Is Mrs Watanabe finally preparing to open her purse?
Ever since Japan’s economic bubble burst in 1989, the country’s conservative mom-and-pop investors (who are often colloquially and collectively referred to in the media by the Watanabe moniker) have mainly placed their cash savings in bank deposits. It’s been a sound choice, as the country’s deflation has meant that the value of their savings rose even as it collected virtually no returns in the bank.
In contrast Mrs Watanabe has largely avoided Japanese equity or corporate bonds for more than a decade, put off by uninspiring corporate profits and equity-market performance, although households account for ¥27 trillion (US$275 billion) of the Japanese Government Bond (JGB) market.
But on April 4 this predictable market dynamic underwent a dramatic upheaval, courtesy of Bank of Japan (BoJ) governor Haruhiko Kuroda.
The governor was appointed in late March by prime minister Shinzo Abe as part of the latter’s over-arching strategy to boost Japan’s economy by re-introducing inflation. True to this vision, Kuroda announced an unprecedented quantitative easing effort, in which the BoJ will purchase ¥7.5 trillion (US$77 billion) worth of JGBs, or roughly 70% of anticipated annual issuance per month from May, up from previous plans to buy ¥3.8 trillion. To top it off, the central bank intends to double investments into exchange-traded funds and real-estate investment trusts to ¥2 billion and ¥60 billion, respectively.
Kuroda is essentially betting that the JGB buying will lead institutional investor funds to buy more stocks and corporate bonds, in turn luring Japanese retail investors to spend some of their savings on Japanese equities and other higher-yielding assets. This would stimulate investment and consumption, and help achieve Kuroda’s stated 2% inflation target by 2014.
The announcement certainly had an immediate impact. Hot money surged into Japanese equities, sending the Nikkei-225 Index above 13,000 for the first time since 2008; as of April 29 it was 14% higher since the announcement. Over the same period, the yen weakened from ¥92 on April 4 to as much as ¥99.9 – in addition to the 20% it had already dropped over the past six months. This helped the stocks of core Japanese exporters to soar at least 10% from the month before. Shares of Toyota Motor and Honda Motor are up 74% and 42% respectively in the past year.
The yields of US Treasuries and European government bonds have similarly dropped over expectations that Japanese funds will quickly seek higher-yielding assets outside the country. Hong Kong-based fixed income traders said they’ve witnessed increased flows into US Treasuries and South Korean bank bonds.
Investment banks and asset managers believe that this is just the beginning. Nikko Asset Management says the Nikkei-225 Index is well on its way to 20,000, while UBS’s wealth management arm said in a May monthly newsletter that it is switching its stance to overweight on Japanese equities by reducing emerging-market equities to neutral. Credit Suisse says it is raising emphasis on Japanese equities further from 6% to 16% overweight. Nomura has revised its forecast for the Nikkei to reach 16,000 from 14,500 and the Tokyo Stock Price Index (Topix) to increase from 1,200 to 1,350 by year-end.
But is Mrs Watanabe truly ready to buy the sort of assets she has avoided for so long?
Most of the improvement in Japanese assets to date can be attributed to foreign investors. Convincing local retail investors to join in will require more fundamental changes. The government has two years to conduct structural reform in industry sectors and the labour market. At the same time the central bank must keep JGB yields low and the yen weak to improve corporate profits.
Standard & Poor’s isn’t yet a fan of the heralded Japanese renaissance. It said on April 23 that it had only been able to tick off monetary easing as a meaningful move by the government to end deflation, and that without broader successes there was a 33% probability that it would downgrade the sovereign rating.
Abe needs to combine financial stability with structural reforms if conservative Japanese households are going to be convinced to both spend and invest their money once more. It’s a tall order.
Breaking the vicious cycle
Mrs Watanabe’s extreme caution about investing is down to two decades of bitter experience.
Japan’s surplus savings have grown since the mid-1970s, but they rapidly increased after the bubble burst as aging baby boomers stashed their cash away in the most conservative of assets. Consumer demand stagnated, which hurt Japanese corporate earnings and fostered weak economic growth, causing deflation. This ongoing problem caused price-earnings ratios in Japan to sink to one of the lowest levels among developed economies, due to weak returns on equity.
This only reinforced the preference of investors for keeping their savings in bank accounts.
“Under the deflationary period, investors do not have to invest in any risky assets because cash is king,” says Hiroki Tsujimura, chief investment officer for Nikko Asset Management.
Abe has a three-pronged approach to pop investors out of this vicious cycle: aggressive monetary policy courtesy of Kuroda; borrowing even more money to spend more than US$2.4 trillion on public works stimulus over the next 10 years; and structural reforms.
One of the most high-profile segments of this is the Trans-Pacific Partnership, a free-trade agreement being negotiated between the US, Australia, Brunei, Canada, Chile, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam, which is aimed at slashing agricultural import tariffs and boosting consumption.
Abe also plans to encourage more women to enter the workforce by improving childcare policies, in an effort to counteract a population that has declined 6% over the past decade, which is a major culprit for slowing growth. Other structural reforms include overhauling regulations in healthcare, energy and the environment, and loosening protection of full-time workers to increase labour-market flexibility.
The three-pronged approach can be effective because it demonstrates the depth of the country’s resolve to eliminate deflation. The strategy has already boosted business sentiment in Japan more than previous attempts during the administration of Junichiro Koizumi, Japan’s last reform-minded prime minister who left office in 2006, and also the last premier to enjoy power for over a year.
“[Abe’s three-pronged strategy] seems to have had a more immediate impact on sentiment and that sentiment is leading to more activity,” according to Gary Dugan, chief investment officer at Coutts. “It’s tentative but we are starting to see an improvement in retail sales, an improvement in inflation expectations. Again this is just in a couple of months but it’s quite a remarkable difference from previous packages which people remained very sceptical about and therefore ran out of steam in about 18 months.”
The public appears to have bought into Abe’s vision, as demonstrated by his 70% approval rating. And now that stagnant assets will lose value, Abe and Kuroda are hoping that will flush investor cash out of bank deposits.
“As inflation expectations rise, some Japanese investors will change to prepare for future inflation. About 60% of the cash is held by the people who have experienced inflation and asset bubbles in the past. So it is not surprising that retail cash deposits will move to risk assets,” says Tsujimura.Fundamental focus
Improving business sentiment would help lure more retail investors to invest more of their assets (56% of which Credit Suisse estimates to currently be in cash) into Japanese stocks. Meanwhile inflation expectations should prompt banks and life insurers, who hold nearly 60% of outstanding JGBs, out of these low-yielding bonds.
“The JGB looks very, very unattractive as our investment objective,” says Yukichi Itakura, executive deputy president for Tokyo-based Sumitomo Mitsui Asset Management Company. “It has such a low yield and there is the risk of interest rates going up. There might be some fear of sovereign debt issues as well. JGBs have been sort of a risk-free asset and now the asset is full of risk.”
Bank deposits would also lose their lustre if Kuroda can stir some embers of inflation in Japan’s long-cold economy.
But Japanese investors will be cautious as they make their return to risky assets. Itakura says although he has never witnessed such a heightened feeling of elation over potential returns in his entire investment career, Japan’s investors are entering uncharted territory.
“People welcomed the aggressive easing but at the same time we don’t know to what extent they can do [it] and how the market can react,” he says.
For individuals who have kept their money away from risky assets, a concoction of excitement and financial uncertainty could be the wrong brew at a time when the government is trying to encourage ultra-cautious investors to take on more risk. And with JGB yields still finding fair value, investors could find it difficult to balance risk in their portfolios due to a lack of safe-haven assets to fall back on.
This is likely to mean that investors will rely heavily on indications of genuine improvement in Japan’s companies and the overall economy before they decide that it’s worth buying equities in particular.Managing JGB volatility
Retail investors are likely to keep a gimlet eye on any signs of improving corporate margins and rising consumption levels.
In theory, the former shouldn’t be a problem. The central bank’s determination to keep interest rates ultra-low while buoying asset prices with its quantitative easing and purchases of exchange-traded funds (ETFs) should make it cheaper for companies to borrow to fund their operations and make further investments.
But this requires a stable market, and right now the JGB market is anything but. The BoJ’s bond buying announcements on April 4 caused widespread confusion in the market, which ironically widened JGB spreads amid a period of record volatility. Intraday yields on the 10-year benchmark rose as much as 30 basis points to 0.6% on April 5.
The BoJ revised its bond buying plans on April 18 by smoothing out purchasing to ease price swings and JGB yield swings moderated towards the end of the month. Strategists such as Yusuke Ikawa from RBS say the BoJ’s revamped bond purchases will eventually push the 10-year yield to 0.4% in the next one to two months, but thinner liquidity and shifting expectations on inflation will leave JGBs vulnerable to sudden spikes in yields.
Heightened volatility prompted Nippon Life Insurance, Japan’s largest life insurer, to slow its purchase of domestic bonds for the next year. Hiroshi Ozeki, general manager in the finance and investment planning department, was cited in an April 22 Reuters article as saying the asset manager may shift into hedged foreign bonds of developed nations that have high liquidity. He expects yields on 10-year JGBs to rise as much as 0.9%.
Life insurance companies are also likely to lower their holdings of JGBs by as much as 3% and switch to foreign bonds, or the equivalent of up to US$100 billion over the next two years, according to an April 17 Morgan Stanley report. If this is the case, individual investors will probably follow suit.
Even signs of a successful BoJ drive towards inflation could raise bond-market volatility.
“We need more time to believe the BoJ’s target,” says Ikawa. “If the BoJ successfully hikes our inflation expectations, then the [JGB] market volatility should increase because the JGB yields are too low if inflation were to reach 2% in two years.”
Investors are also uncertain about whether the BoJ will maintain its bond-purchasing plans once inflation reaches 2%. Such uncertainties make it challenging for companies to calculate their borrowing costs, which could slow their pace of expansion.
With steepening pressure increasing due to the BoJ’s monetary easing plans, many companies are likely to wait until they have a firmer idea of the cost of interest before deciding whether or not to borrow. As a result, their margins are unlikely to shift much.
In addition to bond-market volatility, some companies may struggle courtesy of the weakening yen. A weaker currency raises the cost of commodities, which are typically priced in US dollars. And Japan is a major importer of many commodities. Companies such as Fast Retailing, which outsources a lot of manufacturing and labour to places like China, will also feel the pain.
“Fast Retailing imports roughly ¥400 billion of product per year overseas. As the yen weakens by 20%-30% versus an appreciating renminbi over the last six months, that is likely to have over time a significant impact on their costs,” says a Tokyo-based consumer analyst. “They have a choice. They could either absorb it or pass it on.”
The danger is that companies passing on rising costs to the consumer end up raising inflation to 2% far quicker than the BoJ’s two-year goal, and well before market confidence has resurfaced.Show me hard evidence
While bond markets remain choppy, the feel-good factor of Abe’s new administration does appear to be having a more positive effect on consumption in Japan.
Consumption accounts for more than 50% of GDP, and it rose 0.4% in three months to December last year, although overall GDP fell an annualised 0.4% quarter on quarter.
The rise is encouraging, but it needs to improve over a long period if it is to sustain inflation in a measured manner even after the BoJ’s easing ends. And such a sustained increase in consumption would require some fundamental changes in the economy.
Some of Abe’s stated structural reforms indicate that he is aware of the need for change. Women who begin working as a result of improved childcare support, for example, would increase household incomes and offer more disposable cash to buy products.
But the government must conduct more fundamental reforms to cut household living costs. Japan’s energy sector is dominated by regional utilities that have no competition for power generation, transmission and distribution; if Abe’s administration can introduce such competition it would lower electricity tariffs. Joining the Trans-Pacific Partnership would similarly cut the costs of imported food. Meanwhile enormous amounts of red tape needs to be cut in Japan’s healthcare industry, or healthcare costs in one of the world’s fastest-aging populations will badly dent meagre economic growth.
Such reforms will take time and prove unpopular with the companies that have comfortably enjoyed the status quo for decades. But if Abe can address these issues they will cut living costs for the Japanese, allowing them to spend more on cars and goods. That would bolster consumption figures and convince investors of a positive fundamental change in the economy, helping reassure them that it makes sense to buy Japanese assets.
“The key issue for Abenomics to be successful is to create, let’s argue, 1% GDP growth and 2% inflation for the next five years in Japan. That’s really breaking out of the deflationary tendencies,” says Andrew Milligan, chief global strategist at Standard Life Investments.
He believes that wages must rise at least at the pace of inflation, while the government needs to forge meaningful trade agreements to compensate for uncertainties such as consumer demand from China, which is often affected by political spats between the two countries.
Japan also needs to enhance immigration laws and encourage its citizens to have more children to stem the pace of population decline.
“You’ve got to have the market believe that you’re into a sustainable improvement in growth and you’ve created inflation,” says Dugan. “I don’t think there is any way that Japan can sustain growth and inflation if its population is shrinking.”
Just the beginning
Prime minister Abe and the BoJ’s Kuroda have set out on the right track to address Japan’s persistent deflation and revive economic growth. But retail investors have been let down one too many times when it comes to political efforts to rekindle the economy.
“Abenomics has done a very good job in raising expectations for Japanese GDP for 2013 and 2014 in contrast to a slow Europe and a decelerating China,” says Milligan. “But this is only a one- to two-year cycle, not yet a permanent shift.”
For improving confidence in Japan to stick, Abe needs to introduce some controversial reforms that maintain the good work done over the short term. He and his government must take advantage of strongly favourable public sentiment to push recalcitrant counterparts on difficult negotiations to achieve difficult reforms.
A lot of work must be done, including confronting politicians who are reluctant to disappoint powerful backers, bureaucrats who benefit from the current systems, and companies that have to vastly change their way of business.
The BoJ must maintain a similarly rigorous devotion to its watch of the financial markets. It will need to maintain close contact with JGB traders and other market participants to alleviate sudden spikes in asset prices, and offer as much detail as possible about its market operations in order for investors to best position themselves for the flow of changes in the JGB market, and minimise volatility in this market.
Abe and Kuroda have initiated some much-needed changes to Japan’s economy. But these should be regarded as a first step, not the entire journey. The government will have to show that it is prepared to seriously address Japan’s longstanding problems before Mrs Watanabe proves consistently willing to reach into her purse.