Even if your interest in the Japanese economy is
limited to sushi exports, video games and overpowered motorcycles, you would be
well served to continue reading this entry, for the economic paralysis that
Japan is presently enduring…and the extreme policy responses….is a case study
for what may be awaiting other advanced economies, including the United States.
It serves investors well to ignore the round…yet
insignificant…numbers crossed by major indices and asset classes that the
mainstream media sheepishly love to highlight. Recent meaningless examples
include the Dow at 15,000, the S&P 500 at 1,600 and gold’s 2011 assault on
$2,000 per ounce, which has since petered out with a resounding thud. Yet last
Friday’s breach of 100 Japanese Yen (JPY) to the U.S. Dollar likely is
significant for what it symbolizes about the state of advanced economies, their
growth prospects, debt loads and the steps policy makers have attempted in
order to right the ship.
Just in case there was any doubt that there is a
beggar-thy-neighbor currency war occurring in the developed world, the USD has
risen 27% against the JPY over the past year. In poker parlance, that would be
akin to, “I’ll see your QE3, Mr. Bernanke, and raise you the unlimited
commitment to reflating the economy by the Bank of Japan (BOJ).” The odds-makers
in financial markets have sided with the Japanese, betting that the Fed will
eventually be forced to raise U.S. interest rates before the Bank of Japan
takes its foot off the accelerator (for
those not initiated into the cult of foreign exchange, expectations of interest
rate differentials are a key driver in currency markets….hence the recent
plunge in the value of the JPY). Ironically, much of Mr. Bernanke’s fame
came at the expense of the Japanese when during their lost decade….well decades
now….he chastised them for not being aggressive enough in their policy responses.
An accusation that clearly no longer applies.
Demographics As
Destiny
It hardly seems fathomable that Japan could have gone
so wrong, so quickly. During the 1980s the country averaged over 4% annual GDP
growth as it enjoyed the final stages of its post-war boom and accession to the
top-tier of global manufacturers. Then things got frothy. Asset bubbles, a
stock market crash, zombie banks. And on top of that, the lousiest demographics
in the developed world. As seen in the
chart below, 23% of Japan’s population is age 65 and older. That means a
smaller workforce will be responsible for covering the growing social outlays
associated with a rapidly rising number of pensioners. Similar trends are occurring
in other advanced economies (and in China, thanks to its one-child policy), but
Japan takes the cake.
This confluence of forces kept economic growth stuck in
low gear, averaging in the neighborhood of 1% annually over the ensuing decade-plus.
By the mid-90’s authorities instituted massive fiscal stimulus in hopes of
spurring demand by undertaking large-scale projects. It did not work. Growth
remained sluggish and only showed signs of life during the five years preceding
the global financial crisis, a period in which global growth was largely built
upon a house of cards. Since then Japanese
GDP growth has been negative, leaving policy makers baffled regarding what to
do next.
Let's Try This Again
If the goal of the 1990’s Keynesian fiscal stimulus was
to jack government debt to GDP to the highest ratio in the world, then it was a
resounding success. The U.S. has
famously just crossed the ominous sounding threshold of 100% gross debt to GDP.
Years ago Europe blew through its Maastricht Standard of 60% with some
countries like Italy and Greece doubling that figure. In Japan, the ratio is
broaching 250%. And this does not include private sector and banking debt,
which only put the country more deeply into hock.
Knowing that the fiscal apparatus has already been red-lined,
Japan’s newly elected administration quickly made it known last autumn that it
expected more…..much more….from the BOJ in combatting weak growth. The elbow
twisting worked. The central bank announced unlimited purchases of financial assets,
including Japanese government bonds (aiding the servicing ability of the
aforementioned gargantuan debt load). It has also committed itself to achieving
an inflation rate of 2%, a far cry from the current negative rate of -0.9%.
Rates and
Deflation
Japan’s version of quantitative
easing is already on top of an interest rate regime that makes the current
U.S. Fed seem hawkish. The Fed funds
rate is presently in the range of 0% to 0.25%. To remove that subtle ambiguity,
the BOJ has nailed its rate to 0.1%. Even with sluggish U.S. growth and
distorted treasury markets, the U.S. 10-Year yield has drifted up towards 2% in
recent days, leaving the 10YR-2YR spread at around 165 bps. In Japan, the
spread is 69 bps. A flatter yield curve denotes weaker growth expectations. These
rates are putatively set by markets…ignoring central bank distortions… which
means that investors think that at some point in the future, prices may rise in
the U.S.
Not so in Japan. Why? Because it is already
experiencing a period prolonged deflation. This prospect has long kept advanced
market policy makers awake at night. Yes inflation is lousy as it lowers the
purchasing power of a nation’s citizens, but in highly levered economies,
deflation…or wide-spread falling prices…packs a one-two punch. First is lowers
aggregate demand as consumers put off purchases, expecting prices to drop even further.
Second, lower revenues put corporations at risk of default as they may not be
able to cover fixed interest costs. That could lead to bankruptcies and layoffs
on the corporate side and similarly, home foreclosures on the consumer side. A
classic debt deflationary cycle. And you thought a hangover was tough to shake.
What has surprised experts about Japan is that
deflation has not caused a sudden
collapse, but instead a steady bleed of subpar economic performance. The table above illustrates the menace of
deflation. At present the real rate of return (nominal minus inflation) on the
Japanese 10-Year is 1.72%. Simply put, without the presence of inflation,
consumers may as well keep their money invested...despite paltry rates….as it
at least earns some interest. However, when inflation exceeds interest rates, real
rates turn negative, enticing consumers to spend today vs. losing money in
their savings accounts tomorrow. Case in point: if Japan was already at its 2%
inflation target…..which it never will be….the real rate on the 10-year would
be -1.18%. Time to go shopping.
Monkeying With The Markets
The Bank of Japan’s….as well as the Fed’s and ECB’s….commitment
to low interest rates and asset purchases, by design, greatly impacts financial
markets. On the obvious side, central
bank purchases of safe assets like
government bonds, force investors farther out along the risk spectrum into
high-yield debt, equities and assets emanating from emerging markets. In
addition to goosing demand for risky assets, lower interest rates…at least
theoretically….positively impact asset prices in a couple of ways. First it
enables firms to refinance debt at lower rates, and perhaps undertake
debt-driven activities such as share buybacks, capital investment and acquisitions.
All of which can be welcome developments
for shareholders. Also there is the simple math that lower interest rates
increase the present value of future cash flows from financial instruments,
whether they be bond coupons or dividends. So it is no surprise that a commitment
to asset purchases and low rates should spur an equities rally.
That said, any index that climbs 70% over the course of
52 weeks…especially in a low growth environment…should cause investors’
eyebrows to furl. Yet this is exactly what has occurred with the Nikkei Index,
which has put the rallies in the S&P 500 and European shares over the same
period to shame.
Another catalyst for the Nikkei’s rally is the
aforementioned weakening of the Yen. This, at least on paper, makes sense too,
but with a large caveat. A cheaper currency not only makes a country’s products
cheaper vis-à-vis foreign competitors, but it also boosts
domestically-denominated corporate earnings when foreign profits are translated
back to the local currency. So a weaker
Yen should boost corporate performance…but
at the cost of imported inflation. Japan is a resource poor country, at least
with regard to energy and mining products and to a lesser extent, foodstuffs,
which together comprise 50% of the country’s imports compared to 29% for the U.S.
and 28% for Germany. As these
commodities are traded internationally in dollars, the weaker Yen would cause
prices for the key building blocks of the economy to rise. Yes, the BOJ’s goal
is to drive up inflation, but the imported variety is notoriously difficult to
control.
Revolting Against the Wealth Transfer?
It seems to defy logic that Japan has been able to get
away with its astronomic debt/GDP ratio for as long as it has. One reason for
this has been the fact much of it is held by local creditors, often domestic
savers. Local creditors don’t have to worry about a real or de-facto JPY
devaluation hammering the value of their investments. Italy has been able to bear
its chronically high debt load for similar reasons.
The Japanese propensity to save has been one of the
reasons why its currency has long been considered a safe-haven in times of
economic tumult. Falling currencies and rising inflation tend to punish savers.
The long-standing assumption has been that, for political reasons, Japan won’t garrote
its thrifty citizens by doing anything too egregiously stupid on the policy
front. This latest salvo by the BOJ may have finally thrown this idea out the
window. It now appears that authorities have sided with the corporate sector by
preferring a weaker JPY and rising profitability over the predictability of
real returns in Japanese savings instruments.
But what happens if the savers revolt? They were
notorious practitioners of the Yen-denominated carry trade during the last
decade, borrowing in their low domestic rates and investing in higher-yielding
emerging markets and Australia. Anecdotally this is happening again, this time
with juicy-yielding southern European bonds as the destination. A nightmare….but plausible…scenario is
domestic savers…tired of low rates and messy government finances… dumping
sovereign debt en masse akin to rats fleeing the proverbial sinking ship. Should
a tipping point in local demand be reached, liquidity would dry up, foreign
investors would be second out the door, and interest rates would sky rocket,
driving a wooden stake through the heart of an already comatose economy. Although the need to reflate the economy is
obvious, the risks associated with these policy tools are perilous. Let’s wish
them luck.
Gold As the
Barometer
Although not a gold
bug, the market for the yellow metal at times does provide prescient insight
into the minds of investors and their expectation of price stability and
currency prospects. This is especially true when there is such a divergence in
gold prices in various advanced economy currencies. Although Europe, the U.S.
and Japan have all implemented dovish policies and show no fear in debasing
their currency, it is only the JPY that has continued to lose value against
gold over the past several months.
This means that investors may have a stronger belief
that BOJ officials will keep its foot on the gas long after the ECB and Fed
begin to ease up on asset purchases and low rates. The fact that gold is
hitting record highs in JPY perhaps represents the possibility that the party is over scenario described
above is upon us and Japan may face a future of no growth, illiquid credit
markets and a debased currency. Gold and
other real assets make good investments in times of crisis.
Don't Look Away Now
With regard to these subjects, there are many
similarities between Japan and the United States. Both have high government
debt to GDP ratios, are stuck in a post-crisis, low growth funk, have interest
rates at historic lows and have instituted unprecedented stimulative policy
responses. Much of what has been described here can be placed in the financial repression bucket, meaning
policy aimed at transferring wealth from creditors to debtors to pay for past
fiscal sins. Yet equity markets in both countries are surging. Toss Germany in there
as well, given that the DAX has just touched a record high. Yes, markets should
be forward looking, but record highs in low growth environments give hint that something
is amiss. Should these rallies be fueled
largely by central banks crowding investors out of less risky assets, then
there will be a price to pay once the bubble…..and that is what it would be….finally
pops. Even more daunting is the plight of sovereign debt markets once central
banks dial back their purchases and it is left to market to determine the
credit-worthiness of over-leveraged entities. Recent ambiguous statements about
the how and when of the Fed’s
eventual exit strategy don’t carry much weight being that policy makers are in
unchartered territory and the textbook was tossed out long ago.
On a brighter note, the U.S. is not Japan. Is it
greying, yes? But it is also a nation of net-positive immigration and is alone
among advanced economies with regard to favorable demographics. It is also
resource rich and is on the cusp of becoming even more so if it figures out a
way to take full advantage of newly accessible shale-based energy reserves. It also holds the world’s reserve currency,
meaning that it can get away with backdoor devaluations than other countries
(but on the flipside, it has a much large external debt position than does
Japan). All this said, as Chairman Bernanke did years ago, it would be wise for
U.S. and European investors to study Japanese developments in real time to
determine how its policy successes and misfires impact economic growth and investment
portfolios in the months and years to come.
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