Japan the market to watch if QE2 works, say strategists

Japan will be the market to watch next year if attempts by the US Federal Reserve to reflate the American economy succeed, equity strategists say. 

But that’s a big if, with others noting that predictions of Japan’s resurgence have been plentiful but almost always wrong over the last two decades. 

“The markets are strewn with the dead bodies of attempted Japan bulls,” says Todd Martin, Asia equity strategist at Société Générale. “The difference between now and then is that now we have quantitative easing.” 

Emerging markets have been the big beneficiaries of capital inflows after Fed chairman Ben Bernanke’s announcement of a second, $600 billion round of quantitative easing, or QE2. But if the strategy works in reviving US and global growth, Japanese equities would likely go on a tear, with the yen weakening and Japanese exports surging. 

“In a quantitative easing environment, if we did get inflationary growth for the world that would be extremely positive for Japan,” Martin says. “There is the potential that the planets align and 2011 becomes the year of Japan.” 

A synchronised global growth cycle would be hugely beneficial to Japanese firms and could see the end of more than a decade of deflation. Present values in Japan are based on pessimistic predictions for earnings and poor global growth. 

Japanese equities saw a 17% contraction in earnings in 2010, and have substantially underperformed the rest of Asia. But those trends would be reversed if QE2 works in spurring growth in the US economy and then globally. 

“Right now the market has just been pricing in deflation and a strong yen,” Martin notes. “You could get all of a sudden a 30% earnings growth year in 2011.” 

But Christopher Wood, equity strategist at CLSA Asia-Pacific Markets, does not believe the Federal Reserve’s quantitative easing will succeed, although he agrees that optimists who feel it will, should look to Japan. 

That’s because releveraging in the US would push up US interest rates, meaning relative underperformance in Asia and emerging markets, which would be hit by fears they have left it too late to raise interest rates and tighten monetary supply. 

“In such a macro context, the stock market that would perform best globally would be Japan, since the discounting of higher US short-term rates would mean a sharply weaker yen,” Wood notes. 

“For this reason investors who disagree and believe QE2 will work should buy the Japanese stock market now. Similarly those investors who do not believe it will work, but think it will work for a while before hopes are dashed once again, should also buy Japan now.” 

However, Wood himself does not believe the Fed’s attempts will work, and is continuing to wait for “concrete evidence before assuming private sector releveraging is occurring in the US economy”.

A third wave of quantitative easing is likely as a result, although opposition may be building to US attempts to print money following Republican victories in the mid-term elections. 

Richard Jerram, a long-time Japan expert and head of Asian economics at Macquarie Group, is even less sanguine about Japan’s prospects.

The potential for more aggressive monetary policy in other parts of the world caused him to cut his forecast for the average yen-dollar exchange rate in 2011 to ¥81, from a previous forecast of ¥93. He slashed Japan’s growth forecast from 1.4% to 0.8%. 

“Deflation and the lack of any dynamism to domestic demand is at the heart of the problem, as it results in an excessive dependence on exports, even though the sector is only about one-sixth of GDP,” he wrote in Macquarie’s macro forecast in late October.

“The problem is not too evident when external demand is strong and the exchange rate is competitive, but slowing global growth combined with yen strength spells trouble.” 

A frequent critic of the Bank of Japan, Jerram says Japanese policy in response to the economic crisis has shifted recently from “negligible” to “inadequate”. There may be mild further improvement, and Japan has started to intervene to weaken the yen. 

“Zero rates and existence of excess liquidity gives Japan the potential for theoretically unlimited intervention,” Jerram says. But aggressive quantitative easing “could overwhelm any realistic scale of Japanese intervention”. There’s a risk the yen exchange rate could even be pushed into the ¥70s. 

QE2 is having unintended consequences around the world. And there’s heavy debate about whether quantitative easing works. Joseph Stiglitz, the 2001 Nobel laureate for economics, said last week in a visit to Hong Kong that any growth the US accomplishes as a result of QE2 will simply come at the cost of other nations. 

Martin at SocGen takes an opposing view. “There’s no question there’s a debate on whether QE works or not,” he says. “But inflating away your problem has a long-standing history of success. It is the book on modern central banking.” 

It’s the timing of when that happens that’s at issue, and that will govern Japan’s return to the fold. They used to say that Brazil was the country of tomorrow – and always will be. Maybe that kind of cynicism now applies to Japan.