Is the Sun finally rising?

The country of Japan has (in economic terms) been a write-off for a very long time. But a few things have happened over the past couple of years that are indicating that the Land of the Rising Sun may well be entering a new dawn. Before getting over-excited, it's worth noting what a very wise friend (who has had the unfortunate luck of being in the business of Japanese long/short equity) once told me - "Remember: the Japanese always disappoint". He is, of course, right: there have been false recoveries in 1992, 1995, 1999, and finally in 2005, all of which either petered out or were crushed by serious policy-mistakes.

There is no doubt that Japan has just experienced a very deep recession, but it was a very different recession to that experienced in the West - namely, it was export-led, and businesses were very quick to slash Industrial Production to levels not seen since the early-1980s. Since the dark depths of Q4/Q1, there has been something of a rebound, but it is highly unlikely that consumer demand from the US and other Anglo-Saxon economies will be anything like it has been over the past 25 years (I will cover this in detail in an upcoming post). And for all the noise about China, I find it hard to believe that the Chinese will import significant amounts of consumer goods from Japan in the medium-term - it is very much following a policy of "in-sourcing" - specifically, sending people abroad to acquire the expertise to produce high technology goods and then making its own cheaper versions. So China's rebalancing is good for China, but not really for anybody else (again, I'll do some work on this for a later post). So if Japan is to keep nominal GDP from falling, it is going to have to find an alternative to export-led growth.

The good news is that I think that Japanese policymakers "get it". Or at least some of them do to certain extents. The first example of this is that despite a relatively large (40%)and rapid (18months) appreciation of the Real Trade-Weighted Yen, the MoF/BoJ did not intervene in the the FX market. Since then, it has rebounded about 12%. Certainly, there were noises made when the moves in the JPY became disorderly, but I am reliably informed that the BoJ do not view the Yen as being overvalued, despite the many Investment Bank research departments that do. To see this, take a look at the below chart, showing the Yen as being at about the same levels it was in 2005 (or when USDJPY was hovering around 110). As can be seen from the chart, the real issue was the serious undervaluation of the Yen between 2003 and 2007.

Secondly, the Japanese have enacted an exceptionally large amount (nearly 100trn Yen) of fiscal stimulus over the past year in stark contrast to the half-hearted attempts of the 1990s. They are serious about trying to stimulate domestic demand. And this time, it looks as though the Japanese Consumer (who has been AWOL since 1990) actually wants to spend: opinion polls are predicting a landslide victory for the Democractic Party of Japan (DPJ) who basically have a single-policy platform to stimulate domestic demand.

Specifically, the DPJ have announced (i) that they do not object to a strong JPY, and have floated the idea of the US issuing JPY-denominated USTs, (ii) that they want banks to lend more both to businesses and to households, and (iii) that they wish to move away from the traditional strategy that has been followed by Japanese policymakers of exiting recession via an export-led recovery in favour of supporting consumption.

The first of these tenets has been discussed above, but it is also worth noting the advantages of a strong Yen. Firstly, it encourages Japanese to repatriate their overseas financial assets (although this seems counter-intuitive, there have been significant investment losses that will be cut, and with Japanese baby-boomers retiring, money needs to come back home to fund retirement). Secondly, it increases the purchasing power of the domestic consumer - it is often said that the Japanese regard foreign goods as inferior, but that misses the point: many of the constituent ingredients of Japanese goods come from abroad, and in fact, many of them are produced abroad, just having a SONY label put on them before they are sold. Thirdly, it forces the rebalancing of the economy as Japanese exports become less-competitive on global markets.

On the subject of bank lending, although the Japanese statistics have been revamped a few times over the past 20 years, it's possible to see from the below charts that credit outstanding (after shrinking post-1997, when the banking crisis became acute) began to grow again in 2005. Despite dipping down over the past year, it is still in a broad uptrend. As Richard Koo has pointed out, when the NPLs in the banking system had been cleaned up as part of the 2003 Koizumi reforms, both loan demand and supply returned and Japan was able to grow. This is important, because the banking crisis in the West has put Japanese banks in a competitive position, as they have both (relatively) clean balance sheets and political backing to expand. These is clearly a significant positive for domestically-orientated corporations looking to expand investment and also to consumers.

But what of domestic consumption? It has clearly been the case that consumption has collapsed in Japan on the back of the recession, but the effects of the fiscal stimulus already enacted, and the DPJ's pledge to enact another stimulus aimed at increasing spending should help. Indeed, it has also been floated a few times that a one-off generational tax-break might be enacted, allowing the asset-rich over-50s to pass a portion of those assets to their children. This is important, because many in their 20s & 30s have no recollection of the late-80s asset bubble that has so clearly affected consumer psyche and encouraged domestic saving. There is a corollary here related to the ability of banks to extend credit to households - with some form of financial assets behind them, these uncorrupted consumers will be less likely to be scared by borrowing and spending.

There is another, slightly unrelated, reason why I am getting enthusiastic about Japan. As a colleague's teenage daughter recently pointed out to him - Japan has all of a sudden become "cool", while America has become decidedly "uncool". As an example, how many people have noticed the relatively recent appearance on the High Street of affordable Sushi restaurants such as Yo Sushi, Itsu etc. and Japanese fashion brands such as Muji? It is also striking to see the closure of many branches of American-branded shops such as Starbucks, GAP and Borders. There are likely to be spill-over effects over the next few years as Westerners come to view Japan as a more regular tourist destination.

So how can we capitalise on this? There is the obvious Long Yen trade, but that is likely to be noisy and the levels are perhaps not as great as they have been. But what is interesting to note, is the extent to which the (exporter-dominated) Nikkei has outperformed the (domestic company-dominated) Topix - a striking 10% since March, and the ratio of the two is now at its highest since 2000. To a certain extent this is a result of the momentum-based nature of the risky asset rally since March, but given the strong history of mean reversion in Japanese equities and what appears like a real desire by the Japanese to change their ways, looking for Topix outperformance seems like a great way to play this rebalancing.

Then again... the Japanese always disappoint...