Amy Hatta, Managing Director, International Active Equities Portfolio Manager
Melissa Otto, Director, Active Equity Research
Hideki Shigenobu, Managing Director, International Active Equities Portfolio Manager
July 17, 2013
Japan’s economic rise in the 1980s was meteoric; its economy ascended to second largest in the world and was on a trajectory to overtake the U.S. at the top. But the collapse of two financial bubbles—first real estate, then stocks—ushered in two decades of economic and financial malaise that has been difficult to shake. Since then, the Japanese government and central bank, the Bank of Japan (BOJ), have made numerous attempts to stimulate economic growth and to fight persistent deflation with little success. The equity market remains far below its 1989 peak and the bellwether 10-year Japanese Government Bond (JGB) yielded a paltry 0.57% as recently as April. The Japanese government has borrowed so much to fight these
problems that its public debt-to-GDP ratio is more than 240%, putting it in the same camp as Zimbabwe, Egypt, Sudan and other developing nations, though Japan has remained stable.1
It was surprising, then, when Japanese equity markets recently woke from this two-decade slumber and went on an epic rally from the end of 2012 to late May 2013. Japanese stocks increased by 50% from January to May 22, outgaining all other major markets (see Figure 1).
Newly elected Prime Minister Shinzo Abe sparked this enthusiasm with his promise to cure the nation’s economy via a “three arrow” program that includes fiscal stimulus, aggressive monetary policy and broad-based structural reforms of inefficient industries. This program, known as “Abenomics,” reignited domestic and foreign investor interest in Japanese equities. After Japanese stocks’ strong run in the first months of the year, however, they encountered strong volatility and retreated by about 20% from late May through mid-June. For the year, Japanese stocks remain in positive territory, up about 40%,2 but the May-June pullback may have indicated that investors are wary of the sustainability of this rally, or perhaps pondering whether Abe’s policies are truly transformative or a rerun of previous failed attempts.
TIAA-CREF’s portfolio managers Amy Hatta and Hideki Shigenobu and active equity analyst Melissa Otto recently talked about their perspective on Japanese markets and the impact of new policies under Abe and his cabinet. The following questions and answers summarize some of their views.
Figure 1: Japanese equities have outperformed this year
Source: Haver Analytics, as of July 12, indexed to 100 as of January 2013 levels. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs.
Japan needs to reverse years of economic stagnation so it can begin to address long-term challenges, including massive and growing government debt, a shrinking labor force and a graying population. Persistent deflation and weak growth have squeezed Japanese profit margins for roughly two decades, causing corporations and individuals to become extremely risk averse. This has led to increased savings and reduced spending. Capital expenditures and bank lending have been anemic, for example, and investors have mostly favored JGBs, despite negligible yields.
Our view is that the deep-seated psychological effects caused by deflation will not be fully understood until it ends. The nation has been under a rain cloud of deflation for so long that a string of positive economic developments could trigger a mindset change leading to many beneficial ripple effects, such as increased spending and business activity. Abe aims to contain deflation and create some inflation as a starting point over the next two years, ultimately leading to more economic growth over the long term.
A succession of policymakers and governments has attempted to jolt Japan’s economy out of a 15-year bout with deflation and low growth, though success has been minimal. Coming into office with tremendous support, Abe has promised bold action through his three arrows strategy. The Abe administration quickly and dramatically shot two of the three arrows within months of taking office—first with a $116 billion fiscal stimulus package in January, followed by the Bank of Japan’s massive quantitative easing (QE) program in April under new BOJ governor Haruhiko Kuroda. These are bold steps, far larger and much more coordinated than attempts made under previous administrations.
The BOJ first tried quantitative easing (buying government securities on the open market), in the late 1990s and early 2000s to little effect. A central bank’s QE program typically seeks to spark growth in an economy after interest rates have already been lowered to near-zero, by increasing the supply of money through the purchase of government bonds on the open market. Critics claim QE adds to already large government debts and may hamper rather than help economic recovery. Supporters say that QE has to be large or it will be ineffective.
Kuroda announced a $1.4 trillion bond buying program through 2014, which was a massive shock to markets, as the size of the program far exceeded expectations and is even much larger than the U.S. Federal Reserve’s QE program, as a percentage of the economy. The BOJ aims to achieve 2% inflation within two years through this program, while also doubling Japan’s monetary base over the same period. Achieving that mark would be a major accomplishment.
Abe has yet to shoot the third arrow, structural reform, which may be the most important and difficult of the three to achieve because it requires broad political support. Monetary policy and fiscal stimulus alone will not usher in a new era; Abe needs help from a gridlocked Japanese parliament to implement his broad reform package, which includes restructuring the farming, medical and pharmaceutical industries in addition to encouraging more capital spending and increased bank lending.
With parliamentary elections scheduled in July, Abe’s Liberal Democratic Party (LDP) has an opportunity to achieve a legislative majority in Japan’s upper house. Abe currently enjoys 70% popular support and should secure gains in July, though putting political rhetoric into action will be challenging in such a conservative society, even if he has more parliamentary allies.
Japanese capital markets have swung between extremes of fear and exuberance in just a matter of weeks. Three major market themes have emerged under Abenomics.
Weaker currency: Over the last six months, the yen weakened versus other major world currencies, including the U.S dollar, the Chinese yuan and the euro. A weaker yen can boost profit margins for corporations that rely heavily on foreign trade, such as automakers, which is ultimately good for stock prices. A weaker yen also has historically had a strong correlation to improving stock market returns (see Figure 2). Fixed-income markets also responded favorably to the Fed’s supportive rhetoric. Both investment-grade and high-yield corporate bonds had positive returns, continuing to recoup some of the losses sustained over the prior weeks. U.S. Treasuries also rallied, with the 10-year yield falling from a 2.73% close on July 5 to roughly 2.5% in midday trading on July 12. Mortgage-backed securities also improved. Emerging-market bonds remained in a unique trajectory, with a more muted recovery.
Figure 2: A weaker yen, stronger stocks
Source: Strategas Research Partners, as of June 30, monthly end-of-period data, JPY/US$ exchange rate is on right hand scale, inverted to show weakening yen vs. US dollar.
A roaring but increasingly volatile stock market: Japanese stocks advanced significantly after Abe’s election, but reversed in May after some large drops and an uptick in volatility. The market traded at a 40% premium to its 200-day moving average at the peak of the rally, compared to a more normal 20% premium during previous bull markets, which was one sign that the rally was overheating. Volatility increased after recent mixed economic signals, including slower Chinese manufacturing, the potential slow-down or tapering of the U.S. Federal Reserve’s QE program and increased volatility in the JGB market.
Rapidly rising government bond yields: The yield on the bellwether 10-year JGB has spiked several times, creating some concern that this critical market is stressed. Yields move up when there are fewer buyers. The government represents about 70% of this market, and with the BOJ’s massive QE plan it’s only getting bigger. Some institutional investors may have been spooked by the size of the BOJ’s program and decided to wait on the sideline to see what happens before buying more bonds. This interest rate will be watched closely because large upward movements in yields could trigger other problems, such as a loss of investor confidence and increased funding costs for the government.
The Japanese stock market peaked at 38,818 in 1989. There have been numerous rallies over the last 20 years, though none of them have kept momentum. During the recent rally, the index touched above 15,000, still less than half of its peak (see Figure 3).
Whether the most recent rally is sustainable depends on whether Abe and his cabinet can execute on his broad programs this year and in coming years. It also may depend on whether investors believe that Japan can credibly address its secular issues, such as the growing national debt and a shrinking population. Japan will have extreme difficulty financing its debt in the 2020s if current conditions hold, because the pile will continue to grow while its population simultaneously shrinks. Abenomics does not directly address these issues, which may mean more bold steps are needed to achieve a long-lasting and sustainable economic recovery.
The demographic issues, however, have been well-known for some time, and since the future is unknown, there is always potential for these problems to be solved through a return to economic growth and prosperity. Japan remains the world’s third-largest economy and has enormous resources, including plenty of cash and technology that could work to enhance productivity, even as labor force growth remains stagnant.
Figure 3: Japanese stocks have rallied recently, but remain far below historical peak
Source: Haver Analytics, monthly end-of-period index level of the Nikkei 225 Average, as of June 30, 2013.
It’s possible that the market could correct another 5% to 10%, since prices surged ahead of their underlying fundamentals and a lot of “hot” retail money flowed into stocks in the latter stages of the run-up. Price momentum has been moving many stocks along with the rise and fall of the broader market, while valuation metrics have not been much of a factor. Stocks are no longer considered cheap, though they are around fair value. This can change as markets swing up and down, which calls for discipline along with selective buying and selling.
There are three broad themes that could move markets over the next several months, including the upcoming parliamentary elections, further turbulence in the JGB market and a plan to double the consumption sales tax over two years starting in 2014. The tax will be increased in two increments, from 5% to 10%, and is necessary to appease ratings agencies, which have warned Japan to generate more government revenue or risk the country’s sovereign debt rating. To avoid paying higher taxes, consumers may ramp up purchasing before the increase, which could boost sales and profits through the end of 2013. This is a short-term, tactical view, however, not a long-term secular change in markets.
Looking beyond the tax issue, it’s difficult to predict what will happen as Abenomics is still in its early days. As long as the yen exchange rate stays at around 100 to the U.S. dollar, the stock market should continue to receive support. The yen exchange rate was around 99 to the U.S. dollar in early July.
Given the current trajectory of its debt, government spending, aging population, and shrinking workforce, Japan is on a crash course with many hard choices. But it has time to solve these issues before the markets force it to. We think Japan’s demographics and debt problems will collide sometime between 2020 and 2025, which is when the nation will need to balance its debt externally, meaning it will have to sell Japanese government bonds to foreign investors. Most of its bonds are currently sold internally, which is why it has such low interest rates. As the population declines, however, it will need to pay more competitive interest rates abroad to attract buyers, and doing so would significantly increase an already massive debt burden.
In the meantime, Japan can work on new policies to address items such as spending, costs and immigration policies, which have been culturally challenging in recent times.
Japan’s current monetary experiment, however, is testing uncharted waters, which may have already given some investors reason to pause. While the yen has continued to weaken further and equities appear to have support, the JGB market was rattled when the 10-year yield almost doubled in a single week in May, from 0.5% to 0.8%. Yield spikes—even when interest rates are this low—can spook investors and present challenges such as diverting critical government revenues towards meeting increased payments.
Figure 4: The yield on the 10-year Japanese Government Bond 1990-2013
Source: Haver Analytics, as of June 30, 2013.
While the size and scale of these programs are massive, our view is that the BOJ, Abe and his administration are coordinating their policies and have enough flexibility to maneuver should problems arise over the next few years. It is not our view that inflation will get out-of-control over the next two years. In fact, we think it will be a stretch for Japan to achieve 2% inflation over that period.
It is still too early to tell. There are certainly positive signs in response to Abe’s first two arrows. In addition to the rapid advance of stocks and decline of the yen this year, we have seen evidence of consumers becoming more optimistic as confidence and spending have risen in some sectors. The stock market rally has also generated a surge of new consumer-level wealth—particularly among affluent stock owners who haven’t experienced asset appreciation in several years. Retail and department store sales have increased, luxury spending has accelerated and hotel stays are up.
We can also point to the increased flow of foreign capital into Japanese markets and higher bank lending, which has increased by about 1%. Japan’s first quarter gross domestic product grew 0.9% from the previous quarter, which exceeded most expectations.
Inflation, however, has remained negative at about -0.5% year-over-year as of May. And we have not seen the positive effects spread more widely across the economy, which is one area we are closely monitoring.
Ultimately, without enormous political will, the complex Japanese problems (fiscal deficit, unfavorable demographics, government debt) will not be solved. That’s why we view the third arrow of comprehensive reform as such a critical component of Abenomics. Monetary policy alone will not usher in a new era. A year from now will shed more light on whether these programs are working and whether Japan is experiencing an economic renaissance or whether we’re seeing a rerun of prior failed attempts to jolt this massive but stagnant economy back to life.
1 International Monetary Fund, as of December 2012.
2 Nikkei 225, as of July 15.
The information provided herein is as of July 11, 2013.
This material is prepared by TIAA-CREF Asset Management and represents the views of Melissa Otto, Amy Hatta and Hideki Shigenobu as of July 2013. These views may change in response to changing economic and market conditions. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance is not an indicator of future results.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no guarantee of future results.
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