A pairs trade idea in the Nikkei 225

While most equity markets with the exception of certain Southern European markets have recovered exceptionally from the depths plumbed in the 2008 financial crisis, Japanese equities have been the significant underperformer. It seems that the Japanese government and the Bank of Japan (BOJ) are both powerless to stem the stubborn strength of the yen that continues to pressure the engine of their economy – the export sector. After many interventions expanding the monetary base and numerous government stimulus packages, the Japanese are still in trouble and, looking at the equity market, it seems to point to poor domestic economic prospects with the benchmark Nikkei 225 now dropping since March while other major global equity markets have been rising.

On March 27, the Nikkei hit 10,255 and now currently trades at 8,824, or 14% down, while the S&P has risen some 2.7% in the same period. Why is the Japanese economy struggling and what can we expect for the near future?

Red & Black – Nikkei 225; Green – FTSE 100; Blue – S&P 500

The Japanese economy has been struggling to post a decent growth rate for many years now and remains mired in a liquidity trap. Near zero interest rates, low growth, low inflation (deflation in certain periods) and pretty much a blank reaction to monetary stimulus by the BoJ seems the perpetual dish du jour. Last year in particular was a tough year with the tsunami and subsequent nuclear crisis that hit the economy but, considering these serious economic double whammies, many companies have recovered well and in fact posted presented decent profits over the last 12 months. The problem started again this year, especially since March and derives from a number of factors.

It’s fair to say that the outlook for the world economy is not the best at present. In the case of Japan whose economy depends on exports, it is a major concern when the whole world is slowing and thus expected to import less of their products. Looking at export partners, let’s start with Europe.

Senkaku-Diaoyu islands conflict pressuring stocks

The Eurozone is in deep trouble, trying hard to re-launch its export sector in the face of a newly resurgent euro and, to compound matters, at the same time it is facing contracting internal demand. This will put a brake on imports and so negatively impact Japan. Looking at China, the situation is even worse. The Chinese economy has been slowing down and there is also a growing dispute between the Chinese and the Japanese governments regarding the Senkaku-Diaoyu islands. The conflict seems to be intensifying and is also having a negative impact on Japan exports, not surprisingly into China. If both Governments don’t reach a compromise soon then the negative implications for both parties are likely to be quite severe.

Yen crisis

The Japanese have other another big battle on the table, this time against the US. The yen has been rising substantially over the last few years years and has been particularly resurgent since March – precisely the point when the Nikkei rolled over. In March, USD/JPY was trading at 83.98 but now is trading at 78.45, or 6.5% lower. The impact on Japanese exporters has been huge, and it semms no matter what attempts the BOJ makes to fight against it, it seems to be a lost battle. As Eisuke Sakakibara said: “Japan shouldn’t intervene. The US is against it, so it wouldn’t be effective”. Ben Bernanke and his magical box of never ending quantitative easing programs are posing tough difficulties around the world and Japan is one of the most affected. While equities in Japan may benefit through a knee jerk reaction at the time QE is announced in the US, the story changes with time as a weak USD destroys Japanese exporters…

With all these factors on the table, manufacturers are pessimistic and analysts alike have been downgrading earnings for Japanese companies with some actually expecting the Japanese economy to enter recession. The Japanese Government is pressing the BOJ to act, but monetary policy now has very limited effects give the zero bound that has been reached. The BoJ need to make a major liquidity injection of half a trillion dollars to meet Bernanke head on and solve the Yen crisis once and for all. The picture quite clearly shows why the Nikkei has been performing negatively of late.

Major underperformance

Bearing in mind all we have said here, when we compare Japanese equities with European and certainly the US markets, it points to us that the underperformance has gone too far. Europe is not in much better shape and the US is still struggling to post decent economic growth but the S&P 500 edged up 32% over the last 3 yearS, while the Nikkei gained a tiny 4%. 

Japanese equities now trade on the lowest price to cash, price to book and price to sales ratios than they have for almost 30 years now. A pairs trade  of buying the Nikkei while selling European or US equities looks a good bet to us.