Japan The End of the Beginning Macro Economic Research April 2013

Putting the Recent Moves in Context Japanese equities are up nearly 60% from the November 2012 lows, making it by far the best performing market 2013 YTD (up 33% in USD compared to 11% for the S&P500).

Perhaps the most important driver of the move has been the close to 30% depreciation in the Yen. Since replacing aging hawk Shirakawa as the new Governor of the Bank of Japan, Kurodo has set a target of achieving 2% inflation within 2 years, and accelerated QE to asset purchases of some $75bn per month.

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Japan The End of the Beginning Macro Economic Research April 2013
The sharp move has resulted in some brokers scaling back expectations, for example Morgan Stanleys April 15 piece, the cover page copied below.

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Japan The End of the Beginning Macro Economic Research April 2013
I think they are wrong and a longer term view is necessary to evaluate the moves, a forty year chart of the Yen is shown below.

The longer term chart of the Topix index also puts the recent appreciation into context.

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Japan The End of the Beginning Macro Economic Research April 2013
Also important is current valuations. Despite the gains the Topix 100 index still has a higher dividend yield (1.7%) than any time prior to 2008 (the gold line in the chart below). Earnings growth in 2013 is expected to be around 50%. In addition, the majority of dividend-paying companies have very healthy balance sheets (huge net cash balances are common in deflation-honed Japanese balance sheets) and hence it is easy to conclude that dividend payouts are likely to grow rapidly in 2013 and 2014.

With cash yielding nothing and the long bond trading around 0.6%, on a relative basis equities are yielding 2.8x bonds, higher than any time prior to 2012. This relative valuation imbalance can normalise in two ways a collapse in dividends (which is not plausable near-term given earnings growth and balance sheets) or a sell off in bonds raising yields, or some combination of both. Given the massive QE buying of bonds, any sell off in the face of this would be valuable evidence that Japanese market participants are starting to believe the BoJ can achieve their 2% target. That belief could be very dangerous what real yield would be appropriate for bonds in that environment? What would a significant move up in nominal yields mean for the banking sector (who are massively long bonds)?

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Japan The End of the Beginning Macro Economic Research April 2013
Current Positioning of Japanese Households The Bank of Japan flow of funds data provides an up to date (December 2012) snapshot of household financial assets. The graphic below compares households in Japan, the USA and Euroland, who have financial assets of Y1547tr ($15.5tr), $54.4tr and EUR19.3tr ($25.1tr) respectively.

Two decades of low nominal growth and deflation have massively impacted which financial assets Japanese households own. The largest asset by far is cash on deposit with local banks, despite no yield historically an attractive asset given persistantly declining prices. The second largest asset, Insurance and Pension reserves, is primarily exposure to Yen bonds. For further insights into this the BofJ data can be used to drill down into some of the investment catagories shown above to enable an evaluation on a see-through basis.

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Japan The End of the Beginning Macro Economic Research April 2013
InsurersFinancial Assets Japan Total Y403.8tr ($4.0tr)

InsurersFinancial Assets USA Total $7.0tr

A similar exercise can be done for Pension Fund Assets (Japan (top) Y125.4tr = $1.2tr, USA (bot.) $11.2tr)

While Outward Investment in Securities makes up some 12.5% of Insurance and 20.9% of pension assets, the majority of these exposures are likely to be currency hedged back into Yen, so while there may be some yield pick up, they may not be an effective hedge against Yen weakness.

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Japan The End of the Beginning Macro Economic Research April 2013

%age of Total Financial Assets Equities Investment Trusts Insurance Pension Funds Bonds/loans Cash on deposit Other Total

Japan Total 6.8 4.0 21.1 6.6 2.1 55.2 4.2 100.0

Bonds

Cash

Equities

Off shore Sec

Infn Proof Total 6.8

USA

Equities

6.8 0.8 15.3 2.2 2.1 55.2 0.2 0.3 0.6 1.3 0.7 2.3 3.1 1.6

32.8 11.8 10.8 17.3 9.5 14.6 3.2

32.8 5.5 2.9 8.5

2.9 4.4 2.3

20.4

55.7

9.4

7.0

16.4

100.0

49.7

The aggregated see through data enables us to evaluate Japanese Household Financial asset exposures. With some 76% of assets invested in local deposits and bonds, and some 16% invested in equities and foreign securities, Japanese Households are taking a huge bet that the Bank of Japan will not be successful in reaching a 2% inflation target. The actual positioning is even worse than illustrated above as most of the foreign security holdings via insurance companies and pension funds are currency hedged back into the Yen. Ironically given where yields are, buying equities or foreign bonds will not only provide protection of capital in a weaker Yen/higher inflation environment, but will also immediately increase yield a very rare win/win. What historically was a low risk positioning (cash in the bank) is now fraught with risk of real loss of capital in a very plausable scenario of higher inflation and pegged rates. Foreign Involvement Foreign participation in Japanese equities has dramatically increased. For example, the Wisdomtree Japan Hedged Equity ETF has increased in size from $600m to $7.1bn in 2 quarters. Despite the sharp price appreciation, the portfolio still looks attractively valued, especially given the strong earnings growth expected near-term in Japan.

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Japan The End of the Beginning Macro Economic Research April 2013

Conclusion Japanese households are well positioned for a continuation of the two decades of slow nominal growth and deflation. They are terribly positioned for a successful reflation. I expect the process of reducing the existing risky positioning to have a considerable impact on Japanese equities and a lesser but still significant impact on the Yen going forward. This process has hardly begun, and can be expected to take many years. Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning. Winston Churchill, November 1942

Kevin Cousins is a portfolio manager at Brait Capital Management Limited. ("BraitCM"). This article is prepared by Kevin as an outside business activity. As such, BraitCM does not review or approve materials presented herein. The opinions and any recommendations expressed in this article are those of the author and do not reflect the opinions or recommendations of BraitCM. None of the information or opinions expressed in this article constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Either BraitCM or Kevin Cousins may hold or control long or short positions in the securities or instruments mentioned.

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