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The Fukushima disaster dealt a terrible blow to Japan's pursuit of energy independence, but during the spring of 2012 a confluence of factors offered the prospect of better days ahead for the Japanese economy. Lower crude prices enhanced by an appreciating yen allowed Japan to reduce its trade deficit even while it increased energy imports to compensate for the loss of nuclear power generation capacity in the wake of the disaster. It looked like even Japan's deficit-increasing dependence on imported energy could be mitigated as nuclear reactors started to come back on line in June. With Brent crude (BNO) prices continuing to slide throughout the summer lower energy costs held out promise of recovery for Japan's manufacturing sector and hope for remedy of the country's trade deficit and diminished tax base. We like the iShares MCSI Japan Index ETF (NYSEARCA:EWJ) as the forward P/E of the top 25 holdings is around 11 and in a global QE environment the Nikkei 225 should begin to rally faster than the more overbought S&P 500 (NYSEARCA:SPY).

In the months since Fukushima, Japan has increasingly turned to liquefied natural gas to make up the energy shortfall. Japan must import the oil, coal and natural gas which together account for the greater part of the country's energy consumption. At present, Malaysia and Australia are Japan's largest suppliers of LNG. There are plans to increase imports of cheaper gas from the USA and Canada but these will not mature until 2016.

Despite a commitment to abandon nuclear power by the 2030's, the nuclear option is not completely off the table. The Japanese government has left open the possibility for nuclear reactors already in operation or under construction to be grandfathered into future energy plans. Since these reactors could remain on line not only for the 40 years of their design lifetime but even beyond if extensions are granted, concerns for energy security have thus trumped the protests of the anti-nuclear lobby.

A Less Than Sunny Summer

As the summer of 2012 wore on, the outlook for Japanese recovery and deficit reduction became less rosy. For a time, the dominance of China as Japan's biggest trading partner seemed to insulate Japan from the ill effects of the continuing euro crisis and the struggling American recovery. However, the sluggish world economy finally took a toll on Chinese exports, which dipped sharply to an anemic 1.0% year-on-year growth rate in July. China's central planners' latest 5 year plan emphasized their shift in the focus of economic activity away from exports towards building consumer demand to support its domestic manufacturers. In August, China's year-on-year growth in imports dipped into negative territory at -2.70%, bad news for Japanese exporters.

Recent figures from Japan's Cabinet Office indicate that Japan's economy grew much more slowly in the second quarter than originally calculated. Furthermore, Japanese exports dropped sharply in July. Exacerbating the impact of these economic woes has been parliamentary gridlock, which has hindered government action to reduce the deficit.

Imported oil still accounts for the lion's share of Japan's energy consumption, and during the summer crude prices began to move upwards as the crisis in the Euro reached its peak and American economic sanctions against Iran forced Japan and other oil importers to seek supply elsewhere. On Sept. 15, the American government announced that ten E.U. countries and Japan would continue to be exempted from the Iranian oil sanctions for another 180 days.

While this step promised some relief from the upward pressure on oil prices, current unrest in the oil-rich Middle East is causing skittishness in the oil futures market. We here at AlphaVN are assuming some form of war with Iran is inevitable; the question is when that will occur. Even as the price of Brent crude dipped in response to the announcement of the sanctions exemptions extension, Brent crude futures pegged at a four-month high of nearly $118 per barrel. Clearly a war premium is in place. There are a number of theories as to when war will erupt, but it pays to prepare for it before it happens.

Mixed Outlook

The prospect for a global economic recovery that can benefit Japan continues to stay out just of reach. Hopes for an early respite from the uncertainties fueling the euro crisis receded when at a meeting of Eurozone finance ministers on Sept. 15 the German minister vetoed any transfer of greater powers to the European Central Bank before the end of the year. Meanwhile, a new round of quantitative easing (QE3) announced by the U.S. Federal Reserve on Sept. 14 may give the American economy the hoped-for boost, but the move has also sent stocks and commodity prices soaring and strengthened the Japanese Yen versus it, all of which could be bad news for Japan's trade deficit. The CurrencyShares Japanese Yen ETF (NYSEARCA:FXY) will do very well now that the QE plans of both nations are known and the Bank of Japan will engage in much less QE than the Federal Reserve will.

The strong Yen has been a boon for Japan over the past few years; allowing Japanese companies to invest billions in their ASEAN neighbors in places like Vietnam, Malaysia, Thailand, etc. With the opening up of relations with Myanmar Japanese investors are there as well, looking for oil and gas blocks alongside Exxon-Mobil and others. But that trend may be changing.

The Yen's weakness against the Euro can be seen as the unwinding of the fear trade that gripped markets all summer, sending Japanese debt to unsustainable prices. This trend should reverse in due course, but it may take a while for it to play out as the short Euro trade may have been the most crowded in the history of the world. But with the relative strength versus the U.S. Dollar and Euro all but assured absent a more extreme response by the BoJ, the weakness of the Yen versus the major ASEAN currencies will be a boost to their regional exports while maintaining the advantage of investing in the region's younger countries, namely the currently unstable Vietnam as well as Cambodia and the aforementioned Myanmar.

Japan very wisely took advantage of the post-Fukishima period to lay down a foundation for future growth with a temporarily over-valued Yen. The budget deficits which they are trying to address with a sales tax hike will only if the return on investments in a stronger ASEAN is excellent. Absent war with Iran we expect the ASEAN region to outperform the rest of the world due to their initial response to the global money printing and their resilience in the first half of 2012 which should help Japan weather the storm clouds on the horizon.

Source: Stormy Weather Ahead For Japan's Economic Recovery