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.​


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.​


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. 

Peter Tasker reflects on abe's visit to america

Peter Tasker comments on what Abe's recent and apparently successful visit to the new President of the United States means for US-Japan relations in the future. He makes the point that while the rounds of golf were an excellent start, Trump will require some reciprocity from Japan, just as he is from Europe. Will Mexico be the loser if Japanese companies decide to make new investment inside the US rather than outside?     Peter is, among other things, a well respected commentator on Japanese politics and economics for nearly 40 years. William used to work with him in the mid 1980s in Tokyo.