Investors greeted the gains made by the Liberal Democratic Party of Japanese prime minister Shinzo Abe in the weekend’s Upper House election by bidding the Topix up by 3.8% on Monday. Although much of the immediate rally was powered by short-covering, international investors will naturally ask themselves whether Abe’s reinforced mandate, and his post-election pledge to double down on his “Abenomics” revitalization policies, could potentially initiate a renewed upward leg in the Japanese equity market. In a confusing environment in which global uncertainties are mounting, and market signals, central bank messages and underlying economics all point in conflicting directions, to answer the question investors should consult one time-honored signal: the price performance of Japanese bank shares. While bank shares elsewhere may convey valuable messages, the information in Japanese bank share price performance is indispensable—not only to investors in Japan, but to the wider world too.
A simple but effective rule
The rule is simple: don’t buy Japanese equities if the index of Japanese bank shares is trading below its 18-month moving average. And if bank shares are above their 18-month moving average, the Japanese market is a buy. Essentially, this is an indicator of price momentum. And despite its simplicity, a confirmed reversal in bank shares’ momentum gives more timely and accurate risk-on and risk-off signals than other more closely-monitored metrics, such as commonly-used valuation models or the bank sector’s relative performance.
The beauty of this indicator is that investors do not have to formulate views about whether Abenomics will fail or not, how negative interest rates are affecting the economy, whether the government will double down on public spending, nor whether the yen will strengthen to ¥90 to the US dollar, or weaken to ¥130. It is not that these questions are unimportant, nor that the market is entirely disconnected from economic fundamentals. Rather, it is that one way or another the answers to all these questions are embedded in bank share prices.
The primacy of bank share performance as a directional signal for the Japanese market should be no surprise. Japan is one of the most heavily bank-centered of the advanced economies. Deposits remain the instrument of choice for most savers, whose funds are channeled to borrowers through a nested network of banks. As a result, an effectively functioning banking system is vital to the health of the Japanese economy.
The upshot is that for years the performance of Japanese bank shares has acted as an aggregate signal of the behavior of concerned stakeholders. At any time, any one of a number of triggers might cause investors to head for the exit: real interest rates may be too high, threatening a collapse in the velocity of money; the yield curve may be flattening, either because policies such as negative interest rates are distorting the market, or because the threat of a deflationary crisis is raising its ugly head; banks may be failing to restructure and consolidate in order to boost productivity; or the yen may be strengthening, tightening domestic financial conditions. The list goes on.
But Japanese bank share performance isn’t relevant only to the Japanese market. As the chart above shows, ever since the early 1990s, whenever Japanese banks rolled over, it paid to scale back risk exposure worldwide, as global equities subsequently underperformed Japanese government bonds. The explanation is Japan’s long-standing role as the world’s principal “shock absorber” (see The End Of Japan As A Global Shock Absorber). When such a major industrial power was unable to respond to the danger of deflation by debasing its currency—the case for most of the last 25 years when the yen was overvalued—the impact of global deflationary forces was felt most keenly in Japan, and by Japanese banks especially. The only exception was from 1996 to 1998, when Japan exported its own deflation to the rest of the world by debasing the yen.
For the rest of the world, Japanese banks are once again sounding the alarm. As the mercantilist drive of Abenomics appears to have run out of steam, with the yen strengthening towards ¥100, Japan is resuming its role of global shock absorber. That means when the global economy sneezes, Japan will catch a cold. As the Bank of Japan pursues ever-more unconventional monetary policies, possibly including helicopter money, it is approaching a denouement. The failure of additional monetary easing to avert deflation will destroy all surviving confidence in central bank powers. With little but that confidence currently supporting global asset values, the signal in Japanese bank share performance is ominous indeed.
[Source: Gavekal Research – by Joyce Poon – July 11, 2016]
Reproduced by kind permission of Gavekal Research – http://web.gavekal.com/