A Look Back – Recent Historical Scenarios

LDP Election Victory

After his confirmation as Japan’s new Prime Minister, Shinzo Abe and his cabinet implemented a series of policies meant to stimulate country’s economy. The first part of the package consisted of aggressive expansionary monetary policies to stimulate domestic demand and encourage private investment.

The first part of the stimulus package includes quantitative easing and expansion of open market operations by the Bank of Japan.  From the dissolution of parliament on 16 Nov 2012 until the installation of central bank governor Kuroda on 15 Mar 2013, the Yen weakened by almost 17% against the US dollar. A depreciating currency boosted exports and the equity markets spiked in tandem.

May 23 to June 4 Nikkei Slump

The long rally in Japanese equities and depreciation of the Yen came to a dramatic halt on May 23, 2013. The Nikkei 225 index slumped to its lowest since the March 2011 earthquake and tsunami, dropping close to 15.1% in a period of nine consecutive trading days. This sharp reversal of major market indices spooked investors and caused many investors to question whether this drop heralded the onset of another bear market in Japan. On the contrary, analysts and managers commented that the selloff was in fact long overdue.

The stimulus package had led Japanese equities to rise ‘too much, too fast’. A necessary correction was overdue. Analysts had forecasted a retracement for the positive long running market trends amid rising speculation. Hence, the market slump starting on May 23 was anticipated, though the timing was uncertain.

A Look Ahead – Geopolitical Headwind Scenarios

Though Japanese markets have seen a period of prolonged strength on the back of ‘Abenomics,’ the future remains cloudy with unresolved geopolitical tensions with Japan’s neighbors.

Korean Peninsula Tension

On the Korean peninsula, North Korea has reportedly warned Japan that Tokyo could be its first target if Japan maintains its ‘hostile posture’ to intercepts North Korea test missiles and hostilities break out. In the words of North Korean leadership, any “provocative” intervention on the part of Japan would see Tokyo “consumed in nuclear flames”.

North Korea could decide to launch a high-altitude electromagnetic pulse (EMP) attack instead of a traditional targeted attack given its unproven precision targeting capabilities. AN EMP attack targets the electrical and electronic infrastructure, which would cause economic damage so extensive that it could cripple the nation’s economy even with limited civilian casualties. Interrupted communication networks will severe the financial sector by disrupting financial flows. Consequently, it may take years before Japan shows sign of recovery from such an event.

Diaoyu/Senkaku Sovereignty Dispute

In another potential flashpoint, continued escalation of Senkaku/Diaoyu Islands dispute between China and Japan drew heightened tension across the region in 2012. China and Japan are the world’s second and third largest economies respectively and top bilateral trading partners, with China as the biggest destination for Japanese exports. As rhetoric flared in both countries, Japanese companies especially suffered. Bilateral trade between China and Japan became extremely volatile, with Chinese boycotts of Japanese products, travelling to Japan and damage to Japanese-owned assets. As a result, trade relations deteriorated badly towards the latter half of the year.

If the dispute remains unsettled, it may prompt the imposition of increasingly severe trade barriers between the two countries. Beyond the limited boycotts and military maneuvers already seen, foreign direct investment between the two countries may eventually suffer.  Japanese firms would then struggle to find alternatives that offer similar competitive labor and production costs while losing their largest market. Consequently, any incidents in this dispute could very negatively impact Japan’s economy and investment environment.

HedgeSPA – 28 May, 2013