Posts tagged Japan
The heady cocktail of animal spirits and hope that is the so-called reflation-infrastructure trade has many fans, but perhaps none more so than the monetary policymaking committee of the Bank of Japan. One of the first casualties of last year’s big November rally was the yen, which plummeted in value against the US dollar. That plunge was just fine, thank you very much, in the mindset of Marunouchi mandarins. A weak yen would make Japanese exports more competitive, while the continuation of easy money and asset purchases at home would finally create the conditions necessary for reaching that long-elusive 2 percent inflation target.
Lo and behold, the latest price data show that Japan’s core inflation rate rose 0.1 percent year-on-year in January, the first positive reading in two years. Only 1.9 percent more to go! Expectations of stimulus-led growth, continued weakness in the yen and a return to brisker demand both at home and in key export markets have led Morgan Stanley’s global research team to name Japan as the stock market with the most attractive prospects for 2017.
Patience Has Its Limits
Beleaguered long-term investors in Japan’s stock market would be more than happy to see Morgan Stanley’s prognostications come true – but they have heard this siren song before. The Nikkei 225 stock index reached a record high of just under 40,000 on the last trading day of 1989. As the chart below shows, things have been pretty bleak since those halcyon bubble days when the three square miles of Tokyo’s Imperial Palace were valued by some measures as more expensive than the entire state of California.
If the Morgan spivs are right about Japanese shares, and keep being right, it will represent a decisive break from a struggle of more than two decades for the Nikkei to sustain a level greater than 50 percent of that all-time high value. Prior to 2015, the Nikkei had failed to even touch that 20,000 halfway point at any time since March 2000 (which, as you will recall, was when the US NASDAQ breached 5,000 just before the bursting of the tech bubble). 2015 represented the high water mark of investor expectations for “Abenomics” – the three-pronged economic recovery program of Prime Minister Shinzo Abe – to deliver on its promises of sustained growth. Those expectations stalled out as the macro data releases kept pointing to more of the same – tepid or negative growth and the failure of needed structural reforms to take root. Japan’s problems, as anyone who has studied the long-term performance of the one-time Wunderkind of the world economy will tell you, are deep and very hard to dislodge.
No Really, It’s Different This Time
Abe is not the first prime minister to apply stimulus in an effort to shake the economy out of its lethargy. Massive public works programs have been a hallmark of the past quarter century. Over this time, yields on the 10-year benchmark Japanese Government Bond (JGB) have never risen above 2 percent (including during periods when yields on US and European sovereigns were at 6 percent or higher). The 10-year yield’s trajectory is shown (green trend line) on the chart above. No amount of stimulus, it would seem, was enough to convince Japanese households to go out and spend more in anticipation of rising prices and wages.
So what is it about the current environment that could induce Japanese share prices to break the 50 percent curse for once and all? We would imagine the answer to be: not much. While it is true that both the US and Europe look set to continue a modest uptrend in growth and demand (with or without the reflation jolt catalyzing all those animal spirits), Japanese companies are not necessarily positioned to benefit – certainly not in the way they did in the very different economy of the 1970s-80s when “Japan as Number One” was required reading for MBAs and corporate executive suites. While they have arguably become more shareholder-friendly in recent years, as evidenced by higher levels of share buybacks and the like, corporate business practices remain largely traditional and hidebound. Just a decade ago, these companies blew a once-in-a-lifetime chance to ride the wave of the great growth opportunity that was China – in their own back yard.
There is no magic formula for growth. In a country with an old and declining population (and extremely strict limits on immigration), a supernova-like burst of productivity is the only plausible route to real, organic improvement. Until then, that barrier of 20,000 in the Nikkei may continue to be a tough nut to crack.
The tumult and the shouting dies, the Captains and the Kings depart. Rudyard Kipling’s 1897 “Recessional” comes to mind as we contemplate the remarkably quiet aftermath to September’s much-hyped marquee policy events. Yes, there was a frisson of excitement in equity markets after the Fed lived up to its reputation as the definitive cautious, controversy-avoiding institution of our time. And the yen went hither and yon in the immediate aftermath of the latest blast of new policies from the Bank of Japan.
But as the brief tumult subsides, the S&P 500 is back in its July-August corridor while the VIX has crawled into yet another low-teens slumber. The yen, meanwhile, has blithely brushed aside any notion of bite in the BoJ’s bark and is resuming its winning ways to the consternation of the nation’s policymakers. September is not yet over. With just one week left, though, this oftentimes fearsome month appears poised to go quietly into the night. So is it smooth sailing from now to New Year’s Eve? Is the overhang of policy risk off the table?
Dissent and Stern Words
We start with the Fed, where the policy debate was a simple will-they-or-won’t-they (we thought the matter was settled some time ago for reasons articulated in previous weeks’ commentaries, but still). Chair Yellen pronounced herself happy with the economy and the karmic “balance” of near-term economic risks, and put out a placeholder for December. A pair of hawks (Kansas City’s George and Cleveland’s Mester) were joined by habitual dove Rosengren of Boston in arguing for moving now.
That higher than usual dissent, along with a reasonable likelihood that headline economic numbers won’t deliver much in the way of surprises in the coming months, does raise the likelihood of a December move. In the absence of some global shock manifesting itself between now and the December FOMC meeting, in fact, a 25 basis point move would be our default assumption for the outcome of that meeting.
Unlike last December, though, when a quarter-point move led the way into a sharp risk-off environment in January, we think the Fed could get away with a move without roiling markets. The difference between this year and last? Those silly, yet telling, dot-plots showing where FOMC members see rates one, two and more years down the road. Last year, the consensus view was a Fed funds rate of 3.4 percent by the end of 2018. Reality took a bite out of that, though, down to what is now a 1.9 percent end-2018 view. In fact, apart from two outliers (anyone out there from KC or Cleveland? anyone?), nobody sees rates going above 3 percent for as far ahead as the eye can see. A benign, historically low cost of capital world appears to be our collective future.
The Drunk Archer
If there is a fly in the balm, though, the identity of that fly may well be the other party heard from in Policy Week. The Bank of Japan gave no clear indication going into deliberations as to what it intended to do. On the other side, it left no clear consensus as to what its flurry of policy measures actually meant: was it stimulative, or neutral, or maybe even restrictive in its practical implications? At least one clear winner emerged: Japanese financial institutions. By not further lowering already-negative interest rates, and adding a twist to the current QQE program likely to favor a steepening of the yield curve, the BoJ is sending a little love to its beleaguered member banks. The Topix Bank index jumped about seven percent in the aftermath of the announcement.
The problem with anything the Bank of Japan says, though, is that it has a credibility problem. That problem was very much on display with the other main platform of the Wednesday policy announcement, namely the stated intention to overshoot the longstanding two percent inflation target. The Bank hopes that by explicitly targeting an inflation rate higher than two percent (how high? not clear) it will finally be able to deliver on that monetary policy “arrow” in the original Abenomics blueprint: pull the economy out of its chronic flirtation with deflation.
The problem is that inflation in Japan has been nowhere near two percent for a very, very long time. The idea that a new mindset of inflationary expectations could suddenly take hold to reverse this longstanding trend is extremely hard to take seriously. To use the “arrow” metaphor of Abenomics, it’s as if a stone-cold drunk archer, wildly shooting at and missing a bulls-eye target, decides that the best way to hit the target is to move it even further away! It will take more than words to convince markets of any real change to Japan’s price environment – as evidenced by the yen’s prompt return to strength in the second half of this week.
Hence that “fly in the balm” comment we made a couple paragraphs above. The main risk we see in asset markets today is the credibility risk of the central banks that collectively have been holding things more or less together since the Great Recession. Lose that credibility and you lose a lot. Japan’s economy has been stagnant for 26 years, and policymakers there are still throwing pasta at the wall to see what sticks. In the absence of either normal levels of organic economic growth or intelligent economic policymaking by national governments, a loss of confidence in the ability of central banks to deliver effective monetary policy is not something we can afford to indulge. This is not a risk we see as likely to actualize in the very near-term, but it is a key concern looking ahead to next year and beyond.
Japan was in the news this week mostly for the upside surprise in first quarter GDP; at 1.7 percent, the real growth rate was well ahead of expectations and a reversal of the 4Q2015 contraction. Will better-than-expected growth temper some of the recent chatter about more aggressive foreign currency intervention to bring down the yen? Will Prime Minister Abe go ahead with a second consumption tax hike next April, despite the negative fallout of the previous increase in the tax two years ago? Is domestic consumption, which drove the improved GDP numbers, here to stay, or will these numbers prove as fleeting as April cherry blossoms when the first revision comes out?
Important questions, all. But another news bulletin from Tokyo came to our attention this week, causing us to ponder whether there is anything truly surprising left in the world. The Bank of Japan (BoJ) is gearing up to be one of the largest shareholders in Corporate Japan, with the launch of a new series of exchange traded funds (ETFs) designed explicitly by and for the BoJ. Meet Haruhiko Kuroda, BoJ Governor and hedge fund spiv.
Biggest Shareholder in the Room
For some time now, the Bank of Japan has been a player in the ETF market. Up until recently this activity was generally under the radar, and entailed mostly plain vanilla ETFs that track major blue chip stock indexes like the Nikkei 225. But the volume of purchases has grown steadily over the past couple years, such that the BoJ is now the beneficial owner of about 55 percent of the total volume of Japanese ETFs. That makes it a larger shareholder in Japanese companies than either BlackRock or Vanguard, two of the largest passive index investors in the world. In fact, the BoJ is one of the top 10 shareholders, on the basis of size of holdings, in 200 out of the 225 companies listed on the blue chip Nikkei index. In financial markets parlance, the BoJ is already the “Tokyo Whale.”
But today’s launch of two new ETFs takes the central bank’s involvement in the business of Japan to an entirely new level. These ETFs, dubbed “Human and Physical Capital Funds”, are not your typical plain-Jane ETFs designed to passively track a benchmark index. Companies selected for inclusion in the ETFs will have to meet certain standards of compliance with BoJ policy goals. These include more cash deployed into new business investment and increased wages for company employees. In other words, the central bank is trying to induce companies to do more to stimulate Japan’s economy, by holding out the carrot of buying (and thus lifting the price of) its shares.
“Human and Physical Capital” is the New Smart Beta
The methodology is thus somewhat analogous to the factor-investing approach pursued by so-called “smart beta” strategies. But most smart beta strategies are at least premised on the idea that whatever factors they employ – minimum volatility, momentum, enhanced dividends or whatever else – have some demonstrable success case as value-added factors. There is no empirical evidence to suggest that a factor fund based on a set of explicit central bank stimulus goals would be a worthwhile investment. After all, high labor costs and outsize capital expenditures are generally rather poor predictors of stock price outperformance.
And that is a problem for the Bank of Japan, because legally it cannot purchase more than 50 percent of any individual ETF. Other investors will have to pony up for the remaining 50 percent of these Human & Physical Capital Funds. Japan does have some very large institutional investors in the public sector, including the massive $1.7 trillion Japan Post and the Government Pension Investment Fund – so there could be some concerted aligning of investment policy statements to support the BoJ. Private sector investors, though, may see little reason to make targeted investments in companies whose corporate strategy decisions owe more to central bank pressure than to actual economic opportunities.
Reductio Ad Absurdum
That leads to the larger question of why any central bank should ever become so closely intertwined with the stock market. It is one thing to buy up bonds in the secondary market, as all central banks with quantitative easing programs have been doing for the past seven years. But stocks and bonds are fundamentally different capital instruments, and the big difference is that equity investing correlates to corporate ownership.
We noted above that the Bank of Japan is already one of the top 10 shareholders in the vast majority of Nikkei 225 companies. Institutional shareholders play an important role in corporate governance, which in turn influences the specific strategic and operational decisions companies – private sector companies! – make about how to generate future cash flows from the asset base in place. Having a government-related entity (whether or not nominally independent of other government agencies) as a potentially decisive voice in this regard is troubling. What happens if a company in the Human and Physical Capital Fund builds a factory to produce products for which there is insufficient market demand? Does the central bank step in and place orders for Company ABC’s widgets because nobody else wants them?
It sounds patently absurd. Then again, until recently it would have struck any reasonable person as absurd that central banks would be masquerading as hedge funds. Yesterday’s absurdities would appear to be today’s norms.
The language with which the financial press documents the doings of central banks has taken a notable turn towards military vernacular in recent years. We have “shock and awe” campaigns to talk up growth prospects, and jaw-clenched proclamations of doing “whatever it takes” to stave off collapses in currency, bond or equity markets. Once more unto the breach, dear friends, once more! Descriptions of their policy implementation vehicles are likewise bellicose. Consider the “bazooka” by which Bank of Japan Governor Haruhiko Kuroda fired a new package of stimulus via quantitative easing and negative interest rates back at the end of January. Like most such stimulus programs, the explicit goal was to provide a monetary boost to stimulate economic activity, while the largely unspoken but implicit aim was to weaken the currency (the Japanese yen) and stimulate domestic asset prices. How’s that working out for the BoJ so far? Not so well, as the chart below shows. Since the 1/29 stimulus, the yen has soared against the dollar and the Nikkei 225 stock index has fallen even while world equity markets have enjoyed a broad-based rally.
Hold Your Fire
“Damned if we do, damned if we don’t” must be the frustrated sentiment in Nihonbashi, the Tokyo district where both the BoJ and the Tokyo Stock Exchange are located. Following another policy meeting this week, the central bank announced on Thursday that it would be holding off for the moment on any new stimulus measures. The no-action decision took markets by surprise, as most observers predicted the bank would serve up another cocktail of negative rates and/or increased asset purchases. Once again the yen jumped – this time by four percent in a single day – and stocks cratered.
The official reason for the decision to hold fire, according to Governor Kuroda, was that the bank is still assessing the impact of the January move. It would not be prudent, according to this argument, to implement new policies until members have a better sense of how the current ones are working. He added that the policy impact should be better understood in the not too distant future, giving a guideline of six months or so from implementation as a reasonable time frame. That sets up the possibility for another stimulus move in June, which of course would pull it firmly into the gravitational tractor beam of Janet Yellen and her FOMC colleagues. The Fed meets on June 14-15, and pundits are currently split as to whether rates are likely to rise or remain on hold following that meeting. Should the Fed raise rates in June, Kuroda’s thinking may go, it could give some added force to another round of BoJ stimulus for the Japanese economy. And such a move would be very much in keeping with the Japanese governor’s established penchant for big, dramatic moves rather than incremental policy tweaks.
Running Out of Ammunition?
Such a move would also support an increasingly prevalent view that while the BoJ’s bazooka may be in fine shape, it is running low on ammunition. The decision to move into negative rate territory was controversial when it was announced and continues to be a matter of contention in Japanese financial circles. There are limits to how far into negative territory rates can go, even if no one really knows where that lower bound is. On the quantitative easing side, any moves by the BoJ into riskier asset territory like common stocks are also likely to generate resistance.
Meanwhile, the economy shows few signs of improvement. At this week’s post-meeting press conference the BoJ announced a series of downward revisions to its economic forecasts. Growth is now projected to be 1.2 percent versus the prior estimate of 1.5 percent through March 2017. Inflation – which Governor Kuroda has pledged to see reach the target rate of 2 percent before he leaves office in 2018 – was also revised down from 0.8 percent to 0.5 percent. The likelihood of a return to 2 percent within the next 24 months is looking ever less likely. Labor market conditions have improved but, as in other countries, a fast clip of jobs creation is failing to deliver the kind of wage increases normally seen in the past.
Given this context, it perhaps makes sense that the BoJ would keep its limited store of powder dry for now and hope to get more bang for the buck (ahem, yen) in a June move. But it is a risky gambit; the Fed is far from certain to raise rates then, and any number of other unknowns could manifest between now and then to complicate the policy landscape. Governor Kuroda has two years left in his term to shore up the BoJ’s credibility. Increasingly, that credibility appears to be dependent on events beyond his control.
It’s just a natural continuation of conventional monetary policy, say the central bankers who have unleashed the hounds of negative interest rate policy – NIRP – into the capital markets. The Swedish Rijksbank is the latest to join the club, setting the key bank overnight repo rate at minus 0.5 percent. Even stranger than the rate itself was the accompanying announcement, part of which read thus: “Growth in the Swedish economy is high and unemployment is falling, which suggests that inflation will rise in the period ahead”.
Got that? Sweden’s economy, in fact, is growing at a clip of around 3.5 percent, or more than twice that of the Eurozone. If US GDP were growing by anything close to that rate it’s a pretty sure bet that Janet Yellen & Co. would be hiking rates with nary a second thought. What possible reason could there be for Sweden, then, to send rates below zero? “Global uncertainty” was the phrase the Rijksbank deployed in that same press release, along with a vague reference to recent inflationary weakness. “Everybody else is doing it” seems to be the underlying context, though, and that has the makings of a potentially dangerous trend.
Wonderland Not So Wonderful
We took note in this column a couple weeks back of the Bank of Japan’s joining Club NIRP. Now, as with any easy money policy, two key motivating incentives for negative rates are a weaker currency (to improve trade conditions) and higher domestic asset prices. How’s that working out for Japan so far? Consider the chart below, showing recent trend performance in the Japanese yen and the Nikkei 225.
In fact, the currency and the stock market have both done exactly the opposite of what the BoJ would have hoped. The Nikkei 225 has fallen by more than sixteen percent since the beginning of February, while the yen has strengthened by 8 percent against the dollar. Oops. The point to make here is simply this: NIRP is not, as claimed, simply an extension of the conventional easy money continuum. It is a whole new territory, an unknown land where the normal rules of finance do not necessarily apply. That NIRP is going viral around the globe is, in our opinion, cause for considerable concern.
Here Be Dragons
There are many facets to our concern about the NIRP contagion. A central one is its impact on the financial sector. The fruits of this impact are already visible in the form of a global bear market for the shares of financial institutions. Banks have to hold a certain fraction of their liquid assets in the form of central bank reserves. When the cost of holding these reserves goes up they need to make up the difference elsewhere, either in raising lending rates (counterproductive to growth) or in venturing into riskier lending areas (counterproductive to risk-adjusted capital adequacy). Again – a key objective of any easy money policy is to funnel money back into the economy via bank lending and accelerate its velocity. All the quantitative easing of the last six years has failed to accomplish this objective. It seems a great stretch to imagine that, suddenly, credit demand is going to materialize out of nowhere in response to negative rates. The banks, meanwhile, will have to figure out how to adjust their business models to remain profitable.
The reasoning behind NIRP is also flawed in terms of its capital markets objectives. Negative interest rates have spread into a widening swath of fixed income instruments, primarily (though not exclusively) government bonds. Five year German Bunds currently trade at negative yields, as does the Swiss ten year note. That’s right – if you buy a Swiss government bond and hold it to maturity you are guaranteed to lose money. What NIRP does, then, is to take low-risk assets and make them riskier – a complete perversion of standard capital market theory.
No Country for the Prudent Investor
Bear in mind that institutional investors like pension funds and insurance companies are required by their investment policy statements to hold sizable percentages of low-risk assets in their portfolios. Part of the NIRP objective is to make safer assets less attractive to stimulate purchases of riskier assets like stocks. But a prudently managed pension fund cannot simply take itself out of short term bonds and dump the money into small cap stocks. In this way, again, NIRP is counterproductive.
Finally, NIRP could potentially achieve the opposite of what it wants in terms of guiding inflation back up to those elusive 2 percent central bank targets. Think again about that ten year Swiss government bond we discussed a couple paragraphs above. Nominal bond yields are comprised of two sections: an expected real return (i.e. what the investor expects to earn from the investment after inflation); and inflationary expectations. Say for example that a certain ten year bond yields five percent and that inflation is expected to run at two percent for the next ten years. So that bond’s real return would be three percent and the inflation expectations component would be two percent. Easy math.
In light of that example, what does a yield of negative 30 basis points (about where the Swiss ten year is today) tell us about investor expectations? Only that for a rational investor to hold that security, the investor would have to believe that the most likely price trend for the next ten years would be deflation. If the average price of goods and services in the economy were to fall by one percent annually for the next ten years then it would make sense to invest in a bond, the slight negative return of which would still preserve purchasing power. Of course, deflation is exactly what financial policymakers want to avoid.
Expectations matter in explaining economic behavior and outcomes. The advanced-math models central bankers use in arriving at policy decisions have been shown to be demonstratively poor in accounting for the expectations factor. Want proof? Go back to that chart showing what the yen and the Nikkei 225 did in the aftermath of the BoJ’s NIRP decision. Expectations matter, and central banks ignore them at their – and our – peril.