Published in the Financial Times 18/2/2013
Over the past three months it has become clear what Prime Minister Abe stands for – Awesomely Bullish Equities. Since he kicked off his successful election campaign in mid-November, Japan’s Nikkei Index has risen by 30%, recording the longest sequence of weekly gains since 1959.
Meanwhile the yen has fallen some 20%, an amount comparable to the decline in sterling after it was forced out of the European Exchange Rate Mechanism in 1992. Japan may be about to experience a similar boost to competitiveness as the UK did after “Black Wednesday.”
Blue chip exporters such as Toyota and Panasonic have already revised up their earnings forecasts and there should be further substantial gains ahead. For hard-pressed companies like Sharp and NEC, the risk of default (as measured by the CDS market) has plummeted.
Most satisfying of all, Japan’s government bond market has remained as serene as a zen garden. The five year yield has fallen to 0.13% and the ten year yield is hovering between 0.7% and 0.8%. This is despite rising inflationary expectations as reflected in the differential between yields on inflation-linked and ordinary bonds.
So Japan’s entire yield curve out to ten years now sits below the expected rate of inflation. The phenomenon has become familiar elsewhere in the world, but Japan has more potential for a “great rotation” out of bonds and into equities simply because of the starting point.
After twenty two years of bear market the existence of the equity risk premium is about as credible as the existence of the tooth fairy – which is why Japanese pension funds have just 12% of their assets in domestic equities, against 60% in bonds.
So far, so good. There has been little policy action, but the mere anticipation of a reflationary regime shift has been enough to do the trick. For further progress, however, investors will want reassurance that Mr. Abe is walking the talk.
Already he has quietly dropped his threat to give the 2% inflation target legal status, though that card can still be played if necessary. More worryingly, the joint statement issued by the government and the Bank of Japan suggests the two parties share responsibility for overcoming deflation. That gives too much scope for each to blame the other in the case of a policy stalemate.
A crucial moment for assessing the strength of Abenomics will be the imminent nomination of the central bank’s next governor and two deputies. Investors would like the new personnel to be committed reflationists who are also strong personalities and have good lines of communication with the prime minister and his advisors.
Some sensitivity and political skills will be required too. The triumvirate will have the job of changing the culture of a highly conservative institution seemingly in thrall to Keynes’ maxim that “it is better for reputation to fail conventionally than to succeed unconventionally.”
The main reason for optimism is the political dynamic. In June an election for the Upper House of Japan’s parliament is due. Mr. Abe is a well short of a majority there and will want to have some policy wins to his name . So far he has been one of the few Japanese leaders whose poll numbers have improved after winning an election. The only other within recent memory was Junichiro Koizumi, in 2005. It is no coincidence that 2005 was the last time that Japan experienced a rip-snorting bull market.
Mr. Abe will be only too aware that Japanese leaders can go from hero to zero at alarming speed. He did it himself during his first brief tenure in office. Five others followed him, all lasting a year or less as dismal economic conditions took a heavy toll on their popularity. Unless he delivers results, it could happen again.
Assume that the new leadership of the Bank of Japan is credibly committed to aggressive reflation. Assume that inflationary expectations continue to edge higher, keeping the yen weak. What are the implications for investors?
First, Japanese equities should make back some of their 30% underperformance relative to the world index since 2006. This process has hardly started yet, since the Abe bull market has merely kept track with Wall Street and Europe when expressed in common currency.
Second, government bond yields will have to rise at some point too. But judging by the experience of the US and the UK, central bank buying could keep real yields negative for a good while. That is, after all, one of the key policy levers.
Only when credit demand is reviving and Mr. Abe stands for A Brighter Economy will it be time to end the experiment. Until then, the markets will have the initiative.