22 July 2018

The US market which continues to lead Japan staged a relief rally as we had been anticipating as earlier hopes of avoiding a trade war with China and expectations for a strong earnings season led stocks higher for much of the week. In Japan, the continued weakness in the yen, at least up until Thursday had also helped to underpin some of the sold off names in techs and machinery. However, we think this recovery will prove short-lived as there simply are too many uncertainties ahead which we think investors cannot ignore for too long. 

The r
ecent political events have unfolded more or less as we have been expecting with the US/Russian summit which we touched upon last week proving even more controversial with the US president having had to do some back-tracking on his earlier statement made at the summit. If that was not enough, he invited Mr Putin for another round of talks, managed to criticise the US Federal Reserve for its tightening policy agenda, named both Europe and China as currency manipulators and promised to slap tariffs on all of China's exports to the US. 

Politics also dominate Europe as EU members have been under siege by the US commander and chief for not pulling their own weight in terms of contribution to NATO's budget and not having a level playing field in terms of trade. With more rightist policies being implemented in EU states such as Austria, Hungary, Poland and now Italy, there is far more at stake here than the wrath of a superpower. With Britain's finalised Brexit plans already looking unworkable, judging by some key EU delegates' reactions, there does not seem to be much scope for good news from Europe either. 

Despite severe pressure by American and global autos and auto parts firms in a gathering last week, arguing that the planned $250bn of tariffs on imported autos will hurt everyone including the US makers and the consumers, most experts expect the US to be going ahead with its higher import levies. This will undoubtedly also hurt Japanese makers, particularly one of our top short sell picks, Subaru (7270) which has been in our list since November of last year . 

Meanwhile, talks of BOJ's policy announcement on 31st of July have some anticipating a slight change in the central bank's ultra loose monetary policy stance. Although we think this is unlikely for now, it is important to note that the bank's oversized QE program has already been struggling to meet its annualised purchasing targets as there simply aren't enough JGBs to buy. With wave of maturities further hurting supplies of long dated paper, BOJ has had to ease off on its QE more recently to keep rates from falling into negative territory. 

Moreover, pressure by savers, insurance firms and banks for a more normalised interest rate levels continues to rise. It is also worth mentioning that Japan could also be targeted by the US as another currency manipulator and could explain Kuroda-san's disagreement with Mr. Trump's comments by stating in the latest G20 summit that the strong dollar is merely a reflection of a strong US economy. It would be interesting to see if Japanese policy makers, in attempt to pre-empt the US making such a claim, will also be raising pressure on BOJ to perhaps abandon or lower its inflation goal, while also testing the resolve and independence of Japan's central bank.  

Although Japan's CPI is still rising less than 1% and substantially below BOJ's target of 2%, we see more evidence of rising costs, especially higher input and labor costs which are increasingly being passed on. With Japan's economy humming along for now, hardly justifying this continued monetary stimulus which has pushed the central bank's balance sheet towards 100% of Japan's GDP, we believe that any future tapering operation will prove very tricky as both the yen and JGB yields could notably spike. The government's plans to raise consumption tax from 8% to 10% in October 2019 is another headache for the central bank as it limits the scope of its future normalisation program in case consumption takes another beating after the tax hike. 

Looking at things more from bottom-up, the backdrop is not hugely encouraging in the short term as the impact of higher input costs which we saw first emerging in the last quarter and the more recent slowdown in China have yet to be fully felt in Japan's corporate earnings. Although we see Japan's market as very attractive in the medium term to longer term, we retain our highly cautious stance going into the earnings season and we think the recent bounce in techs and machinery names have provided some more short selling opportunities. 

One name worth mentioning here is Taiyo Yuden (6976) which we have recently added to our short sell picks. This smartphone MLCC specialist has been re-rated in line with Taiwanese names that sell most of their passive components in the spot market and have all benefited from TDK's (6762) decision to pullout of consumer electronics MLCCs and focus on autos. However, with price hikes for Japan's longer term suppliers likely to be more gradual and with Taiwanese makers like Yageo (2327) and Walsin (2492) coming under severe selling pressure last week as end-demand for smartphones remain anaemic, we think Japan's Taiyo Yuden's shares could be facing a significant downside.