East Asia Economic Bloc to Surpass the Euro Nations in 2010

The combined economies of the ASEAN 10 nations of East Asia, Japan, China and South Korea are set to surpass that of the Euro nations by 2010, just as China's economy is eclipsing Japan's.

According to IMF forecasts, the East Asia group's combined GDP in USD will reach 12.668 trillion by December 2009, and account for 21.1% of the global economy. In 2010, these economies as a group are expected to growth 6.8% and exceed the aggregate GDP of the Euro nations (USD12.7133 trillion). By 2014, these economies should be USD17.3445 trillion and approach the US economy (USD17.4194 trillion) in scale.

At the same time, the relative importance of Japan in the region continues to shrink. Japan's share of East Asian GDP was 42% in 2009, but will shrink to 33% by 2014, while China's share rises to 39% in 2009 and on to 48% by 2014.

Tokyo Office Rents Continue to Fall

Japan's deepest recession in the postwar period is taking its toll on Tokyo commercial property prices and rents. If you are searching for office space, its a buyer's market, with older buildings in areas like Shibuya offering rents over 30% lower than those for tenants who have been in place for a couple of years. Owners more desperate to get their office space leased are also offering "free rent" periods of up to six months to offset the cost of restoring existing office space to its original condition and the cost of moving to a new location.

A Nikkei survey of Tokyo and Osaka office rents taken in mid-October shows even Tokyo office rents for newly completed buildings declining for two consecutive years, while rents for new buildings in Osaka are the lowest since August 1998. Average rent levels for both cities are approaching the lows seen in 2000. If you are observant, you can see the empty floors in office buildings throughout Tokyo.

Japan's Online Brokers Consolidate

As one indicator of the health of Japan's equity market, the top five online brokers (SBI Securities, Rakuten Securities, Matsui Securities, Kabu.com Securities and Monex Securities) have seen their combined trading values implode from nearly JPY200 trillion in the March '06 fiscal year back to JPY50 trillion or so in the first half of FY09.

In FY03 (to March 2004), the five online majors had combined trading values of a "modest" JPY50 trillion-plus. As Japan emerged from the Heisei Malaise with the Nikkei 225 bottoming in Q2 2003 and the reformist cabinets led by Junichiro Koizumi had evidently ended the financial crisis and was on its way toward re-invigorating Japan, individual investors returned to the Japanese equity market in droves, and migrated to the online brokers. As trading values for the major five were hitting nearly JPY200 trillion in FY05, a trading commission war broke out, with the online majors scrambling to provide the lowest trading commissions.

At the same time, the FSA (financial services agency) moved to force these brokers to greatly increase their investment in systems to accomodate the surge in trading volumes, while the Tokyo Stock Exchange upped their membership fees because online trading was beginning to effect the TSE's capacity to handle trades as well.

Things however went downhill from there. In January 2006, the Livedoor scandal hit the JASDAQ and emerging markets hard as investors began to question just how good the accounting was at these firms. On closer inspection, other emerging companies also had loose accounting, and a succession of bankruptcies scared individual investors away from wheeling and dealing in newly listed venture companies.

The combination of falling volumes and falling commissions per trade, increased fixed costs with mandated system investments was deadly. Online brokers have coped by offering forex trading as well as foreign securities, but the financial crisis post the Lehman Brothers failure has sent individual Japanese investors scurrying for safety.

Monex Group (8698:J) saw its revenues drop 37% between the March 2006 and March 2009 fiscal years, while ordinary profit imploded 79% and net income slipped into the red by JPY2.1 billion. The Company, a start-up began by an ex-Goldman Sachs partner, first tried to find solace in merging with Nikko's retail broker arm, Nikko Beans, but the Company has recently announced a merger with Orix Securities to get even larger scale merits. After the merger next May, the combined new entity will be second only to SBI Securities. SBI Securities is not impressed, claiming that the merger of two online brokers with very different commission schedules will only lead to a loss of customers.

At the very least, the merger of the two will mean more restructuring in Japan's broker industry, the headcount of which has continued to shrink. Retail giant Nomura Securities tried to hold back the tide of the online brokers by establishing its own online subsidiary Joinvest Securities, but the venture has been an absolute flop, so Nomura is merging the operation. Industry veterans such as Matsui Securities' president see more consolidation, including the possiblity that Monex will eventually merge with Rakuten Securities.

Japanese Corporate Profits Show 2nd QTR of Improvement

The Ministry of Finance's survey of aggregate corporate profits of large companies (over JPY1 billion in capital) shows that the JPY404 billion operating profit loss in the January~March quarter of calendar 2009 was the first aggregate operating profit loss in at least 50 years. Since then, however, Japanese corporate profits have been staging a "V-shaped" recovery.

A Nikkei aggregation of the July^September operating results of 527 major March fiscal year Japanese companies accounting for some 63% of market capitalization shows that consolidated ordinary profit has rebounded to around JPY2, 202.1 billion in the July~September quarter following an unprecedented operating deficit of nearly JPY3 trillion in Q4 FY08 (January~March 2009). This is the second quarter of sequential improvement in Japanese corporate profits.

While aggregate ordinary profit for the group was positive in the April~June quarter (at JPY974.9 billion), the manufacturing sector was still showing a JPY254.7 billion deficit. Most of this improvement has come from draconian cost-cutting, but there was sequential growth in sales of 10% YoY in Q2 FY09 (July~September) on 12% revenue growth in manufacturing. Year-on-year, however, this group's Q2 FY09 sales are still down 23% YoY and earnings are down 42% YoY. From Q3 FY09 (October~December), however, YoY comparisons will suddendly become much easier, and Japanese corporate profits could double YoY in the quarter, even though the forecast for full FY09 is for ordinary profit to decline some 10%-plus YoY.

The profit recovery has helped support Japanese stock prices to date, but has done nothing for Japan's consumers, because the profit recovery in large corporations came at the expense of worker salaries/bonuses, employment and cost reductions that slashed the revenues of SME (small and medium-sized enterprise) suppliers.

Excess Debt: Investors Should be Worrying About Japan, Not the US

The UK's Telegraph (Ambrose Evans-Pritchard)is warning that global investors and governments should be worrying about Japan's debt more than the US debt.

The scenario is that Japan is drifting helplessly toward a fiscal crisis. Simon Johnson, former IMF chief economist, reportedly told the US Congress that Japan's debt path is essentially out of control, and that there is a real risk of Japan ending up in a major default. According to new IMF forecasts, Japan's public debt is seen ballooning to 218% in 2009 from a prior 197% or so, rising further to 227% in 2010 and to a whopping 246% by 2014. This level of indebtedness is unprecedented in peace time economies.

Heretofore, the bulk of Japan's public debt has been absorbed by the private sector through excess savings. But Japan's savings rate has plunged from 15% in 1990 to 2%. Japan's (and the world's) largest pension fund, the GPIF, has become a net seller of JGBs to fund pay-out obligations, and the Japan Post Bank is baulking at adding more JGBs to their $1.7 trillion outstanding balance. If bond rates in Japan were to rise to 3%~4%, it could shatter the government's finances. JGB yields were at 2% as recently as 2007.

Carl Weinberg of High Frequency Economics, always one to not shy away from hyperbole, is quoted as saying that the Japanese debt situation is irrecoverable, with the potential outcome being fiscal shutdown, lost pensions and bank failures. Japan is also again on the verge of a deflation spiral that will exacerbate the debt burden.
Financial markets are beginning to discount this risk, with CDS on 5-year debt jumping from 35bps to 63bps, or above and away global peers like Germany, France, the US and the UK.

More Japan Passing: Tokyo No Longer a Major Financial Center

A Bloomberg survey of 1,452 users reveals that the leading financial centers in the eyes of Bloomberg users is New York (29%), Singapore (17%), London (16%) and Shanghai (11%), while only 1% named Tokyo. London is slipping because of a 50% tax rate on higher earnings and impending EU regulations on hedge fund borrowing, while Japan has all but fallen off the radar screen.

UK/European investors are also turning negative on Japanese stocks, with Standard Life and ING Investment saying they are underweight Japan because of the troubling signals that the new DPJ government is sending investors, i.e.,

1) Statements by the finance minister that Japan will tolerate a strong yen
2) A loan moratorium on smaller company loans
3) The un-privatization of Japan Post
4) No signs of a willingness to take on structural change
5) The need for the big Japanese megabanks to raise an additional JPY1~JPY2 trillion of capital,
6) Changes in maximum rates chargeable by consumer finance companies and an effective open liability for "excess" interest rates previously charged.
7) P/E multiples at 37X average for Japanese stocks, which is noticeably higher than global peers, even though Japan is trading at a relatively cheaper PBR.

India Second in Asia to Attempt an Exit Strategy

Bloomberg There is much talk among traders these days about possible exit strategies of central banks when they become confident enough in their respective economic recoveries to begin removing the excess liquidity that is now driving global stock prices.

India’s central bank has ordered lenders to keep more cash in government bonds, signaling the start of monetary tightening in Asia’s third-largest economy as inflation accelerates. India's central bank added some 5.85 billion ruppes of cash (nearly 9% of GDP) since September 2008 to protect the Indian economy from the global financial crisis. The increase in the liquidity ratio is aimed at draining some of this excess liquidity. according to some analysts, the move points to imminent interest rate action as inflation pressures are building.

India is the second country in the Asia-Pacific region after Australia to initiate an exit strategy. Thus it appears that central banks in the region with healthier economies are now turning their attention to inflation, and to managing the recovery instead of the crisis,including asset price inflation, as strategists are beginning to suggest that the next "bubble" could be in Asia/emerging markets.

Given the strong 8.9% YoY growth in China's Q3 GDP, analysts at Credit Suisse AG and UBS AG, who are among those predicting that China’s authorities will raise banks’ cash reserve requirements as soon as by the end of December, while Morgan Stanley's Stephen Roach insists that China will continue to err on the side of caution (continued stimulus).

Have Japan's JGB Yields Seen Secular Lows?

From the onset, investors had misgivings about the new DPJ-led government’s ability to implement their campaign promise spending plans without resorting to a significantly higher level of JGB issuance.

The Hatoyama Administration was able to terminate JPY2.926 trillion of programs included in the JPY14.7 trillion supplementary budget implemented by the LDP-led Aso Administration, versus a goal of JPY3 trillion savings. For the FY2010 budget, however, at least four ministries ended up asking for more money, despite instructions from Finance Minister Hirohisa Fujii to keep spending, except for campaign promises, below levels in the initial fiscal 2009 budget.

The ministries have evidently used the DPJ campaign promises as an excuse to pork up their budget requests. The Welfare Ministry’s requested FY28.88 trillion, up some JPY3.7 trillion (over 14%) from the initial budget for FY2009. It also withheld spending figures for 11 budget items that it plans to review by year’s end, leaving open the possibility of another increase of JPY1~JPY2 trillion in its budget. The Ministry of Agriculture, Forestry and Fisheries requested JPY2.75 trillion, or 7.5% more than its share of this fiscal year's initial budget. The Ministry of Internal Affairs and Communications wants a 4.8% increase to JPY18.59 trillion On the other hand, the Ministry of Land, Infrastructure, Transport and Tourism, meanwhile, was able to shrink its budget 2.6% to 6.19 trillion yen by slashing spending on public works and in other areas. The Environment, Defense, and Foreign Affairs ministries are also among those turning in smaller budget requests.

The news that the FY2010 budget could well exceed JPY90 trillion is making JGB investors skittish, as the Japanese government may need more bonds financing than initially planned to finance what is expected to be a record budget for the fiscal year starting in April 2010. The other part of the picture is that tax revenues are likely to fall short of government projections by a wide margin.

As the FT has pointed out, Japan’s bond market (already the biggest in the world) could get a whole lot larger if the new DPJ-led government is not able to reign in spending. FY2009’s budgeted increase in JGB issuance was already a whopping JPY130 trillion on top of JPY846 trillion outstanding even before there was any suggestion that additional issuance will be needed. Prime Minister Yukio Hatoyama is already hedging by suggesting that more deficit-covering bonds “may be unavoidable” to offset tax revenue shortages. Japan's Ministry of Finance has requested JPY21.9 trillion yen for debt-servicing costs in the budget for 2010/11, starting next April 1, which is up JPY1.6 trillion yen YoY.

Since JGB yields were trading as high as 2% as recently as 2007 versus around 1.25% at present, we would not be at all surprised to see a return to a 2% handle on the 10-Year JGB in the next couple of years. However, a full scale crash is unlikely even if the DPJ-led government has to resort to more deficit-covering bond issues. JGBs were bid down to current levels because of evidence that deflation is accelerating, and on forecasts for a continued strong yen, which at least once currency strategists sees surging to JPY50/USD. With central governments also significantly diversifying away from USD in their forex reserves into the Euro and the Yen, JGBs could continue to be supported by cash-rich domestic financial institutions, foreign government purchases and foreign investors looking to hedge what they see as structural weakness in USD.

Cash is Now Trash

Market Watch The Bank of America Merrill Lynch survey of global investment managers shows that global investors went underweight cash for the first time in five years in October. Investor risk appetite is at its highest in three years, and asset allocators are now shifting more money out of cash and into equities. A net 39% of surveyed money managers think profits will rise by at least 10% in the next 12 months, up from the 25% who were of that view in September. A net 65% of respondents report believing that a global recession is unlikely in the next 12 months, up from 47% a month earlier.

* Investment managers are now putting more money into European equities, which they see as undervalued. The net 30% saying European equities are now undervalued is the highest since April 2001.

* The dollar is seen as undervalued and the yen as very overvalued, implying central-bank intervention in currency markets could prove successful

* A net 36% of respondents also said they would most like to overweight emerging markets in the next year.

* Conversely, Japan confidence has continued to drop over the past couple of months. A structural underweight in financials is sapping other sectors, making Japan left out of a generally upbeat global view.

Yen to Appreciate to JPY50 per USD!?

Bloomberg is quoting a Sumitomo Mitsui Banking Corp. chief strategist as saying the USD could fall to JPY50/USD next year and eventually lose its role as the global reserve currency. He also sees a likely double dip in the US economy, seeing it deteriorating into 2011 as the effects of deleveraging excess debt take hold. Ostensibly, the USD won't stop falling until there's a change in the global currency system. The strategists believes the big wave of USD weakness can no longer be contained--even with coordinated intervention. The strategist, who is an Elliot Wave chart watcher, sees the USD as being in wave five of a 40-year cycle.

This would appear to be an unmitigated USD crash and burn scenario, not to mention Japan's export sector, which would be devastated by a rough halving of USD vs JPY. If the strategist really believes his call, I hope he has bought his farmland, several months of supplies and guard dog.