Make Japan Great Again (MJGA)

Mar 08, 2024

We hope it won’t just be cherry blossoms making us smile this spring…

Key points

  • Risk assets continued to trade well, as lower government bond yields and hopes for US rate cuts helped consolidate sentiment.
  • Fed Chair Powell’s testimony before Congress was not as hawkish as some feared.
  • Recent meetings give us confidence in an upcoming policy shift by the Bank of Japan. It seems clear that the underlying trend in Japan is one of change.
  • The People's National Congress affirmed a growth target of 5%, but we remain downbeat on China’s prospects.
  • Eurozone policymakers continue to wait for more progress on inflation before easing policy.

US yields tracked lower over the past week, with Powell's testimony to Congress not as hawkish as some may have feared. With the Fed Chair reaffirming a narrative of rate cuts in the months to come, notwithstanding recent strong economic data and an equity market hitting record highs, yields have declined around 20bps from the highs towards the end of last month.

Meanwhile, some softening in recent ISM survey components has been latched upon as a sign that economic activity could be starting to slow. However, it strikes us as premature to jump to such a conclusion given the scarcity of supporting evidence. On that basis, we now feel more inclined to move towards a short stance on US rates, should yields continue to move lower.

Super Tuesday largely confirmed the prospect of the 2024 race for the White House as Trump versus Biden. At this time, Trump continues to look the favourite to secure the Presidency, with the former President recording a solid lead in the six key swing states, which will decide the election. Clearly, plenty can still happen between now and November.

That said, the legal challenge facing Trump may be fading. With a ruling on Trump's appeal that he should enjoy immunity not likely until June, it now appears that Trump is very unlikely to face a trial before September. Given how close this puts the date to this year's election, we suspect this means that the case will be pushed back beyond polling day. In that instance, it may now seem that Trump will only be forced to take the stand should Biden emerge victorious at that time.

Yet with Biden's approval rating currently the lowest of any sitting President at this stage of his tenure, it looks like the Democrats face an uphill battle for the White House. To make matters worse, were Biden to drop out of the race and be replaced by Kamala Harris or Gavin Newsome, indications are that Trump may be even more assured of claiming victory.

In Japan, meetings with investors and policymakers during the past week give us confidence in an upcoming policy shift by the Bank of Japan (BoJ). We believe that the LDP leadership is very close to announcing an exit from the deflationary past, with inflation now seen around 2% on a sustainable basis.

Indeed, we see Japan CPI remaining above this level through the coming year and upcoming wage data are also supportive in this regard. In mid-March, the outcome of the Shunto wage round will be announced and we look for an outcome between 4.5-5%, which would be 1% higher than 2023, which itself registered the strongest growth in the past 30 years.

On this basis, we think that the BoJ will end the Negative interest Rate Policy (NIRP) when it meets later this month. It is possible this could be pushed back to April but rather than the timing, the more interesting aspect will be indications on the future trajectory of rates in the country.

In this respect, discussions with policymakers support our thoughts that a neutral interest rate in Japan, R*, is likely around 1.25-1.5%, with inflation at 2%. On this basis we think that cash rates in Japan rise to 0.5% this year, with inflation overshooting consensus domestic forecasts.

This backdrop remains supportive with respect to short position in JGBs. We see 10-year yields supported at levels which are artificially rich, given that 30-year maturities trade at 1.7%. On this basis we continue to see JGBs above 1.25% by year end, and given that a decline in yields seems very unlikely from current low levels, so we foresee an asymmetrical forward-looking distribution of prospective returns.

BoJ policy action may also be a long-awaited catalyst to boost the yen, with the months ahead set to see yen rates rise, even as they decline elsewhere. This cost of carry in being long yen calls for patience in terms of timing.

However, there is a clear sense that the yen is too low, and it is truly startling to observe how cheap items are in Japan when contrasting to the experience overseas, notably in the US. This misalignment is also a factor that can push up Japan prices and with a wave of tourists likely in the upcoming cherry blossom season, Japanese citizens are struck by the conspicuous consumption of Western tourists.

Meanwhile, we detect rising domestic enthusiasm for Japanese stocks, with institutional investors initially slow to jump on the rally. Japan GDP shrunk in H2 2023, but data are likely to be revised upwards. Q1 GDP data are also going to be soft due to the Noto earthquake.

However, it seems clear that the underlying trend in Japan is one of change. We see more gains and efficiencies in corporate restructuring and rising labour market volatility, as past notions of lifetime employment fade into history. Certainly, it seems the coming fiscal year will be an interesting one in Japan, and it still strikes us that this is a market which many global investors have overlooked for too long.

Elsewhere, in China, the People's National Congress affirmed a growth target of 5%, which few commentators seem to believe is likely to be delivered, notwithstanding data reliability issues. We remain sceptical that Beijing can export its way out of a property-induced slump, as the US and EU have little appetite for additional Chinese imports.

Indeed, the past week has seen further steps in the EU to implement tariffs on cheap Chinese subsidised electric vehicles. Similarly, we sense reluctance to push the economy more toward a consumption-based model, which is seen as a more Anglo Saxon short-termist approach. Consequently, we remain downbeat on China prospects. Nevertheless, we doubt that a Chinese slide into domestic deflation will see falling prices overseas, in an echo to what held true in Japan in the 1990s.

In the UK this week, the Conservative government announced a tax giveaway totalling GBP9 billion. This is relatively modest compared to the GDP30 billion that Truss tried to deliver back in 2022. However, the truth is that Hunt and Sunak have been constrained, given a modest degree of fiscal headroom from the OBR, notwithstanding some relatively optimistic economic estimates.

Meanwhile, with Labour near certain to take the reins in government in November, we sense there will be increased scrutiny on the UK’s fiscal plans in the months ahead. This is a factor that could see a rise in the risk premium attached to UK fixed income assets, and we continue to look for gilts to underperform on a medium-term basis.

Headline inflation in the UK will fall in the next couple of months. Yet with core inflation currently close to 5%, wages at 6%, and a slew of service providers announcing RPI plus price increases in the coming weeks, so we see scope for inflation to trend back to levels much higher than the central bank target.

Consensus positioning on gilts is also quite positive at the current time and we see the risk of investors being disappointed, with the Bank of England unlikely to be able to cut rates, as many might hope. Meanwhile ongoing gilt sales in QT at a time when issuance is already elevated in the context of the fiscal deficit, creates a negative market technical which could be exposed were sentiment in the UK fixed income market start to shift.

In the Eurozone, this week’s ECB policy meeting was relatively uneventful. Policymakers continue to wait for more progress on inflation before easing policy, and we now project a first cut around June. Bund yields appear close to fairly valued in this context.

Meanwhile, we continue to be interested in discussions tilting towards increased fiscal spending on military requirements, which are being given greater urgency, as fears build around the prospect of an isolationist Trump back in the White House. Military spending will boost growth and could add to price pressures in some sectors competing for the inputs and components.

Risk assets continued to trade well in the past week, as lower government bond yields and hopes for US rate cuts helped consolidate sentiment. Some investors are expressing concerns relating to irrational exuberance and it does seem that as stocks push higher, so does investor complacency.

Yet we sense that the AI-driven boom may have further to run in 2024, before it eventually peters out. On this basis, remaining net long in risk exposure, but reducing positions and locking in gains as markets rise continues to seem like the most sensible approach to us for the time being.

Looking ahead

The focus is squarely back on the US data calendar, with upcoming payrolls and then inflation reports ahead of us. We expect to see some incremental softening of US labour demand going forward, though in CPI, we are more inclined to see risks of another number which is higher than the recent disinflationary trend may have previously suggested.

There certainly seems like a lot to talk about (and write about) in the macro landscape at present and certainly plenty of divergent themes across economies and markets. Following the data and listening to policymakers remains key to plotting the path forward and we continue to see opportunities where market-implied pricing seems to diverge from these trends.

It seems like a number of active investors have had a tricky start to 2024, and in some cases may have fallen foul of group think in consensus Wall Street research, or even been led astray by AI quant models which have sent misleading trading signals. There remains plenty of macro uncertainty and we believe adopting an open mind makes sense.

Meanwhile, it may be that some markets like Japan offer more obvious risk/reward opportunities for the time being, hence we are happy to focus our analysis in that direction. Hopefully there will be more to smile about coming from Tokyo, where there is an underlying narrative that the 'lost generation' might be ready to start rising up. Honestly speaking, if bitcoin can hit 70,000, then why not the Nikkei index at 70,000, as my talented Japanese equity colleagues might say....

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