Japan's Attempted Reflation (January 2013)

7/29/2019 Japan's Attempted Reflation (January 2013)

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CONFIDENTIAL

JAPANS ATTEMPTED REFLATIONJANUARY 2013

Prepared by:

M. Cullen Thompson, CFAPresident & Chief Investment [email protected]

Blake BennettAnalyst

[email protected]


2/18

Investing in an Unbalanced World| 2

CONFIDENTIAL

Summary

Monetary policy in Japan is undergoing a monumental change. For the first time in Japans post-bubble era beginning in 1990, it appearspolicymakers intend to drive real interest rates into negative territory. As a result, we believe the yen could continue to weaken and thatJapanese 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 16 th, 2012, Shinzo Abewas 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 ofidiosyncratic, macro and geopolitical reasons, the Japanese economy is faltering. Partly as a result of a strong yen, industrial production andbusiness 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 dangerouscircumstance for an economy carrying the worlds 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, itseems likely the BOJ will confirm a new 2.0% inflation target on January 22 nd. In April 2013, the BOJs hawkish Governor, MasaakiShirakawa, 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 (Slide7). 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 financialcrisis began (Slide 9)

Regardless of whether the BOJ proves successful in achieving their inflation target, the expectation of aggressive policy can have ameaningful 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% beforereaching the levels of 2007

To be clear, the intention of the additional policy measures in Japan is to enlist the portfolio balance channelthat is, to drive realinterest rates negative, forcing Japanese savers out of cash and bonds and into riskier assets (i.e. equities). The Federal Reserve has attemptedthis process twice recently: in 2003 and 2009 (Slide 13), both of which resulted in higher asset prices. By contrast, real interest rates in Japanhave 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 BOJs balance sheet expanded by 25%, the yen weakened by15% and Japanese equities rallied 125%. Of course this occurred during a period of global easing and reflation. In order to achieve todaysstated 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, theSwiss National Bank has expanded its balance sheet by 100% since August 2011

* http://www.boj.or.jp/en/announcements/release_2012/k121030b.pdf

Japans Attempted Reflation


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CONFIDENTIAL

We believe the primary risk to this theme is lack of policy follow-throughthat is, policymakers fail to act to the degree they arecurrently suggesting, as has occurred in the past. We currently believe this risk is minimal given the determined and coordinatedcommunications 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 fundsallocation to Japan is 4% below benchmark (MSCI EAFE). If portfolio managers feel pressure to get to benchmark, some $60 billion couldflow into Japanese equities (in addition to the estimated $20 billion of recent inflows)

Japans debt-to-GDP ratio is above 200%. Therefore, higher interest rates in Japan could be highly destabilizing. Today policymakers areundergoing a delicate balancing act: attempting to increase inflation and inflation expectations so that investors reallocate savings to riskierassets without causing nominal bond yields to rise. We are unsure of whether they can achieve this and continue to expect significant stress inthe JGB market at some point. However, at the moment our focus has been to attempt to profit from a weakening yen and rising Japaneseequities

To be sure, these events have significant implications for the global economy. To weaken the yen, the BOJ needs to buy foreign assets, andgiven the size of the purchases required, the likely candidates would be US Dollar and Euro-denominated assets. Neither the US, nor Europeprefer to see a meaningful appreciation of their currencies

A materially weaker yen also complicates the necessary global rebalancing process: the US and parts of Europei.e. current account deficitcountriesneed 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 Germanythe worlds 2nd

, 3rd

, and 4th

largest economiesneed to engineer moredomestic demand, relying less on exports, or external demand, for growth. A policy-induced shift back towards export-led growth by thesurplus 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 externaldemand in the process

Recently, the yen has weakened by nearly 20% versus the Korean won, one of Japans primary competitors, threatening Korean exports, whichrepresent 50% of its economy

In sum, aggressive actions by the BOJ could escalate into a full-fledged currency war. Investors should be monitoring these eventsclosely


Summary


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CONFIDENTIAL

In nominal terms, economic activity in Japan is below the level of the mid-1990s, representing a potential disaster

for a country with Japans growing debt burden and declining population


450,000

460,000

470,000

480,000

490,000

500,000

510,000

520,000

530,000

Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12

Japan Nominal GDP(in yen)

Source: Bloomberg, Bienville Capital Management, LLC


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CONFIDENTIAL

Therefore, the newly-elected Abe administration has embarked on a national mandate to generate inflation and

higher nominal GDP growth. As a consequence, the Bank of Japans independence appears to be in jeopardy


The Japan Times, January 14, 2012

Prime Minister Shinzo Abe said Sunday that his government will set a medium-term 2 percent inflation targetwith the Bank of Japan in a joint statement expected later this month to help shore up the recession-hit economy.

"What will be important is properly including the price goal of 2 percent," Abe said during a program on NHK inhis latest move to pressure the central bank to be more aggressive in combatting the country's chronic deflationahead of its next monetary policy meeting on Jan. 21 and 22.

Abe said the BOJ's current goal of 1 percent inflation lacks "strong determination" and that the government andcentral bank will come up with "a definite goal and write that it will be 2 percent."

Abe claimed the new target needs to be achieved under a medium-term scenario rather than a long-term one orfinancial markets "will not react."

The prime minister said he believes the next BOJ governor, who will replace Masaaki Shirakawa when his tenureends in April, should be someone who can take "bold monetary steps and is in line with our points."


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CONFIDENTIAL

To generate higher inflation and a weaker yen, the Bank of Japan will have to be highly aggressive. Fortunately it

has a lot of options at its disposal, more so than other central banks


Source: Bank of Japan; Federal Reserve; ECB; BOE; Jefferies; Bienville Capital Management, LLC

Eligible Assets to Purchase Federal Reserve European Central Bank Bank of England Bank of Japan

Government Bonds (Domestic)

Government BondsInternational)

Mortgage-Backed SecuritiesRMBS)

Asset-Backed Securities (ABS)

Corporate Bonds (Domestic)

Equities

Commercial Paper

REITs


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CONFIDENTIAL

Wages continue to deflate, depressing domestic inflation and suggesting the 2% inflation target will be difficult to

achieve. To engineer both inflation and growth for its export-oriented economy, policymakers are focusing on thetrade channel, i.e. a weaker yen. However imports represent less than 20% of Japans economy, meaning the inflationfrom imports, which includes natural resources, would have to overwhelm the entrenched domestic deflation withoutharming consumption


-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06 Mar-09 Mar-12

Japan Average Monthly Earnings(in %)



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Although the Bank of Japans balance sheet has been expanding over the past few years



90,000

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140,000

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170,000

Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12

Bank of Japan - Total Assets(in billion yen)


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CONFIDENTIAL

its aggressiveness pails in comparison to other central banks since the onset of the financial crisis.



50

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Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12

Growth of Central Bank Balance Sheets(January 2008 = 100)

FED BOJ SNB BOE ECB

SNB: +326%

BOE: +306%

FED: +214%

ECB: +134%

BOJ: +48%


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CONFIDENTIAL

The Nikkei remains more than 70% below 1989s bubble highs



5,000

10,000

15,000

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45,000

Nov-86 Nov-91 Nov-96 Nov-01 Nov-06 Nov-11

Nikkei 225 Index


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CONFIDENTIAL

and 40% below 2007s levels. By contrast, thanks to aggressive monetary stimulus which drove real rates

negative, US equities are approaching all-time highs.



600

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1600

6,000

8,000

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Oct-00 Oct-01 Oct-02 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12

Nikkei 225 vs. S&P 500(Index)

Nikkei 225 S&P 500


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CONFIDENTIAL

The dollar-yen exchange rate has broken a long-term trend and appears to be moving towards 100, a level that

would please both Japanese policymakers and export-oriented companies



70

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100

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130

Jan-05 Jul-06 Jan-08 Jul-09 Jan-11 Jul-12

Japanese Yen(Spot)


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CONFIDENTIAL

On a real, trade-weighted basis, which accounts for the deflation of wages in Japan, the yen could fall another 20%

before reaching the lows of 2007



60

80

100

120

140

160

Dec-94 Jun-96 Dec-97 Jun-99 Dec-00 Jun-02 Dec-03 Jun-05 Dec-06 Jun-08 Dec-09 Jun-11 Dec-12

Japanese Yen(Real Effective Trade-Weighted Exchange Rate)


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CONFIDENTIAL

Negative real interest rates in the US have caused significant rallies in risk assets (i.e. the portfolio balance

channel). In 2003, both equities and real estate rallied. In 2009, negative real interest rates and QE have causedequities to rally again



600

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1300

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1600

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

Mar-00 Sep-01 Mar-03 Sep-04 Mar-06 Sep-07 Mar-09 Sep-10 Mar-12

US Real Interest Rates vs. S&P 500(2-Year Treasury - CPI)

US Real Rates (LS) S&P 500 (RS)

+102%

+117%


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CONFIDENTIAL

By contrast, real interest rates in Japan have remained largely positive, encouraging savers to place the vast savings

in cash and Japanese government bonds (JGBs). If inflation rose, real rates would turn negative, inspiring savers tomove out on the risk spectrum



-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

Mar-00 Sep-01 Mar-03 Sep-04 Mar-06 Sep-07 Mar-09 Sep-10 Mar-12

Japan & US Real Interest Rates(2-Year Government Bond - CPI)

Japan Real Rates US Real Rates

Japanese realrates remain

positive

whereasreal rates inthe US are

negative


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CONFIDENTIAL

During the last material monetary easing (i.e. 2003 2005), which did coincide with a global reflation effort, the

Bank of Japans assets expanded by 25%, which helped to weaken the yen by 15%



100,000

110,000

120,000

130,000

140,000

150,000

160,000

Dec-02 Dec-03 Dec-04 Dec-05 Dec-06

Bank of Japan - Total Assets(in billion yen)

+25%


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CONFIDENTIAL

while the Nikkei rallied by over 100% (before declining 60% during the financial crisis).



6,000

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Oct-00 Oct-01 Oct-02 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12

Nikkei 225(Index)

+130%


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CONFIDENTIAL

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Japan's Attempted Reflation (January 2013)

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