Thursday, 18 July 2013

Abenomics selling well

Japanese department store sales, released this morning, were extremely strong.  Once we have smoothed out the influence of the 2011 Tōhoku earthquake and Asian Financial Crisis, we find department store sales are growing at their fastest pace since records began in the early 1990s.  This underlines the conclusions of our recent asset allocation meeting, that the resilience of Japanese consumers gives Abenomics an increasing chance of success.
Source: Ministry of International Affairs & Communications, Bank of Japan
Abenomics, the policy agenda designed to bolster the moribund Japanese economy, comprises three arrows of which the sharpest so far seems to be monetary.  With a full quarter having elapsed since the new monetary arrow was unleashed the results are promising.  The policy centres on a planned doubling of the monetary base in pursuit of a 2% inflation target.  We’ll look at what impact those have in due course but first it is worth discussing what it is that ails Japan. 

There are several causes of Japan’s travails.  The banking system was not purged of non-performing loans until the Koizumi reforms of 2002.  Bank lending had hitherto been shrinking and thereafter began to accelerate, before being stopped in its tracks by the financial crisis and then earthquake/tsunami.  Since then, the recovery in bank lending had begun once more, Japanese banks being uninhibited by bad debts from this particular crisis.  By this point, however, Japan had already gained a new problem: the strong yen.

Before the 2008/09 financial crisis, a brief bull market in Japanese shares had been characterised by the short yen/long dollar carry trade.  This took advantage of an ever-expanding interest rate differential as high commodity prices created inflationary pressures around the world (particularly in the West).  The capital account deficit, created by yield-hunting domestic investors and carry traders, even prompted the Bank of Japan to raise interest rates in response to tentatively rising inflation.
Throughout the financial crisis, however, moments of risk aversion were always characterised by a rising yen, as traders shrank balance sheets.  Once the financial crisis began in July 2007 this accelerated, never truly recovering.  That marked the peak for the US dollar/yen exchange rate.  Thereafter, it became a one-way street of yen appreciation, especially once, in 2008, the interest rate differentials were eliminated.

Over the long term, as you might expect, there is a pretty tight relationship between the value of the yen and Japanese inflation.  The moments in which the relationship breaks down are characterised by high energy price inflation.  Indeed, in the post-financial crisis years, the yen was so strong that we would have expected it to cause even more severe deflation were it not for the fact that energy prices were still rising at 5% per annum.

That, of course, was the result of Japan’s decisions to turn off all its nuclear power stations following the Fukushima nuclear accident.  The combination of a strong yen and higher energy costs were enough to start hurting Japanese trade.

Just as the yen is intuitively negatively-correlated with consumer price inflation, so it is also negatively-correlated with the current account surplus.  In fact, a weak yen ought to bring about an expansion of the current account with a lag of around 18 months.  The very peak for the yen was 75 to the dollar in November 2011, although the most meaningful depreciation only began eight months ago.  On balance, it looks like the current account surplus should start expanding meaningfully pretty soon.
One of our concerns has therefore been: what happens when Japanese exports start booming again?  The answer would usually be that the yen appreciates.  The challenge for Abenomics is to keep the yen weak, keep Japanese exports competitive and bolster demand at home.  The means to achieve this come through the three arrows: a fiscal injection, supply-side reforms to bolster competitiveness and monetary policies in pursuit of the 2% inflation target.

Pursuit of the inflation target is something of a chicken and egg problem. If you generate inflation of 2% then interest rates will be negative and the yen will weaken.  But it is hard to see how the inflation target can be reached without an on-going weakening of the yen.  As Sir Mervyn King used to say about UK inflation, a devaluation causes a step change in prices not a change in the rate of inflation. We were also concerned that the Japanese nerve might buckle as energy and food costs rose whilst wages lagged the rally.  The answer to these concerns comes in the form of one of the most unconventional policies of the lot: telling companies to pay more.

The Ministry of Finance announced it had asked the Japanese business federation, the Keidanren, to tell members to raise wages.  We were fairly sceptical about their willingness to do so as import costs would be weighing on margins already but, evidence suggests, they have been doing this.  Will wage increases be enough to assuage the famously impatient Japanese electorate?

Six months into his current tenure Abe will be watching the polls carefully.  This is the point at which most of his predecessors began to lose popularity.  Abe’s approval ratings have been dropping from a record 76% to below 60% according to some polls.  The recovery in the equity market will presumably help those heady heights to be achieved once more.  Abe was still the most popular of Japan’s last eight prime ministers at the six-month stage. That leaves many of the criticisms of Abenomics rebuffed.  Indeed, not only is the yen weakening but, almost implausibly, the latest money supply data seems to imply that all breadths of money supply are expanding.

What concerns could still remain about Abenomics? The root cause of Japan’s economic malaise must still be considered to be demographics.  Without immigration reform, which the conservative and nationalist Abe will absolutely not promote, the crippling worker-to-dependent ratio will continue to decline.  Savings and investment track this ratio closely and both seem set to continue to decline.  Consumption may expand its share of GDP but it will struggle to achieve absolute expansion which leaves trade as the only barrier to a somewhat inevitable contraction in GDP over the long term.  Beggar they neighbour policies are unlikely to be tolerated forever by Japan’s neighbours.  In the medium-term, however, we remain optimistic on Japan’s ability to generate positive returns.
Guy Foster, Head of Portfolio Strategy

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