We tend to get quite some distance ahead of the markets when we work with macro themes because a year- give or take- gets lost when viewing a chart that extends over a decade or two. However we remain quite fascinated with the idea that Japan is set for a multi-year period of rising asset prices and are encouraged each time we read or hear that our views make absolutely no sense.
One of the key features of a major bottom is apathy and we will argue that the Japanese stock market has that in spades. This is a sector that no one likes for too many reasons to count and that- we will argue- is what bottoms are made of.
Belowwe show the ratio between the CRB Index (commodity prices) and the S&P 500 Index (SPX) from 1980 through 2003. Below is a chart of Japan’s Nikkei 225 Index divided by the SPX from 1990 to the present day.
The first point is that commodity prices peaked on a relative basis in 1980 and did not bottom until 1999. So… when did commodity prices bottom on a relative basis? 1999. When did investors discover commodities as an investment class? Probably around 2006. In other words it took years of positive relative strength by commodity prices before everyone- and we mean everyone- became convinced that this was a must-own investment sector.
The second point is that the Nikkei peaked relative to the SPX in 1990- ten years after the highs for commodity prices- and has now been declining for roughly 19 years. Commodity prices reached a cycle peak in 1980 and bottomed in 1999 while the Nikkei reached a cycle peak in 1990 suggesting at least the potential for a bottom some time around the current time frame.
We are not arguing that the Japanese stock market is going to explode higher. We are suggesting instead that it is making a bottom. If history and human nature remain somewhat constant it will be years before Japan’s relative strength becomes not only noticeable but also fundamentally understandable. After all, crude oil prices fell below 10 back in December of 1998 and did not threaten 150 for close to a decade.
For the sake of argument… let’s assume that we are correct in our view that the Nikkei will start to rise relative to the S&P 500 Index this year. From an intermarket perspective a change in trend for the Nikkei will mean that a number of other markets will change trend as well.
Belowwe show the Japanese 10-year (JGB) bond futures and the ratio between the Nikkei 225 Index and the S&P 500 Index.
The first point is that the intermarket ‘driver’ for Japanese equity markets weakness is rising bond prices and falling interest rates. As long as Japanese interest rates remain flat to lower the Nikkei will remain weaker.
The second point is that post-1990 is actually made up of two trends. From 1990 into 1999 the trend included strength in bond prices and severe relative price weakness for the Nikkei compared to the SPX. From 1999 into 2009 the trend has included a flat bond market (i.e. JGBs holding above 130) and flat relative strength. The Nikkei has held very close to 10 times the SPX for much of the current decade.
The argument would then be that if the JGBs were to break to new highs above 145 then the Japanese stock market would most certainly remain under pressure. If the JGBs trade between 130 and 145 then this market should perform roughly in line with the SPX. However… if Japanese bond prices were to decline below 130… then we will argue with conviction that the world has changed in a manner that will benefit Japanese asset prices.
Below we show a comparison between the Japanese yen futures and the spread or price difference between 3-month euroyen futures and 3-month eurodollar futures.
At present 3-month eurodollars yield approximately 1.38% (i.e. a price of 98.62) while 3-month euroyen yield .68% (a price of 99.32). The price spread or difference would then be 99.32 minus 98.62 which comes out to around .70.
A spread of .70 means that 3-month U.S. interest rates are .7% higher than 3-month Japanese interest rates.
We will argue that the yen is driven in large part by the direction of the trend for relative interest rates. In other words it is not the actual interest rate difference that is important but rather the direction of the trend.
Back in 2007 U.S. short-term interest rates were close to 5% higher than similar Japanese interest rates and the yen was trading around .85. As recently as early this year the spread had fallen back to around .5% and the yen had risen to close to 1.13. Fair enough.
The point is that everyone knows that a strong yen is a negative for Japan’s export-driven economy but often what ‘everyone knows’ isn’t worth that much. What drives both the yen and Japan’s stock market are changes in interest rates. In our scenario- for reasons that will not become apparent for months if not years- Japanese bond prices decline and as Japanese bond prices decline the spread between Japanese and U.S. yields not only tightens but eventually swings in favor of Japan. In other words in our scenario not only do Japanese interest rates move higher but they actually push above U.S. interest rates which, in turn, keeps the yen tracking higher even as Japanese equity prices outperform U.S. equity prices.
