Tuesday, March 12th, 2013

What’s the Japanese for Inflation?

Every few years, macro hedge funds are offered an irresistible trade. A new set of bureaucrats or politicians takes over the Bank of Japan, the LDP or the MITI promising to return Japan to growth and end deflation. The yen falls, the equity market rises, and anybody who is short the yen and long the equity market can look forward to some excellent performance-related compensation.

The latest episode dates back to the beginning of the election campaign which saw Shinzo Abe elected as Prime Minister. Since the election was called on November 16th (opinion polls consistently pointed to a large LDP majority) the yen has depreciated by 15% against the dollar and the total return on the TOPIX has been 37% in yen terms. This is a nice trade for hedge fund managers, but conventional equity managers, who don’t hedge any of their currency exposures, have not been too excited. In dollar terms the TOPIX is up 17% over the same period, which beats the 15% return from the S&P 500, but not by enough to make a difference.

However there comes a time when the investment community has to re-evaluate. If the policy is successful, the Japanese equity market should continue to perform long after the initial shock of the devaluation has worn off. The moment of re-evaluation has now arrived. From the late December to late February, our model which tracks the probability of Japanese equities beating US equities by a wide enough margin in dollar terms to justify the extra risk of holding them, hovered at around 50%. Since the beginning of March this has risen to 80%, its highest level since March 2006. For UK and euro investors the equivalent numbers are 86% and 67%, both relative to the domestic equity index in domestic currency terms.

None of this is prediction that the Japanese economy will suddenly change to a paradigm of rising nominal GDP, controllable inflation and falling deficits. But for the first time in many years investors need to consider whether this is possible. The history of Japan shows that there have been many aborted recoveries, but one day this pattern will end.

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