"Strange Fruit"

Anybody who has travelled to Japan will have their our own stories about how shudderingly expensive it can be - the £200 taxi ride from Narita Airport to the centre of town is the favourite - but here's mine; the high price of a pair of perfect melons (see below). I snapped these in a shop window the other week and those of you who are wondering what the price of a perfect pair of melons is, its ¥31,500 or £143 (US$267) at current exchange rates. Bear in mind that this is a perishable good then that's a lot. I asked my guide from MGI Japan, Hanae Tsuno, what they did if they went unsold and she told me, casually, that "They probably throw them away to keep the price up". The mind boggles.

This is, of course, an isolated and silly example of prices in Japan. In general, they are quite reasonable and comparable with other major cities like London. But still the announcement that Japanese GDP is growing at a higher rate than expected (mainly due to exports and capex rather than domestic consumption) raises the possibility that the Bank of Japan could increase interest rates sooner rather than later. This is of great importance as one of the major underweights in global investor portfolios' is the yen. At the same time we are also mindful of what happened the last time interest rates rose - it caused a massive de-risking of investment portfolios globally which sent emerging market and corporate bond yields painfully higher.

In many respects the problem of predicting Japanese interest rate policy revolves around sorting out whether this is a purely domestic matter or whether Japan is still in the thrall of international economics. It would be thematically nice to think, for instance, that Japan has beaten its dependency on the West and forged and an alliance with the Far Eastern economies, which would represent the historic process replacement and substitution. However, the evidence just doesn't support this. For instance, much has been made of the development of areas like India and Pakistan as future wealth creators and export markets. There is no dispute that these areas have risen in importance in recent years but it would be wrong to exaggerate the fact. If you look at the amount of combined trade Japan is doing with these nations and compare it at the same time with the trade Japan is doing with the U.S. it's easy to see that it may have doubled in recent years but it is still only 2% U.S./Japanese activity (see second chart). In the same way, the proportion of trading Japan does with partners like China, Korea, Thailand, Vietnam etc hasn't changed that much over the past fifteen years. In summary the dependency culture Japan has with the West hasn't been broken yet and a quick look at the high correlation of Japanese bond yields have with the West (not shown here for space reasons) confirms that the two regions are still very much linked. 

Sadly, once again, no matter where you start, you end up wriggling back to discussing the U.S. to define your investment strategy in another country. I know it's boring but it's just the nature of the interconnected world we live in and the data coming out of the United States isn't at all encouraging. There are early signs that the housing market decline is showing up in consumption and prices which should be an international worry - if it continues policy makers in Europe, the UK and Japan can kiss goodbye to the idea that they are going to get much further in their desire to increase interest rates and turn off the tap of money flow that is inflating every major financial asset category in the world from bonds to equities to art and allowing the kind of financial engineering that is not only dangerous but also may be immoral.

But if we return to Japan for a moment, the domestic commentary is much more strident than the international one on interest rates; it's clear that the BOJ are leaving open the door for a December interest rate increase. So far the telltale signs of a decline in the BOJ's current account balance which presaged an interest rate rise earlier this year is not happening so we must see an interest rate increase as a distant possibility and maybe one best looked for in the early part of 2007. Certainly any worsening of the U.S. situation will put an end to such speculation but at the same time we must be mindful of the fact that;

So logically, we are going to stay underweight the yen because of the dependency culture Japan still has on the West but we also have one eye on the type of capital flows that increasingly dictate the difference between investment success and failure and can confound your logic from time to time.