Phase One deal looks to be in the bag
US stock market resumed its year-end rally with S&P hitting new highs before some profit taking set in on Black Friday. Mr. Trump’s decision to sign HK Democracy bill into law provided some angst as China threatened to retaliate. However, as we noted last week, in reality the US president looked forced into this move, openly displaying his displeasure that US congressional law makers are meddling into his foreign policy. We think the Chinese leaders now know that bipartisan hawkish US policy stance towards China has become so consensus that the current US administration is now seen as the most likely leadership to reach a deal with rather than hoping for change in the next US presidential election.
So if anything, last week’s passage of the contentious bill provided a good glimpse of what is to come regarding trade as the two leaders seemed to be going through an orchestrated pantomime that underline the official stance of the two countries while both sides are looking closer than ever to signing the Phase One of the trade agreement. We think that over the next two weeks we shall get a good feel for how much progress we are likely to see for Phase two of trade negotiations.
US stance on existing duties to set the tone for Phase Two
Just to recount, thus far, the US has slapped tariffs on $550bn worth of Chinese products. China, in turn, has set tariffs on $185bn worth of US goods. An additional round of 15% of US duties is scheduled for December 15th targeting Chinese imports not previously covered by U.S. duties and will mainly include consumer tech goods like phones, PCs and tablets which formed a combined $80bn of imports in 2018.
We think these new tariffs will almost certainly be avoided, partly because it will also penalise the US firms the most such as Apple. However, it will be far more encouraging and important for prospects of Phase Two deal to see the US eliminating these planned tariffs altogether. We also think that rather than phasing out existing duties on all Chinese goods that have been imposed in the past year as China has demanded, US is more likely to provide a timeline for such policy reversals subject to progress measured in meeting Phase One demands and we expect China to compromise on the issue.
Improving backdrop leaves us bullish on Japanese stocks
We changed our 18 months of negative stance on our own market in late August sensing that trade negotiations are promising a more positive outcome while global equity weightings in Japan seemed to have hit pre-Abenomics lows which to us indicated a buy signal, especially given Japan’s modest valuations. With capital spending freeze likely to be nearing its end as semiconductor capacity expansion and factory automation orders are starting to trickle through, we regard Japanese firms to be among biggest beneficiaries of US/China trade resolution. However, there is more to our bullish stance on Japan beyond trade issues.
We have dedicated much space in this weekly publication in explaining why we think BOJ has covertly changed its ultra-loose monetary policy stance. After months of complaints by banking and insurance associations, pension funds and those representing Japan’s ageing savers, we think the BOJ chief, finally buckled under pressure in early September by tapering purchases of its longer dated JGB purchases. As we have long argued, ultra-low rates have failed to help most firms which have long deleveraged their balance sheets after the burst of Japan’s own asset price bubble in early 90s. Moreover, it has forced Japan’s financial institutions to take on more risk that regulators would like to see by dramatically raising real-estate related loan assets and CLO purchases. BOJ’s plans for its December operations indicate that further cuts in longer dated JGB purchases are on the cards.
Beyond BOJ’s stealthy regime change, another major positive is changing attitudes in management of Corporate Japan towards improving shareholders returns. Last fiscal year’s share buy backs had already hit record highs surpassing Y6trn. This level looks certain to be surpassed this term with over Y4trn of buybacks having already been announced by August. Moreover, with big firms like Hitachi, NEC, Fujitsu, and most recently, Toshiba and Panasonic aggressively restructuring, shedding or closing non-core subsidiaries and making core ones wholly owned units, their rising operating leverage leaves them with a strong profit growth outlook should industrial activity start to pick up.
Weaker yen leaves more room to taper, improves corporate earnings outlook
What has come as a complete and pleasant surprise to us is the direction of the Japanese currency. Although we have been expecting BOJ to taper despite almost all economist calling for lower long term rates deeper into negative territory only a few months back, we had not expected the yen to behave so well and had some reservation that BOJ’s forced tapering could be tempered by appreciating Japanese unit.
However, the yen has moved in exactly the opposite direction against the Greenback and currently is testing yet another critical hurdle of 109.50 which if cleared leaves the key psychological 110 and then 112 as the next two resistance lines. Perhaps we have been under-estimating the impact of ‘risk-on’ mood on the Japanese unit or perhaps BOJ’s own tapering has helped force asset allocation out of longer dated bonds into riskier overseas assets which has created a positive feedback loop. Whatever the reason, this currency trend not only gives the BOJ more room to continue to taper, but it does also improve corporate earnings prospects for the year ahead which only makes Japanese stock market whose broader index, Topix currently trades at 13x forward PE and 1.2x book, even more attractive.