Seeking Alpha

Europe: 'Japanification' In The Long Term But Opportunities In The Short Term

|
Includes: ADRU, DBEU, DBEZ, DEZU, EEA, EPV, EURL, EZU, FEP, FEUZ, FEZ, FIEE, GSEU, HEDJ, HEZU, HFXE, IEUR, IEV, PTEU, R, UPV, VGK
by: Rothko Research
Rothko Research
Macro, currencies, short-term horizon
Summary

The term 'Japanification' has been used for economies that have been developing similar symptoms as Japan did in the 1990s in the past cycle.

Since the financial crisis, economists have found that the euro area faces strong similarities with Japan, and that the ECB may be forced to follow the BoJ path.

However, we could see some good opportunities in 2020 if governments agree to relax fiscal conditions in order to reflate the economy in the short to medium run.

In the past few years, a number of studies have argued the difficulties that developed economies will have against the 3D problem: Debt, Disruption and Demographics. The term Japanification has been used for economies that have been developing similar symptoms as Japan did in the 1990s in the past cycle. As a reminder, following the top of the equity market reached on December 29, 1989, the post-bubble area surprised many economists as it turned out to be far longer than primarily expected and the 1990s and 2000s are nowadays referred to as the Two Lost Decade. As a reminder, between 1995 and 2007 Japan's GDP (nominal) fell from USD 5.45tr to USD 4.52tr, according to the World Bank (-17% drop), and wages have been declining by around 4 to 5 percent. As a consequence, Japan became the first major economy to set the interest rate at 0 percent in January 2000 and then embark on an unprecedented monetary policy experience (i.e., QE) in March 2001. Since then, it has not managed to get out of this negative spiral and the economy has constantly been leveraging with a debt-to-GDP ratio of 238% in 2019, the highest in the world.

Despite the massive increase in the BoJ balance sheet total asset – BoJ balance sheet is bigger than the GDP of the country (figure 1, left frame) - Abe has failed to lift up inflation closer to its 2-percent target and BoJ officials have constantly been overly optimistic regarding the inflation target. Figure 1 (right frame) shows that core inflation has remained well below the BoJ target for a long time; the little pickup we saw in 2014 was due to the increase in sales tax from 5 to 8 percent (the first in 17 years).

Figure 1

Source: Eikon Reuters

Since the financial crisis, economists have found that the euro area faces strong similarities with Japan, and that the ECB may be forced to follow the BoJ path if officials want to offset the disinflationary forces. One interesting chart shows the dynamics of long-term interest rates in Europe (i.e., Germany), Japan and the US. As you can see, German 10-Y yield used to be strongly correlated to the US 10-Y prior to the financial crisis; however, German 10-Y decoupled from the US 10-Y and has converged towards the Japanese 10-Y yield since then. Hence, some analysts have concluded that investors who have been trying to find value in Europe may experience a similar tragic scenario that investors chasing value in Japanese stocks in 1990 did. For instance, European banks have been trading at very low multiples according to a range of fair value metrics in the past cycle, similarly to Japanese banks in the 1990s. Goldman Sachs (NYSE:GS) recently showed (figure 2, right frame) that European banks’ share prices since the third quarter of 2008 have shown strong co-movement with the path of Japanese banks’ share prices since the last quarter of 1990. According to this chart, value investors in Europe may be trapped in this long-term negative spiral and not generate any return for the next 10 years despite cheap valuations.

Figure 2

Source: Eikon Reuters, Goldman Sachs

Even though we agree that it will be very difficult for Europe to normalize its policy rates back to their pre-crisis levels and get out of this disinflationary environment in the long run, we could see some good opportunities in 2020 if governments agree to relax fiscal conditions in order to reflate the economy in the short to medium run. We saw that fundamentals in Germany have been deteriorating sharply in the past two years with the manufacturing PMI collapsing by more than 20pts to 42.4, its lowest level in 10 years, as the German economy has been very sensitive to the rise in uncertainty around the world, plunging growth expectations. With leading economic indicators such as the ZEW or the IFO surveys still pricing in further deterioration in the economic activity within the next 6 months to come, the probability of Germany entering into a technical recession in the following quarters is important and may push German officials to intervene. Most of the economic slowdown in Europe has been attributed to the drastic deterioration of German economic indicators due to the high uncertainty impacting exports; figure 3 (left frame) shows that the industrial production differential between Germany and the rest of the euro area (ex-Germany) has never been so extreme in the past 25 years. Hence, with a debt-to-GDP ratio of 61%, Germany has room for fiscal stimulus and therefore loosening fiscal conditions could create some opportunities in value investing in 2020 (i.e., banks).

Figure 3

Source: Oxford Economics

Disclosure: I am/we are long EURGBP. 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.