Forgotten Friend | Ed’s Rant

by | May 1, 2018

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Japan’s economic disappointment has coincided with a difficult period in its relationship with Washington, says Michael Wilson. Worse luck…

In a year when Donald Trump’s threatened trade wars are churning up the familiar assumptions in so many Asian investors’ minds, it seems almost impolite to ask whether Japan, a fully paid-up member of the Western world, could ever become embroiled in the US president’s rantings about dirty trade dealing from other Asia Pacific countries? But this is an unpredictable president, and the question is necessarily out there. The Prez has already landed two significant and humiliating blows against his Japanese partners, and it would be no more than realistic to ask what might come next.

China? Yes, we could understand that the president might an arguable case for a trade complaint, even if he does simultaneously have to reckon with the likelihood that only Beijing can afford to finance his own government’s spending-and-borrowing spree. (All those bonds will have to be sold to somebody….) South Korea? That takes a bit more of a stretch, but ships and steel and textiles seem to account for the grumble. But Japan? America’s faithful ally against the Russian and Chinese threat to the Pacific? Really?
Now don’t run away with the idea that Mr Trump is about to dump your clients’ Japanese portfolios into the mire, because Japan’s economy – sluggish, ageing, uninventive, but above all huge – is still an enormously important player.

Tokyo is still the world’s third largest stock market, with over $5 trillion of assets (compared with $7 trillion in London and more than $20 trillion in the United States), and that isn’t going to go away any time soon.

But the speculation about Trump’s intentions have come at a time when the Japanese economy itself is going through a sticky patch.

Fiscal fibs

The news of the moment is that Japan’s central bank governor Haruhiko Kuroda says he’s preparing to phase out the country’s colossal ($250 to $750 billion a year) quantitative easing programme, well ahead of schedule, because he says that the Japanese economy is now growing strongly, and that unemployment is now so low (2.4%) as to imply that the country’s woes are behind it.

Now, we could probably excuse a little hyperbole from a Bank of Japan governor who’s just been reappointed for his second five-year term of office. But there are more questions about the governor’s claim that private consumption is now growing after decades of stalling, and that wages are now rising fast, just as Prime Minister Shinzo Abe’s “Three Arrows” economic plan had proposed. (They’re not.) But the real disappointment is that Japan’s inflation rate is nowhere near the 2% level at which the government has always said it could afford to list the bond repurchasing programme.

That’s important because Japan’s thirty-year flirtation with deflation has often been cited as one of the key reasons for the historically slow rate of consumer purchasing growth in Japan. The argument goes that, if a salaryman expects that the price of a new hi-fi will be lower next year, he may well postpone the decision to buy one, and then the people who make hi-fi equipment will be out of a job unless they can export them instead. (To the United States, for instance). So you can see why Mr Kuroda’s failure to push up the inflation rate beyond 1% (but see below) is a cause for concern: whatever else we might say about Japan’s economic growth – see below – it suggests that Shinzo Abe’s Three Arrows are falling short of their mark.
That, unfortunately, is only half the story. As you’ll be aware, these days China and Vietnam and half a dozen other Asian competitors can beat Japan’s own production costs with considerable ease, so the room for a rapid growth in corporate profits is likely to be restricted unless the country can either (a) get the exchange rate down far enough to export more or (b) persuade the Japanese public to buy more home-manufactured goods. But unfortunately Japan is also set for a sharp rise in sales taxes next year, when the levies on retail sales will go up from 8% to 10%. That won’t please the consumers, who were still paying just 5% sales taxes as recently as 2014; indeed, the 10% rate has already been set back twice, having originally been planned for 2015.

Three blunted arrows

But let’s step back from the doom-mongering for a moment and give credit where it’s due. And let’s give particular credit to the Japanese stock market for a highly satisfactory five-year run– with the Nikkei 225 index rebounding from a late-2012 plateau of just 9,000 to 21,000 in mid-2015 – followed by a rather more bumpy return to 24,000 in early 2018, after a scary flirtation with 15,000 in mid-2016. A fine reward, you’d say, although not one for the faint-hearted.

What’s nagging at investors’ nerves now is that volatility since February has been pretty severe. Partly that’s due to the growing general fears about world trade, of course; but also partly down to the aforementioned stalling of the “Abenomics” programme, which it was Kuroda’s job to push through. In the last month the picture has also been muddied by a nepotism scandal embroiling the PM, which has weakened his political grip and which is widely felt to have blunted the drive of his political reform programme.

Broadly, the original aims of the Three Arrows policy were to restore economic growth in three main ways: by issuing a vast quantity of debt from quantitative easing; by spending a huge amount on infrastructure while reducing corporate taxes; and lastly, by getting the inflation rate back up to 2%, partly by forcing employers to redistribute some of their profits through higher wages to their employees. All right, you may have spotted that none of those targets involves increasing corporate investment or profitability, but let’s leave that to one side for the moment.
So, as we’ve mentioned, Kuroda’s promise back in 2013 was to end the country’s growth-stunting deflationary worries by pushing inflation up to 2% by 2015. In 2018, alas, the underlying inflation rate is stuck at 0.5%, although it does make 1% according to some people’s measures.

More bothersome, though, is that Japan’s underlying economic growth level is running at about 0.8% a year, compared with 2.8% for America, 6.6% for China, and even 1.5% for Britain. Worse was the news that the annualised growth figure for final-quarter 2017 was just 0.5%. Not a great result for a country where the accumulated government deficit has been swelled by 100% of gross domestic product since the Three Arrows policy started in 2013. That brings it to about 260% of GDP in 2018. Phew.

The investment conundrum

So would that strike you as a sufficient basis for a trebling of share prices in those same five years? Would you feel better, perhaps, if we told you that private consumption accounted for the equivalent of a 1% growth in final-quarter GDP, but that that rise had been offset to the tune of 0.3% by a decline in residential investment, and by another 0.3% shrinkage from declining inventory levels? It doesn’t set my heart on fire. But maybe I’m missing something?

Maybe Japanese companies’ profits are soaring in a way that would justify sharply higher share prices, and maybe they’ll eventually be able to start paying their workforces more, so as to put more spending power out onto the high street?

We can certainly hope so. As the spring wage bargaining round got under way, the general level of wage increases was reported to be falling short of Mr Abe’s 3% “target”, but perhaps not significantly so. According to the Financial Times, Nissan has paid its workers another 2.4% this year, Toshiba is paying 2.5% and Hitachi 2.3%. Sharp, however, has offered the full 3% and Toyota 3.3%. Those are all hopeful signs for the consumer economy. Just as long as we accept that Japan’s ageing society is imposing constraints of its own on the nation’s appetite for whizzy new things; the bond domestic market, by comparison, can be expected to soak up more of the pensioners’ cash with every passing year. Which is probably fortunate, under the circumstances.
How does the Tokyo market’s affordability stack up? According to Siblis Research, the Nikkei 225 was trading at a 1.75% yield last autumn, which was certainly an improvement on the 1.34% available in 2014 but still rather tight when compared with London or even New York. (You can probably blame the near-zero inflation and the often negative bond yields for that.) In trailing twelve month terms that amounts to a 1.6% yield, and according to Siblis it represents an average 26% p/e on the overall Tokyo market, of a cyclically adjusted CAPE ratio of more than 28.

The future under Trump?

That’s good enough for me, for the time being at least. I’m holding my Japanese investment trusts, which have lost 10% this year, and not adding to them. But maybe we’d better return to the dark and brooding question that we asked at the outset?

What bothers me is the possibility that Japan’s relationship with the United States may prove to be the next stage in the deteriorating Trumpian foreign policy saga.

It isn’t fashionable to say so, but quite a lot of the accusations that the US president is throwing at Beijing these days could also be directed at Tokyo, if Mr Trump chose to be so rash. In particular, I am troubled by his mistaken idea that America’s trade deficits must inevitably mean that somebody else is cheating, rather than that America needs to either buy less or else correct its trade balance by building more competitive products.

Let’s take the trade deficit, for a start. (That is, America’s $70 billion deficit with Japan.) Bearing in mind what we’ve just said about Trump’s faulty economic logic, we should be in little doubt that what Trump would (erroneously) call currency manipulation is a standard part and parcel of the way that any countries with surpluses are to be viewed? He has, after all, also accused Germany of skewing the value of the euro for its own ends, apparently oblivious to the fact that Frankfurt has no influence or sway on a currency that’s shared with 19 countries and 340 million people…

But anyway. In the absence of a strong domestic consumer market, Japanese export industries do indeed plan their operations with exports in mind, and they tend to cheer when the yen is weak. Forty years ago, Japan did indeed tweak its currency through an informal process known as ‘moral suasion’, but those days have long gone, although there are still some restrictive import tariffs in place. The impact of the weak/strong currency on Japan’s economy may be guessed from the telling fact that the last-quarter slowdown in Japan’s 2017 output (to an annualised 0.7% growth) occurred at the same moment when the US dollar was weakening under the impact of Trump’s enormous borrowing plans, while at the same time the yen was strengthening along with just about every other developed-world currency.

There is, then, something of an awkward balance between Trump’s fiscal policy and everybody else’s growth prospects, and currency strengths are one of the ways that the strains tend to show. (Another is through bond yields.) But, lest we forget, Trump has already delivered two meaningful snubs to Tokyo.

The first came back in January 2017, when a newly-inaugurated Trump cancelled America’s participation in the Trans-Pacific Partnership (TTP), barely hours after swearing solidarity and brotherhood with Prime Minister Abe, who had been his first major international guest in Washington. By the time Abe’s plane landed back home, his country’s hopes of continuing with a deal that covered 800 million people had been dashed by the presidential signature. Not a good start for Trump’s diplomatic record, although hardly the last time that an abrupt U-turn in the White House was to surface.

The next, and perhaps more telling, snub came in March this year, when the US president pointedly refused to exempt Japan from the latest round of punitive 25% trade tariffs on steel and aluminium. Unlike allies such as Canada, the UK or even Mexico, Japan was not considered by Washington to be enough of a trade friend to be similarly eligible. And that must have hurt Mr Abe’s pride, even though Japan’s steel exports to the US are only worth around $2 billion a year. All that Kobe Steel and Sumitomo and Nippon Steel can console themselves with is the thought that at least a third of these steels are specialist high-quality products of a type which America doesn’t (or can’t) make for itself.

Meanwhile, back to the present

The awkward question now (to which none of us have any answers) is this: If Japanese steel exports are felt to be inimical to the US interest, some ask, can Japanese cars or electronics be very far behind?

Well, we know that Trump is inclined to confuse trade and industrial practices with strategic and political interests. We also know that he has accused Japan of being an indolent passenger when it comes to defending itself militarily against external aggression, most urgently from North Korea but most importantly from China itself. And it’s doubtful whether Japan’s constitutional ban on holding nuclear weapons (originally dictated by America, incidentally) will carry much weight in the way that Washington regards its ties to its allies.
This is going to get interesting. And confusing, too.

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