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Global Top Cat

Betting on Japan

By Yiannis G. Mostrous, on Nov. 13, 2014

Next year, we’ll find out whether Prime Minister Shinzo Abe’s “three arrows”—fiscal stimulus, monetary easing and structural reforms—will hit their target, stimulating Japan’s ailing economy and pulling the country out of stagflation.

The biggest x factor remains the implementation of much-needed reforms to taxes, labor policies, agriculture, immigration, education, social spending and the electoral system.

However, the arrows of fiscal stimulus and monetary easing have hit their marks, with the Japanese yen falling to US $0.009 from US $0.0116 at the end of 2012—an outcome that the market widely expected. Even college investment clubs have appeared on CNBC explaining why they had decided to short the yen.

(Click graph to enlarge.)USD JPY TOPIX

Weakness in the yen increases the price competitiveness of Japanese exports in the global marketplace.

A weaker Japanese yen also benefits Japan because the nation is one of the world’s largest net foreign creditors. Assets denominated in a foreign currency, account for 60 percent of Japan’s gross domestic product (GDP), whereas liabilities are yen-denominated; a weaker domestic currency increases the value of these foreign assets.


Not surprisingly, Japanese equities rallied when the yen started to tumble in early 2012.

But Japanese authorities understand that a weak yen isn’t a cure-all. Nevertheless, some investors and commentators fixate on the depreciating currency and its implications, losing sight of the bigger picture.

For example, a weaker yen squeezes consumers, forcing them to pay higher prices for the imported energy needed to run Japan’s power plants. The shutdown of much of the nation’s nuclear reactors after the Fukushima-Daiichi disaster has exacerbated this problem.

And dollar-denominated exports have failed to pick up materially, reflecting weakness in the global economy and Japanese companies opting to build more of their production facilities overseas to counter high domestic energy costs.

As a result, Japanese exports declined 3.2 percent from year-ago levels over the first eight months of 2014. However, manufacturers’ overseas production ticked up.

Policymakers have come to the realization that quantitative easing alone won’t solve Japan’s economic woes.

In September, Bank of Japan Governor Haruhiko Kuroda told attendees of the Jackson Hole Economic Policy Symposium that the central bank had committed “to continuing the increasingly accommodative stance until the 2 percent inflation target is met and maintained in a sustainable manner.”

Kuroda also indicated that Japan would need “some kind of mechanism” to bolster real wages.

These comments suggest that the Bank of Japan will try anything to combat deflation. Although investors shouldn’t rule out more quantitative easing, policymakers appear to be dedicated to pursuing other means to stimulate inflation.

(Click Graph to Enlarge.)Japan Core Inflation

We expect structural reforms to be on the table if Japan’s GDP doesn’t improve and the government increases the sales tax to 10 percent from 8 percent next year.

If the government opts not to go ahead with the previously announced tax hike, the market could interpret this decision as a sign that Prime Minister Abe’s economic program has failed—a major negative for equities and the economy.

At the end of October, the Bank of Japan will publish its semiannual review of the economy, a report that could include a downward revision to its GDP growth forecast. This adjustment wouldn’t come as a surprise. The Bank of Japan’s current projection calls for GDP to expand by 1 percent, while the consensus estimate hovers around 0.5 percent or less.

Japan’s real GDP decline at an annualized rate of 7.1 percent in the second quarter, led by the contraction in private consumption that resulted from the first round of increases to the sales tax.

Japan’s equity market offers respectable values at this juncture. The Tokyo Stock Price Index trades at about 1.28 times book value—not a trough valuation, by any stretch of the imagination, but much lower than its long-term average of 1.64.

(Click graph to enlarge.)TOPIX PB

Corporate earnings have also held their own, with members of the Tokyo Stock Price Index growing their second-quarter net income by 3 percent from year-ago levels.

In addition, nominal employee compensation rose by 1.6 percent from year-ago levels in the second quarter, while labor force participation also ticked up to 59.5 percent in August.

Asset values have also increased, with real estate prices in central Tokyo posting big gains. Official government estimates indicate that land prices ticked up by 4.7 percent relative to the second quarter of 2013.

Our positive outlook for Japanese equities remains undimmed for patient investors who could reap the rewards if the Abe government manages to end deflation.

Although Japan has another year to implement the structural changes needed to foster GDP growth, the asset reflation cycle and a potential expansion of the central bank’s balance sheet should support equities and the domestic economy.

We have updated all of our top 5 Japanese equity positions. See which bets we’ve made when you subscribe to Capitalist Times Premium.


Yiannis G. Mostrous contributes his expertise in emerging markets and international equities to Capitalist Times in his Global Top Cat columns.

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