Stage two of the Japan macro trade

The rise in inflation bodes well for an eventual reallocation into riskier assets byJapanese investors, especially with the conservative stance of holdings today – beyond the public pension fund, any 1% shift from fixed income to equities by Japan’s financial and household sectors would be worth $250bn in flows.

There are good reasons the Japan macro trade was quiet in early 2014. Like many of the 2014 consensus trades, buying Japanese equities and selling the yen have not fared very well. At the time of printing, the TOPIX is down nearly 5% in 2014 and still broadly where it was a year ago. Realized volatility on the Japanese yen is near an all-time low. That being said, there are four clear reasons why the Japan trade has been quiet.

First, heading into the year, the Japanese economy was staring at a major increase in its value added tax rate (VAT). The last time this type of increase was attempted, 1997, it preceded a sharp recession (whether it was the cause of the recession is open to debate).

Second, the early stages of the Japan macro trade were mostly about the unprecedented level of monetary policy stimulus, in other words, the 1st Arrow of Abenomics. As Figure 1 highlights, buying into Abenomics from late 2012 to end 2013 mainly meant selling the yen and buying large-cap, yen-sensitive Japanese equities, both of which benefitted from the Bank of Japan (BoJ) policy easing.

But since the initial easing in April of last year, the BoJ has disappointed markets by signaling little need for further stimulus, and our Japan economics team now forecasts no further monetary easing from the BoJ in 2014. Perhaps partly because of this, the Japan trade has been suffering from a lack of a new natural investor.

Over recent months, net foreign investment in Japan equities has been reversing, as have the significant short yen positions. Meanwhile, Japanese investors have yet to step up in any meaningful way. Indeed, judging from the BoJ’s comprehensive flow-of-funds data (only available though end-2013), Japanese investors have actually been net sellers of domestic equities and foreign assets since the start of the Nikkei surge in Q4 12.

And apart from the BoJ and, to a lesser extent, banks, Japanese investors are still buying JGBs. Finally, the global macro backdrop has not been especially supportive of the Japan macro trade. Most notably, the drop in US yields and weak US dollar have been a drag on USDJPY, which has probably played at least an indirect role in the underperformance of Japanese equities.

There is now a compelling case for Japan to turn more interesting again. The four factors holding back the Japan macro trade should start to fade, or at least be less uncertain. Already, we have made the case for higher US yields as market complacency surrounding Fed rate hike expectations begins to bump up against an increase in US inflation pressures (see our latest Asset Allocator).

While lower US yields should be seen a secondary factor in this year’s Japan trade disappointment, a reversal would likely be modestly supportive. Meanwhile, it is still early days, but indications are that the Japanese economy is weathering the VAT increase reasonably well. Indeed, early trends in domestic demand have been quite encouraging.

Just last week, a survey by Nikkei news of CFOs at major Japanese companies PM Abe will “launch” the 3rd Arrow by the end of June. On the policy front, the Abe administration is set to unveil by the end of June a series of economic and fiscal reform programs that will serve as the backbone of the government’s structural reform strategy (the 3rd Arrow of Abenomics).

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