The main event of last week was the failure by the Bank of Japan to introduce new stimulus (having led or allowed the market to believe they would), and the resulting sell off in the equity market and rally in the Yen. The market reaction was exactly the opposite of what the BoJ would be hoping for, just as it was after they cut rates into negative territory at the end of January. On the surface, it would seem that the BoJ is damned if they do and damned if they don’t.
The primary aim of Bank of Japan policy since 2013 has been to reflate the economy with QQE, or Quantitative and Qualitative Easing. To be more specific, the Bank aims to achieve 2% inflation and has been printing money increasingly aggressively since 2013 to try and meet their objective. As it stands today, inflation is at minus -0.3%, and the Bank of Japan recently pushed rates into negative territory (after approximately 20 years close to zero per cent – what do they really think they will achieve with this move?) in another attempt to get things moving in the right direction.
As with all central banks, the BoJ likes to build a narrative and spin it such that we believe they have everything under control and are just about to meet their objectives. Our favourite Bloomberg headline from Kuroda’s post meeting press conference last week was:
*KURODA: JAPAN’S VIRTUOUS ECONOMIC CYCLE HAS BEEN MAINTAINED
Now, we are very happy to admit that Kuroda was dealt a pretty poor hand when he arrived at the Bank of Japan some three years ago. With disastrous demographics and mountainous debts (to name just two structural headwinds), we always felt that achieving his 2% inflation target (and nominal GDP growth of 4%) was not going to be easy. But to talk about a virtuous economic cycle is pure fantasy. Nobody believes him and he only damages his own credibility when he talks like this. The reality is that Japan are into their third lost decade. Chart 1 below shows nominal GDP which has not grown in over 20 years – not exactly a virtuous economic cycle and more like a patient on life support.
As noted above, the move into negative interest rates at the end of January was taken badly by markets. The Japanese Yen has risen by about 12% against a relatively weak US Dollar over the period and the equity market is down over 5% compared to the MSCI World Index up over 7%. The evidence is that banks do not like negative interest rates as it makes it much harder for them to generate profits. Furthermore, there is plenty of anecdotal evidence that households are protecting themselves against the prospect of negative rates on savings accounts, as they go out and buy safes and physical gold. Kuroda seems to be one of the few in Japan who thinks that negative interest rates is a good idea.
We have written before about demographics (LINK HERE) and the situation is clear. It is almost impossible to have a growing economy when the population, and especially a working age population, is declining (chart 1 being clear evidence of this). Unless productivity growth exceeds the rate at which the working age population is declining, then the economy will not grow in real terms. As can be seen in chart 2 below, as a percentage of the overall population, those of working age in Japan peaked in about 1990. Having already declined from about 70% to approaching 60% today, those of working age are set to make up only about 50% of the population in Japan by 2050. Unfortunately, Japan is simply showing the rest of us our future, and this is not positive for the Global economy in the years ahead.
Not only is Japan struggling with a declining population, it is also ageing rapidly. Retired workers have by definition stopped being productive (in the economic sense) and require an income to live off. With retirees holding a much greater share of their assets in low risk cash and bonds, the zero and now negative rate environment is simply crushing their income. Older people tend to spend less anyway, but with monetary policy crushing their income, it is possible that the Bank of Japan’s policies are actually making matters worse. As shown in chart 3 below, having once been viewed as a nation of savers with a savings rate well over 10%, Japanese households save almost nothing nowadays. With interest rates pegged near zero and a declining working age population, the only way for households to increase their spending power is to either be paid more or to increase debt. With the latter unlikely (older generations are more likely to de-leverage), and the former just not happening as exporters hoard their currency gains, we fail to see how pushing interest rates further into negative territory will help.
So the Bank have Japan (and PM Abe) are in a dreadful mess. We wonder whether they see themselves as struggling to add any more stimulus through more negative rates. They chose not to add more stimulus via QQE, which may be because they are trying to leave themselves with a tiny amount of ammunition in case they need it, or perhaps they realise that increasing QQE and owning an ever greater part of the bond and equity markets has its own limits. Either way, they have painted themselves into a very dark corner indeed.
The current Japanese experiences in terms of demographics, ever increasing Government debt and now increasingly impotent monetary and fiscal policies should be a lesson to the rest of the developed world. The trouble is that if Japan is in a dreadful mess, then the rest of the world are only a few steps behind. Monetary policy everywhere is just unsustainably loose, and yet raising interest rates will risk killing the economy. At the same time, we seem to need to take on increasingly levels of debt for a given unit of economic growth (China being the current worst offender on this front). So central banks are trying their very best to maintain the status quo whilst cajoling markets higher, and yet we know that this cannot continue forever whilst economic growth remains so anaemic.
At some point, something will change. Either central banks wake up and smell the coffee and try and induce a mild recession as they normalise policy and purge previous excesses. Or more likely, central bankers and politicians carry on with their increasingly reckless policies until the whole system comes tumbling down with its own weight, not unlike 2008, but most likely worse.
Of course, as the next crisis unfolds, the siren calls will be for helicopter money – we can clearly hear these calls already. But to paraphrase Rudolph von Havenstein, President of the German Reichsbank from 1908 to 1923, when asked why he kept printing more and more money; “to not do so would have been even worse”.
We obviously hope that our monetary and political leaders refrain from the helicopter money route, but we are struggling to see how they can maintain the current status quo. We continue to believe that 2016 will see much higher levels of volatility and lower equity and credit markets. The recent experience in Japan should serve as a clear warning.
Chief Investment Officer