Active Investing in Japan

The DPJ’s rise (and the LDP’s fall) is no longer debate material, but a welcome reality. As expected, the yen exhibited strength, and looks poised to test ¥92. The Nikkei meanwhile was quite volatile, gapping up, hitting a new ytd high at 10,767, tumbling into the start of the afternoon session to a low of 10,423, to close down 0.4% at 10,492. The star of the day, if you will, was the Jasdaq, up 1% to 50.49, right around its ytd high. Of course, now that the DPJ is in power, the real challenge is to keep campaign promises and stick to them, even if there is near-term pain — rather than postponing the pain as has often been the case.

In terms of the markets and forex, the DPJ has almost certainly created a situation for further yen strength (and sustained relative yen strength after everyone piles into the trade and eventually moves on). Domestic-demand stocks, while not immune to certain negative externalities of a strong yen, are likely to be favored over exporters. The exporters, whether they like it or not, will have to get accustomed to a stronger yen. To summarize the first day of trading after Japan’s historic election, it is suffice to say that politics is front and center as it should be, but the market reaction was diluted by both a dose of reality and by the 6.7% selloff in Shanghai.

Interesting developments in the Nikkei ahead of the parliamentary election at the end of this month, which at this point looks as if it will finally bring an end to LDP rule. A foreign exchange rate of $1/¥94 would have been practically inconceivable prior to the “Lehman shock” (as the Japanese refer to the genesis of the financial crisis), let alone a stock market rally. And now, ahead of what appears to be a DPJ (opposition party) that will let the yen appreciate and focus more on domestic demand (rightfully so), the stock indices are showing no fear of the yen.

A sustained rally in conjunction with even more yen appreciation bodes especially well for the domestic-oriented stocks, of which there are plenty — many that still have saliva-inducing valuations. However, exporters remain the headline grabbers, and it is not clear just how much yen strength can or will be tolerated (one suggestion is ¥87 is the trip wire, a level reached early this year, and a level not seen previously since the mid-90s). That being said, again what makes this all very interesting is that although the strong yen makes Japanese exports less competitive (great instead for instance, for South Korea (EWY: 48.43 +0.21%), it does allow them to invest more in production overseas, a win-win for the Japanese and local FDI recipient economies.

What worries me though is the pace of reform(s) versus expectations, assuming a DPJ victory. Meantime, there is no debating the fragility of the domestic/global economy and the recovery thus far in equities. Domestic and overseas investors are very fickle and just as quickly as money has been flowing in, it can reverse course equally as quickly. The seemingly conservative, opportunistic play would be to go long the yen (FXY: 109.57 -0.03%). The DPJ’s financial advisors (and by extension, one of them possibly being tapped as finance minister) have already gone public saying they don’t intend to intervene in forex, except in extraordinary cases. Another play would be to look at the smaller-cap funds like (DFJ: 41.17 +0.56%) and (JSC: 39.78 +0.65%), but unfortunately, these are not very liquid and are quite fragmented. Time-permitting I will look at posting some specific stock picks.

At the time of publishing, the author does not own any long/short positions in the funds mentioned.

“Recession ends in Japan,” and headlines to that effect portray a different picture than the real one on the streets. In fact, despite the headline rebound in GDP, propping open the hood shows that the outlook for Japan is a return to status quo, little to nil export-driven growth at best, and raises the likelihood of further deterioration. The Nikkei and other benchmarks have had a nice run along with the pretty much global equities rally. However, the GDP was baked in, thus the opportune profit-taking, and meanwhile, serious issues persist, such as a lack of domestic demand and industrial over-capacity.  Even without further government stimuli and/or a return to conspicuous lending and consumption in the West, it is not clear there is any impetus for either the Japanese government or the nation’s biggest companies to take steps in fostering a more balanced economy.

At the time of publishing, the author did not have open long or short positions on any Japanese benchmark index/fund.

In 1996, in The Future of Capitalism, Lester Thurow observed the following:

When a run against the dollar starts, there are enormous amounts of money that can, and will, move into appreciating currencies. Sixty percent of official reserves and 50 percent of private reserves are currently held in dollars. Those funds will certainly move, but they will be a small fraction of the total funds avalanching down the slope. Financial speculators will pile on the downward trends in the dollar and the amounts moving will be  many times the world’s dollar holdings …. Those whose debts are denominated in the appreciating currencies (most likely yen and marks) will find the real value of their debts explode — evaluated in their own currency or dollars. Many will be unable to repay their yen- or mark-denominated loans. Financial institutions in Japan and Germany will take big losses as foreigners default on their loans.

Mr. Thurow’s observation suggests that the yen would appreciate — something it has done and sustained since Sept. ‘08. However, the implications of an even more significant surge in the yen (with a corresponding plunge in the dollar), suggests that it would be detrimental to Japanese financial institutions — and we have witnessed the kind of mayhem that problems at banks can bring to the broader economy, let alone the effects of currency appreciation on exporters.

It seems then, that a lot of the presumed yen appreciation would be short-lived, since damages to the financial sector would likely result in downward pressure on the yen. What is not readily clear today, is how much exposure the financial system, excluding the BoJ/MoF, has to the dollar. In fact, given the significant foreign reserve holdings of the BoJ, it could be the case that a run on the dollar, while certainly resulting in chaos initially, would compel the government to finally look beyond the current account and do much more to encourage domestic-demand.

US$/JPY 2-year chart (source: Yahoo! Finance)

At the time of publishing, the author had no position in JPY/USD.