Over the past weeks, we saw extreme volatility in Japanese equities and investors raised questions about whether we have seen the best already from the Nikkei.¹ Do we still have faith in 'Abenomics'?
Stock Market Volatility Is Up
Nikkei 225 Average, 11 Jun. 2012 – 11 Jun. 2013
Sources: FactSet; Allianz Global Investors.
The volatility in the market was first explained by the rise in Japanese government bond (JGB) yields and general profit-taking led by the high participation of retail investors.
The global bond market has been going through a correction in recent weeks. There are concerns that bond yields will continue to move higher and that the rally we have seen in risk markets will be derailed. However, we should put the fall in bond prices in its proper perspective. US bond yields have only recovered to levels last seen early this year and they are still well below their 2011 highs.
We believe US Treasury yields may have limited room to rise in the shorter term. The US government's borrowing requirements continue to decline and new bond issuance is falling short of Fed² bond purchases. However, as we enter into the next year, the outlook for bonds may not look rosy as bond yields should eventually converge to nominal GDP³ growth, which is around 3 per cent to 4 per cent for the US. Global growth is likely to rebound toward the latter part of the year. Lower commodities prices are positive for consumers and we have seen a recent sharp rebound in US consumer confidence. Most European governments are relaxing on fiscal tightening, and the latest news is that the EU4
just granted France and Spain two more years to bring their fiscal deficits in line.
Worries that the Fed may begin to slow its aggressive stimulus efforts also sent bond yields higher. We believe the money-printing presses will run longer than most investors suspect. The main reason why central bankers in developed economies are pursuing quantitative easing is to short-circuit a deflationary cycle, and in doing so avoid their economies falling into recession. And they need to create inflation. This will not happen unless the velocity of money in their economies begins to pick up. We have yet to see any recovery in the money velocity. Without a pick up in velocity of money, inflation will be hard to come by.
As far as the JGB is concerned, the recent spike in yields should not be seen as the start of a crisis. It may reflect heightened speculative activity by leveraged players in a relatively illiquid market. Most of the jump in JGBs is in real yield due to the elevation of inflation expectations.
Yields Have Increased on Inflation Expectations
Japanese Government Bonds (10-Year Yields), 11 Jun. 2012 – 11 Jun. 2013
Tullett Prebon Information; Allianz Global Investors.
The fact that the BOJ5
is trying to double its monetary base and raise the inflation rate to 2 per cent should have unsettled bond investors in the first place. Indeed, we could argue that Japanese yields will need to rise in order to encourage banks to lend and reflate the economy.
Yields are expected to pose lower volatility in the coming months as the BOJ continues to fine-tune its buying operations. The BOJ plans to have more frequent operations and to purchase smaller amounts each time to allow dealers to manage their inventories better.
Over time, JGB yields should move higher as the economy gathers momentum. Bank lending in Japan rose 2 per cent in April YoY6
, the largest percentage gain since July 2009. Recent reports have shown that banks have increased lending for M&As7
, real estate and natural resources transactions, though loans to small and medium-size companies have remained sluggish. Unlike in the 1990s, when Japanese banks were saddled with huge piles of non-performing loans, banks now have the capital to expand lending and are in a more resilient position to resist external shocks. The housing market has also shown signs of recovery. Housing starts rose 7 per cent in March YoY, the seventh consecutive month of higher figures. The higher demand in property has started to translate into gains in property values, particularly in Tokyo.
It is possible that the efforts by Abe8
could lead to the bursting of the Japanese bond market bubble; but we should note that the ownership of the market in Japan is different from other countries which experienced debt turmoil. In Japan, less than 10 per cent of its debt is held by foreigners, whereas in the US Treasury market, for example, the figure is over 50 per cent. In essence, Japan is undertaking financial repression – the BOJ is keeping nominal rates low but also allows the inflation rate to rise so that real rates are negative. Over time the real government borrowing costs are reduced and the public debt will be lowered as a percentage of nominal GDP.
For Abenomics to work, Japan's government has to pursue reforms to further deregulate the market and to resolve the structural deficiencies of the country. Some of the reforms should include incentives for companies to actively employ a female workforce. The government is expected to promote consolidation in the industrial sector to introduce competitiveness in the industry. The agricultural sector is uncompetitive and is overdue for reform. To strengthen corporate governance, the government is expected to propose new stockmarket guidelines mandating listed companies to have at least one independent director.
Corporate profits have improved mainly as a result of the depreciation of the currency. The yen depreciation has two main effects on corporate earnings. First, revenue earned overseas translated in yen terms will be worth more. The second benefit is that Japanese companies should become more competitive and therefore should boost sales volumes. However, not all exporters will be able to take advantage. For example, Canon faces fundamental problems on its core digital-camera business due to the fact that amateur photographers can now take pictures with increasingly high-resolution smart phones.
As for the stock markets, the P/E10
spread between Japan and the US has narrowed to parity (at 15x P/E). Japan should deliver better earnings growth as it has hit the trough cycle, whereas the US is more at the top of the cycle.
Japan is going to have an upper house election in July and the market is waiting anxiously to see whether Abe will come out with reform policies after the election. We believe this will be the key test for the market.