Japan Market Watch: Have The Dark Clouds Dissipated?

|
 |  Includes: EWV
by: Jieming See

Summary

The April sales tax increase has weakened consumer spending and is expected to lead to a second quarter economic slowdown.

Japanese equities have rallied from May to July despite the onset of the sales tax increase and this presents a good opportunity to short the index.

The last sales tax increase in 1997 preceded a recession in 1998 and the 2014 Japanese economy looks ominously similar to 1997.

In my last article ("Dark Clouds Gather Over The Rising Sun") published on April 25th, I outlined a trading strategy based on shorting Japanese equities in anticipation of a consumer-led slowdown in the second quarter of 2014. Specifically, I recommended using the ProShares UltraShort MSCI Japan (NYSEARCA:EWV) fund to gain a leveraged short exposure to Japanese equities. Since then the Nikkei 225 has rallied 8% from 14,429.26 to 15,620.77 while EWV has plunged almost 20% from 73.95 to 58.53. Despite negative economic news validating my thesis of a consumer led slowdown, equity markets are clearly having a different view of the Japanese economy.

Click to enlarge

Ouch! EWV has tumbled 20% while the Nikkei 225 was up 8% (source: yahoo finance)

Shorting Japanese equities in May has been a big loser. However, I still believe that the underlying fundamentals of the Japanese economy have not improved under Abenomics and this rally presents an opportunity to add to short positions as we await preliminary second quarter GDP data from the Cabinet Office (due 12 August).

The markets are optimistic...

For the period of May to July 2014, Japanese equities have outperformed global peers. The Nikkei 225 was up 8.26% compared to a 4% and a 2% gain for the S&P500 and the Dax respectively. This has halved year-to-date losses for the Nikkei 225 from negative 9.4% on March 28th to about negative 4.12% on August 1st.

Click to enlarge

The Nikkei 225 (blue) has outperformed the S&P500 and the DAX index over the last three months (source: yahoo finance)

Apparently, investors are growing more confident on Japanese equities after the initial fear over the April 1st sales tax hike. But is this confidence justified or is this just one of the many false dawns along the road to economic recovery?

.. while economic growth slows

The economic situation has deteriorated after the sales tax increased from 5% to 8%. Weakened consumption has been a major drag on growth while exports and manufacturing are still declining due to a lack of competitiveness.

After April 1st, retail sales have declined on a year on year basis for three consecutive months. These weak readings clearly point to a gradual softening in consumption. Domestic consumer spending makes up 60% of Japan's GDP .

Click to enlargeRetails sales have dropped compared to the same month last year for the last three readings. (Source: tradingeconomics.com)

Leading indicators like new orders have mirrored the consumer slowdown, decreasing from 1,013.83 JPY billion in April to 837.49 JPY Billion in May (the lowest reading in a year). In other words businesses are not optimistic over future demand be it internal (the Japanese consumer) or external demand (exports).

Click to enlargeNew orders have dipped to the lowest level in a year. (Source: tradingeconomics.com)

Given the weak economic readings, economists are already lowering forecasts for growth. According to a Reuters poll, the economy is expected to shrink for the first time in nearly two years at an annualized 7.1 percent in the second quarter.

Eerie echoes of 1997;the calm and the following storm

A sales tax increase in April, a slowing economy and brewing debt troubles in the world economy (read the collapse and bailout of Espirito Santo Financial group and the Argentinian debt default); these are all reminiscent of 1997 when a combination of internal and external factors (the Asian financial crisis) pushed the Japanese economy into recession in the following year.

Click to enlarge

In 1997 annualized GDP growth slumped to -3.7% in the second quarter after the sales tax increase and recession followed from the fourth quarter of 1997 to the second quarter of 1998 (source: tradingeconomics.com)

If anything is going to be different this time, it's going to one of scale instead of direction. Economic forecasts of negative 7.1 percent annualized rate for the second quarter seems to indicate that things are expected to be worse than in 1997 when the economy shrank only 3.7% in the quarter following the sales tax increase. Recession then followed from the end of 1997 to the first half of 1998.

In 1997 the Nikkei index rallied from May and peaked in July. But as the economic slowdown became clearer to investors, Japanese equities nosedived for the rest of the year to post a double digit loss.

Click to enlarge

In 1997 the Nikkei 225 dropped ahead of the tax hike before rallying from April to July; the index then slumped almost 22% for the year as recession looms.

In an uncanny parallel of 1997, the Nikkei 225 dropped 9.4% at the start of 2014 in anticipation of the tax hike before rallying in the second quarter as initial fears subsided. As the economic slump takes shape in the coming months, will the index look to repeat the -21.53% slump of 1997?

Looking ahead: more dark clouds on the horizon

With the sales tax set to rise again in October 2015, the outlook for the Japanese consumer looks gloomy. This reinforces my bearish view on Japanese equities for the remainder of the year and beyond. It's not entirely impossible that short term monetary or fiscal measures may be introduced to give a short term boost to the markets but these will be akin to treating the symptoms rather than the cause. Abenomics needs to move beyond the first two arrows of fiscal and monetary stimulus to start reforming and restructuring the economy (the third arrow). Only by addressing declining competitiveness and structural weaknesses will Abenomics have any meaningful long term effects. The third arrow is the hardest to implement but the only real solution to the problem of slowing growth.

In upcoming economic data releases, investors will be looking out for the release of second quarter GDP data scheduled on 12 August. This will give us a clearer picture of the post-tax hike slump. For the rest of 2014 I'm continuing to look for opportunities to short the Nikkei index directly via contracts for differences or sell into any rallies to bet on negative quarterly GDP growth. As the Japanese economic engine struggles along the road to recovery, the dark clouds of recession continue to cast a shadow over the path ahead. I'm having my umbrella prepared for the expected downpour.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am looking for opportunities to short the Nikkei 225 index for the rest of the year.