Yen in the hands of for­eign­ers

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

Hav­ing traded in a tight range since late last year, the Ja­panese yen made a tech­ni­cal break­out last week, weak­en­ing be­yond JPY 125 to the dol­lar for the first time since 2002. While Bank of Ja­pan Gover­nor Haruhiko Kuroda came out to jaw-bone against more falls, higher volatil­ity is a worry for in­vestors who have grown used to mak­ing Ja­panese eq­uity gains in US dol­lar terms. We would stick with Ja­panese stocks which con­tinue to ben­e­fit from strong earn­ings and a gov­er­nance-linked re-rat­ing, but sug­gest the adop­tion of a yen-hedge—this is cheap to buy and has lim­ited down­side as there is lit­tle chance of a ma­jor yen strength­en­ing.

The value of a cur­rency is the price where the sup­ply and de­mand of cross-bor­der cash flows bal­ance out: price is set ac­cord­ing to mar­ginal shifts in the sup­ply and de­mand of such cash flows, which con­sist of the trade bal­ance — sur­plus or deficit — and cap­i­tal move­ments.

Since 2008, the fo­cus has shifted from a “carry trade” dy­namic — such that economies with the lower real in­ter­est rates saw cap­i­tal out­flow to places with higher rates — to one dic­tated by the rel­a­tive size of cen­tral banks’ bal­ance sheets. With most de­vel­oped economies hav­ing cut rates to zero, the swing fac­tor has be­come the rel­a­tive size of as­set pur­chase pro­grams. On this ba­sis we showed in De­cem­ber that the yen should reach JPY 125 to the dol­lar by mid-2015.

Stick­ing with this for­mula, the yen should fall to JPY 140 to the dol­lar by the end of 2015. Whether this hap­pens de­pends if the bal­ance sheet size-cur­rency re­la­tion­ship of the last seven years con­tin­ues to hold.

This is where Kuroda’s com­ments come in: the key rea­son he cites for the yen not fall­ing more is that it is al­ready very cheap. He has a point as the yen looks to be the de­vel­oped world’s most un­der­val­ued cur­rency — both on a pur­chas­ing power par­ity ba­sis and when com­par­ing its real ef­fec­tive ex­change rate to both its 10-year av­er­age and 10year trend.

There can be no doubt

that Ja­panese


are again su­per-com­pet­i­tive in global ex­port mar­kets. In ad­di­tion, Ja­pan is shift­ing fo­cus so that a top pri­or­ity for firms is share­holder re­turns. The re­sult should be that earn­ings growth is no longer just a func­tion of move­ments in the cur­rency as has been the his­tor­i­cal re­la­tion­ship. Taken to­gether, the com­bi­na­tion of bet­ter-run com­pa­nies and a cheap yen mean that Ja­panese as­sets are a steal. As a re­sult, cap­i­tal flows should con­tinue to en­ter Ja­pan, pro­vid­ing a coun­ter­vail­ing force to the de­val­u­a­tion pres­sure from the BoJ print­ing JPY 80 trln a year. On this ba­sis, we think the down­side to the yen has rea­son­able lim­its.

The Ja­panese gov­ern­ment also wants to see a slow­down in the yen’s de­pre­ci­a­tion as the mar­ginal cost of fur­ther declines is start­ing to ex­ceed the ben­e­fits. Of­fi­cial logic runs that a more pre­dictable en­vi­ron­ment is con­ducive to firms mak­ing bold cap­i­tal spend­ing de­ci­sions and sus­tain­ing re­fla­tion. Hence the BoJ is likely to con­tinue talk­ing up the yen, but in the event of fur­ther moves down, it will prob­a­bly en­cour­age a ro­ta­tion to­ward do­mes­tic eq­ui­ties on the grounds that they of­fer value.

Putting these fac­tors to­gether, it is in Ja­pan’s in­ter­est to main­tain a rel­a­tively sta­ble yen. The swing fac­tor is likely to be the ex­tent to which for­eign in­vestors are drawn into the coun­try’s fi­nan­cial mar­kets. In this sce­nario, main­tain­ing a yen hedge is likely to cost lit­tle, while eq­uity ex­po­sures should de­liver out­size re­turns. Should for­eign in­vestors fail to rec­og­nize the Goldilocks sit­u­a­tion in Ja­pan of growth that is hot enough to sus­tain cor­po­rate prof­its, but no so strong as to spur mon­e­tary tight­en­ing, then the hedge will serve its pur­pose.

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