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Japan’s Economic Death Spiral Continues

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The Sun Also Sets

I used to be a Japan hand. I spent my junior year in college in 1985 as an exchange student at Kansai Gaidai in Osaka. Upon graduating college in 1986, I worked for JETRO (Japan External Trade Organization), the Japanese government’s trade group. I then spent two years working in the Kagoshima State government’s international division. After this, I spent a year as a Research Fellow studying consumer trends at Kyoto University’s Economic Research Institute.

Japan was in its prime in the 1980s, and I was there. I ended my five-year focus on Japan when I read 1989’s The Sun Also Sets: The Limits To Japan’s Economic Power by Bill Emmott, editor of The Economist. The book lays out several points, among them was that Japan’s advantages were not sustainable and were easily copied. In fact, Japan was following a very basic mercantilist approach to becoming a major exporter. They made high-quality products, manipulated the currency to fuel exports and erode competition, and maintained a positive trade balance by blocking imports through trade barriers. Emmott predicted an end to each of these advantages, and he was right.

Once the cheap yen advantage was removed, Japan began a downward spiral from which it has not recovered, and I don’t think they ever will. Japan has the UK disease; a once great island empire fighting to stay relevant on the economic stage.

Japan won’t recover from its downward spiral.

Japan: A Bystander on the Digital Highway

In the world of bytes and bits, Japan has become a bit-player.

Japan’s fading economic might can be summed up in its share of global semiconductor sales, which has collapsed from 40%+ to barely double digits.

Japan Share Global Semiconductor

At the same time – and very much related – Japan’s share of Global GDP (per the OECD) has fallen from 10% in 1990, to 7% in 2004 and 5% today.

As the Semiconductor market has marched up an impressive 9.2% CAGR, Japan has actually shrunk.

Japan and Global Semiconductor

The latest smartphones come from Korea (Samsung) and America (Apple) and are manufactured in Korea, Taiwan and China. The software comes from America. The latest camera, the GoPro, is American. The electric car that everyone wants is American (Tesla). The consumer electronics that everyone buys come from Korea. Telecommunications and computer products come from American or elsewhere, but definitely not Japan.

A simple snapshot of Japan’s fading importance is evident in US imports as seen below:

US Imports Through August ($B):

                        2013     2014     Gain/Loss     

China            $281     $294     +$13

Germany      $74       $81       $+7

Korea            $42       $45       +3

Japan            $93       $89      -$4B

Other Countries See Exports to the US Growing while Japan’s are Shrinking

Participation in the Digital Economy Matters

Japanese companies have lost the lead in their traditional markets because they don’t make products for the 21st Century digital economy.

In 2013, out of $2.3T in imported goods, the top US imports were:

  • Oil $390B
  • Machinery $311B
  • Electronic and Medical Equipment (ex Smartphones) $300B
  • Vehicles $253B
  • Smartphones $100B
  • Pharmaceuticals $63B

Of the $2T non-oil imports, Japan’s share was $142B (7%).

China’s electronic equipment exports to the US ($120B) almost equaled Japan’s total exports to the US.

Production is Contracting

Semiconductors reflect the shift in Japan’s economic relevance. When Japan led the consumer electronics world, semiconductor sales led industrial production:

Industrial Production

Today semiconductors lag overall industrial production.

Make Stuff People Want, Make It Cheaper

The central problem, as noted above, is that Japan doesn’t really make stuff people want. That’s a long-term problem without an easy solution.

In the short-term, the only means to boost exports will be for major monetary stimulus to crush the yen, and not a little bit. It needs to contract at least 15%. That would boost exports.Going back to semiconductors, a lot of production would shift to Japan if the yen drops.

Yen Devaluation

Back in November 2012, I predicted that Japan would have to go nuclear on the yen; drive it to 100. The BOJ did exactly this, forcing the yen up from ¥80 to ¥100. It worked as production surged, but it has run its course.

More Yen Devaluation Please, Mr. Abe

In early August of this year, I called for yet another gutting of the yen, and of sizable degree. I estimated at least 10% or companies won’t change their behaviors.

A cheap yen only goes so far. It works in commodity products where price is the issue (consumer electronics, cars, etc.). The long-term problem is that the products desired by global consumers are not the products Japan makes, which means exports will slow and production will contract. Eventually the yen will reach 140 yen/dollar.

¥115 is coming, but it still won’t stop Japan’s death spiral. Japan’s economy continues to shrink and the game plan is boost exports by crushing the Yen, but don’t expect it to work.

East Meets West: How the Valley Effects China

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iPhone Sales: Evidence of Online Spending

Moneyball Economics visited a few local stores selling iPhones for the big, long-awaited iPhone 6 release. There were lines but not that deep and none reaching outside the store.  Wait times were no more than two hours. Photos of lines going around the block – like in NYC – reflect unusual circumstances, far from the norm elsewhere.

Apple Store Line

(photo source unknown)

The evidence was certainly not enough to drive the 6.5M figure being whispered for in-store sales. In this case, online sales become much more significant.

Apple hit the whispered 10M unit sales, about $5B worth. It’s hard to find any company that can expect $5B in sales for a week, much less $5B a year, and that’s just a kickoff for the smartphone holiday spending. This promises to be a $60B+ global event over the next few months.

It’s quite possible. A real iPhone release has been two years in the making (the iPhone 5 was a placeholder). A massive and loyal user base is waiting to upgrade.

China’s Struggle for Growth

The Chinese economy is in trouble. The domestic consumer economy is a pale shadow of the export economy, and exports are sluggish and slowing. According to the Port of Hong Kong, total exports grew 2% Y/Y on a rolling average basis, but August contracted (-3%) Y/Y.

Hong Kong Exports

The smartphone will push up the figures in the next few months, but not for long.

It’s hard to be positive about China’s prospects for growth over the next year. As an export-dependent economy, China has no reason to feel positive. The EU is tipping back into Recession. US demand for Chinese goods has matured. None of these things will be countered by growth in the emerging economies.

Surveys of China’s producers (Markit’s Purchasing Managers Index or PMI) indicate production is one cold breeze away from contraction. (Markit surveys 420 manufacturing companies each month.) Production is 50%+ of the economy.

Additionally, new products simply aren’t appearing fast enough. It’s a post-smartphone world. US and EU markets are saturated. The Chinese domestic market has a lot of growth potential, but the total global growth that Chinese manufacturers have been serving is slowing down. Replacing the production is critical to maintaining growth.

The promise of the next high-volume consumer product is centered on connected devices. The idea is that every smartphone owner will want at least two or more peripheral gadgets; glasses and a watch, at the very least.  These devices aren’t taking off though. Instead of a few billion smartphone users and billions of connected devices, we’re seeing a few million connected devices. Apple had to delay the release of their watches into 2015, causing some delay in pick-up. Samsung has theirs ready but sales have been puny at best.

Desperation and Distribution Channels

If Chinese companies can’t grow out of the slowdown, then they can expand out of it. Instead of manufacturing for other companies, many Chinese companies are looking to sell under their own labels and some are looking to move into local markets and participate in the distribution channel. This requires massive infrastructure investment and the payoff is not happening anytime soon.

Chinese manufacturers are starting to seek growth outside of their traditional areas of expertise. High tech companies now entering the ice cream space, for example.

Predicting this slowdown back in 1Q, SouthBay Research said that – despite official Chinese government assertions – some stimulus would be needed by Summer 2015. Indeed, the PBOC just stepped in with some big monetary help and it won’t be the last.

There’s a reason why Caterpillar expects sales to China to collapse (-10%). Global demand is slowing. At the same time, domestic demand has relied on the property bubble, and we all know how spectacularly it burst.

Capital Flight From China to the US

Faced with slowing global demand, a sluggish domestic economy, a collapsing real estate market and a seriously under-performing stock market, Chinese investors are looking for better performance. The US stock market is calling like an oasis in the desert.

While investments in gold have more downside risk and US real estate seems to be peaking, the US equity markets are liquid and seem to have gas left.

Alibaba is a juicy example of capital flight in action. The #1 company in China had the biggest IPO of all time. However Alibaba did not IPO in China and that’s serious loss of face. The likely reason is that important Chinese investors (insiders including government officials) could maximize their returns and, more importantly, keep the money outside of the reach of the Chinese government.

It will be interesting to watch the carrots and sticks the Chinese government puts up to slow capital flight.

Expect Stimulus to Combat Slow Growth

The housing market is crashing, pulling down domestic consumption. Look for some action here in the form of lower down payments or moves to lower interest rates.

Expect monetary stimulus in the form of extra lending.

With slower global demand, China’s consumers are the key going forward. The Chinese government will attempt to keep the yuan flat. A cheaper yuan helps exports but hurts consumers.

This is all good for US equities. A boon in Chinese demand will lead to greater US company sales and a flat yuan keeps the dollar-denominated profits stable (most US companies price in dollars to avoid the yuan trap but there is still exposure to a falling yuan and the erosion of dollar-denominated profits).

Normally a strong dollar is bad for the stock market as it reduces value of offshore profits, slows exports and moves money into alternative investments like bonds. However trends like a Chinese capital flight into the US equity markets will add some tailwind.

This all leads back to our anecdote about iPhone 6 sales. Growth in the mobile phone market is stagnant and other mobile device growth sluggish. The strongest company in China had the largest IPO of all time, but in the US equity market. The Chinese economy is in major need of a kick-start if it wants to keep up with the world.