Yesterday we presented a simplistic analysis of why for Japan "This Time Won't Be Different", a preliminary observation so far validated by the just announced Japanese December current account deficit which was not only nearly double the expected 144.2 billion yen, printing at some 264.1 billion yen, but was only the first back-to-back monthly current account deficit since 1985.
In short - at least in the first month of Abe's great reflation attempt, not only did trade post another whopper of a deficit, but so did the broader current account implying that much more Yen weakness will be needed to generate the structural reforms sought by the new Prime Minister.
But perhaps we are wrong and this time Abe will succeed where he, and so many others, have failed before. And, as is now widely understood, perhaps Japan will succeed in finally launching the necessary and sufficient currency war that would be part and parcel of Japans great reflation, as even various G-8 members have recently acknowledged.
The question is will it, and when?
One attempt at an answer comes from the fine folks at Bienville Capital who have compiled the definitive pros and cons presentation on what Japan must do, and how it will play out, at least if all goes according to plan.
What not even this presentation addresses is what happens if Japan is, in the end, successful in reflating, in the process beggaring all its neighbors, radically shifting the economic lay of the globe, and launching full blown currency war - far worse than anything seen to date, including the dark days of the 1930s.
Below are the highlights:
- Monetary policy in Japan is undergoing a monumental change. For the first time in Japan’s post-bubble era beginning in 1990, it appears policymakers intend to drive real interest rates into negative territory. As a result, we believe the yen could continue to weaken and that Japanese equities could be in the early stages of a powerful rally
- On October 30, 2012 the Bank of Japan and Ministry of Finance issued a joint statement entitled “Measures Aimed at Overcoming Deflation,” setting the stage for “powerful easing,” including what seems to be an explicit attempt to weaken the yen. On December 16th, 2012, Shinzo Abe was elected Prime Minister with a mandate to end deflation (i.e. to reflate the Japanese economy)
- Although Japan has struggled with a deflating economy for nearly two decades, the timing of these actions is not random. For a variety of idiosyncratic, macro and geopolitical reasons, the Japanese economy is faltering. Partly as a result of a strong yen, industrial production and business surveys have deteriorated, and the revenues of several national export champions have collapsed
- Due to negligible growth and deflation, the level of nominal GDP in Japan remains well below previous highs (Slide 4), a dangerous circumstance for an economy carrying the world’s largest sovereign debt burden. As history has proven, debt and deflation cannot coexist
- In return for failing to reflate the Japanese economy, the Bank of Japan is on the verge of losing its independence. At the behest of Abe, it seems likely the BOJ will confirm a new 2.0% inflation target on January 22nd. In April 2013, the BOJ’s ‘hawkish’ Governor, Masaaki Shirakawa, is set to retire, likely to be replaced with a far more ‘dovish’ candidate (Slide 5)
- In implementing monetary policy, the Bank of Japan is authorized to buy domestic and foreign assets, including equities and REITs (Slide 6). Achieving the 2% inflation target will prove difficult as domestic deflationary pressures remain. Wages, specifically, are contracting (Slide 7). Hence policy will need to be highly aggressive
- In recent years, although the BOJ has expanded its balance sheet (Slide 8), it has risen far less than other central banks since the financial crisis began (Slide 9)
- Regardless of whether the BOJ proves successful in achieving their inflation target, the expectation of aggressive policy can have a meaningful impact on the yen and Japanese equities, which remain at low levels compared to previous highs (Slide 10 & 11). Recently, equities have rallied and the yen has begun to weaken (Slide 12). But on a “real, trade-weighted basis,” the yen could fall another 20% before reaching the levels of 2007
- To be clear, the intention of the additional policy measures in Japan is to enlist the “portfolio balance channel”—that is, to drive “real” interest rates negative, forcing Japanese savers out of cash and bonds and into riskier assets (i.e. equities). The Federal Reserve has attempted this process twice recently: in 2003 and 2009 (Slide 13), both of which resulted in higher asset prices. By contrast, real interest rates in Japan have remained positive, benefitting bondholders (Slide 14). High real rates also encourages saving over consumption
- The 2003-2005 analog in Japan is interesting: monetary policy was aggressive, the BOJ’s balance sheet expanded by 25%, the yen weakened by 15% and Japanese equities rallied 125%. Of course this occurred during a period of global easing and reflation. In order to achieve today’s stated goals, the BOJ will need to be far more aggressive. For instance, in order to peg and maintain the Swiss Franc to the Euro at 1.20, the Swiss National Bank has expanded its balance sheet by 100% since August 2011
- We believe the primary risk to this theme is lack of policy follow-through—that is, policymakers fail to act to the degree they are currently suggesting, as has occurred in the past. We currently believe this risk is minimal given the determined and coordinated communications from policymakers, as well as key upcoming events (e.g. Upper House elections, etc.). However, lack of policy follow-through would invalidate the theme
- However, on a valuation basis, Japanese equities are relatively cheap (1.2x Price/Book versus 1.5x for other global indices) and yield 2.7%, more than 3x the yield from Japanese government bonds
- International mutual funds are also currently underweight Japanese equities. Goldman Sachs believes international mutual funds’ allocation to Japan is 4% below benchmark (MSCI EAFE). If portfolio managers feel pressure to “get to benchmark, ” some $60 billion could flow into Japanese equities (in addition to the estimated $20 billion of recent inflows
- Japan’s debt-to-GDP ratio is above 200%. Therefore, higher interest rates in Japan could be highly destabilizing. Today policymakers are undergoing a delicate balancing act: attempting to increase inflation and inflation expectations so that investors reallocate savings to riskier assets without causing nominal bond yields to rise. We are unsure of whether they can achieve this and continue to expect significant stress in the JGB market at some point. However, at the moment our focus has been to attempt to profit from a weakening yen and rising Japanese equities
- To be sure, these events have significant implications for the global economy. To weaken the yen, the BOJ needs to buy foreign assets, and given the size of the purchases required, the likely candidates would be US Dollar and Euro-denominated assets. Neither the US, nor Europe prefer to see a meaningful appreciation of their currencies
- A materially weaker yen also complicates the necessary global rebalancing process: the US and parts of Europe—i.e. current account deficit countries—need to move towards trade balance to achieve sustainable growth (i.e. a weaker USD and euro relative to some peers). By contrast, the surplus countries, notably China, Japan and Germany—the world’s 2nd, 3rd, and 4th largest economies—need to engineer more domestic demand, relying less on exports, or external demand, for growth. A policy-induced shift back towards export-led growth by the surplus countries would only rekindle the global imbalances that erupted in 2008
- Having virtually exhausted its ability to grow through investment, China is unlikely to sit idle as Japan weakens the yen, stealing external demand in the process
- Recently, the yen has weakened by nearly 20% versus the Korean won, one of Japan’s primary competitors, threatening Korean exports, which represent 50% of its economy
- In sum, aggressive actions by the BOJ could escalate into a full-fledged currency war. Investors should be monitoring these events closely
Full presentation: