Japan's Exporters Face Double Whammy - Currency & Margins

The two key factors which have allowed Japanese manufacturers to thrive despite the sharp deflation in their export prices are going into reverse. First, currencies movements against the dollar and the Rmb, are eroding Japan’s competitive position and will intensify the pressure on Yen export prices. Second, at the same time, the stabilization of commodity prices threatens to reverse the terms of trade gains which have compensated for loss of pricing power, and been the motor for margin gains over the last 18 months.

Large manufacturers have noticed: Bank of Japan’s 1Q Tankan survey of 1,087 large-scale manufacturers reported their outlook index falling 4pts to 3, which was the lowest since 1Q13. Only 11% expecting a favourable outlook, compared with 8% expecting an unfavourable outlook and the vast majority, 81%, thinking the future was ‘not so favourable’.  

This fall in optimism does not yet fully incorporate the scale of the currency whiplash now underway: today the yen is trading under 111 to the dollar, whilst the Tankan’s respondents still expect the yen to average 117.5 during FY16.

But the combination of a resurgent dollar and an Rmb determined to hang onto its coat-tails, which has handed Japan’s exporters considerable competitive advantage since 2H14, has reversed. Not only is China explicitly no longer willing to peg its currency to the dollar, but in addition, the US Fed gives every indication it does not wish the dollar to strengthen. Japan’s exporters are the principal competitive victim in these two policy reversals.

Let’s put some numbers on it:
i) between September 2012 and May 2013, the Yen lost 24.1% against the Rmb
ii) between July 2014 and June 2015, the Yen lost a further 19% against the Rmb. Between September 2012 and July 2015, the yen had depreciated by 39.2% against the Rmb.
iii) However, between June 2015 and April 2016, the yen has appreciated 17.9% back against the Rmb, and it has now lost virtually all the gains made during the 2H14 dollar rise

For Japan, this simply means both far tougher international competition from China, implying faster market-share loss and sharper downward pressure on Yen export prices. 

Which brings us directly to the second problem large manufacturers are worrying about: margins.  Looking at the detail behind the fall in the Tankan outlook index, there was no change in expected domestic demand/supply conditions, with the economy expected to remain solidly oversupplied, slightly offset by a small improvement expected in overseas conditions.  Rather, it is margins that are the worry. Currently a net 8% of large manufacturers are seeing their input prices fall, but this isn’t expected to last: only a net 1% expect input prices to keep falling. But the same moderation of deflation isn’t expected for output prices: currently a net 15% report output prices are falling, and a net 13% expect them to keep falling. Result, margins are going to fall. 

Ministry of Finance’s massive quarterly survey of private sector p&ls and balance sheets reveal just how central this is likely to be. The survey allows us to analyse how Japanese ROE has been sustained (and even raised slightly) over the last few years. The answer is simply that operating margins have risen from 3.2% in 2012 to 3.8% in 2013, 4.1% in 2014 and 4.5% in 2015. This has been enough to offset continued decline in asset turns (from 0.95x in 2012 to 0.89x in 2015) and financial leverage (from 2.82x in 2012 to 2.62x in 2015). 

Moreover, we can then disaggregate what is driving those margins. Over the last year, the story has been overwhelmingly one in which a 0.8pp decline in cost of goods sold/sales compensated for deterioration in other aspects of margins (principally SG&A expenses), which cut the margins gain to just 0.4pps. 

And that decline in the cost of goods sold/sales ratio is, in turn, a direct reflection of the rise in Japan’s terms of trade, generated by import prices falling faster than export prices. 

The final chart demonstrates how the trade-off between falling export prices and surging terms of trade has worked during the last 18 months. The very specific problem is that the combination of currency movements and commodity prices which generated this useful trade-off has gone into reverse. During the coming year, we can expect to see the red line (export prices) fall even steeper, but the grey line (terms of trade) also to fall. That in turn will begin to push up cost of goods sold/sales ratio, which in turn will drag down margins and return on equity.  The deterioration in large manufacturers’ outlook captured by the 1Q Tankan only begins to acknowledge that times are about to get a lot tougher for Japan’s exporters.