Japan Economic Update

Japan's markets are closed until Thursday.  The day after they re-open, Japan is expected to report that core inflation fell back below zero for the first time since April 2013.   Abenomics has lost its shine with the economy contracting in four of the past seven quarters. 

In some ways, Abenomics was a typical LDP program of fiscal and monetary expansion but on steroids.  The reforms that are part of the third arrow have largely failed to capture the imagination of investors though we see the corporate governance reforms as significant. 

S&P's recent downgrade of Japan to A+, matching the earlier move by Moody's, was coupled with an ominous warning Abe will likely fail to reverse the deterioration over the next 2-3 years.  Debt-to-GDP is around 246% and the budget deficit during the current fiscal year is near 6.2%, more than twice the size of the US shortfall. 

Abenomics  has succeeded in boosting the profitability of Corporate Japan.  This is a function of the weaker yen and corporate tax cuts.  The weakness of the yen has not been used to boost market shares for Japanese exports but has translated into greater foreign earnings.   

August trade figures released last week showed that exports on a year-over-year basis were up 3.1%. However, this is a function of value, not volumes.  Consider that Japanese exports to the US are up 16% in value terms but are virtually flat by volume.  The value of exports to the EU are up 5.1%, but less by volume.  Exports to China drive home the point.  By value, they are up 1.6%, but down 4.4% by volume.   

In fact, many expect that over the next couple of months Japan may announce additional fiscal support in the form of a supplemental budget.  Expectations of additional monetary stimulus in the form of additional asset purchases are also running high, and will likely be boosted by a the re-emergence of deflationary pressures.    Many look for a BOJ announcement toward the end of next month.

If true, BOJ's Kuroda is not showing any sign that he is moving in this direction.  In fact, the BOJ appears to be soft peddling its preferred measure of core inflation for a measure that excludes food and energy (and alcohol).  It stood at 0.6% in July and is expected to have ticked up to 0.7% in August. 

BOJ's ETF purchases and a weaker yen may have helped lift Japanese equities.  The diversification of Japanese pension funds also pushed in the same direction.  While Abenomics may not be over, the diversification of Japanese pensions appears close to completion.  In the March to June period Japan pensions sold domestic equities breaking a five quarter buying spree.  The large Government Pension Investment Fund appears to be within 3 percentage points of its target weight for domestic bonds, stocks, and foreign assets.  

The foreign appetite for Japanese stocks have waned.  In fact, this quarter through mid-September, foreign investors have more than halved the purchases of the past 12 months.  Foreigners have sold roughly $34.3 bln of Japanese equities since the beginning of July.  This leaves them net buyers of $31.0 bln over past year.  The pace of liquidation has accelerated.  The week through September 11, which is the most current data, saw foreign investors sell a record of a little more than $11 bln of Japanese stocks.   Through September 11, foreigners sold Japanese stocks consistently since mid-June, with only three exceptions in the 14-week stretch.  

One issue that we suspect has not yet gotten the attention it deserve involves Japanese banks.  Data from the Bank for International Settlements shows that Japanese banks surpassed UK banks are the leading cross-border lenders in Q1.  Their foreign claims at $3.53 trillion squeezed ahead of British banks by a minor $10 bln.  The Japanese lending has been concentrated in infrastructure projects and to Asian countries.  

Reports suggest some of the banks' capital that had been previously invested in JGBs has been diverted to foreign corporate loans.  Mizuho, for example, which is Japan's second largest lender,  bought portfolios of  corporate loans in North America from a UK banks, which are re-focusing on its domestic client base. 

The challenge is that the weaker economies, currency mismatches, and other considerations are souring loans, especially to emerging Asia.  Lending to Asia reached $189 bln at the end of March.   Asia, ex-Japan accounted for 9.3% of  the assets of Japan's largest lender  (Mitsubishi UFJ) at the end of March, the largest in at least a decade.  Overdue loans from the region rose 77% in the year through the end of March at Sumitomo, Japan's second largest lender, and  24% at Mizuho.  Moody's has made 63 downgrades in the region, excluding Japan and only 13 upgrades.  That seems to be a key dimension of the challenge facing large Japanese banks. 

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