Naoto Kan, Former Japanese PM (2010)
Financial markets have been in turmoil since the beginning of this year, throwing emerging market equities and currencies, like those of Turkey’s, into chaos. FED’s tapering is one reason. There is liquidity withdrawal so it is normal to expect short term volatility. But what is the problem with Japan? This country has been flying high on the wings of Abenomics. Japanese blue-chips like Toyota and Hitachi are showing record historical profits this year. And yet Japanese stocks still have the capacity to suddenly collapse as much as 600 points or 4% on a given day. Its currency can swing from comfortable 145 Yen to a Euro level to 136 within in few hours. Seriously, what is wrong here?
We lived through a similar situation in 2008. Then too stock prices lost record amounts in a single day while large companies like Toyota were announcing record profits. Those who were reading rosy news could not understand it but we were going through a period which history would later label as the Lehman Crisis.
Granted, there are no risks left in the global economy today that are remotely similar to the Lehman crisis. Unless there are unexpected external events such as a devastating natural disaster or a sudden flare of large-scale international conflict, chances that we will experience a long adjustment period following an unexpected shock are small. Therefore, it is not realistic to expect lasting meltdowns in global financial markets. Emerging markets fragility is associated with withdrawal of easy and hot money. But where is Japan’s fragility coming from?
The optimism surrounding Japanese markets is a new phenomenon. Japan has chronic problems. It is unable to grow, or incapable of creating opportunities for growth. Yet growth is what equity markets need. Even book value related valuation methods assume one can extract growth out of value locked in super cheap assets.
Japan’s macro balances are the worst among developed nations. It has excessive public debt -some 200 plus percent. Its former prime minister once is quoted as saying Japan could be the next Greece. I differ. But Japan has to implement serious reforms to tackle problems that come with an ageing population, contacting economy, and a looming regional crisis with China.
In a nutshell, Japan has built-in impediments to “change”. Either they are behavioral- a natural result of adverse demographics, or structural in the form of rules and regulations, or customs and traditions. If Japan can keep the things “as-is” it is a success story.
It may be true that these impediments make the Japanese society a very safe and harmonious place. But they structurally prevent companies from implementing necessary changes to cope with changing market conditions quickly. As a result they can’t make investments which will lead to long term growth. For example, it is almost a taboo, if not outright impossibility, for a Japanese company to break free from a money-losing business segment. Take Sony as a showcase. The company announced that it expects to lose US$1.1 billion this year. No surprise? Its TV business, which Sony pioneered the Trinitron color technology, alone has lost close to US$8 billion during the last decade. The company finally decided to get out of the PC and TV businesses for good. It should have done years ago. Why did Sony wait so long? Is it denial or resistance to change? Or is it both?
What the PM Abe did swiftly after resuming power was to take necessary steps to make sure the country had a chance to get out of deflation. It welcomed the QQE policy of the BoJ-Japan’s central bank (I am being cynical here; we all know that calling for super easy monetary policy was a priority). As a result the Japanese Yen weakened. Japan, after all, is an export economy. A weaker currency quickly boosted revenues and profits. This is one of the reasons behind the historically high profits we are seeing today.
But that strategy is for short term. Japan cannot keep betting on a weaker currency. It needs long term growth plans. The question is about Abe’s growth strategy, or the third arrow of Abenomics. It is still unclear what will be driving force behind growth. Or more bluntly, what is Japan’s story?
Higher consumption tax will improve public finances which will give the country some credibility. But if you don’t have growth, tax receipts will fall and macro balances will go south again. So without a credible and believable growth story the rosy picture we have today is bound to be temporary. This is why Japanese financial markets can be fragile. Unless there is consensus towards growth, Japan will continue to have propensity to behave like an emerging market.
Granted there is one distinct disadvantage Japan has that other emerging markets do not. Its markets are relatively liquid. When the winds start headways Japan becomes a natural hedge for traders and fund managers who want to hedge their exposure in Asia. But part of this behavioral trait is there because Japan has the worst macro balances, and because the consensus verdict is against Japan when it comes to long term growth. Within the first months of Abenomics shorting Japan was risky because expectations for a quick fix were high. So we had a regime shift which moved valuations from a certain lower level to where they are today. But now Japan needs to create a new story to keep those valuations where they are, yet alone experience a new round of fresh upwards revaluations.
Where does this leave us? Japan, like Turkey and other emerging markets, has a fragility coefficient, especially when analysis tends to turn longish term. What we have seen so far in the positive side has been the story of last 12 to 16 months. Up to now Japan failed to show a convincing story for the long term.
A historical analysis of Japanese equity and currency markets shows that shorting Japan usually yielded profits. Therefore, when markets turn down Japan becomes fragile. As long as there is lack of a long term story boosting long term expectations, Japan will remain potentially fragile. In which case emerging country equity is a better long term bet.