‘Don’t look up’ strategy of Japan’s stock bulls is running thin

With long term rates in key developed economies rising fast as investors come to realisation that core inflation rates will remain well above the targeted 2% level for the foreseeable future, appetite for risk is dimming quickly. With US economic activity seemingly still robust and rising wages looking unlikely to reverse course anytime soon given structural shortages in the labour pool, investors are bracing for more turbulent markets ahead as summer holidays come to a close. 

In Japan, the stock market bulls seem to have fallen silent as the Nikkei has given up much of its gains in the past two months and more interestingly, small cap Mothers Index which is a good measure of domestic sentiment is falling towards its December 22 lows. Indeed, the country’s hollow economic growth led simply by removing Covid restrictions and the weak yen which has inflated the value of exports and led to a boom in inbound tourism, have risen doubts about the longevity of capital inflows and corporate earnings outlook which we addressed in our last publication.

With Japan’s core inflation rate (of deducting both foods and energy components) rising towards levels not far off from those in the US, the stark disparity in government bond yields is not only adding downward pressure on JGB prices but also on the value of the Japanese currency. The latter has had a dramatic impact on dollar-denominated stock market returns YTD with Nikkei index up only 9% and Topix rising by only 7% versus S&P which is up by nearly 14%. These returns in Japan measured in Euro or Sterling are even smaller and more unremarkable.

Although shockingly late in our view, there is finally a growing market consensus, even domestically, that BOJ is notably erring in its monetary policy of suppressing long term rates near zero, leading to plunging value of Japan’s currency, hurting the country’s purchasing power and consumption. As we have also argued, we think the central bank’s inaction in disbanding its yield curve control seems forced upon it by its paymasters at MOF which is determined to keep government’s financing costs down as Japan’s budget deficit continues to explode upwards while almost a quarter of Japan’s annual budget is now set aside to service the country’s debt.

We think it is almost inevitable that the Kishida government will renew the household subsidies introduced in January and due to expire by the end of September, to keep energy and utility costs down, one key component behind the falling headline inflation rate since then. This has created yet another debt trap that the government looks unlikely to get itself out of given that core inflation rate is still rising even with these subsidies and discontinuing them now could prove disastrous not only for the economy but for Japan’s ruling party.

With spending on defence and child bearing schemes also on a dramatic rise with still no clear tax policy of how to pay for all these measures, it is inevitable that net JGB issuance will likely surge from here, adding even more upward pressure on yields. So, although this ‘don’t look up’ strategy has worked well for stock market bulls thus far this year, we think reality beckons as BOJ is forced to abandon its misaligned monetary policy soon enough with far reaching consequences that could reverberate across global capital markets.