Is the World's Third-Largest Economy Falling Apart?

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As world leaders prepare to meet in Japan later this week for the G7 summit, the host country’s economic fortunes are in focus, with some warning that the Japanese economy could continue to decline.

“Japan's April Trade Data showed exports falling a shocking 10.1%, accelerating March's 6.8% decline as the yen declined 4% over that two-month period,” said options strategist Phil Davis. “This is the world's third-largest economy falling apart right in front of us.”

And data on Monday did not provide any relief. The Japanese manufacturing PMI for May came in at 47.6, down 0.6 percent from 48.2 in April, signaling the sharpest decline in operating conditions since December 2012. This marks the fifth consecutive monthly decline and put the PMI below 50 for the third straight month. The index readings suggest continuing weakness in Japanese manufacturing.

“We see the weakness in manufacturing activity through to May as due also in large measure to the weakness of domestic demand,” analyst Masaki Kuwahara said in a research report for Nomura. “We interpret the data as indicating that downside risks remain for the Japanese economy.”

Part of the decline in exports can be attributed to a stronger yen. But with the Federal Reserve decidedly more hawkish, a potential rate hike in June, and a stalemate in the G7, investors can expect the currency wars to heat up.

Ironically, they are battling for the weaker currency to make exports look more attractive.

It is important to watch movements in the U.S. dollar and Japanese yen, as many traders consider it a good gauge for assessing risk in the stock market. Typically, when the yen is down, the dollar is up -- and so is the stock market.

Because many retail traders do not have foreign exchange trading accounts, utilizing the exchange-traded funds that represent the underlying currency is an excellent tool to track trends, offer diversification and also provide a way to trade macro events or hedge a portfolio. For example, if an investor has a long-only equity portfolio and the yen makes a move higher as the macro environment changes, one can purchase shares of FXY as a hedge.

The Week Ahead: Earnings and Data

A handful of actively-traded S&P 500 companies are slated to report this week, including Tiffany, Costco, AutoZone, Best Buy, Abercrombie & Fitch, Dollar General, Dollar Tree and Ulta Salon. 95% of the index has reported with a 67% beat rate, according to data from S&P Global Market Intelligence.

New Home Sales will be in focus following very strong earnings reports from home-improvement retailers Home Depot and Lowe’s. This set of data is a gauge for the demand of housing, as well as economic momentum. If the report is strong, it could imply demand for furniture, appliances, and other housing goods will be higher. The Existing Home Sales report last Friday was quite strong, with an improvement in first-time home buyers and prices

International Trade in Goods, Durable Goods Orders and Crude and Natural Gas Inventories will also be in focus, while several Federal Reserve speakers will be making the rounds this week.

GDP is the all-inclusive measure of economic activity. There are four major categories: personal consumption expenditures, investment, net exports, and government. It helps the Federal Reserve and investors gauge the strength or weakness in consumer spending, business and residential investment, and inflation. Unemployment data and GDP are major factors the Fed considers when creating monetary policy.

Longer-Term Concerns

Markets will continue to be sensitive to speculation around the FOMC meeting in June and a hike in interest rates. New York Federal Reserve President William Dudley said on Thursday that there was a strong sense among Fed officials that markets were underestimating their rate hike plans and June is a “live” meeting.

But does the Fed have to make a move now to maintain credibility?

“While Janet Yellen may have intentions to pull the trigger as soon as possible, most of the macro data indicate that the recovery remains stuck in low gear,” Chief Market Strategist Jeremy Klein at FBN Securities said. “Out of deference to tepid growth and the U.K. referendum on EU membership, I maintain that the Chairman will wait until later in the summer before tightening.”

Finally, more volatility can be expected around the “Brexit” vote on June 23 on whether the United Kingdom should leave the European Union or not. According to the latest Financial Times poll, 47% of participants expect that the UK will stay in the EU, while 41% believe they will leave.

Jill Malandrino is the Voice of America's New York Bureau, focusing on global macro trends and commodities. She can be followed on Twitter @OptionsProfits