Briefing on Japanese economy and stock market
Introduction - a 22 year bear market
The Japanese stock market peaked at the end of 1989 at almost 39,000. The bottom (so far) was in early 2009 when it briefly went below 7,000. Since 2000, it has not been higher than 18,000, and is currently trading at around 9,000.
Returns to international ($ or £ based) investors have however been better than this because of the strength of the yen over this period, and Japanese equities have not been worse performers than European equities over the last 10 years and not much worse than US equities, when adjusted for currency returns.
At its peak in 1989, the P/E ratio on Japanese equities was estimated at over 100, about 6 times higher than in the US. Now it is about 14, in line with the P/E ratio on US shares. The dividend yield of 2.5%, a little higher than in the US.
The 1980s saw a massive property bubble in the Japanese economy. Japanese export industries were incredibly successful and political pressure from the US forced Japan to allow the yen to appreciate. Export profits rose but Japanese investors, scared by the falling value of foreign currencies, kept the money in Japan and Japanese property values and equity prices reached incredible heights. The banking system had no credit analysis, instead relying on keiretsu networks and property as collateral - companies became highly indebted as banks lent freely.
In 1990, the Bank of Japan thought the speculation had gone too far and decided to burst the bubble and raised interest rates significantly. The domestic corporate sector was hit very hard by the higher interest charges and the export sector was hit hard by the higher yen. The economy fell into recession, property prices collapsed and the government attempted several cycles of fiscal stimulus in order for public sector demand to offset the collapse in private sector demand.
Due to the strong sense of shame associated with bankruptcy in Japan and the strong sense of solidarity within the keiretsu network, banks did not foreclose on effectively bankrupt companies - instead they were rewarded by the banks rolling over maturing debt. This was helped by interest rates which were reduced to almost zero. This created huge levels of bad debt and the banking system wrote off its entire capital base before recapitalising and then writing off the recapitalised equity and recapitalising again.
Over the last 20 years, nominal GDP has remained steady - there has been no growth in the size of the economy. However this reflects real growth of about 1% per annum and price deflation of about 1% per annum.
Japan also has a major demographic problem, with the population having peaked in the 1990s. In the first decade of this century Japan averaged 0.8% real growth per annum, but on a per capita basis this is 1.6% per annum - a better result than the US, UK, Germany or France. By 2050 the population of Japan is expected to be 30% lower than today, an average decline of almost 1% per annum.
The apparent and looming shortage of working age population has concentrated the minds of the large Japanese companies. Manufacturing has been shifted to Asia, and companies have continued to invest heavily in labour-saving machinery - the Japanese are world leaders in robotics. They remain strong competitors to Germany in capital goods industries but in recent years have lost competitiveness as the Euro has fallen sharply against the yen.
In many ways corporate Japan is impressive - costs are under tight control, heavy investment means that production techniques are very efficient, companies tend to have net cash rather than debt, and equity market valuations are now fair if not actually cheap.
The problem for Japan is the budget deficit and level of public debt. Japan has run huge budget deficits now for 20 years. Public debt stands at well over 200% of GDP, however this has not been a problem for the government because the Japanese financial system (including Quantitative Easing by the Bank of Japan) has been happy to fund these deficits and roll over the debt at tiny interest rates. 95% of Japanese government debt is owned by Japanese institutions. Yields of 1% or less on this debt do not sound attractive to Western ears but compared with the negative returns from Japanese equities and property and the strength of the yen, Japanese investors have been very happy with their government bonds.
The future for Japan
Until now the huge savings of the Japanese people have been sufficient to buy the new government debt that has to be created to cover its annual deficit. There are reasons to believe that this balance between supply and demand is now coming under increasing pressure. The ageing population means that instead of saving out of income to plan for retirement, the Japanese people are increasingly drawing down on those savings to fund their retirement. The actions of the Japanese Post Office which owns 1/3 of all JGBs are closely watched for any evidence of a slowdown in their purchases.
Should the Japanese financial sector no longer be prepared to fund the government at interest rates below 1%, there would be a crisis of enormous proportions. Even at today’s interest rates the total of income tax revenues is only a little greater than interest payments on its debt. Essentially the Japanese lend money to their government for almost no return instead of paying higher taxes - this has been a (mostly) voluntary decision, but if it were to change, the only option would be for Japan to print the yen to buy their government bonds, which in turn would lead to inflation in Japan and a weaker yen. Such a turn of events would be very positive for the large Japanese exporting companies.
Such a switch from deflation to inflation in the Japanese economy would induce a major change in asset allocation of Japanese savers. The near-zero nominal but positive real return from bonds would no longer be available and the real value of their capital could only be protected via investing in Japanese equities or in foreign currencies.
This shift in Japan will occur at some point (but this has been said for the 7 years) and possibly quite soon, and when it does occur, owning Japanese equities but with the currency hedged, will be a hugely profitable strategy. Until then there is no reason to expect positive nominal growth from the Japanese economy or much return from its equity market.