Ja­pan’s mo­men­tum trade

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

The com­bi­na­tion of a broadly sta­ble macro-eco­nomic back­drop, plen­ti­ful cen­tral bank liq­uid­ity and low mar­ket vo­latil­ity has been kind to in­vestors this year. The year-to-date per­for­mance of most ma­jor eq­uity mar­kets has con­verged, re­gard­less of any di­ver­gence in fun­da­men­tals or profit trends. If noth­ing rocks the boat, there is no rea­son to be­lieve that the cur­rent mo­men­tum can­not con­tinue. In that case, will Ja­pan, which lagged other ma­jor mar­kets over the first few months of the year but which has be­gun to play catch up in re­cent weeks, be able to sus­tain its rally?

We are skep­ti­cal about claims that ‘this time is dif­fer­ent’ for Ja­pan. De­spite all the hype sur­round­ing prime min­is­ter Shinzo Abe’s prom­ises of re­form, so far lit­tle has been done that raises Ja­pan’s po­ten­tial growth rate. Nev­er­the­less, the Ja­panese mar­ket of­fers tac­ti­cal op­por­tu­ni­ties aplenty.

Against the cur­rent global back­drop — with de­cent global growth and a mod­est in­fla­tion trend, to­gether with a group of cen­tral banks (in­clud­ing the BoJ) ready to act at the first signs of trou­ble — Ja­pan does not need to do much to keep its rally go­ing. A con­fir­ma­tion that the econ­omy isn’t fall­ing out of bed would prob­a­bly be suf­fi­cient.

Over the first few months of 2014, the Nikkei de­cou­pled from one of its most re­li­able in­di­ca­tors, un­der­per­form­ing rel­a­tive to an in­dex com­posed of the yen’s ex­change rates against the US dol­lar and the euro. The sell-off in eq­ui­ties over the first four months of the year de­spite the yen’s sta­bil­ity re­flected in­vestors’ con­cerns that April’s hike in the sales tax rate could lead to a re­peat of 1997, when Ja­pan sank into re­ces­sion fol­low­ing an ear­lier sales tax in­crease.

But as we have pointed out be­fore, Ja­pan has learnt its les­son. The 1997 tax hike was ac­com­pa­nied by a with­drawal of other stim­u­lus (like health­care ben­e­fits) which to­gether took JPY 9trn out of con­sumers’ pock­ets. This time around Ja­pan has off­set the pain with tem­po­rary fis­cal re­lief. The neg­a­tive ef­fects of the 1997 tax hike were also mag­ni­fied by the im­pact of the Asian cri­sis. Now, how­ever, Ja­pan’s neigh­bours have mostly re­paired their bal­ance sheets. And al­though China has ac­cu­mu­lated a lot of do­mes­tic debt, there is no ob­vi­ous trig­ger for a sys­temic cri­sis. In­stead, the ef­fect could even prove pos­i­tive for Ja­panese eq­ui­ties, as a grad­ual re­duc­tion in China’s growth po­ten­tial will help to cap global in­fla­tion­ary pres­sure, fa­cil­i­tat­ing the global mo­men­tum-driven party.

In truth, the Ja­panese econ­omy shows no signs of fall­ing out of bed. The in­di­ca­tors are all point­ing to the same mes­sage: the worst has passed. Last month, con­sumer sen­ti­ment reg­is­tered a month-on-month rise hav­ing slumped for six months in a row.

In May’s Econ­omy Watch­ers Sur­vey the dif­fu­sion in­dex for cur­rent eco­nomic con­di­tions im­proved to 45.1 from 41.6, sug­gest­ing that the neg­a­tive im­pact of the con­sump­tion tax hike may be short-lived. The sur­vey’s out­look for the next two to three months also rose, reach­ing 53.8, its sec­ond month in a row above 50. For in­vestors, the ques­tion now is whether the rally can con­tinue as the eq­uity mar­ket catches up with the cur­rency in­di­ca­tor. It would be too much to ex­pect a weak­en­ing cur­rency to pro­pel fur­ther gains, as signs that the econ­omy has bot­tomed out mean the BoJ will be more likely to sit on its hands. So will the stock mar­ket be able to break its tie to the yen once again, this time on the upside? Pos­si­bly. A cor­po­rate tax cut to be­low 30%, due to be an­nounced this month, could be one promis­ing trig­ger.

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