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By Liu-Yue (Louie) Lam, Co-Founder, Chief Investment Strategist, Oxstones Investment Club

History

Prime Minister Abe and the LDP party are back in control of Japan.  Will the second act be any different from the previous time? Japanese politics has been a merry-go-round with the same actors and same results.  In 2006, Prime Minister Abe and the BOJ ended a five year quantitative easing program and raised lending rates while the Japanese economy was still in a nascent recovery.  PM Abe ended up resigning during the financial crisis, and the Nikkei Index ended up losing roughly 50 percent its value while the yen appreciated roughly 40 percent against the dollar during the past five years.

Macro Overview

The Japanese economy is currently in its third recession in five years.  Nominal GDP growth has been roughly 0% the past 20 years.  As recently as last November the Nikkei Index had loss 75 percent of its value from its 1989 peak.  Japan faces multiple secular headwinds including a rapidly aging population, and the highest debt-to- GDP ratio in the world at 250 percent of GDP.

Late to the party, Abe is spiking the punch bowl

PM Abe’s Liberal Democratic Party will face an upper house election in July and will need to quickly show economic progress in order to maintain support.  In an effort to spur growth and navigate the economy out of the current recession the Japanese government will spend 10.3 trillion yen.  In addition, PM Abe and the LDP will have an opportunity to reshape the BOJ as the term of the Central bank Governor expires on April 8 and two of his deputies will also leave in March.  PM Abe is determined to end deflation by devaluing the yen to re-inflate financial assets with the hope that the wealth effect from financial markets will lead to domestic consumption.  We can expect a more aggressive BOJ in combating deflation by unleashing the mother of all quantitative easing programs.

The government and BOJ have recently agreed to adopt a 2 percent inflation target.  This is an enormous undertaking since Japan has not achieved 2 percent inflation for any year since 1997.  BOJ has also announced it will start buying an extra 13 trillion (net 10 trillion due to the impact of maturing securities) in yen-based assets per month via a Fed style open-ended asset purchase program starting in 2014.  These purchases would further weaken the yen currency.

Short term benefits but long term consequences with the current strategy

The political rhetoric is having the desired impact in weakening the yen and appeasing the chorus of Japanese multinationals demanding a weaker yen.  The yen has already declined significantly since last October and recently fell to 93 and may eventually weaken to 95 to 100 per dollar. The Nikkei Index has also benefitted from a weaker yen; surging almost 31% since November.  Japanese stock market performance historically has been highly correlated with Japanese yen movements due to its reliance on an export-based economic model.  Abe’s desire to lower the currency’s value is understandable since the yen has been abnormally strong the past 5 years due to the global financial crisis which ironically made the yen a flight to safety haven.

The key issue is the Japanese economy has been weighed down by a massive amount of debt.  However, PM Abe’s game plan to pile more debt on top of debt in order to spur short term growth has limits and long term consequences.  This is the same medicine prescribe by LDP for many years which has led to a huge national debt pile, zero rates, and twenty years as a zombie economy with chronic deflation and no real economic growth. There are only two possible solutions.  Writing off debt is one way to restore solvency and the other alternative is to attempt to inflate its way out.  Studies have shown that once a nation reaches 100% debt to GDP it’s at a point of no return.  Japan is far beyond that point and has been caught in a liquidity trap so it’s doubtful Japan can grow its debt-laden economy faster than the rate of debt.

Things may become even worst as the global financial crisis shifts its focus from Europe to Japan.  The current BOJ balance sheet to GDP is roughly 40 percent so BOJ is essentially financing government spending.  They will eventually reach a turning point where investors and rating agencies no long accept the value of Japanese bonds and will demand much higher risk premiums which could trigger capital outflow and a JGB crisis.

Investment strategy

In the short run it’s time to party in the financial markets.  Historically, every Japanese quantitative easing program has led to the creation of massive asset bubbles around the globe.  As long as central banks continue to devalue its currencies then investing in gold, silver, base metals, soft commodities, and emerging market equities is a great idea because history has shown that money printing always leads to inflation.

Unfortunately, the Japanese economy will achieve only sluggish growth, the yen will continue to decline to 100 per dollar, and the Nikkei Index should continue to perform well especially multinational exporters.  However, As PM Abe and BOJ turn a blind eye to fiscal and monetary discipline you can expect credit rating cuts and a surge in Japanese bond yields.  Shorting the yen currency and shorting JGB’s seems like a great long term bet.

Ironically PM Abe and BOJ actions will provide cover for the Fed’s own QE program by supporting the dollar and keeping interest rates on US Treasury bonds low.  Japan is on pace to once again become the largest U.S. creditor in 2013.  Thank you Abe!

Conclusion

The title for my latest commentary is derived from the symbolic reference to a popular Japanese fashion brand called ‘BAPE’.  A small luxury for many Japanese citizens is to have daily baths in water at temperatures above 40 degrees Celsius and is a symbolic reference to over-indulgence.  PM Abe recent actions can be seen as an over-indulgence in his political powers.  What happened to central bank independence from politics?  To politically influence and interfere with monetary policies are abuses of power.  PM Abe’s actions remind me of the story of an immature boy over-indulging in a hot bath while leaving the water running too long.  He ends up falling asleep while the water overflows and floods all the neighboring apartments below.  While PM Abe is bathing in the glow of his new powers, he should also be aware of the long term consequences that his policy actions will have not only on the Japanese people but also in creating the next global asset bubble and crisis.

The Japanese are hard-working and resilient.  It’s a tribute to the incredible frugality of Japanese people that they have been able to survive 20 years of no growth and deflation.  But the younger and future generations demand and deserve better.  In most Asian cultures there is adherence to hierarchy and loyalty to tradition.  Japan is still ruled by the same old and corrupt politicians that are out of touch with reality.  There are many smart and ambitious Japanese that understand the need for change but their progress is being blocked by Japanese bureaucracy.

Japan needs to take bold immigration reforms to bring fresh blood and reinvigorate the workforce.  An aging and shrinking population makes it harder to drive a sustainable recovery. They also need deep structural reforms that can improve the competitiveness of the economy.  Allowing creative destruction will free up capital and human resources to reallocate to better opportunities.  Deregulate industries to unleash innovation and create new industries and spur real demand growth.

Never has a country achieved more with so much less in terms of its natural resources and population.  Although, these are difficult times for Japan it has proven throughout history it can overcome dire obstacles.  From Japan’s miraculous recovery from the aftermath from being nuked (the only nation in history to be nuked) to becoming the world’s 3rd largest economy.  I’m confident the Japanese people will triumph again over new challenges.  However, I’m less confident on the time table for the turnaround as crisis times requires brilliant and brave leaders willing to take innovative actions not the same old actors prescribing the same failed medicine for the past twenty years.

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