by Ivan Martchev | February 4, 2013 7:00 am
Albert Einstein is said to have defined insanity as doing the same thing over and over and expecting different results. We’ve all been guilty of that at one time or another, until we finally stop and ponder — ”Lesson learned!” — and correct our course. But nothing in new Japanese Prime Minister Shinzo Abe’s recently announced stimulus package shows he has learned any lessons.
Before the details of his plans were announced, I didn’t have high hopes that Abe’s election promises would ultimately set Japan on the right course. But I admit that a sharply weaker yen and a surging Nikkei 225 suggest that the majority of investors believe that in the short-term, his efforts will have a positive impact — and I agree.
The distinction I’m trying to draw ahead of time is to treat this as a classic rally in the Japanese stock market within the range it has been in for over 20 years. The top of that range is above 20,000 on the Nikkei, so it has a long way to go, even if nothing ultimately changes.
Abe’s stimulus numbers are large enough for the rally to theoretically last for a while. Tokyo plans to spend 10.3 trillion yen ($116 billion): 3.8 trillion yen for disaster prevention and reconstruction, with 3.1 trillion yen directed to stimulating private investment, as well as other measures. The goal is to increase GDP by about 2 percentage points and create about 600,000 jobs.
The trouble with Abe’s plan: It’s the same type of stimulus that has been done before. BNP Paribas estimated that the government spent 33.8 trillion yen in the 1990s and 45 trillion yen in the 2000s on similar measures. Even with that, the average economic growth rate decelerated from 4.6% in the 1980s to 1.1% in the 1990s — when the credit system began to falter — and 0.8% in the 2000s.
If it didn’t work then, why will it work now? Because of more money-printing by the Bank of Japan?
The country is fighting demographic and structural problems that cannot be fixed by printing. The domestic economy needs to be deregulated, and something has to be done about the shrinking and aging population.
The Japanese do not like immigration as a solution, as my good friend Kazuhhiro Ueda has assured me on many occasions. He’s employed by one Japan’s famous exporters that sells its high-quality products all over the world, dealing with production facilities in many continents. Yet when it comes to dealing with foreigners in Japan, the culture of the company (and country) becomes reclusive.
Note that due to the significant decline in the Japanese yen, I don’t believe the surge in the Nikkei can be played with the iShares MSCI Japan (NYSE:EWJ) because the currency decline is reflected in the ETF — the Nikkei 225 is denominated in yen, and the return has been significantly better for yen-based investors. If U.S.-based investors are swimming against the yen current, how can they play this sharp rally in the Nikkei, which likely has further to go as Abe and the BOJ spend money they don’t have?
The answer may be with stocks of companies that can rally faster than the Nikkei because they would benefit disproportionately from Abe’s deficit spending. In theory, financials like Nomura (NYSE:NMR), Mizuho (NYSE:MFG) and Mitsubishi UFJ (NYSE:MTU) tend to benefit from reflation attempts.
Rising inflation in Japan is good for financials in general because it reverses trends that have gotten them in serious trouble over the past 20 years. For the past two decades, deflation in Japan has caused the value of assets to go down while the value of liabilities goes up for most borrowers, which has hurt the financial sector (if your collateral sinks in value below the value of the loan you’re making, you’re in trouble).
This is similar to what U.S. home owners experience when they have a $300K mortgage on a house with a $200K market price. Except that in Japan, deflation is a lot more widely spread than just housing. Deflation in Japan is due to a improperly functioning financial system riddled with bad loans (deflation has a negative feedback loop: the longer it lasts, the more bad loans it creates), excessive regulation in some industries, as well as as shrinking population, to name some important factors.
A steeper yield curve in Japan, when it comes, should be good for bank profits as their interest rate differentials widen with low cost of funding but higher rates on loans. Higher Japanese government bond (JGB) yields are good as long as there’s no rout in the JGB market because that would create losses similar to those seen in the PIIGS countries’ banks.
An overdone surge in JGB yields also isn’t good for the government, which has to borrow 50% of the money it spends every year. That was before the latest stimulus plan.
ADRs of Japanese financials are, as a whole, doing a good job outperforming the Nikkei (and the dollar-denominated large-cap EWJ). But the Japanese small-cap ETFs that I mentioned in December — iShares MSCI Japan Small Cap Index Fund (NYSE:SCJ), the WisdomTree Japan Small Cap Dividend Fund (NYSEARCA:DFJ) and the SPDR Russell/Nomura Small Cap Japan ETF (NYSE:JSC) — have so far underperformed the EWJ.
If Abe succeeds in establishing a positive inflation rate of 2%, small caps should outperform large caps in Japan because historically, small caps tend to have fewer issues with margins in times of rising inflation. This is universally true, even though it cannot be used as a market-timing indicator because the relationship between the operational performance of a company and its share price can stay out of sync for a long time.
The history of such stimulus packages in Japan suggests to me that investors should treat this rally the same way they should have treated any other rally in Japanese stocks in the past 20 years. If Abe begins to more seriously restructure the Japanese economy with policies that address the structural problems I mentioned earlier, this could someday turn out to be the end of a 20-year bear market.
But that has not happened yet, and until it does, do not assume that it’s coming.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in BNP Paribas, iShares MSCI Japan, Mizuho, and WisdomTree Japan Small Cap Dividend Fund for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.
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