“Japan Enters Recession”: In terms of financial news, the headline has become the equivalent of “World’s Oldest Person Dies” — you know you’ll see it again soon; it’s simply a matter of when.
Japan’s economy again made news for the wrong reasons this week with the announcement that second-quarter growth had been revised downward into negative territory. Together with a 0.9% contraction in the third quarter, this meant the country had registered two consecutive quarters of negative growth — the technical definition of a recession. This marks the fifth recession for Japan in 15 years, and it might not be over since the final three months of the year could well bring another quarter of negative GDP.
This news came as no surprise to market participants, as Japan’s Nikkei 225 Index has moved slightly higher in the three sessions since the announcement. This reaction helps illustrate that, right now, bad news for Japan’s economy might actually be good news for its stock market.
Here’s why: The confirmation of a recession steps up the pressure on the Bank of Japan to provide additional monetary stimulus in 2013. The recent performance of the Japanese yen indicates that investors indeed are discounting the likelihood of further monetary easing at the next BOJ meeting on Dec. 20-21. Since its most recent high on Sept. 26, the CurrencyShares Japanese Yen Trust (NYSE:FXY) ETF has traded off from $126.31 to $118.83 — a 5.8% move that’s fairly large by the standards of developed-market currency ETFs.
What’s Next for the Yen?
This puts the yen in a vulnerable position: Using the FXY as a proxy, the yen is just above a lower trendline and possibly forming the right shoulder of a head-and-shoulder technical pattern. While this formation gives plenty of head-fakes, it indicates that the yen could see further weakness if the BOJ exceeds expectations regarding stimulus.
This is an important development for Japanese stocks since a cheaper yen provides a boost to the bottom lines of the country’s exporters — such as Toyota (NYSE:TM), Honda Motor (NYSE:HMC) and Canon (NYSE:CAJ) — that make up a large portion of the country’s equity market. Indeed, all three stocks have rallied hard in the past few weeks.
The impact of a weaker yen is evident when the FXY chart is compared to iShares MSCI Japan Index Fund (NYSE:EWJ).
Japan Is a Godzilla … of Debt
Put it together, and this indicates that from the standpoint of its market impact, the Japan recession news is more likely to help in the short-term than it is to hurt.
Longer-term, however, Japan is a destination that U.S. investors should continue to avoid. Japanese are saving less as the population ages, which means the country is likely to run out of the savings needed to continue funding its massive debt.
This time bomb, which is set to go off within the next decade, could well make Europe’s troubles of the past few years look like a warm-up in comparison. As it is, Japan already has the highest debt-to-GDP ratio in the world at 233%, dwarfing that of Greece (157.7%), Ireland (121.5%) and Italy (120%). The ratio is expected to expand to 250.5% by 2016, which would leave Japan at a level more than double that of the third-worst country at that time (Ireland, still at 121.5%).
Japanese Stocks Are Only Good for Trading
As a result, investors should treat Japan as a short-term trading vehicle to capitalize on volatility, rather than considering the country as a suitable long-term investment. After all, a bounce caused by currency weakness is hardly the foundation for a sustainable rally.
There is some good news, however. With the real economy in the doldrums, the BOJ’s rate cuts and money-printing typically serve to boost financial assets in the region even if they don’t do anything substantive to improve the growth outlook.
In this sense, the play on a Japan recession might be counterintuitive. Rather than looking for an opportunity in Japan itself, investors can consider a move into SPDR S&P Emerging Asia ETF (NYSE:GMF). If the BOJ again puts its foot on the gas, look for this region to outperform its global peers in the first half of 2013.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.