GLOBAL INVESTMENT STRATEGY · Even in dollar terms, the Nikkei has lagged. The direct trigger for...

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March 21, 2014

WEEKLY REPORT

In this Issue: F Strange Economic

Performance .............1

F The Issue Of

Sustainability ...........4

F Strategy ...................6

What To Do With Japan?

GLOBAL INVESTMENT STRATEGY

Editorial BoardChen Zhao Managing Editor

Emin Baghramyan Senior Editor

Mathieu Savary Editor/Strategist

Chester Ntonifor Associate Editor

Laura Lin Senior Analyst

Periodical Japanese stocks have fallen 15% relative to the global benchmark since May 2013. Even in dollar terms, the Nikkei has lagged. The direct trigger for the Japanese stock

market’s poor performance is the yen, which has stopped falling since May. The lack of forward momentum behind the equity market has not only cast a shadow over the so-called Abenomics but has also raised doubts over the sustainability of the Japanese economic recovery.

As far as investors are concerned, the critical question is: should they unfold overweight positions in Japanese equities, or should they simply hunker down and hope that things take a turn for the better?

Strange Economic PerformanceThe Japanese yen has fallen 24% since October 2012. Under normal circumstances, one would expect the Japanese economic recovery to be led by the export sector. Not this time. In reality, the Japanese external sector has seriously lagged the domestic segment of the economy.

For example, export growth has fallen to zero in volume terms, with the non-oil trade balance also plunging into deficit. A weaker yen has not even helped Japan regain global market share; the Japanese export industry has continued to lag and its share has shrunk both globally and within Asia (Chart 1).

On the other hand, the domestic economy has continued to show strength: retail and whole-sale sales growth has been strengthening briskly and private capex has also shown signs of rejuvenation for the first time since 2010. In the meantime, consumer price inflation has crept up, with the headline inflation rate running at 1.4%. Most notably, the secular bear market in Japanese real estate came to an end 18 months ago. Since then, housing prices have risen anew, with condo sales growing strong (see right column of Chart 1).

Many investors are baffled by the export sector’s lack of response to the declining yen. Some say that Japan has already outsourced a large chunk of its manufacturing industry, making the economy much less responsive to the foreign exchange market than before.

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BCA RESEARCH INC. GLOBAL INVESTMENT STRATEGY - WEEKLY REPORT MARCH 21, 2014

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CHART 1

Japan: External Sector Versus Domestic Demand

© BCA Research 2014

The current BCA House View Matrix will be published on the last page of all BCA reports from 19/03/14-25/03/14. During this period you can also find the matrix at: http://bcaresearch.com/research/house-view-matrix.

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96 2000 04 08 12

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0

EXPORTS AS A PERCENTAGE OFASIAN TOTAL IMPORTS**

% %

JAPANESE

TRADE BALANCEEXCLUDING OIL*

TnJPY

TnJPY

* SHOWN AS A 3-MONTH MOVING TOTAL.** INCLUDES CHINA, HONG KONG, TAIWAN, KOREA, THAILAND, THE PHILIPPINES, SINGAPORE, MALAYSIA AND INDONESIA. SHOWN SMOOTHED.

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CAPITAL AREA AVERAGE NEW CONDOMINIUM PRICES* (LS)

TOKYO CONDOMINIUM TOTAL SALES* (RS)Ann%

ChgAnn%Chg

JAPANESE

WHOLESALE & RETAIL SALES VALUE INDEX (LS)

NOMINAL PRIVATE NON-RESIDENTIAL INVESTMENT (RS)

Ann%Chg

Ann%Chg

* SHOWN SMOOTHED.

Others say that a falling yen has simply fattened profits of export businesses (Chart 2), while doing little to promote sales.

Whatever the reason, the interesting question is: with the yen having fallen by over 20%, which represents a big reflationary shock to the economy, why has the recovery been led by the domestic sector instead of exports?

There is no clear answer to this question. My guess is that the Bank of Japan’s (BoJ) quantitative easing, together with a falling yen, has shifted price expectations from deflation to modest inflation. As such, businesses and consumers are no longer willing to hoard cash and delay their purchases. In other words, rising inflation expectations have put upward pressure on consumer and business spending.


With the yen having fallen by over 20%, why has the recovery been led by the domestic sector instead of exports?

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CHART 2

The Japanese Yen And Corporate Profits


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JAPANESE CORPORATE PROFITS* (LS) 18-MONTH RATE OF CHANGE IN

TRADE-WEIGHTED YEN** (Inverted, RS)

TnJPY

%

* SHOWN FOR INCORPORATED BUSINESSES AND ALL INDUSTRIES.** SOURCE: J.P. MORGAN CHASE & CO.

In the meantime, the BoJ has clearly followed the Federal Reserve’s policy script by delib-erately promoting asset price inflation. The Japanese authorities have achieved some suc-cess by lifting asset prices, which in turn has created the so-called “wealth effect”.

Finally, a rising inflation rate in Japan has for the first time in over a decade driven real inter-est rates into negative territory. The negative borrowing costs have compelled savers to save less and encouraged investors to borrow and invest more.

Regardless of these positive developments, the Japanese stock market has seemingly not been able to decouple from the yen. In other words, the equity market has continued to behave as if it were dependent on the support of continued currency depreciation. This has raised an important question over whether the recent economic strength is a sign of a broad economic uptrend, or simply a transitory move that is built on a weak currency.

The Issue Of SustainabilityAbenomics consists of three parts, or “arrows”: monetary reflation via currency devaluation, more fiscal stimulus and corporate restructuring. Out of these three arrows, only monetary reflation has been delivered, while the other two arrows have proven to be nothing more than duds.

Fiscal stimulus is a non-starter, with the implementation of the VAT completely taking away the mild stimulus introduced last year. Overall, fiscal policy under the Abe government has been net neutral, i.e. no new stimulus.

The Abe government’s corporate restructuring plan has been mediocre at best. The Japanese gov-ernment is trying hard to persuade companies to raise pay for workers. This is a joke. It is market forces that should set wage rates, not the government. Only under a centrally-planned system is a government able to decide how much workers can earn, and how much profit companies can keep.

Some critics have pointed out that Abenomics has in fact made the average Japanese citizen worse off: nominal wage growth has not kept pace with rising inflation. As a result, real wage growth has plunged deeper into negative territory (Chart 3). Clearly, if Abenomics cannot bring about income

Out of these three arrows, only mone-tary reflation has been delivered, while the other two arrows have proven to be nothing more than duds.

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expansion, then the net impact of the current economic policy on living standards will be negative.

The biggest problem, or shortcoming, with Abenomics is that it squarely focuses on ag-gregate demand-side management, while there is virtually nothing on the supply side in terms of restructuring. Such a lopsided approach can hardly produce long-lasting positive results.

It is comparably easier to stimulate aggregate demand: increasing government handouts, slashing interest rates or ramping up monetary expansion or fiscal spending will do the trick. However, boosting income growth is much tougher because income growth ultimately rests with labor productivity, and a country cannot produce a sudden increase in productivity with-out engaging in serious supply-side reforms. Falling real wage growth in Japan suggests the economy has supply-side problems.

Even on the inflation front, I am less certain that the Abe government will be able to achieve its ob-jective of generating and sustaining a 2% inflation rate. There is a clear negative correlation between the yen’s exchange rate and domestic inflation: the former can easily shift relative prices between Japan and the rest of the world, thus either depressing or inflating domestic consumer prices.

Nevertheless, such a shift in relative prices is frequently a one-off endeavour – inflation usually falls back once the exchange rate stabilizes. Chart 4 shows that the recent rise in Japan’s inflation rate and inflation expectations are largely a response to the yen’s recent fall. By the same token, if the yen stops falling and stays at current levels for a few more months, the inflation rate will likely fall back to zero.

On a more profound level, inflation is a phenomenon that stems from aggregate demand exceeding aggregate supply. This is obviously not the case for Japan, where private savings still far exceed investment – ergo aggregate supply still outstrips aggregate demand. Therefore, investors should not confuse rising prices on a falling currency with a sustainable gain in price levels based on buoyant demand. The former is transitory, while the latter is more durable.

Finally, how do we know whether the Japanese economy has embarked on an “organic growth” path? Again, we need to watch the stock market. If stocks can rally on a strengthening yen, it could imply that the economy has regained traction on nominal growth.

CHART 3

Wage Growth


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-6

2010 2012

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-4

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JAPANESE TOTALCASH EARNINGS*

NOMINAL REAL**

Ann%Chg

Ann%Chg

* SHOWN SMOOTHED EXCEPT FOR THE LATEST DATA POINT.** DEFLATED BY HEADLINE CPI.

Investors should not confuse rising prices on a falling currency with a sustainable gain in price levels based on buoyant demand.

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CHART 4

Japan: The Yen And Inflation


Should the yen stay at recent level for a few more months, inflation rate will likely fall back to zero zero

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JAPANESE CONSUMER PRICE INFLATION (LS) TRADE-WEIGHTED YEN* (Inverted, Advanced, RS)

Ann%Chg

Ann%Chg

* SOURCE: J.P. MORGAN CHASE & CO.

If, however, stocks continue to be tightly cor-related with the yen, it will suggest that the economy is still very dependent on the life support of a falling yen. So far, the correla-tion between the two is still holding at close to -100%.

StrategyWe are closing our strategic overweight rec-ommendation on Japanese equities for now. With the economy rebounding and inflation approaching 1.5%, both the monetary authorities and the Abe government have become somewhat complacent. There is no evidence that the BoJ will intensify its QE efforts to manage another down-leg in the yen. As such, the Nikkei will likely continue to stall alongside a steady yen.

From a market perspective, foreign investors have been the driving force behind the rising stock market between November 2012 and January 2014, while domestic investors have taken the op-portunity to quietly trim their holdings (Chart 5). Why are domestic investors less enthusiastic about the Nikkei? Do they know something we do not?

CHART 5

Japanese Equities: Who Is Buying And Who Is Selling?


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NET INDIVIDUAL INVESTOR PURCHASES*Tn

JPYTnJPY

JAPANESE EQUITIES

NET FOREIGNPURCHASES*

TnJPY

TnJPY

* SHOWN AS A 52-WEEK MOVING TOTAL.

The Nikkei will likely continue to stall alongside a steady yen.

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In the meantime, the market is still very over-bought after last year’s huge run up, and our Risk Index remains elevated. Chart 6 shows a range of market indicators. All of them suggest the market could still face a period of indiges-tion and underperformance.

So far, Abenomics does not seem to have turned the Japanese equity market into a trending market from a trading one. Therefore, to time the next market move, one has to make a call on the Japanese yen. Our guess is that the BoJ will speed up its QE program, but only under conditions where inflation returns to a renewed decline.

This condition could prevail if the yen stays at current levels for another quarter or so. By then, the rate of change in the Japanese yen will fall to zero, rekindling anticipation that inflation could soon falter. At that point, investors should think about re-entering the Japanese equity market, while shorting the yen at the same time.

Chen Zhao, Managing Editor [email protected]

CHART 6

Market Indicators: Still Overbought


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NIKKEI INDEX52-WEEK RATE OF CHANGE

Ann%Chg

Ann%Chg

COPPOCK*% %

HIGH RISK

LOW RISK

BCA EQUITY RISK INDEX

JAPANESENIKKEI

12-MONTH MOVING AVERAGE

* EXPONENTIAL MOVING AVERAGE OF 11 AND 14 MONTH RATES OF CHANGE.

Abenom-ics does not seem to have turned the Japanese equity market into a trending market from a trading one.


GLOBAL INVESTMENT STRATEGY - WEEKLY REPORT MARCH 21, 2014BCA RESEARCH INC.


Strategy & Market Trends*

EQUITY PRICES / WORLD BENCHMARKS**

BOND YIELDS

SHORT RATES

CURRENCY VS. US$

U.S. FLAT UP FLAT

CANADA DOWN UP FLAT DOWN

JAPAN FLAT UP FLAT DOWN

AUSTRALIA DOWN UP FLAT DOWN

U.K. FLAT UP FLAT UP

EURO AREA UP FLAT FLAT FLAT

EMERGING ASIA FLAT FLAT DOWN FLAT

LATIN AMERICA DOWN DOWN DOWN DOWN

* EXPECTATIONS FOR THE COMING SIX WEEKS TO THREE MONTHS BASED ON A COMBINATION OF OUR ASSET ALLOCATION MODEL, ANALYSIS AND INTUITION. **EQUITY PRICES RELATIVE TO WORLD BENCHMARK EXPRESSED IN LOCAL CURRENCIES.




The purpose of this section is to provide investment ideas independent of our asset allocation model or direct market forecasts. Once recommended, we will monitor the investment recommendation until we close it out.

Strategic Recommendations

This table summarizes our longer-term strategic recommendations. Some of these positions may not necessarily be consistent with our “Tactical Trades”.

POSITION INCEPTION LEVEL INITIATION DATE RETURN COMMENTS

EQUITY RECOMMENDATIONS

LONG GIPS1 100 JANUARY 2014 2.3%

LONG EMERGING ASIA / SHORT LATIN AMERICA 100 JANUARY 2014 -4.1%

OVERWEIGHT JAPAN (HEDGE CURRENCY EXPOSURE) 100 NOVEMBER 2013 -10.5%

UNDERWEIGHT COMMODITY PLAYS2 100 NOVEMBER 2013 5.4%

LONG THE S&P 500 / SHORT OIL 100 OCTOBER 2013 4.1%

FIXED INCOME RECOMMENDATIONS

LONG U.S. 30-YEAR / SHORT U.S. 10-YEAR GOV’T BONDS 96.0 BP FEBRUARY 2014 0.8%

OVERWEIGHT U.K. (REMOVE CURRENCY HEDGE) 100 JANUARY 2007 19.8%

OVERWEIGHT AUSTRALIA (REMOVE CURRENCY HEDGE) 100 JANUARY 2009 41.1%

OVERWEIGHT NEW ZEALAND (REMOVE CURRENCY HEDGE) 100 JANUARY 2009 51.4%

LONG U.S. HIGH-YIELD CORPORATE BONDS / SHORT TREASURYS3 750.0 BP SEPTEMBER 2011 31.4%

LONG ITALIAN 10-YEAR GOV’T BONDS 5.878% AUGUST 2012 39.9%

LONG GERMAN 10-YEAR GOV’T BONDS / SHORT JAPANESE 10-YEAR GOV’T BONDS 100 JULY 2013 7.5%

SHORT SWISS 2-YEAR GOV’T BONDS (HEDGE CURRENCY EXPOSURE) 0.002% AUGUST 2013 0.7%

1 EQUALLY-WEIGHTED BASKET OF GREECE, ITALY, PORTUGAL AND SPAIN. 2 EQUALLY-WEIGHTED BASKET OF CANADA, AUSTRALIA AND LATIN AMERICA. 3 AS OF DECEMBER 7, 2012 RECALCULATED USING BARCLAYS TOTAL RETURN INDEXES FOR HIGH-YIELD CORPORATE AND TREASURY BONDS. NOTE: RETURNS RELATIVE TO BENCHMARK. MSCI WORLD FOR EQUITY RECOMMENDATIONS UNLESS OTHERWISE SPECIFIED. CUSTOM BENCHMARK FOR FIXED-INCOME RECOMMENDATIONS BASED ON GDP-WEIGHTED G10 GOVERNMENT BOND PERFORMANCE.

TRADE INCEPTION LEVEL INITIATION DATE

RETURN-TO-DATE STOP COMMENTS

LONG GREEK EQUITIES 1162.35 JAN 31/14 16.0% 1175 TIGHTEN STOP.

LONG IBEX / SHORT CAC INDEX 2.33 MAR 7/14 -0.1% 2.2

RECEIVE U.S 10-YEAR CPI SWAP / SHORT U.S. 10-YEAR TIPS 2.0% FEB 7/14 2.1% 2.2% TIGHTEN STOP.

NOTE: STOPS ARE BASED ON DAILY CLOSING LEVELS. PLEASE NOTE THAT ALL CURRENCY TRADE CALCULATIONS INCLUDE COST OF CARRY.

Tactical Trades

CLOSE POSITION.




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March 19, 20146-12 MONTHS 2-3 YEARS

U.S. EQUITIES Bullish, medium conviction. Stocks are fully valued. But liquidity settings will remain supportive and profits will benefit from global economic im-provement later this year.

Bullish, medium conviction. Expect 5-6% nominal total return per year.

U.S. TREASURY BONDS Below-average duration, medium conviction. The U.S. economy will improve, although upward pressure on global savings will moderate the rise in yields.

Yields more likely up than down, medium conviction.

U.S. DOLLAR Up, low conviction. The dollar should benefit for as long as EM turmoil persists. However, the path of least resistance for the euro is up in the ab-sence of meaningful ECB action.

Flat, low conviction. A lower dollar makes sense for the US, but other major currencies are hardly attractive.

CHINA Chinese authorities will not let the economy spiral downward, but the main policy focus is structural reform. The main risk is a policy mistake as credit growth slows.

Bullish, high conviction. Aggressive supply-side reforms should improve economic efficiency and the structural appeal of Chinese equities.

EUROPE Use expected selloffs to shift into euro area.

Bullish, medium conviction. Structural valuations now approaching fair value.

JAPAN Equities should recover once EM stress subsides. JGBs “fully priced”.

Bullish bias (equities). Much depends on whether the policy shift is sus-tained as growth and inflation recover.© BCA Research 2014

BCA House View Matrix



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GLOBAL INVESTMENT STRATEGY · Even in dollar terms, the Nikkei has lagged. The direct trigger for...

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