Japan Between a Rock and a Hard Place

 | Jul 01, 2013 | 4:00 PM EDT
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Japanese stocks are back. The question is: How long will it last?

Tokyo's Nikkei 225 index closed higher last night, by 1.28%, and the index is has now climbed 11.3% from the finish on June 13.

Over the past two decades, the knock on Japan's economic policy has been this: The government hasn't been able to stay on course long enough for a recovery to build momentum. Whenever the economy has started to grow, Tokyo has cut back on stimulus, thus sending the country back into recession.

Will Japan do it again in 2013 and 2014?

Right now, the economic program of Prime Minister Shinzo Abe looks like it's paying off in economic growth -- gross domestic product grew at an annualized 4.1% rate in the first quarter. According to the quarterly Tankan survey of big manufacturers, optimism among manufacturing companies rose to a positive 4 in June, reversing from a negative 8 reading in March. Also, according to a survey by the Bank of Japan, large companies plan to increase capital spending by 5.5% in the current fiscal year (ending March 2014). Back in March, companies had expected to cut by 2%.

The problem, though, is the planned increase in Japan's consumption tax -- to 8% from the current 5% -- scheduled for April 2014. (A second increase to 10% would go into effect in 2015.) A tax hike of that size is certainly enough to put an end to the current surge in economic growth.

The government finds itself stuck between a rock and a hard place. It knows that such a tax hike will endanger the current recovery, which has been built on a weak yen. For the current year, the currency has lost 13% this year against the dollar, and it closed today at 99.34 in Tokyo trading. But credit rating companies Standard & Poor's, Moody's and Fitch have rattled their sabers, warning that a failure to raise taxes as planned will endanger Japan's credit rating -- which, over at S&P, is AA- with a negative outlook. The Abe government has said it will make a decision on the tax increases in October.

Oddly enough, the prospect of rising consumption taxes next year might actually add to growth in the short run as consumers push purchases forward to beat the hike. I think any boost from that is likely to be small at this point, but it could well become significant in the fall, when the government is set to decide on the tax -- which will likely push the issue to the top of consumers' minds.

I personally think the tax increase is likely to go through. However, there is also a strong possibility the government will split the difference and opt for a smaller hike in an attempt to keep consumers spending and the ratings companies relatively happy.

Until the fall, though, the yen will remain the big driver for Japanese stocks and company earnings. In today's Tankan survey, Japan's large companies forecasted that the currency will trade at an average of 91.2 to the dollar for the current fiscal year. That's much weaker than the 85.22 level forecast in the previous Tankan survey. If the yen ends up trading in line with estimates, it's bound to lead to a sales climb as Japanese goods get cheaper for overseas customers. It would also lift earnings, with stronger currencies translated into more yen on Japanese income statements.

However, even the current forecast for a 91.2 yen-dollar cross may wind up being too low. Remember, the yen closed today at 99.34 to the dollar.

At any rate, for U.S.-based investors who want to use the leverage that Japanese exporters get from a weaker yen, here's my suggestion: Look at the very liquid, New-York-traded American Depositary Receipts of Toyota (TM).

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