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Japanese Stocks Are Up, But Don't Fall for the Trap

Japanese stocks hit a new 2012 high today (Wednesday) and the yen weakened to a 20-month low against the U.S. dollar as Shinzo Abe was installed as Japan's 96th prime minister.

Abe, who served as prime minister in 2006-2007 but stepped down due to health issues, has vowed to pursue aggressive monetary easing to end deflation and get the Japanese economy growing again.

But the long-term implications of Abe's policies aren't as rosy as the short-term stocks boost.

"The hope is that Abe's promises of fresh stimulus, unlimited spending and placing a priority on domestic infrastructure will be the elixir that restores Japan's global muscle," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "As a veteran global trader who actually lives in Japan part time each year, and who has for the last 20+ years, let me make a counterpoint with particular force –don't fall for it."

Japan's Policy Changes

One of the promises Abe made during this month's election campaign was to pass a 10 trillion yen ($117 billion) supplementary budget for the current fiscal year, which ends March 31, 2013. Abe reiterated his call for the supplementary budget to be passed quickly.

The new government will formulate an "Emergency Economic Plan" by Jan. 11, 2013, which will be incorporated into the 10 trillion yen supplementary budget and will then be presented to the Diet on Jan. 15. Changes to the tax code will be prepared by mid-January, which are likely to include a major cut in the corporate tax rate.

Abe's biggest changes will likely be to Japan's central bank policies.

At last week's meeting of the Monetary Policy Committee — the BoJ's equivalent to the Fed Open Market Committee (FOMC) –the Committee decided to "review the Bank's price stability goal."

In other words, the central bank, which already has an inflation target of 1%, will decide on whether it should raise the target to 2% as Abe has demanded.

In addition, the BoJ last week decided to allow private sector banks to fund the net increase in new lending at the overnight call loan rate of 0.1% for a period of up to four years. The central bank hopes to encourage banks to lend more money by making loans more profitable.

Effect on Japanese Stocks and Yen

Financial markets have been anticipating an economic recovery in Japan. The yen has weakened against most major currencies and is now standing at a 20-month low against the U.S. dollar.

Yen weakness has been interpreted as good news for Japanese exporters. Japanese stocks are at a 2012 high as investors buy manufacturers of export goods such as cars and electronics. Construction shares are also higher in anticipation of extra government spending on public works projects and earthquake recovery.

The yield curve has steepened in the Japanese government bond (JGB) market with long-term rates rising ahead of an expected increase in inflation as the result of Abe's policies. Even so, 10-year JGBs yield only 0.79%.

Japanese Stocks: Long-Term Concerns

While the new policies may result in a short-term pop in economic activity, as Money Morning's Fitz-Gerald pointed out, there are other forces at work that are weakening the Japanese economy over the long term.

Chief among these is the declining Japanese population.

"The demographics are working against the struggling island nation as well," Fitz-Gerald said. "This isn't a policy debate. It's not a partisan issue. It's a numbers game and right now the numbers are getting smaller."

According to Fitz-Gerald, Japan is now a "post mature" society, with a preponderance of old people and not enough younger, productive people having children.

"The implications of this demographic shift are tremendous. The newly elected Abe-san can print all the money he wants. He can build more bridges to nowhere and even double the Bank of Japan's inflation target to 2% if he likes," Fitz-Gerald continued. "It won't make any difference on anything other than a short-term basis."

You can't fight Father Time. Japan's population is getting older and the birth rate is declining as young Japanese forego marriage and family for a more self-centered single lifestyle.

Based on government population projection trends, by 2160, Japan's population will be around 12 million –about the same level as it was in 1600 — down more than 90% from the population today.

If these trends continue, by 2360, Japan's population is projected to be the same as it was at the time of Christ. One hundred years later, in 2460, the entire population of Japan would not fill Tokyo Dome stadium, which has a seating capacity of 55,000.

These projections are intended to be somewhat tongue-in-cheek but the key point is, you can't have sustained economic growth without a growing population.

With traders placing big bets on the success of Abe's policies, which do not address the underlying population trend, the contrarian play would be to trade against this short-term move.

In other words, look for more of the same –a strong yen, strong JGBs and weaker Japanese stocks.

It's not just Japan suffering from population issues. Fitz-Gerald discusses the implications of a declining birth rate for the United States and Europe here.

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