Abenomics: Market Moves Too Good To Be True

BMI View: The Bank of Japan's bond buying programme, and the positive inflation expectations that it has fostered, have proved to be a major boon for local financial assets, with bond yields remaining extremely low and the Nikkei soaring. We are looking for a way of benefitting from a reversal of the positive financial market moves brought on by these inflationary policies, as we believe they will ultimately be found to expedite a fiscal crisis. We are bearish on a volatility-weighted index of the Nikkei, the 10-year JGB, and JPY/US$, and expect to see some major market moves over the coming months.

From the standpoint of Japan's financial markets 'Abenomics' (or specifically the aspect of it which aims to generate inflation at all costs) has been an overwhelming success. The aims of ramping up government bond buying to force investors into risky assets, generate inflation expectations, and depress government bond yields, have all been achieved. With the exception of a few hiccups, such as the surge in bond yields in May, there has been very little push-back from investors, who have seen only the positive implications of a return to inflation.

The problem with generating inflation in an economy with a government debt burden of almost 250% of GDP is that bond yields will face significant upward pressure eventually. It is possible for the Bank of Japan to suppress these pressures only at the cost of weakening the currency. To compensate investors for the loss of purchasing power on Japanese bonds, the yen must fall by a sufficient amount to set up the expectation of future appreciation in order to offset the shortfall in interest rate returns. This is what we are seeing now. The yen has broken below support and looks like it is heading significantly weaker.

Testing Major Support
Japan - 10-Year JGB Yield, %

BMI View: The Bank of Japan's bond buying programme, and the positive inflation expectations that it has fostered, have proved to be a major boon for local financial assets, with bond yields remaining extremely low and the Nikkei soaring. We are looking for a way of benefitting from a reversal of the positive financial market moves brought on by these inflationary policies, as we believe they will ultimately be found to expedite a fiscal crisis. We are bearish on a volatility-weighted index of the Nikkei, the 10-year JGB, and JPY/US$, and expect to see some major market moves over the coming months.

From the standpoint of Japan's financial markets 'Abenomics' (or specifically the aspect of it which aims to generate inflation at all costs) has been an overwhelming success. The aims of ramping up government bond buying to force investors into risky assets, generate inflation expectations, and depress government bond yields, have all been achieved. With the exception of a few hiccups, such as the surge in bond yields in May, there has been very little push-back from investors, who have seen only the positive implications of a return to inflation.

The problem with generating inflation in an economy with a government debt burden of almost 250% of GDP is that bond yields will face significant upward pressure eventually. It is possible for the Bank of Japan to suppress these pressures only at the cost of weakening the currency. To compensate investors for the loss of purchasing power on Japanese bonds, the yen must fall by a sufficient amount to set up the expectation of future appreciation in order to offset the shortfall in interest rate returns. This is what we are seeing now. The yen has broken below support and looks like it is heading significantly weaker.

JGBs: A Powder Keg Awaiting A Spark

The suppression of real interest rates provides a major helping hand to the government's fiscal accounts. Rising inflation supports tax revenues, while interest costs continue to decline along with nominal bond yields. With the BoJ continuing to buy the equivalent of roughly 70-80% of all new bond issuance at present, if the government were to take advantage of these conditions to begin running a primary fiscal surplus, financial repression could ultimately help prevent a default. Unfortunately (with little imminent incentive to act), there appears little appetitive for these fiscal reforms, as was seen with the decision to enact a fiscal stimulus to offset the impact of a sales tax hike, essentially just increasing the size of the government further. It seems likely, then, that the government's debt trajectory will continue to worsen, in spite of these favourable real interest rate conditions. With this in mind, the job of maintaining ultra-low nominal bond yields will become increasingly problematic. We maintain that JGBs are among the worst possible risk-reward investments in the world today.

Testing Major Support
Japan - 10-Year JGB Yield, %

Nikkei Won't Defy The Fundamentals For Long

With the yen weakening and inflation expectations rising, the Nikkei continues to appreciate. The index is up 77% over the past year. What is perhaps more impressive is that in US dollar terms it is the best performing major stock market globally this year. Given that domestic-focussed sectors such as real estate and financials have outperformed the export-focussed sectors, the conclusion that the gains have been driven by a weak yen seems flawed. Rather, rising inflation expectations and a shift to risk appetite are driving both the yen and the Nikkei, with the latter benefitting from a normalisation of valuations, which were previously heavily depressed.

It is very rare to see substantial currency weakness associated with a rise in equity prices in global currency (US dollar) terms, for three simple reasons. Firstly, the weakness in the currency itself poses a headwind to gains in global currency terms. Secondly, the currency weakness usually reflects a deterioration in the country's economic outlook, which should weigh on local equity prices. Thirdly, a weaker currency hurts domestic purchasing power, which, in the case of Japan, represents the bulk of the economy, and is the major driver of revenues for listed companies.

Facing Major Downside Risks
Japan - Nikkei In US Dollar Terms

The gains in the Nikkei, in global currency terms, are even more surprising when considering the risks posed by the fiscal trajectory. The Nikkei in US dollar terms is now close to its highest level since 2000, and while it is not a particularly expensive market, it is by no means cheap. Price-to-book and price-to-sales valuations have doubled over the past year, and the dividend yield is back down at a paltry 1.4%. Given our expectations of weak medium-term economic growth, with significant risk of a fiscal crisis, risk premiums on the Nikkei are nowhere near high enough, in our view.

Shorting Abenomics

We are looking for a way of benefitting from a reversal of the positive financial market moves brought on by the recent policies in Japan. The chart below looks at a volatility-weighted index of the Nikkei, the 10-year JGB, and JPY/US$. The gains reflect the fact that even adjusting for volatility, the losses in the yen have been more than offset by the gains in JGBs and the Nikkei.

A Perfect Storm Is Brewing
Japan - Equal Volatility-Weighted Index Of 10-Year JGB, Nikkei, And JPY/US$, Components (LHS) And Sum (RHS)

Going forward, as the positive impact of the monetary stimulus gives way to fears over fiscal sustainability, we believe that we will see bond yields begin to soar, which will in turn undermine the Nikkei. While the yen is a wild card, and could in fact strengthen in this scenario, this would only come about if the Nikkei were to weaken significantly. Overall, then, we believe that an equal volatility-weighted index of the Nikkei, 10-year JGB, and JPY/US$ is likely to give back all the gains seen over the past 12-months and more.

ASIA ASSET CLASS STRATEGY
ENTRY DATE ENTRY LEVEL % GAIN/LOSS RATIONALE
FOREIGN EXCHANGE
BULLISH ASIA FX BASKET VERSUS NZD 14-Oct-13 0.8143 -1.1% Asian FX is undervalued on the whole and fundamentals are improving, while the NZD is extremely overvalued and faces risks from a widening trade deficit
FIXED INCOME
BEARISH JAPAN 10-YEAR BOND 06-Mar-13 64 0bps A bubble increasingly at risk of bursting as a result of BoJ policies
BULLISH AUSTRALIA 10-YEAR VERSUS 2-YEAR BONDS 30-Sep-13 135 12bps While the downside for 2-year yields has diminished, there is significant room for long-end rates to fall
BULLISH SOUTH KOREA 5-YEAR CDS 11-Nov-13 62 -3bps Price of protection is cheap given potential for external and domestic shocks in 2014
EQUITY INDICES
BEARISH INDIAN SENSEX 8-Nov-13 20,785 1.9 Steep valuations and bearish looking technical picture
MACRO-INDUSTRY STRATEGY
N/A
*As of November 18, 2013. Asia FX basket is an evenly-weighted basket of CNY, IDR, INR, JPY, KRW, MYR, PHP, SGD, THB, TWD. Source: BMI, Bloomberg

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