“The Bank of Japan recently announced that it would start purchasing long-term Japanese government bonds. This quantitative easing program in Japan is roughly equivalent to the size of the program here in the U.S. However, the quantitative easing in Japan is larger than what is happening in the U.S. when compared to the size of Japanese GDP. The recent rally in Japanese equities is a result of the monetary announcement. Should you invest in Japanese equities today? To answer this question, we will take a look at the economic situation in Japan and the actions taken by the Bank of Japan.
Understanding the Japanese Economy
Japan is one of the wealthiest countries in the world. However, Japan has been running an extremely large budget deficit for years. This year alone, the deficit is expected to be approximately 8%. Comparatively, the deficit here in the U.S. is at about 6.5%. In contrast to the U.S., Japan’s inflationary environment is strikingly different. The Japanese economy currently suffers from a deflation rate of -0.2%. In the U.S., there is an explicit target of 2% annual consumer inflation. The U.S. inflation target is typically reached every year. The Japanese have now had 20 solid years of deflation. Since the early 1990s, Japan has never recovered to a level of stable, slightly rising prices.
The Bank of Japan, under its new chairman Haruhiko Kuroda, is targeting that precious +2% annual inflation rate. Why Does Japan Want Inflation? The most important reason Japan wants inflation is that rising consumer prices will help set up a positive economic feedback loop in Japan. To better understand this, let’s examine the negative cycle that occurs in a deflationary environment.
When consumer prices are falling, corporations have to continually lower their prices which cause their profit margins to fall. This is why Japan’s corporate profit margins are now among the lowest in the world. As profits fall, investors are less likely to invest in Japanese companies, and stock values therefore decline. Another way to understand the problems of deflation is to realize that if prices are falling, it makes no sense to buy an item, like a car, today. Instead, the purchase would be put off into the future when prices are expected to be lower.
The Japanese are attempting to reverse this negative deflationary spiral with inflation caused by quantitative easing, or printing money and buying bonds. If the Japanese central bank is successful in causing inflation than consumer prices will rise, profit margins should expand, investments rise, and stock prices go up. Therefore, economic growth increases, the budgetary deficits shrink, and the elected government is happy.
How Japan Intends to Stimulate
Recently, the Bank of Japan said it would buy long-term Japanese government bonds. Under the plan, each month the bank will buy 7 trillion yen worth of bonds, roughly $75 billion. This should result in lower long-term interest rates inside Japan. While the Japanese quantitative easing program may look similar to the American program, the macro economic conditions and objectives are completely different.
In Japan, there is a terrible, chronic budget deficit near -8% a year; 20 years of deflation; and a fully employed economy operating with little to no annual growth.
In the U.S., our quantitative easing programs are designed to lower long-term interest rates, help spur economic growth and reduce unemployment. Until the U.S. reaches a 6.5% unemployment rate, Fed bond buying will continue. In Japan, their unemployment rate is already quite low. Therefore, creating jobs is not the hoped-for result. The Bank of Japan wants money to flow directly through to prices in the economy and stimulate inflation.
Yes, Japanese bond purchasing will lower long bond rates, but the effects will be different. Their actions have already depreciated the yen, raised the demand for Japanese exports, and started the macro ball rolling. The recent rally in Japanese stock prices is a direct result of the bond buying program. While it is unclear if the Japanese monetary activity will cause inflation in the immediate term or a benefit to the Japanese economy, it should continue to push Japanese equity prices higher.
There is however some risk associated with what is going on in Japan. Japan has to get this just right. They want a 2% annual inflation rate without any unintended consequences. Very often, our experience is that monetary policy tends to have unintended consequences. If Japan experiences too much inflation, then a negative cycle of a different sort could start. Too little inflation would mean nothing is achieved and the deflationary feedback loop is not broken. Despite the unknown effect of the Japanese policy in the long-term, for now, the move will likely cause the Japanese equity markets to continue to strengthen. At the end of the day, we feel Japan’s strategy for ending their 20 year deflationary cycle makes sense. Investors should consider adding exposure to Japanese equities in their portfolio”.
Mitch Zacks, Senior Portfolio Manager, www.zacks.com
Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.
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