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What Japan, 1990-2008,Can Tell the US about its Future? John Richards April, 2012
Introduction: Caveats • Part 1. Making sense of what happened in Japan 1990-2008 • Part 2. Focus on Japanese Asset prices • Part 3. Conclusions and implications for the US, • especially US asset prices
Why study Japan? Important in its own right. • Japan is the world’s second or third largest economy; population 126 million. • Japan is “rich.” Per Capita income USD 42K. • Japan is a major source of global savings. Current account surplus of around USD150 bn per yr. • Japan’s households’ financial assets are about the same as those of France and Germany combined. • Japan is of tremendous strategic importance to the US in Asia. • Japan’s population is aging rapidly and shrinking absolutely. • Japan has the developed world’s highest government debt burden (nearly 200 percent of GDP) and highest dependency ratio.
Why Japan 1990 to 2008: the world’s longest running experiment on financial crises, what to do about them, and what happens after the crisis ends. • asset bubbles: how do they happen?; what happens when they burst? • when cyclical downturn and financial crisis coincide • deflation • deleveraging • operational restructuring by business • labor force flexibility • zero interest rate monetary • quantitative easing • communication of monetary policy objectives to the market • large government deficits and massive fiscal stimulus • fiscal consolidation • bank recapitalization via public funds
Caveat: Can history really tell us anything? • “Those who cannot remember the past are condemned to repeat it.” George Santayana • “History … is the big myth we live.” Robert Penn Warren • “[History] is just one damned thing after another.”Arnold Toynbee • “History repeats itself because no one was listening the first time.” Anonymous • “History is written by the winners.” Alex Haley • My personal favorite: “History never repeats itself; at best it sometimes rhymes.”Mark Twain
Caveat: Differences between Japan in the ‘90s and the US in ‘08 • Japan’s problems in the ‘90s were quantitatively larger than those in the US in 2008. • Crisis centered in different sectors: Japan: banks, commercial real estate, business. Households were unaffected. US: households, residential real estate, banks and related financial entities. Business in good shape. • Recognition/reaction speeds.Japanrecognition time very slow (7 yrs). US the financial crisis and the economic downturn coincided – sense of crisis was almost immediate. • Policy response. Initial policy responses were slow and weak in Japan. They were relatively quick and decisive in the US. • Private sector responses. Japan’s businesses and banks were slow to respond; in the US, businesses aggressively restructured and banks recapitalized quickly.
To better understand Japan, I divide the last two decades into distinct periods. • 1990-1997: Denial • 1997-2002: Restructuring • 2002-2008: Earning-Led Growth
Prelude to the crisis • Economic growth averaged around 4% in the 80s, 6% in the 70’s, 8% in the 60’s. • ‘80s growth increasingly fueled by highly accommodative monetary policy, lax bank-lending standards, and excessive business borrowing. • Japanese equity prices tripled and land prices, which had been rising steadily for decades, surged 30% between 1985-1990. • The bubble burst in 1990. Peak to trough, both Japanese equity and land lost around 80% of their values!
1990-1997, Denial or “if things are so bad, why don’t I feel worse?” • Real GDP grew at around 2% • Households not highly leveraged • Household spending grew at around 3.6% per year • Businesses still hoarding labor • Unemployment rate averaged 2.7 • Regulatory forbearance for the banks • Banks kept “zombie” companies alive • Convoy system for dealing with failing financial institutions • Easing monetary policy and doses of fiscal stimulus • 10yr JGB yields fell from 5% to 2%
1997-2002, Japan Restructures • 1997-1998: The financial crisis emerges • Collapse of Yamaichi and Hokkaido Takushouku Bank were too big for the convoy system to handle • Ill timed fiscal consolidation raises taxes • Credit markets freeze up • Japan premium rises to 80 bp in international markets • Equity cross holdings and land as collateral hurt bank capita
The government responds, slowly at first, but then forcefully. • The BoJ eases aggressively. • MoF guarantees all bank deposits and interbank transactions. • Fiscal consolidation abandoned; more fiscal stimulus. • Public funds forced on the banks. • Nippon Credit and Long Term Credit Banks nationalized • FSA empowered to nationalize any bank that did not submit satisfactory restructuring plans. • Non-performing loans dealt with. • Zombie companies liquidated. • Government work out agencies established to buy troubled assets from the banks, including equities. Cross holdings reduced. Tough new accounting standards applied. • Banks consolidated into today’s mega banks.
Greatest changes in the private sector • Business restructures, largely eliminating the three excesses: debt, capacity, labor. • Business re-engineers itself to be complimentary to rather than competitive with the Chinese economy. • Labor market flexibility increases and life time employment ends.
The economy really suffered • Real GDP was barely positive or negative in 4 out of the 5 restructuring years • Deflation gets a toehold • Unemployment rate doubles to more than 5% • Suicide rate rises by 50%
But much was gained. • By the end of 2002, Japan was well positioned for more sustainable growth. • China’s huge fixed capital investment spending lit the fuse.
Earnings-led growth Least studied, but most important of the three regimes in terms of understanding the US today.
2002-2008: Japan’s longest uninterrupted expansion in modern times. Japan Real GDP Growth, 2002-2008 (Q/Q Annualized) Source: RBS Japan Source: Bloomberg
Decomposition of earnings-led growth: capital spending and exports lead; consumption lags. Capital Spending, Exports, Consumption (Growth rates Q/Q annualized) Source: Bloomberg
Corporate earnings growth surges when operating leverage kicks in (2003-2007) and falls when import prices soar (2008). Corporate Earnings Growth (YoY, %) Source: Bloomberg
Characteristics of earning-led growth in Japan • Operating leverage • key to understanding earning-led growth • Restructuring lowers costs • Sharply improves the relationship between top-line revenue growth and bottom line earnings growth
Vulnerability to higher input prices (fuel): Note transition from balanced growth to export dependency as terms of trade deteriorate. Contribution to GDP Growth by Sector Source: Bloomberg
To sum up: key features of earning-led growth • Improved operating leverage drives earnings. • Earnings growth drives the economy. • Growth highly sustainable, but slow. • Exportsstrong. • Consumption, employment weak. • Vulnerableto deteriorating terms of trade.
10yr JGB yields. Rates tend to be range bound at historically low levels despite high deficits and excess liquidity. Why? 10-yr Japanese Government Bond Yields Source: Bloomberg
Business behavior changed: Inventory/Shipment Ratio: exceptionally stable, helping to keep credit demands subdued. Inventory/Shipment Ratio Source: Bloomberg
Businesses keep capital spending in line cash flow so a “financing gap” never emerges despite years of steady growth. Free Cash Flow vs Capital Spending Source: Bloomberg
Bank Lending Growth – Negative when business were deleveraging and barely positive thereafter. Bank Lending: YoY Growth Source: Bloomberg
Restructuring unleashes persistent, if mild, deflationary pressures. Core CPI (includes energy) and CPI less Food and Energy Source: Bloomberg
Japan’s monetary policy: unconventional then, less so now. • ZIRP • Liquidity • QE • Communication • Unconventional Asset Purchases
Yield Curve Dynamics • Trend – Rolling flattening • Tactical – Strong directionality, steeping in sell offs and flattening in rallies • Episodial – Duration grabs (and dumps)
Yield curve dynamics when the policy rate is pegged: rolling flattening is the long-term trend. • Source: RBS, Bloomberg
Volatility relatively low but with sharp spikes Source: Bloomberg, RBS
Japan 10yr Swap Spreads: Depend on the interplay of of credit, balance sheet constraints, and relative supply-demand conditions. Movements may be counterintuitive. Yen Swap Spreads Source: Bloomberg
Credit spread narrow even as risk free yields fall in an earnings-led growth regime. Japan Credit Spreads and JGB Yields Source: Bloomberg
US credit spreads have room to compress significantly further if they follow Japan’s trajectory. US Credit Spread (ratio) vs US Treasury Yields Source: Bloomberg
Implications for the US • Denial: quick recognition and aggressive action needed. Avoid premature fiscal consolidation and tightening of credit. • Restructuring: Fix the banks. Growth will be constrained by bank capital until you do. Banks will resist share dilution. Prefer to ride a steep yield curve. Restructuring on the business side is likely to be painful and deflationary. Inflation low for a long period of time. • Earnings-led growth most relevant for the US now. • Operating leverage persists long after aggressive restructuring comes to an end. This means earnings level off at a high level. • Equities: Should see S&P at 1700-1800 over the next 2 years. Usual exogenous risk factors are the caveat.
Implications for the US (cont.) • Interest rates: Likely to be range bound. Business caution will keep spending in line with free cash flow postponing clash between private and government borrowing. • Yield curve features: strong directionality, a rolling flattening trend, and episodes of duration grabs and dumps. • Volatility: Low but featuring extreme spikes. • Swap spreads: Watch out for counter-intuitive moves. • Credit spreads: Will feature the “great compression” to extremely tight levels. Low absolute rates are not a barrier in the the long run to compression. • High yield looks especially attractive right now. Most room to compress and enjoys an equity kicker. • USD: Dollar friendly