Profitable Japan trade going into reverse as investors grow wary of Abenomics
We need to keep a close eye on Japan's stimulus, which appears to be running out of steam
There are three reasons people in Hong Kong should care about the apparent crumbling of last year's best investment bet - Japan.
One is that local investors snapped up Japan funds with abandon last year, and smartly so: the returns were huge.
Another is that as the world's big money managers shifted their attention to Japan, Hong Kong's stock market got less of it, which means a dead Japan trade could boost flows here, where many stocks are trading at record low valuations.
The third reason is that the astonishingly risky economic programme known as "Abenomics" - which inspired last year's excitement - would never have been launched if it were not for Japan's rising fear of China.
Abenomics essentially works because aggressive devaluation of the yen allows an export-oriented corporate sector to rake in windfall profits (earnings rose an average 46 per cent for Nikkei- 225 listed firms last year), then pressure builds on firms to share the wealth through wage increases and domestic investment sprees.
The end result, if all goes well, is a sustainable consumption boom, the final defeat of deflation and, even, increased productivity if companies invest wisely. But if all does not go well, the stakes have been raised enormously high.
The trade deficit and national debt are at record highs. Japan's stock market has boomed - rising 57 per cent last year in yen terms - which means any fall could be amplified by a bubble-bursting impact.
And if companies acquiesce to political pressure to raise wages and expand domestic investment, they could find themselves anchored with an uncompetitive cost structure in a cutthroat global landscape.
The nominal explanation for adopting such a risky plan is that Japan wants to defeat deflation and end years of lacklustre economic growth.
But many consider the underlying reason is related to China.
Shinzo Abe was elected Japan's prime minister in late 2012 following a particularly heated flare-up in Japanese-Chinese relations, and he regularly addresses the nation in the nationalistic terms of a resurgent and powerful Japan.
Yet confidence in Abe's renewal drive is waning. The Nikkei 225 has lost 12 per cent this year, and short sales as a percentage of total trading volume on the Topix index last month hit the highest level since 2008.
Many fear that the economy will take a big hit after today's increase in the sales tax to 8 per cent from 5 per cent.
The higher sales tax is another reason why Abe is determined to get companies to be more generous with pay, because if prices move higher but wages don't, Japanese consumers will be strangled.
Abe is having a hard time getting business to budge on wages, which actually fell 2 per cent in real terms.
In the face of immense political pressure, some giants like Toyota recently agreed to the first wage increases in years - but they were still pretty paltry. Small and mid-sized firms don't seem to be budging at all.
Why, after profiting so much from Abenomics, aren't Japanese companies willing to share the wealth?
One answer is that executives are not stupid. They know that while the yen can easily be forced upwards by future events, wage increases and capacity investments cannot be quickly undone. Wages are sticky, currencies are not.
Moreover, Abe is trying to get Japanese companies to reverse a trend of setting up an increasing amount of their production capacity outside Japan. But this trend is, in fact, supremely rational.
Japan relies on growth from overseas markets, especially the emerging markets. Locating facilities in these countries not only is cost-effective, but is clever politically, because creating local jobs lowers resentment over imports.
Should Japanese companies move production back onshore, while also raising wages, they set themselves up for up for a huge fall in global competitiveness. Especially if, in the future, they get slammed by a surge in the value of the yen, as they did after the financial crisis in 2008.
Investors are well aware of this, too. Many global fund managers only bought into Japan because of last year's aggressive yen devaluation.
They figured that if Abenomics really did lead to Japanese revival, then the yen's move delivered cream on the top of the cake, but if things went awry, there would be plenty of time to book profits and pull out.
So has that time arrived?
It is hard not to notice increasingly bearish commentary from brokers who, just a year ago, enthusiastically pushed Japan.
Bulls, meanwhile, hope that Abe will double down on his bet. Many think the Bank of Japan is waiting to see how hard the sales tax hits consumption before launching another massive exercise to devalue the yen. Some see the yen dropping to 150 against the US dollar.
If it does, the Japan macro trade will be back on - until then, it's not.