Why investors are brushing off Moody’s Japan downgrade

Moody's: Why we downgraded Japan
Japan suffers rating downgrade

Investors shrugged off Moody's downgrade of Japan's sovereign debt rating, maintaining their bullish outlook on the market despite headwinds facing the world's third-largest economy.

The benchmark Nikkei 225 traded was up 0.1 percent on Tuesday, one day after the U.S. ratings agency cut Japan's credit rating by one notch to A1 from Aa3, citing increased uncertainty over whether Japan Prime Minister Shinzo Abe can achieve his deficit.

In comparison, Standard & Poor's has an AA- rating on Japan, equivalent to the Aa3 level that Moody's had before the downgrade. Fitch Ratings has Japan at A+, on par with Moody's new rating.

"Forget Moody's; continue to buy Japan," said Uwe Parpart, chief strategist and head of research at Reorient Research, dismissing the ratings agency's move.

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"Moody's is wrong to downgrade JGBs [Japanese government bonds] since - in stark contrast to the U.S. – Japanese debt is financed by Japanese savings, which are massive, while U.S. savings are deplorably low and still falling," Parpart wrote in a note.

After years of borrowing, Japan's government is sitting on a debt pile equivalent to 226 percent of gross domestic product (GDP), the largest in the world. The U.S., by comparison, has a debt-to-GDP ratio of 74 percent, which appears modest in comparison but is the highest in the country's history except for a brief period around World War II, according to Brookings.

Yoshikazu Tsuno | AFP | Getty Images

Moody's downgrade is the first reaction by a major credit rating agency to Abe's decision last month delay the second scheduled sales tax hike, seen as pivotal to reducing public debt.

Japan's main credit ratings agencies Japan Credit Rating and Rating and Investment Information (R&I), closely watched by domestic investors who own around 95 percent of JGBs, have not adjusted their ratings.

R&I , which has a AA+ rating, called the government's decision to put off the consumption tax hike "somewhat understandable" on the grounds that the government is pursuing higher tax revenues through economic expansion and the economy is more fragile than anticipated.

Papart shared a similar view: "The postponement of the second leg of the consumption tax by the Abe government was the correct move: Japan cannot tax itself out of debt, rather it must grow out of it."

'Paper tiger'

Chris Konstantinos, director of international portfolio management at Riverfront Investment Group sees Moody's move as a "paper tiger", citing limited fallout in the JGB market.

"I think you have to look at the JGB market – did the JGB market freak out on this news? No just the opposite really. We believe the administration is doing the right thing to try and break the deflationary death spiral," Konstantinos said.

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The yield on the 10-year JGB rose as high as 0.441 percent on Monday following Moody's decision, up from 0.420 percent earlier in the day. The yield stood at 0.443 percent on Tuesday.

Konstantinos's enthusiasm for Japanese stocks remains firmly intact.

"Of all the major markets we track, our base case for Japan is the most optimistic frankly over the next 12 months. A lot of that has to do with the yen," he said, noting the benefits of a weaker yen for the country's export sector.

Jonathan Pain, director at JP Consulting was also unrattled by Moody's decision.

"The Moody's downgrade, it was a bit of a surprise to most of us, but I'll have to put this on the record: Following the great crash of 2008, many of us in the investment industry pay less attention now to the ratings agencies," he said.

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"These were the institutions that were rating toxic collateralized debt obligations at AAA in the lead up to the great crash, so I don't think they have significant credibility in the financial markets today."

Pain remains optimistic on Japan stocks on the basis that the Japanese government and central banks are "throwing everything" at attempting to resuscitate the economy.

"I'm beginning to see continuing evidence that there is a change in the spirit in Japan and I think the Japanese stock market could move higher," he said, forecasting the Nikkei 225 will hit 18,000 in the short-term, up 2.3 percent from current levels, before moving higher in 2015.

Thomas Byrne, senior vice president and regional credit officer, sovereign risk group, Moody's is more wary about the efforts by Japanese authorities to get the economy back on a sustainable path for the long term.

"The government's trying to achieve something that's very difficult," he told CNBC, referring to "the tension" between ending deflation while achieving fiscal consolidation.