Japan: One Step Forward, Two Back

The market's focus in recent days has been on the relatively sharp appreciation of the yen and the decline in equity prices.   Over the past five sessions, the yen is the strongest of the majors, gaining about 2% against the US dollar and flirting with a 2.5 month uptrend.   

During the same time, the Nikkei has slumped over 5% and is easily the worst performing major equity market.   It is now off 12.25% for the year. 

We caution against reading the dollar-yen's price action as particularly dollar bearish.  The pair remains range bound.  The dollar was toying with the upper end of last week as it tested the JPY104 area.  This week it has approached the lower end that extends toward JPY101.20 (last month's low), if not the February low near JPY100.75.  We suspect the near-term risk in on the dollar's upside and extends back toward JPY102.50-80.  

The Nikkei has gapped lower three times in the past four sessions.  Like the dollar against the yen, it looks heavy, but it is approaching a low risk opportunity.  We suspect the market will bounce, and prices will look to fill the vacuum created by the lower openings in recent days.  The 14200 area offers support ahead of the year's low set in early February near 14000, which was also the low from last November.

There are three developments in Japan to note.  First is a corporate governance issue. Earlier this week, Japan's Diet began the process that will likely lead to more outside directors at Japanese companies.  It has long been resisted by businesses.  This is one of the reforms that falls under Abe's elusive third arrow and is a key weakness in Japan.   The LDP is expected to present a formal proposal toward the end of Q2. 

According to Bloomberg, just 1.1% of the Topix listed members have a majority of independent director in the most recent full year filing.  This compares with 65% of the MSCI World Index of companies from high income countries.   Bloomberg data also indicates that only about one-twelfth of directors at Topix companies are independent compared with almost 85% in the US S&P 500 and about 42% in Hong Kong.  

Academic and investment studies find that corporations that have greater board independence and performance linked pay generated greater returns on equity.   Japanese officials tout the reforms as part of the larger effort to make Japanese stocks more attractive to both domestic and international investors.  However, the goodwill it may earn in this area is quickly cut in another area. 

At the end of last week, the Japanese government approved new elementary textbooks whose nationalistic claims is further antagonized South Korea and China.  China says it cannot negotiate with Japan about the disputed islands as long as Abe is Prime Minister, but Japan had hoped to thaw its relationship with South Korea.  The textbook issue underscores a key obstacle blocking improved relations.  

When Americans or European think of WWII, they think about the European theater.   In many ways, the Pacific theater was more brutal.  Historian suggests estimate more lives were lost there than in Europe.  Japan's officials reluctance to fully acknowledge what happened is a source of aggravation for many in the region.  The new textbooks continue to whitewash the events and claim as Japan's islands whose ownership is challenged by China and South Korea. 

Meanwhile, Abe is meeting some domestic resistance, including by his coalition partner, to his efforts to modify the interpretation of the constitutional prohibition against use of military force.  The US defense secretary who was visiting recently endorsed and welcomed efforts by Abe guide Japan into a more pro-active role in collective defense issues.  

Rather than seek a controversial change in the constitution, Abe is pushing for a simple reinterpretation by the cabinet that would allow Japan to participate in the self-defense of a third country.   Now that the new fiscal year is underway, and the budget approved, some reports suggest that political issues, such as these, will dominate the government's agenda over the next several months.