iBankCoin
Tokyo based, expat Cape Bretoner. Learning to live in a de-leveraging world. Better suited to the crusades. CFA & FRM charter holder. Disclaimer: @Firehorsecaper reminds investors to always due their own due diligence on any investment, and to consult their own financial adviser or representative when warranted. Any material provided is intended as general information only, and should not be considered or relied upon as a formal investment recommendation.
Joined Jun 23, 2015
80 Blog Posts

OVERWEIGHT JAPAN

I am very bullish of the Japanese equity market, largely on a currency hedged basis. DXJ is my preferred means of garnering exposure. On a valuation metric, Japanese equities are cheap. In terms of weighting, a market capitalization weighting for Japan would be 8.02%, “Japan Lite” would be 6.02% (75% mkt cap weighting) and GDP weighted would be 5.33%. As I am underweight EM until further notice (est. 2020), I have also put this weighting in my Japan bucket for a round 10% (fully hedged as to currency). Exposure to Japan gives you a lot of EM exposure by default and increasingly Japanese firms are outsourcing the intermediate stages of production in favor of final stage and highest value add onshore. At USD/JPY 135.00 (est. Q1 2017), I’d be inclined to pare the currency hedge back to 50%, the “no remorse” hedge ratio.

The Japanese equity market peaked at 38,000 in 1989. The low was 7,400 in 2009 (17,191 currently). The Nikkei’s absolute level is often dictated more by foreign investor flows than onshore with a low 6% retail participation rate in the stocked market. The comparable participation level for the USA is 33%. Many foreign asset managers have at least moved from underweight to equal weight on Japan in the last 2 years. Beyond nitrous stock boosting QE, another sizeable catalyst is the monumental asset re-allocation of GPIF (Government Pension Investment Fund), the $1.25 trillion behemoth pension fund for Japanese Public Sector Employees (3X CalPERS size and $200bln bigger than NBIM, Norway’s colossal oil funded sovereign wealth fund). The big shift is largely from bonds to stocks (both domestic and international) and while “taper” in not yet in the Japanese jisho (dictionary), GPIF and the BoJ are likely sharing the play book, if you know what I mean.

Bank of Japan (BoJ) Governor, Kuroda-san continues to deliver the QE goods and in addition to the spectre on negative rates, introduced for the first time on Bank reserves (-0.10% from 0.10% ) last week on potentially 250 trillion JPY of Bank reserves, new tools are being developed to achieve the BoJ’s price objectives (2.0% inflation or bust).

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Having lived in Japan for 3 1/2 years (and visited on 25+ occasions since), I know what a perplexing market it can be. After 3 weeks of the ground one thinks they know, i) What is wrong with Japan and, ii) How to fix it. After 3 1/2  years all you can say is, I lived on Japan for 3 1/2 years. There is even a phrase for the folly of shorting JGB’s (Japanese Govt Bonds), the “widowmaker” for the number of traders that have been carried out employing the strategy over the years (definition of a Rates trader is someone who finds a trend and fights it). Even the doctrine of the time value of money has been exorcized by unconventional monetary policy (the Japanese curve is now negative to 8 years and 10’s have been in a 4-6 bp range this week, an all-time low yield for the 10 year maturity).

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Years ago, one would have thought the downside on a short position in bonds would be bound at zero, yet we now stand with trillions of government debt (>22% of global GDP equiv.) trading at negative yields. Japan’s QE has been unique not just in terms of its scale (a full 75% of GDP) but in terms of the asset classes they purchase under their broad mandate. The bulk of the G10 have their balance sheets bloated with bonds exclusively. Japan gorges on bonds as well of course, owning approx. >70% of the market, but they also but corporate bonds, REIT’s and equity ETF’s (estimated to now own 50% of the o/s ETF market).

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Fuji-san: A worthy “bucket list” climb. An active volcano, hence note the Japanese expression, “Only a fool climbs it more than once.”

Global sovereign debt now stands at $59.7 tln. The US is the obligor on 29%, Europe 26%, Japan 20%, China 6% and Rest of World 19%. Metrics like debt to GDP are important, but who owns the debt is just as important. Before the Global Financial Crisis foreign ownership of JGB’s was a paltry 7%. The number for UST was 56% held by foreigners, but with a Fed balance sheet exceeding $4.5 trillion the percentage is comfortably below 50%. If the Fed’s balance sheet were the same relative size at the BoJ’s it would be in excess of $14 tln.

Japanese corporations are very selective about how they deploy their liquidity. Cash & equivalents held by Japanese listed corporations total $1.4tln versus $1.8tln for US Corporations (the Japanese economy is approx. 1/3 the size of the US). Japan is a highly innovative country, holding a full 1/3 of all global patents. Japan is highly homogeneous with 99.38% of the populace Japanese (less than a million foreigners out of a 127mm population).

There is always a great deal of discussion on the poor demographics of Japan. In 1910 Japan has 50mm people versus the current 127mm and with the current birth rate (1mm per annum) and immigration policies they will round trip to 50mm by 2110. Underlying trends are changing though. People are getting married later. There are more women entering the work force and entering the real estate market on their own instead of waiting it out for Mr. Right at their parent place in the burbs. Japan real estate has been hot, up > 20% over the last 2 years. Rentals yields have come off the highs (8-9%) but are still very attractive for a developed market. Foreigners are competing as the bid increasingly (often Chinese but the palette is broadening) against the local Japanese, and with 35 year mortgage rates at 1.35% this week, their is a clear domestic advantage. Tokyo is a sprawling metropolis, with Tokyo-Yokohama holding the record as the world’s most populated urban area.

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The 2020 Summer Olympics are yet another catalyst for a more inviting and worldly Japan. Versus their “stretch” plan for 20mm @ tourists by 2020, Japan had 19.73mm in 2015, up 47.3% in number and 71.5% in spend (3.48 tln JPY) over 2014. Again, the Chinese dominate the flow at 40%. Japan is making great effort to further press the momentum coming into the olympics with 10,000 English signs being installed and more subtle tweaks like allowing tattoo sporting guests to enjoy the sprawling network of natural hot springs peppered throughout the land. Most establishment have a long standing ban on ink as “unclean” but it has more to do with the fact that in the old days only the Yakusa (organized crime) had tattoos.

Japan has < 2% of the world’s population and yet has 15-20% of world wealth (even after a 26 year bear market). As noted, traditional analysis can be daunting. I like to look at Japan as a big insurance company that uses its own currency. The drive is there, the work ethic is there, but if they were forced to annuitize, they would still be much better off than most of planet Earth.

These are the key reasons I’m bullish on the Japanese equity market, but the currency hedging decision is a critical component. JCG

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19 comments

  1. bravo

    Great blog Firehorse. Thanks for sharing.

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  2. grandmaster

    Informative post, thanks.

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  3. jon v

    I’m short via ewv. I think Japan is going down the tubes

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    • jon v

      I believe negative interest rates will be proven in due time to have been a major mistake globally as it kills banks and therefore lending. It’s counterintuitive but I believe this is the end result. Plus it kills the Japanese consumer intent on saving. Japanese equities are trading at extremely high multiples.

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  4. firehorsecaper

    The Japanese people have been TARPing the banks since the Japan bubble burst in 1989. The Japanese banks (although Nomura was down a full 10% today) have been generally getting stronger, largely because they have not been fined back to the stone age like most US and European players. A negative rate on reserves is meant to promote lending, not curb it, i.e. if they lend it out it is not longer on deposit with the BoJ. JCG

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    • jon v

      I agree it’s meant to promote it but I think neg int rates sends a negative signal. Look no further than European banks performance

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  5. nocturne

    Am I correct that The gov’t has paved the way for casino gambling, possibly through legislation?

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  6. firehorsecaper

    On EWV short, I think it is a bad idea. You are long a levered instrument on a higher beta underlying with a better fundamental valuation than other developed markets. Keep your stops tight. There is a reason the EWV has only 13mm in AUM and nearly no volume.

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  7. dyer440

    Good post. Much easier to simply short Yen and be done with it?

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  8. firehorsecaper

    Casinos. Topic for another blog as a complex topic, but bill to effectively remove Casino gambling from the criminal code was tabled and removed in 2015 before consideration. You can only bet on the ponies “officially”, but in terms of #’s more Japanese play Pachinko (12K outlets). More recently “coin pusher” machines are more popular. Generally seen as a socials blight. Near zero tourist take up. Lottery (Takarakuji) is popular but nowhere near the scale of the $70bln + spent in the US.

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  9. firehorsecaper

    Short JPY outright is one leg of the stool, but I think the Nikkei goes up in a ratio of 2-2.5:1 vs JPY weakening on a 1 year to 18 mth horizon.

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  10. edwardrooster

    Well done, I always enjoy your posts. I like your multi-factor, time frame appropriate positioning.

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  11. Dr. Fly

    Dcm and ntt have crushed it over past 12 mos

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  12. jon v

    Why no mention of the impact of a yuan devaluation? Also where do you get your low valuation argument from? I’m showing a cape at the same levels as the us at around 25

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  13. firehorsecaper

    Yuan devaluation was covered in O’ Canada (piece prior). Japan took a lot of the FX game out of their auto numbers (biggest export category) in particular but building out huge production capacity in North America, first Canada and then USA. I think Yuan deval has been overstated as a risk from here , esp. versus Japan. Great Wall Motors is not competing with Toyota yet.

    On CAPE alone valuations is a wash to US I agree, but P/E is about 2.0 lower and price to book is significantly lower 1.3X for Japan versus 2.7X for USA. Some degree of activism seems to be seeping into the Japanese market as well.

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    • jon v

      The activism argument has played out for decades. Unfortunately its not in the Japanese culture to cut the fat like the US. On a par with US in terms of CAPE, I’d take US every day over Japan due to demographics and long term growth potential.

      I think you’re understating the market’s impact from a Yuan deval. Japan would get crushed.

      It all comes down to where you see the markets going, though, really. If you think down, then Japan underperforms (it has since July (pre-meltdown)

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  14. pb

    I knew a chick that lived in Japan, late oughts, Hiroshima. Not once did she observe a Japanese using a credit card. Cash only. I believe they consider their banks to be technically insolvent. In theory, despite the massive printing efforts, there may not be enough yen floating around to cover their leveraged derivative bets. Your thoughts?

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  15. ibanknothing

    Plenty of people use credit cards in Japan. Most people have a worse perception of the government than banks.

    Abe won the last election with lowest voter turnout on record.
    http://asia.nikkei.com/Politics-Economy/Policy-Politics/Record-low-voters-help-ruling-coalition-snare-two-thirds-majority

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  16. firehorsecaper

    PB,

    Credit card use is low in Japan when compared to other countries, less than 10% of consumer spending is on credit versus 21% for the USA. People generally pay off their cards. The Japanese invest conservatively, up to 50% allocated to cash & equiv. and the Banks are not usually the first stop. Yucho and Kampo (Japan Post Bank and Insurance respectively) hold almost $3tln in assets versus Japan GDP of $4.2tln. My focus was on GPIF asset re-allocation but changes are afoot at Yucho/Kampo as well where the govt was executed a successful IPO this quarter on the road to full privatization. Their biggest holding is currently JGB’s but no market indigestion is evident yet, 10 year JGB’s are at an all time low yield of 1bp and the curve is negative to that point.
    On liquidity, there is plenty of liquidity in the system, 3.5x 2010 levels. Most vanilla derivatives have migrated to exchanges, greatly reducing the cpty risk borne by the Japan banking system.

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