Is the ‘Abenomics’ experiment over before it begins?

The sharp rise that Japanese equities have been experiencing since the fourth quarter of 2012 may be coming to a (short term) end as the special confluence of circumstances that conspired to put the proverbial boot up the equity market are beginning to fade out. Japanese equities rose a stunning 80% between November and May, a move that put the financial markets out of sync with the real economy.

Monetary policy is being used as the primary tool against an economic crisis around the world but its positive effects are having ever shorter shelf lives. Without fiscal measures boosting consumer and investor confidence, trying to generate inflation or to boost asset prices artificially is a bold measure but sadly, as the Japanese experience showed during the 90’s, with all too short-lived effects.

Shinzo Abe

Since becoming the Japanese Prime Minister in December  2012, Shinzo Abe promised a “shock and awe” monetary policy with the aim of generating 2% inflation in just two years. His promises were not taken lightly by investors, and whom collectively quickly moved their bets from the Euro breakup to the Yen fallout. Investors from overseas, in particular US hedge funds, quickly directed their money to the Nikkei while simultaneously shorting the Yen against the Dollar. For a while it was a spectacular trade that generated some of the highest returns, particularly where levered, for a number of decades. This move led to exponentially higher equity prices and put pressure on Yen.

Japanese investors have been a little more sanguine however, having seen numerous false dawns with sharp rallies that were only retraced and new lows ultimately reached. To them, their historic experiences have left them scarred and they have yet to fully buy into the so called ‘Abenomics’ as the medicine which would cure the dormant Japanese economy.  Even though the bond market has been experiencing serious tremors, they have remained invested in Japanese Government Bonds (JGB) whils overseas investors have been buying equities. Time has yet to tell who will be proved correct although we believe the equity market will continue its ascent higher in the coming months.

The Japanese economy has been stagnating since 1995 with interest rates near zero for a quite unbelievable 18 years. Between 2001 and 2006, the BOJ engaged in further unconventional monetary easing measures akin to what we know as QE, throwing more than 30 trillion Yen at the economy. Again, without success.  During this period, we have seen companies going through a deleveraging process that has cleaned their balance sheets of the bad debts from the bubble era and unwound some of the incestous corporate cross holdings that has been a hallmark of the Japanese market. They’re healthier now but still  unwilling to borrow. That is the real problem for Japan. No one, neither corporate’s or consumer, is really willing to borrow even though money seems to be free.

With a lost link between the money supply and money creation, monetary policy is as good as dropping water into the ocean. It doesn’t work and institutional Japanese investors know it. That is why they have so far kept their JGB holdings.

Such was the frenzy and momentum behind the equities rose that domestic retail investors also joined the party, for a time, further helping the bull story. Problem for Abe is if the equity market slumps back towards the old lows and catches retail investors whilst bond yields rise and so inflict losses on the holders of these. That would, ironically, increase the likelihood of renewed deflation and render his valiant efforts at a reflation redundant. We do not subscribe to this scenario however.

At some point, bond investors had to sell part of their bond portfolio’s to hedge against duration risk. Long-term bond prices start dropping with yields rising. This is the main reason why the equity rally stalled 2 weeks ago and why the Nikkei is down almost 20% over the last 14 days. The whole rally equities experienced occurred in the assumption interest rates won’t rise. With the rise, investors will now require lower equity prices and/or higher earnings. Abenomics is now falling apart and an increase in corporate profits will be needed before the market rises substantially once more. Bold monetary action is not enough anymore and the Yen will has also stopped appreciating.

When interest rates rise led by a real economic expansion,  this is a healthy mix of rising profits and higher tax collection. But when interest rates rise before the economy improves, and really as a consequence of monetary expansion, we have a real problem. Government will have to engage in fiscal consolidation – something that is undesirable at present.

Richard Koo from Nomura thinks Abenomics won’t ultimately lead anywhere for the Japanese economy and that it is premature for the government to even think about fiscal consolidation. He believes monetary policy needs to be fine-tuned instead. We agree with him. It’s time for the world to stop pretending the global economy is healthy. If you want an economy to grow, the best way is to create conditions for it instead of throwing money at it. Something that Ben Bernanke has yet to learn that will, in our opinion, be his ultimate legacy.