15 April 2018

Markets last week seemed calmer on the surface with easing tensions on trade. Chinese officials adopted a more conciliatory tone, advocating the country’s open market policies, and promising to further open its financial sectors to foreign players by June 30th. Nevertheless, China also warned that any further unilateral action on trade by the US will be met with its own comprehensive list of import duties on US goods.

Japan market participants were also relieved by the most recent trend in the yen/dollar rate which we highlighted last week, building on its bounce above its crucial 105.50 support line which was severely tested in the past month. Meanwhile, chart technicals seem to support a trend reversal towards a weaker yen, at least in the very short term.

We emphasise in the short term as we believe market turbulence will continue and volatility levels will remain elevated. Thus, we expect the yen to to remain generally firm in a ‘risk-off’ market mode. Furthermore, we suspect that the coming strong corporate earnings which many hope will re-ignite the US market’s uptrend, looks to us as having been largely priced in as shown by the weakish reaction of US banking stocks following their strong earnings showing last Friday.

We think, the macro picture is looking increasingly ominous, especially in the US where geopolitical tensions, trade and budget deficit concerns have weighed heavily on momentum stocks. Moreover, with the US Treasury flooding the market with its heavy bond issuance while short term rates are also quickly rising, We don’t see the ingredients needed to push the US stock market higher.

We also think that rising input costs from structural shortages in many key components, not to mention, the most recent rise in oil price will either feed through to consumers or it will erode corporate earnings. Neither of these scenarios bode well for key global stock markets which have been strongly supported by cheap money, and low inflationary expectations.

We also believe that the rally in oil price should continue as increasingly hawkish US stance towards Russia and Iran could add fuel to raging fires that have engulfed many parts of the Middle East. With Saudi’s ARAMCO IPO looking increasingly certain for 2019, the Kingdom seems to be pushing for higher oil price and has convinced other Gulf states to retain OPEC’s production cuts. This is also good news for US frackers which have cranked output, and are starting to sign big oil and gas export contracts with European and Asian buyers.

In the US, last week’s whopping $64bn treasury bond auctions seemed to confirm fears of falling appetite among overseas investors. Moreover, for the Japanese investors, the flattening US yield curve from surging short term rates have made hedging the currency risk in owning US treasuries as not worthwhile. With US Budget deficit looking to surpass $1trn by 2020, as tax cuts and spending increases look certain to worsen the US government finances, the coming oversupply of bonds alone could push longer term rates higher, even if inflation somehow remains subdued.

Back in Japan, labour shortages are also looking inflationary with recent years of economic recovery creating bottlenecks across the industry. Indeed, with Japan’s population falling by a record 372,000 in 2017, and the declines should only accelerate from here, policy makers are being forced to ponder further opening Japan’s borders to foreign workers and force corporations to adopt a more female-friendly working environment.

As Japan’s economic expansion remains fairly healthy, we suspect rising prospects for higher prices will force the BOJ to slow its oversized QE operations far sooner than the central bank seems to be guiding for. The fact that BOJ has been increasingly addressing its possible exit timing shows that the central bank is preparing the market.

Although the bottom-up picture in Japanese stocks looks very encouraging, with corporate payout ratios on the rise and valuations remaining relatively modest, the deteriorating global macro picture keeps us cautious. We remain negative towards momentum stocks, particularly tech names which have led much of the rally, following US names. For investors interested in viewing our ideas, especially those looking for short sell opportunities and pair trade ideas in Japan, please contact us.