Pathfinder Monthly Commentary: Investing in Japan – an emperor with new clothes?
Japan has securely hooked its wagon to the QE train. Both its currency and equity markets have responded with significant moves this year. What exactly is happening and how should investors react? Is this a short term move or long term game changer for Japan?
Wednesday, May 1st 2013, 10:59AM
by Pathfinder Asset Management
Japan is the world’s third largest economy but on many economic and demographic measures it does not look like a compelling investment destination. Here’s a quick economic roundup:
- Staggering debt levels: Japan’s government debt to GDP ratio is an eye-watering 233% (the highest in the developed world – not even Greece or Ireland can match it). Total debt (being public plus private) to GDP is 500%. If its’ near zero interest rates rose to 2% then almost all government revenue would be swallowed up servicing debt.
- Zero growth and deflation: Japanese equities surged through the 1980s before collapsing in 1989. Its economy has since been gripped by a death-spiral of zero growth and deflation. In fact it has not grown in real terms - the “lost decade” has continued for 23 years. Deflation discourages spending (because the price will always be cheaper next month) meaning the velocity of money circulation slows and so does economic activity.
Below we show the price collapse of Japanese equities in blue (measured by the Nikkei 225) and the downward grind of CPI inflation (in orange):
Like most OECD countries Japan lives with unhelpful demographics and in particular an aging population. Unfortunately their problem is extreme, with 30% of the population now over 60 years old. Below we show the working age population as a percentage of the total population – this ratio has been in decline since the early 1990s. This is not a recipe for economic success:
Despite the demographic time bomb and economic stagnation, the Nikkei 225 is up strongly this year. How can that be?
In November 2012 a new Prime Minister (Abe) was elected. He announced an aggressive plan to beat deflation by targeting growth. His economic plans (aptly named “Abenomics”) are in simple terms explained as the “2+2+2+2” plan:
• 2% growth
• 2% inflation
• 2 x the monetary base
• within 2 years
That is an ambitious plan given Japan’s years of deflation and no growth.
Will the cunning plan work?
Unlike his predecessor, the newly appointed Bank of Japan (B of J) Governor Kuroda is compliant with his Prime Minister’s wishes. He surprised markets in early April by announcing extremely aggressive easing targets. The current monetary base (being bank reserves plus currency in circulation) is ¥138 trillion (US$1.38 trillion). The B of J expects it to be ¥200 trillion (US$2 trillion) by year end and ¥270 trillion by the end of 2014. That is an awful lot of new money to be created.
The B of J increases the money supply (by creating new money) to buy Japanese Government Bonds (JGBs). This forces JGB prices up and yields down – the yield on 10 year JGBs is only 0.53! This in turn leaves JGB sellers (local Japanese institutions) flush with funds. The theory is that they can lend to Japanese businesses (good for growth), reinvest in Japanese equities (sending the Nikkei up) and/or move the money offshore to invest in foreign bonds (sending the Yen down).
Because some of the money will end up in offshore markets, Japan’s actions are widely seen as positive for equity markets globally. This of course is all good – until (a) the time comes for the B of J to withdraw newly created liquidity, (b) it creates an asset bubble somewhere in the world or (c) other countries react to the lower Yen and Japan’s new competitive trade advantage.
What are the risks for Japan?
The biggest risk for Japan is how the rest of the world responds. The G20 has not (yet) publically criticised Japan for its forced currency devaluation – in fact the mid-April G20 meeting was seen as quietly acquiescing. But they will not sit back and watch indefinitely as Japan becomes more and more competitive as an exporter. The US, China and Taiwan must react at some point.
The US Treasury commented in a Congress report that Japan must “refrain from competitive devaluation and targeting its exchange rate for competitive purposes.” The South Korean Finance Minister said the Yen is “flashing a red light” for Korean exports. From here we would expect Japan to argue vocally that their policies directly target inflation and growth (not currency weakness) and at the same time quietly allow the Yen to continue its slide.
Another risk for Japan is importing inflation. A lower currency (Yen down 14% year to date against the US$) makes its exporters more competitive – for example 70% of Sony’s revenue comes from outside Japan. But a lower Yen also pushes up the cost of imports, eventually hurting both domestic consumption and competitiveness.
How have investors responded?
A CNBC headline on 17 April read “Fund Managers Say Goodbye China, Hello Japan”. The article quoted a Bank of America Merrill Lynch survey of 252 fund managers. All of them expect Japan’s economy to strengthen over the next 12 months – but only 13% expect China to be similarly robust. At 25 April the Nikkei 225 is up 16% year to date while the MSCI China Index is down 7%. (As a good yardstick the S&P500 is up 11% for the same period).
Clearly investing in Japan has been a good move since Abe’s election last November. But there is a catch - money printing has driven the Yen down hard. While a Japanese ETF may be up 16% year to date, a Japanese ETF with currency hedging to the US dollar is up almost double that – by 30% over the same period. In this QE world the impact from hedging (or not hedging) currency cannot be ignored.
What next for Japan?
An OECD study in 2010 predicted that a 10% Yen depreciation would lift Japan’s GDP by 0.4% in each of the following 4 years. That growth would effectively be “taken” from other countries, as global GDP would be unchanged. Inflation would also move up by 0.4% in year one and slightly less in each following year. All good so far – except that interest rates would need to rise by 150 basis points within 3 years to contain inflation (remember if Japan’s rates rise to 2% virtually all government revenue is swallowed up servicing debt). The desired growth and inflation may have a price – a massive increase in the country’s interest bill. (Note that these OECD predictions were based on a 10% Yen depreciation - the recent actual move has been even larger).
We believe that the Yen has even further to slide. The 100 level for the Yen (100 Yen to 1 US dollar) has proved to be a barrier that has been recently tested several times but not crossed. We expect the Yen to soon move through the 100 barrier and possibly by another 20% over 12-18 months. We also expect the Nikkei 225 to climb further. As a result we remain significantly over-weight Japan (but emphasise the need for hedging Yen currency exposure).
Despite our positive near term view, we do not see Japan as a healthy long term investment destination. Its debt level will become a crippling burden as the workforce shrinks and the older generation draw down on savings (rather than providing an endless pool of funding for the government). The short term investment story (12-18 months) is encouraging, the long term one is not.
John Berry
Executive Director
Pathfinder Asset Management Limited
Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz
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