The Japanese Topix Index is up more than 40% this year (and nearly 71% since July 2012) thanks in large part to Prime Minister Shinzo Abe's unlimited stimulus initiative known euphemistically as "Abenomics."
The argument behind this spending is a classic one, at least in economic terms: stimulate the economy to produce higher inflation, weaken the currency and aid the exporters.
But like Fed Chairman Ben Bernake's spending here and Draghi's spending in Europe, it's ultimately going to fail.
Sure the short-term effects are great...a wildly enthusiastic stock market that's trading at the highest levels seen in 4.5 years, a relaxation of risk and fresh strength in export focused companies that are showing stronger results on a devalued Yen. No question, I'll take a bull market any day.
It's the hangover I'm worried about - nobody knows how long this run will last.This is especially problematic because most investors don't have the discipline needed to trade in and, of course, out when the party stops.
Piercing the Veil
I bring this up because it's not popular right now to look behind the scenes or inside the kimono, as the old expression goes:
- Although Japan is known as an export market, it actually imports more than it exports, to the tune of $857 billion in imports versus $793 billion of exports. This is particularly a vexing problem with regard to fuel. Ninety-six percent of Japan's reactors remain off-line since the earthquake/tsunami of 2011. The corresponding rise in liquid natural gas expenditures was more than 50% in Q1 at 624 billion Yen. That hasn't yet hit earnings, especially in power intensive manufacturing sectors.
- Japanese citizens have experienced a 27% drop in purchasing power (against the USD) since September 2012, when the Yen began its slide. At the same time, costs are going up faster than wages. I see the effects in my neighborhood (in Tokyo) daily as once spotless cars go unwashed, paint is peeling off buildings and the formerly flawless facade of Japan starts showing some cracks.
- The Japanese mortgage market is backfiring in reaction to stimulus. Case in point, the latest data from Mizuho Securities shows rates rising at a time when they should be falling thanks to the Bank of Japan flooding the system with cash. The 30-year mortgage, for example, rose from 1.80% to 1.81%. Contrast that with the U.S. which saw mortgage rates fall by nearly 50% in reaction to Bernanke's stimulus from 2008 to May 2 all the way to 3.35%.
- Combined public, private and corporate debt was already approaching 500% of GDP before this stimulus. Nobody knows how much higher it can go, but to say the nation is functionally bankrupt is an understatement.
- The population is literally dying off and household savings are in decline. This means the excess capacity needed to absorb newly minted Japanese bonds is also in decline. Unless, of course, Japan goes to external sources. But then, there's a real problem...international markets will demand higher rates to cope with higher risks. Derivatives traders are already lining up to play this game the way they did with Greece, Spain and Italy. The true cost of capital will more than double.
- Volatility risk is rising, so this game is already underway. Because the Bank of Japan is buying government bonds, they are effectively locking out other market participants and reducing liquidity. Not surprisingly, volatility is rising and the markets are going to fast become addicted to implicit BOJ support the way a drug user depends on his next "fix."
Are There Any Winners?
Yes. Quite a few actually: 310 out of 521 Topix companies that have reported since April 1 have beaten analyst estimates soundly.
But to really home in on the winners, you've got to focus on those sectors that will derive the biggest benefits from Abenomics: Japanese financial companies, car makers and industrial ceramics.
The financial companies are pretty easy to understand. The flood of government liquidity will help them generate higher profits while also flushing
them with cash.
If they lend it into the system instead of hoarding it like the big banks in the United States, there could be some huge profits working their way to the bottom line.
My favorite is Sumitomo Mitsui Financial Group, Inc. (NYSE: SMFG):
Japan's second-largest bank by market value, recently reported record net
income of 790 billion yen ($8 billion), which represents a 52% increase over the previous year.
The company also announced it raised its annual dividend by 20%, to 120 yen.
As of December 31, 2013 the company reported profit margins and operating margins of 18.28% and 37.37%, respectively.
When it comes to car makers, I like Daihatsu (Tokyo: 7262.T or OTC: DHTMY). I could easily go with Toyota (NYSE: TM) given its global scale, but the much smaller Daihatsu has stayed largely focused on its home markets.
The company recently announced the April 8, 2013 launch of its new MEBIUS, a
hybrid passenger vehicle, built under an OEM arrangement with Toyota. The MEBIUS represents the second hybrid vehicle supplied under an OEM arrangement after the ALTIS.
In fact, Toyota actually owns 51.3% (218,649,000 shares) of Daihatsu shares, as of March 31, 2013).
With a focus on Japanese (nationwide) sales, the company once again demonstrates its domestic focus. Also, sales of MEBIUS could be boosted at a time when Japanese consumers are feeling the impact of increasing fuel costs as a result of a weakening Yen.
In the industrial ceramics sector, I like Kyocera (NYSE: KYO). While many Japanese hi-tech manufacturing companies are struggling to remain competitive in markets they once dominated, Kyocera has charted a clear path forward.
The Kyoto-based company recently reported FY3/2013 Components Business Sales of ¥725.1 billion, which represents a 12.89% increase over the same
period a year ago.
The company's Electronic Device Group and Applied Ceramic Product Group sales were up ¥42.8 billion and ¥31.7 billion, respectively on strength from Kyocera Display Corp and expanded solar energy business in Japan, respectively.
I think we could see the solar energy business lead to increasing sales as a result of Japan's shutdown of its nuclear power-producing operations. I also expect Japan to become the world's second largest solar market after China as this shift matures.
Looking forward, the company is forecasting FY3/2014 net sales, profit from operations, pre-tax income and net income attributable to shareholders of ¥1,400,000 million, ¥140,000, ¥150,000, ¥96,000, which would represent increases of 9.4%, 82%, 48%,and 44%, respectively over the same period a year ago.
At the end of the day, stimulus is what it is...a well-intentioned but completely flawed effort to master the immutable laws of money.
That's why you want to go with investment choices that have the equity necessary to underwrite the risks that come with it.
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