Monetary policy and economic growth
With an annualised growth rate of 3.9%, the Japanese economy picked up momentum in the first quarter, stabilising its economic uptrend.
At the same time, fears are growing that Japanese central bankers could be pressured into normalising their monetary policy accordingly, which could be detrimental for equities. These fears seem to be unfounded.
The Bank of Japan should continue its extreme expansive policy for some more time to come, and potentially even expand it some more. One reason for this might be found in the still lagging consumer price inflation. The Bank of Japan brought in Quantitative Easing to boost prices but low inflation has forced the central bank to postpone its own inflation target of 2 % to the year 2016, and there is a high probability that this objective will have to be pushed back even further.
However, should deflation fears fade, the overall interest rate basis might nevertheless rise in Japan. The Bank of Japan is aware of this risk to economic development, which will probably keep it on course to keep rate levels low until a sustainable growth path is seen. As the IMF advised the Bank of Japan to prepare to expand its Quantitative Easing-programme, Japanese central bankers may find international backup for their course of action.
Considering the above mentioned and divergence between monetary policy, Fed and BoJ, the yen's devaluation could continue in the coming months.
This is supported by the technical chart analysis in which we saw a breakout of the sideways range of the USD/JPY currency pair between 122 and 115.50 JPY since December last year. With the rise above the 122.60 JPY level, bullish signals on multiple time frames were generated with a potential measured target around 135 JPY.
By taking out the distance of the triangle from the weekly chart that developed since December, and adding it to the breakout level, we get a theoretical measured target of around 128.50 JPY.
Looking at the monthly chart, it becomes even more interesting as we see the 78.6% retracement downward move from the 2002-high to the 2011-low. From a technical point of view, this could have paved the way up to the 2002 high at around 135 JPY, with an intermediate level at 125.60 JPY, thus representing the October-high of 2002.
The USD/JPY pair recently rallied and then pulled back to retest its 122.00 breakout point as new support, which is common. Should it continue to hold, then the rally could really start in earnest. Should the pair fall back below 121.50, the situation could flip and recent action could result in a false breakout with further downward risk.
On 10 June, Bank of Japan Governor Kuroda confused the markets by saying it is hard to believe the USD/JPY will decrease, thus intensifying the correction in the USD/JPY pair. This rebound effect soon faded as the Japanese government backpedalled away from his comments on valuation.
On 14 April we had a similar situation when Japanese PM Abe’s advisor Hamada expressed that the appropriate rate for JPY against USD should be around 105 JPY. This also led to some declines which soon faded, and only a month later we saw the start of the current rally.
Corporate Governance, shareholder-value and the Government Pension Investment Fund (GPIF) are additional drivers
An important factor which could further fuel the run of Japanese equities can be found in the potential adaption of a more Western Corporate Governance model by Japanese corporations, which form part of the reforms summarised by Abenomics.
One of the goals of Abenomics is to raise the rate of Return-on-Equity (‘ROE’) in Japan. Traditionally Japanese companies haven’t attached as much importance to ROE as Western companies.
In the US, the Return-on-Equity level recently reached around 14.0%, compared to roughly 8.3% in Japan. At the same time, Japanese companies continue to sit on huge cash levels which can drag down ROE as returns on cash sitting in a bank tend to be low along with interest rates. In 2014 the cash holdings of Japanese companies reached a record volume of 46%, compared to Japanese GDP.
One way of narrowing the gap between Japanese and Western ROE can be found in stock-buyback-programmes, which have been gaining popularity in Japan. According to PM Abe’s reform programme, the principles of shareholder value, which have traditionally come after stakeholder value in Japan, are meant to gain in importance. This change is already underway as last year, dividend payouts by Japanese companies surged by 33%.
Because of this, Japanese equities may not only attract more foreign investors, but also Japanese retail investors, as bonds currently trade at zero yield levels and inflation may slowly pick up. A stabilising factor for Japanese equities can be found in the world’s largest pension fund GPIF, which pronounced its intention last year to increase its domestic equity weighting to 25% from roughly 17%. Other Japanese funds could follow this lead.
The chart situation for the Nikkei 225 allows room for further potential upside. A decades-long downtrend in the Nikkei 225 was finally broken last year, a significant technical turning point.
Currently the Nikkei 225 is reaching the 127.2%-extension of the distance between the 2007 high and 2008 low, just below the high from the year 2000 around 20,850. It wouldn’t be a surprise to see the rally lose its momentum. At 18,300, the 2007-high, it might find support.
An appreciation above 21,000, on the other hand, could trigger another rally up toward 22,750 and maybe even 24,300. This scenario depends on the 18,300 level holding, the Bank of Japan keeping its stimulus/QE programme up and the US maintaining an upward economic trend that enables market participants to digest a potential US rate hike.
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