Poor recovery exposes fragile health
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An overvalued yen, huge debt and high real interest rates hamper Japan’s economic recover—but the government supports growth and is pressurising the central bank to tackle deflation.
Japan’s economic recovery proved to be sluggish in 2009 by past standards. In more normal cycles, a sharp bounce in the Organisation for Economic Cooperation and Development leading indicators would have forced most asset allocators to overweight Japanese equities. Even experienced investors have been surprised by the way the market has underperformed its western counterparts and other Asian markets.
The economy has recovered, but not on the scale that it should have done. Real GDP growth was 4.8% for the third quarter of last year but was later revised down. While private inventory and net exports supported the numbers, there were some nasty revisions down to capital expenditure only weeks after the data was released and, more worryingly, the deflator was minus 2.6%.
”The Bank of Japan’s balance sheet has shown no growth since the collapse of Lehman Brothers”
The domestic economy is fragile and this was borne out by the Tankan survey of non-manufacturing Japan where sentiment is still sluggish. This is partly offset by better sentiment indicators within the manufacturing sector, such as automobiles and semiconductors. Some second-round effects are also arising, such as a pick-up in manufacturing, overtime hours worked and a fall in the unemployment rate. However, the speed of cyclical improvement is likely to slow as the inventory cycle and fiscal policy mature. The real focus will be on whether end demand really comes through. (article continues below)
Looking at the year ahead, we can be more confident that the drags on growth in 2009 might be alleviated, at least to a degree. The strength of the yen has crippled Japanese manufacturing and, as a consequence, domestic consumption. Having hit a 14-year high versus the dollar and strengthened by 40% against the Korean won, the Japanese currency looks overvalued. It is the combination of this higher yen, coupled with deflation that has meant real interest rates in Japan have been high relative to the rest of the world.
The yen has tracked American short rates, so either a change in American monetary policy or a move towards quantitative easing in Japan should weaken the yen significantly. We expect that Japan’s tight monetary conditions will ease this year, at a time when overseas policy stimulus is withdrawn.
Until December, the Bank of Japan had allowed current account balances to fall and also various programmes aimed at easing the corporate sector’s access to credit to end. However, the bank announced that it was making available another ¥10 trillion (£67 billion) of funding to keep the three-month rate at 10 basis points, and that it was also unwilling to tolerate the consumer price index below 1%.
Given we know that the deflator is extremely large it would seem premature, as most commentators have done, to write off the Bank of Japan’s chances of adopting quantitative easing. Japan has a history of changing policy in a series of incremental steps and an important one has been made already. At a time when most central banks have seen their balance sheets expand, the Bank of Japan’s balance sheet has shown no growth since the collapse of Lehman Brothers.
Apart from the yen’s strength, a massive surge in new domestic issues has unnerved the market. More than ¥2 trillion has been announced or come to the market, the largest of which was the $10 billion (£6 billion) deal in Mitsubishi Bank to bolster its core tier one ratio. This has been in conjunction with issues for Hitachi, NEC and T&D Life.
While more will be announced this month (particularly in the bank sector) these have become well-documented and any delays in implementing global bank regulations may mean issue sizes are somewhat smaller than feared.
With regard to Japanese politics, the stockmarket adhered to the mantra of “better to travel than to arrive” and has become disenchanted with the new Democratic Party (DPJ) led by Yukio Hatoyama. A government that is left-of-centre and redistributive has been interpreted by investors as another disaster for Japan incorporated.
The DPJ’s election was a big shift in the political landscape and it is still too early to consign the party to the scrapheap. The policies for supporting the economic recovery are only starting to emerge and have a meaningful impact on the real economy.
For instance, the recent ¥7 trillion supplementary budget will take effect this year. The new government has also been intensively lobbying the Bank of Japan to take action against deflation. With gross debt of 200% of GDP, debt markets will not give the government a lot of time to send the right signals to the market.
On earnings, we can expect a strong period for profit momentum versus western markets. Japanese companies slashed both fixed and variable costs in the first half of 2009. This cost-cutting will be of huge benefit if sales are revised up and the currency depreciates significantly.
