06 May 2018

We are keeping a very close eye on macro-economic and geopolitical developments in the US as leading factors in influencing Japan's stock market direction. Indeed, the easy money era in the US which have kept stocks on a steep upward trajectory is quickly drawing to a close and the so called 'new normal' looks to have turned out to be nothing more than an aberration following the global financial crisis 10 years ago.

Although Friday's relief rally offset much of last week's losses in the US stock market, encouraged by strong employment numbers, all is not well on the macro front and we cannot see stocks finding their footing anytime soon. As we have been consistently underlining, with input costs rising almost across the board, record US corporate earnings results are increasingly being seen as near their peak levels while stocks still look priced for perfection.

With oil price also heading towards $80, pushing US gas pump prices towards $3, and labour shortages also starting to appear, fears of profit margin compression is starting worry market participants. With the US policy makers most likely to pull out of the Iran nuclear deal by May 12th deadline, and rising trade barriers, particularly with China, likely to put upward pressure on import prices, some of this unwelcome inflationary pressures coming through look to be self-inflicted.

With long term interest rates in the US more likely to be heading towards 4% level this year, stocks are also unlikely to remain attractive on discounted cash flow basis as earnings models will have to be pricing in higher risk free rates. With the earnings season now behind us, bulls whom were hoping that record corporate earnings, partly propelled by this year's corporate tax cuts would push share prices even higher are now searching for other pretexts to hold on to their positive market outlook.

Rising US interest rates, and high levels of dollar denominated debt issued by overseas borrowers in the past few years are also leading to early signs of stress in emerging market currencies with Mexican Peso, Polish Zloty, Russian Rubble, Turkish Lira, Argentina Peso and Indonesian Rupiah all struggling of late against the Greenback. Although the yen had also weakened from its strong levels in late March, we think the fast growing trend towards de-dollarisation of global trade combined with potential for a 'risk off' mode in global capital markets will keep the Y$ rate capped below the 110 level and we strongly suspect its critical 105 support line to be tested again fairly soon.

This week, we have taken the more scenic route to get back to our thoughts on our own market, Japan. To be sure, Japan's CPI is yet to reflect much inflationary pressures, still hovering just below 1% with BOJ chief having lifted its time-line for its inflation target of 2%. Although investors would be forgiven to worry far less about higher long term rates in Japan, higher input costs are also brewing there while economic growth of the past few years has greatly exposed severe labour shortages which are becoming increasingly notable across the industry.

With BOJ's balance sheet said to be already close to 90% of Japan's GDP versus 20% in the US and 40% in Europe, and the central bank now owning 40% of all JGBs issued (purchasing over 90% of all long-dated issuance in the past year), we believe even a slight tempering of its over-sized QE program could lead to sharply higher long term rates. We also worry that any unwinding of its Y6trn annual purchases of ETFs could lead to some notable indigestion in the stock market.

As far as our Japan stock picks are concerned we remain generally short tech names while we favour the financial sector as well as some heavily sold off industrials where prospects of restructuring is starting to look fairly promising. For those interested to view our recommended long/short list as well as our suggested pair trades, please contact us to be added to our 3 months trial service.