Tuesday, 18 November 2014

Japan. Well that's what happens when you pick the wrong benchmark.

The Vapours song has been done to death with respect to ‘Turning Japanese’ but it has to be put back in its vinyl sleeve (if you own a scratched original like me) as any hints that the West was getting close to Turning Japanese have just been flummoxed as when it looked as though convergence of growth was on the cards - Ka-Bang. Japan hits warp drive and vanishes into its own hyperspace of negative growth leaving the West languishing behind with its growth looking relatively similar to a bamboo shoot on a balmy day.

Back in Spring 2013 I remember writing a string of Japan linked posts and going back over them it really doesn’t feel as though much has changed. Back then our greatest scepticism was that targeting inflation was a poor choice as inflation is a symptom of growth rather than a cause, especially in Japan. The post The Japanese Grand National highlighted the  hurdles that Japanese QE had to overcome and our scepticism towards it doing so. That view has so far been pretty much vindicated. We can have a review of the points made then.

1) The cash injections are indeed huge and as a proportion of GDP, dwarf the US actions. On this basis alone decrease in the cost of money through the huge cash injection will dilute the money/goods ratio. But global connectivity spreads the flood increasing liquidity everywhere just as the US actions did. The melting of the Greenland ice sheets means sea levels in New Zealand rise a bit. Japanese banks may be queuing outside the study of the BoJ ready to have their orders to lend spelled out to them, but TMM wonder how much of it will ultimately remain domestic as the real demand for credit is in the West "Roll up, get your cheap funding here", rather than within a domestic culture that saves rather than borrows. The flow out of yen to achieve this moves the affect to FX (2). We are already seeing the liquidity tsunami with Japanese lifers hoovering European bonds at the expense of JGBs. Check France / Japan 10 year spreads today. (Note - remind Eurogroup to write thank you letter)

 No reason to believe that this isn't still the case though the yield differentials have narrowed dramatically so the pressure for leakage is lessened. 

2) FX driven inflation tends to be a one off shock, unless you can get your currency to crawl lower but then the incremental moves are just smaller. It's all good, but do it too much and things start getting bad quickly, either due to a lack of investor confidence or trade partners setting up tariffs. FX driven inflation can be seen as the wrong type of inflation if it doesn't drive wage demands higher but locally stifles purchasing power.

As suggested this appears to be what is happening and the lead/correlation between FX rate and inflation is real. Indeed it looks like growth tracks usdjpy, but not straight usdjpy, it tracks the rate of change of usdjpy. If usdjpy stays flat for a while growth falls. Perhaps this latest fall in growth is the  106-109 usd/jpy pause and we are seeing it reveal itself laggardly. Which if true, should see the new spike to 116+ reflected in a rise in next quarter's GDP figures. Which might be why Abe pulled the trigger early.

3) Expectations of inflation rising will most probably first be seen through the FX function, which as we said could be transitory (unless this goes Weimar). So once the FX starter motor of inflation expectation is done a continued domestically driven inflation has to take over. As with the west this will have to be associated with wage inflation which we know can be extremely stubborn and culturally even more difficult to kick off in Japan. 

Yup, wage growth has been extremely stubborn and it isn't good inflation unless it comes with wage growth. And nope, there doesn't seem to be anything apart from FX led inflation around.

4) Propensity to spend now rather than later. If, as we gather, the BoJ is hoping to increase inflation in the service sector we wonder how increases in inflation expectations will increase demand, as most services are not hoardable. A consumer who anticipates the cost of haircuts going up cannot go and get his hair cut 20 times now in order not to have any later. The same applies for most of the service industries that we can think of. Entertainment, accountants, lawyers, medical services, transport, maintenance - it's all time spaced. So what do you do if you are a consumer who thinks inflation is going to go up. You don't buy tech as that depreciates faster than jpy can. Once you have bought a car a year early, and the furniture you were putting off, maybe had a holiday, there is little else apart from putting on financial hedges. Property? Japan considers property as a depreciating asset and "An unusual feature of Japanese housing is that houses are presumed to have a limited lifespan, and are generally torn down and rebuilt after a few decades, generally twenty years for wooden buildings and thirty years for concrete buildings" and is taxed as such. However this could imply that the price of the land that they are built on rises. 

The dread part about this function is maybe that early growth was just this. The Householder stocking up on single purchase durables and now is done. Day to day services cannot be purchased early and hoarded. So what next?

5) Real rates are very important to the investor as a measure against returns, but TMM would suggest that to the man on the street the cost of a loan on something he isn't going to sell again (so won't consider for asset growth - see furniture, household stuff) is the cost of loan against how much more he thinks he will earn in the future. Wage inflation rather than CPI. So if wage inflation stays flat (as it has in the UK) then his real interest rate will not be negative. This is where the investor, who is always looking at resale value is very different to the consumer, who as a "consumer" by definition won't have anything left to sell on. 

No wage inflation to devalue debt. So borrowing not perceived to be cheap. No joy here.

6) And where do they save? Overseas where the yields are and you are hedged against the expected FX driven inflation. BoJ policy change does not remove the incentive for Mrs Watanabe to borrow locally and buy Aussie bonds. It may even increase it.

If you know the next wave of JPY is about to hit then US Treasuries look damn attractive, especially as your neighbour who bought them a year ago is sitting on a 17% return in yen terms.

7) Domestic investment will react to FX moves as wage costs become more competitive. We see no problems with this last fence. In fact once this occurs the finish line of growth is clearly insight. We just have to hope that all the other fences have already been cleared.

Well we couldn't see any problems at the time as global competitiveness in a world of growth would have been expected. But the world is slowing and there is no sign of a race to switch production to Japan.

As said at the beginning of this post, the primary problem we saw and still see with Abenomics is the assumption that a symptom of growth (inflation) is a cause of growth. It now looks as though the result of Abenomics is higher inflation (success) but no growth (fail). Which is of little surprise.

It would look as though Abe is either going to have to go further than backing down on sales tax and issuing further Yen tsunami alerts and do something about the culture of Japan where 'saving' is an Olympic sport, and demographics would suggest that a healthy dose of immigration would be like a shot in the arm for balancing both the demographics and also diluting cultural habits. It's either that or a one way trip to the cabinet with the family sword in it.

But there is a glimmer of laggardly hope. The rise in USD/JPY seen over the last few weeks and the collapse in oil prices may be storing up a surprise lift in GDP for the next quarter.

Finally it really does feel that we are due a follow up to the 'Japanese Laughing Gas' post too, now that Dr Aghi has been proven correct and all the patients are back in A+E after they have come down from their Abe laughing gas high.

Maybe tomorrow.


Anonymous said...

C Says,
Very good. Couple of things ;
1. Japanese output gap ,labour slack?
2.Wages , FX multiplier on repatriated earnings means those blue chips have not had so much to distribute for many a year.
In other words creating some labour based inflation in Japan looks a lot more likely t me than any other developed economy that I can think of.
IMO, their big mistake was the VAT increase - came much too early indeed when I thought about it I couldn't actually see the why behind it at all. To me they were presuming to tax the gains from increases in real spending beoofre they actually had created any ! So Japanese !

Frankly ,the Japanese have only one option although I don't know if they really understand it.
Debt to GDP over 200% plus. Population of 127 million but now falling in number. 23% are 65 +.
Compare to US debt/gdp 72% (ish) pop pf 300 million expanding at an healthy clip of 2 to 3% with only 12% over 65. Compare resources for energy and food production the staples of an economy.
Frankly, the great wonder of the 21st century is why is the JYen valued as it is? I suspect because for years far too many smart guys have been trying to screw the Jap bond market when in fact they should have been doing a Soros on the currency. Japan has got a UK sterling early 90's moment coming. They can zig and they can zag ,but it's coming anyway.

Polemic said...

thanks C