When we look at Japan, one can understand just how quickly euphoria and prosperity can turn into misery…
While the present day global free flow of capital has many advantages over the capital barriers of the past, it also has many drawbacks that have often resulted in severe bubbles and crises. Japan prospered during the 1980s due to the free flow of this capital but, the same capital that set the country on the path to prosperity, also helped generate one of the biggest asset bubbles the world has ever seen. One that in fact took more than 20 years to burst completely (if the burst has in fact ended at all!).
Japan still has major challenges to face in the near future, however to us it offers still a good investment opportunity, particularly versus the S&P 500 which looks wildly expensive relative to Japan on most “value” measures.
The Great 1980s
During the 1980s, Japan saw a large inflow of money seeking new investment opportunities after the bursting of the Mexico bubble. To avoid the appreciation of the yen, which would erode the competitive international position of Japanese companies, the BoJ accumulated dollar-denominated assets while allowing the monetary base to expand. Consequently, Japanese banks quickly accumulated large reserves and which they were willing to use to extend ever more credit. The relaxation of rules governing real estate loans allowed the banks to expand credit to such an extent that when ranked by assets, most Japanese banks were once the largest in the world, although not by profits. With so much money entering the country, the wealth of Japanese households expanded substantially and real estate and financial asset prices exploded.
At the end of the 1980s, the market value of Japanese equities was, it may be difficult to believe now, actually double the market value of US equities. At the same time, the market value of real estate in Japan was twice the market value of real estate in the US. This number is even more spectacular if we take into consideration that Japan has just 5% of the US land mass and that 80% of its land is mountainous. It is said that at some point the value of the land under the Imperial Palace in Tokyo was greater than the value of the whole of California! Of course it was becoming ever more obvious that the buying frenzy was not backed by fundamentals. An elastic supply of money was allowing for too much credit expansion and with land values and asset prices ever increasing, the bubble was bound to pop at some point – sound familiar?
The Bursting of the Bubble…
In 1989, a new BoJ governor decided to deflate the real estate bubble by imposing restrictions on credit. From that point on there was no turning back. Demand for real estate decreased, and the bubble started to burst. Over twenty years on, and the country has still not found the path back to growth. Perhaps this is why the Fed continues to allow the equity bubble in the U.S to roll on? With an enormous debt burden acting as a continuous brake on economic growth, a shock to household net wealth would only exacerbate this and so they no doubt believe “bubblicious” equity and bond prices are a better alternate. Jury’s out on that one…
The subsequent attempts by the Japanese Central Bank and Government to save the country in the aftermath of the bubble merely delayed the necessary adjustments the country was in need of. They allowed for many insolvent companies to stay in business for many years, and which so prevented a necessary decrease in supply of goods when demand was depressed. Instead, supply adjusted very slowly to demand. The final outcome has been 20+ years of stagnation, a government debt level that surpasses one quadrillion yen or, put another way 200% of GDP (thank God they are not in the EU!!), and a Central Bank that is becoming the virtual owner of the country on the back of huge asset purchases. Again, sound familiar?!
Japanese PM Shinzo Abe
With Shinzo Abe as the new Prime Minister, Japan is now throwing everything it can at the situation in terms of monetary policy in one last desperate attempt to reflate the country, and which they may or may not achieve.
The massive reflation attempt will most likely eventually generate high inflation which will push all prices higher, including asset prices. This means that the Nikkei may benefit from the BoJ policy and asset prices may explode – just like we have seen in the States. Of course, if you exchange your pounds or dollars for the yen to invest today in a market that eventually goes higher, you still incur in the risk of losing money if the yen loses value, which is very likely. This is why it is important to hedge the yen of taking a position on Japanese equities.
If inflation doesn’t pick up in Japan and cause a nominal price blow off, at least you have the fundamentals on your side at present. Japanese stocks are still trading 60% below their record highs seen in 1989, while US stocks are at new record highs. On average, Japanese stocks are trading at a modest premium to one times book value, while US equities are a good deal over 2 times and in the tech sector which arguably is similar to many Japanese companies, 10,20 or 30 times book values are not uncommon!
While still being a risky investment, we believe Japanese equities are a worthwhile component in a properly diversified portfolio.