Should investors also be smiling after Friday’s rally? Photo by Junko Kimura/Getty Images.
On Friday, the BoJ expanded its lofty stimulus program and Japan’s huge pension fund announced it would jack up its allocation to stocks, a one-two punch sending markets surging. Headlines hyped the Nikkei 225’s 4.8% rise, but you only got that if you invested in yen—in dollars, the Nikkei rose only 1.88% as the yen weakened further, sliding -2.8% vs. the dollar.[i] Headlines globally cheered the move as loudly as markets did, but in our view, there isn’t much to celebrate—we’ve seen these sentiment surges in Japan before, and we see no reason to believe this one should last. These moves aren’t stimulus for Japan’s economy or meaningful long-term market drivers—the swing factor remains structural reform, and reform remains largely absent.
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When BoJ Governor Haruhiko Kuroda launched “quantitative and qualitative easing” (QQE) last April, his target was a 2% annual inflation rate in two years. For a while, observers thought Japan was on track. But September’s CPI report, released Thursday night, showed slowing inflation for the second straight month. This seems partly the trigger for the BoJ expanding QQE (with a 5-4 vote). Total asset purchases will jump to ¥80 trillion annually (from ¥60-70 trillion), with most of the increase going to Japanese bonds (annual purchases of exchange-traded funds and real estate investments trusts to around ¥3 trillion and ¥90 billion, respectively, from ¥1 trillion and ¥30 billion). Relative to the economy’s size, Japan’s is the world’s biggest QE program: The planned ¥80 trillion in annual purchases are about 32%[ii] of Japan’s monetary base and 16% of GDP,[iii] while US QE topped out at about 25%[iv] of its monetary base and 6% of GDP.[v] As a byproduct, the yen will likely continue weakening, as it did surrounding QQE’s launch.
Meanwhile, the Government Pension Investment Fund (GPIF) announced plans—officially separately from the BoJ[vi]—to dump some bonds and hike its domestic and foreign equity targets from 12% to 25% each. Japan’s pension fund is ginormous—about ¥127 trillion (about $1 trillion) in assets. So some say this is a huge influx of previously sidelined cash, which should theoretically support returns. But color us skeptical. To meet the new quotas, GPIF will have to buy about $86 billion in Japanese stocks and $115 billion in foreign. Big numbers! But not big relative to the actual markets. Those new Japanese purchases amount to 2.75% of Japan's investable market—peanuts. The foreign purchases are even peanuttier, at 0.33% of the MSCI World ex-Japan's investable universe.[vii] Plus, for every buyer, there is a seller, so the impact could very well be zero-sum. Moreover, the government has paid a lot of lip service to raising the GPIF equity target for well over a year.[viii] Since markets are pretty darn good at discounting widely known information, its long-term impact is likely minimal.
Hence why we expect this rally is the short-term, sentiment-fueled variety. We've seen this movie before. Exhibit 1 shows Japanese stocks’ relative returns since Abe was elected on December 15, 2012. Japan outperformed wildly through spring 2013, fueled by promises of unlimited monetary easing (eventually fulfilled with QQE), fiscal stimulus (fulfilled in the 2013 and 2014 budgets) and structural reform (a unicorn). Expectations shot sky-high—a classic sentiment boost. But in June 2013, when Abe finally released his first reform package, reality started setting in. His agenda was all low-hanging fruit and long-term targets. Politically difficult measures like labor market reform were missing. Same song, second verse when he tried again that September, after his majority strengthened its grip in the upper house. Take three, this past June, was similarly disappointing. We fail to see why this stimulus-driven sentiment boost should prove any more lasting than the prior one, as long as reform stays on ice.
Exhibit 1: MSCI Japan vs. MSCI World Index
Source: FactSet, as of 11/3/2014. MSCI World Index and MSCI Japan returns in USD with net dividends, 12/14/2012-10/31/2014. Japan is outperforming when the line is rising.
Moreover, QE and a weakening currency introduce negatives. For starters, QE isn’t very effective—QQE doubled Japan’s monetary base, but broad money supply is crawling. (Exhibit 2) Why? QE pulls down long-term interest rates—shrinking the yield spread (a proxy for banks’ profit margins, a huge disincentive for banks to lend. (Exhibits 3 and 4) Loan growth has turned positive since QE began in late 2010 (that was before they added the extra Q), but it’s growing off a very low base after having contracted for years. It’s also slow: September’s 2.3% y/y loan growth rate is less than half the US’s 6.3%.[ix] And unlike the US, Japanese loan growth does not appear to be on an upswing—it’s just dawdling along.
Exhibit 2: Japan Monetary Base vs. M2 Money Supply (Jan. 2009-Sept. 2014)
Source: Bank of Japan, as of 11/3/2014. Average amounts outstanding for each period.
Exhibit 3: Yield Spread
Source: FactSet, as of 11/3/2014. Japan 10-Year Government Bond Yield minus Overnight Policy Rate, 12/31/2008-10/31/2014.
Exhibit 4: Loan Growth
Source: FactSet, as of 11/3/2014. Outstanding of Deposits and Loans, Loans and Discounts, Total of Banks and Shinkin Banks, 1/31/2001-9/30/2014.
QQE also hasn’t had the desired effect. Yes, CPI has risen. But this is largely a function of pricy imports—namely natural gas and other Energy sources, which Japan has been forced to import after idling all nuclear power plants post-Fukushima. Stripping out energy and April’s consumption tax hike, inflation remains lackluster. (Exhibit 5) We are fairly confident rising energy prices and sales taxes—without a corresponding bump in wages—is not so good for Japanese people. What the BoJ really wants is money supply, output, prices and wages growing together—a happy expansion. This is not what we see today.
Exhibit 5: Japan CPI
Source: FactSet. The sales tax impact to core/core was 1.5% in April and 1.7% for all subsequent months. Core CPI does not reflect impact of sales tax. 10/30/2009-8/29/2014.
As for the yen, a weaker currency is not a net benefit for Japan—something even Abe now admits. One, it’s responsible for those afore-mentioned pricy fuel imports, hurting people and businesses alike. Two, few Japanese exporters sell goods made start to finish with local parts and resources—the weak yen raises input costs, offsetting much of the currency’s export boost. Much of that boost is purely a currency conversion phenomenon, too: Exports are up in value terms but struggling in volume terms. The weak yen hasn’t materially stimulated actual output. (Exhibit 6)
Exhibit 6: Japan Export Volumes, Values and the Yen
Source: FactSet, as of 10/9/2014; Trade Statistics of Japan, as of 9/18/2014. Japanese export values and export volumes, 9/28/2012-8/29/2014.
In short, the Japan story remains unchanged since Abe took office: Structural reforms are the swing factor, and the scales look unlikely to tip any time soon. While Abe has made numerous pledges, actions are largely lacking. Some noteworthy measures are in the works, like plans to trim the corporate tax rate from 35% to 29% by 2019. But Japan likely won’t get a real, lasting boost without items like corporate governance, labor market and freer trade reforms—things crucial to Japan’s long-term competitiveness. Many of these remain unpopular with Abe’s political benefactors (particularly the agriculture and corporate conglomerate lobbies), which benefit from the status quo. To date, we haven’t seen any evidence Abe has the clout (or willingness) to seriously take on these and other entrenched interests.
Things could always change. But talk is cheap, and expectations are high. We see little likelihood Japan’s reality meets expectations over the foreseeable future—for long-term investors, we think the best opportunities remain outside the Land of the Rising Sun.
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[i] FactSet, as of 11/3/2014.
[ii] Bank of Japan. Monetary Base as of 9/30/2014.
[iii] St. Louis Federal Reserve, as of 10/29/2014. Q2 2014 GDP.
[iv] St. Louis Federal Reserve, as of 10/29/2014.
[v] St. Louis Federal Reserves, as of 10/29/2014.
[vi] We point this out because one might otherwise think the BoJ expanded QQE to soak up all those JGBs the pension fund will sell, lest demand for JGBs fall while debt is at 220% of GDP.
[vii] FactSet, as of 11/4/2014. MSCI Japan IMI Total Market Cap is over $3.1 trillion and MSCI World IMI Total Market Cap is $37.8 trillion.
[viii] And rumors have swirled since at least January 2013.
[ix] St. Louis Federal Reserve, as of 11/3/2014. September US Loans and Leases in Bank Credit.