Misunderstandings about yen appreciation JAPAN

Misunderstandings about yen appreciation

􀂄 A strange quarter

Oct-Dec 2009 was a strange quarter. The Asian economy was expanding, and the

US economy was on a recovery track at an accelerated pace. Inflationary

expectations increased in the US. The VIX declined and suggested that the

market’s risk appetite was increasing. Japan benefited from such trends. Japan’s

real exports rose a strong 5.0% qoq in Oct-Dec. Thanks to strong external demand,

real GDP rose 4.6% qoq (annualised), suggesting that the recovery has been

sustained. Exports remained strong and grew a strong +40.9% yoy in January.

External demand is expected to contribute to real qoq GDP growth in Jan-Mar as

well. Meanwhile, market sentiment was very weak in Oct-Dec.

􀂄 Market sentiment deteriorated because of the yen’s strength

In late November, the government declared that Japan is in a state of ‘deflation,’

and concerns about a deflationary spiral and a double-dip increased. The yen’s

strength was the key reason. A stronger yen tends to enhance deflationary

expectations, depressing market sentiment. Partly reflecting the decoupling of bank

stocks in the US and Japan, Japan’s 3m LIBOR has risen and remained above that

of the US since last September. The BoJ left the reversal unattended until

December when it finally decided to increase the supply of 3m funds. Increased

risk tolerance globally probably resulted in larger US dollar carry trades. Strong

external demand and weak overseas investments by Japanese companies have been

behind the yen’s strength in the first place, and the reversal of the interest rate

levels pushed the yen higher.

􀂄 Strong yen not due to weak overseas growth should not cause a double-dip

The stock market tends to be very sensitive to the yen’s strength, thus the Nikkei

index trended lower. However, growth was strong in Oct-Dec, so the market may

have been overly concerned, and indeed, the Nikkei rebounded. If the yen is not

driven higher by weaker overseas growth, we do not believe that Japan’s export

recovery would come to a halt due to the yen’s strength. Indeed, Japanese exports

are highly correlated with US household consumption. Thus far, they have both

been recovering more or less in tandem. Meanwhile, the yen/dollar rate and exports

are not highly correlated.

􀂄 Misunderstandings about yen appreciation causing excessive concerns

A higher yen could actually negatively impact corporate earnings. Export oriented

companies’ earnings results are compressed by a higher yen. However,

surprisingly, aggregate earnings of large manufacturers are not strongly correlated

with the yen/dollar rate. Historically, large manufacturers’ aggregate recurring

profit has tended to be negatively correlated to the yen/dollar rate. A higher yen

does not necessarily compress recurring profit. Exceptional periods include the

early 1990s during the collapse of the economic bubble and at present alongside

the collapse of the credit bubble. In both cases, the yen’s rise coincided with a

weak economy in the US. At other times, when exports (earnings) were strong, the

yen rose, and when exports (earnings) were sluggish the yen weakened; the

stabilisation mechanism of the trade balance may have been functioning more

effectively. If the yen’s strength is causing the market to be overly concerned (the

market’s misunderstanding), then if and when the yen’s strength runs its course,

the stock market’s upside may be large. When the US economic recovery

accelerates and makes it seem very likely that the Fed could hike rates in H2, that

could potentially be the time when the market reverses its course. Link to full report here UBS SECRUTITES

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