- Mixed macroeconomic data out of Japan clouds analysis of the efficacy of "Abenomics."
- Geopolitical concerns, active currency markets and changing wage and tax levels destabilize sensitive Nikkei's epic 2013 run.
- Conversely, don't be too eager to short JGBs.
- Acknowledge fattening tail risk through side bets and watch the data.
Anyone who was long the Nikkei (NYSEARCA:EWJ) in 2013 enjoyed a near 57% increase thanks to the quantitative easing enthusiasm of Japanese Prime Minister Shinzo Abe, a policy affectionately portmanteau-ed as "Abenomics." Now that's how you QE, folks!
...Or is it? Year to date, the Nikkei is falling, along with most of the developed capital markets. While the U.S. unwinds its latest QE program, Japan's program stays the course. In the most recent Federal Reserve meeting, the previously clear criteria for continuance of QE unwinding was made suddenly opaque by comments by new Chair Janet Yellen. As investment-minded economists spin to predict what the correct new metrics are for the United States, Japan has a clear and present target: 2% inflation.
Japan is a nation long plagued by economic woes, enduring lengthy bouts of recession and stagnation since the popping of the Japanese asset price bubble in the late 80's and early 90's. The destruction of asset value decreased consumption propensity, which has limited real GDP growth and encouraged periods of deflation.
One of the "arrows" of Abenomics seeks to ameliorate economic conditions in Japan by increasing inflation. So far, it seems to be working - however, there are reasons to doubt this apparent success. Furthermore, increasing headwinds threaten the maintenance of the purported successes and the Japanese economy as a whole. These realities will manifest in capital markets, and investors in Japan should position for fattening tail risks.
In this article I will provide perspective on several of the leading forces influencing the Japanese economy.
Cost-Push, Demand-Pull Or Liquidity Trap?
Earlier in the article, I said that Japan had a "clear and present target" for inflation. This is true: 2%. However, how do you know if you've hit the target when you can't see your arrow? As is the case for any field that is comprised of statistics, macroeconomics faces the problem of measuring things. Inflation, not so incidentally, is rather challenging to accurately measure.
Within the Abenomics framework the "arrow" of monetary policy is meant to accomplish two things:
- End deflation with an inflation target of 2%
- Push real interest rates down
The below graph shows the progress of inflation control:
(Graph created by author, official data from www.stat.go.jp)
The dashed vertical line indicates November 2012, the month when the current policy began. There are three metrics of inflation on the graph: all items, all items less fresh food and all items less fresh food and energy. Clearly all three strongly changed course shortly after the onset of these policies, indicating an end to deflation and a period of inflation.
Not So Fast
The distinction between these three metrics is not minor, and it suggests a powerful idea: inflation is not as high as is being touted, as suggested in this article. Let's take a closer look at these metrics since November 2012:
(Graph created by author, official data from www.stat.go.jp)
The equations that are color coded represent the regression formula for each data set. The chart below specifies their slope and r-squared value:
Regression of CPIs
|Data Set||Slope Value||R-squared value|
|All items, less fresh food||0.1047||0.8265|
|All items, less fresh food and fuel||0.0474||0.4061|
In a very simplified sense, the slope represents a rate of inflation. Notice the tendency of the CPI data sets' slopes to approach a horizontal slope as the commodities are removed from the data - this is significant. This excellent observation was made in a superb research paper on the efficacy of Abenomics by Joshua Hausman and Johannes Wieland of the Brookings Institute. I advise all serious investors to read the full report, which checks in around 50 pages. It can be accessed here.
The meaning and significance of this suggestion can be broken down as follows:
- While it would seem Abenomics ended deflation and began a period of inflation, the purported rate of inflation may be overly zealous.
- It is possibly misleading because two large contributors to the calculation of the CPI are fresh foods and fuel - both commodities.
- This is especially intriguing because the commodities in question were, in general, at higher than usual values over the course of the aggregation of these data points.
- Japan's energy situation and appetite makes these figures especially telling, as the next section will discuss.
In short, this is a casual suggestion that some - not all - of the inflation in Japan is due to commodity prices. This is potentially a non-extreme example of cost-push inflation that is unfortunately coinciding with Abenomics. Inflation with static fuel costs could be nearly one third of the otherwise all in inflation rate.
Polar Vortex, You Say?
The "Polar Vortex" was a theory about slowed economic growth and activity in North America during the winter months this year. It has been so thoroughly lambasted in the press and bloggo-sphere that not much else needs to be said. Whether fact or fiction, the cold weather did seem to correlate well with some unusually dramatic natural gas price swings in Northern America.
The price Japan pays for natural gas is generally anywhere from 2-4x as much as the going rate in the U.S. Furthermore, Japan is the world's largest liquid natural gas importer, the second largest coal importer, and the third largest net oil importer. (www.eia.gov)
Since the Tohuku Earthquake in 2011, Japan has been increasing its gas, oil and coal usage considerably to make up for the lost energy supply - all while prices soar. Here's the increase in usage by type of fuel:
And here's the increase in price by fuel type:
The hypothesis of commodity based cost-push partial inflation seems clear and confirmed by Japan's increasing demand of fossil fuels, which is a demand that coincided exactly with increasing costs across all subcategories of fuel type demanded.
International Concerns And Currency Markets
The situation in the Ukraine and Crimea has increased tension all over the world, and it appears to be yet another flame hovering around the still sensitive tinder box of barely recovering economies of the world. The effects on Japan's economy are indirect, but worthy of consideration.
The yen (NYSEARCA:FXY) has long been thought of as a stronghold for currencies during problematic economic times. As buy-ins occur, the yen strengthens against whatever currency the inflows are coming from. One of the premiere tenets of Abenomics is to devalue the yen, so when large amounts of foreign capital flow towards the yen, it is exactly contrary to what Prime Minister Abe seeks to do to the domestic currency.
In general, Abe's policy is working: the yen devalued approximately 25% since the onset of policies. However, these gains have been enduring a stress test of sorts as geopolitical tensions rise and foreign money returns to the safe haven of the yen.
Keep in mind that the above chart is oriented USD:JPY, not JPY:USD. Right around November of 2012 the yen enjoyed a great depreciation, and has gone horizontal since the initial devaluation. While there would likely be concerns of greater magnitude if the yen were to suddenly strengthen, it is worth monitoring, especially as it also influences CPI due to import costs.
Closer To Home
It would seem that annexations and land acquisitions are en vogue parlor games of global powers. In fact, one must wonder if they were ever out of vogue. Indeed, the latest Asian installment of such issues is the long running dispute over the Senkaku Islands between Japan and China.
Mediations are going poorly and tensions remain taught, as this story chronicles.
Death And Taxes
"The last time Japan raised taxes the Prime Minister was forced out of office." Such lines and variations thereof are often in Prime Minister Abe's ears, as the first consumption tax increase in decades hits the streets in the coming week.
How apropos of a suddenly fragile stock market to draw comparison to one of the worst crashes in the past 50 years. Let us not forget that the previous tax increase came on the heels of the Japan asset bubble, whose recessionary devastation was so supreme so as to have created "The Lost Generation." Quite the opposite from now, after a banner year for wealth in Japan and in the middle of a massively aggressive economic policy.
While the previous tax increase was like adding more injury to insult and injury, or like the knife of Brutus perhaps, this tax increase seems more like a speed bump. It is expected to dampen GDP figures - more so than one might generally expect, in fact. Japan's aged population is considered to be a bit more careful with its purchases. There has been suggestions of foresight on part of Japanese spenders of these taxes, as jubilant spending in 1Q14 has been reported.
Debt, Ender Of Fortunes?
Japanese Government Bonds - JGBs - have been the fatal temptress of many an investor. Shorting these debt instruments can be such a vicious trade that it is casually referred to as the "widowmaker trade." Many brave souls yearn to succeed with this trade, not unlike shorters of 2013's brand name momentum stocks.
Similarly to the momentum stocks, accused of being overvalued (to put it moderately), JGBs are issued by the most indebted country in the world. Japan's debt is more than double its GDP. How could this trade be a widowmaker when it seems like a no brainer?
In a word, insulation. The market for JGBs is well insulated by the Bank of Japan and Japanese institutional investors. Around 70% of JGBs are purchased by the Bank of Japan, and Japanese institutional investors make up a significant amount of the remaining 30%. Furthermore, low yields on the JGBs attract little foreign interest, especially as the appetite for higher returns continues to elevate, such as those of Brazil.
The Japanese government has monumental incentives to keep its bond market in decent shape. Valued around $1.3 trillion, the Government Pension Investment Fund of Japan is the largest pension fund in the world, and it is of financial importance to much of Japan's elderly population. The GPIF portfolio is comprised of 55% JGBs, a not inconsequential sum.
However, insulation has its costs. The low yield is giving the GPIF a rather bad return on its investment, especially when compared to the Nikkei's run last year. Couple that with forced inflation, and it is a bad asset class to be holding at more than 50%. The GPIF is reportedly being encouraged to diversify its holdings, especially towards the Nikkei.
The Sum Of All Uncertainty
It's a fluid situation. There are no clear answers. Here are some of my thoughts:
- Put May 15th on your calendar - that's when preliminary data is schedule to be released for 1Q14. I'm expecting strong expenditure and inflation data. Here's why: spending was reported to be at record levels in anticipation of the VAT tax increase. Also, oil and gas prices were at elevated levels for much of this time period due to winter demand and geopolitical concerns in oil-rich areas. Depending on what happens between now and then, there may very well be an attractive entry point before then.
- The currency situation is complex. Some cash hoarding may be expected due to the tax increase, but a sense of nationalism may prevail as consumers continue to spend as normal. The monetary policy will clearly be doing its best to increase inflation and draw down interest rates, and the first wage increase in 22 months might allow consumers to loosen their pockets - or better yet, to increase their market exposure. Not to mention household wealth continuing to climb.
- Geopolitics might tamper with investor sentiment and oil prices for some time to come, and effects of both will be seen in Japanese capital markets.
- Is the NASDAQ (NASDAQ:QQQ) doomed to dip further? Will subsequent outflows of U.S. equity markets bring down the Nikkei, or might some money go east to find better returns? If macro data looks reasonable from Japan, I would not be surprised to see increased foreign investment.
- Speaking of foreign investment, how 'bout that real estate market? Urban luxury properties hit highest levels since 2008 - maybe Japan will follow Europe's lead: first the luxury properties appreciate, then comes the rest. I think there remains long-term angst over Japanese real estate prices, but that tune may change as China's real estate market suddenly seems frothy.
- The doomsday scenarios for Japan: another natural disaster, problems with the Senkaku Islands, or a yen that strengthens too much, increasing JGB interest payments and threatening a default.
And here are some plays I like, in no particular order:
- Long EWJ, long FXY. Hedge a long Nikkei bet with a side bet on yen strength.
- Long EWJ, long brent, short eastern European emerging markets (NYSEARCA:ESR). Geopolitically safe.
- Long EWJ, short QQQ (or TQQQ for the risk seeker). A bet on capital flows that I find appealing for various reasons not mentioned (namely my feelings on QQQ).
As you'll notice, I generally favor long Nikkei bets at this time. This is a slight preference, and the preference is not yet a conviction. That is why I don't hold any positions yet - I can't get past my sense of unease. That being said, I am trying to find the right blend of assets to phrase my investment beliefs in the region, and part of that belief is optimism going into 1Q14 GDP data reporting.
Share your perspectives in the comments - I would love to read other prognostications on Japan's economy!
Disclaimer: I hold no active positions in Japanese markets as of article submission, but may very well hold long and or short positions by time of publication. Furthermore, these positions may be spread out through various asset classes and may change constantly. I reserve the right to do so.
Additional disclosure: I have no positions in any stocks, currencies or commodities mentioned but may initiate long and or short positions in any and all mentioned within 72 hours.