- could "speak no evil":
"It could be costly to fail to provide accommodation (to the market)". - Janet Yellen
But as we posited in early 2013, Emerging Markets have indeed been the victim of "Abenomics" given in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.
It has clearly been the case for Emerging Markets which have been lagging as well the surge in the Nikkei index - graph source Bloomberg:
The aggressiveness in the reflation trade has once again been further illustrated by Friday's price action, which saw the Nikkei surge by 1.95% and the Topix by 1.68% - graph source Barclays / Bloomberg:
"UNSTOPPABLE! NKY went up another 2% pushed by USDJPY going through 100. Intraday was one way: NKY opened up 75bps to close up 1.95%. With realized volatility going higher and high demands for options from clients, VNKY remained elevated at 25.6. The volatility curve went up sharply today again with high correlation to the cash spot. 1Y +1.2% 5Y +0.5%. Option market was very busy as each move up of spot was triggering volatility moves. We saw a lot of interests on calendar spreads, call ratios and skew. Long term volatility remained well bid as Structured Products desks are looking to buy back volatility in the rally. Client flows were active: lot of interests in 2014 upside calls from Jan14 to Dec14. We saw a lot of risk reversal crossed on the exchange for clients getting exposure on the upside. At this level even if Bollinger bands & RSI suggest NKY is overbought, we should expect NKY to go higher and test the 16,000 level again very soon. Interesting to notice the dynamic between rates, FX and Equities at the moment. We saw a large drop in JGB around the close, triggering some weakness in USDJPY (yield adjustment)." - Barclays
Dynamic between FX and Equities? Of course there is! As illustrated by this Bloomberg graph displaying the not only the surge of the Nikkei and the weakness in the USD/JPY but also the reverse Itraxx Japan CDS index:
And went it comes to expect more from the Nikkei until at least the end of the year, this is as well validated by the fall in the Nikkei 3 month 100% Moneyness Implied Volatility and the fall in the Itraxx Japan, representative of the credit risk perception for corporate Japan - graph source Bloomberg:
As per our January conversation, "If at first you don't succeed...", once again we will slightly break our Magician's Oath.
As a reminder on the Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."
Back in January we argued:
"We have to confide, that since our October post, we have continued "practicing" the effect of our magicians "secret illusions" by having been short JPY against USD (via proshare ETF YCS) and we have been as well long Nikkei but in Euros via a quanto ETF (currency hedged) but until you all become magicians, we have to stop revealing tricks unless, of course, dear readers, you all swear to uphold the Magician's Oath in turn*, but we ramble again..."
When it comes to going long Nikkei but in Euros, we must confess, we have been adding again. Reason being, and on that point we agree with Exane's note from the 8th of November entitled "The end", is that Japan might be high risk but worth it for now:
Furthermore Exane added on Japan the following points:
"After 6-months consolidation, corporate earnings have grown into share prices. Valuations are reasonable, and there is still plenty of upside to the earnings base. We see the Yen headed south and equity prices north.
From setting the investment world on fire in the first 5-months of the year, Japan has morphed into something of a forgotten story over the last 5-months. USDJPY has traded sideways over this period, as has the Nikkei. And after May’s spike higher, the 10-year JGB yield is back at April’s levels too.
After such an aggressive price move earlier in the year, a period of consolidation is understandable. But this has allowed the Japanese market’s earnings base to grow into the pricing move. EPS for the MSCI Japan is on course to advance almost 60% in 2013.
The dynamics of the Japanese equity market, as they stand on consensus numbers looking into 2014 are summarised in the following table:
This is an obvious and clear benefit to the Japanese corporate sector with a positive direct translation impact on overseas earnings and also potentially the secondary transaction impact – whereby improved Japanese competitiveness leads to market share gains. The following chart shows that the Japanese equity market’s EPS forecast has followed the path of USDJPY over the course of the last year:
As the US cycle matures the downward pressure on the Yen is likely to intensify. The BoJ is likely to hold bond yields lower via direct asset purchases at a time when the US backs out of QE. Further as the Japanese start to have some success in creating a degree of inflation, the real yield on Japanese government debt is likely to fall.
As we show in the following chart the yield premium on 2-year JGBs deflated by CPI over the 2-year Treasury deflated by US CPI has captured pretty well the big directional moves in USDJPY. With the ‘real yield’ on 2-year JGBs likely to fall and the real yield on 2Y US bonds potentially rising this clearly points to downward pressure on the Japanese currency. That should feed straight back in to supporting Japanese shares.
Put simplistically we fail to understand how a 20% fall in trade-weighted Yen fully reflects the central bank’s commitment to double the monetary base. There must be, to our minds at least, further to go in this trade.
While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket:
"A multistage (or multi-stage) rocket is a rocket that uses two or more stages, each of which contains its own engines and propellant. A tandem or serial stage is mounted on top of another stage; a parallel stage is attached alongside another stage. The result is effectively two or more rockets stacked on top of or attached next to each other. Taken together these are sometimes called a launch vehicle. Two stage rockets are quite common, but rockets with as many as five separate stages have been successfully launched. By jettisoning stages when they run out of propellant, the mass of the remaining rocket is decreased. This staging allows the thrust of the remaining stages to more easily accelerate the rocket to its final speed and height." - source Wikipedia
On that point we agree with Exane's take for more Japanese upside:
The underpinnings of the Japanese equity story are still there. It seems to us more likely the market has just got a little trade fatigue. In this respect, there are potential catalysts on the horizon that can re-create a degree of enthusiasm.
First, most clearly the sales tax increase of next April is seen by many economists as likely to prompt an acceleration in the pace of central bank asset purchases. That should clearly be helpful for the assets bought directly – but also in suppressing bond yields and forcing yield-seeking investors up the risk curve. Furthermore, this is likely to put more downward pressure on the Yen that should feed back into enthusiasm for the earnings prospect of Japanese companies. The stock market should respond.
Second, the missing link in the Japanese story this year has been some evidence that labour market reforms – a key component of PM Abe’s third arrow – can be pushed through the Japanese parliament. This is clearly the most controversial and politically difficult element of the policy suite. While so far Mr Abe has chosen to use his bullets on politically easier reform measures, progress on labour markets would be seen as a particularly important development by international investors." - source Exane
We don't see Japanese going "cold turkey" for the time being hence our stance.
Of course given everyone and his dog has been focused as of late on the "magician tricks" from the Fed, we would have to agree with David Bowers take in the Financial Times in his article from the 13th of November entitled - Monetary shock from Japan eclipses Fed taper concerns :
"If you cannot see the wood for the trees, then how do you expect to see the elephant in the room? One of the casualties of the market’s obsession with the Federal Reserve’s monetary easing “non-taper” has been a loss of perspective. The world has forgotten that the real monetary shock of 2013 has been the change in policy by the Bank of Japan.
In the words of the Bank for International Settlements’ annual report, when the world’s third-largest central bank decides “to double the size of its monetary base, double its holdings of Japanese government bonds and exchange traded funds and more than double the average maturity of its government bond purchases”, investors ought to sit up and take note, especially when it comes with a 20 per cent currency depreciation.
This is “unilateral QE” with a vengeance – of a similar magnitude to the Fed’s QE3 but applied to an economy a third the size of the US. Japanese monetary policy is never going to be the same again, with consequences that will extend beyond Japan’s borders.
The main reason why Japan is still a sideshow in the minds of investors is because that is exactly where it has been for the past 20 years. Many asset managers have only known Japan as a taker, rather than a maker, of the global narrative. The sharp rise in the Nikkei in the first few months of this year may have been impressive, but it is the seventh occasion in 21 years when the market delivered six-month returns in excess of 30 per cent; the previous six were all false dawns." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.
One of the consequences of the BoJ’s policy shift has been to weaken the yen and boost the dollar. In recent years, dollar strength has been associated with soft commodity prices and weak pricing power in the traded goods sector. That has hurt emerging markets with their high exposure to commodities and global supply chains.
In short, the initial impact of Abenomics has been to export deflation to the rest of the world. This can also be seen in the lower-than-expected inflation rates in the US and eurozone. These are the unintended consequences of the BoJ’s actions. You may not want to invest in Japan, but you do have to understand that it matters enormously whether Abenomics succeeds or fails.
The initial shock may have been deflationary; but it could yet turn out to be reflationary if Japan succeeds in getting companies to save less and invest more. Japanese corporates have run themselves for cash rather than for growth; their saving has been the counterpart to the government’s borrowing. Were we to see double-digit capex growth next year – led by the non-manufacturing sector – the labour market would tighten to a point where real wage growth returns." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.
"For the past quarter of a century monetary policy has been run for creditors, not debtors. That favoured instruments such as Japanese government bonds. But if the BoJ succeeds in generating sustained inflation then the asset allocations of the past 20 years could quickly become obsolete. The launch of the Nippon Individual Savings Accounts, and the review of public pension funds’ asset allocation, are important developments.
Japan has been practically invisible for the past two decades, a passive bystander to China’s rise. But Japan’s moves clearly have the potential to disrupt the Asian narrative. If Japan recovers, it would provide a new source of final demand for the region; if it fails, then the risk is it exports more deflation via further yen depreciation. It would be ironic if Japan’s attempt to reform ended up destabilising China’s own reform process. The stakes could not be higher." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.