Japan: Something Needs To Break

| About: Deutsche X-trackers (JPN)


Deflation begets deflation.

The strong Yen is not what the BOJ has been looking for. Harhuhiko Kuroda just cannot catch a break!

Despite a debilitating debt burden, Japan borrows at negative rates!

Beware the widow-maker.

Time for an update on Japan. Here's what's going on.

You are likely already familiar with the dynamics of a vicious deflationary cycle: price declines beget (and ultimately cause, due to the self-fulfilling prophecy dynamic of market prices) further price declines and economic stagnation results, as people choose to stash, rather than spend their income based on expectations of lower prices and thus higher purchasing power tomorrow than they had today.

Indeed, this is an example of a macro-inefficient, but micro-rational equilibrium. What that convoluted jargon (that I made up!) means, is that individuals/firms in Japan are acting rationally. They are doing what they should be doing, based on expectations about the future built from experience in the past. But when all of these perfectly rational decisions. It's an inefficient, but highly stable equilibrium. And that's the worst sort for policy makers seeking to maximize collective utility and in effect save the micro-level actors from themselves.

Here is JPYUSD (Pending:JPYS) (NYSEARCA:JYN) in yellow, overlaid with Japanese inflation in blue (core CPI YoY %):

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Japan hasn't had a good few years since the financial crisis (and they weren't exactly the image of robust growth before, either). Here is Real Japanese GDP YoY. The red dashed line represents 0% growth, so all periods below the line represent a quarter of real output contraction.

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Before I talk about any more economics and before I get into the financial characteristics of the country, one piece of demographic context is imperative for understanding the oddity of Japan's economic situation: old people. Japan has a lot of them:

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While this chart very successfully demonstrates the trend, I think some comparisons are in order to demonstrate the magnitude of Japan's demographic, well, let's call it a challenge. In the below chart, white line/blue shaded is Japan, light blue is U.S., Green is India, and Purple is Nigeria:

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There are two more essential phenomena when it comes to understanding the fascinating Japan dynamic: debt and interest rates.

Below is a global comparative analysis of global indebtedness. First, from The Economist, we have overall debt, so this includes household, firm, and government debt:

Next up, we have a comparison of just government debt. So that should theoretically be a key input to investor perceptions of sovereign credit risk... but as we will see with Japan, heinously high levels of government debt have not sated investor appetite for negative yielding JGB's! (don't worry if that seems paradoxical, contradictory, or otherwise absurd... I don't know anyone to whom it makes intuitive sense! Sometimes the world is just weird!) But I digress. Here is Japanese government debt compared to other nations:

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While such a debt burden might lead one to rationally expect high borrowing costs. To make a micro-comparison, a middle class family with outstanding debts 2.5 times their annual income would not be considered a good credit risk! But countries are different. Japan has $9.8T (yes, with a T!) in outstanding debts, and no one expects them to ever pay them off (except if some black swan event were to occur such as Japan experiencing a technological breakthrough of the magnitude of, say, the internet... but the odds of that are, well, not great) but, Japan's debts are denominated in JPY. That's why Japan can maintain a nice shiny A as its credit rating, as well as borrow at mind-bogglingly low rates. I use the term 'mind-boggling' quite literally--it boggles my mind that Japan gets paid to borrow Yen. Here's the yield curve:

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Japan has an old population, is experiencing deflation, has a highly valued and steadily appreciating currency, has the most indebtedness in the world, and can borrow at less than 0% interest. I'll leave you to come to your own conclusion, but that doesn't strike me as cause for celebration in the form of a doubling of the Nikkei (OTC:NTKIF) (OTC:NTETF) (NYSEARCA:JPXN) (NYSE:JPN).

(if I were talented with computers, I would insert a little cartoon of Haruhiko Kuroda holding up the Nikkei in the below graph... but I think you get the idea)

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Something needs to change: Japan is defying gravity. But then again, it has been for years. It's a well-known adage that being early is just another way of being wrong. With the Yen and Japanese debt, that has been all too true for many of the greats--so much so, that the bearish Japan trade has come to be known as the widow maker. Here's what we know, though: something needs to break... this cannot hold.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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