Buying Japan Against the Crowd

6 mins. to read
Buying Japan Against the Crowd

So here we are again at a junction where policymakers have only two choices: one leads to a merry-go-round that ends and starts at the exact same point; the other leads to a dead-end, forcing a return to the departure point. This has been the choice faced by policymakers over the last few years and it will take some time until they realise the only option they have is to retreat and find an alternate path. The Japanese government and the BOJ are moving in circles; the Yen and the Nikkei can only move in the same circular fashion. Policy action from the government and the central bank appears to be losing impetus, leading to a stronger yen and a weaker Nikkei. However, Prime Minister Abe’s bold bet to reflate the Japanese economy seems credible and I believe new firepower may be added during the month of September.

Monetary and fiscal policy are currently a hot potato game. Now, it is Mr Kuroda’s turn, an opportunity he uses to cut interest rates and increase asset purchases, and of course help the yen to retreat against the dollar to boost the country’s exports. But then comes Ms Yellen’s turn, which she uses to neutralise others’ action by keeping rates flat for longer than expected. The move benefits corporate America, as foreign earnings converted into dollars become more valuable. Then comes Mr Draghi, who despite being caught between a rock and a hard place tries to implement something similar to other central banks. The long-appreciating Euro is then pushed back to earth. This game – let’s call it “Currency Wars” – is also played by Mr Carney (it is his turn today) and many others around the world.

The only problem with this game is the fact that everybody is trying to do the same thing at the same time.

With the entire developed world struggling, almost all central banks want to cut short any uptrend on their home currencies. The move is self-defeating and everybody becomes worse off. Maybe they could learn something from Nobel Prize Winner John Nash, who long ago explained the nature of a non-cooperative equilibrium. His theory could easily be applied to global central bank moves to explain how we could benefit from improved global coordination. To some extent, the gold standard was a kind of a global coordination – one with its own pitfalls but which at least didn’t allow for these kinds of beggar-thy-neighbour policies. In the same vein, some recent research shows that coordination within a country between fiscal and monetary policy may also be desirable, as it leads to greater welfare. But what we currently have within the EU in general and the Eurozone in particular is a complete divergence between member state governments and the ECB. The ECB purchases government assets while governments are required to cut back their expenses. Such policies act in opposite directions and a time comes when there is no government debt left to purchase… Ridiculous to say the least…

Back to the Japanese case, we are currently at the departing point once again. This is the time when monetary policy seems insufficient and fiscal policy needs a boost for the yen to depreciate and the Nikkei to rise, at least until another central bank moves to neutralise the yen depreciation. Last week the BOJ decided to keep interest rates unchanged and doubled its ETF purchases, in measures that were seen by the market as falling short of expectations. Yesterday was Abe’s turn to announce a new stimulus package of 4.6 trillion yen (£34 billion). The market took it poorly, as investors pushed the yen higher, pushed bond yields higher, and sold Japanese shares. But if there’s one country that’s serious about reflating its economy it must be Japan, and there is a high likelihood that its policymakers may become bolder if this doesn’t work.

It seems a lifetime ago when Japan was a rising star. The dynamism of the 1980s ended in the 1990s when the Japanese economy was frozen and entered a dormant state that would last for more than two decades. Nominal GDP in the country was around 5.3 trillion USD in 1995 but just 4.1 trillion USD in 2015 – a decline of 22%. In the same period, China would become the rising star, as its nGDP rose from 732 billion USD in 1995 to 10.9 trillion USD in 2015 – a 15-fold rise.

Japan nGDP

During the two decades from 1995 to 2015 inflation in Japan retreated and Japan faced deflation or simply no inflation – with the exception of 1997, 1998, 2008 and 2014 (years when inflation was positive).

Japan deflation

Upon being elected at the end of 2012, Abe approved a bold three-arrow programme to reflate the economy. The success of the programme has been mild at best so far. I believe that the main reason for this is because fiscal measures will take some time to accomplish their goals and monetary policy seems ineffective to boost either prices or GDP. The BOJ has expanded its balance sheet from 158 trillion yen to 433 trillion yen since the end of 2012 and has even introduced negative interest rates, without the expected success.

central banks' balance sheets

True, Japan has experienced massive asset reflation. The Nikkei, for example, was trading below 10,000 when Abe was elected at the end of 2012 and peaked near 21,000 last year. Unfortunately, the same kind of enthusiasm was never found among consumers, as the monetary policy transmission mechanisms seem to fail. Orthodox economics fails to model the connection between the financial and the real economy in a convincing manner. Higher asset values have not translated into higher wages and higher consumption, as is usually modelled. The growth in base money is no longer multiplied into “money” that is able to generate consumer inflation but instead into “money” that is able to generate asset inflation. This is not a problem endemic to Japan. Monetary policy is failing everywhere. In societies where households don’t own much risky assets, low risk-free rates may have an effect that works in the opposite direction. I believe that is the case with Japan and Europe. Lower interest rates are failing to convince businesses to invest and penalising households.

But while monetary policy is failing, I believe Japan will be one of the first countries to realise that the current situation requires changing. They will most likely adopt new measures tailored to boost household income directly. Although previously shunned by Mr Kuroda, helicopter money (or something similar) is a possibility. Japan is already examining the possibility of issuing 40-year debt in September and the government will make specific investments to boost the economy. At the same time, some structural measures will be put in place to help reflate the economy.

While the market is clearly nonplussed by the measures already announced, I believe it is underestimating Abe’s determination. Since the end of 2012, the USD rose 16% against the yen and the Nikkei 225 rose 60%. With both easing slightly since their peaks in mid-2015, I believe this is a new opportunity to enter the Japanese market. The yen currently trades near 101.00 against the dollar and the Nikkei currently trades near 16,010. The latter is a good candidate for a long position with an accompanying currency hedge against the yen (unless there is a fundamental change in the meantime). For those looking for leverage, I would avoid 2x and 3x ETFs at this point. I don’t expect a linear movement in any of the assets, which means an investor would most likely be caught in the constant liquidity trap when investing in a leveraged ETF. Later in August I will return to the subject of leveraged ETFs to explain the conditions under which leveraged ETFs work the best and the risks they represent. For now the best approach is to use margin from the broker or from spread betting.


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