Description

(note - the above metrics are all in JPY) 

Japan is on the cusp of experiencing a multi-decade inflection point in inflation and growth.  For the first time in a couple decades there is a complete consensus and reasonable path for driving change.  If the current administration is successful, there is a good chance that Japan is in the early stages of a secular bull market.    

The Japanese equity market is the most compelling globally and is likely to appreciate by ~100% over the next 2-3 years.

What are They Doing

There is no recent precedent for what Abe and Kuroda are doing today in Japan. 

Japan has endured two decades of deflation, no growth, depreciating equity/real estate markets and at least a decade of political inconsistency and instability.  Due to these dynamics, Japanese households and corporates have hoarded cash.

Abenomics is focused on mobilizing this cash through an expectations shock.   As deflationary expectations transition into inflationary expectations, that cash will be mobilized into financial assets and the real economy and growth could accelerate.

In order to spark this activity, Kuroda is in the process of increasing the money supply by ~40% of the total equity market cap in Japan over the next 2yrs. 

Additional actions by Abe will likely aid in this process. Two of the most powerful potential changes are increasing the GPIF allocation to domestic equities and foreign bonds/equities as trillions of $s in corporate cash will follow their lead.  And reducing corporate tax rates from ~35-40% down to 20-25% which will make Japan competitive vs rest of asia and drive increased FDI and faster corporate profit growth.

These actions will drive the yen weaker and increase asset prices.  Asset price movements will flow through into higher corporate profits, higher wages, increased capex and increase household spending.  There is a good chance that this process works and will become a positive reflexive cycle.

Misperception

There are 3 “bear” camps of investors on Japan today:

1)      The flow through from the actions taken will blow up the JGB market.  Large fiscal deficits and increased QE/increasing inflation expectations will cause JGB yields to spike and the system to implode

2)      The actions taken so far just wont work.  There hasn’t been enough fundamental evidence to have conviction in the flow through

3)      We missed it.  The appreciation in asset markets already reflects the likely fundamental improvements.

Investors are completely missing the fact that the actions taken are so dramatic and the determination so strong that the flow through is going to cause an acceleration in growth that disproves the above. 

Real GDP is currently growing at 2%+.  If you layered on 50bps per year from the yen depreciation and 50bps a year from increased domestic spending from asset appreciation, that is 3% real growth.  If .5-1% of deflation becomes 1-2% inflation, nominal GDP growth would be 4-5%.  Japan could be the fastest grower in the developed world for the next 5-10yrs.

With 4-5% nominal GDP growth, Japan Inc could generate a 15%+ ROE in the next few years which is on no one’s radar. 

The deficit could go from ~10% to <5% within a few years even if interest rates were to continue to increase at a measured pace (and remain in the 1-3% range indicated by Kuroda).   The fiscal trajectory would reverse and the perception of fiscal unsustainability and concerns around the JGB market would dissipate.

Valuations

Assuming the above flow through and the Nikkei trades at ~1.1x book a few years out and will be generating a 15%+ ROE.  It also currently trades at a ~6-7% FCF yield and will be growing FCF by 25%+ for many years. 

The markets could easily double over the next few years. 

Key Recent Signposts

We have observed several signposts indicating that Abenomics is starting to flow through to the real economy:

• 1Q real GDP grew at ~4% annualized vs expectations of ~2.7% and this was pre Kuroda’s actions on April 4^th
• Bank lending growth has accelerated to 2-3% YoY
• Consumer sentiment/confidence surveys have improved dramatically and are approaching 06/7 peak levels and we are just getting started
• April data for cash earnings (including bonus/overtime) rose by .3% YoY, the biggest increase in 12 months +
• Japan’s Business Federation survey of major listed corporations indicates that mid year bonuses will increase by 7.4% in 2013, the largest increase since the 8.4% rise in 1990
• The latest Land Ministry survey indicated that land prices rose in 80 or 53% of the 150 areas surveyed in 1Q 13, up from 51 or 34% in 4Q 12. 

Risks   

• Something happens to the people - Kuroda and Abe are key
• Abe begins to focus on constitutional issues as opposed to economy
• JGB yields spike as confidence is lost
• A global macro shock (ie EM/China  issues) would cause a big setback especially if it happens in the early innings of Abenomics
• the flow through from the weak yen/strong equity markets is less than expected

Catalyst