Can Japan Grow With Fiscal Austerity?

• The primary driver behind the recent selloff in global equity markets appears to be a growth scare, i.e., that fiscal austerity in Euroland, continued tightening in China, and the lack of meaningful job growth creation in the US could lead to a double dip in the global economic recovery. So far, the economic data indicate these fears may be overblown, but stock prices of course lead the economy by six months to a year.
  
• The US S&P 500 is still not technically in bear territory as defined by a 20% peak-to-trough decline, while the index and many other indices have broken down through 50-day and 200-day MAs which is usually the sign of an interim correction, not just a speed bump. Last week, the S&P 500 struggled to regain its 200-day MA and just barely succeeded in doing so. While this probably means the risk of a heavy selloff below February 2010 and July 2009 lows (i.e., below 900) has noticeably abated, we don't expect to see another meltup before the end of the summer.
  
• The resignation of Yukio Hatoyama and instatement of Naoto Kan as prime minister has breathed new life into Japan's Democratic Party of Japan, and has raised hopes for conflicting outcomes. While Kan is seen as favoring a weak JPY, his (and his cabinet's) hawkish fiscal stance mean JPY strength, not weakness. Further, achieving or even maintaining economic growth amidst widespread fiscal austerity is usually considered an economic contradiction, even in the best of times. At this point, we believe Kan has more credibility vis-a-vis his fiscal austerity stance than for his economic revival stance.
  
• Since fiscal austerity implies lower, not higher growth (as well as JPY strength), this appears to have triggered significant foreign selling, despite selected quotes of constructive comments by foreign investors in the Japanese press regarding the new Kan Administration. Thus the short-term economic risk for Japan may be to the downside, not upside, even though Japanese government and BOJ monthly reviews still describe Japan's economy as "steadily recovering".
  

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