Japan's Recovery Hopes Uncertain in the Mid-Term

As was the case with other major international economies, Japan showed reassuring signs of recovery over the summer, though the process of economic normalization appears to be far from over.

The country’s industrial sector improved sharply, with production up 1.4% month-over-month in September (against consensus estimates of +1.1% month-over-month) from +1.6% month-over-month in August. Nevertheless, industrial production dropped by 18.9% on a year earlier. Another positive signal came from a sharper than expected (+0.9% month-over-month versus 0.2% month-over-month) increase in retail sales for September. As in the case of industrial production, retail sales fell 1.4% from the same period a year ago but improved on August (-1.8%). Retail sales are also seen improving further in the coming months due to the resilience shown by the labor market, with the unemployment rate unexpectedly down from 5.5% to 5.3% in September. Therefore, national accounting data due November 16 will likely confirm that Japan has joined all the other countries emerging from recession in Q3.

Although the Japanese economy should continue to show signs of improvement in the short term, its medium-term outlook remains clouded in uncertainty. First, Japan has a long way to go before solving the problem that has plagued its economy the most over the last few years: deflation. The national data for September showed that deflation persisted into September, -2.2% year-over-year for the cpi measure and -1% year-over-year for the cpi core. The October’s data for Tokyo even suggested that a further deterioration might be likely in the short term, so that some economists believe that Japan will not move out of deflation for at least two to three years. Indeed, private consumption is highly unlikely to recover any time soon, so as to trigger an increase in retail prices, as the improved employment scenario combined with a 1.6% year-over-year wage cut in September.

Against this backdrop, there are slim hopes of a recovery led by domestic factors and only a significant improvement in exports could trigger a sharper upturn in the economy.

But exports are hampered by the yen's sharp appreciation in recent months, particularly against the U.S. dollar and, consequently, the Chinese Yuan, which is pegged to the U.S. currency. Compared with the June 2007 peak, the yen has advanced by over 27% against the US Dollar, eroding profitmargins for the nation's exporting companies. Based on the OCSE Purchasing Power Parity estimate, at current levels the Yen is overvalued by over 30% against the U.S. dollar.

Therefore, a devaluation of the yen is the most efficient way to spur growth in Japan’s economy in the short term even though it appears difficult to implement, given that almost all major international economies rely more or less explicitly on their currency devaluation to revive the economy.

In the medium term, the major cause for concern for the Japanese economy is the high level of public debt. According to the International Monetary Fund estimates, in fact, public debt may rise to 218% of GDP this year, and reach 227% and 246% in 2010 and 2014, respectively. The sharp increase in the supply of government bonds is likely to intensify tensions in the bond market going forward as purchases by domestic investors may soon fall. The savings rate of Japanese families declined from 15% in the ‘90s to around 2% today because of the ageing population and workforce reductions. These tensions have already begun to emerge, with yields on ten-year notes up 11 basis points in October and the cost of the insurance against default in Japan in the credit default swap market exceeding the levels seen in the U.S., Germany and the UK. An increased securities offering and softer domestic demand could therefore lead to increased yields, with severe repercussions on the public budget and investor portfolios. Considering also the possible devaluation of the yen in the medium term and the low bond yields, we warmly recommend not to invest in the Japanese bond market.

Disclosure: No positions

Comments

[Mad Hedge F...:]

nft As much as I want to find a trade in Japan and therefore have an excuse to go there again, my searches have recently come up empty. With America maintaining its lead in innovation and the creation of new business models, and China taking over the world’s low end manufacturing, it is hard to see a future for Japan. Can a country of 127 million live only off of the high end manufacturing of luxury cars, video games, and electronics? The country is increasingly looking like a “has been” emerging market. During my career, I watched GDP growth rates fall from a white hot 10% in the sixties, to 4% in the seventies and eighties, to 1% in the nineties and the early 21st century. Are we flat lining at 0% in the teens? That leaves fertile ground only for stock pickers who are willing to do the local spade work to find one hit wonders like Toyota and Fast Retail. That is a job best left to country specialists, like my old friend, 40 year veteran Ed Merner, who runs the Atlantis Japan Growth Fund (LSE-AJG) traded in London, which has shot up a sizzling 80% in six months.

Nov 05 11:54 PM