Stage Set For Nikkei Rally

The Japanese economy might not be a pretty sight from an outside perspective owing to the myriad factors working against policymakers. Despite the troubling outlook, certain assets could certainly outperform given the circumstances, namely equities especially if the Bank of Japan expands its quantitative and qualitative easing program further. Considering the challenging external situation, it is not difficult to believe that policymakers will attempt to weaken the Yen further to maintain export competitiveness in the current leg of the global currency war. With that in mind, any weakness in the Yen is likely to see valuations become cheaper, propelling the Nikkei 225 higher versus other global benchmarks.

The Fundamental Picture

The Japanese economy has spiraling for over a decade as waves of deflation combined with a prolonged period of ultra-low interest rates failing to produce results. Although “Abenomics” as it was termed was able to largely turn around the economy to a degree, inflation and growth targets remain elusive for the globe’s third largest economy. Shinzo Abe, head of the Liberal Democratic Party and current Prime Minister, instituted the new set of drastic policies in the hopes of stimulating growth in a nation facing a burdensome amount of retirement liabilities coming due with the looming demographic time bomb. With the reproduction rates well below population replacement levels, the typical population pyramid has become inverted as the nation ages rapidly. Lack of growth of the base layers of the population make it extremely difficult for the island nation to indefinitely grow its way back to a healthy economy.

Aside from the demographic troubles, younger generations are experiencing difficulty when it comes to finding full-time employment, compounding problems in an economy where many workers are not retiring and extending working years due to limited retirement savings. The zero interest rate environment has particularly hurt savers in present economic conditions. While on the headline, unemployment stands at 3.30% wage growth has been stagnant with Japanese consumers seeing gradually eroded purchasing power in spite of persistent deflation. The export market is well supported at current levels due to Yen weakness, one policy benefit buoying many of Japan’s largest multinationals. However, the export economy neglects to address the underlying debt problem facing policymakers.

Expanding the current quantitative easing program past the JPY 80 trillion mark is undoubtedly a drastic step. Central Banker omnipotence is already being questioned in the United States following last week’s move to leave rates on hold. Should Japan’s policies be similarly questioned, it could see the Bank of Japan lose control with debt-to-GDP levels surging past reasonable levels. The Central Bank is running out of assets to buy, meaning the mandate could soon shift towards equities and futures especially with the bond market rapidly running dry. With the pool of available assets shrinking by the day, the only reasonable place to expand further is into capital markets. When combined with the additions to the monetary-base and sustained weakening in the Yen, the upside for the Nikkei is substantial if this is the inevitable direction.

The Technical Take

At current levels, the Nikkei 225 is technically in bear market territory after falling more than 20% from highs. Although year-to-date, the index remains positive, having gained 3.55% and risen 10.72% year over year, the last 3-months have seen the benchmark fall over -10.43%. The difficulties facing the outlook stem not only from the real economy, but moreover the difficult external situation in the region. Asia in general is feeling the pinch of the global trade downturn with China responsible for much of the recent financial market volatility. The Nikkei 225 in particular has seen its fair share of intraday swings, rising as much as 7.70% in a session earlier in the month after plunging precipitously in August. On a more medium-term basis, the index is trending below both the 50 and 200-day moving averages, a bearish indication.  However, the lack of emergence of the death cross is a silver lining and even with current downward pressure, the benchmark has the catalysts to rally back higher.

Since the depths of the most recent lows, the Nikkei has been setting up in an emerging head and shoulders bullish pattern with key resistance at 18465 paving the way towards the upper bounds of the shoulders at 19120. A break above this level would signal additional momentum to higher if confirmed by greater volume. The ideal place to take Call positions to taken advantage is below support at 17945 targeting 18465 as an exit.  However, in the event that prices slip below the neckline at 17745, it would likely indicate a breakdown in the pattern an indication of further downside following the brief rebound, with Put positions targeting lows at 17415. Should the Bank of Japan announce an easing expansion, a sharp rally towards resistance levels is likely with increased probability of the index reaching new multi-year highs in response.

Conclusion

While Japan is mired in what could be viewed as an existential crisis, it does not necessarily mean lack of opportunity for potential investors. With the Bank of Japan likely to engage in increasingly-risky strategies in order to meet stated targets for inflation and growth. While these measures are unlikely to produce the desired effect, the one ancillary benefit will be the continued weakening of the Yen. Attractive valuations for Japanese equities will end up pressuring the Nikkei 225 higher as a result.  When combined with the near-term technical setups, Call positions in the short-term might be well warranted despite the longer-term headwinds facing exporters and the economy which might drag the benchmark lower, necessitating Put positions to leverage any crisis and panic.