by Ron Rimkus, CFA
Japan's Nikkei index is on fire. In just the past six months, the benchmark is up 55% as of this writing. Why? Pretty simple: New Bank of Japan Governor Haruhiko Kuroda has announced that the Bank of Japan (BOJ) will begin purchasing approximately ¥7 trillion worth of bonds annually in a major new quantitative easing program. In short, Japan will be printing gobs of money and all of this money has to go somewhere. That may look like great news for investors who hold Japanese equities, but from where I sit, this has all of the classic makings of one big investment bubble.
Sources: CFA Institute, Dow Jones.
Even though Japan has been providing monetary stimulus for many years, the new policy represents a major expansion of the country's existing response to deflationary pressures in the economy. Moreover, this expansion comes on the heels of an already massive stimulus programs launched by U.S. and European Union policymakers. The impact has been immediate: The Yen is depreciating (and the G-20 has provided its blessing). The Nikkei is surging. Japanese real estate indices are skyrocketing.
This is how bubbles are made. First comes reflation. Then comes buy-in from market participants, followed by buy-in from the real economy. Then comes malinvestment. Then comes the inevitable decoupling of valuations from underlying fundamentals — and then, finally, bust and ruin. Japan is now in the "buy-in from market participants" phase.
The scale of stimulus is massive. Japan is now printing enough yen to pay for about 16% of its GDP each year. Note that, by way of comparison, the United States is (currently) printing "only" about 6% of annual GDP. The graph below charts the change in money supply (M2) in Japan versus the United States relative to each country's respective GDP levels historically. The graph uses changes in M2 for the historical data and in each case uses the announced money printing relative to expected GDP for 2013. Although expansion of the monetary base does not perfectly translate into expansion of money supply, in the long run it is a relatively good measure.
Sources: CFA Institute, St. Louis Fed, World Bank.
To put these events into context, it is instructive to look at the economic history of Japan. As I have previously written, economic pressures have been building in Japan for some time, making change from the status quo inevitable. Japan's citizens, through Abe's election and his appointment of Kuroda to the BOJ in late 2012, have simply chosen to act now with massive money printing. Naturally, this ultra-loose policy has lit the currency markets on fire. In fact, the new QE program ranks as one of the most notable events in Japan's economic history, on par with the Plaza Accord in 1985, which triggered a 50% appreciation in the yen in the following two years, and the Reverse Plaza Accord in 1995, which sparked a more than 40% depreciation in the yen in the following three years or so.
Japan: ¥/$ 1971–2013 (Inverted Scale)
Sources: CFA Institute, St. Louis Fed.
Thus far, the Yen has declined against the dollar by 22% from its market peak six months ago. A closer look at recent history shows the decline more clearly.
Sources: CFA Institute, St. Louis Fed.
The tool that the BOJ uses to execute this policy is the purchase of bonds in the secondary market, a move that creates an artificial, if massive, incremental demand for JGBs. This policy is forcing Japanese asset managers to reconsider their risk positions. Already, Japanese asset managers are ramping up their exposure to the Japanese stock market. Additionally, the weak yen is reigniting the yen-carry trade, in which investors (from all over the globe) borrow in a declining Yen and purchase higher risk assets to earn the difference. Of course, this wave of liquidity need not stay in Japan. New money is like water: It flows freely, filling voids. So Japan's easy money will find its way to already bubbly markets — perhaps U.S. high yield assets or emerging market stocks, to name but a few possibilities.
A declining yen will help delay Japan's economic decline. Many export-oriented companies will benefit from stimulated demand and Japan's trade deficit will improve. In addition, the country's massive foreign asset portfolio will benefit from a falling yen as the foreign-denominated income streams produced by these assets are converted into larger numbers of yen over time. But that won't save Japan. The problems are structural: a declining population, loss of leadership in many industries, a crowding out of research spending in favor of transfer payments, loss of the nuclear power fleet due to the Fukushima disaster, and the escalation of energy imports at ever-higher prices as the yen declines. In order for Japan to turn things around, they will have to manufacture major productivity gains, which seems very unlikely.
In the near term, monetary policy will buy Japan some time. Apparently, time enough to create a bubble — which incidentally should have legs over the next year or two — supporting both the equity markets and real estate in the near term. However, Japan does not appear to be solving any of its structural problems. In the inevitable bust, each of the structural problems will likely end up more severe. Perhaps more troublesome, in the aftermath of a popped bubble, the banking system will weaken further and there won't be enough money circulating through Japan to maintain the status quo. The country will be forced to look abroad for more support for high JGB prices (and low yields).
In other words, Japan's JGB funding mechanism won't survive the next bust.