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“In the 1500s, Motonori, a feudal lord of the era, sought to teach his sons the virtues of cooperation. He gave each of his sons an arrow and invited them to break them, which they did easily. He then gave each son three arrows and invited them to do the same. Try as they might, they could not break three at once. This, he told them is the value of cooperation. One arrow is easily broken, but three held together are stronger than the strongest warrior alone can break.”

                  Japanese folktale (from ClearBridge Investments, Oct 2013)

Commentary & Analysis
Is it time to buy the Japanese yen?

Though many are optimistic and there are positive signs, Mr. Market hasn’t yet issued its final verdict on Japan’s three-arrow strategy.

Source: ClearBridge Investments, October 13, 2013 Institutional Perspectives

So far the first arrow from the bow has proven a success; the yen has weakened and stock prices have soared. In fact, these two price series, seemingly impacted by aggressive monetary policy, are highly correlated as you can see in the chart below comparing the Nikkei 225 Stock Index and USD/JPY:

It’s not just liquidity that’s driving stocks, earnings have improved for Japanese companies and investors are betting this will continue as Japanese multi-nationals become increasingly powerful competitors thanks to the currency.

But as Newton’s Third Law of physics says, “For every action, there is an equal and opposite reaction;” Japan’s current account deficit is climbing along with the falling value of the currency.

From Bloomberg today:

Japan’s current-account deficit widened to a record in November as imports climbed, underscoring challenges for Prime MinisterShinzo Abe as he tries to drive a sustained economic rebound.

The 592.8 billion yen ($5.7 billion) shortfall in the widest measure of trade, reported by the Ministry of Finance in Tokyo today, was larger than the median forecast of 368.9 billion yen in a Bloomberg News survey of 24 economists. The deficit is the biggest in comparable data back to 1985.

Is this a problem? Maybe! Why? The second arrow (flexible fiscal policy) is predicated on sustainable government debt. Local funding has been the bedrock for Japanese government bonds. If Japan has to go hat in hand to international investors for funding, because of the rising current account deficit, it will likely force up interest rates on Japanese paper, increasing the cost of government funding. This concern is real, when you consider the following factoid from the Bank of Japan:

The share of Japanese households with no financial assets rose to a record high of 31 percent. Falling incomes forced people to spend their savings. The major reason for this rise: declining regular income.

Success of corporate Japan on the one hand adds to government revenue in terms of taxes. But it also takes away, as it reduces the pool of corporate savings for Japan to draw upon. Thus, the big bet is on improving the economy as the domestic pool of savigs is waning.

And though we are seeing headline inflation pick up in Japan (another tool for fiscal flexibility), let’s put this into perspective. Below is a chart showing Japanese CPI going back to June 1967.

Governments tend to like inflation as it allows them to payoff outstanding government debt more easily. But one wonders if Japan can be successful here given the powerful global deflationary forces still in play, especially if demand from China is indeed waning as many analysts speculate.

And of course the huge appreciation of the Chinese currency (yuan) compared to the Japanese yen probable doesn’t help Chinese growth, though it does make Japanese goods look very competitive to Chinese citizens. Overall, I would suspect the Chinese government isn’t too happy when it views the chart below:

The Nikkei was clobbered last night—down 3.08%. Will $-yen follow? At least near-term that is our bet. And the surprise for 2014 could be the yen strengthens at lot more than people expect if those arrows remain in the quiver.