What’s next for the Japanese economy and the yen?

The Japanese economy has been hit hard by a record high yen, weak levels of global demand, an aging population and natural disasters at home and abroad. All of which weighed heavily on Japanese stocks last year, with the Nikkei 225 falling from around 10500 at the beginning of the year to around 8500 at the end of the year. Yet, less demand for the yen and an improving economic situation offshore may be combining with reconstruction efforts at home to provide a glimmer of hope from the Japanese economy.

But are we already approaching the tail end of an equity rally in Japan?

Retail sales figures this month surprised on the up-side, coming in at +2.0%m/m (exp. 0.0%m.m). This year we have also seen merchandise trade exports improve, but this has been somewhat offset by an increase in imports over the same period.

There was a lot of chatter making the rounds last year about the high yen and its negative impact on the Japanese economy, and the JPY weakness we have seen this year is not helping as much as some people may think. Since the beginning of the year we have seen USD/JPY pull-back by around 7%, which has helped exports regain some of their appeal and brought February’s trade balance figure into surplus. But year-to-date the cumulative trade deficit still stands around JPY1.38 trillion on a BOP basis, and given that we usually see imports rise more than exports when the yen weakens, we expect a trade deficit for some time to come.

A prolonged trade deficit raises concerns about the outlook for Japan’s current account surplus, which consists of the balance of trade and net income from overseas. If Japan’s huge offshore assets are dragged down by the nation’s aging population then this is going to raise concerns about the ability of the government to fund debt domestically. Tokyo is already looking at a debt-to-GDP ratio of over 200%, which may create sovereign risk if the government looks like it will become unable to meet its debt obligations. Clearly, this is not good news for the Japanese economy or equity prices in general.

Upcoming Data

Between 00:15-00:50 tomorrow there are a slew of data releases out of Japan. First up is manufacturing PMI (prior 50.5), which we expect will be bolstered by a resurgence in demand for Japanese exports stemming from an improving US economy, and in turn leading to higher export orders and increased hiring by manufactures. Also, strong export growth and an expansion in output should help lift industrial production, thus we are looking for around a 1.4%m/m increase in the headline figure tomorrow.

As a result of falling prices for fresh food, consumer prices in Japan and Tokyo are expected to soften to 0.0%y/y and -0.1%y/y, respectively. National CPI figures excluding food and energy are expected to remain unchanged at -0.9%y/y. Conditions in labour market have generally improved this year, but more people returning to the workforce has caused the UE rate to increase in the last few months. Yet, we agree with the general consensus that the increases in the UE rate will have paused in Feb, keeping it at 4.6%.

The Yen

The Graph below clearly illustrates there is a correlation between equities in Japan and the yen, but it is unclear whether the Nikkei 225 is reacting directly to the falling yen. Instead, it is more likely the optimism we are seeing flow into Japanese stocks stems from an overall improvement in risk sentiment, based around an improving global outlook, which is also leading investors away from the safe haven yen.

Nikkei 225 (Orange), JPY (White) – Daily

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Last year the government’s intervention in the FX market, aimed at weakening the yen, was not nearly as effective as Tokyo would have liked, but the BOJ’s monetary easing this year has had a more permanent and prolonged impact on JPY, largely as a result of an improving global growth outlook. Towards the end of last year there was a lot of uncertainty surrounding the European crisis and renewed fears of a double-dip recession in the US. Stronger economic numbers out of the US and some bold action by the ECB to increase banking liquidity, have helped ease concerns about a global economic slowdown. Hence, we have seen the yen weaken significantly against the US dollar.

The improving global outlook may result in more downside for the yen as investors pour back into risk assets. This will combine well with a flood back into USD if the US continues down the path of recovery, which may see USD/JPY breach the 85.00 level for the first time since April 2011.

However, the future of AUD/JPY is not as certain. Overall, the strength in AUD and weakness in JPY earlier in the year helped push AUD/JPY higher, but a recent pick-up in economic data out the US has resulted in the aussie and the yen competing for the title of weakest currency. Over the last month the aussie has won that battle – against USD; AUD has lost around 3.29%, whereas JPY has only lost around 1.46% - causing AUD/JPY to drift lower, and we think this highlights more underlying weakness in the aussie than the yen. Therefore, we suspect the aussie will continue to depreciate against the yen as long as the US leads a global economic recovery.

Source: Forex.com

29.03.2012