Thursday, February 28th, 2019
In January 1990, the Japanese stock market as measured by the Nikkei 225 index was trading at above 38,000 points. Today, some 29 years later, the index is sitting just above 21,000 points – the same level as in both 1995 and 1999. This indicates that there has been a miserable long-term return from the equity market of the third largest economy in the world.
Nikkei 225 1990 to present (log scale)
The fall and subsequent long-term drift of the Japanese stock market is worthy of reflection because it may well guide us in understanding the long-term effects (measured in decades) of excessive QE and negative yielding interest rates. It may help us appreciate how these policies affect the interplay between market earnings (eps) and the price-earnings ratio of a market saturated with excess liquidity. How short-term market excesses are replaced by markets drained of stamina.
This is important because last month the US Federal Reserve indicated that QE4 was now a possibility in the US. Further, there is growing evidence that the European Central Bank may once again stall the normalisation of interest rates across Europe and hold them at negative yields. This analysis is pertinent and timely because Germany is teetering on the brink of a technical recession and Italy is again enduring a decline in economic growth. Indeed, the whole of the European economic zone is slowing. These are worrying signs that challenge the logic of maintaining excessive monetary stimulation which appears to have achieved so little.
It is interesting to note that just as the IMF was downgrading the outlook for Europe it was upgrading, ever so slightly, the outlook for Japan. However, the upgrade was a trivial 0.2% to target growth of just 1% in Japan in 2019.
Figure 2. IMF 2019 forecast changes vs October
What has happened in Japan as QE has relentlessly rolled forward?
Has it created inflation or price bubbles in risk assets?
In recent editions of The View, we coined the phrase “the Japanese Syndrome” to describe the possible outlook for developed world economies and particularly their equity markets. We have done this because we perceive that the last twenty years of persistent QE and excessively loose monetary policy in Japan, presents the best historical precedent for understanding the enduring effects of QE.
Our opening thoughts are that the excessively loose monetary settings in Japan – particularly over the last 15 years (which encompasses “Abenomics”) – has destabilised and distorted the normal workings of Japanese investment markets and therefore its normal economic cycles. It has acted to dampen inflation and it has supported the Japanese government in financing its horrendous debt (240% of GDP) without any interference from foreign creditors.
To expand upon the above, we draw upon several graphs that track the recent history of Japan and its place in the world economy.
Our first chart shows that today, Japan’s government has the highest debt to GDP ratio of any developed economy. Gross debt is 240% of GDP and net debt is 150%.
Figure 3. Government Debt (as a % of GDP, 2018)
The ability of the Japanese government to manage this level of debt is totally reliant on the support of the Bank of Japan (the BoJ, their central bank) which has acquired (through QE) about 50% of all Japanese bonds on issue.
Figure 4. Percentage of Government Bonds Owned by Central Bank (2018)
Source. Thomson Reuters, National Central Banks
The next chart shows that while the US, Canada and the UK central banks have lifted cash rates well above the low points recorded after the GFC, Japan (and the Eurozone) have maintained rates at negative yields.
Figure 5. Official nominal interest rates at low-point & now (%)
Source. Thomson Reuters, Capital Economics
The point must be made that negative cash rates have failed to stimulate economic activity over the longer term and the maintenance of these monetary policies is surely questionable. Over the last twenty years, Japan has endured a sustained low growth period punctuated by numerous mild slowdowns in economic activity.
Some background on Japan sometimes thought of as “the sick man of Asia”, helps provide context. Although Japan holds the position as the world’s third largest economy, China’s economy is now double the size of Japan’s (despite being on par just eight years ago). Japan’s working-age population is set to decline by eight million people between today and 2030, overtaken by both the Philippines and Vietnam. Japan’s total population today is 126 million, the Philippines’ 105 million and Vietnam’s 96 million.
Japan’s productivity – a critical countermeasure to declining human capital – ranks sixth in the region, lower than all other G7 countries. Japan’s defence spending is less than a fifth that of China’s, despite increases since 2013 and moves to amend the constitution on its Self Defence Forces. Its armed forces have felt the impact of demographic decline too: Japan has less military and paramilitary personnel than Sri Lanka; meanwhile, China has almost 11 times the number of troops. Japan lacks sheer manpower.
Japan’s Shinzo Abe and Donald Trump
While acknowledging that Japan has a rapidly ageing demographic, and this has created a headwind for growth, we see similar demographics appearing across Europe and most of the developed world.
Figure 7. Ratio of workers to pensioners, Japan
Source. Japan Cabinet Office, White Paper on Aging 2017
The rest of the developed world is not far behind Japan.
Figure 8. World population
Source: Deutsche Bank
Our next chart focuses on the declining trend in the market Price Earnings Ratio of the Japanese Nikkei index. While the current PER is not a record low, it has broken below trend lines and is currently well below its longer-term average. There is no price bubble in the Japanese stock market despite zero bond yields. Rather the market looks like it is deflating along with the Japanese economy.
Nikkei 225 Index Price-Earnings ratio fell to historical low band level.
Figure 9. Nikkei 225 Best PE Ratio
Source. Bloomberg, iFAST complications
While we often refer to the “Rule of 20” to quantitatively review the value of an equity market, we now believe that this rule of thumb is of little relevance in analysing the Japanese stock market. The “Rule of 20” adds the market PER to the long-term bond yield (ten-year) or the rate of inflation. A figure below 20 indicates value and a figure above 20 suggests overvaluation.
With the Japanese ten-year bond currently having a zero yield, and with inflation barely 1%, the Japanese market superficially may look cheap. However, this measure affected by relentless QE has suggested that the Japanese market has been either cheap or very cheap for the last ten years.
QE has compressed the Japanese bond yield to a point where it is no longer a relevant reflection of the risk-free required return. Nor does the bond yield reflect the actual rate of inflation or the risk of inflation. Most significantly, the bond yield reflects nothing for the risk of default because it seemingly can’t happen if the BoJ continues to print money.
How much money has the BoJ printed? Our next chart shows the explosive growth in the central bank’s balance sheet to 110% of GDP – some 3 times greater than the European Central Bank.
Figure 10. Central Bank balance sheet (as a % of GDP)
Source. Thomson Reuters, Capital Economics
The next chart compares the PERs of major equity markets to the longer-term average of the world index. The Japanese market sits below average as do other markets which have been affected by QE such as Germany, Spain and Italy. The other markets with lower PERs are economies with “centralised governments” whose markets do not trade fairly or openly.
Figure 11. Stock market price to earnings ratios, January 2019
Source. IBISWorld 01/01/19
Despite very loose monetary policy over many years, the BoJ (under the leadership of Haruhiko Kuroda since 2013), has been unable to engineer inflation. Its current target is 2%.
In recent years, Japan has created near-record low unemployment and higher participation rates in the workforce (particularly females) – yet inflation remains stubbornly low as does wages growth.
The next table shows that Japan has sustained a long period where deflation was more the norm than inflation. Over twenty years, while world average inflation has been 2% per annum, Japan averaged 0.1% per annum.
Figure 12. Cumulative annual CPI inflation, 1996-2016 (%)
Source. IMF World Economic Outlook, October 2018
Abenomics has maintained fiscal deficits, but below their post-GFC peak when measured as a % of GDP. The current fiscal deficit of 3.5% of GDP ranks second behind the US (projected 5% deficit).
The current target date for a return to fiscal surplus by the Japanese government has recently been reset from FY2020 to FY2025. The extension of five years to balance the budget shows that QE continues to shield the Japanese government from fiscal responsibility.
Figure 13. Government deficits (% of GDP)
Looking forward, some downside risks again exist for the Japanese economy. There is a planned consumption tax increase in 2019 which could hinder near-term growth momentum. Weaker global growth and heightened uncertainty, either from trade or geopolitical tensions, could also undermine growth, trigger yen appreciation, equity market shocks and renew deflationary risks.
The next two charts emphasise the economic growth quagmire that Japan has endured. Over the last 18 years, Japan has barely managed real growth of 1% per annum and its economy has grown by just 15% over the last 18 years.
Compare that to the US which has grown by about 50% and China by 400%.
Figure 14. World’s 10 largest economies, projected real GDP (trillions of 2010 dollars), 2000
Source. US Department of Agriculture
Figure 15. World’s 10 largest economies, projected real GDP (trillions of 2010 dollars), 2018
Source. US Department of Agriculture
During the next decade, Japan is forecast to endure more of the same with low growth rates. The same outlook will also afflict Germany, France, the United Kingdom and Italy. QE may help an economy survive and it may even sustain it, but it does not help it grow.
Figure 16. World’s 10 largest economies, projected real GDP (trillions of 2010 dollars), 2025
Source. US Department of Agriculture
Our closing point is to observe the pernicious effect of low or negative interest rates on the financial system (and particularly on the banks). It is the financial system that creates credit and capital for investment. It is important that capital flows to productive enterprises to maintain economic activity and growth. It is essential that banks are profitable and do not take on excessive risk to be so.
However, for the last decade in Japan, negative interest rates and negligible interest spreads have squeezed bank margins and pushed banks to engage in risky activity.
This was recently highlighted in a report by credit agency, Fitch Solutions, which declared that Japan faces a potentially nasty 2019. Fitch Solutions is warning of “downside risks” for Japan’s banking sector because they “have increased lending toward riskier companies in order to cushion profits in a negative interest rate environment”. As a result, Fitch says, capital adequacy ratios “have been declining” and posing “financial stability risks when the economy is likely to slow in 2019”.
Given the similar environment across Europe, we would suggest that there is every reason to suspect that the European banking system is also likely to move into distress if interest rates continue to be held in negative yield territory. That distress would be heightened if long term rates fall below short-term cash rates and create a negative (or inverted) yield curve.
As we noted in last week’s The View, the US Federal Reserve has now slowed (maybe even stopped) cash rate adjustments as cash rates moved perilously close to long term yields (2.6%). Meanwhile, in both Germany and Japan, the maintenance of negative cash rate settings and unrelenting QE has depressed long-term bond yields to ridiculous levels.
Figure 17. 10-year Government bond yields (%), 15th Feb 2019
Source. Thomson Reuters
Lessons from Japan
Surely the lesson for the developed world is that sustained and excessively loose monetary policy is not a panacea for an economy. Indeed, based on the Japanese example and current observations of Europe, these monetary policies have the potential to do more long-term damage than good.
The destabilisation of the financial system and the enduring pressure on banks and financial institutions to productively direct or allocate capital through the economy will create recurrent needs for government bailouts. Importantly, it will destroy the ability of pension funds to achieve returns that meet pension liabilities.
The “Japanese Syndrome” is becoming a growing risk for Europe and the whole developed world. It has the potential to infect asset markets for as long as central banks fail to properly price the cost of credit and manipulate bond yields for the benefit of their insolvent governments.
The offset to benign growth, deflation and an ageing population lies with the emerging powerhouses of China and India. Indeed, without their emergence, the developed world would be quite sick and unable to reinvigorate growth.
The Japanese Syndrome is one where low growth and mild recessions replace cyclical booms and busts. Tightening and loosening monetary policy as a mechanism for managing credit and targeting inflation becomes obsolete. Excessive budget deficits, which don’t stimulate growth but are consumed by social services and bailouts, become the norm.
More importantly, the connection between risk-free returns, bonds and equities breaks down. PERs drift lower and companies are increasingly encouraged to return capital to shareholders as they can’t deploy it to generate meaningful returns.
The developed world must evolve a co-ordinated agreement to lift interest rates simultaneously across the world. Japan and Europe must be encouraged to reflate their debt and credit markets before they drag the whole developed world into a sustained period of low growth and thus low returns on capital. Reminds me of the old song by The Vapors, “I’m turning Japanese, I think I’m turning Japanese, I really think so …”