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Greetings,

We tend to think of Japan as this demographic wasteland, where adult diapers sell better than infant diapers and growth is non-existent. However, Japan’s labor market is sizzling at the moment, and employers are grappling with the most severe labor shortage in 25 years. The jobless rate in the world’s third-biggest economy sank to a 20-year low of 3.1% in October and overall monthly earnings gained for a fourth straight month. This is a major development considering Japan’s desperate efforts to push inflation above 2%, up from +0.3% Y/Y currently.

The latest Tankan Survey for 4Q showed solid growth in the non-manufacturing sector. A closer look into the details reveals that most of the growth is coming from construction and real estate, related to Tokyo’s booming property market. Part of that is related to the Tokyo Olympics in 2020, but the other tailwinds include ultra-low interest rates (35-year mortgage rates are currently 1.55%), lots of cash, the formation of numerous REITs and strong demand from Chinese buyers. Loans extended by commercial banks totaled ¥10.1 trillion ($82 billion) this year for real estate investment alone. This is the first time in seven years that commercial banks lent more than ¥10 trillion to the real estate market.

Furthermore, new real estate loans by "shinkin" banks (credit banks) are at ¥2.1 trillion (about $17 Billion), the first time that has gone beyond ¥2 trillion. If you were to judge Japan’s economy based on labor and real estate, it might look like animal spirits are alive and well. However, all of this optimism is being driven, at least partially, by huge QE purchases. And it’s debatable whether or not those asset purchases can grow much from here.

With about ¥40 trillion ($330 billion) of notes maturing in 2016, the BOJ will need to increase total bond purchases by about ¥10 trillion next year to meet its goal of expanding the monetary base by ¥80 trillion annually. That’s easier said than done now that the world’s largest pension fund, GPIF, is essentially finished rotating from JGBs to stocks. There are other firms with substantial JGB holdings, like Japan Post Bank, but the list of potential sellers is shrinking rapidly, making QE expansion difficult.

At the same time, China’s currency, CNY, has been accepted into the IMF’s SDR basket, and suddenly the PBoC isn’t shy about devaluing its currency. That’s a huge problem for Japan, because it would lose a major competitive advantage in the export market if JPY can’t weaken at the same pace. A further expansion of QE would weaken JPY, but, as mentioned, that’s getting harder to accomplish and it simply isn’t warranted by labor market conditions.

The Nikkei 225 is up around 6.4% Y/Y, the worst annual performance since Abenomics kicked off in late 2012. If the BoJ can’t figure out a way to engineer an expanded balance sheet or weaker JPY, we could be looking at a precipitous fall in the Japanese stock market. Prime Minister Abe still has several options, including tax cuts and increased spending (creating JGB supply for the BoJ), but he’s still talking about a tax hike in 2017. The economy is doing better and there are reasons to be optimistic on Japanese asset prices, but the risk/reward seems heavily skewed to the downside.

The Cup & Handle Fund is up around +5.0% YTD, and +6.0% Y/Y. Overall I’d say this year’s performance was satisfactory. It was a difficult market to trade at times and others did far worse, but again, we’re not here to make 5%. We’re here to make outsized returns and that’s what we’ll be gunning for next year. I’ll have my annual “5 Bold Predictions” letter out next week, but in the meantime happy holidays and thanks for a good year! If you’d like to start receiving these letters click here.

With that I give you this week's letter:

December 17, 2015

As always, if you have any questions or comments or just want to vent, please send me an email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld

Managing Editor – Cup & Handle Macro