Turning Japanese Won’t Help Japan Turn Itself Around: The Geopolitical — Stock Market Connection

The mindless rally in equities in the face of a stern Federal Reserve and a wounded banking sector means that consumers will keep spending and businesses keep hoarding employees in the vain belief all will work out in the end. But a recession caused by rising unemployment is the drastic medicine needed to stop this hoarding and get both American firms and workers to return to rationality. The irrationality of quitting the work ethic and passing along higher prices is effectively turning American firms into zombies, a fate endured by the Japanese after the bubble burst in 1990, and persisting to the present. Turning Japanese is the last thing the West needs in the face of increasingly hostile Eurasian illiberalism. But at present investors are blithely ignoring the nexus of geopolitics and economics and instead gleefully fighting the Fed. The volatility risk premium is pointing to a range-bound market over the next few days, while my technical reading of key stocks in the S&P 500 is bullish. Yesterday's cross-asset action brought one positive factor for US stocks. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there were also several negative factors across global asset classes. Oil is pointing to stagflationary conditions. The US yield curve is falling and in the current context that is bearish. Expect the S&P 500 to rise modestly over the next few days.

Key to long-term confidence is the continuation of the liberal economic order and the resolution of the Ukraine war in favor of democracy and capitalism. Should Russia keep the war going another year the odds of a break in US-European support for Ukraine would rise and the greater confidence China would have in breaking the Western alliance by creating informal allies among popular illiberals like Mexico’s AMLO and Hungary’s Orban. The Trump indictment could be the fillip that brings American illiberals to power in 2024 as popular figures like Ron DeSantis soar above the unpopular Trump, and that would crystallize the change from a liberal world order to a statist, protectionist and culturally declining West.

A near-term consequence of this sad scenario is Japan. Already Japan is changing from a pacifist nation to a military one that seeks self-sufficiency, having watched Ukraine fall into catastrophe because of lack of preparation and naive belief that Eurasian autocrats would never go to war. Brookings notes “Critically, the NDS judges that Russia’s aggression was possible because Ukraine’s defense capability was insufficient for effective deterrence…In response to threats both general and specific, the new strategy calls for “fundamentally reinforcing Japan’s own capabilities.” For example, Japan’s unprecedented call for “counterstrike capabilities” results from a frank recognition that China and North Korea’s ballistic and cruise missile arsenals could overwhelm Japan’s air and missile defense systems.”

Here the financial markets collide with geopolitical changes. Japan needs to finance this militaristic change but due to accumulated deficits the nation will need high confidence in both its economic resilience and the global economy of which it’s highly intertwined. Brookings cautions that “the ambitious new spending targets were announced before a concrete plan for how to fully finance them. With an approval rating hovering between 30% to 40%, it’s not clear how much political capital Kishida (or his successors) will have to push through potentially unpopular funding measures. Tax increases in Japan have long been politically precarious. At a minimum, Kishida’s LDP will need support from Komeito, its more “dovish” junior coalition partner with a clear track record of diluting major national security-related initiatives championed by LDP conservatives.”

And Japan is vulnerable to the global financial system. Reuters notes “Japanese regional lenders will be well able to weather even "large" losses on their foreign bond portfolios thanks to strong capital buffers, a senior banking regulator official said, rebuffing concerns fuelled by U.S. banking woes.” Whenever a regulator is compelled to reassure markets then the facts belie the opposite. As the Fed reacts to high employment and continued service sector inflation with higher rates, the very issue that harmed the regional banks persists instead of easing.

Moreover Japan isn’t a healthy economy to being with, as their once-vaunted trade surplus is now a chronic deficit, while demographics keep declining and innovation is sparse. The East Asia Forum notes “the conservative big business federation Keidanren issued an important policy paper on 11 March 2022. ‘Start-up Breakthrough Vision 10X 10X’ calls for a tenfold increase in venture capital (VC) funding for start-ups and the creation of 100,000 new dynamic companies over the next five years.” This extraordinary idea rests on the reality that there actually hardly any small dynamic companies in a country that is statistically the 3-largest economy in the world.

Liquidity dynamics don’t support a healthy financial system until and unless we get a recession that cures inflation and forces unviable companies to rationalize or give up the ghost. Unfortunately that scenario will make it hard for Japan to get anything done, and that would easily buoy Eurasian autocrats to keep trying to destroy the liberal world order. The sooner the US equity market capitulates and brings down employment the nearer the Fed will be to cutting interest rates and bringing about an inflation-less recovery. That is Japan’s best-case scenario for getting its own house in order and doing its part to solidify the liberal world order.

My current positions include a very large cash position, 3M (MMM), Pfizer (PFE), the levered ETF UPRO and inverse levered ETF SPXU, all of which net out to a modestly long position in large-cap equities.