Enigmatic Outlook

18/11/2013 at 5:36 pm

Winston Churchill famously observed of Russia in 1939 that it was “a riddle, wrapped in a mystery, inside an enigma”. To outside investors, much the same can be said of Japan. Can Abenomics, which in policy terms amounts to the same again (but this time with feeling), really change the dreary landscape of Japan’s lost decades for the better? Is this a question we can even answer yet?

Last week’s GDP data certainly confirmed the Japanese recovery. And just as interestingly, consensus forecast data compiled by Bloomberg a few days earlier showed that inflation expectations for next year ticked up to 2.4%. That would be the highest rate since 1997. Together with a consensus forecast of 1.6% for 2015 this would represent the strongest rate of sustained price growth since the opening years of the 1990s – finally, a real end to deflation.

There is the matter of an increase in sales taxes to account for, of course. Coming in next April this is expected to have a material impact on GDP over the first two quarters and on prices over the year as a whole. (The consumption tax is being increased as a nod to containing the national debt.) Even so, the change in sentiment since former Prime Minister Yoshihiko Noda dissolved parliament – almost exactly a year ago now – is significant.

There is arguably something of a contrast between expectations for prices and growth, however. While inflation is expected to return to a much happier level, GDP is only forecast to put on 1.6% next year and 1.2% in 2015. This is below the average for the five years leading up to the Great Recession, and well below the 4% level of growth seen in the boom years of the 1980s (when inflation averaged a not especially troubling 2.6%).

This is difficult to weave together into sense. On the one hand, Abenomics is expected to put an end to decades of deflation. On the other, the growth impact is expected to be disappointing. Given the history of the last 30 years it actually seems very bearish to expect Japanese inflation to take off without growth picking up at the same time. And yet with the stock market up 68% over the last 12 months investor sentiment in Tokyo has been anything but.

We should not read too much into this since economic forecasts are works of fiction. It is possible that Abenomics disappoints, as some expect, and what Japan actually gets is disappointing growth, a significant fall back in prices after the effect of the sales tax wears off and a return to conversations about the stratospheric level of gross government debt and the demographic death spiral. It is equally possible that Abenomics succeeds and that the Japanese economy motors back into life. After all, the country’s share of global GDP increased from 10.6% in 1979 to 18.1% in 1994, according to World Bank figures. Since then it has slipped back down to 8.3%: a shade lower than where it stood all the way back in 1972.

If the economic outlook is enigmatic though the prospect for Japanese asset prices is even more so. Inflation expectations have risen considerably, yet the ten-year government bond yields 0.6% – a little below where it stood a year ago, well under the 1.1% averaged since the beginning of the Great Recession and a million miles away from the 5.5% averaged over the late 1980s and early 1990s. There is the faster pace of central bank buying to take into account, at least for the moment; but with deflation killed off this should surely be expected to unwind. Unless deflation is not killed off after all …

On the equity side of things the picture is even less certain. Japanese equity market valuations are a law unto themselves. Bloomberg puts the p/e for the Nikkei 225 at 22x. While this beats every other major market, it is actually rather low for Tokyo. Even when bond yields and inflation were at more “normal” levels a quarter of a century ago, the market was still comfortable with multiples of 60x and higher for several years. A lot of this reflected hysterical optimism of course, but still. An earnings yield of 4.5% compares favourably with a risk free rate of 0.6% and inflation of 1.5-2%. Yet the fact that the earnings yield was quite often under 1% while bonds were at 5% suggests that the Japanese market pays these valuation niceties very little attention whatsoever. And who is to say a p/e of 60x will not become the new normal again, whatever happens to interest rates and inflation – if Abenomics should work, after all …

It is not really possible to write off the world’s third-largest economy as an investment destination. But if we think we should understand what we are investing in, Japan presents us with a particularly steep challenge. Despite the stock market optimism of the recent past, this has if anything got worse: everyone seems to be expecting Abenomics to have a bracing effect, but there is little clarity on how this will translate into outcomes. And there is no clarity at all on how the major asset classes should behave no matter what the eventual outcome is.

Stock pickers will find some names of interest and bond investors have little to lose by staying away. But it is very difficult indeed to put together a medium term case for either loving or loathing Japanese assets – and that, in itself, should augur caution.


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