Christopher Wood

christopher.wood@clsa.com

(852) 26008516

Verbal guidance in Japan?

Singapore
The latest Federal Reserve statement has not changed anything in the continuing tapering off debate with all eyes on tomorrows payroll data. Meanwhile, based on the revised US GDP data, nominal GDP growth continued to slow in the first two quarters of this year. Thus, US nominal GDP rose by 2.9%YoY in 2Q13 and a revised 3.1%YoY in 1Q13, down from 3.8%YoY in 4Q12 and an average of 4.6%YoY in 2012 (see Figure 1). This is an important point to GREED & fear since the view here remains that government bond yields are correlated to nominal GDP growth.
Figure 1

US nominal GDP growth

8 6 4 2 0 -2 -4

(%YoY)

New data

Old data

Source: US Bureau of Economic Analysis

Figure 2

US personal savings as % of disposable income

8 7 6 5 4 3 2 1

(%DPI)

New data

Old data

Source: US Bureau of Economic Analysis

The other point worth noting from the revision to the national accounts announced by the Bureau of Economic Analysis (BEA) yesterday is an upward revision to the personal savings rate. The US personal savings rates for 2012 and 1Q13 have both been revised up by 1.5ppts from 4.1% and 2.5% of disposable income respectively to 5.6% and 4%, while the 2Q13 savings rate is running at 4.5% (see Figure 2). This stems from a change in the way pensions are accounted for. Before the BEA only counted cash paid into pensions. Now it includes the full value of pensions promised, be they company pensions or government pensions. This makes it
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Christopher Wood

christopher.wood@clsa.com

(852) 26008516

look like consumers have more room for manoeuvre. In reality, however, they cannot monetise today these pension promises. The Japanese stock market has so far not responded enthusiastically to the LDPs victory in the Upper House election on 21 July. Indeed the Topix is down 4% since the result was announced (see Figure 3). This is in part because Prime Minister Shinzo Abe has not exactly rushed to announce structural reforms while market focus is turning towards the potentially negative consequences of the first part of the proposed hike in the sales tax due to be implemented in April 2014. This is because Abe has said he will make a final decision on this after seeing the growth data for second quarter GDP. The preliminarily figures are due to be announced on 12 August and the revised figures on 9 September.
Figure 3

Topix

1,300 1,200 1,100 1,000 900 800 700

Topix

Source: Datastream

Indeed the Nikkei reported last Saturday that Abe has asked for a second opinion on the economic impact of raising the sales tax and will entertain various ideas for changing the timing or size of the increase (see Nikkei article Abe To Weigh Options For Sales Tax Hike, 27 July 2013). According to the news article, Abes aides have begun assessing four options for the sales tax hike. The first one is the plan approved by the Diet last summer, namely raising the tax from 5% at present to 8% next April and to 10% in October 2015. A second option will spread the hike out evenly over five years, while the third will start with a 2ppt increase followed by three 1ppt hikes. And the last considered option is apparently to abandon the tax hike plan altogether. It should be noted that changing the timing or size of the sales tax hike would require new legislation. For this and other related reasons GREED & fear agrees with CLSAs Tokyo-based Japan strategist Nicholas Smith (see CLSA research Benthos - The election playbook, 18 July 2013) that the next BoJ meeting on 8 August has become important as the next potential catalyst for a Tokyo stock market rally. This is because the market will be looking to BoJ Governor Haruhiko Kuroda for some Flexible Mario-like verbal commitment that he will do whatever it takes to move Japan out of deflation. True, Kuroda has so far done as much as anyone could reasonably expect in terms of the BoJs purchases of JGBs since the annualised rate of central bank buying is running at Y74tn compared with the commitment made on 4 April of Y50tn a year (see Figure 4). Still in his verbal comments, Kuroda has been less convincing. Thus, he has expressed concerns about rising JGB yields even if rising bond yields would be an inevitable logical consequence of any successful effort to move Japan out of deflation.

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Christopher Wood
Figure 4

christopher.wood@clsa.com

(852) 26008516

JGBs held by the Bank of Japan

200 180 160 140 120 100 80 60 40

(Yen tn)

JGBs held by the Bank of Japan

BoJ target

Source: CLSA, Bank of Japan

Still there is another reason why the stock market will increasingly be looking for more explicit verbal guidance from Kuroda. This is because, as also discussed by Smith, there is a fundamental contradiction behind so-called Abenomics. For if Abe is ostensibly committed to moving Japan out of deflation, he is also claiming to want to pursue structural reforms, such as labour market reform, which if implemented would initially at least be deflationary. The same is true of the sales tax increase, long sought by the Ministry of Finances budget bureau, even if it would initially have the positive, albeit artificial, impact of front-end loading demand. This suggests that the financial markets will be looking to the central bank to make it crystal clear verbally that it will be prepared to combat, via whatever means deemed necessary, the potential deflationary consequences of the other aspect of Abenomics assuming, generously, that Abe actually pushes through with real structural reforms and the proposed sales tax increase. How might Kuroda do this? Well, one possible way would be for the current BoJ chief to indulge in more aggressive forward guidance or other verbal manipulations as a mean of keeping markets on-side. What is evident is that if the BoJ chief does not venture further down this road, in terms of making explicit the central banks determination to meet its 2% inflation target in about two years, there is a growing risk of equity market disappointment. On this point, GREED & fears guess is that Kuroda will eventually come to play the verbal guidance game with more vigour. But there is a risk that he will have to be forced into such behaviour by the markets. Meanwhile, what about the actual progress made to date in defeating inflation? The BoJs favoured inflation measure, core CPI excluding fresh food, did turn positive in June. But this was primarily the result of higher electricity charges caused by the governments continuing failure to turn back on nuclear power plants. Thus, Japan core CPI excluding fresh food rose by 0.4%YoY in June, the biggest year-on-year rise since November 2008, while electricity prices rose by 9.8%YoY in June, the largest increase since March 1981. By contrast, Japans CPI excluding food and energy still declined by 0.2%YoY in June (see Figure 5).

Thursday, 01 August 2013

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Christopher Wood

christopher.wood@clsa.com

(852) 26008516

Figure 5

Japan core CPI inflation and CPI excluding food and energy

4 3

(%YoY)

Japan CPI excluding food & energy Japan core CPI inflation (excl. fresh food)

2 1 0 -1 -2 -3

Source: CLSA, Japan Statistics Bureau

It is worth noting again that, despite the growing cyclical optimism on global growth, Japan s export data in US dollar terms does not yet show any sign that the goals of Abenomics will be helped by a significant pick-up in external demand. Indeed Japans export data in US dollar terms is even weaker than the rest of Asias. Thus, Japanese exports declined by 12.5%YoY in US dollar terms in June and were down 13%YoY in 2Q13. By contrast, Asia ex-Japan exports declined by 0.4%YoY in US dollar terms in May and were up 2.8%YoY in April-May 2013 (see Figure 6).
Figure 6

Japan export growth and Asia ex-Japan export growth (in US dollar terms)

60 40 20 0 -20 -40 -60

(%YoY, 3mma)

Japan

Asia ex-Japan

Source: CLSA, CEIC Data

For now, GREED & fear continues to take the view that the most likely outcome of Abenomics is another asset inflation cycle, which will be given a further boost in due course by more verbal and monetary intervention from the BoJ. Still it will be interesting to see in the next few months what Abe does, or does not do, with his electoral mandate. With his popularity rating still reasonably high at 63% (see Figure 7), if not at its highest, now is surely the time for action if he really does believe in structural reform.

Thursday, 01 August 2013

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Christopher Wood

christopher.wood@clsa.com

(852) 26008516

Figure 7

Approval ratings of Shinzo Abes cabinet vs other recent prime ministers

90 80 70 60 50 40 30 20 10 0 1

(%)

Koizumi Fukuda Hatoyama Noda

Abe (2006) Aso Kan Abe (2012)

6 7 (months in office)

10

11

12

Source: CLSA, Nikkei polls

Meanwhile if only able to own domestic or export stocks in a Japanese equity portfolio, GREED & fear would own domestic stocks because of the greater conviction here on asset inflation than on external growth despite the undoubted help provided by the weaker yen and lower breakeven points to Japanese manufacturers. This, however, means for bottom-up-orientated investors owning inferior quality companies. This is the dilemma facing fundamental investors in Japanese equities, as opposed to those trading in and out of ETFs.
Figure 8

Japan housing starts

30 20 10 0 -10 -20 -30 -40

(%YoY)

Japan housing starts

Source: CLSA, Ministry of Land, Infrastructure, Transport and Tourism (MLIT)

With this preferred domestic focus in mind GREED & fear will remove an exporter from the Japan long-only portfolio this week and include another housing company since the sector has sold off in part on concerns that the sales tax hike may be delayed. Accordingly, the investment in Honda Motor will be removed and replaced by an investment in Daiwa House (see Figure 21). Meanwhile, the Ministry of Land announced yesterday a 15.3%YoY growth in June in nationwide housing starts (see Figure 8). For more on this sector read a research note published yesterday by CLSAs Tokyo-based property analyst Cenk Simsek (Japan housing - Rising momentum, 31 July 2013).

Thursday, 01 August 2013

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Christopher Wood

christopher.wood@clsa.com

(852) 26008516

Aside from the asset inflation story, the other growing probability in Japan is long-delayed postearthquake reconstruction and classic LDP-style public works spending. On the subject of public works, it is encouraging that the latest data shows that the amount of contracted public works increased by 25.2%YoY to Y4.07tn in 2Q13, the highest level since 3Q03 (see Figure 9).
Figure 9

Japan amount of contracted public works

6 5 4 3 2 1 0

(Yen tn)

Value

%YoY (RHS)

(%YoY)

30 25 20 15 10 5 0 (5) (10) (15) (20) (25)

Source: East Japan Construction Surety (EJCS)

Figure 10

Shanghai Composite Index

3,600 3,400 3,200 3,000 2,800 2,600 2,400 2,200 2,000 1,800

Shanghai Composite Index 200-day moving average

Source: CLSA, Bloomberg

There is no doubt that sentiment on China remains more bearish than at the start of the year as reflected in the Shanghai Composite Index which remains 6.8% below its 200-day moving average (see Figure 10). The latest data on China diesel demand also again highlights the slowdown in the Chinese economy. Thus, China diesel demand declined by 0.7%YoY in 2Q13 and is down 0.2%YoY in the first half of this year (see Figure 11). Still this does not mean that the Chinese economy is falling apart. The residential property market remains relatively robust. Residential volume sales in 13 large cities tracked by China Reality Research (CRR) are still up 27%YoY in the year to 24 July and in eight tier 3 cities they are up 39%YoY. As for the trend in prices, the CRR property price index of 120 for-sale residential projects in 40 2nd and 3rd tier cities rose by 0.3%MoM and 4.2%YoY in June (see Figure 12). While outstanding property loans rose by 18.1%YoY to Rmb13.56tn at the end of June, up from 16.4%YoY at the end of March (see Figure 13).

Thursday, 01 August 2013

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Christopher Wood

christopher.wood@clsa.com

(852) 26008516

Figure 11

China diesel demand growth

25% 20% 15% 10% 5% 0% -5% -10% -15%

(%YoY)

China diesel demand growth

Source: CLSA, CEIC Data

Figure 12

CRR Property Price Index

7% 6% 5% 4% 3% 2% 1% 0% -1%

(%MoM) %MoM %YoY (RHS)

(%YoY)

35% 30% 25% 20% 15% 10% 5% 0% -5% -10%

-2% 2007

2008

2009

2010

2011

2012

2013

Note: Based on average selling prices at the 120 for-sale residential projects in 40+ 2nd and 3rd tier cities tracked by CRR. Source: China Reality Research (CRR)
Figure 13

Growth in China property loans outstanding

50 45 40 35 30 25 20 15 10 5 0

(%YoY)

Growth in China property loans oustanding

Note: Including real estate development loans and mortgages. Source: CLSA, PBOC, CEIC Data

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Christopher Wood

christopher.wood@clsa.com

(852) 26008516

Yet the property market is not accelerating in a manner which suggests imminent aggressive renewed tightening. Meanwhile, the continuing strong land acquisition by developers suggests there is still confidence in the durability of the cycle. Thus, new land bought by 26 leading listed developers tracked by CRR rose 63% in volume terms and 173% in value terms in June (see CRR report Property: Land Market Update, 24 July 2013). This picture of a China which is slowing, but not falling apart, is the message of a new column written by head of China Reality Research, David Murphy (see The Real Deal: A clear-eyed view of China with David Murphy, 26 July 2013). Meanwhile, the trillion dollar question remains how committed to reform and restructuring the new PRC leadership will prove to be. The best signal on this will be the Third Plenum of the 18th Central Committee of the Communist Party of China due to be held around October. But it is already evident that the new leadership is much more committed than its predecessor. The latest evidence of this was the announcement on Sunday in the form of a one-line statement by the National Audit Office that there will be a nationwide audit of all levels of government debt, which presumably will focus on local government debt. Meanwhile, the key pressure point for a return to more aggressive stimulus will be a material pick up in unemployment. So far this has been very marginal, as noted by Murphy. Still one evidence of contractionary pressure is that, based on the latest CRR quarterly SME survey, blue collar income growth has slowed from 9.3%YoY to 6.6%YoY over the past quarter (see Figure 14 and CRR report SME Quarterly: 2Q13, 15 July 2013).
Figure 14

China average wage growth of factory workers

20%

(%YoY)

Unskilled factory workers Skilled/managerial workers

15%

10%

5%

0%

-5%

Note: Based on CRRs quarterly survey of around 160 Chinese SMEs in about 60 cities. Source: CRR

If the China story this year is all about the extent to which the new leadership is ready and able to reform the economic model, it is self-evident that the China-driven slowdown in emerging market growth is now consensus with the latest cover of The Economist featuring precisely that theme (The great deceleration, 27 July 2013). One entirely non China-related aspect of the emerging market deceleration has been the relatively dramatic slowdown in India, the result in large part of a series of self-inflicted own goals. Recent weeks have seen renewed tightening moves by the Reserve Bank of India (RBI) in stark contrast to the easing posture which has been in place since the beginning of 2012. Thus, the RBI increased both the Marginal Standing Facility (MSF) rate and the Bank rate by 200bp on 15 July to 10.25%. They are now 300bp above the repo rate of 7.25% (see Figure 15). Additionally the RBI imposed a cap of 1% of deposits in the banking system, or Rs750bn, in terms of banks ability to borrow from the RBI at its repo window. The central bank also announced it would sell Rs120bn of bonds on 18 July. Then on 23 July the RBI further cut the
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christopher.wood@clsa.com

(852) 26008516

limit on bank borrowings from the RBI under the daily liquidity adjustment facility (LAF) from the aggregate limit of 1% of system deposits to 0.5% of deposits for each individual bank. The RBI also now requires banks to maintain 99% of their daily cash reserve ratio requirements as opposed to the previous minimum of 70%.
Figure 15

Reserve Bank of India policy rates

10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0

(%)

Marginal Standing Facility Repo rate Cash reserve ratio (RHS)

(%)

6.5 6.0 5.5 5.0 4.5 4.0 3.5

Source: RBI, Bloomberg

Figure 16

Indian rupee against the US dollar

42 44 46 48 50 52 54 56 58 60

Indian rupee/US$ (inverted scale)

62 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13
Source: CLSA, Bloomberg

The key motive behind all these moves has been to try to shore up the rupee which had broken through the psychologically critical Rs60/US$ level. The measures had succeeded in stabilising the currency until Tuesday (see Figure 16). The irony here is that the currency market seems to have sold off in response to the message conveyed by the central bank in its pre-policy meeting macro assessment released on Monday when it stated that recent tightening measures had provided, at best, some breathing time and that the tightening strategy would only succeed if reinforced by structural reforms to reduce the current account deficit and step up savings and investment. This is a familiar refrain from the RBI and it will be interesting to see if the next RBI governor will be more effective in applying pressure on Delhi than the current relatively battered incumbent Duvvuri Subbarao who is due to step down in early September. Still investors should not bet on it though, in GREED & fears view, it will be a definite positive for sentiment if the

Thursday, 01 August 2013

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Christopher Wood

christopher.wood@clsa.com

(852) 26008516

next RBI Governor is, as expected, the current Chief Economic Advisor to the Finance Minister and former IMF chief economist, Raghuram Rajan. The Indian story has now become all about the outcome of the approaching general election which has to be held by May 2014. Clearly, the stock market would most like to see a BJP-led coalition led by Gujarat state leader Narendra Modi. For now that looks more like a possibility than a probability due to the BJPs lack of coalition partners. Modis appeal is also primarily to the urban middle classes, not the rural masses benefitting from Congress populism of which the latest example is the proposed Food Security Act, the pet scheme of Italian-born Congress leader Sonia Gandhi. Meanwhile, the main point to be made about the approaching election is the sheer unpredictability of the outcome. This is evident from the release of two opinion polls over the past week giving precisely contrasting messages, one showing rising support for the BJP, one showing less. Thus, CNN-IBN opinion poll results published over the weekend suggest that BJP will emerge as the largest party with about 156-164 seats in the 543-seat parliament, up from 116 seats in 2009. Congress is predicted by the same poll to lose about 70 seats from 206 seats in 2009 to 131-139 seats. Then Times Now came out with another opinion poll on Tuesday projecting that the opposition NDA coalition would win 156 seats with the BJP alone getting only 131 seats, while the ruling UPA coalition would win 136 seats with the Congress pegged to 119 (see Figure 17). This compared with the April poll results which projected the BJP would win 141 seats. This, therefore, suggests that both the BJP and Congress will fall well short of forming a government. Remember that the total number of seats required to form a government is 272 in the 543-seat parliament.
Figure 17

Projected parliamentary seats won by BJP/Congress and allies

Party / Alliance BJP BJP allies NDA Congress Congress allies UPA

2009 Apr-13 poll election Times Now 116 16 132 206 21 227 141 24 165 113 15 128

Jul-13 poll Jul-13 poll CNN-IBN Times Now 156-164 13-19 172-180 131-139 15-21 149-157 131 25 156 119 17 136

Source: CLSA, CNN-IBN, Times Now

Amidst this confusing picture, the key points to note are that it appears for now to be much easier for the Congress to secure coalition partners, such as regionally focused parties, than the BJP. While the view of CLSAs India office is that the BJP will need to win at least 200 seats on its own to form the next government, which compares with the 116 seats it won in 2009. That is the challenge facing Modi. But he is definitely a very different type of Indian politician with a track record of clean and efficient government in Gujarat. In GREED & fears view the bigger the sense of crisis in India, the better his chance of winning. Meanwhile, the risk for the stock market is that foreigners are now panicked further out of their equity positions by the chronically weak rupee. Having bought a net US$15.1bn worth of Indian equities in the first five months of this year, foreigners have sold US$2.8bn in the past two months. Meanwhile, CLSAs Indian economist Rajeev Malik now forecasts that the rupee will
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christopher.wood@clsa.com

(852) 26008516

reach Rs65/US$ by the end of 2014 (see CLSA research Infofax Daily: India policy - Politically correct RBI, 31 July 2013).
Figure 18

Cumulative foreign net equity investment in Indian equities

40 36 32 28 24 20 16 12 8 4 0

(US$bn)

India cumulative FII net equity investment

(4) Jan 11 Apr 11 Jul 11

Source: CLSA, Bloomberg

Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13

The debate on who will succeed Billyboy Ben at the Fed has picked up momentum in the media over the past week with opponents to the Larry Summers candidacy making their concerns very clear. Interestingly, this criticism has come as much from the Democratic left as the Republican right. This has also raised focus on an increasingly apparent phenomenon, and one which was the subject of a recent interesting article in the International Herald Tribune (On view, tensions among Democrats; Obama speech highlights a new divide on the left over economic disparity, 26 July 2013). That is the internal divide in the Democratic Party on economic policies. This is because many on the left of the party are concerned that the policies of the Obama administration have done more to help Wall Street than ordinary Americans given the preference for bailouts under Tiny Tim, and given the lack of any compelling evidence of a pickup in ordinary Americans income growth. Aside from the issues raised over the Summers candidacy, these concerns are also shown by a new bipartisan effort to re-establish the Glass Steagall Act which legally separated investment banking from commercial banking. This 37-page long legislation was passed in 1933 and repealed in 1999. GREED & fear refers to a bill brought before Congress in mid-July jointly sponsored by Democrat Senator Elizabeth Warren, Republican Senator John McCain and two other senators. What is interesting about the renewed Glass-Steagall debate is that the left and the right tend to agree on the need for reform while the moderate centre seems most in hock to the still ultra-powerful banking lobby. The left sees the need to reform high finance while the right wants to remove the threat to taxpayers caused by allowing financial institutions to make leveraged bets with federal government insured deposits. In similar vein, the above mentioned article notes that Senator Warren is also proposing that college students and recent graduates still burdened with the legacy of student debt should only have to pay the same annualised interest rate for a year, as the Fed offers banks, namely 0.75% based on the Federal Reserve's discount rate.

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Christopher Wood
Figure 19

christopher.wood@clsa.com

(852) 26008516

US student loans held by the federal government

600 500 400 300 200 100 0

(US$bn)

US student loans held by the federal government

Source: Federal Reserve - G.19 release on consumer credit

GREED & fear can easily imagine the appeal of such arguments; most particularly as federal government-guaranteed student debt has become a meaningful number in aggregate while its annualised growth still accounts for a large part of the overall growth in consumer debt. Thus, outstanding student loans held by the federal government rose by 21.8%YoY to US$566bn at the end of May, up from US$104bn at the end of 2008 (see Figure 19). While federal student loans have increased by US$101bn in the 12 months to May, accounting for 64% of the total increase in consumer credit of US$158bn (see Figure 20).
Figure 20

US annualised consumer credit flows

200 150 100 50 0 (50) (100) (150) (200)

(US$bn, annualised)

Revolving credit Federal student loans Other non-revolving credit

(250) 2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Source: Federal Reserve - G.19 release on consumer credit

The above sort of policy initiatives being championed by Warren also highlights why, if ordinary Americans income growth does not recover soon in a meaningful way, investors should expect political debate to move further in this direction. This would suggest a path to debt haircuts and the like where creditors in the form of bondholders and banks take the hit. The potential threat to municipal bondholders caused by the bankruptcy of Detroit in mid-July is another reminder of this. The issue here is who takes the loss; bondholders or former city employees hoping their pensions will be honoured. So far the financial lobby has done a remarkable job of preventing debt forgiveness given its clear culpability in the financial crisis. Still that does not mean that its lobbyists will prevail forever. The growing threat of debt haircuts in the not too distant future also illustrates the absurdity of the continuing Basel based practice of imposing arbitrary risk-weightings on
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christopher.wood@clsa.com

(852) 26008516

certain types of bank assets. Indeed it is extraordinary that this approach is still continued after it had been so discredited in 2008 but, at least now, simple leverage ratios have also become part of the discussion - as is evident from this weeks capital raising by Britains Barclays Bank. In GREED & fears view leverage ratios should be the only part of the discussion on bank capital with the Basel approach discarded completely. But if that is the correct way to go it is also highly unlikely since the 0% risk-weighting on government debt under Basel continues to incentivise banks to buy their own governments debt, a highly relevant point at present in the context of the Eurozone periphery.
Figure 21

Japan absolute-return long-only thematic portfolio Theme Real Estate Weight Stocks (%) 29 Mitsubishi Estate Mitsui Fudosan Sumitomo Realty Sekisui House Daiwa House Autos 11 Isuzu Motors Toyota Motor Mazda Motor 15 Keyence Fanuc Nabtesco Mitsubishi Heavy 8 Sumitomo Metal Mining 23 Sugi Holdings Tsuruha Holdings Seven & I Lawson Avex Group 3 Japan Airport Terminal 5 Sumitomo Mitsui Trust 6 Ship Healthcare Nihon Kohden Description real estate company real estate company real estate company property developer property developer truck maker automaker automaker optical-sensor maker industrial robot maker precision gear manufacturer heavy machinery maker gold & non-ferrous metal miner drugstore operator drugstore operator convenience-store operator convenience-store operator music & video business Haneda airport operator specialist financial institution medical equipment distributor medical equipment manufacturer Weight (%) 10 6 5 4 4 3 4 4 4 4 4 3 8 6 6 4 3 4 3 5 3 3

Machinery

Gold mining Consumer

Airport Financials Healthcare Source: CLSA

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