Sept 7, 2019 Diminishing Policy Choices and the Implications
A Case Study of Japan
In the summer of 2018, we turned negative on growth momentum based on our leading indicators, and the market narrative has now caught up with our thesis. We have also shared with readers that most of our recommendations to institutional clients are predicated upon the easing expectation of the central banks as they are responding to the 1-3y mini reflation cycles we have discussed before. For further details, please refer to our thematic piece, “Navigating the End of Market Cycle”.
As global sovereign yields continue to fall, fears of ZIRP are back. Roughly 1/3 of global DM bonds have negative yields. Greenspan was quoted on Wednesday saying that negative rates in the US are “only a matter of time.” In that respect, Japan remains the country with the most amount of experience. So it’s worthwhile to have another look at the economic history of the land of the rising sun, and in particular assessing what lessons we can learn (or unlearn) for the rest of the world.
Currently, Japan is in a bit of a pickle. Growth has been slowing. (Manufacturing PMI below)
Chart 1. Japan Manufacturing PMI
The domestic economy will be slowing from a declining population (basically forever).
Chart 2. Japan Nominal GDP vs. Japanese Population
Data Source: Bloomberg
And the rolling trade balance turned into a deficit late last year.
Chart 3. Japanese Trade Balance
The BoJ and MoF have already attempted to use the tools at their disposal to stimulate domestic spending, but those effects have long since faded. Despite of the fact that sovereign debt to GDP has ballooned to 238% of GDP, of which about half is owned by the BoJ, Japan’s nominal GDP has barely grown at all in 2 decades.
Chart 4. Japanese GDP at Current Prices
One of the main issues is simply that the elderly won’t spend any more and are averse to risk taking. They are spending as little as they can. For the economy as a whole, this means that economic activity would be declining unless there is some mechanism to convert the savings into expenditures. That is essentially what the government is doing. By issuing JGBs and spending the proceeds, the Japanese government is essentially turning the savings into expenditures, thereby staving off a deeper contraction in economic activity.
Since the crisis, the Japanese government has managed to slowly reduce its budget deficit, but it’s hard to see how they can ever run a budget surplus on a sustainable basis and turn the debt/GDP ratio around. Which means 300% debt to GDP is only a matter of time. That sounds a bit crazy, but how does it matter? What’s the difference between a Yen of currency and a Yen of Japanese government debt anyway? If either just sits around in a bank somewhere, without the bank using it the create loans, does it matter? Investors tend to point to the Weimar Republic and Zimbabwe as examples of what can happen when the central bank keeps monetizing, but in those cases, the rate of monetization were several orders of magnitude bigger.
In here and now, the BoJ has already exhausted their typical tools, which makes the country highly vulnerable to another global recession. The last time the BoJ cut rates to -10bps in early 2016 the Yen strengthened 17% vs the Dollar over the next 7 months. That occurred in the context of a global slowdown and bond rally, much like now, but it was enough to make the BoJ think twice about further cuts. The BoJ has already bought so much of the JGB float that participants in the JGB market are complaining about market functioning. More corporate bond purchases are a possibility, but it is questionable how much additional purchases will matter given that spreads are fairly tight already. Does that mean the BoJ is out of bullets, and only fiscal policy choices are left?
The whole purpose of central bank easing is to incentivize risk taking at a time when fear is rampant. Said differently, the goal is to make risk-free assets unattractive relative to risky assets. Historically, this meant making cash less attractive, and when short term interest rates hit zero, this extended to making long duration sovereign debt less attractive relative to risky assets. When even long duration sovereign debt yields are at the floor, there isn’t much else to do except just buy risky assets directly. Specifically, REITs and equities. For Japan, there is actually a good academic argument for buying risky assets directly, because the embedded risk premiums are very high. The current Japanese Equity Risk Premium is ~740bps vs the 30y JGB yield. In comparison, in the US it is just 320bps. It can be argued that if the BoJ can tighten that risk premium, companies will be able to access cheaper financing and use that to invest more, hire more, etc. Chart 5. Equity Risk Premium – Topix vs. SPX
The problem is that there is a global discount rate for risk assets in a world of free capital flow – i.e. there are no capital controls. For example, other than company specific concerns, there is no reason that Toyota’s Free Cash Flow should be discounted at a different rate than GM’s. So to reduce the equity risk premium in Japan, the BoJ will need to impact the discount rate globally. That’s a very tall order for the BoJ to handle alone.
One might wonder why aren’t Japanese corporations conducting significant share buybacks themselves given the high equity risk premium. The Topix has a dividend yield of 2.6% vs both cash and 30y JGBs yielding around zero. Value Investor Michael Burry, made famous in the book “The Big Short,” noted in an interview this week that
“It is not hard in Japan to find simple extreme undervaluation — low earnings multiple, or low free cash flow multiple. In many cases, the company might have significant cash or stock holdings that make up a lot of the stock price.
The government would surely like to see these companies mobilize their zombie cash and other caches of trapped capital. About half of all Japanese companies under $1 billion in market cap trade at less than tangible book value, and the median enterprise value to sales ratio for these companies is less than 50%. There is tremendous opportunity here for re-rating if companies would take governance more seriously. Far too many companies are sitting on massive piles of cash and shareholdings. And these holdings are higher, relative to market cap, than any other market on Earth.”
It seems like a no brainer to use the cash and buy back equity! Except the S&P Japan buyback index has been sharply underperforming since 3Q 2017, and is now below pre-Abenomics levels: Chart 6. S&P Japan Buyback Index vs. S&P Japan Index
What gives? Specifically, why aren’t Japanese companies willing to spend the large cash on their balance sheets? There isn’t a liquidity problem. Cash has option value that is highly useful during period of economic dislocation or growth, but since Japan’s economy isn’t all that much riskier than other DM countries, it’s hard to explain why Japanese companies would want to hold so much more cash than their DM competitors. Dr. Burry (and Third Point before him) suggested that corporate governance is the main problem. And maybe it is for specific companies, especially in the small cap space. But it seems like for the broad large cap market as a whole, short term liabilities (red) have increased in line with the increase in cash & cash like assets. (green)
Chart 7. TPX Index vs. TPX Current Liability and Current Asset [cid:image007.png@01D566F0.4BE1A180]
Data source: Bloomberg
In fact, the increase in short term liabilities have been faster than the increase in cash like assets, which has resulted in a decline in the current ratio. Chart 8. TPX vs. TPX Current Ratio
Data Source: Bloomberg
This may be one reason Japanese equities haven’t performed as well, despite the fact that they are now only trading at a small premium above book value: (1.1 vs 3.3 for the S&P 500) Chart 9. TPX vs. Book Value Per Share
Data Source: Bloomberg
The point is that for the broader Japanese equity market, the problem is not what it may seem. On balance, it does not seem like Japanese corporations are sitting on significant excess cash relative to their needs, which means that further policy efforts to penalize cash holdings (i.e. via negative rates) will not necessarily spur a push into stock buybacks.
Nevertheless, without a lot of other options, cuts further into negative territory is likely for the BoJ. ~80% chance of a 10bp cut at the 10/31 meeting is priced in. The hope is that a small cut will be more beneficial for the economy than hurtful for the agents of credit creation – the banks. This is despite of the fact that Japanese banks have underperformed the broader market by 46% since the peak of the Abenomics program, and on an outright level is basically unchanged from then. Chart 10. TPX Bank Index vs. TPX Index
The market correctly priced the decrease in earnings due to lower risk free rates, as the PE Ratio (2nd panel) is basically unchanged despite the index declining significantly.
Chart 11. TPX Bank Index, PE Ratio and Price (2nd panel) to Book Ratio (3rd panel) [cid:image011.jpg@01D566F0.4BE1A180]
A final point to consider is that within the context of a balanced portfolio of equities and bonds, if the bond portion becomes less negatively correlated to equities because yields have hit a floor, to keep the portfolio at the same level of risk the manager has to reduce the amount of equities in the portfolio. This is a key point for the rest of the world, we think.
The point here is that conventional easing, in the form of more negative rates, more sovereign bond purchases, are clearly hitting limits. What’s left is the going further out the risk curve and using the printing press to tighten risk asset premiums directly.
Like other policy initiatives such as QE, the BoJ has already started going down this road. Currently, the BoJ owns about half a trillion Yen of Japanese REITs, vs a market cap of ~14.5 trillion, and 26.7 trillion of ETFs vs an equity market cap of ~340 trillion. The question is: how effective is it?
Let’s first have a look at the impact on equities. The BoJ holdings of ETFs has steadily increased since purchases started in 2011, such that the BoJ is now a top 10 owner in about half of Japan’s listed companies. Yes, the equity risk premium – defined here as the earnings yield minus the 30y JGB yield has actually increased, almost monotonically, since the program started, and even after the purchase pace was accelerated to ~2% of the market cap per year.
Chart 12. BoJ Holdings as % of Equity Market Ca vs. Equity Risk Premium [cid:image012.png@01D566F0.4BE1A180]
Data Source: Bloomberg
For JREITs, the purchase program jumped out of the gate quickly and seemed to have better results. After hitting a buying pace of ~2.5% per annum of the market in 2012, the REIT risk premium declined quickly, though how much of that was due to starting valuations is a question. Chart 13. BoJ Holdings % of JREITs Market Cap vs. JREIT Risk Premium [cid:image013.png@01D566F0.4BE1A180]
Data Source: Bloomberg
In aggregate, it’s probably fair to argue that purchases will likely need to hit at least 2% of market cap a year to be effective for tightening the Risk Premium. Note that we are focusing on the Risk Premium here, rather than the outright level, because we are interested in how central bank purchases will affect the relative valuation vs risk free bonds now that the latter are nearer their lower bounds. Most of the academic studies conclude that the buying programs have supported the outright level of prices. [See Barbon and Gianinazzi (2018) Charoenwong et al. (2019) and Harada and Okimoto (2019)] However, it’s worth noting that corporate earnings have been broadly increasing during this time. Even relative to earnings, it is not clear how much the purchase program has had an impact: Chart 14. BoJ Holdings % of Market Cap vs. TPX Index PE Ratio [cid:image014.png@01D566F0.4BE1A180]
Data Source: Bloomberg
For the rest of the world, we think it is only a matter of time before risky asset purchases become part of the policy tool kit. After all, it is the next iteration of the whole purpose of easy monetary policy and the printing press. Clearly, given the intrusion of public interests into private, and the increased likelihood of fiscal dominance, we will probably need to see a global recession before this weapon comes out. But given Japan’s experience, we would caution readers from getting blown away by ‘shock and awe’ aspect of such programs. Furthermore, it seems quite likely that without directly purchases of risk assets, or despite them, risky asset premiums are likely to increase as yields get closer to their effective floor, wherever that may be. As bonds become less negatively correlated to equities, volatility targeting programs and managers must reduce their equities ownership. Where the new risk premium level will be is anyone’s guess, but Japan has already shown that 700bps is not out of the question.
The risky asset premium is not the only lever that the Japanese have used. One of the goals of Abenomics was to weaken the Yen, given the impact on inflation. Other countries would retaliate if the BoJ simply printed Yen and sold it in global FX markets, so instead the authorities forced the large Japanese pension funds to sell Yen denominated assets in their portfolios to buy foreign assets unhedged. The initial impact was a large depreciation in the Yen, but like lowering interest rates, that action alone is not free. The large currency mismatch means a Yen strengthening will result in large mark to market losses for the pension funds, along with the expected negative impact on the profits of Japanese exporters. In a sharp global risk off scenario, the simultaneous strengthening of the Yen, expected weakening of expected corporate profits will mean significant negative mark to market impacts of the pension funds’ assets. And because Japanese fixed income does not have room to rally further, there will be very little in the Japanese pension portfolio to offset the pain. How the Japanese pension managers will react in that scenario is anyone’s guess, but it’s hard to imagine that they will have the fortitude to even rebalance to their target weights and buy more foreign equities in such a scenario. The press will of course have a field day talking about the mark to market losses. It seems quite possible that voter outrage at the mark to market losses results in a highly inopportune shift out of risk assets, as well as an increase in currency hedges. In aggregate, in the next global recession, the combination of the effects of: falling earnings, compounded by a sharply strengthening Yen, itself compounded by currency hedging flows from Japanese pensions, could mean a much more volatile Japanese equity market relative to its peers. This may be another reason the Nikkei has underperformed the S&P (white) more than currency effects alone could justify. Chart 15. Nikkei/SP Ratio vs. USDJPY.
As the monetary policy ammunition is running out across the globe, we think global central banks will at least try to cut interest rates further into negative territory and start to purchase risky assets such as equities and REITs. Ultimately, fiscal measures will have to be launched upon next downturn, and since global leverage is at all time highs, fiscal stimuli have to be underwritten by central banks – i.e. fiscal and monetary policy coordination.
Our case study in Japan indicates that further large scale of asset purchases, including stocks, may not be enough to compress risk premium of equities. We acknowledge that Japan has chronical demographic headwinds, which is also true in Europe and many other Asian countries such as South Korea and China. We recognize that in a world of free capital flows, the effects of any country’s monetary stimulus are global rather than local and local assets will benefit more from such stimulus, which explains why Japanese REITs have been more responsive to BoJ’s asset purchases than Japanese equities. It is no surprise that in countries with closed capital accounts like China, the stimulus will have a large response from domestic asset markets. Therefore we argue that to support global equity markets, a synchronized and coordinated large scale asset purchases of shares may be needed.
Our case study also highlights a tail risk that has been underestimated by the market. In the next global down turn, the currency appreciation of JPY due to the unwind of carry trade will lead to significant market-to-market closes of Japanese pension funds due to their heavy overweight to foreign assets (both US treasury and risky assets) without currency hedging, and at the same time, their Japanese stock holdings may experience larger losses as Japanese exporters will face significant currency headwinds. And to make the situation worse, their bond portfolios provide much less diversification benefits as rates hit negative territory. Japanese pensions may be forced to hedge the currency risks, which will only pour gas to the fire on the JPY appreciation, creating further pain for Japanese exporters, whose shares are held by Japanese pensions. Please do not hesitate to reach out to us for questions and feedback. Good luck! Dao Capital Advisors
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