Japan’s Bullish Case: From ‘Trust Me’ To ‘Show Me’

It is one thing to set an inflation target, but quite another to reach it.

Japan Inflation Target
Japan’s high government debt burden, poor demographics, and the prospect of a VAT tax hike next year all suggest that the exit from deflation will not be straightforward. At the very least, with Japanese stocks now trading at 17-times consensus 2013 earnings (a 20% premium to the global average), the bullish case for Japan has shifted from a “trust me” story to a “show me” story. Having promised so much, policymakers now have to deliver.

Fortunately, there are reasons to be optimistic. Many of the key drivers of deflation – falling land prices, corporate deleveraging, the shift of workers from highly paid full-time positions into lower wage temporary contracts – have largely run their course. The geopolitical threat posed by China’s ascendency in the region has also emboldened Japanese leaders to finally bring the economy out of its funk. In an auspicious sign, GDP grew 3.5% in Q1, boosted by exports and improving consumer confidence.

In any case, investors are in for a bumpy ride. The Bank of Japan is trying to raise inflation expectations (which is bad for bonds) by buying bonds (which is good for bonds). Threading this needle will not be easy. Ultimately, the BOJ’s policy actions should translate into somewhat higher nominal JGB yields but lower real yields. Real rates in Japan have declined significantly but remain above comparable real rates in the U.S. As real rates in Japan continue to drift lower, Japanese stocks, after a much needed consolidation period, will eventually resume their ascent, while the yen will come under renewed pressure.

Gold, Liquidation And The Dollar

We continue to recommend underweight positions in precious metals within the commodity complex.

Gold, Liquidation And The Dollar

Speculators are still net long gold futures and gold ETF liquidation continues. These shifts are no longer at an early stage, and the “panic lows” of last month have survived their first test. Still, the combination of a rising dollar and firm global bond yields is not friendly to gold (and silver).

The multi-decade relationship between the U.S. equity risk premium and gold prices points to further headwinds and reduced demand for “safe havens” like gold. The dollar outlook is complex, but what is clear is that the trade-weighted dollar has risen above the 84 level that offered resistance in mid-2012. An extension of the current deflation scare would likely keep gold under pressure, given the Federal Reserve’s reluctance to extend quantitative easing any longer than absolutely necessary.

Overall, our recommendation to avoid bottom fishing gold and silver remains intact. Gold would stabilize in the $1300-1400/ounce zone if the dollar bottoms out.

Stay tuned.