As much as moviegoers knew that Arnold Schwarzenegger in the movie Terminator “will be back”, investors knew inflation would eventually return to Japan. Yet unlike the hugely successful sequel which saw Terminator fans celebrating the return of their hero, investors in Japan have been anything but celebratory. Are investors proving to be too pessimistic, or is there reason for their pessimism?

We know that the case for a Japanese recovery hinges on one important variable: inflation. So at first glance, investors’ pessimism seems irrational, since the return of inflation will ultimately bring about a virtuous cycle – as goods and services produced by Japanese companies increase in price, underlying earnings increase; this leads to higher wages, which ultimately leads to more spending in the economy and so the virtuous cycle continues.

Like the rest of the world, Japan has in fact been experiencing inflation. The Bank of Japan (“BoJ”) increased its annual inflation rate forecast for the year ending March 2009 to 1.8% from 1.1%. Therefore the first part of the equation of the virtuous cycle seems to be there; that is, Japan has seen an increase in consumer prices (goods and services) which should lead to higher company profits and wages, and ultimately greater domestic spending in the economy. Yet there is something very disturbing about the current price increases, which could mean that Japan’s recovery falters at the first obstacle (again).

Although Japan has been experiencing inflation, this increase is mainly imported. Increasing food and energy prices, the source of every country’s malaise at the moment, is the culprit. Since Japan is a net importer of these goods, Japanese companies are not benefitting from this inflationary environment.

Yet the prospects for companies are even more bleak than that. Demand from Asia, which constitutes about half of Japanese exports, has fallen this year. Exports to America are declining fast. Now Europe, which has so far proved to be the most stable trading partner is looking like it will join the group. And even though some analysts proclaim that higher inflationary expectations will ultimately lead to higher wages, it is very unlikely that in an environment of declining earnings and greater economic uncertainty, companies will increase their fixed costs by increasing workers wages.

So as promising as it seemed at first glance, the return of inflation to Japan's shores is not the welcome sequel investors had hoped for.

Disclosure: Long Japan

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