Published in Financial Times 19/6/2013
I know it’s over and it never really began, but in my heart it was so real. You don’t need to be a fan of The Smiths to wonder if the recent vertiginous slump in the Topix Index marks the end of another in the long series of Japanese false dawns.
Yet surely it is much too early for the soil to be falling over the head of Abenomics. No stock market can carry on rising at the rate of 10% per month, as the Japanese market had done between mid-November and mid-May. No major currency can continue plummeting at the rate that the yen did over the same period. The reaction, when it came, had to match the dynamics of the preceding action.
According to Sir John Templeton bull markets are born in despair, grow amid scepticism, mature amid optimism and die amid euphoria. From the start there was precious little euphoria about Mr. Abe and his policies. One prestigious British magazine announced his election triumph in tones of the darkest foreboding, suggesting that the political stability of the entire region was imperilled. Some domestic commentary has been worse. Japan’s equivalent of The Sun has been splashing headlines about the “insanity” of Abenomics from day one.
Even within the investment community some viewed the sharp rise in shares and decline in the yen not as welcome signs of successful reflation, but as omens of disaster. Proponents of the “Abegeddon” thesis – which calls for an explosion in government bond yields and a currency collapse of Zimbabwean proportions – have been more vocal than ever.
Likewise, Mr. Abe’s “third arrow” structural reforms were dismissed as “disappointing” even though they cover a dizzying variety of issues – from encouraging more Japanese to study overseas to restructuring agriculture and doubling foreign direct investment – that no previous Japanese administration, nor any Western government has ever tackled simultaneously.
The stock market greeted Abenomics with unambiguous approval, but it is important to remember the depths to which it had sunk. Even now the Topix Index is flirting with 40 years lows relative to the S&P Index in common currency. If investors were to get as bullish about Mr. Abe as they were about ex-Prime Minister Koizumi, the Japanese market would need to outperform the US by 70% in dollar terms.
Already there are signs of life in the real economy – consumer confidence has soared to multi-year highs and profit momentum, almost uniquely in today’s world, is strongly positive- yet these improvements are fragile. If the recent correction in markets were to morph into a full-scale retracement, the wheels would come off Mr. Abe’s entire project.
The reason is that asset values are the key transmission mechanism for moving Japan from long, lingering balance sheet recession to potential balance sheet boom. If over the next two years the equity market returned to its levels of 2006-7 – not absurd as corporate earnings will achieve new highs this year – and real estate prices rose 15% and the yen stabilized in the 100-110 band, the total increase in the national “shareholders’ equity” would be equivalent to 100% of GDP. Japan’s net government debt is about 170% of GDP, so this would constitute a dramatic improvement. Capital losses in the bond market would be trivial in comparison.
If Japanese assets were overvalued , that would be a dangerous manoeuvre. However the Topix Index is barely above its 50 year moving average – meaning that someone who had been averaging into the market since the era of JFK and Mad Men would be sitting on a capital loss. And a recent OECD study concluded that Japanese house prices were the most undervalued in the 27 countries covered.
Furthermore the issue of inequality is much less serious in Japan than in the US or UK. Thanks to twenty four years of severe bear market, wealthy Japanese are underinvested in risk assets like everyone else.
So what should be done? Whatever it takes, is the answer. Far from Abegeddon erupting, inflationary expectations are subsiding and the problem remains yen strength, not weakness. In other words, the markets are questioning whether the Bank of Japan has done enough. The solution is to be more aggressive. This can be done by front-loading the schedule for bond purchases or by buying substantial amounts of Topix ETFs, a policy initiated by the BoJ’s ultra-conservative former governor, Masaaki Shirakawa.
To adapt The Smiths again, an economy in deflationary stagnation is a bit like a girlfriend in a coma. It’s really serious. Strong medicine is needed for the patient to pull through.
Reference: I know It’s Over (Johnny Marr/ Steven Morrissey), Girlfriend in a Coma (Johnny Marr/ Steven Morrissey).