The tectonic plates are moving beneath the Japanese markets

For many investors Japan has become a market they have felt happy to ignore for some time now. It can be argued that nothing has happened in the Japanese economy over the last 20 years as nominal GDP growth has been essentially zero over the period, although this disguises real growth of about 1% per annum offset by deflation of a similar amount. The budget deficit has been allowed to run at very high levels as the private sector has chosen to run a large financial surplus and moved from being very highly geared in 1990 to now having substantial net cash on its balance sheet. These deficits have been almost entirely financed by Japanese institutions, content to own JGBs yielding 1% or less, because the deflation still gave them reasonable real returns. The yen has benefited from these real returns, the continued trade surplus and the lack of enthusiasm displayed by the Bank of Japan to engage seriously in Quantitative Easing, in sharp contrast to the Central Banks in the other Western economies. The Nikkei stock market index fell more than 80% from its 39000 peak at the end of 1989 to its October 2008 low.

As with the devastating earthquake that did so much damage to Japan last year, so the tectonic plates beneath the Japanese financial markets now seem to be moving.

The nuclear disaster at Fukushima has led to almost all of Japan’s nuclear electricity plants being closed down over the last year. This in turn has resulted in a shortage of domestically produced electricity and a strong rise in Japanese energy imports, to the extent that the long-acclaimed trade surplus has now turned into a deficit, removing one of the key props to a strong yen.

The demand and supply picture of the JGB market which for so long has seen a balance between the enormous supply from the large budget deficit and the heavy demand for bonds from domestic financial institutions is in danger of deteriorating as the aging of the population is reaching a critical point where net inflows of contributions into pension funds are now more than offset by payments of pensions to those who have retired. The largest pension fund, the Government Pension Fund has now reached this position, so that the core investor in JGBs for many decades is now a net seller and will remain so for many decades to come. The budget situation remains dire, normal expenditure of Y90 tr for fiscal 2012, revenues of only Y42 tr leaving a deficit of Y48tr ($600bn) before a further Y3.8tr of earthquake reconstruction expenditure. Annual debt interest of Y22tr is over half of tax revenues. Austerity moves to curtail the budget deficit are likely to send the economy back into recession and so attention has turned to the Bank of Japan and its historic determination to avoid unconventional monetary policies as the only route left to ease the situation.

With the retirement of BoJ Governor Shirakawa later this year, the vacancy for his successor has created a Monetary Policy Committee more amenable to carrying out the government’s wishes. February saw a new turn in Japanese monetary policy as the BoJ announced a firm inflation target of 1% and an intention to overcome deflation, to which end it announced a Y10tr increase in Quantitative Easing. It is committed to further such moves until its inflation goal is in sight.

Financial market movements in recent weeks indicate that this as a significant move. The Japanese bond markets are no longer pricing in deflation, the yen has fallen sharply and broken its long term uptrend against the other major currencies and the Japanese equity market has broken its 5 year downtrend. The Second Section of the Tokyo Stock Exchange where the smaller domestic Japanese companies are traded has risen every trading day for 6 weeks, beating the 1975 record which marked a new bull market from the late 1974 lows. Such market action is rare and typically indicates that all the potential sellers have sold their positions. Japanese markets should not be ignored – important changes are occurring – sell JGBs, buy the equity market and hedge the currency.

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