The dramatic reversal of the Japanese market’s fortunes in past month might be a preview of things to come and an abject lesson in the dangers of monetary experiments
Since the end of December, the Japanese market has been falling like a rock. Since it reached its high late last year, it has fallen 11% into official correction territory. It is surpassed only by Brazil, which has fallen 14%. Earlier this week it fell 4.2% in one day alone. Is this a temporary correction or something more serious?
It is easy to compare Japan to the US market’s recent pull back. Both markets are up to impressive levels. Japan’s market has risen 57% in one year alone, so a bit of a fall is healthy. Before another leg up markets are supposed to drop a bit.
Surprisingly, the drop of Japanese shares has occurred when economic data has been improving. Inflation is finally growing for the first time in 15 years. The labour market has improved. Corporate earnings are unusually strong. The electronics company Sharp, was profitable for the first time in years. Toyota’s earnings grew 500%. Japanese corporations are some of the few who are actually revising guidance upwards. Twice as many are increasing their forecasts as are lowering them about the reverse for US firms. So why is the Japanese market tanking?
To answer the question, it is good idea to examine why the Japanese market has grown so much in the first place. The obvious reason is the economic policies of the Prime Minister, Shinzo Abe. This policy, named Abenomics, is made up of three parts or as Mr. Abe refers to them, arrows. The first is a monetary policy. This is the most obvious. It involves massive amounts of monetary stimulus, far more than America’s quantitative easing. The object of this policy is to encourage growth by eliminating deflation. The second is fiscal policy to provide temporary direct stimulus to the Japanese economy. Unfortunately this requires raising Japan’s massive debt, the largest in the world, at least in the short term. In the long term it is supposed to be balanced by extra revenues to bring the debt down. The third requires structural reform to make Japanese government and regulatory environment friendlier to markets.
The first and easiest, monetary policy, has been exceptionally successful one area, debasing the Japanese currency. The yen has fallen 20% in 2013. This makes Japanese exports far more competitive and gives a giant boost to corporate profits. This type of currency war normally provokes a response from competitors, but so far there have been few complaints. The possibility of Japanese growth is supposed to be a net positive for the world.
The problem is that the other two arrows have hardly been implemented. There has been extra spending, but paying for it might be a bit more difficult. There is supposed to be an increase to the consumption tax in April, but that revenue might be offset by a cut in corporate tax. The third arrow, regulator reform, has been limited.
In fact, it appears that the actual reason for the growth may not be real growth at all, but simply a distortion from the lower yen. For example, most of the success Abenomics has had increasing inflation is the result of the rise imported energy costs due to the fall of the yen. Toyota’s increase in profit is from the same source. Toyota increased sales this year by only 5%, but operating profits from sales of cars in the US went from a $137 loss to a profit of $632 thanks to the fall of the yen. Its profits in Europe were even greater thanks to yen depreciation. With this type of leverage it is hardly surprising that the Japanese market goes up or down basically on the day to day strength or weakness of the yen. The Japanese market is up 27% over the past year far better than the S&P in the US. But if you look at the Japanese market in dollar terms it is exactly the same.
The point is that monetary policy can provide a short term boost to an economy but it cannot eliminate structural imbalances. The Japanese, like the Chinese, have favoured investment over consumption, although not anywhere near the same degree. To rebalance they have to provide give household disposable incomes a larger share of GDP rather than favour the Japanese corporate sector with its huge financial surpluses.
But this is not happening. Even though corporate profits are at record levels, their workers have seen little of it. There are slight increases from overtime but the rigidities of the labour market make it difficult to increase the base wages. This will become increasingly painful as inflation heats up. The result will be to decrease the one thing that Japan needs to increase, consumer demand.
Whether the precipitous fall in the Japanese markets will continue in the near term is difficult to tell. The one certainty about markets is that they go up and down. In Japan’s case, the swings have been impressive. But to sustain a long term rally, actual economic growth is required and that has not been evident. So the dramatic reversal of the Japanese market’s fortunes in the past month might be a preview of things to come and an abject lesson in the dangers of monetary experiments.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)