Japanese Equities Are In Good Shape For Now

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Includes: DBJP, DEWJ, DXJ, EWJ, EWV, EZJ, FJP, FXJP, GSJY, HEWJ, HFXJ, HGJP, HJPX, JEQ, JPN, JPNH, JPNL, JPXN
by: Long/Short Investments
Summary

The Japanese economy is plagued by adverse demographic conditions, large fiscal deficits, and high debt burdens, which asymmetrically skews risk downward.

Debt costs nonetheless remain very low, which helps stabilize credit growth relative to GDP growth.

With the BOJ’s continuation of ultra-low rates and high levels of debt monetization through QE, this provides an environment amenable for equities in the short term.

The longer-term picture remains hazier.

Thesis: Purely from a macroeconomic perspective, Japan's economy is not in the best shape due to slow growth and a massive debt load. But the Bank of Japan's ("BOJ") benchmark policy rate of minus 10 bps and $60 billion equivalent worth of asset purchases per month have created a relatively sound environment for the country's stock market, especially as economic data have returned higher-than-expected growth and inflation levels.

First a brief background on Japan's economic situation.

Overview

Japan is the third largest economy in the world behind the US and China, and accounts for 5.5%-6.0% of all global economic activity, using its economic output of $4.4-$4.5 trillion and about $79.5 trillion in estimated global GDP.

Accordingly, its performance has a material impact on global performance. But ever since its credit crunch in 1989, the country has been plagued by low growth and frequent recessions.

While the US has had just two recessions since 1991, Japan has had five, including two since the financial crisis.

Since 1989, Japan's inflation rate has been negative nearly as much as it's been positive.

A recent uptick in global economic activity has helped, but Japan still suffers heavily from the deflationary malaise. A small and stable amount of inflation is good for an economy given it incentivizes consumers to spend their money, as they know it'll lose value over time if it's held onto. With deflation, when you know a dollar tomorrow is worth more than a dollar today, there is typically hoarding behavior, which leads to less consumption and lower growth.

The country has a few main obstacles to getting the economy going on the right track again:

(1) Demographics - Japan's average age is about 46. As the population ages, dependency ratios - or the retirement age population relative to the working age population - increase, creating more budgetary strain on social security and other entitlement programs. Though Japan's jobless rate of 2.8% is the lowest it's been since the mid-1990s (shown below), the economy doesn't produce enough new workers to satisfy corporate demand.

As discussed in a previous article, the Phillips curve's prediction that a tight labor market will cause inflation will break down if substitute workers are virtually non-existent. When this occurs, current workers lack the ability to bargain for higher wages. These wage hikes are costs companies generally pass off in the form of higher goods and services, producing inflation.

This is the labor situation we see in other developed markets as well, including the US and European Union.

(2) Budgetary issues - As entitlement payments increase as a fraction of the budget and the relative proportion of workers decreases, maintaining a balanced budget becomes progressively more difficult. Japan has not been able to do so since the early-1990s.

(3) Too much debt - From the financial crisis and Japan's own host of economic tribulations, the country's budget deficit ran from 7.8% to 9.5% of GDP from the 2009-2013 inclusive five-year period. In 2014, 2015, and 2016, its deficits came to 5.5%, 4.8%, and 4.5% of GDP, respectively.

This has caused a mountain of central government debt to pile up at over 250% of GDP. This metric is the highest in the world and more than the next-highest (Greece) by over 70 percentage points.

At the time of the 1989 down-cycle and in the few years thereafter, debt-to-GDP was a very manageable 60%-70%. But by the early-1990s, it began ballooning out of a worsening demographics situation and each economic shock has consistently exacerbated the situation.

Even if a bettering economic situation (for now) allows the deficit to narrow to about 4% of GDP, with an annual GDP output of $4.4-$4.5 billion, this would still entail close to $200 million being added to the national debt each year.

As the supply of debt increases, holding all else equal, this lowers its price. When prices lower on debt, yields increase. With its mountain of debt and precarious fiscal situation - currently largely offset by ultra-low rates - if some unexpected shock were to cause yields to surge (e.g., inflation), this would greatly impact Japan and its financial markets.

What all this has led to…

BOJ policymakers have attended to these issues through very easy monetary policy, through a sub-zero benchmark rate and the highest amount of asset purchases in the world as a relative proportion of GDP. (The BOJ's asset purchase rate is roughly on par with that of the ECB's, but Japan's economy is just 38% of the size of the EU's taken collectively.)

The policies have worked to some degree, with QE bidding down credit costs to stimulate lending demand, which in turn helps engineer economic activity. Growth has picked up to around a 1.6% y/y rate and CPI inflation is slightly above zero at a 0.2% y/y clip.

The question, however, is how effective these policies will be in the future. When you bid down credit to the point where people would be indifferent between holding cash or a bond, it's difficult to stimulate further as there's no longer any juice to be squeezed out of the spread. This has forced the BOJ to go further out over the risk spectrum with its purchases beyond sovereign debt, to corporate bonds and exchange-traded funds.

The BOJ's policies are favorably impacting its equity markets

Based on the BOJ's consistent upward revisions in growth expectations over the past six months, it's unlikely to ease further in the months ahead. With inflation and growth rising above prior expectations, the Nikkei 225 has seen a 17% surge over the past year.

Even if the BOJ had alternative policy measures to ease - which they currently do not - the central bank has gone about as far as it can in terms of how much stimulation it can provide to the economy. The positive thing is that the ¥80 trillion (USD$720 billion) in annual asset purchases is continuing to go through the financial markets.

Given, as above-mentioned, the BOJ has ventured beyond sovereign debt and into corporate debt and ETFs as well, a lot of this liquidity is going directly into the stock market. Even when macroeconomic fundamentals are subpar, QE can be a strong tailwind for stocks. Moreover, this is likely to continue through 2017, though a tapering of asset purchases is a potential in 2018, much like what the ECB is doing in the EU currently.

Manufacturing has benefited from an upswing in tech demand and a weak yen, which makes its exports cheaper globally. However, the yen's volatility - from uncertainty on the US trade situation and April's geopolitical tensions on the Korean peninsula (yen is a safe-haven asset, with over a 90% correlation to gold) - adds uncertainty and Japan's economy is still reliant on growing its export capacity. The economic boost from tech demand is likely to persist into Q3.

Short Term vs. Long Term

Overall, the situation is favorable for Japanese equities. There's a lot of liquidity in the system, which is likely to remain into 2018, and a lot of this will find its way into stocks.

But the longer-term picture is shakier due to the seemingly unresolvable demographics situation, rising fiscal burdens, a high debt load, and the BOJ's inability to stimulate the economy further using current policy levers.

I am long an index of Asia Pacific equities more generally, mostly because I believe the current situation is favorable in the short term and partly as an overall portfolio diversifier. But Japan, mostly due to its extreme level of indebtedness, is very susceptible to systemic shocks that could throw its currency and stock and bond markets for a loop.

Debt eventually needs to be paid and the combination of a low growth economy and debt at 2.5x annual economic output are not enviable circumstances. The BOJ has largely done all it can do with monetary transmission now fairly weak. More of the focus must necessarily shift to fiscal policy.

Getting out of an indebted situation will rely on printing money (which it's already doing through QE) and spending less relative to revenue taken in (hard to do as a consequence of demographics). The debt could also be written down or involve wealth transfers of some form in order to plug the gap. Some have bet on the BOJ losing control of the situation in some form, but even though the risks in Japan are skewed to the downside, there is absolutely no timetable on such a matter.

Conclusion

Muted consumption and sluggish business investment have undermined Japan's economy for nearly three decades. Expectations of weak growth and inflation have reinforced these trends in addition to an adverse demographic situation. High debt brings on greater systemic risk, but relatively stable economic conditions and ultra-accommodative monetary policy have kept debt funding costs low.

The BOJ is doing the right thing in keeping nominal interest rates well below the nominal growth rate through QE, which has helped stabilize the rate at which debt has grown relative to the growth rate of the economy. Its extensive easing regimen continues to introduce more liquidity into the system to directly support stock prices. And global economic conditions appear relatively favorable through 2018, if not longer.

This has made some smaller level of exposure to Japanese equities a decent position to hold for now. Nevertheless, forward returns look mediocre going forward, like virtually all other developed markets.

Disclosure: I am/we are long VPL. 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.