The Japanese Topix Index is up more than 40% this year (and nearly 71% since July 2012) thanks in large part to Prime Minister Shinzo Abe’s unlimited stimulus initiative known euphemistically as ‘Abenomics‘.
The argument behind this spending is a classic one, at least in economic terms: stimulate the economy to produce higher inflation, weaken the currency and aid the exporters.
But like US Fed Chairman Ben Bernanke’s spending and Draghi’s spending in Europe, it’s ultimately going to fail.
Sure the short-term effects are great…a wildly enthusiastic stock market that’s trading at the highest levels seen in 4.5 years, a relaxation of risk and fresh strength in export focused companies that are showing stronger results on a devalued Yen. No question, I’ll take a bull market any day.
It’s the hangover I’m worried about – nobody knows how long this run will last.
This is especially problematic because most investors don’t have the discipline needed to trade in and, of course, out when the party stops.
Piercing the Veil
I bring this up because it’s not popular right now to look behind the scenes or inside the kimono, as the old expression goes:
- Although Japan is known as an export market, it actually imports more than it exports, to the tune of $857 billion in imports versus $793 billion of exports. This is particularly a vexing problem with regard to fuel.
Ninety-six percent of Japan’s reactors remain off-line since the earthquake/tsunami of 2011. The corresponding rise in liquid natural gas expenditures was more than 50% in Q1 at 624 billion Yen. That hasn’t yet hit earnings, especially in power intensive manufacturing sectors.
- Japanese citizens have experienced a 27% drop in purchasing power (against the USD) since September 2012, when the Yen began its slide. At the same time, costs are going up faster than wages. I see the effects in my neighbourhood (in Tokyo) daily as once spotless cars go unwashed, paint is peeling off buildings and the formerly flawless facade of Japan starts showing some cracks.
- The Japanese mortgage market is backfiring in reaction to stimulus. Case in point, the latest data from Mizuho Securities shows rates rising at a time when they should be falling thanks to the Bank of Japan flooding the system with cash.
The 30-year mortgage, for example, rose from 1.80% to 1.81%. Contrast that with the US, which saw mortgage rates fall by nearly 50% in reaction to Bernanke’s stimulus from 2008 to May 2 all the way to 3.35%.
- Combined public, private and corporate debt was already approaching 500% of GDP before this stimulus. Nobody knows how much higher it can go, but to say the nation is functionally bankrupt is an understatement.
- The population is literally dying off and household savings are in decline. This means the excess capacity needed to absorb newly minted Japanese bonds is also in decline. Unless, of course, Japan goes to external sources.
But then, there’s a real problem…international markets will demand higher rates to cope with higher risks. Derivatives traders are already lining up to play this game the way they did with Greece, Spain and Italy. The true cost of capital will more than double.
- Volatility risk is rising, so this game is already underway. Because the Bank of Japan is buying government bonds, they are effectively locking out other market participants and reducing liquidity. Not surprisingly, volatility is rising and the markets are going to fast become addicted to implicit BOJ support the way a drug user depends on his next ‘fix’.
Are There Any Winners?
Yes. Quite a few actually: 310 out of 521 Topix companies that have reported since April 1 have beaten analyst estimates soundly.
But to really home in on the winners, you’ve got to focus on those sectors that will derive the biggest benefits from Abenomics: Japanese financial companies, car makers and industrial ceramics.
The financial companies are pretty easy to understand. The flood of government liquidity will help them generate higher profits while also flushing them with cash.
If they lend it into the system instead of hoarding it like the big banks in the United States, there could be some huge profits working their way to the bottom line.
At the end of the day, stimulus is what it is…a well-intentioned but completely flawed effort to master the immutable laws of money.
That’s why you want to go with investment choices that have the equity necessary to underwrite the risks that come with it.
Keith Fitz-Gerald
Contributing Editor, Money Morning
Publisher’s Note: This is an edited version of an article that originally appeared in Money Morning (USA)
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