The Japanese economy has been a leading indicator of the impact of various regimes: stealth quantitative easing, ultra-dovish monetary policy, zero interest rates, an aging population, slowing growth, etc. All these factors have played out in some form or another in other developed economies with a lag of 10–20 years. Thus, looking at Japan might give us some insight into what is coming in the global markets.
Let us take a step back and see how Japan has evolved over the last few decades.
In the early 1990s, Japan’s real estate and stock market bubbles burst, and the economy went into a tailspin. Since then, Japan has suffered sluggish economic growth and recessions (known as "Japan’s Lost Decade"). Such has been the lasting impact on Japan that its real GDP in 2021, which stood at $5 lakh crore, is the same as it was in 1994. There has been no real growth in GDP for over 25 years.
Factors like demographic shifts, reduced fiscal policy effectiveness, the banking crisis in 1998, and ineffective budgeting have contributed to this sustained economic pressure. Japan has been in a deflationary environment for as long as one can remember, which induced the Bank of Japan (BOJ) to introduce unconventional monetary policies and mechanisms, including yield curve control, constant quantitative easing, and more.
I might be wrong, but going by the current situation Japan finds itself in, its best-case scenario going forward would be somewhat of a financial repression. The Japanese government has wanted structural inflation for decades, and thus I think, they will not try to curb it just when it has started to show green shoots now (inflation above the 2% target rate). I expect them to allow inflation to remain higher than interest rates, which is effectively what they are doing right now (inflation at 3%+ and yields still close to zero). Inflation higher than interest rates (negative real yields) will effectively inflate away the debt on their balance sheet. This is crucial as current debt levels (Govt. debt to GDP at 263%) seem unsustainable.
Here’s a good article on what financial repression is, how it happened in the past, and its consequences for asset classes like debt.
The best way to position your portfolio in a such a situation is to be an asset owner. Thus, I would prefer holding Japanese equity over the debt market. Some level of monetary-led inflation is good for the stock markets. There are other factors at play as well, and we will look at them in more detail.
Looking at the Debt market first
After the asset bubble in Japan (1987–90), Japanese banks made two major changes to their balance sheets on the asset side. The first was a shift from loans to Japanese government bonds (JGBs) as loan growth slowed. The second was a shift from JGBs to US treasuries as ‘Abenomics’ and Bank of Japan policies drove long-term rates to zero in the last decade.
The two charts below show how long-term rates have moved in the Japanese bond market along with the changes in the Bank balance sheets.
Source: Macrobond
Implications
The sharp reversal you see in the JGB bond holdings of the domestic banks is basically due to the BOJ’s actions. Since 2013, the BOJ has bought most of the JGBs sold by domestic banks. The idea behind this was to drive down long-term interest rates and kick-start the stagnant Japanese economy. Then, in 2016, the BOJ introduced Yield Curve Control (YCC). Under YCC, they moved away from numerical targets for asset purchases and promised to buy as many bonds as required to keep the 10-year yields close to zero.
What this has led to is massive bond-buying by the BOJ. As of March 31, 2023, the BOJ owned ¥576 trillion out of the ¥1,080 trillion of outstanding JGBs, excluding treasury discount bills.
The proportion of outstanding JGBs held by the BOJ exceeded 50% for the third straight quarter in Mar’23. It is unusual for a central bank to own over half of the outstanding government bonds. The Japanese central bank's holding of JGBs has grown more than fourfold, from 11.5% as of December 2012, when former BOJ Governor Haruhiko Kuroda took office, to over 50% today.
With constant debt issuances and ultra-easy monetary policy post-1990, the Government debt-to-GDP ratio has soared and currently stands at over 260%. Add the private debt to it, and the picture does not look good. At such high debt levels, increasing interest rates will cause havoc, which is why the Bank of Japan (BOJ) has been adamant about keeping rates close to zero and controlling the yield curve through constant intervention in the bond market.
Japan Budget Breakup
Another aspect to look at is the budget spending of the Japanese government. This throws up some eye-watering statistics.
Source: Nippon.com
Nearly 1/4 of the budget of the Japanese government is spent just on servicing debt payments. Add to this the ever-increasing mandatory spending on social security and unproductive tax grants to local government bodies, and nearly 2/3 of the budget is spent. This leaves very little room for spending on productive assets, which could have high multiplier effects on the economy and, thus, sluggish growth.
Japan’s bond dependency is at 31%, i.e., the debt-to-revenue ratio. Until the 1980s, the gap between tax revenues and expenditures was relatively small, so the amount of new debt issued for each fiscal year never exceeded ¥15 trillion. However, with the collapse of the bubble economy and prolonged economic stagnation, the balance of payments deteriorated as a result of repeated fiscal stimulus packages and tax cut policies, making it necessary to increase the issuance of JGBs to fill the gap [Link]. (See chart below)
Tax revenue began to recover in the 2010s, and the consumption tax was raised in October 2019, but spending ballooned to implement economic measures to deal with the COVID-19 pandemic, so JGB issuance saw another big increase in fiscal 2020. Given this trend, government debt will climb over ¥1,080 trillion in 2023. While economic policies have kept interest rates extremely low to date, a rise would make the burden of interest payments even heavier[Link].
Source:Nippon.com
There have been talks about dropping yield curve control (YCC) in Japan, whereby they no longer continue to intervene in the market to control yields. Make no mistake, with nearly 25% of the budget being spent on interest payments, there will be yield curve control. They have to control interest rates, otherwise, the Japanese debt market blows up. There might be changes in the way they carry out yield curve control, but YCC will continue. Overall, given the macro picture, I would avoid the Japanese debt market currently.
Japan is sort of a template here. It is 20 years ahead of everyone else. What we have seen in Japan are demographic pressures, deflation, QE and QT policies, and yield curve control. All these aspects that the Japanese have experienced have been reinvented in 10–20 years in Western economies. The European Central Bank has already started to do some yield curve control, albeit in a different way than its Asian peers. The ECB is buying bonds to limit the differences between yields for the strongest and weakest economies in the eurozone. We could see some form of yield curve control in the US as well, perhaps in the coming years.
The Debt Spiral
The Japanese government will have to keep issuing debt (persistent QE), but the problem now is that the BOJ effectively owns half of that debt already. Also, if you break down the purpose for which the debt is being issued, most of it is issued simply to refinance the existing debt rather than for any capex in the economy.
There is not enough room for the BOJ to keep financing this debt. This is a clear funding problem that we are looking at. The Government could likely induce domestic Japanese banks to actively buy the debt issuances. That would make things more interesting. If the Japanese banks have to start buying the JGBs in bulk, they will have to sell their foreign assets. With the magnitude that we are looking at, a bulk of the selling by Japanese banks will be in the most liquid assets, US Treasuries. This selling, in turn, will also put upward pressure on yields in the US economy. So, there are significant global consequences to the actions of the BOJ.
Impact on Yen
The yield curve control policy introduced in 2016 was fairly successful for several years. It kept the rates low for borrowers, and the market participants felt that the cap on yields was credible. This has now started to change big time as rising interest rates in the US and elsewhere create a yield gap with Japan. This induced investors to sell assets in Japan (sell yen) and switch to buying higher-yielding alternatives abroad, creating significant downward pressure on the yen (the yen has depreciated from around 100 yen per USD in 2021 to 140 yen per USD today).
In the below chart, the blue line shows the %yield gap between US and Japan 10-Year bonds and the red line is the USD/JPY price movement. The yield gap is now close to 3.6%. The last time we saw this, was in the 1995-2000 period when JPY depreciated significantly.
Source: Macromicro
With the continuous printing of money by the BOJ to finance the debt and policy persisting with a close to zero interest rate, I'm not expecting any major positive moves in the Yen; unless ofcourse there are significant monetary policy changes like the lifting or atleast easing of the Yield curve control (should theoretically could lead to some appreciation/stability). We might see government intervention to keep the yen from depreciating much further (around 150 yen per dollar mark). But a technical breakout above that, could mean furt
Japanese Equity Markets
The Japanese equity market has been one of the most underappreciated and under-owned markets in the last decade. With value investing taking more prominence over the last 1-2 years, Japan has been a beneficiary given the country’s relatively higher concentration of asset-heavy, cyclical stocks. In 2023, the Nikkei 225 Index has been on a significant upswing (27% YTD). The comeback of inflation in the economy, along with several structural changes in corporate governance standards, are acting as tailwinds for the equity market.
What has changed?
The Tokyo Exchange recently finalized its market restructuring rules. Simply put, the exchange wants executives to ensure that share prices reflect the company’s value more accurately. This has resulted in more focus on balance sheet restructuring, an increase in share buybacks, and an increasing focus on profitability and disclosures—all these steps are music to the investors’ ears. Among the latest measures was one that directed listed companies to "comply or explain" if they are trading below a price-to-book ratio of one—an indication a company may not be using its capital efficiently.
The exchange warned that such companies could face the prospect of delisting as soon as 2026. Part of the optimism in Japanese stocks stems from how specific and tangible the Tokyo exchange’s requirements are this time around, as compared to the promises made by former Prime Minister Shinzo Abe in 2014 to shake up the staid ways companies operate in Japan.
If the companies do follow up on the plans laid out, expectations are that they will have to return more capital to shareholders in the short run, in the medium-term stop accumulating assets, implying much higher dividends and buybacks permanently, and in the long run shift their business models to become less capital-heavy, which would likely raise market valuations.
The below article covers some of the measures that are being taken:
With inflation coming back, nominal growth has started to pick up in Japan, with the government pushing for wage growth so consumer spending sustains a decent growth rate. The Japanese government is trying to get inflation to stick after years of struggle with deflation, to the extent that the BOJ has kept short-term interest rates negative.
I am still wary of the recent rally in Japan because being this overly optimistic about these changes in Japan did not work well in the past. Those were empty promises before. While this is perhaps the biggest risk, this time around, things are looking more optimistic on the ground. Other than this, recessionary risk is the obvious one, with Japan being a cyclical market.
Foreign investors have been continuously buying Japanese stocks in H1FY23. I expect the Nikkei 225 Index to consolidate a bit given the recent rally (up almost 27% in H1FY23) and offer a better entry level. In terms of valuations, the Nikkei Index trades at 1.3x and remains one of the cheapest in terms of multiples among the major economies. Nearly 50% of the listed stocks in Japan have a P/B ratio of less than 1, so there is scope for re-rating, which offers a little comfort. Considering the risk and reward, I would look to take up some exposure to Japanese equity in the portfolio (5%).
That is a wrap on Japan and how things are shaping up. By the way, Canada’s 5-year yield hit the 4% mark on 7th July 2023. It is significant because the last time it happened was during the 2008 crisis. Watch out for the real estate market, which has been running hot in Canada for a long time. More on it in the coming article. Till then, have a great weekend!
Regards,
Shivam Jain
Disclosure: I’m not a SEBI Registered Investment Advisor. All content on this website is purely for educational purposes. Please consult your financial advisor before making any investment decision.
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