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.

Seeking Safety In Aussie Bonds

Despite the current re-flation attempts by the world's monetary policymakers, I still see deflation as the overriding theme going forward, owing to private sector deleveraging. With this in mind, Australian long duration bonds look particularly attractive for a number of reasons:

1. Yield Looks Attractive:
The current yield on the Australian 10-year bond is an attractive 5.4%, having risen from a low of 3.7% in December 2008, and is back to levels seen in 2006 when the global credit binge was in full swing. The nominal yield compares with the trailing dividend yield of 4.2% for Australia's ASX200 equity index.

2. Public Sector In Credit, Private Sector In Turmoil:
At the end of 2008, the Australian government was actually a net creditor, with net assets of roughly 7% of GDP. While the figure is likely to deteriorate this year as a result of the fiscal stimulus measures, the government's net debt ratio is still expected to remain in balance. This is extremely rare in today's world, and compares very favourably with Japan (95%), Italy (90%), and the US (60%) according to OECD figures.

By comparison, Australia's private debt burden is massive. Having peaked at roughly 165% of GDP in 2008, it has since fallen to around 150% and remains at twice the level seen at the start of the Great Depression. While government handouts have helped support private sector demand so far this year, a major private sector deleveraging process has begun, which will see savings rates rise for years to come. Indeed, the household saving ratio rose to 3.6% in Q209, continuing the uptrend seen since 2002 when the rate reached a low of -4.0%. This should continue rising towards the long-term average rate of 7.6%, with an overshoot highly likely. This could make for a perfect storm in the long-term government debt market.

3. Prudent Policy Limits Inflation Risk:
Unlike in the US and UK, where there is a huge risk that policymakers will continue to try everything they can to devalue their currencies to combat the ensuing deflationary forces, the Reserve Bank of Australia (RBA) is likely to continue acting relatively prudently. The Australian government has also been less willing to assume the debts of the corporate sector than the US and UK governments, which should keep gross debt levels low over the coming years. The government, which has run surpluses in its fiscal accounts for the past decade, will run a nominal fiscal deficit of 'just' 4.6% of GDP this year, way below the double-digit levels of the US and the UK. The relatively low willingness to take on more debt should continue to drive down perceived default risk at a time when other developed world governments are facing heightened default concerns.

JGB Bull Run Nearing An End?
One way to hedge the near-term risk would be to take a bearish stance on Japanese 10-year government bonds, as we see increasing potential for yields here to rise over the medium term.
I know I am not the only ones over the past decade to suggest that the bull market in Japanese government bonds could be ending. However, given the continued deterioration in the economy, this is becoming increasingly likely. Indeed, it is not inconceivable that Japan's balance of payments surplus could turn to a deficit, such is the weak outlook for global demand, which would likely force the Japanese government to offer higher interest rates on its debt in order to entice savings from overseas. On the contrary, we could also see Australia's current account deficit flip to a surplus as the private sector pays down the external debt it has accumulated from decades of current account deficits. This would add to the forces driving down long-term yields.

Australia More Creditworthy
Supporting my view that Australian long-term bonds will outperform those of Japan going forward is the current 10-year bond interest rate differential. At 411bps the spread is historically high and we believe that it is nearing its cyclical peak. What is more, given that the CDS market is currently pricing in a higher default risk in Japan than in Australia (and rightly so), this highlights the attractiveness of the current sovereign bond spread in terms of default risk.