Japan's Deflationary Dragon

Aug. 24, 2016 2:57 PM ETDCMYY, NTT, KDDIY, JEQ, JPMV14 Comments
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  • PM Shinzo Abe introduced an eye-popping Y28.1 trillion stimulus package, the largest such package in the world at the beginning of the month.
  • In the face of such liquidity pouring into the Japanese financial system, corporate earnings and investment declined sharply in the 2nd quarter while household spending remained flat.
  • Second quarter growth would have contracted without the front-loading of new governmental spending in the current fiscal year.
  • The continued appreciation of the yen remains relentless--over 17% YTD.

Earlier in the month, Prime Minister Shinzo Abe announced yet another stimulus program in the hope of breathing new life into the country's moribund economy. The package now totals an eye-popping ¥28.1 trillion as the biggest stimulus package in the world just got a good deal bigger. New government spending comes to ¥6.2 trillion with about ¥4.6 trillion of the new money being conveniently front-loaded into the current fiscal year. The fresh spending was enough to expand GDP growth for the quarter at an annualized rate of 0.2% which was much weaker than the 2% annualized pace of the 1st quarter but, importantly, kept the 2nd quarter from actually contracting. The program includes ¥2.5 trillion in welfare spending, ¥0.6 trillion for small businesses and ¥2.7 trillion of fresh reconstruction funding to deal with the earthquake on the island of Kyushu last year. The package also included childcare subsidies for low income citizens of up to ¥15,000 per year.

While bank lending has expanded for the past 58 months running through July, the pace has begun to show signs of fatigue. Household spending was up 1.2% in February just a month after the Bank of Japan (BoJ) dropped its overnight deposit rate into negative territory, with maturities of up to 10-years now carrying negative yields. Fitch lowered Japan's credit outlook to negative in June citing the country's debt load that claims the odious title of the world's biggest, challenging the government's commitment to actually fixing the problem. Still, Japanese debt is overwhelmingly domestically held and yen-denominated which means Tokyo holds the option of monetizing the debt by stoking up the BoJ's printing presses. Accordingly, default is a very distant probability.

Household spending has trailed off measurably in the months that followed. The appreciation of the yen has been relentless. After starting the year at ¥120.66 to the dollar, the yen has strengthened to ¥100.09 through yesterday's market close (23 August)-an appreciation of just over 17% in the course of 8-months' time. Not surprisingly, Japanese export value dropped almost 6% through the end of the 2nd quarter and has logged its ninth consecutive decline through the end of July as a strong yen lost ground against just about every major currency in world markets.

A related issue in regard to the strength of the yen is the price of Brent crude on world markets. All of Japan's 48 operable commercial nuclear reactors were shut down after the March 2011 tsunami and resulting triple meltdown at the Fukushima Daiichi nuclear power station created serious public doubts about the safety of atomic power in earthquake prone Japan. Prior to the disaster, nuclear power supplied about 13% of Japan's energy needs leaving a huge hole in the Japanese energy supply equation. That gap was filled by imported oil which quickly flipped Japan's trade balance negative. Since Fukushima, oil prices have sketched out a negative correlation to the yen as the strength of world oil prices and the weakness of the yen changing places with the peak of world oil prices in June of 2014. By September, the transition was complete. With trading data suggesting much of the fits and starts in oil prices over the past few months largely due to institutional bets in anticipation of OPEC signals on yet another attempt at production freeze, sustainability of current crude price levels remains problematic. The intense political rivalry between Iran and Saudi Arabia and the demonstrable untrustworthiness of non-OPEC member Russia in policing such agreements in the past notwithstanding, logistical difficulties abound in putting such an agreement into place. It goes without mention that given all three producers are pumping as much oil as possible, a freeze at current elevated levels would have questionable impact on ever-burgeoning world supply that stubbornly exceeds demand. With US production falling outside of any such agreement, the downward pressure on prices for the foreseeable future is a likely scenario. The yen will continue to strengthen as a result.

Corporate earnings and investment took a sharp downward hit during the quarter, mostly stemming from the seeming runaway value of the yen and weak global demand, especially in China and emerging markets in both Asia and further afield. With borrowing costs at historic lows, announced corporate buyback programs hit ¥3.9 trillion through the end of May, twice that of share buyback programs in all of and almost 70% more than the first five months of 2015-the biggest year ever for such programs.

Over the same period household spending, about 60% of GDP, fell flat, blamed mostly on private sector wage compensation that eked out a mere 0.3% annualized growth rate through the end of the 2nd quarter. The brightest light in this gloomy picture of 2nd quarter economic activity was in the housing market which experienced a 21% spike during the quarter as many took advantage of historic low interest rates to buy homes and apartments.

In July, the BoJ announced that it would essentially double its purchases of ETFs on national and regional exchanges to ¥6 trillion a year, up from the ¥3.3 trillion for the past year. Since 2012, the BoJ has purchased almost ¥9 trillion of ETFs which have created a host of trading anomalies as markets adjust to the direct and deep pocketed BoJ purchases while market valuations of targeted companies soar due in large part to central bank largess. Asset managers busy themselves creating highly specialized ETF baskets of targeted stocks specifically for BoJ purchases. The same activity has cropped up in the UK as asset managers cater to the specific buying programs of the Bank of England.

Japanese telecommunication companies appear to be a persistent play. NTT DoCoMo (DCM), Nippon Telephone & Telegraph (NTT) and OTC listed KDDI (OTCPK:KDDIY) are all telecommunication providers and large domestic employers. Each of the companies maintains a reasonable market valuation, price/book ratio, return on equity and yields just shy of 2%. These companies and a variety of other Nikkei/Topix listed companies are captured in Aberdeen Japan Equity Fund (JEQ), a closed-end fund that lists on the New York Stock Exchange. I-Shares Edge MSCI Minimum Volatility Japan (JPMV) is an ETF with a slightly different basket of Nikkei/Topix listed companies that is also listed on the New York Stock Exchange.

GDP growth through the end of the 2nd quarter badly underperformed consensus estimates of 0.7% annualized growth. As we have seen, the economy eked out a 0.2% annualized growth rate and even then only due to the front-loaded government spending for the current fiscal year. Otherwise, GDP growth would have contracted for the quarter. To many, the anemic growth performance for the quarter in the face of the world's largest stimulus program suggests the limits of large-scale asset purchase programs in raising both inflation expectations and overall domestic demand. Given the tsunami of liquidity that has flooded the Japanese financial system since 2012 and interest rates hitting historic lows, households and corporations continue to hoard cash. Surprisingly, survey research by the Association for Financial Professionals suggest corporate treasurers worldwide are far from being cash averse-as their most liquid asset is now at its highest level since 2011. The survey suggests negative rates are causing people to save, rather than spend cash. Anecdotally, OECD data has detected elevated savings rate in the negative interest rate environments of Germany, Sweden, Japan Denmark and Switzerland-all at the highest levels since the data was first collected in 1995. Of course, aging populations have a greater propensity to save, ultra-low inflation rates affords people the extra cash to stash into a plethora of saving instruments and central banks have likely failed of adequately communicate their intentions or to adequately appreciate the importance of capital mobility. On the latter point, the greater the mobility of capital, the less effective negative interest rates become as a determinant of investor behavior. Similarly, where financial and saving vehicles are limited and traditional forms of banking more dominant, choice is more limited and capital is more domestically focused and less sensitive to forex volatility. The concentration of negative interest rates in the northern European theater speaks loudly to the mobility of capital and household savings. The din is much less pronounced in Japan where sheer distance places limitations on the flight of household savings while in southern Europe more traditional forms of banking and lower levels of financial sophistication combine to limit household choice. In Italy upwards to a third of all holders of Monte dei Paschi di Siena's debt were small, largely unsophisticated retail investors who were aggressively sold such instruments under the guise of safe, dividend latent retirement vehicles. Little wonder when EU bail-in rules went into effect this January past that threatened to wipe out the savings of many of these retail investors that a private sector arrangement would be found to deal with the depletion of the world's oldest bank's exhausted capital reserves. Accordingly, lowering interest rates into negative territory to stimulate spending and growth is just as likely to exacerbate a savings glut that becomes insensitive to further reductions in borrowing costs.

One interesting facet of the government's ¥28.1 trillion package is the tiny ¥1.7 trillion tranche earmarked for domestic infrastructural projects. On the announcement, the yield on the 10-year note was up 23 basis points in a single day-the biggest jump in almost three years. Infrastructural projects would require government borrowing rather than simply having the BoJ print money to purchase public sector debt or equities on the country's stock exchanges. Some of the infrastructural spending will likely not happen for years, so the impact will be muted both domestically-and internationally. The international component here comes from the first attempt at fiscal policy since the wind-down of the American Recovery and Reinvestment Act (2009) in 2010. Importantly, Japanese yields rose across the yield curve in anticipation of demand for government debt. It's a trend that could catch on across the developed world as central banks and governments both search for new approaches to stimulating economic growth.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DCM, NTT, JEQ over 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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