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Marcuard's Market update by GaveKal Dragonomics
Having traded in a tight range since late last year, the Japanese yen made a technical breakout last week, weakening beyond JPY 125 to the dollar for the first time since 2002. While Bank of Japan Governor Haruhiko Kuroda came out to jaw-bone against more falls, higher volatility is a worry for investors who have grown used to making Japanese equity gains in US dollar terms. We would stick with Japanese stocks which continue to benefit from strong earnings and a governance-linked re-rating, but suggest the adoption of a yen-hedge—this is cheap to buy and has limited downside as there is little chance of a major yen strengthening.
The value of a currency is the price where the supply and demand of cross-border cash flows balance out: price is set according to marginal shifts in the supply and demand of such cash flows, which consist of the trade balance — surplus or deficit — and capital movements.
Since 2008, the focus has shifted from a “carry trade” dynamic — such that economies with the lower real interest rates saw capital outflow to places with higher rates — to one dictated by the relative size of central banks’ balance sheets. With most developed economies having cut rates to zero, the swing factor has become the relative size of asset purchase programs. On this basis we showed in December that the yen should reach JPY 125 to the dollar by mid-2015.
Sticking with this formula, the yen should fall to JPY 140 to the dollar by the end of 2015. Whether this happens depends if the balance sheet size-currency relationship of the last seven years continues to hold.
This is where Kuroda’s comments come in: the key reason he cites for the yen not falling more is that it is already very cheap. He has a point as the yen looks to be the developed world’s most undervalued currency — both on a purchasing power parity basis and when comparing its real effective exchange rate to both its 10-year average and 10-year trend.
There can be no doubt that Japanese firms are again super-competitive in global export markets. In addition, Japan is shifting focus so that a top priority for firms is shareholder returns. The result should be that earnings growth is no longer just a function of movements in the currency as has been the historical relationship. Taken together, the combination of better-run companies and a cheap yen mean that Japanese assets are a steal. As a result, capital flows should continue to enter Japan, providing a countervailing force to the devaluation pressure from the BoJ printing JPY 80 trln a year. On this basis, we think the downside to the yen has reasonable limits.
The Japanese government also wants to see a slowdown in the yen’s depreciation as the marginal cost of further declines is starting to exceed the benefits. Official logic runs that a more predictable environment is conducive to firms making bold capital spending decisions and sustaining reflation. Hence the BoJ is likely to continue talking up the yen, but in the event of further moves down, it will probably encourage a rotation toward domestic equities on the grounds that they offer value.
Putting these factors together, it is in Japan’s interest to maintain a relatively stable yen. The swing factor is likely to be the extent to which foreign investors are drawn into the country’s financial markets. In this scenario, maintaining a yen hedge is likely to cost little, while equity exposures should deliver outsize returns. Should foreign investors fail to recognize the Goldilocks situation in Japan of growth that is hot enough to sustain corporate profits, but no so strong as to spur monetary tightening, then the hedge will serve its purpose.
