04 August 2019

All eyes on the strengthening yen as BOJ's options are all but exhausted
Trade conflicts have once again given an otherwise, bullish US stock market another jolt and as usual, has taken Japan down with it. As we mentioned last week, the strength of the yen against the dollar which itself is appreciating against Euro and Yuan is another key negative factor for the Japanese market. With BOJ clearly boxed in with its option to reflate looking very limited, the Japanese currency looks likely to appreciate much further. Having broken down below its key short term support of 107, the yen/dollar rate is heading towards early January lows of 105 when the stock markets bottomed.

Corporate earnings projections look set to be notably revised down next season
Corporate forex projections are being readjusted to around 108 level although most firms have refrained from revising down earnings estimates until they get a better sense of market conditions by the end of this quarter. Indeed, having seen the bulk of Japan's corporate earnings so far, we should see notable downward revisions in analyst projections, particularly for next year where many had expected a strong recovery.

US/China Trade dispute unlikely to be resolved anytime soon
With US/China trade talks having been concluded fairly quickly last week, there were already signs that China was no longer in much of a hurry to clinch a trade deal. However, Mr Trump's tweet last Thursday that he will impose an extra 10% tariffs on $300bn worth of Chinese exports of high-tech goods removed any possibility of a swift resolution as China has been demanding that all tariffs introduced under Trump to be removed as gesture of good will. Trump's latest tweet over the weekend that "things with China are going very well", and US consumer is not paying for higher import duties is hardly reassuring.

Japan/South Korea spat adds more uncertainties, particularly for technology
Japan's own dispute with South Korea has also escalated with Japan removing South Korea from its list of preferred trading partners. With South Korean chip makers having been seen front-loading their orders for supplies from Japan to mitigate any disruption risks, we expect big distortions in bookings, similar to what we have seen in the case with Huawei whose Japanese suppliers like Sony (6758) and TDK (6762) have seen strong order inflows ahead of any potential ban but face a subsequent plunge in Huawei's orders. This makes investing in Japan's technology supply chain particularly challenging.

Semiconductor market showing signs of bottoming...
To be sure, the semiconductor sector has been seeing more positive signals emerging that would indicate that we are close to bottoming of demand. We are particularly focused on data centre demand which we continue to believe will eventually lead the cycle higher as hyper-scaling investments of Big Data resume. In the shorter term, the big power outage in 2D NAND lines of Toshiba Memory/WDC has helped lower bloated inventories while Japan/Korea spat has also raised scope for tighter supplies in DRAM. With logic chips holding up relatively well among foundries and investments in 5G chips and cutting edge tools using EUV lithography also showing strength, there are good reasons to raise exposure to stocks that could dodge the current trade disputes.

But recovery prospects remain bleak, especially for Japanese suppliers
However, given that Korean chip makers contribute nearly 40% of total global semiconductor capex and considering uncertainties regarding the potential supply disruptions they face from Japan's export restrictions, we think their spending is unlikely to show any notable recovery, even if we have reached close to the bottom. Indeed, when spending does recover Japan's material and equipment suppliers could miss out if Koreans opt for sourcing their needs elsewhere over the medium term.

Removing South Korea from its preferred list Japan risks big retaliation
Interestingly, Japanese suppliers of semiconductor materials and gasses which fell under last month's export restrictions have reportedly yet to receive their special export licenses. With chip makers usually having three months worth of stock, we should have a good idea of Japanese government's resolve in pursuing its hawkish stance by early stage of Q4. We also think it is dangerous to assume that this is just sabre rattling, especially if South Korea retaliates with its own export curbs to Japan. Already many Japanese goods are being boycotted by Korean consumers.

Geopolitical risks providing interesting cross-border pair trade opportunities
Although our long/short focus is purely on the Japanese market, given this unique backdrop and particular challenges facing Asian technology names, there look to be interesting opportunities for some cross-border pair trades such as long the American chip maker, Micron (MU) and short Korea's SK Hynix (00660) or long Germany's Siltronic (WAF) and short Japan's Sumco (3436) which relies heavily on its wafer sales to South Korea. In general, we think long/short strategies look poised to make a big come back, especially if value names finally start to outperform growth.