27 May 2018
In last week's issue, we expressed our surprise that despite brewing economic turmoil in emerging markets and Europe, the yen had failed to strengthen in line with our expectations, raising questions about its safe haven status. Having moved up above its key psychological level of 110, and its 200 day moving average for first time since January, the yen finally showed its merits in a 'risk-off' market mode by snapping back to 109 level, once again underlining that Japan remains the world's largest creditor and with EM currencies and Euro looking to be in big trouble, the Japanese currency's status as a major safe haven has been re-established.
With most emerging market currencies convulsing from fast rising US rates, and Euro under serious selling pressure as the new ruling coalition in Italy look to be tearing EU's fiscal rule book, we cannot see any other outcome but for the yen to strengthen further and test its key 105 support against the dollar once again. Any stronger than that would provide heavy headwinds for corporate earnings which are already suffering from rising input costs and severe labour shortages.
That brings us to our somewhat controversial view that the current muted rate of growth of less than 1% in Japan's CPI is most misleading and looking at Japan's corporate earnings, it does seem highly likely that economic conditions look ripe enough to see these rising costs being passed on. We thus see BOJ tapering far sooner than what it has been guiding for.
The big question is will BOJ be able to control JGB yields from greatly spiking higher once it is forced to reduced its totally over-sized QE program which we feel the Japanese economic conditions simply do not warrant. Come what may, we believe Japan's yield curve will steepen which should provide a big boost to financial stocks which we very much continue to favour.
Moving on, geopolitics is playing a big part in market's sectoral performance with threat of rising tariffs on autos which represent 30% of Japan's total exports, hurting car stocks, especially those manufacturers like Subaru and Mazda which export much of their cars to the US. Also anxieties over car parts and components being exported to the US also raises some risks even for those who have substantial onshore production in the US like Honda and Toyota. Ultimately though, we think higher US tariffs can only exert more upward pressure on future prices and lead to higher inflation and interest rates in the country.
Good news is that China on the other hand, has quickly become the bastion of free trade and looks to lower its tariffs from July and Japan's car companies with good exposure to the region should see some benefits, albeit at net earnings level as most of their Chinese-related operations are 50-50 JVs with Chinese partners and earnings derived from them are booked only as equity method contributions. However, parts makers should be better positioned as long as they are not disrupted by electrification of autos which Chinese policy makers are pushing aggressively with stricter average fuel economy from their respective fleets.
Domestic political situation in Japan also remains shaky with Abe's support dwindling with latest allegations of cronyism rocking the LDP. With ruling party's leadership race likely to heat up ahead of September's deadline, we see party's candidates looking to differentiate themselves from the current leadership by potentially adopting popular policies such as abandoning nuclear power plant restarts, postponing the consumption tax hike plans and leaving Japan's pacifist constitutions untouched. We thus, see potential short selling opportunities in some key sectors by Autumn if Abe's position weaken further.
In short we see plenty of uncertainties ahead which keep us cautious, especially regarding the momentum names of last few years which have yet to fully crack. For those interested to view our recommended long/short list as well as our fast growing list of suggested pair trades, please contact us to be added to our 3 months trial service.