well in Japan after the election, shorting Japanese government bonds is a much better risk-reward prospect. However, if current trends resemble past election market rallies, a continued rise in Japanese stocks is unlikely. Heading into the elections, I recommend shorting the Japanese stocks in terms of US dollars through the iShares MSCI Japan Index ETF. The lack of a fundamental basis for this rally and technically overbought conditions of the Nikkei make current prices a good entry point.

Disclosure: I am short EWJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also plan on entering a long position of JGBS heading into the Japanese election with the next three trading days.