Some of our older readers may remember the 1980’s for more than discos and recreational drugs. In fact, they may recall the emergence of Japan as a growing power player in an increasingly globalized economy. At the time, Japan was making money hand over fist exporting cheap consumer products to American consumers hungry for a Datsun 240 Z, a Sony Walkman, or a Nintendo. The rush of cash filled the coffers of Japanese corporations and eventually made Japan the third largest economy in world. On the way, wealthy Japanese investors acquired iconic U.S. real estate and entertainment companies (Empire State Building and Columbia Pictures). Amazingly, this was all accomplished less than 50 years after an atomic bomb left Japan decimated. It’s no wonder this is referred to as the post-war miracle!
This economic miracle was built on an export model whereby Japan invested heavily in education, research, and manufacturing – all paid for by an accommodative monetary policy of credit creation at artificially low interest rates. Continued accommodative monetary policy kept the Yen from appreciating against foreign currencies, which sustained years of expanding exports and GDP growth. However, competitive products and changes in consumer behavior brought an end to Japan’s export supremacy and GDP growth began to wane. Unfortunately, without expanding exports and GDP growth, Japan’s credit-driven export model failed to support a Japanese economy that had become dependent on this winning formula. Today Japan has the highest debt-to-GDP (238%) of any developed country, a depreciating currency, and trade deficits at record highs. Exacerbating the situation is a demographic imbalance where 25% of the population is elderly and adult diapers surpass those of baby diapers – an equation that does not bode well for a growing workforce that supports an increasingly aging populace. One might argue that the government might do well to pay people to have babies, but even this would take at least a generation to yield benefits.
The Japanese financial challenge didn’t sneak up on anyone, least of all the Japanese people who have voted for a leadership change eight times since 2006 in hope of finding a solution. The latest Prime Minister, Shinzo Abe, introduced Abenomics at the end of 2012, his version of the quantitative easing policy promulgated by Ben Bernanke and a growing list of developed-country central bankers. While U.S. economic growth has picked up (some argue that continued QE has actually dampened economic growth), Japanese economic growth has been non-existent over the past four years and a deflationary mindset seems embedded in Japanese consumers. With mounting political and financial pressure, Japan announced a stimulus plan on October 31st that shocked the financial markets (no hyperbole intended). The scope and scale of the proposed stimulus is triple the size of the Bernanke/Yellen plan of Quantitative Easing (QE) on a relative basis. As such, some consider Japan’s plan to stimulate their economy to be “desperate” and tantamount to an “all-in” bet, while most consider the plan “extreme” relative to even the most radical of stimulus plans offered by other advanced economies over the past several years.
The announced plan calls for Japan’s central bank and main government pension fund to inject trillions of Yen ($1.4 trillion) into their economy in less than two years. Moreover, the liquidity injection would be used to buy not just bonds, but stocks and real estate as well. The numbers and timing are astounding. Japan’s central bank will be purchasing the equivalent of more than twice the amount of new bonds issued by the government, which means that they will be purchasing existing bonds in the open market, many of which will be bonds held by Japan’s $1.1 trillion Government Pension Investment Fund (GPIF). The GPIF announced that its sale of bonds would reduce its bond allocation to 35% from 60%, with the proceeds being used to more than double their equity allocation from 24% to 50%, equally split between Japanese and foreign stocks. In addition, the BOJ will triple its annual purchases of ETFs and other equity securities. The announcement moved the Nikkei Stock Average 7% higher on the week and the S&P 500 to an all-time high – and Japan hasn’t even begun their new bond and stock buying program. Increasing their equity allocation by 100% would be considered aggressive by any standard. To do so with the equity markets so far off their lows and some at their all-time highs provides an understanding of the term “desperate.” Moreover, the Japanese central bank is making an “all-in” bet that this stimulus plan will boost growth, lift inflation expectations, and end two decades of stagnation.
It is interesting to note that this historic and radical monetary stimulus plan was not unanimously decided upon by the Bank of Japan, but rather a split decision with four of the nine BOJ decision makers dissenting. The success of Japan’s stimulus plan will be judged over the months and years to come. However, in the meantime the Yen will continue to depreciate, which reduces real wages further – a trend directly counter to increased spending and GDP growth. We are highly skeptical of the success of the reflationary efforts of the BOJ and, as such, we are 50% underweight Japan equities relative to the MSCI All Country World Index.