Saturday, 3 October 2009

Nikkei: Structural Bear Beats Cyclical Bull

After breaking through support the Japanese Nikkei index looks under serious pressure, with 9,700 the next level to watch. Fundamentally, the economy is a disaster, as weak global demand continues to expose the domestic deflationary stagnation. The recent high of 10,800 looks likely to have marked the cyclical high for Japanese equities, which would mark yet another lower high. A lower low is coming.

There have been a number of factors weighing on the Nikkei in recent days. The unexpected improvement in Japan’s unemployment rate, which fell from 5.7% to 5.5% in August, has been outweighed by a confluence of negative factors. Firstly, the stronger yen, driven partly by Finance Minister Hirohisa Fujii’s comments that a strong currency has generally been good for the economy because it has boosted domestic purchasing power, was a major driver. The poor Tankan survey results, which showed large businesses are aiming to cut spending by 10.8% this year, more than the 9.4% planned three months ago, also hurt market sentiment. The two largest forces weighing on the market, however, which pose a serious threat going forward, were the Chicago PMI data suggesting that the US economy remains in depression, and Japanese CPI data confirming that domestic deflation is deepening.

Export Dependence Remains Key Risk
These two factors sum up the struggles facing the Japanese economy. Starting with the fall in the Chicago PMI, this shatters any hope of a sustainable US andglobal recovery – something which the Japanese economy (and export-sector dependent equity markets), has relied heavily on in recent years to revive it from its deflationary stagnation. With the help of the weak yen (thanks to the carry trade) and strong global demand, the Japanese economy and the Nikkei staged a respectable recovery from 2003 to 2007, with the latter rallying 140% from peak to trough, as exporters lead the way. The current outlook, however, with a strong yen and weak external demand, is far less sanguine.

Deflation Accelerating
With that in mind let me turn your attention to the recent inflation data. As the accompanying charts show, Japan is clearly stuck fast in deflation. Core CPI came in at -2.4% y-o-y in August, the largest fall on record, and the September Tokyo CPI showed a similarly worrying trend. While the year-on-year figure fell by 2.0%, the actual index shows the extent of the deflationary mire that the economy remains in. The price index is the same level now as it was in 1992, and has fallen a staggering 9.5% since the October 1998 high.

Misguided Policies Mean A Slow And Painful Death
As underlying fundamentals of the Japanese economy continue to deteriorate, and deflation continues to trump re-flation efforts, any signal that global demand is waning is likely to weigh heavily on the Japanese economy and asset markets. It was no surprise that the Japanese economy contracted more than any other developed market in Q109 when the pillar of external demand gave way. Indeed, the failure of macroeconomic policies in the wake of the asset price collapse of the 1990s has been partially hidden by the strong export sector, while fostering a climate of mild and protracted deflation. The government has sought to reduce the debt load of the corporate sector and expand that of the public sector to fill the gap in demand. While low interest rates have prevented a debt-deflationary spiral similar to the Great Depression, they have also failed to force about the necessary liquidation of malinvestments created during the bubble era. As such, while public debt has ballooned, corporate debt remains high. The economy is no closer to embarking on a sustainable recovery as the private sector is yet to work off its imbalances and the public sector has created a host of new ones.

Cyclical High Is In
Continued core deflation has been a symptom of the asset bubble bursting, and has come in spite of the inflationary policies pursued by the government. The large liquidity-fuelled cyclical rallies seen in the Nikkei have brought lower highs and lower lows, as the underlying fundamentals have continued to deteriorate. It is looking increasingly likely that the recent high of 10,800 will mark the top of this cyclical (rather than secular) bull market, which could open up much further downside for the index. While continued price deflation – a sign that the economy is trying to heal itself – will help to support real incomes, it is likely to result in further asset price weakness in Japan over the medium term. The sooner this occurs, though, the sooner a sustainable recovery will be enjoyed.

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