Why the TOPIX index might finally make new highs after 25 years

Peter Tasker's article reflects on what is going right in Japan and why after 25 years the TOPIX index might finally break upwards through the 1800 barrier. At the very least, it should be food for thought for those who are still bearish on Japan's future.

Colour coded queues

Back from six days in Japan, I never cease to wonder at how central Tokyo functions so efficiently.   Imagine Shinagawa Keihin Kyukoo (ie. Tokyo Yokohama express) station, where one of the Haneda airport shuttles departs from.  Trains depart from each platform every three minutes and passengers queue in one of four colour coded areas on the platform at each door, with a separate area for those exiting the trains.  When the train comes in, the appropriately coloured queue streams on board.  The station announcer sits on a dais a few feet higher so he can see what’s going on.  I did notice green coloured ‘walkways’ on the Victoria line platform at King’s Cross on my return but they were broadly ignored by Londoners.  It is two years since I last visited Japan.  There’s no doubt more of a spring in their feet: the crane count is up, employment is close to full in real terms and there is more appetite for risk taking at the individual level.  But there is a greater realism that Japan’s future depends largely on what the US and China decide and, as elsewhere in the world, the millennial generation is choosing not to make large purchases, which makes it more difficult for companies to incentivise them. Out in the boondocks, it looks much more subdued.  We drove down empty motorways and stayed at onsen (hot spring resorts) which had as many foreigners as Japanese staying.  Local town centres continue to hollow out and the number of uncultivated paddyfields - unthinkable ten years ago because of the tax advantages of being a ‘farmer’ – continue to grow.  When a mountain road was closed for repairs, there was a female (again, that would not have been thinkable ten years ago) construction worker there to tell us which way to go, despite there being a map as well.  You can read that as hidden unemployment or as a sign of Japanese attention to detail.It is also not a revelation that Japan is much better at dealing with its elderly population.  My mother-in-law, who suffers from a mild form of dementia, lives with my sister-in-law and husband. Both have jobs, so she is picked up from home every day by carers and taken to a day care home, where she can have a bath, is able to do a range of activities and, above all, can socialise.  In the evening she is delivered back home just before my sister-in-law returns.  The cost is below £50 a day.   It must be a kinder way of dealing with the problem than what happens here in the UK. Whither Japan?  In my last blog, I came off the fence on the side of the bulls, mainly because I believe Japan is so connected to the recovering Chinese behemoth.  My visit confirms that the recent encouraging macro-economic domestic data is consistent with what is happening on the ground.  However, demographics and a less than entirely functional financial system – even after many bank mergers – may hold it back. To find out more about Linchpin's advice and support in Japan click here.​

November update on global liquidity

As regular readers of the Linchpin blog will know, I am presently upbeat about China’s prospects and consequently for other economies in Southeast Asia.  Our friends at CrossBorder Capital have released end October data on money and credit flows, which corroborates this picture.  While global liquidity is still about neutral (48 on a scale of 0 to 100), and China’s a bit higher than average, capital flows are heavily skewed towards China and Southeast Asia.  We think this is safe haven money which fled in 2015/6, and is now being invested into these economies as returns on investments improve again.  The combination of adequate liquidity and strong capital flows is quite bullish for these equity markets, at least for the time being. Other trends remain in place: the Eurozone and the UK are at the top of the liquidity cycle while the US looks very late in the cycle.  Given domestic Japanese liquidity remains low, the strength of the Japanese stockmarket seems to be because it is increasingly in the Chinese orbit.  However, we are less positive about the Japanese market than some commentators right now, particularly after its post-election rise. If you would like to read CrossBorder’s update, which represents the most timely macro-economic data available, it is available for purchase here. ​

Investors, watch the People's Bank of China!

At 31 trillion renminbi the People’s Bank of China (PBOC) is now the largest central bank in the world by some margin.  It also operates differently to other banks in one crucial respect - it sets domestic banks overnight reserve targets rather than operating through reserve maintenance windows which allow some flexibility.  This gives it more direct control over domestic credit, as can be seen by the fact that over the last 40 years the credit multiplier (ie. the ratio between the total pool of credit, including shadow banks, and the PBOC’s balance sheet) has remained almost unchanged at about five times.  In contrast, both the US and the Eurozone’s equivalent numbers have varied by about 400%, demonstrating that the Federal and the Reserve and the ECB have more limited control over their economies. An important consequence of this is that interest rates and bond yields, which we have always seen as the ‘price’ of money’ rather than a policy tool anyway, do not give any signals about the PBOC’s policy stance.  The clearest signal of domestic monetary policy is given simply by the size of the balance sheet. In 2015, there was a 15% tightening, both in order to ensure the Chinese currency was included in the IMF’s SDR basket and also as part of an anti-corruption drive.  This resulted in a sharp contraction in the economic growth rate, capital outflows, and sharp falls in equity markets both in China and other Emerging Markets.    Today the balance sheet is growing at a 12% annualised rate.  In our view, this is clear evidence of easier monetary policy, which will in turn lead to a faster growing Chinese economy.  As well as Chinese markets, other Emerging Markets and Japan and commodity prices can be expected to benefit.   Some commentators are misled by rising bond yields, currently 4%, believing this is a signal of tighter monetary policy and a faltering economy.  In contrast, we see this simply as a higher ‘price’ of money as economic confidence returns and appetite for safe assets declines. It is not all good news: if the PBOC has more control over its domestic economy than western banks, it has the ability to turn the taps off as well as on.  The next major financial crisis may well emanate from this source.  That is why we say all investors need to watch the Chinese central bank. Our data comes from our friends at CrossBorder Capital, who have published a more detailed analysis on this subject and have for many years kept a careful eye on Chinese monetary policy.  If you would like to purchase their report, please email us on research@linchpin.uk.com. ​

Japan - coming off the fence on the side of the bulls

I wrote an update a few weeks ago on Japan (‘Japan - Glass Half Full? Or Empty?') arguing that the market is being pulled between positive and negative factors.  At that time, I sat on the fence which way it would fall but things have, as is their wont, moved on. Most obviously, Prime Minister Abe now looks likely to call an election this autumn on the back of a disorganised opposition and North Korea’s provocation.  He may still look at the spectre of Theresa May and draw back, but it is probable that he will win a mandate out to 2021.  This would give him another four years to wear down the bureaucrats, particularly in the Ministry of Finance, who form the stoutest opposition to Abenomics. It is also becoming clearer that the Chinese economy has weathered the travails of 2015 and is on its way back up.  The evidence is in the capital flowing back into China, as much as the headline data. This is important to Japan, which since the war has developed from being an outsourced manufacturing offshoot of the US economy (I exaggerate, of course) to a producer of high-end goods for the world.  They now find themselves primarily as an intermediate goods producing satellite of greater China’s: for example, consumer goods imports from China are very roughly equivalent to exports of intermediate goods back there, in considerable contrast to Japan’s trade surplus with the US.  At a simplistic level, a stronger Chinese economy can only be good for Japan. There is also the suggestion from our friends at CrossBorder ('Japanese Monetary Policy in a Chinese-Dominated World') that that as their economy has become more linked to China’s, Japanese monetary policy has shifted too.  Historically their focus has been on preventing extreme yen strength against the US dollar but it looks as if it is turning to a more pro-cyclical one of aiming for currency stability against a basket of Asian currencies.  It may be a symptom of this change that, whereas historically a strong yen/dollar exchange rate has tended to mean a weak Japanese equity market, over the past couple of years we have seen periods of market strength at the same time as the yen has strengthened.  What does this mean for the Japanese equity market?  I will come off the fence and suggest it is probably positive overall, mainly because a renewed Abe term reduces uncertainty and it appears that Japan has found an economic model to replace the post-war one based on the US.  But I’m not as bullish as some: the scope for policy error remains, foreign investors are no longer underweight and Japanese corporate cashflow remains subdued, albeit slowly improving.​

JAPAN - GLASS HALF FULL? OR EMPTY?

The Japanese stockmarket has doubled since late 2012, but the TOPIX index is still beneath its early 2015 highs, albeit the trend has been a rising one in the past twelve months.    There are strong positive as well as negative forces at work, and it is still unproven which will win. The bulls point to the re-emergence of inflation, now fairly consistently running at 0.5% in the country and probably higher in Tokyo, and consequently some nominal GDP growth after twenty years of no progress.    2nd quarter GDP’s initial estimate came in at a 4% annualised figure.  The ‘glass half full’ crowd look at the close links with the Chinese economy, which is undoubtedly on a recovery track, and the achievements of Abenomics in nurturing some green shoots and even some animal spirits domestically.   Labour market tightness and credit growth are both at highs not seen for several decades.   At the corporate level they point to improving corporate governance, conservative accounting, low levels of leverage, and relatively low valuations placed on earnings streams. The bears, on the other hand look at the lack of funding liquidity in the economy, and in particular the inability of the corporate sector to generate cash.    On the liquidity analysis I follow (see the Liquidity pages on this website),  Japan is absolutely bottom of the Developed Markets with a score of 21 on an index of 0 to 100.     Demographics is another big stick with which to beat Japan, though other countries, even China, are rapidly finding themselves facing similar problems. After nearly five years of Abe’s  predominance, opposition is beginning to emerge.   The pretext is a fairly minor scandal, and other politicians such as Ishiba and Kishida are beginning to position themselves as alternative Prime Ministers.  But, as Peter Tasker  points out in his blog, the real opposition is the financial bureaucracy in the Ministry of Finance, who still do not ‘get’ Abenomics.  The risk is that Abe’s successor, if there be one, is not sufficiently heavyweight to be able to face the latter down, and Japan makes yet another policy mistake by raising taxes. My view is that none of this will derail Japan’s long term future:  it is set on the path to recovery from its deflationary era.   It will benefit from both its closeness to the Chinese economy, and also increased spending as a result of military tensions around North Korea.   However, I am more ‘glass half empty’ on the stock market:  political uncertainty and lack of liquidity is not the best of backgrounds. I shall be visiting Japan in early November, and will update this blog after my visit.​

WHAT WILL MAKE THE LOW VOLATILITY TREND CHANGE AND WHICH STRAWS IN THE WIND SHOULD INVESTORS BE WATCHING? 

The VIX index has recently hit all-time lows: a conundrum for investors  who see gathering signs of cracks appearing in the US edifice, such as poor economic data, a sliding US dollar, political logjams hurting prospects for healthcare and tax reform, high stock market valuations and a US Fed seemingly committed to reverse QE and raise rates. Our friends at CrossBorder Capital have written a report looking at how the various volatility indices covering bonds, equities, and currency interact with each other, in an attempt to understand what might break the current low volatility trend, and what investors should watch.  They argue that volatility moves between extended periods of high and low risk, and that bond volatility indices such as the Merrill Option Volatility Estimate (MOVE) index exhibit a causal relationship with forex and currency - ie. investors should watch them first and foremost.     What might change the trend?  According to CrossBorder’s analysis, traditional liquidity factors such as Linchpin use, and the Federal Reserve’s ‘Forward Guidance’ statements on the path of policy rates are more powerful predictors of MOVE than term premia or the level of quantitative easing or moderating.   Of course, there are also known and unknown political factors, such as the spat with North Korea, which may well turn out to be the catalyst for a change in the volatility trend.  In the absence of these, it’s yet another argument for keeping a close eye on liquidity, as we do at Linchpin. If you would like to purchase the CrossBorder article, please email us on research@linchpin.uk.com or find out more through the liquidity page on this website. 

japanese corporate governance

At a seminar a couple of weeks ago, I heard an ESG expert call the standard of corporate governance in Japan ‘extraordinarily low’.  I challenged him at the end of the session, pointing out that Japanese corporates tend to make decisions based on the very long-term, which was precisely the behaviour we are trying to encourage.  I also reminded him that in 2015, as part of the Abenomics reforms, Japan adopted a Code of Corporate Governance which is almost identical to the UK’s. The Japanese, unlike some nations, tend to obey laws. In the ensuing debate it was pointed out, quite correctly, that Japanese boards tend to have little diversity and rarely include foreigners; that shareholders are still some way down the pecking order, compared to in the US or the UK; but that governance in Japan is improving faster.  I would add that Japanese corporates do not have the same incentive to boost profits since corporation tax, rather than executive pay, is based on reported earnings per share; as a consequence that number tends to be conservative. The empirical evidence is in Japan’s favour too.  When we look at where the world’s major scandals and governance problems have come from in the past 20 years, they have almost all emanated from the US: Enron, subprime, the banking crisis… There will always be rogue companies, and Japan is no exception, but there has been an interesting shift over the past few years.  The Olympus scandal which broke in 2011 - where management had been misreporting profits over many years - was only uncovered when a gaijin (ie. a non-Japanese) manager took over.  It was an old-style Japanese governance failure, ie. management covering something up to avoid personal shame or embarrassment.  However, the Toshiba debacle this year was much more similar to bad governance in the West - poor decisions were made based on incomplete, ineffective or non-existent corporate governance procedures, but not for personal reasons. While an ‘extraordinarily low’ corporate governance standard is certainly not the case, how are shareholders treated in Japan today?  The level of buy-backs in 2016 at 5.3tr yen was some 60% higher than in 2015 and dividends at 11tr yen were 10% higher.  The buy-backs were generally done out of cash reserves and not via increased leverage, as is so often the case in the West.  It is also worth noting the increased level of mergers and acquisitions as zaibatsu slowly unwind the links of the last 70 years by selling or buying in quoted subsidiaries.  What’s more, these transactions tend to be done at premiums, which historically was not always the case. Japanese corporate boards tend to reflect the society, which is more male-dominated and certainly more homogenous (call it xenophobic if you prefer).  The corporate structure will always be closer to the European model where shareholders are one of a number of important stakeholders rather than the US one where shareholders are the top priority.  However, I would have more trust in the sustainability of a Japanese company’s earnings than its equivalent American one, simply because Japan still has its long-term culture in place.  I do also buy the argument that improvements in Japanese corporate governance are accelerating which, at the margin, is likely to lead to improvements in share ratings. 

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