Japan — All in with Abenomics

Fred Copper, Senior Portfolio Manager | June 6, 2013

  • Japan has gone all-in in their battle against deflation and stagnant growth.
  • Prime Minister Shinzo Abe has committed to a fiscal and monetary blitzkrieg, and there’s no going back.
  • Huge uncertainty and massively divergent outcomes will manifest as continued jaw dropping volatility in the financial markets.


Price return of Nikkei Index, November 2012 — May 2013


Source: Bloomberg, May 2013, Past performance does not guarantee future results. It is not possible to invest directly in an index.

Think these types of stock market returns are crazy? Get used to it. Could the Japanese stock market go up another 50% from here? Yup. Could it drop 50% from here? Yup. Unfortunately I can’t tell you with any certainty which it is likely to be (though my best guess is the returns do occur in that order), but what I can tell you is moves of that magnitude are part of the investing landscape now. Japan has gone all-in in their battle against deflation and stagnant growth. They ultimately had no choice. The problems of zero growth and accumulating imbalances were unsustainable. They could have continued on their stable but doomed trajectory, and things could have gone on quietly for a while, but we would have ended up here eventually.

Prime Minister Shinzo Abe was elected with a mandate to break Japan out of its decades long rut of deflation, so that is what he endeavored to do, and now that he has started, he can’t stop. If the current policies aren’t working, he will double down. With both gross and net debt as a percent of GDP among the highest in the world, entrenched deflation, and a declining population, the decision to target inflation has mandated that all the chips be put on the table. Nominal economic growth is real growth plus inflation. Real growth will be hard to get. Real growth is a function of population growth and per capita productivity. We know the population is declining and a productivity adjustment of the required scale would be miraculous. So we need inflation. To accomplish that, Abe has committed to a fiscal and monetary blitzkrieg. To change perceptions that have been embedded over decades you need to demonstrate unqualified commitment (rational irrationality — like playing chicken).

But there is no going back. If real growth is virtually impossible, nominal growth becomes entirely a function of inflation. If the efforts to achieve inflation are unsuccessful, the fiscal and monetary burden will become crushing. Debt will be up and GDP will not, pushing the Japanese government debt market ever closer to the long anticipated tipping point. Further, all hope would be lost. These are the big guns. If they are not sufficient, there is nothing else to try.

Further, even if they get what they want, it is far from certain that a benign outcome is assured. Let’s assume the program is successful, and the target of 2% inflation is achieved. It is highly unlikely that nominal rates can be kept below this rate, i.e. negative real rates, for very long given that most sources of non Bank of Japan (BOJ) demand have been largely satiated and a guaranteed loss after inflation is not a great incentive for new investors to fill the void. At 2% nominal interest rates (0% real in this scenario), debt servicing costs become approximately 80% of current tax revenue. Now, higher inflation would also drive up tax revenue which we aren’t reflecting, but even in the desired outcome we still find ourselves in something of a race — which comes first, higher interest rates or higher growth? The answer isn’t clear, and yet is critical to the ultimate outcome. Huge uncertainty and massively divergent outcomes will manifest as continued jaw dropping volatility in the financial markets.

GaveKal’s Anatole Kaletsky summed the situation up perfectly: “The fiscal and monetary expansion already implemented in the first few months of Abenomics have been so extreme that there is no turning back. Unless Japan can achieve much faster economic growth, Abe’s borrowing and spending radical experiment with macroeconomic stimulus will create a debt and monetary overhang so huge that it will bankrupt the financial system and quite possibly trigger hyper-inflation. In short, Abe has bet his country on the success of his economic program. He will now be forced to do whatever it takes to achieve strong growth, both through macroeconomic stimulus and structural reform. The financial arithmetic of Abenomics means that tolerable stagnation is no longer an option for Japan.”

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Fred Copper

Senior Portfolio Manager
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