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Japan: A Shelter From Deflation
Marcuard's Market update by GaveKal Dragonomics
One key cloud over the global economic landscape is very weak corporate pricing power. After last week’s European Central Bank meeting, we saw Mario Draghi peppered with more questions about deflation than about the traditional euro-crisis bugbears. The US recovery faces a similar challenge. The all-around fear is that deflation will prevent the OECD’s struggling economies from reaching escape velocity. Is there an exception? Yes, in Japan—the only major economy providing any recognizable shelter from deflation.
Japan is winning the battle against deflation through sheer determination. Its central bank is aggressively printing, and has essentially committed to keep doing so until its goal of 2% inflation is achieved. Its success rate has been impressive so far. The latest non-food CPI reading of 1.3% compares to –0.5% ten months ago. In the last couple of weeks, inflation expectations rose substantially to reach 2.1% on a five-year time frame. Under “Abenomics,” growth is picking up faster than capacity expansion; the resulting narrowing output gap also points to more upward price pressure.
The question, of course, is whether Japan can continue to win its battle if other OECD countries don’t. Recent concerns about the state of the global economy have sent safe-haven flows into Japan, making the Bank of Japan’s job all the harder. Our short-term view is that Japan is on top of this. As we have said before, much of the success of Abenomics depends on maintaining a “wealth effect,” and a psychological sense that Japan is restoring its manifest destiny as a major global economy. Hence, we expect Japan to respond to the current challenges with ever-more monetary aggression. In this sense, Japan’s market should be seen as a relative shelter from deflation.
But winning the country’s two decade long battle with deflation will take more than just printing madly. Over the longer term, we recommend watching for two key variables: i) a sustained pick-up in the velocity of money, and ii) increases in nominal wages.
While recently there have been early signs of rising wages, we expect that a bigger boost to real wages, domestic demand and eventually nominal wages, will come via lower energy bills. Prime Minister Shinzo Abe has committed to re-open nuclear plants, and recently the political winds seem to be shifting to his side. This is underlined by the defeat of two anti-nuclear candidates, including former Prime Minister Morihiro Hosokawa, in Sunday's Tokyo gubernatorial election. This sign of political focus is one key reason we would remove the hedges on Japanese equities we recommended last month amid signs of rising political risk.
If there are black clouds, it is on the inability of Japanese banks to outperform the benchmark index given all the free money that the BoJ provided. This shows that banks are sitting on money rather than facilitating credit creation. Until the banks or the government find ways to “activate” the stock of money (hopes are on structural changes which unlock Japan’s productivity potentials), Japan remains a tactical trade that is 100% dependent on monetary aggression.
