Global Recovery Plus Increased Risk Appetite Equals Weaker Yen

Standard Chartered says the yen's strength may stall at 91.30, which looks like a chartist's call. High Frequency Economics says the yen's strength may reverse because current strength is either speculative or driven by non-price related motives for the purchases, like a yen carry trade reversal.

Japan's economy is expected to decline over 6% this year, while Japan’s tax revenue fell short of the government's forecast in FY2008 by about JPY 2.2 trillion ($23 billion), and could by JPY4~JPY5 trillion short in FY2009 as the government is projecting only a 3%-plus decline. A record JPY13.9 trillion extra budget passed in May, will be mostly funded with debt, bringing new bond sales to an unprecedented JPY44.1 trillion, and total bond sales will surge to JPY130.2 trillion, the highest ever.

Yet JGB (Japanese bond bulls) see 10-year JGB yields at 1.30% by end 2009, versus 1.335% today. JGBs, say the bulls, will benefit from growing inflation and waning loan demand, and Japanese banks are using depositor savings they can't find anybody to loan to to purchase JGBs.

Is demand for JGBs boosting the yen? Not likely. Net portfolio outflows (domestic investor purchase of foreign securities including stocks, bonds and notes) has surpassed foreign buying of Japanese securities by JPY19.52 billion in the first six months of 2009. The net commitment of large speculators by CFTC stats (Commodity Futures Trading Commission) is long, but only about 1/3rd of the prior peak in December 2008-January 2009. The net balance ofinteroffice accounts of foreign banks in Japan, which an October 2007 BOJ IMES (Institute for Monetary and Economic Studies) working paper identified as a major force in the yen carry build-up (and prior to the credit crisis of 2007) is now back to negative, meaning foreign banks are already holding net long positions in Japanese assets and have been for some time.

Foreign exchange futures contracts on the Tokyo Financial Exchange show open interest on all leverage forex contracts doubling from 193,860 contracts in March to 394,150 contracts recently, and USD/JPY contracts surging 2.5-fold from 39,030 contracts to 96,931 contracts since January, but growth in these contracts is a sign of selling, not buying pressure from mainly Japanese retail investors in the yen.

There was however a noticeable 14% reversal in the open interest on USD/JPY in June with talk of the government limiting the amount of leverage that Japanese retail punters could use on margin forex trades. In addition, net portfolio investment flows were inward, not outward in the last week, according to MOF data.

Consequently, we have a problem with the "safe haven" buying explanation given for the yen's recent strength. The yen is not a safe haven from its economic fundamentals, which are horrible and strongly imply increased government debt issuance. Yes, Japan does have a balance of payments surplus but it is shrinking on plunging exports, and some 92% of the demand issued in Japan is owned by the Japanese themselves, making this debt largely self-finance-able. But savings rates are already only 1.8% and could go negative over the next several years while government debt soars to 2X GDP.

We also have a problem with the yen carry trade reversal theory, given the current position of net interoffice accounts of foreign banks in Japan. A more likely short-term explanation is a) repatriation by Japanese companies/overseas portfolio investors and b) a partial unwinding of some leverage retail forex positions. Given a return to confidence in an economic recovery, however, the strong yen move could evaporate fairly quickly as Japanese institutional investors chase more attractive yields overseas and retail forex punters also chase yield overseas.

Japan Recovery? Not So Fast

In early July, the BOJ (Bank of Japan) upgraded its core assessment of Japan's regional economies for the first time in nearly three years, ostensibly on signs of improvement in exports and production. But the upgrade merely reflected the view that "the pace of deterioration is slowing". The report after after the BOJ in June raised its assessment of Japan's overall economy for the second straight month on data suggesting the economy bottomed out in the January-March quarter. A Bloomberg survey of Japan economists shows the expectation that Japan's GDP growth will show its first annualized uptick (+2.3% annualized) in a year, versus a record 14.2% annualized plunge in Q1 calendar 2009.

But data from the Cabinet Office implied the recession will continue for months to come, with companies delaying outlays on new plants and equipment. A leading indicator of core capital expenditures, core machinery orders, fell 3.0% in May from April, and much more than the economy watcher consensus, which was for a 2.0% rise.
The Ministry of Finance's data on the current-account surplus slipped 34.2% in May from the same month last year, as the trade surplus fell 22.1%. The latest data echoed customs-cleared trade figures released last month showing a sizeable drop in the surplus in May. MEITI production data indicate a leveling off of the sharp bounce in production seen so far.

Thus while the bounce in production from depressed lows to get inventories under control, the number of companies entering bankruptcy with debts of at least 10 million yen rose 8.3% on the year to 8,169 in the first half of 2009, surpassing 8,000 for the first time since 2003 at the bottom of the Heisei Malaise, according to Tokyo Shoko Research data. Similar data released by Teikoku Databank shows that the number of corporate bankruptcies in the first half of 2009 advanced 16.6% on the year to 7,023, with total debts soaring 52.2% to JPY4.59 trillion.

More Japan Passing: China's GDP Set to Overtake Japan's

Relative to its developed and now emerging economy rivals, Japan's once rising sun is now sinking. Ten years ago, Japanese electronic majors like Sony (6758.T) and Toshiba (6502.T) were shocked to learn that they had been overtaken in stock market capitalization by Asian rivals such as Samsung Electronics and Taiwan Semiconductor. Now, with China's economy set to grow over 7% this year despite the deepest global recession in the postwar period while Japan's economy will plunge over 6% by OECD forecasts, Japan's government will soon see the ultimate shocker--i.e., Japan is about to fall off its perch as the free world's second-largest economy.

The China Daily is reporting that China could be the economy that pushes Japan off its perch as early as in the next few months. While there are still massive qualitative differences, China's GDP in 2008 was $4.22 trillion against Japan's $4.84 trillion.

On average, the populace in Japan is still on the average much more wealthy, as the IMF figures show Japan's GDP per capita purchasing power parity was $34,100 last year or 24th in the world while China's was only $5,962, or 99th in the world. Thus qualitatively, China still has a long way to go before it matches Japan in terms of other "developed" nation metrics such as environmental quality or the use of science and technology to boost productivity.

For growth investors, however, China has long since taken over Japan as the target of direct foreign investment, while the ex-Japan Asian region now boasts a combined stock market capitalization worth nearly 25% of global stock market capitalization versus only 8% for Japan's stock market. Japan's authorities have been wondering for some time where all the slick investment banker types living in gilded "Gaijin Ghettos" in Japan have gone, and what these captains of finance now think about Japan.

The sad fact is that they are just not that interested anymore, not with strong continued growth in BRICs nations beginning with China and India, and chronic xenophobia among Japanese companies regarding out>in M&A as well as foreign investors who demand too much corporate governance or simple returns to shareholders. Meanwhile, their Asian counterparts are actively tapping deep US capital markets with ADR issues and slick PowerPoint presentations while the majority of the 3,800 or so listed companies in Japan don't even bother to issue English earnings results or annual reports, and actually resent ADR custodian banks issuing unsponsored ADRs based on their stock.

Japan's Mobile Carriers: Squeezing Earnings from Porn Downloads and Handset Makers

Bloomberg Mobile carriers NTT Docomo (9437.T), KDDI (9433.T) and Softbank (9984.T) are doing a booming business in mobile phone data traffic. In fact, its too good. NTT Docomo and KDDI have been forced to impose limits on the heaviest users with unlimited data download plans, and Softbank is considering the same.

What appears to be straining the $74 billion network is movie downloads. More than 91 million Japanese surf the Internet by mobile phone, downloading movies, games and music, and Juniper estimates Internet usage over phones in Japan is three times the level in the U.S. The heaviest download demand however appears to be porno, as Japan’s top two pornography providers, Hokuto and Soft on Demand Co., say sales to mobile phone users are driving revenue growth. According to Bloomberg, privacy laws in Japan prevent the carriers from seeing what customers download.

Global revenue from porn downloads to mobile phones and other devices is estimated by Jupiter to more than double to $4.9 billion in the next five years to 2013. The Tokyo carriers' customers are complaining of stoppages or slow Web access mainly around midnight when traffic from "heavy users" spikes. Japan has more than 1,000 companies producing adult-oriented movie content, generating a whopping 17,000 titles in 2008. Industry watchers say the Japanese adult content Internet sites have as many as 1,000 new customers a day, each paying up to JPY10,000 for a sign-up fee. For example, Bloomberg is reporting that revenue at Soft On Demand's mobile site has surged 40% over the past year and now draws in about JPY15 million/month. Annual sales in Japan's pornography market are believed to be around JPY100 billion. Teikoku Data Bank, a Japanese credit research company, estimates that the largest player in the space,Hokuto, has revenues of JPY14.7 billion.

The porn distributors of course are unlisted. Stock prices of Japan's three major mobile carriers have noticeably lagged the rally in Japanese stocks since March lows, with NTT Docomo falling 22% and KDDI falling 21%. Softbank has bucked the trend in rising over 30% because of the introduction of Apple's second generation i-Phone. In terms of earnings, NTT Docomo and Softbank see basically flat earnings in FY09, while KDDI expects about 9% growth--all better than the continued profit declines in Japanese corporate profits as a whole. P/E valuations range from 12.6X for NTT Docomo to 46.3X for Softbank.

Leading Japanese mobile phone carriers have cut their basic monthly fees and call rates to one-fifth the levels of 15 years ago, but their respective market shares have meanwhile held more or less stagnant, suggesting a lack of real competition in the industry. The number portability system, introduced in October 2006, has failed to radically alter the industry landscape. Furthermore, growing market saturation is making it increasingly difficult for firms to change the 5-3-2 ratio to their advantage. That said, Japan's three mobile phone carriers had a combined operating profit margin of 17.2% in the year through March 31, 2009, which came at the expense of the 10 handset makers whose margin was only 0.8%. Carriers improved their results by curtailing kickbacks that enabled sales agents to offer phones at rock-bottom prices. Handset makers, meanwhile, saw shipments plunge, with combined sales dropping 35% and operating profits plunging 76%. Five ended fiscal 2008 in the red, up from three at the end of fiscal 2007.

Undoubtedly to the delight of "heavy" data download users, the Japanese cellular industry has launced a high-speed wireless service based on the WiMAX protocol. The end of next year will see the start of a service that will enable data transmission at close to speeds now possible only via fiber-optic lines.

Japan's Debt Dependence At Some Point Will Push Up Long Rates

Japan's fiscal condition was already the worst among the major economies before the global recession hit. The Japanese government expects debt/GDP to reach 170% by 2009/2010, meaning the primary budget deficit could rise to 8.1% in FY2009/2010, up from only 3.9% in 2008/2009. The OECD however sees Japan's debt/GDP spiralling to 197% in 2010.

The Aso Administration has already been forced to abandon a pledge to achieve a primary fiscal balance by 2010. With the current recession, Japan's FY2010 budget will be the first in the postwar period where revenues from debt (JGB issuance) will exceed tax revenues. With general budge expenditures of around JPY90 trillion, tax revenues of around JPY40 trillion would imply a need to issue JPY50 trillion of new debt. FY09 planned issuance is already high at JPY44 trillion, but this is based on the government's forecast of minus 3.1% growth, whereas the OECD is forecasting minus growth in excess of 6%. In the OECD scenario, tax revenues could fall to the JPY30 trillion level, necessitating JGB issuance of more like JPY60 trillion rather than the JPY44 trillion already budgeted.

Long bond (10 year) bond yields already jumped temporarily to 1.5% in June on concern of oversupply of JGBs, but have since slipped back to the 1.3% range. If the above OECD scenario scenario for GDP growth is more accurate than the Japanese government's current 3.1% estimate, JGB yields are set to go noticeably higher as the Japanese government needs to issue extra debt--in other words, Japan could also see a buyer's strike by the bond vigilantes demanding higher yields. This of course would further hamper what is already seen as a very anemic recovery in 2010 ("recovery" with GDP growth of less than 1.0%).

Tokyo Market Being Left Behind in Best Quarterly Stock Market Performance in 20 Years

The FT and others are pointing out that global stock markets through June recorded their best quarterly performance in more than 20 years after literally imploding during the global financial crisis. Tokyo's Nikkei 225 is up 23% and better than the S&P 500's 15% or the FTSE 100's 8%, but emerging markets like China and India have surged more than 50%.

The result is that the total market capitalization of Asian markets (World Federation of Exchanges data to end May, including Asia Pacific markets) now account for more than 30% of global stock market capitalization, and the market cap of Asian markets is now higher than that of European (including Africa and the Middle East) stock markets. While North American (including Middle, South America) still dominate with market cap of $15.25 trillion, Asian market cap is back up to $11.6 trillion and closing the gap.

On the other hand, market cap of the Japan market is under 10%, meaning global index investors are increasingly passing Japan by. Other Asia on the other hand has growing demand supported by a growing population, better economic growth potential and was relatively less affected by the US subprime crisis. China (Shanghai) is up 62.5%, Russia is up 50.6%, India is up 50.2% and Brazil is up 38.8%--leaving Japan's 12.4% gain in the dust (January~June performance).

Similarly, the recent IMF numbers (Q1'09) show that the Japanese yen's share of global central bank reserves was only 2.9%, versus 64.9% for the US dollar and 25.9% for the Euro, which gives you a pretty clear indication of how central banks view the usefulness of the Yen as a global currency.

The inconvenient truth for Japan is that it is being passed by its Asian neighbors, as its economy has become more cyclical, i.e., declining more in recessions and lagging in recoveries, and a rapidly aging population is quickly reducing the nation's savings rate (to only 2%) at a time when government debt threatens to balloon to 200% of GDP.

For growth investors, the BRICs/emerging markets are clearly preferred.

Stock Investing: Even Robots Can Do It

The FT is reporting that Monex, an online Japanese brokerage, plans to introduce a long-only "stock robot fund" that will be operated by Japanese fund manager T&D Asset Management. The fund's managers consist of four computer models created by prize winners in a competition held by Monex. The developers of the models include individual investors, professional and amateur computer programmers as well as IT and financial technology researchers. More than 4,000 models are being simulated. The Kaburobo Fund will invest in the top 500 stocks listed on the Tokyo Stock Exchange.

Random walk theorists in the early 1980s insisted that, since stock prices "rationally" discount all available information, even a monkey throwing darts could theoretically outperform many fund managers, and that seeking consistent alpha was a waste of time. Brokerage firms have long used algorithms (mathematical models) to automatically trade stocks, and the US market almost melted down in 1987 because of program trading, i.e., leveraged trading based on computer programs.

Thus a stock robot fund is not outlandish as the article would seem--but it is the first time in our memory that automated stock picking has been promoted so openly as a viable mutual fund. The trend heretofore had been to promote "star" fund managers that enjoyed a loyal following of investors...bye-bye highly paid fund managers?

Perceived Expensive Valuations Have Hedge Funds Shorting Japan

After a fall to record lows, it is probably not surprising that Japanese stocks have seen their steepest rally in 56 years. This, believe hedge fund managers like The Children's Investment Fund, Bridgewater Associates, Highbridge Capital Management and Farallon Capital (the last three managing over $80 billion), presents an opportunity to short Japanese stocks, and they have been shorting selected Japanese stocks over the past three months, according to filings to the Tokyo Stock Exchange.

On the surface, the rally has produced some of the highest valuations among the 40 largest equity markets in the world. Ostensibly, a decline in P/E valuations to the average valuation of 21X over the past five years would drive the Topix down by 48%. Company aggregate forward earnings forecasts show JPY21.9/share for FY2009 to March 2010 versus a loss of JPY12.99/share in FY2008, on a combined loss of JPY1.5 trillion.

While there is definitely a limit to how far Tokyo equities can recover on the hope that a $150 billion stimulus package and a bottoming-out of global demand, just moving from the deficits of FY08 back into profit will produce a noticeable pop in corporate profits in FY09. Moreover, we question the usefulness of trying to value Japanese companies at what are an historical trough in earnings.

Foreign as well as domestic hedge funds like Myojo Asset have been shorting electronic stocks like Toshiba, Casio, Mizuho Financial Group and Sumitomo Realty. Growth expectations for Japanese stocks are already very low, with the combined PSR (price to sales ratio) being a mere 0.24X, according to Bloomberg data. Many stocks are also trading near their stated book value, which is cleaner than the US market because Japanese corporate balance sheets are in general more debt free. This has at least some long-only foreign investors betting against the hedge funds and on a cyclical recovery.

This does not mean however that Japan has solved or has even begun to address its structural problems, which if anything will deteriorate further with massive new debt-financed stimulus. Consequently, while a return to "normalized" earnings could get the Nikkei 225 back up to 12,000 in the foreseeable future, structural weaknesses in domestic demand should continue to hobble economic growth and mean Japan's economy will again underperform on the upside coming out of the recession.

(June 1, 2009. Bloomberg)

J-REITs to Get JPY1 Trillion Bail-Out, But Investors Aren't Buying Just Yet

Japan's J-REIT market was launched in 2001 amid a lot of doubt among foreign investors that the market would ever take off, but take off it did, particularly from 2003, when Japan's decade-long "Heisei Malaise" ostensibly ended, and the Nikkei 225 bottomed at around 7,600 in April of that year.

Thereafter, over 40 J-REITs were listed, and the Tokyo J-REIT index soared from 1,000.00 at its inauguration in March 31, 2003, to a May 2007 high of 2,592.16, representing a nice 2.6-fold gain over a four year period. But Japan's J-REIT market has since fallen on hard times, very hard times. Since the global financial crisis erupted following the failure of Lehman Brothers in September 2008, J-REITs have been struggling to hold on to purchased properties, let along acquire new ones. The rapid-fire failures of many newly emerged real estate developers who were J-REIT sponsors and the first bankruptcy of J-REITs themselves caused serious balance sheet and liquidity concerns. Consequently, the Tokyo Stock Exchange's J-REIT index plunged from the May 2007 high to a February 2009 low of 720.96, or 72.2% lower than the historical peak just two years earlier.

As J-REIT stock prices crashed, they did begin to attract foreign investor attention, especially as a J-REIT takeover, would ostensibly present a back-door means of acquiring a portfolio of attractive Japanese properties. In early 2008, it was hoped that the creation of a Northern Trust Global Investments NETs J-REIT ETF to list on the NYSE Arca to track the Topix J-REIT index might stimulate the market, but the J-REIT index was in a structural bear market even before the global financial crisis delivered a virtual coup-de-grace, and the NETs ETFs were liquidated in February 2009.

Only 5 of the listed J-REITs saw unrealized gains on property holdings between August 2008 and March 2009. J-REITs remain under pressure because banks will renew existing loans but not provide new loans, and as J-REIT sponsors themselves fail, this seriously hinders the J-REITs ability to get refinancing and rollover maturing bond issues as property appraisers have sharply lowered appraised values particularly on residential properties due to falling residential property prices. Fund raising alternatives, such as issuing preferred shares, are not an option for J-REITs. As a result, there were only 92 property acquisitions by J-REITs in FY08 versus 501 in FY07, and the market for J-REITs and private real estate funds declined by 1% in second-half 2008 to around $217 billion.

While talking about it since March, the Japanese government (specifically, the Financial Services Agency and the Land Ministry) appears to be in the final stages of pumping over $10 billion into the J-REIT market and removing impediments to consolidation in the industry. The market-weighted average yield has recently been as high as 7%, but investors remained leery because of balance sheet and liquidity risk.

The government has decided to intervene in the market as J-REITs are seen as the key to reviving Japan's sputtering urban center property market, because J-REITs were the major factor in the "mini-boom" in urban center property coming out of the Heisei Malaise. The 40-plus J-REITs still own more than $74 billion of prime commercial and residential real estate, and dumping by cash-strapped J-REITs is dragging down property prices.

Since the government has no intention of saving all of the 40-plus J-REITs, the survivors could boil down to those J-REITs with financially strong sponsors, and with property portfolios that were acquired between Q3 2001 and Q2 2004, or before the "mini-boom" in Japanese property. For US and European private equity investors wishing to get their hands on deeply discounted J-REITs selling at significant discounts to the value of property held, they must be prepared to pony up enough funds to clear maturing bond issues and refinance debt of the target J-REIT.

The J-REIT survivors will probably include, a) Japan Real Estate (8952.T), b) Global One Real Estate (8958.T), c) Mori Trust Sogo REIT (8961.T), d) Orix Jreit (8954.T) and e) Fukuoka Reit (8968.T)

Growing Poverty in Japan Means No Consumer-Driven Recovery

Foreign investors have long been of the view that Japan’s economy is like a basic materials stock, i.e., relatively more sensitive to movements in the global economy. As the chart at left shows, Japan's GDP has tended to perform worse on the downside and lag on the upside. The reasons for this are structural weaknesses in domestic consumption on the one hand and waning global competitiveness on the other.

While Japan’s unemployment is still low by OECD standards, it is now near 5% versus 2% in the early 1990s. More importantly, the ranks of Japan's working poor are growing rapidly. While the popular image of Japan overseas is of a relatively well-to-do nation with a high savings rate, OECD numbers indicate that Japan actually has one of the highest rates of relative poverty in the OECD--i.e., where people are living on one-half of less of the median income of OECD nations. Moreover, Japan's savings rate is now down to the 2 percent level and lower than the rapidly rebounding US savings rate.

According to data from Japan's labor ministry, there were 45.43 million in the workforce in 2007 that were working full time. However a total 10.3 million of these workers earned less than JPY2 million (US$21,000), while 6.66 million earned between JPY1 million and JPY2 million (US$10,600 and US$21,000), and 3.66 million earned less than JPY1 million (US$10,600). Contract workers (as opposed to "full-time" workers) with no pension benefits or job security have grown to 30% of the workforce. People in their 20s and 30s who cannot find work have become a regular feature of the economy. This situation was exacerbated by the deep recession. The other factor in declining average incomes is the rise in older retiree households.

Average household income in 2007 was the lowest in 19 years and down 16% from a peak in 1994. Moreover, Japanese households have never recovered the JPY623 trillion (US$6.6 trillion) lost in personal wealth from plunging real estate and stock values during the Heisei Malaise, as well as JPY37 trillion (US$394 billion) of foregone interest income from the move to a zero interest rate regime to stimulate the economy and keep the banking system afloat.

Given these depressing numbers, it is highly unlikely that the Japanese consumer can pull Japan's economy out of its tailspin anytime soon. Consequently, any recovery in Japan is basically contingent on a recovery in global trade, with the recovery in corporate profits being largely contingent on the prevailing exchange rates applied to the revenues from this trade.