Currently the Japanese central bank is grappling with a stagnating economy. Falling population statistics driven by an aging population along with a high savings rate has made it difficult for Japan to generate GDP growth. The Japanese economy is still in a bit of a tenuous position following the TEPCO/ Fukushima Daiichi nuclear disaster. With varying indicators and events working against the Japanese economy, investors are probably wondering if the positive stream of economic news is a fluke.
Throughout the course of this article I'll predict the future trajectory of Japan's economy and currency.
Setting the stage
Usually I include a bit of background information on the topic I'm writing about to ensure that you're able to follow along with the logical arguments I make throughout the course of an article.
Currency can be created in two ways: fractional reserve lending, or artificial asset purchases from the country's central bank. Fractional reserve lending is caused when banks lend out the vast majority of assets on the balance sheet, which leads to a currency multiplier effect. Low interest rates encourage borrowers to borrow due to the basic theory of supply and demand. The lower the price, the higher the demand. Therefore buyers of debt would be more inclined to borrow cash if the interest was 3% rather than 5%. Why? Because it's cheaper, hence central banks depend heavily on lowering the interest rate in order to stimulate lending. If lending increases, the currency multiplier increases, thus inflation occurs.
However the other alternative strategy is asset purchases. The central bank creates currency and buys assets. The assets increase in value thus encouraging consumption due to the wealth effect. However, that's not all, the central bank reduces the total supply of treasury assets that can be owned, which forces investors to buy higher risk assets, which creates a trickle-down effect for higher risk securities, thus closing the spread between lower and higher risk bonds (measured by credit rating at similar maturities). In other words, investors turn to corporate bonds and municipal bonds, because the interest income earned from zero risk securities decreases to a point that it's a negative real return. This causes investors to chase after riskier assets that are more likely to beat inflation, thus generating a positive return.
Granted, just because you increase the total amount of currency in an economy by displacing assets doesn't necessarily mean the cash enters into the economy. While, most have argued that point. I think that excess cash chasing after higher risk investment opportunities results in a trickle-down effect. This is because municipal and corporate debt is generally used for capital expenditure spending. The other alternative to raising debt is refinancing, which results in greater economic profit, which could also trickle down or increase assets on deposit. In either case, inflationary policy is actually very effective when given enough time to play out. Let's further examine Japan.
The Japanese economy
The USD/JPY has been able to sustain a fairly strong up-trend in its value since 2012. I'm pretty sure any Forex strategist would have no idea that the Yen would depreciate so significantly in the span of just two years against a basket of global currencies. Granted, I only show you the chart of the USD/JPY, but it's not just the US Dollar it's depreciating against. It's depreciating against just about every other currency in the world.
Currently, the Federal Reserve is on track to reduce some of its quantitative easing program. Yeah a $10 billion monthly reduction doesn't mean a whole lot when compared to the historic scale of the bond purchase program. However, it's a sign of things to come, and most would generally agree that markets are forward looking enough, to price in the impact from a reduction of bond purchases.
Granted, I don't think markets can fully price in the impact of falling bond purchases. Because the determinant of falling demand hasn't occurred; anticipation of falling prices, and actual reduction of demand are two different demand determinants. Both will cause U.S. interest rates to increase going forward.
Currently the USD/JPY is trending higher. Following the break above the symmetrical triangle formation, the dollar-yen now trades at 105.13. The dollar-yen is above the 20-, 50-, and 200-day moving averages which is indicative of a strong uptrend.
Currently the Bank of Japan has increased the amount of assets on its balance sheet by 82.53% over the past five years. The rate of increase has accelerated between 2012, and 2013. This implies that Japan is waging all-out war on deflation.
Japan's stimulus is starting to produce some results. Japan's industrial output has climbed by 5% in December. The CPI has increased by 1.2% in the month of December, and beat the CPI expectations of 1.1% that economists have had.
The consumer price index and GDP has been able to increase in 2013. The unemployment remains low, and has decreased marginally in 2013. Japan has some of the lowest unemployment rates in the world as there's very little structural unemployment. However some economists are concerned about rising inflation with limited wage growth.
For now, based on the Japan Consumer Income growth index, wage growth isn't expected to improve by much in the foreseeable future. The consumer income growth index is based on sentiment, so it's not necessarily indicative of the future, but it gives us an idea on future trends. If inflation steepens, household consumption may pullback due to rising prices if wages don't rise in response. This is why economists focus heavily on real GDP growth, because it excluded gains in GDP that were driven purely by inflation. Unfortunately, Japan's real GDP growth has been low, and this also corresponds to the low population growth.
Population growth has been non-existent over the past five years. The lack of population growth has a negative impact on real GDP over the long-term. This is because a larger population increases total addressable market, thus encouraging producers to increase production to sell to a larger number of consumers entering into the labor force in future years.
Future outlook on Japan
Despite flat population growth, and wage pressure from rising inflation and low wage growth, I believe that the Japanese economy presents two unique opportunities for investors. First is the wealth effect, causing high-risk assets to exhibit further appreciation. Second, is depreciating currency, giving investors the ability to attempt currency arbitrage.
I expect the Japanese central bank to continue its money market operations and that asset purchases will be in a range of 60-70 trillion yen. The vast majority of the asset purchase is composed of Japanese government bonds. The Japanese central bank wants to reach 2% CPI before tapering asset purchases.
Given the fact that Japan's asset purchase program has now become significantly larger than the United States', it's likely that the Japanese yen will continue to depreciate against the dollar. This should result in export growth, which will have a positive impact on GDP. Companies that depend heavily on exports like Sony (NYSE:SNE), Honda Motor Company (NYSE:HMC), and Toyota Motors (NYSE:TM) should be able to report better EPS growth due to FX translation.
I expect interest rates to remain low, while at the same time I expect the dollar-yen pair to appreciate further. An effective currency arbitrage would involve borrowing cash from Japanese banks, and investing it into US-based capital expenditure spending. This is because it's likely that the dollar will be able to appreciate in an environment of monetary restraint/tapering. Likewise, when a borrower of Japanese debt repays the debt following the currency transaction, investors can lock in gains from the currency trade, which would offset the interest expense. Also, since interest rates are low in Japan, investors can enjoy the benefit of accelerated growth in one market, and low interest rates in another market. The falling value of the Japanese currency is just an added benefit that goes along with the ride.
Japan should be able to experience a modest economic recovery in future years. The dollar-yen currency pair should exhibit continued appreciation, giving investors the option of currency arbitrage. Investors can also earn high rates of return by having a heavily leveraged position in the USD/JPY currency pair.
Japanese ADRs should be able to report better earnings growth from currency translation. The unique environment puts Japanese companies in a better position to invest into foreign opportunities (low interest, depreciating yen). Export growth will help to stimulate GDP growth despite worsening population growth. Japan's quantitative easing should also encourage investment into riskier asset categories; therefore the Nikkei 225 will continue to appreciate. This gives investors the other alternative of owning the iShares MSCI Japan Index Fund (NYSEARCA:EWJ).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.