The Nikkei, the yen and Abenomics

Japanese stocks took another battering as a rising yen continues to rattle Ms Watanabe, Japan’s archetypal small-time investors. The Nikkei 225 has lost almost 20% from last month’s high, after what is looking to be one of the worst days for the index since the massive sell-off on May 23. It appears investors may be losing faith in Abenomics, or at least Abe’s third arrow which has thus far failed to provide the market with the guidance its needs on the future of structural reform in Japan.

In April, the BoJ as part of Abe’s second arrow and under the leadership of Governor Kuroda announced a massive programme of bond buying aimed at spurring inflation. Contrary to popular belief, the rally in Japanese bond yields suggested that the market has some faith in the ability of the BoJ and the government to spur inflation - as bond yields are an insight in the bond market’s inflation gauge. At the same time as bond yields were going crazy, the yen was falling. As USDJPY rocketed above 100.00 the Nikkei was rising alongside, largely because a weakening yen was great news for Japanese exporters and other trade exposed sectors.

Recently, a rising yen, in conjunction with negative global sentiment and investors loosing patience with Abe’s third arrow is hitting Japanese equities. Is this part of a natural retracement or something more sinister? As the long as the yen continues to strengthen we suspect the Nikkei’s upward momentum will be limited to say the least.

However, the long-term prospects for Japan’s economy appear to be improving, as evidenced by slightly improved domestic data (Japan’s annualized Q1 GDP was 4.1%, from a prior 3.5%). While we don’t yet have complete guidance on what Abe’s structural reforms are going to be, we don’t think the details thus far are particularly bad. Upper house elections in July will tell us whether the LDP (Abe’s Party) will secure an outright majority as they did with the lower house, thereby allowing the government to pass legislation even more unopposed, a rarity in today’s world.

At present it looks like Abe will secure a majority, which may bode well for the Japanese economy. Abe’s third arrow is looking like it will burrow much further into the heart of some economic issues in Japan than was previously thought possible. However, as previously stated the government’s lack of guidance on potential labour market reforms is worrying the market.

Overall, the current volatility we are witnessing in Japanese equities due to the rising yen and jumpy bond markets isn’t entirely surprising, especially after a massive drive towards Japanese equities since late last year when Abe announced his three pronged attack on deflation and stagnant growth. Hence, assuming the yen doesn’t fall off a cliff, which we think it won’t, then the Nikkei may push higher later in the year as Abe’s three arrows carry the economy out of its slump.