Sunday, November 4, 2007

Where is Japan Heading?

by Claus Vistesen

[This is a big one and if you are not in the mood I recommend that you just skip down to my summary which should give you the main thrust of my argument and analysis. This note also features over at my personal weblog Alpha.Sources.]

I would imagine that the answer to the question above remains quite at the forefront of many an investor's and economic analyst's mind. In this entry I will try to most modestly give interpretation of the road which lies immediately ahead for Japan's economy as we are about to receive Q3 GDP numbers on the 13th November. As per usual I am basing my analysis on the firmly established principle of standing on the shoulders of giants as well as I will field my traditional array of monthly charts updating the evolution of prices and household spending. Moreover, I will also, in the light of comments received outside the walls of the JEW and Alpha.Sources as well as the general interest in the subject, give my interpretation of where the Yen is going to be positioned in the months and quarters to come. Lastly, I will note the rather large and ugly downside which has emerged in the realm of the housing market and residential investment since this might just be the push which shoves Japan into a near recession path as we get to Q4 2007. I will finish off with a summary including remarks on the future course of policy at the BOJ as well as some brief comments on what seems to be clear signs of reform fatigue in Japan as well as the potential of uncertain times at the BOJ with respect to governance.

As you will see, Edward already has some snippets up (on JEW) on September exports, industrial production, and retail sales as well as the labour market. If we take a brief look at what these data releases have to say we can see that the outlook is steadily beginning to look ever so wobbly for Japan although, as I will also show below, household spending seems to be making a most welcome comeback. In terms of the external position we had one of the most negative news points as exports slowed quite significantly. Yet, we must always remember that there are two sides to the trade balance and an offsetting decline in imports helped to keep the trade balance to a record surplus. Yet, this does confirm the general outlook that the external environment just might be cooling off into the rest of 2007 from what has also been a red hot frantic pace. What remains is clearly that since external demand constitutes the main driver for Japan's economy any faltering on this account will translate swiftly into growth rates. On industrial production the picture is still somewhat clouded by the earthquake a few months back and as such the decline in September's IP comes on the back of a surge in August and should really be read accordingly. What should be noted however, as you can also see by the graph Edward fields is that IP still remains high relative to the beginning of the year which suggests that the readings should be taken with a pinch of salt. In this way I would not be surprised to see a further drop in October which would pair the surge seen in August and bring us back to a point below the high levels of Q4 2006. Finally, on retail sales Edward reported that they managed to push up a small 0.5% increase y-o-y thus showing some very welcome numbers outside the red for the first time in 2007. Yet, two things need to be remembered here. Firstly, as Edward notes there is a low base effect here since sales in September 2006 were comparatively low; this will become even clearer below. Secondly, the m-o-m evolution showed that retail sales extended a four month decline which goes to show the dynamics restricted on 2007.

Thus enlightened on what has already been noted at JEW why don't we move on to the new stuff. In tradition with my previous notes let us begin with the evolution of prices. Before I show you the chart we should dispense with the non-event that the BOJ chose to hold rates steady the day before yesterday. The statement from the BOJ as well as the recently published Outlook Report (Takehiro Sato has a round-up over at MS' GEF) did not really reveal much as to where we are going in terms of a rate outlook but did explicitly and quite as expected cite the global economic trend in credit markets as a source of uncertainty. In reality, a recent small but concise article from The Economist pretty much sums up the situation in its title sentence; The Bank of Japan would like to raise interest rates, the economy won't let it. And one of the obvious reasons can be seen below ...

As can readily be observed Japan remains mired in deflation with all three indices tugged firmly in negative territory. Regarding the officially deployed price index (core CPI) which is the CPI excluding fresh food (green line) we can see that this is virtually flat at -0.1%. In this respect, do also note that you, my dear reader, are getting a special treat here at Alpha.Sources (and JEW) with the inclusion of the index stripped of energy and fresh food. In this way we should be especially focused on this measure in the light of the fact that oil and gas are trading at very high levels at the moment. This of course does not mean that this can be used to anything as regards to economic/financial position making but it does go to show the 'real' price dynamics in Japan in the sense that it tends to be biased toward the effects of internal demand and activity in Japan. In general and on the probability of a positive yearly inflation reading in 2007 this has been somewhat of a mute point and as such a virtual improbability since the figures for the summer months came in. Regarding the official forecast, the just published Outlook Report sliced the previous F3/2008 forecast from 0.4% as it was made in April to 0.0%. If you are in to the more arcane matters of inflation forecasting the Outlook Report also fields projections for inflation readings in 2009 based on estimates of the output gap. Morgan Stanley's Takehiro Sato also ventures the official in house projections from the US investment bank. The bottom line seems to be that we are going to see a 0.4% inflation rate by F3/2009. In my honest opinion, I believe that such forecasts are complete word salad since no-one can say what will happen during 2008 let alone as far ahead as 2009, yet this is the forecasts as they are and we should keep them in mind. On balance, I don't see Japan escaping deflation anytime soon and this most emphatically goes if we home in on the core-of-core index (i.e. excluding fresh food and energy). An upside to this call would a be a pass through of high energy and base commodity prices but so far such effects have been muted, the anecdotal evidence on Tokyo's mayonnaise prices notwithstanding.

If we move on to indicators for domestic demand (living expenditures) the figures noted above on retail sales promise to bring some good news relative to what we are accustomed to in this area. Below I field the traditional three charts; one of the bread-and-butter y-o-y figure reported by the media, one of the seasonally adjusted m-o-m evolution, and finally a real monthly index (100=2005) to give the big picture.

If we look initially at the first figure which displays the headline number from the official statistical sources we note that the last two months have shot up significantly (although commentators seem to be attributing this to the illusive 'weather' effect). More importantly however, at this point we need to go back and consider what Edward said about a low base effect regarding the retail sales. In this way, the September reading on living expenditure has 'low base effect' written all over it but nevertheless we should not deny that it was an overall positive reading which as I said is most welcome reading. If we turn to the m-o-m figures however which are furthermore seasonally adjusted we indeed note a positive reading which extends a two month consecutive positive reading after three negative readings. Also do note that the recent two months' positive readings are below 1% which should not be interpreted as bad in itself but merely a reflection of the relative measures here. Finally, we need the big picture I think to finish off and in this way we can see that the long term index edged up but is still below the levels of Q4 2006 and the first months of 2007. As a very final data point Ken Worsley also informed us that auto sales rose in October by 2.0% which is the first gain in a very long time. In summary, on domestic demand and although the figures above form a clear basis for, at least a slight, optimistic sentiment household spending in Japan is still, by all measures, sluggish. The point is quite clearly that given the nature of Japan's demographic profile we are unlikely to see domestic demand be the main driver of growth which is then to say that on the margin the Japananese GDP account is not going to be carried by households spending. Regarding actual forecasts I put forward the notion a while back that I didn't think the official and widely reported figure for living expenditures would exceed 1% on a y-o-y basis. So far we are looking at a rolling average of 0.92% which of course includes the last two months' rather above par performance. I am consequently sticking to my prediction.

Before moving on to an analysis of the Yen and where it might be heading I want to touch upon another aspect which is weighing significantly on the short and medium term outlook in Japan. Normally and even though global financial and economic analysis has been littered with accounts struggling housing market practically everywhere we have not been hearing a lot about housing in Japan. Of course, we have had steady reports about a bubble in office building prices in downtown Tokyo but that of course masks a much more diversified picture; The Economist linked above marks it down well ...

Although land prices appear to be booming, prices nationwide are falling once sales in Japan's three biggest cities are stripped out.

More generally we need to understand that the housing market and construction in general have not been the driver of the recent 'expansion' in Japan as it has been the case in many other countries; at least not directly although in many ways the issues are interlinked here since the global housing boom has permitted many countries to really wamp up consumer spending which in turn has benefited Japan's export sector and corporate sector in general. The lack of housing dynamic in Japan may be due to various institutional factors but most prominently I think is quite simply the prolonged path which Japan has taken in the demographic transition. These structural points notwithstanding it was recent changes in regulations concerning and essentially delaying housing starts which suddenly made all kinds of skeletons come rattling out of the closet as Housing starts plummeted 43 percent in August; Quote Bloomberg.

Japan's worst housing slump in four decades and rising oil prices threaten growth in the world's second-largest economy, Cabinet ministers said.

``There is concern that a decline in housing investment will become a factor pushing down gross domestic product,'' Economic and Fiscal Policy Minister Hiroko Ota said in Tokyo today. ``I'm more focused on the downside risks to the economy.''

Housing starts fell 44 percent in September and 43.3 percent in August because of stricter rules for obtaining building permits. The government this week said it would relax the regulations after industry criticism that they were too onerous.

This of course looks pretty bad at face value. In order to substantiate this further and as a service to you my dear reader I am featuring below some comments from a Japan mailing forum which I am lucky to be a member of and which contains a lot of very smart observers of Japan and essentially 'people' on the ground. I cannot divulge the name of the commenter but this should matter little in this context ...

Some worse news is hidden in these figures: housing starts on condominiums have fallen 74.8% and even worse, starts on condominiums in the Tokyo area, the locomotive of Japan's real estate business have fallen 85.9%. As well as the worried voices within the industry itself, such as building materials, other voices have begun to be heard expressing clear worry about the knock on effect of these falling housing starts. Some economists are wondering out loud how much falling condominium sales will effect the sales of automobiles, for instance. Real estate in Tokyo, and to a lesser extent several other big cities such as Nagoya, has been the only spot of joy in a general murky panorama of Japan's internal economy.

As should be pretty clear and although the full extent of this is not known it has basically opened up a virtual abyss of downside regarding Japan's economic performance going forward.

As the final topic in this installment I promised above to also have a look at the Yen; where it is now, what drives it, and most importantly where it is likely to go. Let us begin with a chart to get us started which plots the Yen against the USD, EUR and AUD; remember that the y-axis is denominated in Yen which means that movements up means that Yen depreciates against the target currency.

Regarding the immediate position of the Yen we can see that it has fallen steadily against the three currencies in questions during the past 1 1/2 year although of course the recent assertion against the USD on the back of the expectations and now real evidence of the Fed's rate cuts. This also underlines the rather peculiar situation at the moment in global FX markets where the Dollar is taking a beating against almost everything which moves. In this immediate context it means that a wedge has now developed between the USD/YEN which for all intent and purposes could look as a good buy (long position) and the EUR/YEN which looks more like a sell (short position). Such traditional logic however should be applied with extreme caution since when we are talking about Japan where a whole gamut of structural and cyclical factors tend to exert a rather unique influence on the movements in the Yen. I am surely not able to give an exhaustive account of all these factors but here are nevertheless some remarks. As a very first frame we need to consider the probability that the BOJ is going to raise rates and more importantly close the interest differential gap with the rest of the OECD. I think this is unlikely which as an initial intro should give you an impression to where I see the Yen. Apart from this there are three factors I want to emphasise.

The first issue which should immediately be noted is the carry trade which is an inbuilt and lingering phenomenon of wide global interest differentials. A lot of things have been said about the Yen carry trade, whether it can continue to keep the Yen subdued and subsequently what will happen if it unwinds? One thing which is important to note here is the distinction between an overall normalization of interest rates in Japan which in itself would effectively flush out carry trading and then the potential for unwinding of carry trades at any given point in time. In this way, it is crucial to understand that even though the structural pre-requisites for (Yen) carry trades are likely to linger you can still get burned! This has perhaps best been substantiated since Spring where the credit market turmoil began and where volatility returned to markets. In this way, the carry trade and thus also the Yen tend to be synonymous with risk taking and as such considerable volatility in the Yen seems de driven by the general risk appetite in the market. In general on the carry trade we should also note that flip side of shorting the Yen where especially the Aussie and Kiwi (NZD) have been all time favorites for Japanese retail investors and others as currencies being 'carried'; the chart above of AUD/YEN substantiates this. The bottom line is that the carry trade still seem to be weighing on the Yen (except it seems against the USD at the moment) albeit with the important qualifier that the recent market turmoil has made gung-ho tactics substantially more hazardous.

The second thing I would like to emphasise is related to the issue of carry trade and concerns the structural decline in Japanese home bias whereby Japanese investors, retail as well as institutional, tend/will tend to move funds into foreign denominated assets which would then tend to hold the Yen down. Now, the argument for the decline in home bias is essentially vested in a long term view and economic analysis but signs of a decline in home bias can also be found in the present. The most enticing evidence comes of course from those notorious Japanese housewives who, equipped with some basic FX trading software, have been hard at work to bet against the Yen and as we have seen especially Kiwis seem to have been a favorite dish. Anecdotal evidence of the housewives seem to have abated somewhat in the recent months but what remains is a trend which indeed should be watched both as regards to retail investors and thus those savvy housewives as well as of course institutional investors such as pension funds and perhaps even a sovereign wealth fund (SWF) if and when it comes.

The last thing I would like to note is something which has emerged on the back of the recent rather violent decline in the USD against almost all currencies and thus also the Yen. In this way and in the context of how external demand and in this way also the US economy is crucial to Japan's growth prospects we must also consider the probability that the authorities in Japan are going to intervene if the Yen drifts up too much. A week ago I voiced this probability noting that anything close to a USD/YEN rate of 100 would bring out the ropes and lassos. Recently, Morgan Stanley's Stephen Jen also put the limit at 100. What is more important however than the limit itself is of course the idea of intervention. More generally, which I will treat in more detail in my summary below the whole structure of the BOJ is entering somewhat of a limbo as we move closer to the time where the current governor Toshihiko Fukui is to be replaced.

The bottom line on the Yen is that structural forces are likely to keep the Yen down. First and foremost is of course the whole inbuilt economic situation which effectively seems to hinder any attempt by the BOJ to raise rates although as well will see below markets are mumbling about a quick December raise. In general, I don't want this to come off as an endorsement of a sure bet on the carry trade and mindless short Yen positions. Especially, the re-emergence of risk aversion would almost surely make such positions (highly leveraged as they usually are) very expensive to keep on the books if the Yen were to shoot up. In line with my promise above and a call on the Yen for the remainder of 2007 I don't see a raise from the BOJ which should serve as a principal indication. Sudden market woes and credit risk sparks notwithstanding an interesting play could be to go for a move of the USD/YEN towards 118-120 from its current level of about 114-115 although of course any talk about Dollar strength at this point and until the end of 2007 and beginning of 2008 seems rather contrarian. As for the EUR/YEN it is trading awfully high at the moment as a result of a Euro on helium and I would really not want to stick my neck out here. If you want more technical advice on FX trading is my weapon of choice.

In Summary - Movements at the BOJ and Political Risks?

As I have already ostensibly hinted above I don't see how the BOJ will be able to raise rates in 2007. There are two principal reasons for this. Firstly, deflation is not likely to dissipate and especially not with economic momentum destined to slow down. This then brings me to the second reason which relates to the extent of the economic slowdown which seems certain to be rolling in at this point in time. It is really difficult to say at this point. Industrial production as a leading indicator of corporate capex and activity seems to be holding up as well as household spending has been showing some positive signs lately. Yet, coupled with what seems to be a slowdown in external demand as well as a looming correction in residential investment it seems as if the ground is getting shaky indeed. Moreover, I am uncertain for reasons stated above that domestic demand will remain much of a driver of growth since the momentum measured exclusively on 2007 is one of a down trending path. On industrial production we will just have to wait and see how much downward it has to go on the back of the earthquake rebound in August. The bottom line on the economic side of things seems to indicate that as regards to economic fundamentals the BOJ will find much difficult to wring that 0.5% refi rate upwards. Moreover and to add to the uncertainty, it seems as if the political situation might also be turning somewhat sour.

Consequently and before I sign I want to briefly mention another risk which is emerging and which is contributing to the uncertainty is the general political situation both in terms of domestic policy and also most emphatically within the ranks of the BOJ and thus monetary policy decision making. Concerning the former we need to think back to the ousting of Abe which really put the spotlight on a political life in Japan riddled with scandals and what can only be interpreted as poor and half made decisions. Moreover and very important the sacking of Abe also revealed a public which by and large had lost confidence in the politicians' ability to do something with the issues facing the Japanese society and economy. Of course this is past us at this point with Fukuda entering as new Prime Minister but as Robert Alan Feldman brilliantly puts down in just a few words there is now a significant risk of 'political backsliding' and essentially stalemate. The first point I would like to point out is the paralysis which may emerge as a function of a split majority divided on the two chambers in Japan's bicameral system ...

Policy paralysis risk has already emerged in some areas, such as defense policy. In seeking to force a general election, the opposition party, the Democratic Party of Japan (DPJ), is using all possible methods to pressure the government. A key part of this strategy is to use the power of the Upper House, where the DPJ recently won a majority, to stall appointments of candidates for government posts. Many such appointments require the approval of both houses of the Diet, and so the capture of the Upper House by the DPJ gives that party veto power over appointments.

Yet, much more significant is the stalemate and as Feldman puts it 'the backsliding' as Fukuda sees it appropriate to roll back a lot of the initiatives instigated during Abe's reign.

The biggest policy risk is backsliding. Already, the Fukuda government has reversed course on several important reforms. The new government wants to freeze the legislated increase of medical user charges, continue road tax earmarking, and focus on tax hikes (rather than spending cuts) as the main source of deficit reduction. Moreover, there is persistent talk of a major supplementary budget, in order to pay for policy changes. Once the momentum for a supplementary budget grows, it is very likely that many politicians – who face a general election soon – will opt for more spending.

On top of the current rigid state of domestic policies another slight risk has emerged that the BOJ might end up without a governor come spring time 2008. The reason for this shores up, as Takehiro Sato tries to explain here, on the same political quagmire Feldman refers to above where the Democratic Party of Japan holds a majority in the upper house and Fukuda's Liberal Democratic Party which still controls the lower house (the Diet). Normally and according to Japan's constitution the Diet holds precedent but not in this case as regards to the appointment of the BOJ's executive posts. This has thus created a situation in which the DPJ might use their majority in the Upper House to stall the appointment of new BOJ executives as the current members are up for replacement in the spring. The concrete situation as it may unfold is this;

But if the selection of the next BoJ leaderships is postponed because of a general election, the Bank would inevitably face its own form of political vacuum. It would have to conduct the MPMs in April (8th-9th, 30th) and May (19th-20th) without a sitting Governor or Deputy Governors (i.e., with a six-person board), or under Article 23 it is possible that the Cabinet would extend the terms of the incumbents in the interim.

What this means for the BOJ policy is difficult to say but I tend to agree with Sato that under such conditions anything but an abrupt change in economic fundamentals (one way or other) I would meand that policy changes would/should be suspended. This however opens a new risk in the sense that the current and presiding board at the BOJ might see its December or January meetings as the only possibility to raise for quite some time thus ending/entering the year at 0.75%. The reason for this scenario would seem to be Morgan Stanley's high probability forecast that Q3 GDP numbers due on the 13th of November will show a respectable growth clip. As I have argued above I am somewhat uncertain about this but given the underlying political dynamics I concede that the risk has emerged for a hike to 0.75% in December or January although I am not ready to take it aboard in my general forecast.