Commodity Prices and Japan Stocks

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Feb 7, 2011 - So far, soaring crude oil and agricultural commodity prices are being taken in ... When Will Rising Oil Prices Crimp the Stock Market Rally?

February 07, 2011

Market Vane Indicator Market Technicals Market Trading Volume Yen

Closing Values

Direction Bullish

Indicator Topix

Week Close 935.36

Prev. Week 919.69









Interest Rates





Best Sector 1 Mo.


JGB Yield (%)



Worst Sector 1 Mo.





Economic Momentum





Sources: Tokyo Stock Exchange, Nikkei Financial,

Commodity Prices and Japan Stocks So far, soaring crude oil and agricultural commodity prices are being taken in stride by equity investors, at least in the developed markets. But in a 2005 analysis, the IMF quantified the effect of a sustained increase of about $37 in oil prices to $80/bbl as reducing GDP growth in the industrialized economies by 0.6% and raising the CPI by 1.0%--i.e., rising commodity prices do represent a potential threat to the global economic recovery. So far, economists and business leaders such as the chairman of the Institute for Supply Management say US manufacturers at least will be able to prevent rising raw-material prices from squeezing earnings by combining some price increases with gains in productivity and growing sales. While soaring crude oil and food prices are generally not (yet) seen as a big deal in the U.S. and developed markets where there is still excess capacity, it has become a very big deal in many emerging markets, creating political unrest and prompting the World Bank and IMF to declare a “food crisis”. In 2008, riots broke out in at least a dozen countries as food prices hit record highs, and unrest about the cost of living in 2011 has already toppled the government in Tunisia, sparked unrest in Egypt, and has Algeria, Yemen and Morocco scouring the world for grain. As more and more people in formerly poor nations enter the global middle class, they’re beginning to exert growing pressure on world oil and food supplies while the US Fed floods the financial markets with QE2—i.e., an inflation trade extraordinaire. In Japan, the primary issue for the time being is deflation, not inflation. There will likely be a considerable lag before rising food and energy prices become a serious issue, because the rise in global market prices is being significantly mitigated by the continued strength in the yen. Thus any talk of the Japanese deflation "trade" being in trouble, and JGBs or the Yen on the verge of major weakness, appear to us to be very premature. That said, real estate stocks are rebounding on market recovery expectations, and trading company stocks are buoyant because a substantial part of their business is driven by prices and trading in basic materials and foodstuffs. Indeed, these stocks are and should continue to outperform not only the Japanese benchmarks, but even the S&P 500. Subscribe or renew at



TJI Model Portfolios

Sources: Tokyo Stock Exchange, Yahoo Japan, Yahoo

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When Will Rising Oil Prices Crimp the Stock Market Rally? Commodity prices beat gains in stocks, bonds and the dollar in 2010 as China, the biggest user of everything from cotton to copper to soybeans, led the recovery from the first global recession since World War II. "Peak oil" concerns became very evident from 2004, when strong oil demand ran up against capacity constraints. Under the worst-case scenario, there will be just enough energy resources left in the next half-century for either a messy and maybe violent contest for the remaining spoils, or a heroic cooperative effort toward radical conservation and transition to a post-fossil-fuel energy regime. However, there is no agreement among exports on exactly when “peak oil” will be reached. The HOP! research project quoted nine projections which have us reaching peak oil anywhere between 2006 and 2020. In contrast, IHS CERA’s (Cambridge Energy Research Associates’) reference case for global liquid productive capacity shows growth through 2030 to around 115 million barrels per day and finds no evidence of a peak in supply appearing before that time. CERA’s projection based on the analysis of fields currently in production and those yet to-be produced or discovered, and including conventional and unconventional oils, is for an “undulating plateau” occurring after 2020 and persisting for one or more decades before declining slowly. During the plateau period the demand growth will need to be met by non-traditional and unconventional liquid fuels. Exploration is not yet in terminal decline, and while some 12 billion barrels of oil has recently been discovered annually, the five-year moving average is actually growing, according to CERA.

Source: CERA (Cambridge Energy Research Associates)

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But the Sharp Rise in Oil Prices Will be Felt The most obvious impact of higher oil prices is the transfer of income from oil consumers to oil producers. As the propensity to spend of those who lose income (energy consumers) is generally larger than the propensity to spend of those who gain income (energy producers), there will be some fall in demand. (a) There is a rise in the cost of production of goods and services in the economy, given the increase in the relative price of energy inputs, putting pressure on profit margins. (b) There is an impact on the price level and on inflation, (c) there is both a direct and indirect impact on financial markets, (d) depending on expected duration of price increases, the change in relative prices creates incentives for suppliers of energy to increase production and investment. For the industrial countries as a group, this means real GDP falls below the baseline growth rate while real domestic demand follows a similar profile but with a somewhat greater short-term loss. In December 2000, the IMF estimated that a permanent rise of $5/bbl in oil prices would result in a cumulative five-year reduction of real global GDP by 1.1 percentage points. A May 2004 IEA study showed the OECD economies shrinking by a cumulative 0.8 percentage points with a permanent $10/bbl increase in oil prices that would also raise unemployment 0.2 percentage points and the CPI 1.1 percentage points. The negative impact on the more energy-dependent emerging economies would be higher. Further, a 2005 analysis by the IMF quantifies the effects of a sustained increase of about $37 in oil prices to $80/bbl. In this model, the industrialized economies lose 0.6% points of GDP growth and the CPI is boosted 1.0% points. But notice that the impact diminishes the later the report is made—i.e., a higher impact in 2000 that is declining over time, because of “negajoules”, or the amount of energy savings calculated from 1971 energy intensity.

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Consequently, most economists and investors are still sanguine about the surging price of crude oil even though it is again breaching $100/bbl. The chairman of the Institute for Supply Management says US manufacturers in the U.S. will be able to prevent rising rawmaterial prices from hurting earnings in coming months by combining some price increases with gains in productivity and growing sales. If anything, higher prices have come as a relief…just as long as they do not get too much out of hand. Conservation and technology have significantly reduced the amount of energy required to fuel economic growth. That said, over half of the US population makes the median income of $50,000 or less, meaning that gasoline and food expenditures as a percentage of income are over 16%.

Investor Complacency is High The VIX S&P 500 volatility index is now back to prior lows. In short, investors expect calm markets. However, the VIX lows often coincide with turning points in the markets. So far, equity investors are nonplussed about rising commodity prices and if anything see these rises as a sign of economic recovery. But the steepness of the rise in commodity prices does need to be watched, as it is both a function of strong demand for raw materials from emerging markets and excess liquidity supplied courtesy of the U.S. Fed’s QE2. The International Energy Agency's chief economist said recently that China's needs could drive oil to $110 per barrel by 2015, but WTI crude is already breaching $100/bbl again. The U.S. Department of Agriculture has cut its harvest estimates for soybeans and corn, highlighting growing supply constraints in key foodstuffs. According to the United Nations' Food and Agriculture Organization’s Food Price Index, prices are nearing peaks reached during the global food crisis of 2008. In 2008, riots broke out in at least a dozen countries as food prices hit record highs, and consumer unrest about the cost of living has toppled one government in Tunisia, sparked unrest in Egypt, and has Algeria, Yemen and Morocco

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scouring the world for grain. As more and more people in formerly poor nations enter the global middle class, they’re beginning exert growing pressure on world oil and food supplies.

Source: EconomPic Data

Thus while soaring crude oil and food prices are generally not (yet) seen as a big deal in the U.S., it has become a very big deal in many emerging markets, creating political unrest. No One is Positioned for Inflation in Japan In Japan, the issue is deflation, not inflation. The former deputy governor of the BOJ, Kazumasa Iwata, sees an escape from deflation in Japan as unlikely at least through the fiscal year ending in March 2013, meaning the Bank of Japan is very likely to stick to its ultra-loose policy. In domestic portfolios, the weightings of Japanese equities is at record lows while JGB (bond) weightings are at record highs. The BOJ last month nudged up its price forecast for the fiscal year starting in April, reflecting higher commodity prices, and forecast an early escape from Japan's economic doldrums, but downplayed any expectations of imminent monetary easing. While Mr. Iwata does believe that recent commodity price threaten the global economy by squeezing corporate profits and people's incomes, there will likely be a considerable lag before food prices in Japan start rising. The import portion of the BOJ’s corporate goods price index has been stable thanks in large part to the strength of the yen, and Japanese companies are still hard-pressed to pass on increased input costs due a deflationary mindset among consumers. Given soaring crude oil prices as well as food prices, some traders believe the Japanese deflation "trade" may be in trouble, and that JGBs and the Yen are looking increasingly vulnerable. They see an ostensible collapse in JGBs (yield surge) as a golden opportunity to buy Japanese stocks, but we don’t see it that way. Any yield surge from a wholesale dumping of JGBs is more likely to trigger an equity selloff, not a rally. Consequently, we see this as a potential market risk, not opportunity.

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Japanese Stocks that Are Outperforming the S&P 500 The better scenario is that economic recovery dispels the heavy mood of deflation in Japan, causing an inflation, not deflation, premium to be discounted in bond yields and a gradual depreciation of the yen. Since the Fed signaled it would be introducing QE2 in late August, the S&P 500 has taken off and not looked back. Every girl (sector) is getting to dance in this rally, with the “risk-on” trades doing the best. The Japanese benchmark indices have gone along for the ride, but still are basically bringing up the rear vis-à-vis the US equity market and until very recently, emerging markets. That said, there are a few stocks that have consistently outperformed not only the Japanese benchmark indices (Nikkei 225 and Topix) but have also outperformed the S&P 500. Two of these stocks are the integrated trading companies Itochu (8001) and Marubeni (8002). These companies are global traders, with their finger on the pulse of not only Japan’s trade with the world, but increasingly between emerging market countries. Their

bread and butter s trading in the mineral, energy and food resources that have seen surging prices and high trading volume. Consequently, they are benefitting more than any other

Japanese firm from soaring commodity prices, and their stock prices reflect this.

Trading companies have seen their stock prices rise some 120% from March 2009 lows. As we already have Sumitomo Corp. (8053) in our model portfolio, we are content with our current exposure to the trading companies. Another outperformer has been Nissan (7201), despite the negative effects of the strong yen. Nissan’s stock has surged some 160% from March 2009 lows on a strong showing in China, and more recently hopes for a U.S. economic recovery and growth in U.S. new car sales. The company has also recently shot past rival Honda (7267) in global sales for the first time in decades to become Japan's second-largest auto maker. Nissan chief Carlos Ghosn says Nissan is focused on growth in India, China and Russia, and as he has the sales data to back it up, investors believe him. Nissan’s China sales rose 35.5% last year to 1.02 million vehicles, making China Nissan’s biggest market. Nissan is already in our model portfolio as well.

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The other surprise outperformer has been Sumitomo Realty (8830) which has performed

even better than the trading companies from March 2009 lows despite a weak real estate market characterized by falling commercial property prices and rents. Merrill Lynch was early

in going bullish on the Japanese real estate companies several months ago, but is being increasingly joined by other foreign brokers in recommending major Japanese real estate companies who seen not only a bottoming but also signs of recovery in Japan’s real estate markets. The November announcement by the Bank of Japan that they would begin buying J-REITs with part of the JPY5 trillion created on their balance sheet to ensure easy credit and stimulate Japan’s sputtering economic recovery. Here again, Sumitomo Realty is already in our model portfolio.

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Global Markets

Sources: FTSE, MSCI/Barra While the U.S. rally in the past month is being led by energy (+8.1%), industrials (+4.4%) and technology (+4.2%), global sector performance is being led by financials, then consumer staples.

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Intermarket Analysis

GSCI Agriculture Index

Gold Futures



USD Index

Copper Futures



JPY Index

10 Yr U.S. TB Yield Index



Gold is now consolidating despite the ongoing violence in Egypt, while strength in copper and agri commodities indicate there is, a) still a good deal of excess liquidity sloshing around and b) global demand continues to recover. Contrary to the bull case for Japan in 2011, however, the JPY Index remains in a strong uptrend, while move in US treasury yields is also so far muted. This however has not deterred foreign investors shunning consolidating stock prices emerging markets from buying into the Japan recovery story. With the Nikkei 225 seeing some resistance at 10,500, smaller cap stocks and indices offer better upside potential for the time being.

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Japan Market Charts Nikkei 225: Some Resistance at 10,500

JASDAQ However Back to May 2010 Highs

JPY/USD: 26-Week MA Still Exerting Upward Pressure

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Topix Sector Performance

Mining and textiles/apparel continue to lead the Topix higher, while the buying tide is lifting essentially all boats except shipping, other products and airlines.

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