Markets Insight
April 14, 2014 7:20 am
Sceptics underestimate Japan’s policy shift
Bank of Japan has gone far beyond Draghi-style promises
Oscar Wilde once remarked that “anyone who lives within their means suffers from a lack of imagination”. If that is the case, the eurozone periphery and Japan may have more in common than appears. But it fails to explain why investors are treating the two regions so differently.
If Spanish five-year bond yields can halve in less than two years to fall below those of equivalent US paper; if Italian 10-year bond yields can trade at an all-time low of 3.25 per cent; and if Greece (which some investors would argue is still technically insolvent) can borrow for five years with the promise of a 5 per cent coupon, then maybe thinking the unthinkable about Japan is not so absurd. If Spanish and Italian bonds can escape the clutches of the eurosceptic bears, perhaps Japan can wriggle free from deflation.
The extent of the regime shift at the world’s third largest central bank continues to be underestimated. The BoJ has abandoned a creditor-friendly policy stance and adopted one that is more debtor-friendly. In contrast, the ECB is still in creditor-friendly mode.
The BoJ is prepared to be bold because it has seen the consequences of 20 years of “stability” in a deleveraging environment, whereas the ECB is still obsessed with monetary stability.
Worries about the aftermath of the recent consumption tax rise in Japan are understandable but misguided. The real revolution lies in the change in Japanese monetary policy. This is now being run to discourage saving (especially corporate saving), to re-risk existing savings, and to encourage borrowing (especially by smaller enterprises).
The BoJ wants to kick-start a domestic credit cycle. One of the consequences of deflation was that Japanese bank lending did not grow in the 10 years to June 2013. Falling prices caused the real value of debt to rise and reduced the value of collateral against which banks can lend. With nationwide land prices falling some 5 per cent a year over the past 20 years, it is no wonder there was no loan growth. Stabilising the value of collateral remains key.
Two further changes are needed. The first is a break of the link between the yen and Japanese equities. Many overseas investors see Japanese equities as a hedged play on the currency. They also believe Japanese stocks have always been negatively correlated to the yen. That is incorrect.
The second change is the re-risking of Japanese savings. Japanese government bonds have outperformed Japanese stocks by 3 per cent a year for the past 20 years, courtesy of the BoJ’s creditor-friendly monetary policy. But that era is over.
If the next decade sees growth of 1 per cent and inflation of 2 per cent, it is possible that JGBs at some stage could yield as much as 3 per cent. In which case, it will not look clever to be running a vast public pension fund with 55 per cent of its assets in JGBs.
Even if bond yields do not go up, the 45 per cent of the Government Pension Investment Fund’s non-bond assets will need to return 8 per cent a year to deliver annual returns of 4.2 per cent to pensioners. A central bank regime shift demands a corresponding shift in investment strategy and asset allocation. That is both a challenge and an opportunity for asset managers. Japan could do with some large domestic macro hedge funds to act as a catalyst in this transition. Maybe it is time for a fourth arrow.
David Bowers is joint managing director of Absolute Strategy Research
If Spanish five-year bond yields can halve in less than two years to fall below those of equivalent US paper; if Italian 10-year bond yields can trade at an all-time low of 3.25 per cent; and if Greece (which some investors would argue is still technically insolvent) can borrow for five years with the promise of a 5 per cent coupon, then maybe thinking the unthinkable about Japan is not so absurd. If Spanish and Italian bonds can escape the clutches of the eurosceptic bears, perhaps Japan can wriggle free from deflation.
Just as no one fully appreciated the importance of the pledge by European Central Bank President Mario Draghi to do “whatever it takes” to save the eurozone, they are similarly sceptical about the Bank of Japan’s commitment to end deflation.
But the BoJ has gone far beyond Draghi-style promises: it has presided over a 25 per cent depreciation of the yen during the past 18 months; it is in the process of doubling the money base in just two years; and it is actively committed to 2 per cent inflation.
Paradigm shift
If the ECB did this, the markets would regard it as a major paradigm shift; but because Japan has done it, somehow it does not “count”. Indeed, looking at the relative performance of Japanese equities (in dollar terms) versus the MSCI World Index, it is as though Prime Minister Shinzo Abe’s initiatives never happened: the trend of Japanese equity underperformance remains intact. Year to date (in local currency terms), Japanese equities have done worse than the Russian stock market.
The BoJ is prepared to be bold because it has seen the consequences of 20 years of “stability” in a deleveraging environment, whereas the ECB is still obsessed with monetary stability.
Worries about the aftermath of the recent consumption tax rise in Japan are understandable but misguided. The real revolution lies in the change in Japanese monetary policy. This is now being run to discourage saving (especially corporate saving), to re-risk existing savings, and to encourage borrowing (especially by smaller enterprises).
The BoJ wants to kick-start a domestic credit cycle. One of the consequences of deflation was that Japanese bank lending did not grow in the 10 years to June 2013. Falling prices caused the real value of debt to rise and reduced the value of collateral against which banks can lend. With nationwide land prices falling some 5 per cent a year over the past 20 years, it is no wonder there was no loan growth. Stabilising the value of collateral remains key.
Two further changes are needed. The first is a break of the link between the yen and Japanese equities. Many overseas investors see Japanese equities as a hedged play on the currency. They also believe Japanese stocks have always been negatively correlated to the yen. That is incorrect.
The strong negative correlation has really only been in place for the past decade. For the previous 30 years there was a modest positive correlation. One way to judge if “Abenomics” is “for real” is if this negative correlation breaks down. It has not happened yet: we think it will.
If the next decade sees growth of 1 per cent and inflation of 2 per cent, it is possible that JGBs at some stage could yield as much as 3 per cent. In which case, it will not look clever to be running a vast public pension fund with 55 per cent of its assets in JGBs.
Even if bond yields do not go up, the 45 per cent of the Government Pension Investment Fund’s non-bond assets will need to return 8 per cent a year to deliver annual returns of 4.2 per cent to pensioners. A central bank regime shift demands a corresponding shift in investment strategy and asset allocation. That is both a challenge and an opportunity for asset managers. Japan could do with some large domestic macro hedge funds to act as a catalyst in this transition. Maybe it is time for a fourth arrow.
David Bowers is joint managing director of Absolute Strategy Research
Copyright The Financial Times Limited 2014.
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