Less Bad is No Longer Enough to Maintain the Rally   

• The US and global equity markets have been rallying from March lows on short-covering and monetary stimulus. As we cautioned last week, equity investors are now perceiving increased risk in the bond markets and in the USD, while the Fed has actually downgraded its assessment of the US economy compared to January. Recent news about China is not all positive either, with economists now suggesting China could see a W-shaped recovery, and others reporting that economic activity in China began to slow in April and slowed further in May.
• The corollary to USD weakness is JPY strength, which will be exacerbated by fund repatriation by Japanese companies with the passage of tax breaks on the repatriation of profits and dividends from overseas subsidiaries from April of this year.
• As every experienced investor knows, Japan's economy is very leveraged to global trade centering on China and the US, while domestic consumption is being structurally hobbled by a secular decline in household income that has been exacerbated by the worst recession in postwar history.
• Some Japan economists are estimating positive Q-Q growth in Q2 calendar 2009 and 3% annualized growth in Q3. However, any meaningful recovery in Japan's economy (and ostensibly the stock market) will require a substantial recovery in exports, industrial production and consumer spending. While Japan does have a $150 billion stimulus package in place, it is actually the fourth since October of last year, with the first three having little visible impact.  Thus any real Japan recovery probably awaits a recovery in global trade.
• The first stage of the rally was essentially a "policy rally". The next phase will need to be driven and economic and corporate profit fundamentals. Inevitably, the transition from a policy to a fundamentals-driven rally involves an interim consolidation. Thus further gains await signs real recovery, not just "less bad".
• We fully expect the Nikkei 225 to consolidate as the S&P 500 confirms downside support, but do not see the Nikkei 225 falling below 8,000.

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